UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
ENVIRONMENTAL FINANCIAL ADVISORY BOARD
JAN 1 1 2006
Honorable Stephen L. Johnson, Administrator
United States Environmental Protection Agency
1200 Pennsylvania Avenue, NW
Washington, DC 20460
Re: EFAB initial findings concerning use of the financial test and corporate guarantees to
meet financial assurance requirements under RCRA programs
Dear Administrator Johnson:
At the request of the Agency, the Environmental Financial Advisory Board (EFAB or
Board) has convened a workgroup to address a number of questions concerning the financial
assurance requirements for Office of Solid Waste and Emergency Response programs. These
requirements address closure, post-closure, corrective action and other aspects of the Subtitle C
(hazardous waste), Subtitle D (solid waste) and Subtitle I (underground storage tank) programs.
The goal of the financial assurance requirements is to ensure that an obligated party has the
financial capacity to meet its obligations. A range of mechanisms are available to regulated
entities to meet these requirements including: (1) trust funds; (2) satisfying the corporate
financial test; (3) corporate guarantees provided by a corporate parent, sibling corporation, or
other firm with a substantial business relationship that does meet the financial test; (4) insurance;
(5) letters of credit; and (6) third-party sureties (payment or performance bonds).
Pursuant to the specific charge developed by the Agency, the EFAB workgroup has
reviewed various reports and documents, met with Agency staff and state officials responsible
for administering the RCRA programs, held a 2-day workshop in New York City, met with
representatives of regulated entities, and held numerous meetings as well as telephone
conferences of the subcommittee. Early on, it became apparent to the subcommittee that in light
of the complex and multi-faceted nature of the financial assurance requirements and the issues
concerning them, that we should break the work down into more manageable pieces and focus
sequentially on them. In this letter we provide our initial analysis and response concerning the
use of the financial test and corporate guarantees. The financial test mechanism relies on an
evaluation of the financial viability of the regulated entity; the regulated community prefers this
method since all other mechanisms require an additional cost. As we complete our review of the
other mechanisms, we will apprise you of our responses to the questions posed by the Agency
along with our findings.
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Commendation of Agency
At the outset, we want to commend the Agency's leadership for the initiative it has taken
to assess the efficacy of the financial assurance requirements, to consider improvements and to
contemplate where they might be extended to other activities regulated by the Agency. The
RCRA Subtitle C, D and I programs have been in place for 20 to 25 years; the Agency acts
responsibly when it reviews critical aspects of the programs to assess how well they have
worked, to identify any problems that need to be addressed, and to assess whether changes or
foreseeable trends in the external environment indicate the need for program adjustments or
improvements. We understand that there are other related efforts underway that may offer
additional insights that would need to be taken into account in making decisions concerning the
financial assurance requirements. We appreciate the interest in the project as well as the
cooperation we have consistently received from Agency staff at all levels.
Substantial private and public monies have been expended to date to remediate past waste
disposal problems and those expenditures are expected to continue. In light of concerns about
the public's confidence in corporate financial disclosures, there is a need for prudence in
assessing the public exposure to future unfunded waste sites. This situation is exacerbated by
concerns that pensions and other financial obligations may impair the financial capabilities of the
potentially responsible parties, as well as the companies that may provide third-party assurance.
The Current Financial Tests
The financial assurance regulations for hazardous waste facilities, municipal solid waste
facilities, and underground storage tanks are contained in different parts of the Code of Federal
Regulations. The financial tests vary for costs associated with closure and post-closure and for
costs associated with liability coverage, but both rely on the same basic financial concepts. We
have worked from the hazardous waste regulations which provide, in 40 CFR Parts 264 and 265,
subpart H, for closure/post-closure costs, that in order to demonstrate financial assurance, an
owner or operator must meet one of the following two options:
Alternative I:
(A) Two of the following three ratios:
A ratio of total liabilities to net worth of less than 2.0;
A ratio of the sum of net income plus depreciation, depletion, and amortization to total
liabilities of greater than 0.1; and
A ratio of current assets to current liabilities of greater than 1.5; and
(B) Net working capital and tangible net worth each at least six times the sum of current
closure and post-closure care cost estimates being covered by the test; and
(C) Tangible net worth of at least $10 million; and
(D) Assets in the United States amounting to at least 90 percent of total assets or at least six
times the sum of the current closure and post-closure care cost estimates being covered by
the test.
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Alternative II:
(A) A current rating for the owner or operator's most recent bond issuance of AAA, AA, A or
BBB as issued by Standard and Poor's or Aaa, Aa, A or Baa as issued by Moody's;
(B) Tangible net worth at least six times the sum of current closure and post-closure care cost
estimates being covered by the test; and
(C) Tangible net worth of at least $10 million; and
(D) Assets in the United States amounting to at least 90 percent of total assets or at least six
times the sum of the current closure and post-closure care cost estimates being covered by
the test.
