United States
Environmental Protection
Agency
Underground Injection
Control (UIC) Class VI
Program
Research and Analysis
in Support of
UIC Class VI Program
Financial Responsibility
Requirements and Guidance
December 2010
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Office of Water (4606M)
EPA816-R-10-017
December 2010
http://water.epa.gov/drink/
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Contents
1. Introduction 5
2. Summary of April and May 2009 Financial Responsibility Webcast Discussions 6
3. Research and Analysis on Financial Responsibility Instruments 15
I. Summary Matrices 16
A. General Financial Considerations 16
B. Considerations for GS 23
II. Research and Preliminary Analysis 28
A. General Financial Considerations 28
B. Considerations for GS 44
4. Rationale for Financial Responsibility Instrument Selection 59
I. Introduction 59
A. Summary 59
II. Historical Precedent 60
III. Potential for Instrument Failure 60
A. Owner or Operator Failure 61
B. Third Party Failure 61
C. Other Factors 61
IV. Resource Implications for the Owner or Operator and the Director 62
A. Director's Review and Monitoring 63
V. Recommendations and Rationale 63
A. Trust Funds 65
B. Letters of Credit 65
C. Surety Bonds 66
D. Insurance 66
E. Escrow Account 66
F. Financial Tests and Corporate Guarantees 66
G. Minimizing Instrument Weakness by Combining Instruments 67
5. Presentation on Financial Responsibility to Ground Water Protection Council 68
I. Summary of Meeting Discussion 68
II. Presentation 70
6. Director's Examination of Third Party Stability 74
I. Financial strength requirement based on credit ratings 74
A. Credit rating requirements consistent with self-insurance requirements 74
B. Credit rating by any Nationally Recognized Statistical Ratings Organization
(NRSRO) 75
C. [SELECTED] Hybrid of Option 1 and Option 2 75
II. Minimum Rating 75
A. [SELECTED] Minimum credit rating using the same option chosen for the credit
rating requirement 75
B. Broader range of minimum rating options 76
III. Minimum Capitalization 76
A. [SELECTED] Financial ratios consistent with the financial ratio test requirements
for self-insurance 76
B. Specific dollar value capital requirements 76
C. Minimum capital standards prescribed by the appropriate Federal banking agency.. 76
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 2
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D. Successful completion of the new comprehensive stress test for banks 77
IV. Ability to pass the bond rating when applicable 77
A. Financial ratios consistent with the bond rating test requirements for self-insurance 77
B. Bond rating by any Nationally Recognized Statistical Ratings Organization
("NRSRO") 78
C. [SELECTED] Hybrid of Option 1 and Option 2 78
7. Rationale for the Selection of Self Insurance Requirements 79
I. Financial Coverage Criteria 80
II. Bond Rating Test 80
III. Financial Ratio Test 81
IV. Corporate Guarantee 82
8. Evaluation of Minimum Tangible Net Worth 83
Options 83
Objective for Setting TNW 84
Calibrated Model 85
Results 86
Context 87
Appendix A: Costs to the Owner or Operator for each Mechanism 88
Appendix B. Technical Description of Geologic Sequestration (GS) Financial Responsibility
(FR) Model 90
Appendix C. Calibration of GS FRModel Parameters 96
Tables and Figures
Table 2.1: Summary of Topics in Webcast Discussion organized by Type of Financial
Mechanism 6
Table 3.1: How is the financial stability of a third party provider determined? 16
Table 3.2: What weaknesses are associated with the third party's financial stability
determination? 17
Table 3.3: Under what conditions are the full estimated costs not covered? Does the mechanism
manage uncertainty in cost? 18
Table 3.4: What factors drive the costs associated with the securing/maintaining the instrument?
What is the relative cost of the instrument to the owner or operator? 19
Table 3.5: What is the historical use of the instrument? For environmental obligations? 20
Table 3.6: Under what scenario is the instrument best or most commonly utilized? 21
Table 3.7: Which conditions may lead to instrument failure (e.g., cancelation or non-renewal,
breach of contract, misrepresentation, the agency does not take action)? 22
Table 3.8: Do states prohibit the use of certain mechanisms? How accessible is the instrument in
states where GS is likely to take place? 23
Table 3.9: What factors make the instrument more/less easy for the Director to review or use? 24
Table 3.10: What is the likely total administrative burden/complexity of the review for the
Director (i.e., EPA or the state regulator)? 25
Table 3.11: Which GS phase(s) is the instrument best suited for? 26
Table 3.12: For each individual GS phase, can the specific weaknesses of an instrument be
minimized by combining it with another mechanism? 27
Figure 4.1: GS Project Activities 59
Table 4.1: Instruments Best Suited for GS Activities 60
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 3
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Table 4.2: Regulatory Risk, Oversight Effort, and Costs to Owners or Operators 63
Table 4.3: Instruments Best Suited for GS Activities 65
Table 6.1: Definitions of Financial Coverage Criteria 80
Table 6.2: Explanation of Bond Rating Test 80
Table 6.3: List of Financial Ratios 81
Table 6.4: Explanation of Corporate Guarantee 82
Figure 8.1: Coverage Criteria and Tests for Qualifying for Self-Insurance 83
Figure 8.2: Chart of Criteria Thresholds for Self-Insurance 87
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 4
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1. Introduction
This document provides some of the supporting research and analysis for the financial
responsibility requirements (40 CFR 146.85) and guidance (EPA 816-D-10-010) for the
Underground Injection Control (UIC) Class VI Program. It is intended to provide insight for the
Program's Directors, Geologic Sequestration (GS) well owners or operators, independent third-
party providers, and the general public. Financial responsibility requirements are designed to
ensure that owners or operators have the resources to carry out required GS activities related to
closing and remediating GS sites if needed, during injection or after wells are plugged, so that
they do not endanger Underground Sources of Drinking Water (USDWs). These requirements
are also designed to ensure that the private costs of GS are not passed along to the public. This
document describes the following research, analysis, and stakeholder input:
Summary of Financial Responsibility Webcast Discussions
Research and Analysis on Financial Responsibility Instruments
Rationale for Financial Responsibility Instrument Selection
Presentation on Financial Responsibility to Ground Water Protection Council
Rationale for the Selection of Third Party Stability Evaluation Recommendations
Rationale for the Selection of Self Insurance Test Requirements
Evaluation of Minimum Tangible Net Worth
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
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2. Summary of April and May 2009 Financial Responsibility Webcast Discussions
In April and May 2009, EPA sponsored a series of webcasts on financial responsibility for
carbon dioxide geologic sequestration (GS) wells. The goal of the series was to encourage
information sharing on potential financial mechanisms that well owners and operators could use
to meet the financial responsibility requirements for GS projects. EPA used the information
gathered through the webcast series to inform its decisions as it developed guidance related to
financial responsibility for GS wells. The webcasts addressed the following topics:
Trust Funds, Letters of Credit, and Surety Bonds with Standby Trust Agreements (April
28, 2009)
Insurance (May 20, 2009)
Self-Insurance: Financial Test and Corporate Guarantee (May 26, 2009)
EPA provided the following disclaimer to the webcast participants:
"The purpose of this public webcast series is information sharing. Views or opinions
expressed during the presentation belong to the speaker and do not necessarily represent the
views and opinions of the U.S. EPA.
EPA does not have express authority in the Safe Drinking Water Act to accept and use funds
for financial assurance. Consequently, the Agency cannot implement some of the financial
assurance mechanisms described in these webcasts due to the requirement under the
Miscellaneous Receipt Act to deposit funds EPA receives for the use of the Government into
the Treasury."
The following matrix summarizes the webcast discussions by financial mechanism.
Table 2.1: Summary of Topics in Webcast Discussion organized by Type of Financial Mechanism
Strengths
Availability and applicability to GS based on participant experience
Trust Fund
Standby Trusts
Letter of Credit
Surety Bond
Small operators commonly use them with standby trusts.
May be easier to obtain than other instruments.
Used regularly and they work fairly well.
Two participants said that they are easy to obtain.
May require the least amount of money. Costs vary from $900 to $3000 annually.
Small operators may commonly use them with trust funds.
In areas with many Class II wells, banks may be accustomed to issuing them.
Typical for small operators in at least one Region.
Three participants said they are frequently used during permitting because they
are easy for operators to obtain and administer.
Work fairly well and are less of a burden for implementation.
In areas with many Class II wells, banks may be accustomed to issuing surety
bonds.
May be used often because they are easy for operators to obtain and administer.
Frequently used during permitting.
Work fairly well and are less burdensome during implementation.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
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Insurance
Commercial scale implementation will reassure mainline carriers who fear losses,
so that they will start to accept risk of GS projects.
FutureGen, which was sited but then cancelled, proposed insurance as a financial
mechanism. Similarly the state of Texas chose insurance, which eliminated the
issue of which events are covered by which mechanisms.
Companies have explored specific insurance avenues in both mutual and
commercial insurance (Zurich, etc.).
DOE worked with environmental insurers to determine how to manage their risk by
using environmental markets to fill in gaps of risk management.
Financial Test
and Corporate
Guarantee
Self-insurance has been successful in other programs; there is a lack of evidence
to suggest it should not be an acceptable instrument in the DIG program.
Appropriateness of instruments for different project phases
Trust Fund
At least one state is considering trust funds for longer-term phases of GS.
It makes sense that trust funds would apply to construction and operation, but it is
not clear that they would apply to closure.
Two participants said that for the short term initial phases, trust funds make sense
but they may not be the best instrument for longer term closure and monitoring
phases.
There could be uncertain long-term applicability if these instruments must be
drawn upon in 40 or 50 years.
It may be more useful to have money in the second phase in the event that
something occurs.
A trust fund would be more appropriate than insurance for closure and post-
closure.
Letter of Credit
It makes sense that letters of credit would apply to construction and operation, but
it is not clear that they would apply to closure.
For the short term (initial phases) letters of credit make sense but they may not be
the best instrument for longer term closure and monitoring phases (two
participants).
Uncertain long-term applicability if these instruments must be drawn upon in 40 or
50 years.
May be more useful to have money in the second phase in the event that
something occurs.
May be difficult over the long term because it may be necessary to deal with two
different entities.
Surety Bond
At least one state is considering them for early project phases.
Although surety bonds are historically thought of as go-to mechanisms for liability
coverage, the availability of multiple mechanisms could help keep prices down.
Surety bonds could apply to construction and operation, but it is not clear that they
would apply to closure.
Uncertain long-term (closure and monitoring) applicability if these instruments must
be drawn upon in 40 or 50 years.
It may be more useful to have money in the second phase in the event that
something occurs.
Surety bonds may be difficult over the long term because of working with two
different entities.
A surety bond would be more appropriate than insurance for closure and post-
closure.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
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Insurance
Financial Test
and Corporate
Guarantee
Other
Differences exist between coverage of liabilities versus performance, as in
plugging and closure. The proposed rule may fall into the category of
performance-based liability.
When combining an insurance policy with other FA mechanisms like a surety bond
for a single activity, which mechanism would kick-in first if a GS owner/operator
fails?
Insurance probably works best for the operational phases of a facility because
activities are well established. Insurance becomes problematic during site
closure and post-closure care.
Insurance would be a viable option through well construction.
The usefulness of insurance depends on the time frame of the project. May be less
effective during post-closure, but also not ideal during operation. Insurer would
hopefully remedy the situation of a company going out of business.
Insurance could be used successfully during closure period, but has risks during
construction if the policy is not fully funded.
The possible failure of the insurance company is a problem.
The insurance timeframe is typically long-term and would pair well with the long-
term nature of GS such as final care of a plugged well.
A participant suggested that EPA should estimate the risks and costs associated
with GS wells, such as extreme events. This analysis would help inform what
size a company needs to be to pass a financial test.
With more GS experience there will be more certainty regarding the best financial
mechanisms. There may be benefits to focusing on near term - first address
plugging then site closure and long-term care (two big unknowns).
Self-insurance mechanisms are great while the companies are making money, but
the economy may not be reliable.
Several participants expressed that they have reservations about the use of these
mechanisms for any phase.
Interest exists in mechanisms for long-term phases.
Which issues and events are covered under emergency and remedial response?
FR is based on events that threaten USDWs.
Any mechanisms for GS FR would need to have longevity to outlast the project
lifespan.
There is experience under RCRA to define which mechanisms apply to which
phase.
A forfeiture bond would be more appropriate than insurance for closure and post-
closure.
One GS project has provided experience through the injection well plugging phase,
which costs approximately $8 million; costs associated with site care and closure
are unknown.
Different phases of the projects may require different types of instruments - some
instruments may be applicable to some phases but not others.
The different phases of GS projects have not been sufficiently defined to assess
the applicability of one instrument versus another.
The typical time period/longevity of the instrument (and the companies providing
the instrument) should match the project phase.
Participants' assessments of relative strengths of each instrument
Trust Fund
Standby Trusts
Letter of Credit
Surety Bond
Insurance
Third-party mechanisms such as trust funds are acceptable.
Standby trusts are acceptable with letters of credit and surety bonds.
Third-party mechanisms, including letters of credit are acceptable.
Surety bonds stand "head and shoulders" above other options.
Surety bonds are less inconvenient than letters of credit and trust funds.
Insurance can be categorized into more than two options. Instead of just captive
and third-party, there are three choices: single, captive, and group.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
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Other
Can one mechanism provide more environmental certainty than others?
Can EPA determine the relative efficiency of each mechanism?
Participant Concerns
Specific requirements of the rule
Trust Fund
Standby Trusts
Letter of Credit
Insurance
Financial Test
and Corporate
Guarantee
Other
There is concern about the regulatory wording for trust funds. A trust fund should
be fully funded before it is accepted by EPA.
Standby trusts are only needed for Dl programs.
Letters of credit are sometimes tied to a bond.
Specific requirements should not be written into the GS rule. Because of the
economic downturn, insurance companies have suffered losses in investment
portfolios.
Two participants said that specific rules may discourage participation in a down
market.
It is important for underwriters to have the best information possible.
EPA should specify the appropriate part(s) of the project cycle where insurance
may be used.
Self-insurance mechanisms need to be available. An adaptive approach would
solve the unknowns relating to financial assurance.
It will be important to get mechanisms in place that share liability to get projects
moving.
Operator should be required to provide results of the financial tests and CFOs
should provide Income and Bank Statements (including where the actual figures
came from and if they differ from what is published) and attest to their validity.
If financial tests are allowed, the criteria should be set conservatively so that only
the very strongest companies qualify.
Will the final GS rule include the type of detailed FA requirements now spelled out
for Class 1 hazardous wells in 40 CFR 144 Subpart F or will guidance provide
more detail?
How long will the proposed post-injection site care requirement be?
How often are particular instruments used?
Standby Trusts
Surety Bond
They are used less often and may be more typical for small operators who use
them with surety bonds.
Often used in Dl programs.
They are used less often and may be more typical for small operators who use
them with standby trusts.
How to prevent fraud and failures?
Letter of Credit
Surety Bond
Does U.S. Dept. of Treasury have an approved list for sureties?
Regions should resolve situations when a bank changes hands and transfers funds
from letter of credit to trust.
Some EPA regions use Standard and Poor's and Moody's but not A.M. Best's
surety rating service.
Bond ratings may not be a good measure due to recent failure of several AAA-
rated companies. However, there may not be a better alternative.
At the beginning of the project there needs to be a process in place to manage
surety bonds.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
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Financial Test
and Corporate
Guarantee
Other
Captive insurance has the potential for "smoke and mirrors."
At least one Region has not had a business failure in cases where a Class 1 or
Class II DIG owner/operator relied on these mechanisms.
A Class 1 operator in Ml used a financial test for FA but the Region did not
adequately review the financial test and later the company went bankrupt.
A Class 1 operator received a permit in December, and they were bankrupt by the
following September.
Most companies favor the financial test and corporate guarantee, despite their
problems.
The bond rating test may not update company performance frequently enough.
It may be sufficient for net worth to be 6 to 1 0 times the cost of the phase.
Concerns exist about sole reliance on self-insurance. Corporations are often
complex and may obscure who has responsibility. The recent, collapse of some
large corporations suggests it's hard to gauge corporate health.
Two participants asked, "What happens if a company fails?"
EPA has no plugging funds, whereas some other programs have plugging funds
that are industry supported. Therefore, if the owner/operator fails, EPA has no
financial means to plug wells.
There are differences in the content of the income statement and what a CPA
provides. Regulator must work to ensure that the numbers can be duplicated.
The Form 10-K, for publicly traded companies, is often better than the annual
report to shareholders.
Mechanism may be less readily available than others
Standby Trusts
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate
Guarantee
Banks are not always willing to offer these agreements and their availability may
vary across the nation.
Standby trusts are not easy to obtain and typically include additional bank
charges/fees.
Standby trusts can be more problematic and banks may be reluctant to establish
these agreements.
Some operators may not want to pay a fee for an empty account.
Two participants noted that they are not as available as they once were.
A lack of availability may not hinder large corporations that might be involved in
GS.
Not as available as once were, but more available than letters of credit.
It may be worth asking insurers what new types of instruments may become
available.
There is some interest in using gas and electric mutuals for insurance, but mutual
companies may be reluctant to provide the high levels of coverage that may be
needed for GS.
It is uncertain what insurers will be willing to offer and if insurance is appropriate.
There is a limited insurance marketplace.
Companies may use captive insurance to manage risk if the market seems too
expensive (e.g. wants a $100,000 premium for $10, 000, 000 in coverage).
There are currently very few third party mechanisms available for GS. Some
insurance companies will only insure during the phase where the company is
making money (i.e., injection).
Pooling risk may be a good option, but it can take time for a pool to grow.
With limited third party options, it may not work well to eliminate self-insurance as
an option.
Mechanism may be less attractive than others due to convenience or applicability
Trust Fund
Letter of Credit
Trust funds have high "hassle factor."
Letters of credit have high "hassle factor."
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
10
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Surety Bond
Financial Test
and Corporate
Guarantee
Other
When bonds and activities are worth well over a million dollars for wells, it requires
significant effort every year for evaluation, especially with a change of ownership.
States "get stuck" with self-insurance since Federal Law allows it.
Financial tests do not accurately reflect company health.
Trust funds have high "hassle factor."
Cancellation of FR policies
Insurance
Other than non-payment of premiums, under what conditions is cancellation
possible?
If the insurer thinks the owner did not disclose all available project information,
then the policy is void from the beginning. See case with Zurich and EPA.
DIG does not have a provision for cancellation with notice for fraud.
EPA should reduce the possibility of cancellation.
It is important to consider whether the event is covered by insurance and to think
about who certifies a valid claim. EPA should be careful about what provisions
are allowed for cancellation, such as only for non-payment of a premium but not
for bankruptcy.
Other Considerations
Use of forms and form language
Insurance
Financial Test
and Corporate
Guarantee
Other
A certificate shows evidence of a policy, but does not ensure conformance to
regulations.
One company has been working with underwriters for 2. 5 years. AEGIS & EIM
coverage forms are very broad with the specific language written into the
policies. It is very important to understand policy coverage (e.g. definition and
coverage associated with "waste products" could be critical). There is an ongoing
debate between underwriters and industry; Zurich is developing a paper on this
topic.
ORCR said that they do not specify how companies must prepare their financial
statements.
Operators should use language from forms that the Region provides. Region
experience comes from CO2 companies who submitted financial statements.
Guidance on specific language to use in mechanisms should be provided.
IL uses language from RCRA for DIG.
Development of guidance
Trust Fund
Letter of Credit
Two participants said that EPA should develop strong guidance on trust funds.
It is necessary to have a good foundation in the regulations and to provide
guidance that deals with specifics.
Two participants said that there should be more guidance on the transfer of
ownership, including an emphasis on the responsibility of the present operator to
notify the Region about transfer of ownership.
Two participants said that guidance can expand on what is in the rule, but the
regulation is also important since it is enforceable.- The rule and guidance need
to be clear.
There is an advantage to having certain elements in the rule.
Requirements should be included in the rule.
Companies with a bond or trust agreement are held liable until a new company
steps in.
Need to develop FR language for Class II guidance since it is currently lacking.
Language used in Class 1 FR is inappropriate for Class II due to differences in
authority.
EPA should develop strong guidance on letters of credit.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
11
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Surety Bond
Insurance
Financial Test
and Corporate
Guarantee
Other
EPA should develop strong guidance on surety bonds.
Companies with a bond or trust agreement are held liable until a new company
steps in.
One issue that may require guidance is specifying who will pay the premium for the
insurance. Operating companies tend to come and go and insurance companies
will likely outlive them.
Some Regions need to turn to a specialist in their financial mechanism evaluations
to assure that the information is correct. One Region has an expert who works
specifically on financial responsibility for Class 1 wells.
The financial statement could leave taxpayers in a vulnerable position. One Region
has taken enforcement action against companies that failed to meet their
performance ratio for Class II wells. In such cases, they have worked with an
outside contractor who was knowledgeable about finance.
Reliance on a financial test creates enforcement problems.
States often have a need for expert assistance. OECA has provided financial
assurance training to regions and states, which has been a large undertaking.
EPA should consider the multiplier requirement, which may be more protective
than a set number.
Financial statement text should require a paragraph that directly indicates that
money has been set aside for a particular action, like plugging. This should be
clearly spelled out in the regulation.
The lack of corporate finance expertise within EPA means it would be important for
corporations to take the lead in ensuring that the information provided to EPA is
clear and concise.
Will guidance coincide with final promulgation of the GS rule?
What types of financial assurance do other countries require?
EPA should create guidance that is simple to use, such as a checklist, so that
operators, banks, surety bond officers, and Regions are aware of the various
mechanisms.
Guidance should be similar to the 1990 Class II well guidance document, as well
as include a system to determine plugging costs.
Guidance should not be modeled too closely on the Class II guidance. Guidance is
not easily tied to enforcement, and it would be better to have requirements in a
regulation.
Class II guidance could not have same level of detail as the Class I regulations
regarding FR because of statutory authority constraints.
Issues regarding pay-in periods
Trust Fund
Letter of Credit
Other
Pay-in periods are allowed because they give small operators opportunity to
manage FR overtime with limited capital.
At least one state is looking at pay-in periods for long-term FR over the life of the
project.
There is an existing enforcement case involving pay-in period with letter of credit.
