Let me preface this by saying I'm not a housing lawyer, but have done work on landlord tenant housing issues, particularly disrepair, so I believe I may weigh in here.
Anyway, generally speaking, you will be liable for any damage caused to the property of the lodgers, or to any injury and/or loss suffered by the lodgers as the direct result of the towels accelerating or exacerbating a fire that you caused.
What is important to note, is that you would be at fault here if a fire damages the tenants/their property only if:
The fire is negligently started by you (in this case, the existence of the towels would not matter)
A fire, that is not your fault - which would otherwise not have damaged the tenant's property or injured the tenants - ends up doing damage/harm to the tenants because of your towels.
What point 2 is saying is: even if the towels catch on fire and does damage, it would not necessarily be your fault, but the fault of the person who started the fire. The only time you would be in trouble for the damage caused by someone else's fire is if you towels are shown to be the reason why the fire spread to the tenants' rooms. This is awfully hypothetical, because generally, towels or not, a fire will spread.
I am unaware of any byelaws or statutes which forbid a person from insulating their house with whatever material they want.
From my research the regulations on insulation exist for builders of a house (See the Building Regulations 2010) - they can't just insulate a house with whatever they want. But you as landlord should not be limited by this, in my opinion. It is possible that your local council may have regulations to this effect, so it may be prudent to check in with them.
Towels are not inherently dangerous so unless you are stuffing your entire house with highly flammable towels I think you are relatively safe from a negligence claim.