In 1991, EPA proposed revisions to the financial test for hazardous waste facilities (50
FR 30201, July 1,1991). The proposed revisions, which to date have not been the subject of
final action by the Agency, would change the financial test requirements by requiring
compliance with one of two ratios under Alternative I, and modifying the remaining ratio
requirements to specifically ensure coverage of the closure and post-closure costs and have
minimum net worth/working capital remaining. The goal of the 1991 revisions was to address
the following concerns: 1) that the test was less predictive of potential bankruptcies; and 2)
some large financially sound companies were not allowed to use the financial test. The revisions
did not propose any changes to Alternative II.
Agency Questions
In its charge to the Board, the Agency posed the following concerning the financial test
and corporate guarantee:
EPA and its state government partners seek general advice on how to improve the
financial test and corporate guarantee. Specific questions that have arisen include:
• What are the strengths and pitfalls of the financial test and corporate guarantee?
• Should EPA adopt the financial test proposed in 1991 for hazardous waste, or have
advancements in financial analysis provided better potential tests in the meantime?
• What, if any, new or different financial tests or protections might be appropriate?
Observations
The Board would offer the following general observations from its review to date of the
financial test and corporate guarantees to provide some context for our responses and
recommendations:
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The GAO reports that there has been no systematic collection of data with regard to
the efficacy of the test. While initiatives are underway at the state and federal levels
to commence such collection, it has been difficult for the Board to define the exact
nature of any problems with the test in the absence of such information. Thus, our
recommendations are based not on specific failures of the financial test, but on our
knowledge of prudent financial practices and the availability of existing expertise in
the financial services sector.
The EPA Inspector General reports that some states have placed restrictions on the
use of the financial test and/or the corporate guarantee. The Board has limited
information on the application or scope of such restrictive use. States are concerned
that they do not have expertise on their staffs to review the financial documentation
and assess compliance with the financial test. This is particularly important since
some state regulators have primary responsibility for the enforcement of many
financial assurance requirements.
The state concerns highlight the fact that oversight of the financial assurance
requirements rests with federal and state officials whose responsibilities involve the
protection of public health and the environment—and normally do not involve
financial regulation or oversight. In some instances, state and federal officials have
limited staff capacity to undertake reviews of complex financial documents and to
make sophisticated judgments.
Regulated entities—primarily large public companies—that utilize the test do not
believe it is appropriate to change the existing test without sound evidence showing
that the test has not achieved its intended purpose and that changes are necessary to
assure that the risks presented by its use are not appreciably larger—or less
acceptable—than when the test was adopted. Members of the regulated community
also warn that any proposal to modify the test would cause disruption among the
regulated community in meeting their requirements under the test.
We note that we have seen very little information concerning the utilization of the
financial test by small entities, and particularly those without a bond rating. If the
small company is private, it is not subject to the same financial disclosure
requirements imposed on public companies, and the issues with respect to use of the
financial test may be different from those for publicly owned companies.
The use of the financial test can be affected by the nature of the business of the
regulated entity. Some regulated entities are primarily in the waste transport, storage
and disposal business while for others such activities represent a relatively small part
of their overall business operations.
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• Finally, because the financial test requirements are relative to the estimated closure
and post-closure costs, confidence in the integrity and relative accuracy of those
estimates is integral to whether the financial test provides adequate assurance. And,
to the extent the financial test is being used with reference to projected remediation
costs, the timing of the imposition of the financial assurance requirement as well as
the determination of the amount to be secured have to be carefully considered in
tandem with the structure of the financial test itself.
Findings and Recommendations
The Board has found that many regulated parties rely on their credit ratings to use the
financial test for meeting their financial assurance requirements. We believe that the use of
independent credit analysis, i.e., credit ratings, is a cost-effective mechanism for demonstrating
financial assurance and should continue to be an alternative for those companies that have
investment-grade ratings on their debt. Many of the large public companies that are obligated to
provide financial assurance are participants in the debt markets and carry ratings on their bonds.
We believe that the investment grade credit quality benchmark of Alternative n is an
important threshold that should be required in Alternative I. The Agency and its state
counterparts should view themselves as potential creditors with respect to the financial assurance
requirements. Requiring credit substitution in the absence of investment grade credit quality is a
common practice in the financial services industry, and we recommend that such a standard
apply to Alternative I as it does for Alternative n.
We find that credit ratings help address the limited capacity for undertaking extensive
credit analysis by state regulatory bodies. We do caution, however, on the definition of the
ratings that may be used to demonstrate financial assurance: the requirement currently is the
"most recent rating." Many companies issued secured debt (with collateral or mortgage pledge)
that would carry a higher rating as a result of that securitization. The requirement should be
based on the "senior unsecured" or "senior implied" rating which is a statement of fundamental
credit quality without regard to a specific pledge of assets. The rating should also be current,
reviewed at least within the past 24 months.
We find that the methodologies used by the credit rating agencies are a reliable
assessment of credit quality. They are comprehensive, historical and dynamic, in that they
address both financial performance and financial position to assess market dynamics; incorporate
liquidity; address reinvestment; and consider the overall performance of the industry in which
the regulated party operates. The ratings incorporate trends, reviewing financial performance
and business operations over time for signs of credit deterioration.