Do pay-in periods meet the intent of FR demonstration?
Pay-in periods may be appropriate in some situations. FA would be a small portion
of project cost for large corporations.
Is there any experience with failures during the pay-in period?
One Region does not allow pay-in periods longer than 2-3 years. They also set
requirements in an administrative order or other enforcement action.
Legal Issues
Letter of Credit
Insurance
States and EPA do not have legal resources to use letters of credit.
Owners could use a disclosed document endorsement to substantiate which
documents are disclosed and that they are acceptable to all parties.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 12
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Other
Who is the most appropriate signatory for FR?
Although corporations are set up to minimize risk, those signing FR papers may
not be as familiar with risk or GS work as GS project engineers are.
With complex corporate structures, EPA needs to ensure the proper legal entity
has responsibility for providing the financial assurance.
Costs
Letter of Credit
Insurance
Financial Test
and Corporate
Guarantee
Other
Letters of credit can tie up $500,000 to $1 ,000,000.
The applicability of insurance and the costs involved are site-specific.
How do underwriters come to decide on the price of a policy and whether they
have sufficient knowledge of GS to make accurate estimates?
There is concern about regulators needing to rely solely on the work of
underwriters. Regulators have a limited ability to evaluate the appropriateness of
costs for corrective action, emergency response, and closure.
There is concern that large companies would not want to tie up a lot of money in a
financial mechanism and will instead want to submit financial statements.
The cost of well plugging should be based on contractor's cost for remediation.
Ability of mechanisms to manage risk
Insurance
Financial Test
and Corporate
Guarantee
Other
Utility companies may utilize captive insurance, but they are interested in the ability
of third party insurance to use the marketplace to absorb some financial risk.
There is concern that EPA, rather than states, would end up implementing GS
programs, potentially leaving the federal government with the risk.
Regions without a Class I program do not have experience with insurance. There
may be problems related to the differences in how underwriters and
owner/operators view risk and cost parameters. The Agency may need to come
up with a risk assessment tool.
Captive insurance is less reliable, but a standby trust agreement may provide a
mechanism for the insurer to pay for corrective action in the event of bankruptcy.
The financial test and corporate guarantee is a high risk FR mechanism and
requires a lot of information to provide effective assurance.
Two participants said that self-insurance is high risk and even an independent
third-party analysis is unlikely to provide additional information. Overall, the
process takes a lot of time.
There are differences in mechanisms based on the risk covered and the
willingness of third parties to cover that risk.
Rating systems and standards
Trust Fund
Letter of Credit
The need to constantly monitor the company, plus other complications, indicate
why trust funds are a simpler approach to demonstrating financial responsibility.
The need to constantly monitor the company, plus other complications, indicate
why letters of credit are a simpler approach to demonstrating financial
responsibility.
The success of letters of credit depend on a company's relationship with the bank
and the amount of liquid assets the company has. Letters of credit are secure
from bankruptcy because they are not part of the companies' assets. In addition,
a state-administered fund is more like a risk retention group.
The question of appropriateness of bond ratings applies to these instruments.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 13
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Insurance
For group insurance, states and the federal government should build off of the IRS'
criteria. EPA should look at how insurance is financed for various organizations
-whether it is rated or unrated, and various measurements. EPA should, at
least, consider captive insurance.
EPA should not propose eligibility requirements for insurers. Participant believes
the market will drive the selection of financially viable insurers.
Even the most stringent or specific criteria would not restrain market forces. In New
York, where there is a robust insurance commissioner, established criteria have
not prevented financial problems from occurring.
It would be nice for EPA to provide a list of approved insurance providers.
Would the list of insurers change based on ratings? This may be one reason that
this type of list would not be found in the regulations. Insurer's current financial
health may not be a predictor of their financial health 50 years from now.
Financial Test
and Corporate
Guarantee
Two participants said that a $10 million threshold seems low relative to the size of
GS projects and what needs to be covered.
A $10 million threshold does not even seem sufficient for the well drilling.
Even with 10 day notice after bankruptcy proceedings have started, there is very
little the regulator can do.
Third-party methods provide more protection than self-insurance.
Financial tests are difficult to conduct on multi-level companies because it may not
be clear which level of the company is responsible.
There is concern about date of financial test vis-a-vis post-injection site care
timeframe.
The regulator needs to know the rationale behind a company's bond rating to know
whether it is high or low risk.
Numbers can be manipulated; passing the ratios may give a sense that a company
can meet their FR obligations. However, these ratios may not be as secure as
other mechanisms where money is set aside.
Other
Since the companies pay the rating agencies, the rating agencies may resist giving
a company a rating below investment-grade. The rating agencies know the
negative effect that such ratings have on companies. Moreover, ratings tend to
lag behind the company's performance if they are close to the threshold.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 14
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3. Research and Analysis on Financial Responsibility Instruments
This chapter includes two sections. The first section contains matrices summarizing EPA's
research and preliminary analysis related to the various financial responsibility instruments.
Detailed notes are provided in the second section. Both sections address the following questions
based on comments to the proposed rule; public financial responsibility webcasts held in spring
2009;l and publicly available literature, including peer-reviewed journal articles and government
and non-government reports:
1. How is the financial responsibility of a third party provider determined?
2. What weaknesses are associated with the third party's financial stability
determination?
3. Under what conditions are the full estimated costs not covered? Does the mechanism
manage uncertainty in cost?
4. What factors drive the costs associated with the securing/maintaining the instrument?
What is the relative cost of the instrument to the owner or operator?
5. What is the historical use of the instrument? For environmental obligations?
6. Under what scenario is the instrument best or most commonly utilized?
7. Which conditions may lead to instrument failure (e.g., cancelation or non-renewal,
breach of contract, misrepresentation, the agency does not take action)?
8. Do states prohibit the use of certain mechanisms? How accessible is the instrument in
states where GS is likely to take place?
9. What factors make the instrument more/less easy for the Director to review or use?
10. What is the likely total administrative burden/complexity of the review for the
Director (i.e., EPA or the state agency)?
11. Which GS phase(s) is the instrument best suited for?
12. For each individual GS phase, can the specific weakness of an instrument be
minimized by combining it with another mechanism?
1 EPA. 2009. Webcasts on Financial Responsibility Instruments for Geologic Sequestration (GS) Wells. EPA 815-D-09-001.
(http://www.epa.gov/safewater/uic/pdfs/meetin gs_uic_summarywebinars_financial_responsibility.pdf).
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 15
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Summary Matrices
The following matrices summarize research and analysis on financial responsibility instruments for geologic sequestration wells.
A. General Financial Considerations
Table 3.1: How is the financial stability of a third party provider determined?
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate
Guarantee
Escrow Account
Type of third
party
Banks,
savings and
loans, credit
unions
Insurance
company
Financial Regulator
(Non-environmental)
State or Federal
Depends on charter
type of institution
State or Federal
Listed on Treasury
Circular 570
State
Non-government
Rating
Credit rating
agency
Relative Ease of
Monitoring Third Party
Easier
Harder
Hardest
Key Considerations
Third party must be regulated and
examined
Third party must be in good standing
Third party must be listed on Treasury
Circular 570
Third party must be in good standing
Third party must be regulated and
examined
Third party must be in good standing
Captive insurance inherits the risk of
self-insurance
N/A - By definition, no third party is involved
Banks,
savings and
loans, credit
unions
State of Federal
Depends on charter
type of institution
Credit rating
agency
Easier
Third party must be regulated and
examined
Third party must be in good standing
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
16
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Table 3.2: What weaknesses are associated with the third party's financial stability determination?
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
Insurance
Financial Test and
Corporate Guarantee
Escrow Account
Stability
Demonstration's
Relative Ability to
Predict Third-party
Bankruptcy or
Insolvency
Strong
Strongest
Weak
Federal Finance
Regulator
Variable Review
Period
Examinations are
likely to be infrequent,
or based on
complaints
Annual Review
Institutions reviewed
and listed (and
unlisted) annually
None
State Finance
Regulator
Variable Review
Period
Examinations are
likely to vary by
state and be
infrequent, or
based on
complaints
Non-government
Rating
Variable Review
Period
Credit rating agencies
may be reluctant to
lower credit ratings of
client companies
Key Considerations
Government examinations and
non-government ratings should
be frequent
Accuracy and value of
examinations and ratings
diminish overtime
Third-party institution's financial
condition can change quickly
Captive insurance inherits the
risk of self-insurance
N/A - By definition, no third party is involved
Strong
Variable Review Period
Examinations are likely 1
based on complaints
o be infrequent or
Examinations are
likely to vary by
state
Credit rating agencies
may be reluctant to
lower the credit
ratings of client
companies
Frequency of government
examinations and non-
government ratings
Accuracy and value of
examinations and ratings
diminish overtime
Third-party institution's financial
condition can change quickly
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
17
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Table 3.3: Under what conditions are the full estimated costs not covered? Does the mechanism manage uncertainty in cost?
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate
Guarantee
Escrow
Account
Adverse Conditions/Risks Leading to Inadequate Coverage
of Estimated Costs
Owner/
operator
fails
X
Investment
Risk
(Market
volatility or mis-
management)
X
Third -party
Litigation
(leading to
inadequate
funds)
Cost
Under-
estimation
by Owner/
operator
X
Policy Exclusions
or Payment
Limitations
Imposed by Third
Party
N/A - Not a stand-alone instrument
X
X
X
X
X
X
X
X
X
X
Key Considerations
Owner/operator could become insolvent before trust fully funded
Pay-in period should be short and/or include an enforcement order to ensure
that trust is fully funded
Risk level of investment portfolio is important
If trust fund fully funded at its inception, then coverage based on cost
estimation will be adequate
Incentive to underestimate costs to lower amount of credit held as liability
If letter of credit obtained for full amount of covered activities then coverage
based on cost estimation will be adequate
Litigation delays have negative effects on environmental results and lead to
inadequate funds to cover activities
If estimates increase on a surety bond, RCRA requires the Company to make
up the shortfall
Incentive to underestimate costs or seek one policy for multiple facilities to
lower premiums
Drawing on insurance policies may require litigation for abandoned facilities
or the bankrupt companies
Boilerplate language proposed by Director can minimize exclusions
"Cap policies" could guard against expenses beyond original estimates
DIG Class 1 requires guarantee that funds available when coverage begins
Only financially strong companies can/should be selected to use this
mechanism
Decision for coverage must be based on highly accurate financial information
Insurance underwriters do risk analysis to determine appropriate costs for
policy; owner/operator attests to accuracy of information they provide
Analogous to holding funds in low interest account
Investment risk is based on possible mismanagement of funds
If escrow is fully funded at its inception, then coverage based on cost
estimation will be adequate
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
18
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Table 3.4: What factors drive the costs associated with the securing/maintaining the instrument? What is the relative cost of the
instrument to the owner or operator?
Trust Fund
Standby
Trust
Letter of
Credit
Surety
Bond
Insurance
Financial
Test and
Corporate
Guarantee
Escrow
Account
Fees
X
X
X
X
X
Collateral/
Deposits
X
Premiums
X
X
Estimate of
Costs as %
of Total Cost
-2% (total)
No data
available
1 .5 - 2%
(annual)
0.5-15%
(total)
No data
available
<0.5% (total)
1 - 2% (total)
Logistics of Claim
Payment
Third party uses
fund to meet
obligations,
otherwise assets
returned to the
owner/operator after
it meets obligations
Surety seeks
reimbursement from
purchaser for claims
paid
Typically pay claims
for both solvent and
insolvent clients
Ability to fulfill
obligations is based
on financial health at
time payment is
needed
Key Considerations
Cost is full cost of environmental obligation; funded by owner or operator
with third-party administration
Annual costs determined by pay-in schedule (if any); can be limited (2-3
years in one EPA Region) and enforcement actions are taken if
necessary
Fees vary by institution, fund amount, what other services from same
institution used, investment activity, and trustee involvement
Cost is typically an annual fee; fees vary by institution, fund amount, what
other services from same institution used, investment activity, trustee
involvement
Cost based on small percent efface value, paid on an annual basis;
interest fees at market rate if credit drawn
Financial health of purchaser determines whether collateral and/or
deposits required
Letter of credit is classified as an accounting liability; relative cost may
include limits to borrowing power
Cost is a function of credit-worthiness of purchaser; emphasis on
prequalification
Typically, premium paid based on face value of bond prior to project
start; premiums often on a sliding scale
Each state has provisions for when to release a bond
Cost is premium established by underwriter's assessment of site-specific
risks; price reflects greater likelihood and range of possible claims
May be fee for initial risk assessment
Cost is limited to securing an accountant's review of financial statements
prepared for other purposes
Least expensive option for owner/operator; based on assessment of
company worth; does not require third-party backing or setting funds
aside
Cost is full cost of environmental obligation; funded by owner or operator
with third-party administration
Fees paid to third-party administrator to open and maintain account;
managed accounts typically have a minimum investment requirement
Account may accrue interest to cover administrative costs defined in
agreement
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
19
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Table 3.5: What is the historical use of the instrument? For environmental obligations?
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate
Guarantee
Escrow Account
Used under RCRA
since 1982 (including
Class I Hazardous)
X
Listed in
Class II
Guidance
X
Other Non-UIC
Programs
X
Key Considerations
Under DIG, funds may be deposited into the trust in phases; either over
the term of initial permit or over remaining operating life of injection well
(whichever is shorter)
EPA has administered trusts under other environmental statutes such as
C ERG LA
Not a stand-alone instrument, but historically used with letter of credit and surety bond for Direct Implementation programs
X
X
X
X
No
X
X
No
X
No
X
X
X
X
X
Used in some State Revolving Fund programs
Used for other environmental programs
Used under Surface Mining Coal and Reclamation Act of 1977
Banks may be accustomed to issuing bonds in areas with many Class II
wells
Bonds may be used often because they are easy for operators to obtain
and administer
Used regularly in direct implementation programs
Used frequently in permitting
Used for environmental risk management since 1957 Price-Anderson Act
Not listed in Class II Guidance, but not prohibited
Nuclear project licensees required to obtain maximum amount of private
liability insurance available on the market, and licensees are strictly liable
for "extraordinary nuclear occurrences"
Used for other environmental programs
Controversial
Historically justified to minimize the sum of costs to public and industry
Used for ground water discharge and wastewater system permits in MA,
Ml, and TN; preferred mechanism for MA DEP over letters of credit which
are less secure
Magnitude of dollar amount in escrow and time period held in escrow are
likely significantly shorter than for some GS activities
Used in environmental liability court cases
Certificate of Deposit (cash holding similar to escrow account) has been
used by MT and Ml UIC programs
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
20
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Table 3.6: Under what scenario is the instrument best or most commonly utilized?
Size of Firm
Type of Activity
(certain vs. uncertain)
Key Considerations
Trust Fund
Varies
Small operators benefit from
pay-in period
Certain
Full amount set aside
Low uncertainty depends on pay-in period; Director must
monitor payments into the trust
Standby Trust
Not a stand-alone instrument, but typically used with letter of credit and surety bond for Direct Implementation programs
Letter of Credit
Varies
Firm must be financially
healthy
Certain and uncertain
In short term, given credit limit
not exceeded
May be appropriate for company with good financial
health/creditworthiness
Bank takes risk of project failure, but bank could fail; firm
may provide deposit/collateral to secure
Risk of shock to creditworthiness; may affect ability to
borrow, but less impact on cash flow than trust funds
Surety Bond
Varies
Requires demonstration of
significant cash flow which
may limit small operators
Certain
Performs best with known,
future obligations
For guaranteeing performance of known, future obligation
Provider pays if principal cannot (insolvency/
abandonment)
May be available only to projects that are many years
from closure
Insurance
Varies
Cost of policies driven by
market and site-specific
factors, which will dictate size
of participating firms
Uncertain
Designed for uncertain risks
with a known probability of
occurring
Occurrence policies better for long term; allows claims to
be filed after end of policy if cause of claim occurred
during policy period); not preferable for insurers
Long-term policy may be difficult to obtain, and risk of
insurance firm solvency
Insurance on certain activities is conceptually similar to a
surety bond
Financial Test
and Corporate Guarantee
Large
Company must have high net
worth; financially stable
Certain and uncertain
High financial assurance risk
Evaluation of actual financial strength can be difficult
Company net worth must be significant (i.e., sufficient to
exclude under-capitalized firms); financial health and
stability are key
Overall gives less protective coverage
Escrow Account
Varies
Must be able to make onetime
payment to account
Certain
Full amount set aside
Typically used (in non-GS scenarios) as short-term
method to compel buyer to finalize transaction
Certificate of Deposit (cash holding similar to escrow
account) has been used by MT and Ml DIG programs
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
21
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Table 3.7: Which conditions
agency does not take action
Trust Fund
Standby
Trust
Letter of
Credit
Surety
Bond
Insurance
Financial
Test
and
Corporate
Guarantee
Escrow
Account
Owner/
operator
Failure
X
Failure of
Third
Party2
X3
X
X
X
X
N/A4
X
may lead to instrument failure (e.g., cancelation or non-renewal, breach of contract, misrepresentation, the
?
Cancellation
or Non-
renewal
X
X
X
X
Inaccurate
Assessment of
Owner/operator
Health
X
X
X
Key Considerations
Partially fails if not fully funded at time that is needed
Low risk that firm that administers trust could go out of business
May fail if allowed to close (i.e., maintenance fees not paid)
Low risk that firm that administers trust could go out of business
For Class 1 hazardous wells under RCRA, letter must be irrevocable and issued
for 1 year minimum, 120 day notice for cancellation
Could fail if change of bank ownership could transfer to a trust; requires good
rating for new bank for financial demonstration
Not insured by FDIC
Refusal of issuing entity to honor bond requirements
RCRA requires 120 day notification of cancellation
If too many bonds issued to one corporation, risk may not be adequately
diversified in terms of reinsurance
Inadequate bond ratings and risk of assuror financial failure may cause
instrument failure
Cancellation terms and exclusions typically agreed upon by both parties (e.g.
non-payment of premiums, perhaps due to bankruptcy)
May feature exclusions that weaken coverage (e.g. pre-existing conditions)
Captive insurance is likely to fail if parent company becomes insolvent
Class I hazardous wells must contain provision to allow transfer of policy to a
successor owner or operator with consent of insurer
Failure may be caused by bankruptcy of entity that has passed a Corporate
Financial Test
Difficult to assess all environmental obligations of a single firm
Bond ratings may not be adequate given recent economic trends
Multilevel companies have complex finances; subsidiaries that become
autonomous from parent companies must put new financial assurance in place
Partially fails if not fully funded at time that is needed
Low risk that firm that administers trust could go out of business
2 Including lack of third-party independence from covered activity
3 Primacy states may have the ability to establish individual or pooled trusts, in which case there is no risk of third party failure because the state itself is the trustee
4 Independent auditor could be considered third party
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
22
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B. Considerations for GS
Table 3.8: Do states prohibit the use of certain mechanisms? How accessible is the instrument in states where GS is likely to take
place?
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate Guarantee
Escrow Account
Allow
X
Likely
to Allow
X
X
X
X
X
X
X
Prohibit
Some
prohibit
captive
insurance
for RCRA
Some
prohibit
Likely Level of
Accessibility
High
Based on firm's ability
to contribute cash or
cash equivalents
Unknown
High
At least one region
agrees they are one of
most common
instruments
Medium
Historically available;
potentially difficult to
secure in future
High
Private insurance used
in 26 states for
environmental risks
High
Accessible but test
must be set at
appropriate level
Unknown
Key Considerations
A preferred method for states; secure and readily available
Must be combined with letter of credit or surety bond
Not known to be prohibited in states where GS likely to take
place: CO, IL, KS, KY, LA, Ml, MS, MT, NM, NY, ND, OK, PA,
TX, UT, WA, VW, and WY
WA specifically allows use for GS facilities
May be difficult to secure in future due to increased costs and
risks of unknown obligations; access also limited by phase,
site characteristics, or accuracy of costs
Not all insurance products available in every state
Captive insurance is prohibited for RCRA financial assurance
in AL, NY, TX, and VA; allowed in CA, CT, MO, OH, and WA
At least one state (MT) has banned financial test for UIC
demonstrations
Some states do not allow use for mining reclamation; not
allowed under BLM 3809 regulation or on federal lands
administered by USFS
Some firms may meet financial tests immediately prior to filing
for bankruptcy protection
Escrow accounts are typically used for transactions and
holding money over a short period of time
Some states set maximums on the length of time that a lender
can request the money to be held in escrow
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
23
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Table 3.9: What factors make the instrument more/less easy for the Director to review or use?
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate Guarantee
Escrow Account
Instrument
Regulated by
Financial
Industry
Regulator
X
Relative Level of Effort
Required to Review/Use
Low or Medium
Review trust fund balance
with cost estimate
N/A - Not a stand-alone instrument
X
X
X
X5
X
Low
Less frequent monitoring
Low
May be more convenient
to review and use
High
Complex evaluation due
to different state
regulations and lack of
transparency
High
Regular financial
monitoring for solvency
Medium
Review bank statements
to compare with cost
estimate
Risks to Director
Some vulnerability to
insolvency of trustee
Sometimes difficult to obtain
Litigation to obtain funds
Variation in quality, eligibility,
and transparency of insurance
company
Corporate financial auditing
not an in-house strength of
DIG program
Instrument not yet tested for
GS project magnitude
Key Considerations
Liquid assets are easy to use and review
Trust funds are regulated under state and
federal regulatory regimes
Some primacy states may be able to act the
trustee and establish individual or pooled trust
funds
Can only be altered with agreement of
purchaser, provider, and beneficiary
Level of effort for initial review is greater than
that for long-term monitoring
Automatic renewals reduce administrative
burden
Reliant on federal or state review of third party
May be less liquid but more convenient than
letters of credit and trust funds
Owners/operators influenced by market
factors
Company objectives, methodology, and
evaluations could be considered proprietary
business information
Insurance policies are regulated under state
regulatory regimes
Solvency determinations require extensive
commitment to monitoring and verification
Option for third-party audits
Some risk of insolvency of trustee dependent
on economic climate
MA DEP: instrument easy to review relative to
letters of credit
Independent auditor is regulated
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
24
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Table 3.10: What is the likely total administrative burden/complexity of the review for the Director (i.e., EPA or the state regulator)?
Trust Fund
Standby
Trust
Letter of
Credit
Surety
Bond
,_
Financial
Test and
Corporate
Guarantee
Escrow
Account
Level of Administrative
Burden
Low
Less frequent monitoring
Low
Less frequent monitoring
Medium
Less frequent
monitoring; potential for
re-demonstration and/or
negotiation and litigation
Medium
Annual evaluation;
potential for re-
demonstration and/or
negotiation and litigation
High
Policies complex due to
site-specific variations
and differences by state
High
Evaluations and re-
evaluations are frequent
and data intensive
Medium
No history of use for
large magnitude projects
Implementation
Steps Needed
Initial
Demonstration
X
X
X
X
X
X
X
Annual Valuation
X
X
X
X
X
X
X
Readjustment
X
X
X
X
X
X
Withdraw
X
X
X
Termination
X
X
X
X
X
X
Key Considerations
Director is unlikely to have challenges accessing funds since funds are liquid and set aside/dedicated to
specific activity
Annual valuation/re-adjustment to ensure fund provides total coverage and firm meets schedule during
pay-in period
Lack of monitoring increases risk of funding shortfalls
Some primacy states may be able to act as the trustee and establish individual or pooled trust funds,
relative to a third-party trust, this may increase the initial burden but decrease the annual valuation burden
Initial demonstration to review language and verify that trustee is appropriate
Must be used with surety bond or letter of credit; account for additional burden
Annual valuation needed to ensure funds as standby trust
Annual valuation needed to ensure total coverage
Initial demonstration depends on Director's review of financial institution's solvency
May be issued for short periods, therefore many opportunities for non-renewal; may need frequent re-
demonstration if finances fluctuate overtime
Withdrawal depends on third party; may require negotiation or litigation
Annual valuation needed to ensure bond provides total coverage
Initial demonstration depends on Director's review of financial institution's solvency
Surety may cancel agreement: potential need for re-demonstration if fluctuation in financial condition
Withdrawal depends on third party; may require negotiation or litigation
Initial demonstration depends on Director's review of financial institution's solvency; possible re-
demonstrations to avoid cancellation of policy or if finances fluctuate overtime
Withdrawal depends on third party; may require negotiation or litigation
Agency capacity for review
Director must perform initial and annual review of financial condition (e.g., financial statements and
calculations/ratios) and ensure solvency; may be substantial effort
If owner/operator fails to perform obligations, Director may have to negotiate or litigate
Agency capacity for review
Total burden likely to be substantial until history of using escrow with FR
Director, owner/operator, and escrow agent likely to work together to ensure instrument established with
appropriate provisions for obligation and timeframe
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
25
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Table 3.11: Which GS phase(s) is the instrument best suited for?
Corrective Action and
Phased Corrective Action
Injection Well
Plugging
Post-injection Site
Care and Site Closure
Emergency and
Remedial Response
Key considerations
Trust Fund
Best
Fully-funded trust minimizes the risk to the public for well defined
activities. Beyond third-party failure and cost escalation, risk is limited to
investment portfolio risk (typically low)
Funds will be available but
there may be too little
money (public pays) or too
much money (inefficient
use of funds)
Strength of trust fund is based on
being fully funded (i.e., 100% of
estimated costs set aside)
Most costly to owner or operator
because funds must be set aside in
advance
Standby
Trust
N/A - Not a stand alone instrument
Letter of
Credit
Best
Beyond third-party failure
and cost escalation, risk
stems from the
appropriateness of the
defined credit limit
Surety
Bond
Good
Beyond third-party failure
and cost escalation, risk
stems from the
appropriateness of the
defined credit limit
May be unreliable for longer time periods,
but some regions have had success over
periods of time up to 20 years
Surety providers are unlikely to
underwrite bonds over longer time
periods where there is considerable
uncertainty, however some regions have
had success over periods of time up to 20
years
Appropriate for emergency
and remedial response in
construction and operation
phases but may be
unreliable or unavailable
for post injection site care
period because of
uncertainty and risk over
long time periods
Perform well so long as the credit limit
is not exceeded
Risk of exceeding the limit is not
pooled across owner or operator
Risk of third-party failure is higher than
for a surety
Perform equally well so long as the
credit limit is not exceeded
Blanket bonds (multiple sites under a
single bond) present a much higher
risk
Insurance
Can be used for either short-term or long-term applications depending
on the terms of the policy; likely best and most readily available in the
operational phases because the activities and timeframe are well-
defined (operator is making money and can pay premiums)
Best
Ideal for activities with
uncertain frequency and
costs to diversifying
environmental risk and
handling the numerous
possible scenarios
Timing is a significant issue as insurers
prefer to restrict the scale, timeframe,
and predictability of exposures
Best applied to operational phases.
Captive insurance inherits the risk of
self-insurance
Financial
Test and
Corporate
Guarantee
Good, but provides no financial recourse if owner or operator fails
Performs well when used for uncertain and certain risks; however, high financial assurance risk to the
public
Equivalent to a waiver of third-party
instruments for large and historically
financially stable firms
Primary reason to allow self-insurance
is for public policy, not for financial
responsibility
Escrow
Account
Good
Historically utilized for well
defined short-term costs
Trust funds may be preferred over the
mid and long term, funds in escrow would
likely generate less interest
Likely to perform poorly
when used for uncertain
risks; funds do not
respond to contingencies
beyond cost estimate
Never used in UIC program
May not require a pay-in period like a
trust fund
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
26
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Table 3.12: For each individual GS phase, can the specific weaknesses of an instrument be minimized by combining it with another
mechanism?
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
(Note differences in
payment bond vs.
performance bond)
Insurance
Financial Test
and Corporate Guarantee
Escrow Account
Potentially Effective Combination
Trust
Fund
Letter
of
Credit
X
Surety
Bond
X
Insurance
X
Escrow
Account
Weakness
Minimized Through
Combination
Lonq-term cost
uncertainty
Associated with
emergency and
remedial response
Key Considerations
Trust fund could be used for response activities up to a
threshold value, then an alternative instrument could be used
only when costs exceed the threshold
Additional administrative burden may be undesirable
Not considered a stand-alone instrument
X
X
X
X
X
Changes in financial
markets or firm's
credit & lonq-term
cost uncertainty
Affects cost and
availability
Long-term cost
uncertainty
Associated with
emergency and
remedial response
High premiums
Associated with
well-defined
activities
Letter of credit has a fixed value; response activities may
exceed that value
Trust fund may split up potential costs for post-injection site care
and site closure; insurance may help manage long-term cost
uncertainty
Additional administrative burden may be undesirable
Surety bond has a fixed value; response activities may exceed
that value
Trust fund could be used for response activities up to a
threshold value, then a payment bond could be used only when
costs exceed the threshold
Additional administrative burden may be undesirable
Payment bonds, trust funds, letters of credit, and insurance
can be combined for a facility if together their value is at least
equal to estimated costs
Performance bonds, financial tests, and corporate guarantees
cannot be combined with other instruments
Firms lower premiums by utilizing trust fund or escrow account
to cover activities up to pre-established value; insurance used to
cover uncertain costs
Provides additional stability and lower risk
Additional administrative burden may be undesirable
The primary driver for utilizing the financial test and corporate guarantee is to avoid the use of other third-party mechanisms
X
X
X
Long-term cost
uncertainty
Associated with
emergency and
remedial response
Escrow accounts only desirable for short-term activities
May be desirable to utilize another instrument or combination of
instruments instead of escrow accounts
Research and Analysis Supporting Financial Responsibility Requirements and Guidance
27
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//. Research and Preliminary Analysis
Notes:
All information that can be attributed to a source is cited with a footnote.
Analysis is tailored to answer the questions in this matrix, and carries no citations.
Information on captive insurance is grouped with third-party insurance. Discussions
related to captive insurance are called out in bold text.
A. General Financial Considerations
1) How is the financial stability of a third-party provider determined?
Trust Fund & Standby Trust
Trust funds and standby trusts are typically provided/administered by regulated financial
institutions, such as commercial banks, savings and loans, mutual savings banks, credit
unions, and licensed foreign banks.6 The financial strength of the trust fund or standby
trust provider is relatively easy to monitor because oversight is usually already in place.7
The stability of the institutions could be inferred by whether or not the institution (1) is
regulated and examined by a federal or state agency,8 and (2) is in good standing with its
respective federal or state financial regulator (depends on state vs. national charter). The
financial institution's standing may be inferred by the number (and frequency) of
enforcement actions taken by the financial regulator.
Letter of Credit
Letters of credit are typically provided by regulated financial institutions, including
commercial banks, savings and loans, mutual savings banks, credit unions, and licensed
foreign banks.9 The financial strength of the letter of credit provider is relatively easy to
monitor because oversight is usually already in place.10 The stability of the institutions
could be inferred by whether or not the institution (1) is regulated and examined by a
federal or state agency,11 and (2) is in good standing with its respective federal or state
regulator (depends on state vs. national charter). The financial institution's standing may
be inferred by the number (and frequency) of enforcement actions taken by the financial
regulator.
Surety Bond
A surety bond is usually issued by an insurance company, however, surety bonds are not
insurance. The surety becomes liable only when the owner or operator fails to comply
with requirements.12 The financial strength of the surety bond provider may be relatively
6 U.S. EPA. 2009. RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Trust Fund. United States Environmental Protection Agency.
Available online at: http://www.epa.gov/waste/hazard/tsd/td/ldu/financial/documents/tfund-fs.pdf
7 Boyd, James. 2001. Financial Responsibility for Environmental Obligations: Are Bonding and Assurance Rules Fulfilling Their Promise?
Resources for the Future. Discussion Paper 01-42. Available online at: http://www.rff.org/documents/RFF-DP-01-42.pdf
8 For example, see 40 CFR 144.63(a)(l) or U.S. EPA. 1990. Federal Financial Responsibility Demonstrations for Owners or Operators of Class II
Oil- and Gas-Related Injection Wells. United States Environmental Protection Agency. EPA 570/9-90-003. Available online at:
www.epa.gov/R5water/uic/ftp/ffrdooc2.doc
9 U.S. EPA. 2009. RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Letter of Credit. United States Environmental Protection
Agency. Available online at: http://www.epa.gov/waste/hazard/tsd/td/ldu/fmancial/documents/loc-fs.pdf
10 Boyd. 2001.
11 For example, see 40 CFR 144.63(d)(l) or U.S. EPA. 1990.
12 U.S. EPA OIG. 2001. RCRA Financial Assurance for Closure and Post-Closure. 2001-P-007. Available online at
http://www.epa.gov/oig/reports/2001/finalreport330.pdf
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 28
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easy to monitor because oversight is usually already in place.13 However, the same
difficulties in oversight that apply to insurance (e.g., complex finances obscuring credit
ratings) may apply to surety bonds.14 The stability of these institutions could be inferred
by whether or not the institution (1) is listed on U.S. Department of the Treasury, Circular
57015 (consistent with Class I requirements and Class II guidance16) and (2) is in good
standing with its respective federal or state regulator (depends on state vs. national
charter). The financial institution's standing may be inferred by the number (and
frequency) of enforcement actions taken by the regulator.
Circular 570 is published annually and lists firms qualified to write surety bonds,
provides information on admitted reinsurers, pools and associations, Lloyd's syndicates
and surety underwriting limitations.17
Insurance
Insurance is typically issued by an insurance company. Under Class I Hazardous
requirements, the insurance company must be "licensed to transact the business of
insurance, or eligible to provide insurance as an excess or surplus lines insurer, in one or
more States."18 The financial strength of insurers may be monitored through credit
ratings. Companies like A.M. Best and Standard & Poor's provide in-depth reports and
ratings such as the Financial Strength Rating to evaluate the financial health of insurance
companies based on measurements of their ability to pay back claims based on the
policies and contracts that they hold.19 However, the financial stability of independent
third-party insurance providers may be difficult to determine because reinsurance or
fronting may further obscure the financial stability of an insurance policy or provider.20
Financial Test and Corporate Guarantee
N/A
Escrow Account
Like trust funds and letters of credit, escrow accounts are typically administered by
regulated financial institutions, including commercial banks, savings and loans, mutual
savings banks, credit unions, and licensed foreign banks. The financial strength of these
institutions is easy to monitor because oversight is usually already in place. The stability
of these institutions could be inferred by whether or not the institution (1) is regulated
and examined by a federal or state agency, and (2) is in good standing with its respective
federal or state regulator (depends on state vs. national charter). The financial
institution's standing may be inferred by the number (and frequency) of enforcement
actions taken by the regulator.
13Boyd. 2001.
14 U.S. EPAOIG. 2001.
15 Department of the Treasury, Circular 570, is available online at: http://www.fms.treas.gov/c570/.
16 For example, see 40 CFR 144.63(b)(l) or U.S. EPA. 1990. Federal Financial Responsibility Demonstrations for Owners or Operators of Class
II Oil- and Gas-Related Injection Wells. United States Environmental Protection Agency. EPA 570/9-90-003. Available online at:
www.epa.gov/R5water/uic/ftp/ffrdooc2.doc
17 U.S. EPA. 2009. United States Environmental Protection Agency RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Surety Bond.
Available online at: http://www.epa.gov/waste/hazard/tsd/td/ldu/financial/documents/sbond-fs.pdf.
18 40 CFR 144.63(e)(l)
19 Sources available online at: http://www.ambest.com/about/; http://www3.ambest.com/ratings/default.asp:
http://www.insure.com/articles/interactivetools/ratingslookuptool/sandp/define.isp; http://www.standardandpoors.com/ratings/insurance/en/us
20U.S. EPAOIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 29
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2) What weaknesses are associated with the third-party's financial stability
determination?
Trust Fund & Standby Trust
A trust fund and standby trust may be vulnerable to bankruptcy of the financial institution
serving as trustee. Limiting acceptable trustees to regulated entities minimizes the risk of
bankruptcy of the trustee. This reduces the risk of non-payment substantially.21
Using credit ratings provided by a credit rating agency.22
o Firms are reviewed frequently by credit rating agencies. In recent years, rating
agencies have made an effort to review institutions seeking credit more
frequently.
o No hard and fast rule for how often ratings are done. At a minimum, ratings are
done every time the institution seeks credit, or every year (or two at the most),
which ever is more frequent.
o For institutions seeking credit regularly, this may mean several reviews each year.
o Although the ratings are public, the reports providing more detail are by
subscription only.
Letter of Credit
Although bank and saving and loan deposits are covered by federal deposit insurance
(e.g., escrow account), the courts have explicitly ruled that this coverage does not extend
to standby letters of credit.23 During the webcast discussion, a participant suggested that
Regions should resolve situations when a bank changes hands and transfers funds from
letter of credit to trust.24
Surety Bond
A potential weakness associated with the Circular 570 listing for certified surety bonds
includes annual authorization or listing. Additionally, although underwriting limitations
for bonds exist, it is possible for these limits to be exceeded by the company if
reinsurance or co-insurance is used to cover the "excess risk."25
During the FR webcasts, a participant noted that A.M. Best's Issuer Credit Rating can be
used in addition to Standard & Poor's and Moody's and stated that bond ratings might
have historically been a good measure, but now several AAA-rated companies are
receiving TARP money, so it may not be a good measure anymore. Several webinar
participants suggested that surety bonds were "head and shoulders" above other financial
mechanisms, but they also may be less convenient than trust funds and letters of credit.26
21 U.S. EPA. 1996. Subtitle C and D Corporate Financial Test Analysis Issue Paper: Assessment of Financial Assurance Risk of Subtitles C and D
Corporate Financial Test and Third-Party Financial Assurance Mechanisms. March, 18, 1996. Available online at:
http://www.epa.gov/osw/nonhaz/municipal/landfill/financial/famc/paperlO.pdf.
22 Susan Kendall. 2010. Moody's Investor Service. Personal communication with Charles Hernick, January 25, 2010.
23 U.S. EPA. 1996.
24 U.S. EPA. Unpublished. Notes from EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Trust Funds, Letters of
Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009)
Treasury Department. 2009. Department of the Treasury's Listing of Approved Sureties (Department Circular 570). Available online at
http://www.fms.treas.gov/c570/notes.html.
26 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologic Sequestration Wells: Trust Funds, Letters of
Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009)
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 30
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Insurance
Ratings and other measures of financial health of an insurance company will reflect the
health of the company at the time of the assessment - this determination will lose
accuracy over time and will need to be revisited periodically.27
Rating services do not guarantee the financial health of an insurance company nor do
they address the performance or appropriateness of specific policies for a given purpose.
They also do not consider deductibles, penalties for cancellation or surrender, timeliness
of claim payments, or the likeliness of denying claims for reasons such as fraud.28
During the FR webcasts, a participant noted that the rating agencies know that below
investment grade ratings (indicating a high credit risk) can have negative consequences
on financial institutions. Since companies pay the rating agencies, there is some concern
that the ratings may not always reflect the current company performance accurately
(potential weakness for all instruments).
In the case of captive insurance, in which financial assurance is provided through a
wholly-owned insurance company subsidiary, the financial stability of the parent firm
will dictate the ability of the insurance plan to cover necessary remediation costs; this
poses an unacceptable level of risk. Financial stability of independent third-party
insurance providers may be difficult to determine. Reinsurance (by the captive) or
fronting arrangements which transfer risk from a commercial insurer to a captive may
further obscure the financial stability of a captive insurance policy or provider.29
Financial Test and Corporate Guarantee
N/A
Escrow Account
Like a trust fund or letter of credit, an escrow account may be vulnerable to bankruptcy
of the financial institution providing financial assurance. Limiting financial institutions to
regulated entities may help minimize the risk of bankruptcy. Additionally, FDIC
insurance coverage may guarantee that up to $100,000 in funds would be available even
if the financial institution was insolvent.
3) Under what conditions are the full estimated costs not covered? How do cost estimates
inform the establishment/use of the instrument? How well does the mechanism handle
uncertainty in cost?
Trust Fund
Trust funds are funded with the amount of money estimated to pay for the full cost of
covered events. If a trust fund is fully funded at its inception, then coverage based on the
cost estimation will be adequate. Depending on the estimated costs of covered events,
owners or operators may opt to fund the trust over time through the use of a pay-in
period. Thus, incompletely funded trusts are relatively common. However, when a pay-
in-period is allowed, if a firm becomes insolvent before a trust is fully funded, the actual
27 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologic Sequestration Wells: Insurance (May 20, 2009).
28 Source online at: http://www.insure.com/articles/interactivetools/ratingslookuptool/sandp/defme.isp
29 U.S. EPAOIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 31
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amount of available coverage will be inadequate.30 Accordingly, shorter term pay-in
periods are preferable.31
Investment risks will also impact the ability of the instrument to cover all estimated costs.
The assurance risk of a trust fund invested with a low risk investment policy (e.g.,
Treasury Bills) is negligible (i.e., virtually assures that at least 100 percent of the invested
funds will be available when needed). The moderate to high risk investment policy (e.g.,
stocks, futures, and stock or commodity options) poses some degree of assurance risk, but
the difference is not significant.32 A fully funded trust fund invested conservatively has
virtually no risk of failure, but this low risk depends heavily on an accurate cost estimate.
Typically, the major risk is that a trust fund will not be fully funded when the facility
becomes insolvent.33
Standby Trust
N/A. Standby trust funds are not considered stand alone instruments.
Letter of Credit
The amount of credit required for letters of credit depends on the cost estimate of covered
events. Owners or operators may have an incentive to underestimate costs in order to
lower the amount of credit they hold as an accounting liability.34
Surety Bond
Surety bonds also rely heavily on accurate cost estimates. Under RCRA, if the cost
estimate increases on a surety bond the Company must either increase the value of the
bond, or obtain alternate financial assurance mechanisms to make up the shortfall. If the
estimates decrease, the Regulator may approve a reduction in the face value of the surety
bond.35
The Office of Inspector General (OIG) noted that litigation may result if an insurance
company acting as the surety refuses to comply with the terms of the bond. The delays
and resources spent on litigation have negative effects on environmental results, resulting
in inadequate funds available to pay for both performance of covered activities and any
litigation fees.36
Insurance
In the process of procuring insurance, owners or operators will typically approach
potential insurers with information about their site, the coverage they are seeking, and the
range of pricing they anticipate. Then the insurers will respond to indicate what type of
policy they are willing to offer to the owner or operator.37 Owners or operators as insured
entities have an incentive to underestimate costs in order to lower premiums or other
payments.38 However, at the time that the owner or operator applies for the insurance
policy, they will often be required to attest to the accuracy of the information that they
30Boyd. 2001.
31 Boyd. 2001.
32 U.S. EPA. 1996.
33 U.S. EPA OIG. 2001. Page 21.
34 U.S. EPA OIG. 2001.
35 U.S. EPA. 2009. United States Environmental Protection Agency RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Surety Bond.
Available online at http://www.epa.gov/waste/hazard/tsd/td/ldu/financial/documents/sbond-fs.pdf
36 U.S. EPA OIG. 2001. Page 19.
37 Northern Kentucky University and University of Louisville. 2005. Brownfields Insurance for Public Sector-led Development Projects:
Experience and Methods. http://www.brownfieldstsc.org/pdfs/bf_case_studies_report.pdf
38 U.S. EPA OIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 32
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have provided - any false information or omissions can result in the cancellation of the
policy by the insurance company. Insurance underwriters will also do their own risk
analysis (i.e., cost estimation and probability assessment) based on their own experience
and site-specific characteristics to determine an appropriate cost for a policy.39
UIC Class I Hazardous Wells: Require that the "face amount" of the policy must equal at
least the current cost of closure or post-closure, i.e. the policy must guarantee that funds
will be available for closure or post-closure whenever it occurs. The "face amount" is the
total amount the insurer is obligated to pay.40
If an owner or operator runs multiple facilities but insurance does not account for
multiple facilitates, insurance coverage may not be sufficient to satisfy all activities. For
example, owners or operators of hazardous waste treatment, storage or disposal facilities
are required to have liability coverage for accidental occurrences. The amount of
insurance required is per owner or operator, regardless of the number of facilities
operated.41
The regulator's ability to use funds may be limited by an insurance company's
procedures and payment schedule, such as reimbursing the regulator for cleanup costs
instead of providing direct access to the funds. States have also expressed concern that
drawing on an insurance policy may require litigation, especially if the facility has been
abandoned or the company is in bankruptcy.42
Exclusions may be included to reduce the insurer's risk exposure and, correspondingly,
the customer's cost of coverage. However, these voluntary coverage limitations are
inappropriate for the purposes of environmental assurance. Coverage limitations, though
potentially desirable for the customer and insurance provider, undermine the ability to
recover costs and ensure future environmental obligations. Therefore, many state
programs rely on the use of boilerplate endorsements that must accompany instruments
used to demonstrate coverage. These endorsements require the insurer to acknowledge
the scope of coverages required by regulation and rule-out any coverage limiting
exclusions.43
Specific insurance policies called cost cap policies could help to guard the insurer against
expenses that are beyond the originally estimated costs for the project. Cost cap policies
can be used for a remediation project where the insured pays for a percentage of the clean
up costs (called a self-insured retention) and the insurer paying the excess costs.44
Financial Test and Corporate Guarantee
EPA OIG discovered cases in which corporations that were successful in a Corporate
Financial Test in one year later became financially unstable. A firm using the financial
test to satisfy obligations cannot guarantee it will have funds for closure and post-closure
in the event that it becomes insolvent. For conducting closure and post-closure, the public
bears the risk of the firm's insolvency.45
Northern Kentucky University and University of Louisville. 2005.