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We believe that the current Alternative I test does not provide the same level of scrutiny
offered by a credit rating. On balance, we recognize that a test that affords that level of scrutiny
may be deemed to be too complicated for codification, and may impose administrative
complexities on the regulated parties. The Board recognizes that the Agency seeks to have the
test fulfill a least-cost criterion. Inevitably, there will be a tension between this goal and the goal
of transparency with a "comprehensive" test. There is a real risk that additional
comprehensiveness of a test will come at the expense of a test that is much more complex,
difficult to understand and administer—and that marginal gains in reduction of risk have to be
weighed against those potential costs.
Thus, the Board recommends that the Agency consider that all companies using the
Alternative I test to meet their obligations receive an independent third-party assessment of their
credit position using methodologies currently employed by the credit rating services and other
financial institutions, which is already being done for the companies using Alternative n. We
believe that parties are already disadvantaged in their ability to use the financial tests due to the
limitations on its acceptance in some states. Using an independent third party will relieve the
states of the administrative burden of reviewing financial statements (along with concerns about
their capacity to adequately undertake such review); such a third party would also be able to
render an opinion as to whether the party met an investment grade standard of credit quality.
While the third-party review is more costly than the simplicity of the existing Alternative I test, it
is less costly than purchasing third-party instruments and seems to address the current concerns
better than the 1991 proposal.
Next Steps
The Agency has also posed the following questions to the Board:
• Should EPA continue to allow corporate siblings to guarantee the obligations of
another subsidiary, or should guarantees only be allowed for parents and higher level
companies?
• Does the current level of disclosure of cleanup obligations in financial statements
provide sufficiently reliable information for use of a financial test?
The Agency has also posed questions with respect to insurance and other third-party
credit mechanisms. The Board does not feel that it has adequate information at this time to make
a recommendation with respect to the corporate guarantee or the cost estimation elements of the
financial test, but has developed a plan to address these issues. We look forward to providing
further communication to you in this regard in the near future.
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If the Agency decides at some point to go forward with changes to the financial test, the
Board would be pleased to work with the Agency to develop specific proposed changes. We
would also note that the Board has identified looking at the financial assurance requirements of
other federal agencies as a potential source of ideas for an enhanced financial test. If the Agency
believes it would be desirable for the Board to do so, it will add this to its work schedule.
We will, of course, be pleased to respond to any questions you or the Agency may have
concerning this initial report, and we look forward to continuing to work with the Agency as this
project continues into its next stage.
Sincerely,
A. Stanley Meiburg
Executive Director
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^4^ \ UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
§ WASHINGTON, D.C. 20460
% PROI^
FEB 21 2006
OFFICE OF
SOLID WASTE AND EMERGENCY
RESPONSE
Mr. A. Stan Meiburg
Executive Director
United States Environmental Protection Agency
Environmental Financial Advisory Board
61 Forsyth Street, S.W.
Atlanta, Georgia 30303-8960
Dear Mr. Meiburg:
Thank you for your letter of January 11, 2006, to Administrator Johnson
regarding the Environmental Financial Advisory Board's initial findings on the financial
test and corporate guarantees as methods to meet financial assurance requirements under
RCRA programs. My staff and I appreciate all the work the Board has done on this
important topic, and recognize the Board's consultation with a broad range of interested
parties. EPA greatly appreciates your inclusion of State and EPA staff in many of your
meetings on this topic.
The Board made several recommendations, which the Agency will take under
advisement. We're particularly interested in the Board's advice that EPA and the States
should consider the financial assurance requirements from the view of a potential creditor
when evaluating financial assurances. In that light, we take note of the Board's
endorsement of independent credit analysis as a cost-effective mechanism for
demonstrating that facility owner/operators can meet their financial obligations, and we
will take that view carefully into account in any actions we take to upgrade financial
assurance requirements. We also acknowledge the issues the Board identified with
Alternative I of the current financial test, which does not depend on an independent credit
analysis, and the Board's recommendation that bond ratings be based on the fundamental
quality of the most recently issued bond. We note that EPA took this approach in the
recent standardized permit rule, published in September 2005 (70 FR 53420), which
requires that bond ratings be based on senior unsecured debt.
Internet Address (URL) • http://www.epa.gov
Recycled/Recyclable -Printed with Vegetable Oil Based Inks on Recycled Paper (Minimum 50% Postconsumer content)
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Again, thank you for providing the Board's findings and recommendations. EPA
appreciates the expertise and experience that the Board brings and values the insights it
can provide. We also appreciate the Board's offer to provide continued assistance should
EPA ultimately move forward with changes to the financial test. As you noted in your
letter, there are other related efforts underway that may offer additional insights as EPA
takes its next steps in addressing this important issue. EPA looks forward to continuing
its work with the Board and receiving the Board's findings in response to the other
questions presented to the Board.
Sincerely,
5usan Parker Bodine
Assistant Administrator
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