40 U.S. EPA. 2009. Summary of EPA Webinars on Financial Responsibility for Geologic Sequestration Wells. Available online at:
http://www.epa.gov/safewater/uic/pdfs/meetings uic summarvwebinars financial responsibilitv.pdf
41 U.S. EPA. 1988. FINANCIAL ASSURANCE. Available online at:
http://yosemite.epa.gov/osw/rcra.nsf/ea6e50dc6214725285256bf00063269d/e4c040961571e0778525670f006bc76alOpenDocument.
42 U.S. EPA OIG. 2005. Continued EPA Leadership Will Support State Needs for Information and Guidance on RCRA Financial Assurance.
Report No. 2005-P-00026. http://www.epa.gov/oig/reports/2005/20050926-2005-P-00026.pdf.
43Boyd. 2001.
44 Northern Kentucky University and University of Louisville. 2005.
45 U.S. EPA OIG. 2001. Pages 10-11.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 33
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During the FR webcasts, participants agreed that fully-estimated costs would not be
covered by self-insurance mechanisms unless financial tests and corporate guarantees are
based on highly accurate banking information about the companies, and a conservative
approach to designing the tests should be followed to be sure that only the strongest
companies are selected to use this mechanism.46
Escrow Account
An escrow account, like a trust fund, would be funded with the amount of money
estimated to pay for the full cost of covered events. Depending on the terms of the
agreement, an escrow account could be fully funded at its inception, so coverage based
on the cost estimation would be adequate. While there is some documented risk involved
with the mismanagement of the escrow funds by a third-party, the investment risk would
be lower than for a trust fund. Placing the funds in escrow is analogous to placing the
funds in a low interest (e.g., 0.5%) savings account at a financial institution.
4) What is the relative cost of the instrument? What factors drive the costs associated with
the securing/maintaining the instrument?
Trust Fund
Trust funds are funded by the owner or operator and thus are not technically purchased,47
but instead are administered by a third-party. Therefore, the total cost of the trust fund is
the full cost of the environmental obligation for which financial assurance is being
demonstrated plus the overhead costs associated with the instrument. Set up costs
including legal fees may be high.48
Trust fund costs may be incurred at one time, or if a pay-in period is allowed, annual
costs are determined by the pay-in schedule for the fund (until the trust is fully funded).49
Trustee's fees can be expected to vary depending on the specific institution chosen, the
amount of funds held in trust, the extent to which the owner or operator uses other
services of the institution, and the extent and type of investment activity and trustee
involvement.50
During the FR webcasts, participants mentioned that smaller operators benefit from trust
funds with a pay-in period it gives them the opportunity to manage the financial
requirement over time. Pay-in periods are limited by EPA (2-3 years in one region) and
enforcement action taken if companies fail to comply.51
After obligations are fulfilled, trust assets are returned to the firm. It is essential that
regulators monitor payments into the trust.52
U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
47Boyd. 2001.
48 Communication with Jeff Green, Wealth Management Group at Citizens Bank.
49 U.S. EPAOIG. 2001.
50 U.S. EPA. 1983. Service Charges on Standby Trust Funds. 530-SW-83-001J. Available online at:
http://vosemite.epa.gov/osw/rcra.nsf/ea6e50dc6214725285256bf00063269d/AB6301907BFC7CC08525670F006BBA6A/Sfile/12147.pdf.
51 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
52Boyd. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 34
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Standby Trust
Trustee's fees can be expected to vary depending on the specific institution chosen, the
amount of funds held in trust, the extent to which the owner or operator uses other
services of the institution, and the extent and type of investment activity and trustee
involvement. The operator of a hazardous waste management facility established a letter
of credit and a stand-by trust fund (containing $1 to keep it active) and the trustee (i.e.,
the bank) then levied a $1,500 per annum service charge on the stand-by trust fund.53
Standby trust costs vary from $900 - $3,000 per year.54
Standby trust costs are essentially an annual fee to keep the trust open so that it can be
utilized when needed.
Letter of Credit
Banks may require collateral or deposits before providing a letter of credit, depending on
the purchaser's financial health. Letters of credit are typically priced as a small fraction
of their face value and are granted for annual terms. Typically, letters of credit are
automatically extended after one year, subject to the purchaser's continued good credit
and adherence to contract terms.55
The premium for a letter of credit is typically 1.5 to 2 percent; if the loan is drawn on, a
market interest rate, of approximately 6 to 8%, is applied to the loan.56
Letters of credit can require $500,000 to $1,000,000, according to a webcast
participant.57
A letter of credit is classified as an accounting liability, and limits the holder's borrowing
power.58 Therefore, the relative cost may include more than the actual cost of securing
the mechanism.
Surety Bond
The cost of obtaining a surety bond is a function of its credit worthiness (or financial
solvency). The Surety generally places emphasis on prequalification. With either type of
surety bond, the Surety retains the right to pursue reimbursement from the Company for
funds paid on its behalf. Similar to a bank with a Letter of Credit, the Surety provides the
Company with its financial backing. In return for the Surety's guarantee, the Surety
generally receives a premium based on the face value of the bond.59 The premium is
typically around 2.5 percent of the contract price, and is based on a sliding scale (e.g.,
2.5% is applied to the first $500,000 of a $1,000,000 surety bond, while 1.5% is applied
to the remaining $500,000).60
53 U.S. EPA. 1983. Service Charges on Standby Trust Funds. 530-SW-83-001J. Available online at:
http://vosemite.epa.gov/osw/rcra.nsf/ea6e50dc6214725285256bf00063269d/AB6301907BFC7CC08525670F006BBA6A/Sfile/12147.pdf.
54 U.S. EPA. 2009. Notes from Webcasts on Financial Responsibility for Geologic Sequestration Wells. Unpublished notes from April 28, 2009
webcast.
55Boyd. 2001.
56 Communication with Jeff Green, Wealth Management Group at Citizens Bank.
57 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
58 U.S. EPA OIG. 2001. Page 22.
59 U.S. EPA. 2009. United States Environmental Protection Agency RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Surety Bond.
Available online at: http://www.epa.gov/waste/hazard/tsd/td/ldu/financial/documents/sbond-fs.pdf.
60 Communication with Paul Patalano, DeSanctis Insurance Agency.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 35
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One participant mentioned that although surety bonds have historically been thought of as
the go-to mechanisms for liability coverage, the participant offered the opinion that the
availability of multiple mechanisms could help keep prices down.61
As compared to insurance, surety bonds or letters of credit provide bonding on the basis
of credit principles, and a bond's expenses are covered by a bond premium set by the
underwriters. Insurance on the other hand, has premiums based on expected payments, so
if the expected costs for a GS project are unpredictable, then the premiums could be
insufficient to cover the potential costs, and underwriters could refuse to write the policy
or else require substantial collateral. For example, hardrock mining premiums are often 1-
5% of the value of the bond with smaller firms having to pay 15-20% more and large
firms paying less than 1% to obtain a surety bond. TX, CA and IL allow operators to post
cash, surety bonds or certificates of deposit (CDs) to cover plugging at a cost ranging
from $4000-$ 15,000 per well or "blanket" bonds to cover a whole well field up to 50
wells or so. CA has surety bonds, cash or CDs worth $17 million on 240 bonds since
January 2004, and 85% used cash to cover 49,153 wells and 502 orphaned wells. Illinois
used surety bonds, cash, CDs and letters of credit for 32,100 wells of which an estimated
4,000 were abandoned. Texas used letters of credit, surety bonds and cash for a total $221
million (5% cash, 32% surety bonds, 63% letters of credit and more are shifting towards
surety bonds since new state regulations came into effect). Texas has 10,547 orphaned
wells which may have had to be plugged using bond funds. Each state has its own
provisions for when to release a bond (i.e., prior to closure or after proof of plugging,
etc.).62
Typically, bonds are used to guarantee performance of a known, future obligation. Bond
agreements typically assume that the principal bears ultimate responsibility for the loss;
the bond provider pays only if the principal is unable to do so because of insolvency or
abandonment. Consequently, bond pricing is primarily a function of the principal's
bankruptcy risk, and bonds tend to be priced as a simple percentage of their face value.63
When bonds are issued to satisfy regulatory obligations, the coverage mandated by the
regulations defines the bond provider's obligation. In cases where the regulatory
requirement and the bond's language are in conflict, courts tend to favor the regulatory
definition of coverage. Courts also accord little credence to a surety's claim of
misunderstanding a surety agreement.64
Insurance
The cost of an insurance policy is driven by the premiums collected by the insuring
party.65 Premium costs are highly site-specific and depend on the underwriter's
assessment of risks. Insurance policies would be developed specifically for each project;
sites that are better suited for GS would be assessed as having lower risks of failure and
would be priced accordingly.66
61 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09).
62 Gerard, D, E.J, Wilson. 2008. Journal of Environmental Management 90 (1097-1105). Available online at
https://www.researchgate.net/iournal/0301-4797 Journal of Environmental Management
63Boyd. 2001.
"Boyd. 2001.
65 U.S. EPA OIG. 2001.
66 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologic Sequestration Wells: Insurance (May 20, 2009).
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 36
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Insurers generally require a risk assessment prior to issuing a policy. Owners or operators
generally pay for the risk assessment to be conducted, which can prove to be a financial
burden for some firms.67
Insurers typically pay the claims of both solvent and insolvent clients. This means that
insurance is priced to reflect a greater likelihood and range of possible claims.
Consequently, insurance is usually priced with much greater sensitivity to the risks
presented by the insured than other mechanisms such as bonds.68
During the FR webcasts, a participant expressed concern that with captive insurance
companies were more likely to use "smoke and mirror" tactics to obtain approval because
they could use company data as proof for their financial stability.
Financial Test and Corporate Guarantee
During the FR webcasts, participants tended to agree that the self-insurance option was
less expensive for companies because they did not have to tie up money in expensive
financial mechanisms.69
Escrow Account
Like trust funds, escrow accounts are funded by the owner or operator and thus are not
technically purchased, but instead are administered by a third-party. Therefore, the total
cost of the escrow account is the full cost of the environmental obligation for which
financial assurance is being demonstrated plus the overhead costs. Escrow accounts
typically have a defined administrative cost (included in the escrow agreement)
associated with the account that is paid to the third-party administrator on an annual
basis. The costs to establish the account average around $5,000, and some financial
institutions may have a minimum threshold (e.g., $20,000 for unmanaged, and
$1,000,000 for managed accounts).70 Depending on how the account is managed, escrow
accounts may accrue enough interest to cover administrative costs, but will certainly
accrue less interest than a trust fund.
5) What is the historical use of the instrument (e.g., variance in use over time)? For
environmental obligations?
Trust Fund
Trust funds have been used to demonstrate financial responsibility under RCRA since
approximately 1982 and have been recommended in guidance for Class II wells since
1990.71
Standby Trust
Standby trust funds are not considered stand alone instruments, but have been used as a
component of financial responsibility demonstrations under RCRA since approximately
1982 and have been recommended in guidance for Class II wells since 1990.72
61 Porter, Winston. 1986. Liability Regulations. EPA. Available online at:
http://yosemite.epa.gov/osw/rcra.nsf/ea6e50dc6214725285256bf00063269d/ld2a50fa09eea3148525670fD06c0081IOpenDocument
68Boyd. 2001.
69U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
70 Communication with Jeff Green, Wealth Management Group at Citizens Bank.
71 For example, see 1982 RCRA guidance entitled "Financial Assurance for Closure and Post Closure Guidance Manual" or U.S. EPA. 1990.
72 For example, see 1982 RCRA guidance entitled "Financial Assurance for Closure and Post Closure Guidance Manual" or U.S. EPA. 1990.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 3 7
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Letter of Credit
Letters of credit have been used to demonstrate financial responsibility under RCRA
since approximately 1982 and have been recommended in guidance for Class II wells
since 1990.73
Letters of credit are widely used for RCRA financial assurance.74
Surety Bond
Bonds are required under the Surface Mining Control and Reclamation Act of 1977 for
coal mining projects where they are known as reclamation bonds.75
Surety bonds have been used to demonstrate financial responsibility under RCRA since
approximately 1982 and have been recommended in guidance for Class II wells since
1990.76
In areas with many Class II wells, banks may be accustomed to issuing surety bonds.
Bonds may be used often because they are easy for operators to obtain and administer.
They are frequently used during permitting.77
Surety bonds are used regularly, especially in direct implementation programs.78 Widely
used for RCRA financial assurance.79
Insurance
Insurance has been used to demonstrate financial responsibility under RCRA since
approximately 1982. However, it was not recommended in guidance for Class II wells in
1990.80
Insurance has been used for environmental risk management since the 1957 Price-
Anderson Act, which contained financial requirements for nuclear projects. Licensees are
required to obtain maximum amount of private liability insurance available on the
market, currently $300 million (or show proof of comparable resources); licensees are
strictly liable for "extraordinary nuclear occurrences." 81
Financial Test and Corporate Guarantee
Financial tests have been used to demonstrate financial responsibility under RCRA since
approximately 1982 and have been recommended in guidance for Class II wells since
1990.82
Widely used for RCRA financial assurance.83
Escrow Account
Escrow accounts have not been used for UIC well financial responsibility in the past, but
have been used by the courts and by states for two financial responsibility purposes: first,
73 For example, see 1982 RCRA guidance entitled "Financial Assurance for Closure and Post Closure Guidance Manual" or U.S. EPA. 1990.
74U.S. EPAOIG. 2001. Page 57.
75 Gerard, D, E.J, Wilson. 2008. Journal of Environmental Management 90 (1097-1105). Available online at
https://www.researchgate.net/journal/0301-4797_Journal_of_Environmental_Management
76 For example, see 1982 RCRA guidance entitled "Financial Assurance for Closure and Post Closure Guidance Manual" or U.S. EPA. 1990.
77 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells.
78U.S. EPA. Unpublished. Notes from EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Trust Funds, Letters of
Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009)
79U.S. EPAOIG. 2001. Page 59.
80 For example, see 1982 RCRA guidance entitled "Financial Assurance for Closure and Post Closure Guidance Manual" or U.S. EPA. 1990.
81 U.S. EPA. 2009. Summary of EPA Webinars on Financial Responsibility for Geologic Sequestration Wells. Available online at:
http://www.epa. gov/safewater/uic/pdfs/meetings_uic_summarywebinars_financial_responsibility.pdf
82 For example, see 1982 RCRA guidance entitled "Financial Assurance for Closure and Post Closure Guidance Manual" or U.S. EPA. 1990.
83 U.S. EPAOIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 38
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in many environmental liability court cases, firms have been compelled to provide funds
to cover remediation costs of their contaminated properties; these funds are often held in
an escrow account until the remediation can be performed. However, the escrow accounts
are only active during the remediation period, which would typically be much shorter and
better defined than some GS phases. Second, escrow accounts have been used by a few
states (e.g., Massachusetts, Kentucky, and Michigan) as a financial mechanism for
environmental activities when securing some type of permit. For example, in
Massachusetts (MA), for a firm to secure a ground water discharge permit, it must secure
the costs for the immediate repair or replacement of its privately owned wastewater
treatment facility (e.g., at a mixed use residential/commercial building) in an escrow
account. The agreement remains in place as long as the firm holds the permit from the
state (although it is unclear how long this may be). The MA Department of
Environmental Protection used letters of credit as a financial mechanism for this permit
program, however due to issues with expiring or lagging letters of credit, the MA DEP
now uses escrow accounts because they are more secure, and easier to transfer and
monitor. The state has not yet needed to draw on the accounts as a result of enforcement
actions.84
The firm may also use a trust agreement for a capital reserve account as an alternate
financial mechanism. As a second example, in Nebraska, the Department of
Environmental Quality requires that waste tire haulers provide financial assurance for the
removal, closure, and abatement of waste tires and materials. The waste tire hauler may
use an escrow account as the financial assurance mechanism. The escrow agreement
remains in place until the termination of the account by all parties to the agreement, or
until the firm is no longer required to demonstrate financial responsibility under Nebraska
law. In either example, the magnitude of the dollar amount in escrow and the time period
that the funds are in escrow is likely to be significantly shorter than for some GS
activities.
6) Under what scenario is the instrument best or most commonly utilized (e.g., size of firm,
cost, uncertainty)?
Surety Bond
Typically, bonds are used to guarantee performance of a known, future obligation. Bond
agreements typically assume that the principal bears ultimate responsibility for the loss;
the bond provider pays only if the principal is unable to do so because of insolvency or
abandonment. Consequently, bond pricing is primarily a function of the principal's
bankruptcy risk, and bonds tend to be priced as a simple percentage of their face value.85
Insurance
It is in the public interest that the use of claims-made policies (those that provide
coverage for claims presented to the insured and reported to the insurer during the
coverage period) be accompanied by additional safeguards to provide assurance over
long timeframes. For example, regulations may require that the coverage period of a
claims-made policy be extended beyond the policy's cancellation date. Occurrence
84 Communication with Alan Slater of the MA DEP.
85Boyd. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 39
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policies cover claims arising even after the policy period has ended, providing the cause
of the claim occurred during the policy period. Insurers like to avoid occurrence
coverage, as a way to reduce the scale and enhance the predictability of their exposures.
From the standpoint of public policy, however, occurrence coverage addresses the goals
of assurance better than claims-made coverage.86
Uncertain activities (e.g., future ground water contamination) tend to be assured via
87
insurance coverage.
Financial Test and Corporate Guarantee
Under RCRA, firms must have a net worth greater than $10 million.88
During the FR webcasts, participants indicated that a $10 million threshold seemed low
relative to a GS project for coverage under self-insurance. Many agreed that third-party
mechanisms provide more protection than self-insurance. Regulators who use self-
insurance have found that additional time is required to regulate due to the need to follow
details about the company's financial health, and there are sometimes multi-level
companies who have different responsibilities within the company regarding self-
insurance. Also, within days of declaring bankruptcy, funds from the company are often
no longer available to take care of a site. Finally, numbers can be manipulated within a
company's record to make them look more financially sound, so accuracy in evaluating
actual financial strength can be difficult.89
Escrow Account
Escrow accounts are typically used for short-term transactions in real estate, mergers and
acquisitions, or hard asset loans, to compel the buyer to finalize the transaction. Based on
current analysis, there is little information available to characterize how an escrow
account is most commonly utilized for environmental liability or if escrow accounts are
commonly utilized for long-term transactions. It is expected that a firm would have a
stronger incentive to use trust funds or bonds, which are likely to accrue more interest
over time, and be characterized as a "better" long-term investment for the firm.
7) Under what conditions does the instrument totally fail (e.g., cancelation or non-renewal,
breach of contract, misrepresentation)?
Trust Fund
During the FR webcasts, a participant suggested that a trust fund must be fully funded to
be acceptable.90
EPA OIG recommends that the third party providing financial assurance be financially
independent from the activity being covered.91
86Boyd. 2001.
87Boyd. 2001.
88 U.S. EPA OIG. 2001.
89 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
90 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
91 U.S. EPA OIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 40
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Standby Trust
The standby trust may fail if it is allowed to close prior to being funded and is therefore
not available when needed.
Letter of Credit
A letter of credit could fail when a bank changes ownership and the letter of credit is
transferred to a trust, but as long as the rating of the new bank is good, the financial
responsibility demonstration could still be acceptable.92
If the issuing institution fails, the credit is not available to fund remediation activities.
Letters of credit are not insured by the FDIC.93
Designed properly, beneficiaries can draw on the letter of credit if its term is not extended
and if a replacement form of assurance is not put in place.94
EPA OIG recommends that the third party providing financial assurance be financially
independent from the activity being covered.95
To avoid instrument failure by cancellation or non-renewal, under RCRA for Class I
hazardous wells, the letter of credit must be irrevocable and issued for a period of at least
1 year. The letter of credit must provide that the expiration date will be automatically
extended for a period of at least 1 year unless, at least 120 days before the current
expiration date, the issuing institution notifies both the owner or operator and the
Regional Administrator by certified mail of a decision not to extend the expiration date.
Under the terms of the letter of credit, the 120 days will begin on the date when both the
owner or operator and the Regional Administrator have received the notice.96
Surety Bond
If a surety issues a large number of bonds to facilities in one corporation, the surety bond
risk might not be adequately diversified in terms of reinsurance.97 A surety bond could
fail if bond ratings are wrong.98
Many bonds are "penal bonds" that authorize the forfeiture of an entire bond amount for
failure to perform as agreed. As a result, even though the performance failure may have a
relatively small cost, a larger bond sum can be collected by the government. This is by
design, however, and is agreed upon mutually by the parties before the fact. Accordingly,
penal bond collections represent a less worrisome form of confiscation, and more a
penalty used to motivate compliance with performance standards.99
Despite regulations that typically guard against the possibility of assuror insolvency by
requiring U.S. Treasury certification of bond issuers, assurer provider bankruptcies are
relatively common, and there is no insurance against an assuror's financial failure.100
Refusal of issuing entity to honor bond requirements.101
92 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
93 U.S. EPA OIG. 2001.
94 Boyd. 2001.
95 U.S. EPA OIG. 2001.
96 40 CFR 144.63(5)
97U.S. EPA OIG. 2001. RCRA FA review, http://www.epa.gov/oig/reports/2001/fmalreport330.pdf
98 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
"Boyd. 2001.
100 Boyd. 2001.
101 U.S. EPA OIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 41
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The overall assurance risk for EPA's surety bond mechanism is a function of the
assurance risk for all firms and the failure rate for Circular 570 firms. Assurance risk is
extremely low for firms in any net worth category.102
To avoid instrument failure by cancellation or non-renewal, under RCRA, the Surety is
required to notify both the Company and the Regulator by certified mail of its intent to
cancel the bond. Under the terms of the bond, the surety may cancel the bond by sending
notice of cancellation by certified mail to the owner or operator and to the Regional
Administrator. Cancellation may not occur, however, during 120 days beginning on the
date of the receipt of the notice of cancellation.103
If the Company fails to provide alternate financial assurance and receive written approval
of the new mechanism by the Regulator within 90 days, the Regulator can direct the
Surety to pay up to the amount guaranteed by the bond into the standby trust fund.104
EPA OIG recommends that the third party providing financial assurance be financially
independent from the activity being covered.105
Insurance
Instruments should not be easily withdrawn by providers if costly environmental
problems develop. In most situations, insurers and those insured voluntarily agree on
cancellation terms and coverage exclusions. For instance, nonpayment of premiums is
typically grounds for cancellation.106 For Class I Hazardous wells, "the insurer may not
cancel, terminate, or fail to renew the policy except for failure to pay the premium." 107
UIC Class I Hazardous Wells the policy "must contain a provision allowing assignment
of the policy to a successor owner or operator" that depends on the consent of the
insurer.108
One concern associated with insurance is that the policy may feature "exclusions" that
weaken coverage. For this reason, regulators must carefully verify that policies fully
cover the kinds of claims subject to assurance requirements. In general, contract law
offers protections against the use of exclusions that are not voluntarily agreed to by the
insured or by the beneficiaries of assurance. Misrepresentations of an insurance contract
by an insurer (e.g., coverage when coverage was in fact excluded) are not tolerated.109
RCRA requires that insurers do not include pre-existing conditions exclusions that would
invalidate the purpose of the policy and/or are based on suspected rather than known pre-
existing conditions. Pre-existing conditions exclusions must be specifically based on
factual information known at the time the contract was entered into.no
During the FR webcasts, one concern was that if an insurance company feels that the
owner/operator did not disclose all of the available information about the project, then the
policy is void from the beginning. There is a court case involving Zurich North America
10/U.S. EPA. 1996.
103 40 CFR 144.63(b)(8) or (c)(8)
104 U.S. EPA. 2009. United States Environmental Protection Agency RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Surety Bond.
Available online at http://www.epa.gov/waste/hazard/tsd/td/ldu/financial/documents/sbond-fs.pdf
105 U.S. EPA OIG. 2001.
106Boyd. 2001.
107 40 CFR 144.63(e)(8)
108 U.S. EPA. 2009. Summary of EPA Webinars on Financial Responsibility for Geologic Sequestration Wells. Available online at:
http://www.epa. gov/safewater/uic/pdfs/meetings_uic_summarywebinars_fmancial_responsibility.pdf
109 Boyd. 2001.
110 Marcia Williams. 1987. EPA Guidance On Exclusions For Pre-Existing Conditions In RCRA TSDF Insurance Policies. Available online at:
http://vosemite.epa.gov/osw/rcra.nsf/ea6e50dc6214725285256bf00063269d/bc5ce94el913f2b88525670f006cl844iOpenDocument
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 42
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and EPA. UIC does not have a provision for cancellation with notice for fraud.111
Webinar participants indicated that insurance companies can cancel for non-payment of
premiums, and non-payment would likely occur in the case of bankruptcy112.
EPA OIG recommends that the third party providing financial assurance be financially
independent from the activity being covered.113
Increased attention should be given to the use of captive insurance plans. Although
captives are entirely appropriate as a risk-reduction tool for firms, they are inappropriate
as a demonstration of financial assurance because the captive insurer's financial strength
is tied to that of the parent company. Thus, unlike a third-party insurer, a captive insurer's
ability to absorb claims is weakest when its strength is most neededupon the
insolvency of the parent. Some, but not all, assurance programs prohibit the use of
captives as an assurance instrument. A problem for regulators is that identification of
captive policies can be difficult because policies do not necessarily specify the insurer's
structure.114 Captive insurance will fail if parent company becomes insolvent.115 As
discussed in question #3, Captive insurance is prohibited as a financial assurance
mechanism under Subtitle C of RCRA in the following states: AL, NY, TX, and VA. It is
allowed in CA, CT, MO, OH, and WA.116
Financial Test and Corporate Guarantee
The problem with corporate guarantees is that there exists no financial instrument
dedicated to environmental obligations. The degree to which a firm's assets are obligated
to other liens or creditors may not be readily apparent. From a bookkeeping standpoint
alone, it is very difficult to assess all the environmental obligations attached to a single
firm. Firms often operate multiple facilities with multiple obligations in multiple
jurisdictions. Adding up all these obligations and accounting for them properly is crucial
for assessing a firm's ability to internalize costs years in the future. Environmental
assurance accounting is a problem not only for regulators untrained in its subtleties, but
for accountants themselves.117
Bankruptcy of entity that has passed a Corporate Financial Test.118
A participant stated that bond ratings might have been a good measure a year ago, but
now several AAA-rated companies are receiving TARP money, so it may not be a good
measure anymore.119
If a company is bankrupt, some alternative mechanism to pay would be necessary, and
financial tests are difficult to conduct on multi-level companies because it may not be
clear which level of the company is responsible. Other drawbacks cited by webcast
participants included the timeframe and need for updating the test over time. Some
participants were concerned that if self-insurance (financial test or corporate guarantee)
was eliminated as an option, the viability of GS may be limited, but self-insurance used
111 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologic Sequestration Wells: Insurance (May 20, 2009)
112 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
113 U.S. EPA OIG. 2001.
114Boyd. 2001.
115 U.S. EPA OIG. 2001.
116 U.S. EPA OIG. 2001.
117 Boyd. 2001.
118 U.S. EPA OIG. 2001.
119 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 43
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within a framework of industry-wide pooling of resources, could work. A participant
noted that self-insurance may be sufficient while a company is doing very well
financially, but if economic times change then failure is a possibility. A participant cited
a case where a company passed the test and then nine months later went bankrupt.
Therefore, participants argued that the financial test or corporate guarantee must be
designed to be very conservative in selecting companies for self-insurance so that only
the strongest companies are allowed to use self-insurance. 12°
If a subsidiary uses a Corporate Guarantee from its parent company to provide RCRA
financial assurance and the subsidiary subsequently becomes autonomous from the parent
company, the Corporate Guarantee no longer satisfies RCRA financial assurance
requirements. New financial assurance must be in place at the time the subsidiary
becomes independent.121
Escrow Account
To prevent failure, the third party providing financial assurance through the escrow
account should be financially independent from the activity being covered.
B. Considerations for GS
8) Do states prohibit the use of certain mechanisms? How accessible is the instrument in
states where GS is likely to take place?
Trust Fund
GS is likely to continue taking place in at least 18 states (AL, AZ, CA, CO, IL, KY, MI,
MS, MT, NM, ND, OH, TX, UT, VA, WA, WV, and WY).122 It does not appear that any
of these states will prohibit the use of trust funds to cover environmental and other risks.
It seems that this form of assurance (along with other cash /cash equivalents - i.e. letter
of credit) is a preferred method as it is a very secure and many times is readily
available.123
As trust funds are funded by the Firm itself, they are very accessible if the firm has the
capital to contribute to cash or cash equivalents. Kuipers (2003) mentions for projects
with long-term closure costs, forms of cash are the most practical way to assure financial
responsibility.124
120 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologic Sequestration Wells: Self-Insurance: Financial
Test and Corporate Guarantee (May 26, 2009)
121 U.S. EPA. 1984. Parent Company Guarantee For Newly Independent Company. Available online at:
http://vosemite.epa.gov/osw/rcra.nsf/ea6e50dc6214725285256bf00063269d/a78bf6cc0672f5e08525670fOQ6bbda8iOpenDocument
122 Based on DOE Regional Carbon Sequestration Partnership (RCSP) sites and other known sites.
123 Kuipers, Jim. 2003. Putting a Price on Pollution - Financial Assurance for Mine Reclamation and Closure. Mineral Policy Center. MFC Issue
Paper No. 4. March 2003. http://www.earthworksaction.org/pubs/PuttingAPriceOnPollution.pdf
124 Kuipers. 2003
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 44
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Letter of Credit
GS is likely to continue taking place in at least 18 states (AL, AZ, CA, CO, IL, KY, MI,
MS, MT, NM, ND, OH, TX, UT, VA, WA, WV, and WY).125 It does not appear that any
of these states will prohibit the use of Letters of credit.
Surety Bond
GS is likely to continue taking place in at least 18 states (AL, AZ, CA, CO, IL, KY, MI,
MS, MT, NM, ND, OH, TX, UT, VA, WA, WV, and WY).126 It does not appear that any
of these states will prohibit the use of surety. The State of Washington specifically allows
surety bonds for GS facilities.127
Historically, surety bonds have been readily accessible for environmental obligations.
However, there is a potential due to increased costs and risk of unknown environmental
obligations, that surety bonds may become more difficult to secure as an assurance
mechanism. An example of increased difficulty in securing surety bonds is what has
occurred regarding mining reclamation and that mining reclamation and closure bonds
are considered high-risk. The increased risk for mining reclamation occurred due to
uncertainty about bond duration, concerns about enforcement, along with realization that
cleanup and closure of modern mines is significantly more expensive than initially
projected.128 There is a potential that access to surety bonds may be limited in certain GS
situations and may be dependent upon the site characteristics and accuracy of cost
projections.
Insurance
GS is likely to continue taking place in at least 18 states (AL, AZ, CA, CO, IL, KY, MI,
MS, MT, NM, ND, OH, TX, UT, VA, WA, WV, and WY).129 It does not appear that any
of these states will prohibit the use of insurance to cover environmental and other risks.
For example, private insurance is used in 26 states to cover some of the cost of cleaning
up leaking underground storage tanks.130 However, not all insurance products will be
available in every state.
Captive insurance is prohibited as RCRA financial assurance in under Subtitle C in the
following states: AL, NY, TX, and VA. It is allowed in CA, CT, MO, OH, and WA.131
Financial Test and Corporate Guarantee
GS is likely to continue taking place in at least 18 states (AL, AZ, CA, CO, IL, KY, MI,
MS, MT, NM, ND, OH, TX, UT, VA, WA, WV, and WY).132 It does not appear that any
of these states will prohibit the use of a Corporate Guarantee to cover geologic
sequestration. Some states do not allow Corporate Guarantees for mining reclamation and
they are not allowed under the Bureau of Land Management 3809 regulation or on
federal lands administered by the U.S. Forest Service.133
Based on DOE Regional Carbon Sequestration Partnership (RCSP) sites and other known sites.
126 Based on DOE Regional Carbon Sequestration Partnership (RCSP) sites and other known sites.
127 State of Washington. 2008. Proposed Rule (Washington Administrative Code, Chapter 173-218, Underground Injection Control Program)
Available online at http://www.leg.wa.gov/pub/billinfo/2007-08/Pdf/Bills/Senate%20Bills/6001-s.pdf
128 Kuipers. 2003
129 Based on DOE Regional Carbon Sequestration Partnership (RCSP) sites and other known sites.
130 Source online at: http://www.gao.gov/new.items/d07152.pdf
131 U.S. EPA OIG. 2001.
132 Based on DOE Regional Carbon Sequestration Partnership (RCSP) sites and other known sites.
133 Kuipers. 2003.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 45
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Financial test and corporate guarantee can be readily accessible as an assurance
mechanism. However, in some states the financial test amounts to very little support
documentation and firms have continued to meet financial tests right up to the moment of
their filing for bankruptcy protection.134 Even though a Corporate Guarantee is accessible
it doesn't guarantee the firm will have significant financial resources in the future.135
Escrow Account
Because of their use in transactions and for holding money, escrow accounts are not
likely to be prohibited in any states. However, states have different requirements for the
maximum value that a lender (for mortgages) can ask to be put in escrow.
9) What factors make the instrument more/less easy for the regulator to review or use?
Trust Fund
Trust funds are already regulated under state and federal regulatory regimes.136 They are
liquid assets which potentially make them more attractive to regulators from an ease of
use viewpoint. Some regulations (i.e., 40 CFR 264.143) stipulate that trustees be only
those regulated or regularly examined by a federal or state agency. These requirements
could lessen the trust's vulnerability to the insolvency of a financial institution acting as
trustee.137
Standby Trust
Standby trust funds are not considered stand alone instruments, however, see discussion
on trust funds above.
Letter of Credit
Letters of credit require regulators to spend less time monitoring the company as
compared to insurance or other options. The success of the letters of credit depends on
the company's relationship with the bank and the amount of liquid assets the company
has138 because a letter of credit can only be altered with the agreement of the purchaser,
the provider, and the beneficiary. The credit provider does not generally pay out on
claims. Rather, the purchaser indemnifies the bank, making the bank liable only if the
purchaser defaults.139 During the initial demonstration, letters of credit are roughly
equivalent in review complexity compared to bonds or insurance. However, during
EPA's FR webcasts, a participant and EFAB member indicated that EPA and States do
not have legal resources to use letters of credit; he noted that surety bonds are a much
better choice for that reason. 14°
Surety Bond
During the FR webcasts, participants noted that when bonds and activities are worth well
over a million dollars for wells, they require a significant effort every year for evaluation,
134 Kuipers. 2003
135 Mahan, Jeff. RCRA Financial Test and Corporate Guarantee. Department of Toxic Substances Control. Sacramento, California.
http://www.dtsc.ca.gov/LawsRegsPolicies/Regs/upload/HWMP_FR_FinanTestCorpGuarantee.pdf
136U.S. EPA OIG. 2001.
137Boyd. 2001.
138 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
139 Boyd. 2001.
140 U.S. EPA. Unpublished. Notes from EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Trust Funds, Letters of
Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009)
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 46
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especially with a change of ownership. In this respect, the mechanism may be less
attractive compared to others due to convenience or applicability. An EFAB member
commented that surety bonds stand "head and shoulders" above other options, however,
surety bonds are more convenient than letters of credit and trust funds.141
Surety bonds are usually purchased from an insurance company, but they are not
insurance. Within RCRA, the surety company becomes liable for closure and post-
closure only when the owner or operator fails to comply with closure or post-closure
requirements.142 Sureties usually pay out on claims only if the purchaser defaults so
sureties are less liquid than letters of credit or trusts, and the regulator may find that they
are less easy to use for that reason. Surety bonds may be used often because they are easy
for owners or operators to obtain and administer, and are frequently used during
permitting. Under most programs, surety companies must be certified by the U.S.
Treasury Department to qualify as an acceptable source of assurance. Surety bonds, like
letter of credit, cannot be cancelled unless prior notice is given to the regulator, and the
government is the beneficiary of the bond in the event of default by the principal.143 In
areas with many Class II wells, banks may be accustomed to issuing surety bonds. If the
regulator wants to draw on the bond for closure and/or post-closure care (as is currently
applicable to RCRA), the Regulator must send a written notification to the surety that the
company has failed to perform in accordance with the requirements of the Bond.144 On
the other hand, the state may have to litigate to obtain the funds. For example, in one
case, years of litigation took place when an insurance company refused to comply with
the terms of a performance bond for facility closure.
Insurance
During the FR webcasts, participants noted that insurance companies currently go
through site-specific consultation and a methodology to estimate costs. Over time,
insurers gain the ability to perform rigorous cost estimations. However, participants were
concerned that for GS, insurers would be estimating costs for something that has never
existed. In a future paper, EFAB will analyze failures and identify what works in the
field, what works in the insurance industry, and how to handle proprietary business
information. EFAB intends to give a set of operating principles set forth in a paradigm so
that it's mathematically certain that it will work.145
Insurance can be difficult to evaluate and monitor146 for a regulator. Since insurance is
primarily regulated by states, differences in state regulations contribute to the
complexities regulators would face in evaluating insurance policies. For group insurance,
states and the federal government could build from IRS criteria based on how insurance
is financed for various rated and unrated organizations. Since regulators are not privy to
an insurance company's site-specific evaluation of its insurance policy objectives,
regulators may have a difficult time understanding the complexities of what the policy
will cover. Also, insurance companies may not always provide a transparent policy for
ease of use and review by a regulator. For example, in NY, a robust insurance
141 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comments by
instrument. (Version 10-21-09)
142 U.S. EPA OIG. 2001.
143Boyd. 2001.
144 U.S. EPA. 2009. United States Environmental Protection Agency RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Surety Bond.
Available online at http://www.epa.gov/waste/hazard/tsd/td/ldu/financial/documents/sbond-fs.pdf.
145 Unpublished. 2009, Cadmus notes on EPA Environmental Financial Advisory Board Meeting, March 16-17, 2009.
146 U.S. EPA OIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 47
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commissioner established criteria that have not prevented financial problems from
occurring between the insured and insurers. There is another factor that can make
insurance and other third party FR mechanisms difficult for regulators to use; GS project
owners and operators will be influenced by market forces in selecting their insurance
policy, rather than an insurance company's eligibility criteria, and some insurance
companies will be better than others. If market forces impact the quality and eligibility of
an insurance company, then it will be left to regulators to interpret policies and make
difficult judgment calls on whether the insurance is adequate. This complexity for
regulators is a drawback of insurance. Even if EPA made a list of qualified insurance
providers, such a list may not be good for 50 years into the future.147
Financial Test and Corporate Guarantee
Financial tests and corporate guarantees are designed to determine whether a company
has adequate liquid assets to demonstrate financial responsibility. Federal regulations
(applicable to RCRA) allow financial test requirements to be met for the company by use
of a corporate guarantee that is provided by a third party company with strong ties
(corporate parent, sibling company) to the original company. After evaluating the test or
guarantee, a regulator would need to conduct at least annual updates to try to predict
whether a company will remain solvent, so regulators would have to take the time
necessary to evaluate the tests and keep updated in order to predict future problems with
the company. Self-demonstration requires the government to monitor the firm's financial
condition over time. Accordingly, regulators must regularly audit these financial data to
determine their accuracy and adequacy. Note, however, that corporate financial auditing
is not a traditional strength of environmental regulators.148 A Corporate Financial Test
may be difficult to review or use because of "company mergers and acquisitions,
difficulties in predicting the long-term survivability of individual firms, and evaluating
financial test submissions from firms with facilities in many states. OIG suggested a
future national database that could track financial status for the purpose of FR to make it
easier for regulators to track and to find updated information."149 Regulating corporate
guarantees is a daunting task that may involve interpretation, verification, and monitoring
of the financial tests over time requiring either significant in-house accounting expertise
or reliance on third-party audits. 15°
Escrow Account
Escrow accounts are relatively secure, while remaining liquid, and would be managed by
a single bank, making them easy to evaluate. However, there is less incentive for a firm
to use an escrow account over a trust fund, because the interest accrued over time will be
limited when compared to a trust fund. Furthermore, escrow accounts have not yet been
used for environmental liability projects with a magnitude comparable to a GS project.
147 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
148 Boyd. 2001.
149 U.S. EPA OIG. 2001.
150 Boyd. 2001.
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10) What is the likely total administrative burden for EPA or the state regulator (e.g., initial
and/or annual reviews)? What is the complexity of the review?
Trust Fund
Webcast participants indicated that trust funds may have a lower administrative burden
than other instruments because they do not require that the financial health of the assuring
entity be monitored constantly.151
The total administrative burden for a FR demonstration using a trust fund is driven by (1)
the initial demonstration, (2) monitoring the fund's valuation during the pay-in-period, if
it is allowed, (3) ensuring that the fund's valuation matches revised cost estimates (annual
valuation and periodic readjustment), and (4) the termination of the trust fund. The initial
demonstration would require a review of the submitted paperwork, but no review of the
trustee's financial condition, as long as the Director is confident in the respective state or
federal regulator's review of the third-party. Monitoring the fund's valuation during the
pay-in-period is necessary for ensuring that fund provides total coverage for estimated
costs on the agreed upon schedule. A lack of monitoring would increase the risk of
funding shortfalls. The burden associated with the termination of the trust fund would be
a one-time occurrence, taking place either to fulfill unmet obligations, or to reimburse the
owner or operator. Because funds in a trust are set aside and dedicated to a specific
activity they are liquid, and the Director is unlikely to have any challenges accessing the
funds.
Standby Trust
Although standby trust funds are not considered stand alone instruments, when used in
conjunction with a letter of credit or surety bond the total administrative burden would
include (1) ensuring the fund's existence as a standby (annual valuation), and (2) the
termination of the standby trust. The burden associated with the termination of the trust
fund would be a one-time occurrence, taking place either to fulfill unmet obligations, or
to reimburse the owner or operator.
Letter of Credit
Webcast participants said that letters of credit work fairly well and are less of a burden
for implementation.152
The MA DEP noted that letters of credit have historically been difficult to review due to
lags and expirations. The state has since switched to using escrow accounts.153
The total administrative burden for a FR demonstration using a letter of credit is driven
by (1) the initial demonstration, (2) ensuring that the letter of credit's valuation matches
revised cost estimates (annual valuation and periodic readjustment), and (3) the return of
the letter of credit. Because of the letter of credit may be issued for a period as short as
one year, the creditor has the option not to renew the agreement on an annual basis. For
long-term obligations associated with GS, the number of opportunities for non-renewal
may be high and may result in the need for re-demonstrations by the owner or operator if
their financial condition fluctuates greatly before the environmental obligation is
151 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comments by
instrument. (Version 10-21-09)
152 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comments by
instrument. (Version 10-21-09)
153 Communication with Alan Slater, MA DEP.
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fulfilled. The initial demonstration would require a review of the submitted paperwork,
but no review of the trustee's financial condition, as long as the Director is confident in
the respective state or federal regulator's review of the third-party. The burden associated
with returning the letter of credit if the owner or operator fulfills its obligations is
minimal. However, if the Director needs to draw on the letter of credit, the funds come
from the third-party itself (funds are not set-aside), therefore accessing the funds may
require negotiation or litigation.
Surety Bond
A webcast participant suggested that surety bonds are less of a burden for implementation
than other instruments. However, they may be difficult to manage over the long term if
there are changes in ownership. Also, a bond for a large sum (well over a million dollars)
can require significant effort every year for evaluation, also in the case of changes in
ownership.154
The total administrative burden for a FR demonstration using a surety bond is driven by
(1) the initial demonstration, (2) ensuring that the bond's valuation matches revised cost
estimates (periodic readjustment), and (3) the cancellation of the bond. Because the
surety has the opportunity to cancel the agreement, there may be a need for re-
demonstrations by the owner or operator if their financial condition fluctuates greatly
before the environmental obligation is fulfilled. The initial demonstration would require a
review of the submitted paperwork, but no review of the trustee's financial condition, as
long as the Director is confident in the respective state or federal regulator's review of the
third-party. The burden associated with the cancellation of the bond if the owner or
operator fulfills its obligations is minimal. However, if the Director needs to draw on the
surety bond, the funds or the completion of obligations come from the third-party itself
(funds are not set-aside); accessing the funds may require negotiation or litigation.
Insurance
OSW guidance suggests EPA or authorized states conduct periodic reviews of basic
policy language to ensure that only acceptable pre-existing condition exclusions are
used.155
Insurance language can be complex, and regulators may not have the necessary expertise
to interpret insurance policies.156
The total administrative burden for a FR demonstration using insurance is driven by (1)
the initial demonstration, (2) ensuring that the policy's coverage is adjusted along with
revised cost estimates (periodic readjustment), and (3) the cancellation or use of
insurance. The insurance company can cancel the policy; therefore, there may be a need
for re-demonstrations by the owner or operator if their estimated costs or financial
condition fluctuates greatly before the environmental obligation is fulfilled. The initial
demonstration would require a review of the submitted insurance policy, but no review of
the trustee's financial condition, as long as the Director is confident in the state
regulator's review of the third-party. The burden associated with reviewing the insurance
policy may be substantive due to variations among policies (i.e., site specific policies,
154 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comments by
instrument. (Version 10-21-09)
155 Marcia Williams. 1987. EPA Guidance On Exclusions For Pre-Existing Conditions In RCRA TSDF Insurance Policies. Available online at:
http://vosemite.epa.gov/osw/rcra.nsf/ea6e50dc6214725285256bf00063269d/bc5ce94el913f2b88525670f006cl844iOpenDocument
156 U.S. EPA OIG. 2005.
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varying requirements by state). The burden associated with the cancellation of the
insurance policy if the owner or operator fulfills its obligations is minimal. However, if
the Director needs to draw on the insurance policy, the funds or the completion of
obligations come from the third-party itself (funds are not set-aside); accessing the funds
may require negotiation or litigation.
Financial Test and Corporate Guarantee
Corporate financial tests must be reevaluated and re-administered on a particular
schedule, creating administration costs for regulating agencies and regulated entities.157
The total administrative burden for a FR demonstration using a financial test is driven by
(1) the initial demonstration, and (2) annual reevaluations. The initial demonstration
would require a review of the submitted financial statements and calculation in a direct
review of the owner or operators financial condition. Therefore, unlike third-party
mechanisms, it is the Director reviewing the financial condition of the owner or operator
instead of a third-party. The burden associated with reviewing the owner or operator's
financial condition may be substantive to check that financial calculations (ratios) and
other financial documents (bond ratings, or annual statements) are complete and accurate.
There is no additional burden if the owner or operator fulfills its obligations. However, if
the owner or operator fails to perform is obligations the Director can only pursue
negotiations or litigation necessary to complete the required activities.
Escrow Account
The total administrative burden for a FR demonstration using an escrow account is likely
to be greater than the burden for trust funds until the instrument has a longer history of
being used for FR demonstration. The regulator would need to work closely with the
owner or operator and the escrow agent to ensure that the instrument was established with
provisions that work for the type of GS activity and timeframe required.
11) Which GS phase(s) is the instrument best suited for? (Considering short- or long-term
application)
Trust Fund
The strengths of trust funds are based on a fully-funded trust, which fully insulates the
risk to the public of the owner or operator failing (for certain environmental activities).
To the extent there is a pay-in period, these strengths are diminished because the owner
or operator could fail prior to the trust becoming fully funded.
For well-defined activities lacking "environmental risk" (i.e., certain to occur) such as
well plugging, post-injection site care, and site closure, a fully-funded third-party trust
minimizes the risk to the public of paying for these activities. As a result, it implies that
trust funds are the most costly to the owner or operator who must deposit the funds in
advance and pay for the administrative costs of the trust on an ongoing basis. Risk is
limited to (1) investment risk (although one can choose the relative riskiness of the trust's
investment portfolio), (2) risk from the failure of the trustee firm, and (3) risk of cost
escalation.
'U.S. EPAOIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 51
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For activities with uncertain frequency and costs, such as emergency and remedial
response, trust funds may perform poorly because the pool of funds in a trust does not
respond to contingencies outside those embedded into the cost estimate.
For activities that continue over the long-term (i.e. post-injection site care, site closure,
and emergency and remedial responses in the post-injection site care period), trust funds
are fairly reliable. During the FR webcasts, at least one state planned to use trust funds
for longer-term phases of GS, and several webcast participants indicated that trust funds
were less risky than insurance policies that require the owner or operator to continue
paying premiums in order to continue coverage.
o However, two webcast participants expressed concern that trust funds may not be
the best instrument for longer term closure and monitoring phases.158
For the case of uncertain long-term activities (i.e. emergency and remedial responses),
the above analysis of uncertainty and timing can be combined. Funds will be available in
the trust, but it is likely that there will be too little funds (in which case the public is
worse off because it must pay for any environmental obligations) or too much money in
trust (an inefficient use of funds that unnecessarily raises GS costs).
Standby Trust
Standby trusts are not considered stand alone instruments. They are used exclusively for
the short term fulfillment of environmental obligations.
Letter of Credit
During the FR webcasts, participants discussed the appropriateness of instruments for
various project phases and noted that letters of credit would apply to construction and
operation, but probably are not suited for closure or the monitoring phase. It was
uncertain whether the letter of credit would still be useable after 40 or 50 years.159
Widely used for RCRA financial assurance during hazardous waste landfill closure and
post-closure care. 16°
For letters of credit a bank evaluates that an owner or operator is financially strong
enough for the bank to pay for its obligations in the event of the failure of the owner or
operator. The administrative burden of determining creditworthiness is paid for by the
owner or operator (instead of being paid for by the government). Two other features of
letter of credit are the credit limit (i.e. a limit to what the creditor covers), a fee paid for
by the owner or operator to obtain this credit backing (a small fraction of the credit limit,
as well as deposited collateral). Hence, letters of credit are also similar to surety bonds -
their cost is a function of the credit limit, the financial health of the owner or operator,
and risks faced by the owner or operator.
Letters of credit perform equally well for certain and uncertain environmental activities,
so long as the credit limit is not exceeded. Importantly, the risk of exceeding the limit is
not pooled across owners or operators.
For activities that continue over the long-term (i.e. post-injection site care, site closure,
and emergency and remedial responses), letters of credit may be less effective than other
instruments because they are granted for an annual period, upon which the creditor
158 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
159 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
160 U.S. EPA OIG. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 52
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reconsiders extension (although there may be automatic renewal), and the risks of shocks
to creditworthiness are not pooled across owner or operators.
Surety Bond
During the FR webcasts, participants noted that surety bonds have uncertain long-term
(closure and monitoring) applicability if these instruments must be drawn upon in 40 or
50 years. Other participants suggested that a forfeiture bond would be more appropriate
for long-term care than insurance.161 It is worth noting that surety bonds are widely used
for RCRA financial assurance when a hazardous waste landfill is active.162
As time horizons expand, surety providers are unlikely to underwrite bonds over longer
time horizons where there is considerable uncertainty. GS projects that intend to use
surety bonds should be able to "clearly delineate timeframes and levels of responsibility."
Bonding for GS projects is likely to be an effective financial mechanism if transaction
costs are low and with "well-defined agreements and agreed upon definitions of
compliance and non-compliance, a high probability of detecting non-compliance, a
limited number of contracting parties, and a well-defined time horizon for regulatory
compliance."163
A surety company pays-out on its surety bond, up to a certain limit, in the event of failure
of the owner or operator. Unlike banks offering letters of credit, surety companies are
more focused on pooling the risk of failure across owners or operators - perhaps through
the surety company's purchase of insurance. There can be more investment risk with a
surety bond than with a trust fund, because the surety company's investment strategy
cannot be specified by EPA (unlike for a trust fund); however, because the surety
company is more risk averse than a bank, the investment risk is lower than a letter of
credit.
Surety bonds perform equally well for certain and uncertain environmental activities - as
long as their limit is not exceeded. For uncertain environmental activities, surety bonds
may not handle the numerous scenarios for environmental obligations as well as
insurance because their structure of contingency payments is different than it is for
insurance.
For activities that continue over the long-term (i.e. post-injection site care, site closure,
and emergency and remedial responses), surety bonds are as reliable as the surety
company itself. As a result, surety companies may be reluctant to offer long-term surety
bonds.
Note that blanket bonds, where all of an owner or operator's sites are covered under a
single bond (as if it were a single site), are inferior because they do not cover the full
scale of the owner or operator environmental obligations and hence present a much
higher risk of the public paying for the owner or operator's environmental obligations.164
Insurance
For activities with uncertain frequency and costs, such as emergency and remedial
response, insurance is the ideal instrument for diversifying environmental risk and
161 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
162 U.S. EPA OIG. 2001.
163 Gerard, D, E.J, Wilson. 2008. Journal of Environmental Management 90 (1097-1105). Available online at
https://www.researchgate.net/iournal/0301-4797 Journal of Environmental Management
164Boyd. 2001.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 53
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handling the numerous scenarios possible in this GS phase. Moreover, insurance
companies internalize much of the administrative burden of overseeing owners or
operators by creating the incentive for reducing uncertain environmental risks due to
improved technology and/or management.165
o However, because insurance payments cover the most contingencies, insurance
policies can be complicated and have a high administrative burden.
The biggest issue for insurance is timing. Insurers prefer to restrict the scale, timeframe,
and predictability of their exposures. For instance, insurers prefer policies that cover
claims made during the coverage period (preferable the period of time during which the
owner or operator is paying premiums) and avoid policies that cover claims arising after
the policy's coverage period has ended.166
o Insurance can be used for either short-term or long-term applications depending
on the terms of the policy. It is expected that shorter terms with finite policies will
be easier to obtain, while longer-term policies that cover broader areas will be
more expensive and harder to obtain.
During the FR webcasts, participants suggested that insurance probably works best in the
operational phases of a GS project because the activities and timeframe are well-defined,
and hopefully, the project is fully covered by insurance thereby lowering risk. However,
for long-term phases, insurance is less likely to be useful due to either a company going
out of business or leaving the business at the end of the operational phase.167
The insurance company Zurich has developed what they call the Geologic Sequestration
Financial Assurance plan which covers closure and post-closure costs, and a CCS
liability plan which covers pollution event liability, business interruption, control of well,
transmission liability, and geomechanical liability.168
During the FR webcasts, a participant said that insurance probably works best for the
operational phases of a facility. During the injection operations, the activities are not
unusual technological activities (with the exception of sequestering the carbon dioxide).
According to the participant, insurance becomes problematic during site closure and post-
closure care. The participant wondered how an insurer ensures financial responsibility for
that period of time. He suggested that a forfeiture bond, surety bond, or trust fund would
be more appropriate. Another participant agreed that insurance would be a viable option
through well construction.169
For well-defined activities lacking "environmental risk" (i.e., certain to occur) such as
well plugging, post-injection site care, and site closure, insurance may be less appropriate
because there is no environmental risk to diversify. In effect, insurance on certain
activities is conceptually similar to a surety bond.
Note that captive insurance, where the insurer is an owner or operator's parent firm.
However, because the insurance company is not owned by a third party, captive
insurance inherits the risks of self-insurance.
165 Boyd. 2001.
166 Boyd. 2001.
167 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
168 Presentation at the United States Energy Association by Lindene Patton. and Zurich. 2009. The Climate Risk Challenge: The role of insurance
in pricing climate-related risks. Zurich Financial Services Group. Available online at: http://www.zurich.com/NR/rdonlyres/E2B5B53E-llDB-
47AF-91E4-01ED6A2BDCA3/0/ClimateRiskChallenge.pdf
169 U.S. EPA. 2009. Notes from Webcasts on Financial Responsibility for Geologic Sequestration Wells. Unpublished notes from May 20, 2009
Insurance webcast.
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Financial Test and Corporate Guarantee
In an EPA analysis of RCRA subtitle C and D corporate financial tests, the estimated
financial assurance risk to the public (of having to pay for the environmental obligations
of a owner or operator) is an order of magnitude higher when self-insurance is used than
when a third party instrument is used. 17°
During the FR webcasts, participants stated that self-insurance is good while the
company is making money, but if the economy slows, or a company fails, then the ability
to pay for long-term phases may not be adequate.171
Widely used for both short-term and long-term RCRA financial assurance.m
Self-insurance FR demonstrations are equivalent to a waiver of third-party instruments
for large and historically financially stable firms. If the firm's net worth is large enough
and its risk of failure low enough, the government effectively guarantees the fulfillment
of environmental activities in event of the owner or operator's failure. For this reason,
self-insurance is a very controversial means for demonstrating financial responsibility.
The financial test and corporate guarantee could be used for any or all GS activities and
phases. The historical justification for self-insurance is to minimize the sum of the costs
to the public and the costs to industry. Because of the comparatively higher risk, a public
policy rationale should factor in to the decision to allow self-insurance demonstrations
GS activities requiring financial responsibility. Therefore, the primary reason to admit
self-insurance is to promote GS as a matter of public policy. When a self-insured
company fails the fundamental purpose of FR-ensuring that the polluter pays-is thwarted
because the public bears the risk of any unfulfilled obligations.
Another factor to consider in allowing self-insurance demonstrations for FR is market
spillover effects. Because only larger low-risk firms qualify for self-insurance, the cost of
risk-pooled private FR instruments (i.e., insurance) will be much higher because the
higher risk or smaller firms will be in need of third-party FR instruments. This may
provide firms utilizing self-insurance with a comparative advantage and may also inhibit
the development of robust third-party instrument markets, especially in the early years of
commercial GS activity.
Escrow Account
Escrow accounts perform almost exactly like trust funds and hence similarly suited for
GS activities.173 The difference between the two FR instruments is that escrow accounts
have a lower cost to set up, less oversight (trust funds cost more to set up because
resources are spent on setting up stronger oversight), may not allow a pay-in period, and
their funds are kept in a highly liquid form (a simple interest bearing account like a
savings or money market account at a bank) which costs little to oversee but causes
escrow accounts to generate minimal interest. As a result, escrow accounts are usually
utilized for short-term transactions in real estate, tax payments, mergers and acquisitions,
fulfillment of court orders, and for hard-asset loans to serve as a commitment device that
compels the depositor to not renege on an agreement. In the case of GS, where the
relative time horizon is measured in decades, a trust fund's investment strategy is likely
170 U.S. EPA. 1996.
171 U.S. EPA. Unpublished. Analysis of Outcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comments by
instrument. (Version 10-21-09)
172 U.S. EPA OIG. 2001.
173 Kuipers 2003, and Boyd. 2001.
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to outperform an escrow account in terms of accrued interest. As a result, there may be no
benefit (or actually greater costs) to using and escrow account instead of a trust fund.
Therefore, escrow accounts are likely only to be used for the shortest-term activities such
as phased corrective action or for serving as a temporary account akin to standby trusts.
12) For each GS phase, can the specific weaknesses of an instrument be minimized by
combining it with another mechanism?
Trust Fund
Trust funds, letters of credit, surety bonds guaranteeing payment, and insurance can be
combined for a facility if together their value is at least equal to the closure or post-
closure cost estimate. Surety bonds guaranteeing performance, financial tests, and
corporate guarantees cannot be combined.174
Trust funds may work most effectively for well-defined activities and phases such as
corrective action, injection well plugging, and post-injection site care and site closure.
However, the uncertain frequency and costs associated with emergency and remedial
response may not match the trust fund's relatively fixed value (i.e., response activities
may be more or less than estimated costs) and may occur with an unknown timing. The
unknown timing of response activities could create problems if the trust is not fully
funded when response activities are needed. For emergency and remedial response it may
be possible to combine a trust fund with another third-party mechanism to split up
potential costs. That is, use the trust fund for response activities up to a pre-established
value, versus the trust fund plus another third-party instrument for response activities
costing more than what is available in the trust fund. By pursuing this approach the owner
or operator uses the trust fund as set-aside financing to cover lower-cost activities, and
purchases risk assurance (letter of credit, surety bond, insurance) to make up the
difference for high cost activities. However, from the Director's perspective, the
additional burden and complication from reviewing more than one instrument may be
undesirable.
Letter of Credit
Trust funds, letters of credit, surety bonds guaranteeing payment, and insurance can be
combined for a facility if together their value is at least equal to the closure or post-
closure cost estimate. Surety bonds guaranteeing performance, financial tests, and
corporate guarantees cannot be combined.175
Letters of credit may work most effectively for well-defined activities, near term
activities, and phases such as corrective action or injection well plugging. However, the
longer-term nature of post-injection site care and site closure and the uncertain frequency
and costs associated with emergency and remedial response may not match value of the
letter of credit. Changes in financial markets and changes in the owner or operator's
credit rating may affect the cost and availability of letters of credit. For post-injection site
care and site closure, it may be possible to combine a letter of credit with a trust fund to
split up potential costs covered by the credit provider (i.e., the bank). This may provide
additional stability and lower risk from the creditor's perspective. For response activities,
'U.S. EPA OIG. 2005.
5 U.S. EPA OIG. 2005.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 56
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it may be possible to utilize insurance to manage the uncertainty associated with cost.
However, from the Director's perspective, the additional burden and complication from
reviewing more than one instrument may be undesirable.
Surety Bond
Trust funds, letters of credit, surety bonds guaranteeing payment, and insurance can be
combined for a facility if together their value is at least equal to the closure or post-
closure cost estimate. Surety bonds guaranteeing performance, financial tests, and
corporate guarantees cannot be combined.176
Surety bonds may work most effectively for well-defined activities and phases such as
corrective action, injection well plugging, and post-injection site care and site closure.
However, the uncertain frequency and costs associated emergency and remedial response
may not match the surety bond's fixed value (i.e., response activities may be more or less
than estimated costs). For emergency and remedial response it may be possible to
combine a surely bond with a trust fund to split up potential costs. That is, use the trust
fund for response activities up to a pre-established value (that the owner or operator can
afford to set aside) and then use the surety bond for response activities with more
predictable costs. By pursuing this approach, the owner or operator uses the trust fund as
set-aside financing to cover low-cost activities, and purchases a surety bond to make up
the difference for high cost activities. However, from the Director's perspective, the
additional burden and complication from reviewing more than one instrument may be
undesirable.
Insurance
Trust funds, letters of credit, surety bonds guaranteeing payment, and insurance can be
combined for a facility if together their value is at least equal to the closure or post-
closure cost estimate. Surety bonds guaranteeing performance, financial tests, and
corporate guarantees cannot be combined.177
Insurance is likely to be most suitably matched to manage the uncertain frequency and
costs associated with emergency and remedial response. However, the well-defined
activities and phases such as corrective action, injection well plugging, and post-injection
site care and site closure may also be managed by insurance. Owners or operators could
lower their insurance premium payments by setting money aside in a trust fund or escrow
account to pay for activities up to a pre-established value (that the owner or operator can
afford to set aside) and then use insurance to cover remaining costs in the event the owner
or operator fails to perform. This may provide additional stability and lower risk from the
insurance company's perspective. However, from the Director's perspective, the
additional burden and complication from reviewing more than one instrument may be
undesirable.
Financial Test and Corporate Guarantee
N/A. The primary driver for utilizing the financial test and corporate guarantee is to avoid
the use of the other third-party mechanisms.
5 U.S. EPA OIG. 2005.
7 U.S. EPAOIG. 2005.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 5 7
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Escrow Account
Escrow accounts may work most effectively for near-term activities and phases such as
corrective action or emergency and remedial response during injection. The longer time
periods associated with all other GS phases make escrow accounts a relatively
undesirable mechanism. Although any of the instruments could be combined with an
escrow account over the long-term, it may be more desirable from both the perspective of
the owner or operator, and the regulator, to simply utilize another instrument (or
combination of third party instruments such as insurance, surety bonds or letters of
credit).
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 58
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4. Rationale for Financial Responsibility Instrument Selection
/. Introduction
The rule "Federal Requirements Under the Underground Injection Control (UIC) Program for
Carbon Dioxide (CC^) Geologic Sequestration (GS) Wells" establishes a new Class VI well with
specific requirements for the underground injection of CC>2 for the purpose of GS. The rule
contains specific provisions for owners or operators of GS wells to demonstrate and maintain
financial responsibility for corrective action on wells in the Area of Review (AoR), injection
well plugging, post-injection site care and site closure, and emergency and remedial response.
Figure 4.1 shows the various phases of a GS project; the activities for which financial
responsibility must be demonstrated are shown in bold.
Figure 4.1: GS Project Activities
Injection/
Operation/
Area of Monitoring Post- _
Review and Well Injection Well Injection Site Long-Term
SltinS Corrective Construction AoR Reevaluation Care Care
Action and
Corrective Action Closure
and Phased
Corrective Action
Emergency And Remedial Response
*Please note that the timeframes in this exhibit are not to scale. Activities for which financial responsibility must be demonstrated are shown in
bold. Financial responsibility demonstrations will coincide with permitting (or revisions made after permitting), therefore Area of Review and
Corrective Action prior to permitting (i.e., prior to well construction) are not activities for which financial responsibility must be demonstrated.
EPA will describe the types of financial instruments that owners or operators can use to meet the
requirement in GS Class VI Guidance entitled "Financial Responsibility for Class VI Wells."
This paper provides EPA's rationale for making decisions on the financial instruments
recommended for Class VI financial responsibility demonstrations. The intended audience is GS
well owners or operators, EPA and state regulators, and the general public.
A. Summary
EPA based its decision making with emphasis on USDWs protection on an analysis of (1) the
potential for instrument failure, and (2) resource implications for owners or operators and
Directors (see a summary of EPA's research and preliminary analysis, including input from
GWPC and EFAB in Appendix A). In its evaluation, EPA considered a broad set of instruments
for financial responsibility demonstrations: trust funds, letters of credit, surety bonds, insurance
policies, escrow accounts, and financial tests and corporate guarantees. Based on the analysis of
these instruments, Table 4.1 indicates the relative suitability of the various financial
responsibility demonstrations for each project activity.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 59
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Table 4.1: Instruments Best Suited for GS Activities
Corrective Action
1 . Trust fund
2. Letter of credit
3. Surety Bond
4. Escrow Account
5. Financial test and
corporate
guarantee*
Injection Well
Plugging
1 . Trust fund
2. Letter of credit
3. Surety Bond
4. Insurance
5. Financial test and
corporate
guarantee*
Post-injection Site
Care and Site Closure
1 . Trust fund
2. Insurance
3. Financial test and
corporate
guarantee*
Emergency and
Remedial Response
1. Insurance
2. Letter of Credit**
3. Surety Bond**
4. Financial test and
corporate guarantee*
*Financial tests and corporate guarantees present the lowest direct costs to owners or operators but the highest risk to the public. Therefore, the
reason to allow financial responsibility demonstrations utilizing this instrument is to enable GS as a matter of public policy.
"Letters of credit and surety bonds are likely most appropriate for emergency and remedial response during operation phases.
The sections that follow address the following topics:
The historical precedent and context for using trust funds, letters of credit, surety bonds,
insurance, escrow accounts, and financial tests and corporate guarantees for financial
responsibility demonstrations.
The factors leading to instrument failure, which ultimately result in costs to the public.
The resource implications, to the owner or operator and the Director, associated with
utilizing the financial responsibility instruments.
Additional information explaining which instruments EPA recommends for particular GS
activities and why.
//. Historical Precedent
All of the instruments EPA considered have been used previously for financial responsibility
demonstrations. Several of the instruments have been used in the UIC program for both Class I
and Class II wells. All but insurance and escrow accounts were specifically named in the
guidance for Class II wells. With the exception of escrow accounts, all of the instruments have
been used in the Resource Conservation and Recovery Act (RCRA) program since 1982 to
provide financial assurance for hazardous waste activities, including Class I hazardous wells.
Although escrow accounts do not have a history of use in the UIC program, certificates of
deposit have been used by the Montana and Michigan UIC programs and were perceived by the
states to have similar functionality. Although standby trusts are not considered stand-alone
instruments, they have historically been combined with letters of credit and surety bonds when
EPA is the Director instead of a state (i.e., for direct implementation programs) and are discussed
below in this context.
///. Potential for Instrument Failure
EPA understands that all financial responsibility instruments have some risk of failure and
acknowledges that the purpose of requiring financial responsibility demonstrations is to
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 60
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minimize the risk that costs will be transferred to the public. Although the extent of the risk
varies among instruments, adverse conditions resulting from owner or operator failure, market
volatility, third-party litigation, cost underestimation, and policy exclusions or limits may
contribute to partial or total instrument failure. With proper implementation, oversight, and
enforcement at the state and federal levels, instrument failure can be minimized along with the
associated financial (e.g., clean up or enforcement costs), environmental (e.g., ground water
contamination), or social (e.g., environmental justice) impacts.
The total failure of financial responsibility instruments is most likely to occur as a result of
owner or operator failure and, for third party instruments, the failure of a third party. EPA
defines owner or operator or third party failure as financial insolvency leading to unfulfilled
requirements, or the outright abandonment of environmental obligations.
A. Owner or Operator Failure
For all instruments except financial tests and corporate guarantees, the risk of instrument failure
is partially mitigated by the fact that the fund or liability is held by a third party. Therefore, for
third-party instruments, both the owner or operator and the third party must fail in order for the
instrument to fail. In contrast, if the owner or operator becomes financially insolvent (e.g.,
bankrupt), then the financial test and corporate guarantee immediately fails. If the trust fund or
escrow account is not yet fully funded due to a pay-in period, financial insolvency of the owner
or operator at the onset of the GS project or over time may also lead to a partial instrument
failure.
B. Third Party Failure
Trust funds,178 standby trusts, letters of credit, surety bonds, insurance, and escrow accounts are
managed or sourced from a third party and are therefore affected by third-party failure.179 This
failure may occur as a result of bankruptcy of the instrument administrator or issuer, cancellation
of the account or policy due to non-payment of fees or premiums, or a change in third-party
ownership. However, EPA notes that third-party failure must coincide with owner or operator
failure for complete instrument failure to occur. If the third party fails, but the owner or operator
remains solvent, the owner or operator can secure an instrument from another third party (that is
acceptable to the Director), thereby minimizing the long term financial risks to the public.
C. Other Factors
EPA is aware that accounts and policies for trust funds, standby trusts, letters of credit, insurance
policies, and escrow accounts may be cancelled in the event that the owner or operator does not
pay the necessary monthly or annual fees. Furthermore, the third party may terminate an account
or policy based on changes to the owner or operator's financial status, or for other reasons.
Therefore, in the event of cancellation or non-renewal, EPA recommends that the owner or
operator have a defined period of time to secure a new financial responsibility instrument. This
can help minimize the probability of cancellation or non-renewal creating breaks in coverage.
178 EPA recognizes that primacy states may have the ability to establish individual or pooled trusts, in which case there is no risk of third party
failure because the state itself is the trustee.
179 The failure of a third-party audit (i.e., inaccurate audit) could contribute to the collapse of the financial test and corporate guarantee
instrument.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 61
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EPA also understands that surety bonds and insurance may fail when the financial health of an
owner or operator has been inaccurately assessed by the third party. Similarly, financial tests and
corporate guarantees may fail when the financial health of an owner or operator has been
inaccurately assessed by the Director. EPA recognizes the difficulty of analyzing the complex
finances of multi-level firms.
Considering these factors, EPA recognizes that a combination of financial responsibility
instruments could be used to limit the risk of instrument failure and potential costs to the public.
Combining instruments to minimize their weaknesses is discussed in more detail in Section V.
IV. Resource Implications for the Owner or Operator and the Director
EPA recognizes that all third-party instruments require the owner or operator to pay fees (upfront
or annual fees) or monthly premiums to secure and maintain the instruments (Table 4.2, total
cost to company). EPA anticipates that these overhead costs will vary by institution, the amount
of coverage, and the level of investment activity for instruments like trust funds and escrow
accounts. Letters of credit may also require a cash or hard asset collateral in addition to the
premium. Therefore, EPA anticipates that the costs that owners or operators will incur to obtain
financial assurance will vary by instrument type. For third-party instruments, the costs paid by
the owner or operator include the overhead cost needed to secure and maintain these instruments
with the third party. Additionally, the total cost of trust funds and escrow accounts will also
include the total estimated costs of the GS activity.180 In the case of financial tests and corporate
guarantees, overhead costs will include only those needed to demonstrate maintained financial
health.
In addition to variations in costs, there will be different logistics and processes involved if an
owner or operator or the Director must access or request funds. In some cases, unused funds may
be returned to the owner or operator, while in other cases the third party may seek
reimbursement from the owner or operator. EPA recognizes that logistical aspects of the
instruments have differing resource implications for the owner or operator and the Director.
180 Because the costs of the activity are paid for by trust funds and escrow accounts, or the owner or operator is reimbursed, estimated costs are
paid (i.e., set aside) upfront. However, when demonstrations are made with surety bonds and letters of credit, activity costs are paid for by the
owner or operator and the secured financial responsibility instrument is only used in the event that the owner or operator cannot complete the
activity.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 62
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Table 4.2: Regulatory Risk, Oversight Effort, and Costs to Owners or Operators
Trust Fund
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate Guarantee
Escrow Account
Total Cost to
the Company*
High
High
Medium High
Medium**
Low
High
Estimated
Overhead Cost
as a Percent of
Total Cost
-2% (total)
1 .5 - 2% (annual)
0.5 -15% (total)
No data available
<0.5% (total)
1 - 2% (total)
Relative
Financial Risk
to the
Government*
Low
Low
Medium Low
Medium
High
Low
Oversight and
Enforcement
Effort Needed*
Medium Low
Low
Medium Low
Medium
High
Medium Low
* Except for information on escrow accounts, relative rankings are based on U.S. GAO. 2005. Environmental Liabilities
(http://www.gao.gov/new.items/d05658.pdf) and EPA OIG. 2005. Continued EPA Leadership Will Support State Needs for Information and
Guidance of RCRA Financial Assurance (http://www.epa.gov/oig/reports/2005/20050926-2005-P-00026.pdf).
* * Includes captive insurance, which inherits the risk of self insurance.
The Director's goal in reviewing a financial responsibility demonstration is to minimize the risk
that the instrument will fail and leave the public bearing the costs (Table 4.2, relative financial
risk to the government). The costs to the Director for an initial review, reevaluations, and
monitoring will vary among instruments. During the initial review of the financial responsibility
demonstration, For third-party instruments, the Director should consider the stability of the third-
party financial institutions to minimize the risk of instrument failure. In the case of financial tests
and corporate guarantees, the Director needs to evaluate the stability of the owners or operators
themselves. See Chapter 6 "Director's Examination of Third Party Stability."
A. Director's Review and Monitoring
EPA acknowledges that the initial review of the financial responsibility demonstration,
reevaluations, and monitoring take time, regardless of which instrument is proposed. Trust funds,
letters of credit, surety bonds, and escrow accounts require the lowest total oversight and
enforcement burden for the Director. Insurance and financial tests and corporate guarantees have
the highest levels of administrative burden. Insurance policies will be complex due to site-
specific variations and differences within states. Financial tests and corporate guarantees are
data-intensive and require frequent evaluations and re-evaluations for solvency. Financial
auditing and review of financial mechanisms are resource intensive processes that require access
to specific expertise or training for which additional capacity may need to be developed within
the UIC program.
V.
Recommendations and Rationale
Considering the characteristics of the instruments and the characteristics of GS project activities,
some instruments may be better suited for certain GS activities than others. In general, the GS
activities requiring financial responsibility demonstrations can be characterized as environmental
obligations that are either relatively well-defined in terms of when they will occur and how much
they will cost, or uncertain in terms of when (and if) they will occur and how much they will
cost. The following descriptions characterize GS phases in terms of certainty and sequencing.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 63
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Corrective action on wells in the AoR, as described at 40 CFR 146.84, presents some
uncertainty in terms of when it will occur and how much it will cost. Corrective action
that will occur early in a GS project during the AoR phase will be well-defined.
However, the extent of future corrective action undertaken during the operational phase
will depend on subsequent AoR re-evaluations. If the initial AoR delineation proves to be
inaccurate, additional corrective action may be required that was not considered at the
onset of the project. While the duration of the operational or injection phase of a GS
project will vary by site, for the purposes of this discussion, EPA anticipates that
corrective action will occur within a 20 to 30 year period.
Injection well plugging., as described at 40 CFR 146.92, is relatively well-defined in
terms of when it will occur and how much it will cost. Well plugging occurs later in a GS
project lifecycle, following the operational phase of injection for either a particular well
or the project as a whole. EPA anticipates that plugging a well will take place over a
period of weeks, not years.
Post-injection site care and site closure, as described at 40 CFR 146.93, is relatively
well-defined in terms of when it will occur and how much it will cost. Post-injection site
care and site closure occur last in the GS lifecycle. For the purpose of determining
financial assurance, the post-injection site care period will be at least 50 years and site
closure will occur at the Director's discretion.
Emergency and remedial response activities, as described at 40 CFR 146.94, in contrast
to the three activities described above, are relatively uncertain in terms of when (and if)
these activities will occur and how much they will cost. Additionally, the timeframe
during which these activities may occur over is the longest (i.e., 70 years or more).
Based on the characteristics of the instruments and the characteristics of GS project activities,
EPA recommends the following financial instruments as "best" or "good" for Class VI financial
responsibility demonstrations (Table 4.3).
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 64
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Table 4.3: Instruments Best Suited for GS Activities
Trust Fund
Letter of Credit*
Surety Bond*
Insurance
Financial Test and
Corporate Guarantee
Escrow Account
Corrective Action
and Phased
Corrective Action
Best
Best
Good
Injection Well
Plugging
Post-injection Site
Care and Site
Closure
Best
May be unreliable
for longer time
periods
(>20 years)
May be unavailable
over longer time
periods (>20 years)
Not ideal for operational phases
Emergency and
Remedial Response
May be too little or
too much money
Most appropriate for
ERR during operation
Best
Good, but provides no financial recourse if owner or operator fails
Good
Trust funds may be preferred over
the mid and long term
Likely to perform
poorly for uncertain
risks
* Standby trust is needed in addition to the letter of credit or surety bond if EPA is implementing the program.
The following subsections provide a brief rationale for the recommended uses of these financial
instruments based on the characteristics of GS project activities described above, and the
instrument characteristics summarized in sections III and IV.
A.
Trust Funds
Trust funds are best suited for corrective action, injection well plugging, and post-injection site
care and site closure demonstrations. These activities are relatively certain both in terms of
occurrence and cost. A fully-funded third-party trust represents the lowest the risk to the public
of paying for these activities. Although the cost of the instrument is essentially the full cost of the
activity, the owner or operator recovers this cost (in the form of reimbursement) following the
fulfillment of the activity. In addition, costs to the Director are relatively low. For activities with
uncertain frequency and costs, such as emergency and remedial response, the trust will likely not
have the right amount of fundstoo little money is a partial failure of the instrument that must
be borne by the public and too much money represents an inefficient use of funds that
unnecessarily raises GS costs.
B. Letters of Credit
Letters of credit are best suited for corrective action and injection well plugging demonstrations.
Letters of credit perform equally well for certain and uncertain environmental activities, as long
as the credit limits are not exceeded. The cost to the owner or operator is a function of the credit
limit, the financial health of the owner or operator, and risks faced by the owner or operator.
Costs to the Director are low when automatic renewals take place and no litigation is needed. For
activities that continue over the long term (i.e., post-injection site care, site closure, and
emergency and remedial responses), letters of credit may be unreliable because there are more
opportunities for the third party to cancel the line of credit. Moreover, their application over
longer time periods (i.e., greater than 20 years) is uncertain. Therefore, letters of credit may not
be effective for post-injection site care and site closure.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 65
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C. Surety Bonds
Surety bonds are good for corrective action and injection well plugging demonstrations. Surety
bonds perform equally well for certain and uncertain environmental activitiesas long as the
limits are not exceeded. The cost to the owner or operator of a surety bond is greater than a letter
of credit but less than a trust fund. The cost to the Director may be higher for a performance
bond than for a payment bond if litigation is required to get the surety to fulfill the activity. For
activities that continue over the long term (i.e., post-injection site care and site closure, and
emergency and remedial responses), surety providers are unlikely to underwrite bonds over
longer time periods where there is considerable uncertainty.
D. Insurance
Insurance policies are best suited for emergency and remedial response demonstrations.
Insurance is the ideal instrument for diversifying environmental risk and handling the numerous
possible scenarios associated with emergency and remedial response.181 However, because
insurance policies may cover a wide range of contingencies with wide ranging costs, they can be
complicated with high administrative burdens. For well-defined activities such as well plugging,
post-injection site care, and site closure, insurance is less appropriate because there is no
environmental risk to diversify.
E. Escrow Account
Escrow accounts are good for corrective action demonstrations. Escrow accounts perform almost
exactly like trust funds and hence are just as reliable. The difference between the two financial
responsibility instruments is that escrow accounts have a lower cost to set up, less oversight
(trust funds cost more to set up because resources are spent on establishing stronger oversight),
and their funds are kept in a highly liquid form (a simple interest bearing account like a savings
or money market account at a bank), which limits risk and the administrative costs but causes
escrow accounts to generate minimal interest. In the case of GS, where the relative time horizon
is measured in decades, a trust fund's investment strategy is likely to outperform an escrow
account in terms of accrued interest. As a result, there may be greater costs from lost investment
income and no benefit to using an escrow account instead of a trust fund. Therefore, escrow
accounts are likely only to be used for the shortest-term activities such as phased corrective
action or for serving as a temporary account, similar to standby trusts.
F. Financial Tests and Corporate Guarantees
Financial tests and corporate guarantees may be useful or "good" for corrective action, injection
well plugging, post-injection site care and site closure, and emergency and remedial response.
While offering the lowest cost to owners or operators, self-insurance represents the highest
financial risk to the public. Additionally, the Director at the state or Regional level may need a
high level of financial expertise to review the demonstration with confidence. EPA recommends
that the Director should only accept demonstrations when the risk to the public of the GS owner
or operator failing is acceptably low. However, EPA may consider the added risk to the public
181 Captive insurance, where the insurer is an owner or operator's parent or sibling firm, inherits the risks of self-insurance because the insurance
company is not owned by a third party. Captive insurance is excluded from this discussion.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 66
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worthwhile to facilitate the realization of broader anticipated public benefits from GS (i.e.,
climate change mitigation, economic development). Ultimately, the Director has discretion over
what level of financial risk to the public is acceptable.
G. Minimizing Instrument Weakness by Combining Instruments
Since many of the instruments used for financial assurance are better suited to certain GS
activities, EPA has stated that it is possible to combine financial instruments to obtain full
coverage for all of activities requiring a demonstration. This implies utilizing different
instruments for different GS activities requiring demonstrations, but it can also mean combining
instruments for the demonstration for a single activity (e.g., well plugging). EPA recognizes,
however, that Directors may be reluctant to allow combined demonstrations due to the likely
additional burden in their review process. In general, trust funds, letters of credit, surety bonds
guaranteeing payment, and insurance can be combined for an activity if their combined value is
at least equal to the cost estimate for the respective GS activity. Surety bonds guaranteeing
performance, financial tests, and corporate guarantees cannot be combined for an activity.182
182 U.S. EPA OIG. 2005. State support. http://www.epa.gov/oig/reports/2005/20050926-2005-P-00026.pdf
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 67
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5. Presentation on Financial Responsibility to Ground Water Protection Council
On January 27, 2010, a short presentation was used to receive state input on EPA's initial
analysis on Financial Responsibility (FR) instruments for Geologic Sequestration (GS) in the
proposed Class VIUIC well class. A total of 48 participants representing EPA Headquarters and
Regional offices, and State Underground Injection Control (UIC) programs attended the meeting.
/. Summary of Meeting Discussion
EPA stated that the proposed rule specifies a general duty for FR in four phases of a GS
project.
EPA stated that the Office of General Council has encouraged EPA to be as specific as
possible about which instruments are allowable for FR demonstration and why an
instrument should not be allowed for a demonstration. The benefit of being specific in the
rule is that when an instrument is denied later on, the state or EPA has a lower probability
of being sued for being arbitrary and capricious in its decisions.
EPA asked for input on what might cause a FR instrument to fail?
o A state noted that if the trust fund is administered by a state instead of a bank, it
reduces the likelihood of failure. In addition to using a state administered trust
fund to cover anticipated (estimated) costs, the state could collect and set aside
fees during the permitting process in an emergency fund, to provide an added
level of financial security for the state.
o A participant from Montana shared an example of instrument failure: an insurance
company that posted 15 or 20 surety bonds for UIC wells simply went out of
business. This resulted in a period of 3 years where several operations in the state
did not have a FR instrument. Ultimately, the facilities were able to secure bonds
from another third-party.
o Montana provided another example of instrument failure, which resulted from the
use of Certificates of Deposits (CDs). In this case, the well owner or operator
persuaded the bank to return the money held in the CD without the state's
permission. The state did not have any recommendations on how to avoid this
situation. Indeed, regardless of policies, rules, or regulations, human error may
inevitably cause the state to bear the cost of cleanup or closure in some cases.
A participant recommended that the instrument language could do a better
job of specifying that funds can only be released upon the Director's
authorization.
Montana no longer accepts CDs from out-of-state banks.
o Michigan has faced problems with CDs being returned to the bank. In one
situation, the state ended up with an orphan well. Generally, the state has
encountered a number of cases where financial institutions have failed. In these
cases, alternative instruments were successfully identified and implemented.
o In an effort to minimize insurance failures, Texas passed a statute allowing FR
demonstrations with insurance; but since the requirements and language were so
restrictive, the state has not seen any applications of insurance.
EPA asked how suitable are existing FR instruments for GS?
o Participants noted that some of the instruments may not be available under state
law. For example, in Montana, financial test and corporate guarantee would not
be allowed under state law. However, other states do allow the mechanism.
o In Montana, an owner or operator can keep a cash reserve (CD), which is
conceptually similar to an escrow account. Montana stated that a benefit of using
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 68
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cash (CD or escrow account) over all other instruments, including a trust fund, is
that all the state needs to do is say "release the money." In all other cases, the
state may need to prove that the obligation has not been fulfilled, and that it must
be fulfilled.
o Montana stated that a benefit of a surety bond is that in the event that the state
says "release the money" the surety has an incentive to pressure the owner or
operator to fulfill the obligation, so that the state does not have to.
Montana stated that pore bonds only apply to underground activities, but
not above ground cleanup; however, this is outside the scope of the GS
final rule.
o In Oregon, a number of instruments will be available. Since the GS program
crosses agencies, one agency will focus more on FR.
A participant from an EPA Region asked if there are any states that can share how they
administer the financial test. No examples were provided.
A participant from Montana emphasized that FR is different for Federal and state
Directors. Although FR is important for states, EPA should keep in mind that some states
will be able to collect fees and establish state trusts (individual or pooled trusts), or use
existing state trusts to fund cleanup when instruments fail.
Texas assumes that the future experience with Class VI will be similar to Class I.
However, the value of the instrument will be very different. The bond may have a face
value of $ 10k for Class I well, but that Class VI bond values may be much higher.
o EPA added that it was asked to consider the experiences from RCRA in its
decision-making.
Montana stated that it is more concerned about the value of the instrument (i.e., value is
reflective of accurate cost estimates) than the existence of various instruments.
o EPA added that it is developing guidance to assist with the cost estimation
process.
The states recommended that flexibility be provided to encourage/promote GS projects.
As many instruments (tools) as possible should be on the table.
A participant from Montana added that the state would not object to a ranking of which
instruments are recommended for which applications. Indeed, guidance specifying how to
implement each instrument would be beneficial.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 69
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//. Presentation
Geologic Sequestration
Financial Responsibility
Joe Tiago
USEPA
Office of Ground Water and Drinking Water
UIC Program
January 27, 2010
Ground Water Protection Council
Austin, Texas
^w^ 1^ I^LA Geologic Sequestration Financial Responsibility
V "^
^^^^^QgS^^^H
Share information on financial responsibility:
- Preliminary analysis
- Decision making process is ongoing
Understand State experiences
Ask key questions related to the potential use
of financial responsibility instruments for
geologic sequestration wells
ifSf ^fTp^ Geologic Sequestration Financial Responsibility 2
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 70
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Background
Goal of FR
- Ensure that owners or operators have the resources to carry out
activities related to closing and remediating GS sites if needed
during injection or after wells are plugged, so that they do not
endanger USDWs
Proposed GS rule specifies a general duty to obtain FR at 40
CFR 146.85
In the proposed GS rule, owners or operators must
demonstrate and maintain FR for four activities/phases
- Corrective action on wells in the AoR
- Injection well plugging
- Post-injection site care and site closure
- Emergency and remedial response
x>EPA
Geologic Sequestration Financial Responsibility
manciai Kesponsiomty
Instrument Types
Instruments
Third-Party
Instruments
Surety
Bonds
Letters of
Credit
Trust Funds
Insurance
Escrow
Account
&EPA
Self-Insurance
Instruments
Financial
Test
L
Corporate
Guarantee
Geologic Sequestration Financial Responsibility
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 71
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Responsibility instruments for GS?
Trust Fund
Letter of Credit
Surety Bond
Insurance
Financial Test and
Corporate Guarantee
Escrow Account
Corrective Action Injection
and Phased Well
Corrective Action Plugging
Post-injection Site
Care and Site Closure
Best
Best
Good
May be unreliable for
longer time periods
(>20 years)
May be unavailable
over longer time
periods (>20 years)
Likely appropriate and available in the operational phases
Emergency and
Remedial Response
May be too little or too
much money
Most appropriate for
ERR during operation
Best
Good, but provides no financial recourse if owner or operator fails
Trust funds r
Good
the mid and
nay be preferred over
ong term
Likely to perform
poorly for uncertain
risks
Geologic Sequestration Financial Responsibility
.jat might cause a Financial
Responsibility instrument to fail?
^
Trust Fund
Standby Trust
Letter of Credit
Surety Bond
Insurance
Financial Test
and Corporate
Guarantee
Escrow Account
Owner/
operator
Failure
X
Third Party
Failure
X
X
X
X
X
N/A*
X
Cancellation
or Non-
renewal
X
X
X
X
Inaccurate
Assessment of
Owner/operator
Health
X
X
X
£ CDA
*5*^f^lA Geologic Sequestration Financial Responsibility 6
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 72
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Discussion Questions
Based on your experience, please share your
thoughts on the following:
1. Potential for Instrument Failure:
- Under what circumstances have you experienced
Financial Responsibility instrument failure?
2. Use of Financial Responsibility Instruments for
Different Phases of a Project:
- What are the advantages and disadvantages of using
self-insurance (a financial test) for all GS phases?
- What is your experience with the usefulness of
escrow accounts vs. trust funds?
- What is your experience with the use of insurance
well plugging vs. emergency and remedial response?
x>EPA
Geologic Sequestration Financial Responsibility
hank You!
For Additional Questions:
JoeTiago, MS, MPH
Tiago.Joseph@epa.gov
Additional Resources:
EPA Geologic Sequestration of Carbon Dioxide Website:
http://www.epa.gov/safewater/uic/wells_sequestration.html
Text of the Proposed rule for Federal Requirements Under the UIC Program for
Carbon Dioxide (CO2) Geologic Sequestration (GS) Wells:
http://www.epa.gov/fedrgstr/EPA-WATER/2008/July/Day-25/w16626.pdf
Docket for the rule: www.regulations.gov, Docket ID EPA-HQ-OW-2008-0390
&EPA
Geologic Sequestration Financial Responsibility
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 73
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6. Director's Examination of Third Party Stability
This chapter describes EPA's rationale for guidance recommendations on the examination of
third party stability. Because the failure of the third parties providing trust funds, standby trusts,
letters of credit, insurance, and escrow accounts may increase the likelihood of instrument
failure, the stability of the third party should be factored in to the Director's decision on the
acceptability of the demonstration. EPA understands that in most cases financial institutions
acting as third parties are regulated by a non-EPA state or federal regulator (e.g., the U.S.
Department of the Treasury). For example, the strength of a surety bond provider can be inferred
by whether or not it is listed on the U.S. Department of the Treasury's Department Circular No.
570 as an approved surety. Because the institutions are reviewed and listed (and unlisted)
annually by the Department of the Treasury, the stability determinations for surety bond
providers may require the lowest effort. Alternatively, the third party's standing may be inferred
by the number (and frequency) of enforcement actions taken by the financial regulator.
EPA recommends that the third party should also be regularly evaluated by an independent rating
agency. Similar to the use of bond rating tests for an owner or operator seeking to use the
financial test and corporate guarantee, bond ratings and credit ratings can be used for third
parties. Most financial institutions acting as third parties are likely to be evaluated by credit
rating agencies and have publicly available ratings (although detailed reports explaining the
rationale for the rating may not be public). Credit ratings are reviewed on a regular basis
(typically annually or semiannually) and should be available at the owner or operator's request.
The GS rule at 40 CFR 146.85(a)(6)(ii) specifies that third-party providers must either
Pass financial strength requirements based on credit ratings, or
Meet a minimum rating, minimum capitalization, and ability to pass the bond rating when
applicable.
In order to provide clear guidelines for owners or operators and the Directors, EPA can make
recommendations on each component of the Rule requirements: (1) financial strength
requirement based on credit ratings, (2) minimum rating, (3) minimum capitalization, and (4)
bond rating. Described below are several options for interpreting each of these requirements. The
selected option, and the rationale for choosing this option, is also noted for each component.
/. Financial strength requirement based on credit ratings
A. Credit rating requirements consistent with self-insurance requirements
For self-insurance, the Rule requires a bond rating in the top four categories of either Standard &
Poor's (AAA, AA, A or BBB) or Moody's (Aaa, Aa, A, Baa). These ratings categories could also
be recommended for third-party credit ratings. This maintains a consistent method (and set of
metrics) for determining any provider's financial strength and stability. Using the same
thresholds is a logical choice since the purpose in both cases (self-insurance and third-party
provider) is the sameminimizing the likelihood that the provider will be unable to meet its
financial obligations.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 74
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B. Credit rating by any Nationally Recognized Statistical Ratings
Organization (NRSRO)
EPA could recommend that third-party providers provide a credit rating of the Xth highest
category (e.g., 3rd or 4th highest) as determined by any NRSRO. Credit rating thresholds would
be determined based on a comprehensive analysis of failure rates of firms in each rating category
offered by each NRSRO. This option provides some potential benefits and weaknesses compared
to Option A. A potential benefit is that the credit ratings are not limited to just two rating
agencies (Standard & Poor's and Moody's). A potential weakness is that categories may not be
consistent among rating agencies (i.e., a 4th highest rating from one agency could mean
"adequate" or "moderate risk" while a 4th highest rating from another agency may mean
"inadequate" or "substantial risk").
C. [SELECTED] Hybrid of Option 1 and Option 2
In considering the strengths and weaknesses of Options A and B, a hybrid interpretation may be
desirable, specifying specific rating agencies and their associated recommended ratings. For
example, EPA could recommend specific rating agencies along with their associated credit
ratings that correspond to those of Standard & Poor's and Moody's. This provides more
flexibility than Option A and eliminates the potential weakness mentioned for Option B.
Rationale: Considering these factors, EPA recommends that owners or operators demonstrate
that third-party providers have a credit rating in the top four categories from either Standard &
Poor's or Moody's, consistent with the requirement for self-insurance. However, EPA
acknowledges that greater flexibility can be used for third-party credit ratings. Therefore, at the
Director's discretion, the owner or operator may alternately submit a comparable rating from any
NRSRO as long as the owner or operator can demonstrate the credibility of this rating compared
to the recommended ratings.
//. Minimum Rating
A. [SELECTED] Minimum credit rating using the same option chosen for
the credit rating requirement
EPA may interpret minimum rating to mean minimum credit rating. The benefits of this option
are that it is easy to specify in the Guidance and it lessens the number of financial measures that
Directors must become familiar with. A potential weakness, however, is that this option may
lead to confusion about when a third-party's financial stability should be judged based on part 1
of 40 CFR 146.85(a)(6)(ii) or part 2 (i.e., why require a credit rating or a credit rating plus).
Rationale: Introducing other types of ratings would require the Director to have a broader
familiarity with financial metrics in order to evaluate the financial responsibility demonstration.
Therefore, EPA clarifies that the minimum rating means a minimum credit rating. Furthermore,
EPA clarifies that third-party providers will be required to meet the credit rating requirement at
40 CFR 146.85(a)(6)(ii), however, if the Director has concerns about the third-party provider or
its credit rating, the Director can request additional information to satisfy part 2 of 40 CFR
146.85(a)(6)(ii) (i.e., minimum rating, minimum capitalization, and bond rating if applicable).
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 75
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B. Broader range of minimum rating options
In this option, "minimum rating" could be described as an issuer, credit, securities, or financial
strength rating. Using this broad definition would provide greater flexibility for the third-party
provider. For example, the provider may have an "acceptable" credit rating, but have a "very
strong" or "exceptional" financial strength rating and thus would submit the financial strength
rating instead of the credit rating as an indication of financial stability. Furthermore, the
difference between parts 1 and 2 of 40 CFR 146.85(a)(6)(ii)would be clarified. Pursuing this
option would mean that an owner or operator who submits a rating for part 2 of 40 CFR
146.85(a)(6)(ii) would simply be a making different demonstration of third-party stability.
///. Minimum Capitalization
A. [SELECTED] Financial ratios consistent with the financial ratio test
requirements for self-insurance
EPA could recommend that third-party providers meet the minimum thresholds for the following
financial ratios: Debt-Equity, Assets-Liabilities, Cash Return on Liabilities, Liquidity, and Net
Profit. Since these ratios are the required capital thresholds for self-insurance, this option is
similar to Option A for credit ratings and thus has the same potential benefits and weaknesses.
Rationale: The rationale for choosing this option is the same as for choosing Option A for credit
ratings. The Director would be familiar with these ratios because of the self-insurance financial
tests. Additionally, these ratio thresholds were chosen with GS activities in mind while the
thresholds in the other options may not be as applicable to GS activities.
B. Specific dollar value capital requirements
In choosing this option, minimum capitalization could be specified as meeting capital
requirements of annual capital, surplus, and undivided profits of at least $[X]. This option is
more straightforward than Option A and may be easier for third-parties to provide. However, it
would require targeted research to choose an appropriate threshold value relevant to all potential
third-party providers and, furthermore, it would require additional rationale for recommending
thresholds different than those required for self-insurance.
C. Minimum capital standards prescribed by the appropriate Federal
banking agency
The Federal Deposit Insurance Act requires Federal banking agencies to establish minimum
capital standards for their regulated entities. For example, the Federal Deposit Insurance
Corporation (FDIC) requires institutions to maintain capital levels that meet both the leverage
capital ratio requirement and the risk-based capital ratio requirement. The thresholds for these
requirements are summarized in the table below.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 76
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Well Capitalized
Adequately
Capitalized
Leverage
>= 5% and
>= 4% * and
Tier 1 Risk-Based
>= 6% and
>= 4% and
Total Risk-Based
>=10%
>= 8%
or a Leverage ratio of = 3% if the bank is rated a composite 1 and is not
experiencing or anticipating significant growth
* The "risk-based requirement" includes both Tier 1 Risk-Based ratio and Total Risk-Based Ratio
Institutions that do not meet the minimum thresholds are in violation of FDIC requirements
because they are considered at risk of insolvency. Potential benefits of using these capital
standards are that they are well-defined, easily accessible, and the rationale for choosing them is
easily explained. Potential weaknesses are that although federal thresholds may have been good
predictors of historical bank failure, recent legislation has been aimed at raising these standards,
they may still not be as robust as the standards in Options A or B183'184.
D. Successful completion of the new comprehensive stress test for banks
This option involves recommending that third-party providers that are banks pass the new stress
tests conducted by the Department of the Treasury. These tests built upon existing regulatory
capital requirements to assess whether institutions have adequate capital to see them through
economic reversals, but were intended to be more transparent than existing requirements in order
to restore confidence in the banking system. This option has the benefit of considering financial
stability in more adverse economic conditions. However, potential weaknesses of this option
include that not all third-party providers will have stress test results (it was only required of
banking institutions with assets in excess of $100 billion)185, that the stress test considers only
short-term stability (one year into the future)186, that there have been concerns about political
interference (by law, bank regulation is to be carried out by the independent banking
agencies)187, and that the reliability of these tests is not well established (these tests are still a
new procedure).
IV. Ability to pass the bond rating when applicable
A. Financial ratios consistent with the bond rating test requirements for self-
insurance
For self-insurance, the Rule requires a bond rating in the top four categories of either Standard &
Poor's (AAA, AA, A or BBB) or Moody's (Aaa, Aa, A, Baa) for bond ratings. These specific
ratings could also be recommended for third-party providers. This option parallels Option A for
183 Estrella, A., S. Park, and S. Peristiani. "Capital Ratios and Credit Ratings as Predictors of Bank Failures." 2002. Federal
Reserve Bank of New York Working Paper. .
184 Enrich, D., D. Fitpatrick, and M. Eckbald. "Banks Won Concessions on Tests: Fed Cut Billions Off Some Initial Capital-
Shortfall Estimates; Tempers Flare at Wells." WSJ.com. May 9, 2009.
.
185 Fact Sheet: Financial Stability Plan. U.S. Department of the Treasury. 2009 .
186 June Oversight Report: Stress Testing and Shoring Up Bank Capital. Congressional Oversight Panel. June 9, 2009.
.
187 Bozzo, Albert. "Most Banks Well Capitalized But May Need More, Fed Says." CNBC.com. April 24, 2009.
.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 77
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credit ratings. It therefore has the same potential benefits and weaknesses of Option A for credit
ratings.
B. Bond rating by any Nationally Recognized Statistical Ratings
Organization ("NRSRO")
This option is a broader interpretation of the Rule where the Guidance could recommend that the
third-party provider have a bond rating of the Xth highest category (e.g., 3rd highest or 4th
highest) as determined by any NRSRO. This option parallels Option B for credit ratings. It
therefore has the same potential benefits and weaknesses of Option B for credit ratings.
C. [SELECTED] Hybrid of Option 1 and Option 2
In considering the strengths and weaknesses of Options A and B, it may be desirable to
recommend a hybrid interpretation, specifying specific rating agencies and their associated
recommended ratings. This option could be broader than Option A but not as broad as Option B.
For example, the Guidance could recommend specific rating agencies along with their associated
credit ratings that correspond to those of Standard & Poor's and Moody's. This provides more
flexibility than Option A and eliminates the potential weakness mentioned for Option B.
Rationale: This option was selected for the same reasons that Option C was selected for credit
ratings. Again, for bond ratings, the Guidance will recommend the self-insurance ratings from
Standard & Poor's or Moody's and will also mention the alternative of a comparable bond rating
from any NRSRO. The appropriateness of these alternate ratings must be proven by the owners
or operators and will be evaluated at the Director's discretion. Furthermore, EPA clarifies that a
bond rating is only required when it exists (not all third-party providers will have bond ratings).
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 78
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7. Rationale for the Selection of Self Insurance Requirements
This chapter describes EPA's rationale for the selection of various self-insurance test
requirements. The self-insurance requirements described at 40 CFR 146.85 are designed to
ensure that owners or operators have the resources to carry out activities related to closing and
remediating GS sites if needed during injection or after wells are plugged, so that they do not
endanger USDWs and to ensure that the private costs of GS are not passed along to the public.
These self-insurance requirements are based on the historical precedent established by the
detailed guidance "Federal Financial Responsibility Demonstrations for Owners and Operators
of Class II Oil- and Gas-Related Injection Wells" (EPA 570/9-90-003) as well as rule
requirements described at 40 CFR 144.63 for Class I hazardous waste injection wells.
EPA chose to follow precedents by selecting of self-insurance requirements for Class VI wells so
that they closely follow Class I hazardous waste well requirements. Additionally, EPA has
included financial tests from the Guidance for Class II wells that are substantially different from
the financial tests described at 40 CFR 144.63. For owners or operators selecting the financial
ratios test option, EPA is requiring owners or operators to exceed all five ratio thresholds to
ensure the demonstration of their financial health and stability in as many ways as possible.
EPA's approach for the selection of self insurance test requirements is also consistent with the
approached recommended by the Environmental Financial Advisory Board (EFAB). When
charged with the task of recommending financial assurance mechanisms for the new Class VI
wells, EFAB "recommended use of Class I financial assurance mechanisms [based on their]
familiarity with, and belief in, the effectiveness of these mechanisms."188 EPA's approach with
regard to the bond rating test is specifically supported by EFABs primary recommendation 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."189
! Report on Financial Assurance. EFAB. March 2010. Page 6.
' Report on Financial Assurance. EFAB. March 2010. Page 2.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 79
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Financial Coverage Criteria
Table 6.1: Definitions of Financial Coverage Criteria
Financial
Indicators
Net Working
Capital (NWC)
Total Assets
Tangible Net
Worth (TNW)
Requirement
NWC must be at least six times the sum of
the current cost estimates for all required
GS activities.
Assets in the United States must amount to
at least 90 percent of total assets,
or
at least six times the sum of the current
cost estimates for all required GS activities.
TNW must be at least six times the sum of
the current cost estimates for all required
GS activities.
Rationale
Consistency with
Class I Haz Regs at
40CFR144.63(f)(i)(B)and
40CFR144.63(f)(ii)(B)
Consistency with:
Class I Haz Regs at
40CFR144.63(f)(i)(D)and
40CFR144.63(f)(ii)(D)
Six times threshold is established for
consistency with:
Class I Haz Regs at
40CFR144.63(f)(i)(B)and
40CFR144.63(f)(N)(B)
//. Bond Rating Test
Table 6.2: Explanation of Bond Rating Test
Requirement
For an owner or operator to pass the financial test,
EPA recommends that the bond's rating be one of
the four highest categories (i.e., AAA, AA, A, or BBB
for Standard & Poor's or Aaa, Aa, A, or Baa for
Moody's). The owner or operator should also submit
an annual report of its bond rating.
Rationale
Consistency with:
Class I Haz Regs at 40CFR1 44.63(f)(ii)(A)
Class II Guidance
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 80
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///. Financial Ratio Test
Table 6.3: List of Financial Ratios
Type of
Ratio
Debt-
Equity
Assets-
Liabilities
Cash
Return
on
Liabilities
Liquidity
Net Profit
Financial Ratios
Total Liabilities
Net Worth
Current Assets
Current Liabilities
(Net Income + Depreciation
+ Depletion + Amortization')
Total Liabilities
(Current Assets - Current
Liabilities')
Total Assets
Net Profit
Threshold
<2.0
> 1.5
>0.10
>-0.10
>0
Rationale
Consistency with:
Class I Haz Regs at
40CFR144.63(f)(i)(A)
This diverges from:
Lonci term liabilities to net worth
threshold recommended in Class II
Guidance. The total liabilities threshold is
used so that only one debt-equity ratio is
needed and EPA is not specifying the
ideal distribution of current vs. long term
liabilities.
Consistency with:
Class I Haz Regs at
40CFR144.63(f)(i)(A)
This diverges from:
Current liabilities to net worth < 1.0
recommended in Class II Guidance.
Both the Class I and Class II ratios
include current liabilities (one on the
numerator, one on the denominator,
therefore leading to the sign change).
The current assets to current liabilities is
used so that a "current" picture is
created (net worth includes all assets
e.g., current, long term, etc.).
Consistency with:
Class I Haz Regs at
40CFR144.63(f)(i)(A)
Class II Guidance
Consistency with:
Class II Guidance
Consistency with:
Class II Guidance
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 81
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IV. Corporate Guarantee
Table 6.4: Explanation of Corporate Guarantee
Guidance Text
Rationale
The Director might allow the corporate guarantee if it
is issued by a parent corporation that owns at least
50 percent of the subsidiary's voting stock, has been
in business for at least 5 years, and has a net worth
of at least $100 million.
Consistency with:
Class II Guidance, which states:
o A parent corporation must owns at
least 50 percent of the subsidiary's
voting stock
o Companies in business less than
five years or whose net worth is
less than $1 million may be
ineligible for use of financial
statements or blanket coverage
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 82
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8. Evaluation of Minimum Tangible Net Worth
EPA's final rule creates a new Class VI well for the geologic sequestration (GS) of carbon
dioxide. If an owner or operator fails during the life cycle of a GS project, then the project's
environmental liabilities could fall to the public. Liabilities could include corrective action on
wells in the Area of Review (AoR), injection well plugging, post-injection site care, site closure,
and any emergency and remedial responses. To protect the public from the risk of paying for
these financial liabilities, the proposed rule contains specific provisions requiring an owner or
operator to demonstrate and maintain financial responsibility by either securing an instrument
from an independent third-party or by utilizing self-insurance. Self-insure is available to owners
or operators who assure the regulator (and the public) that they are unlikely to fail. To
demonstrate adequate financial responsibility, EPA requires that the self-insuring owner or
operator meet specific financial coverage criteria and pass either a bond rating test or a financial
ratio test. The coverage criteria and tests should ensure that owners or operators are unlikely to
fail and leave the public with a large financial liability. The Director has the discretion to
approve (or deny) an owner or operator's bid to use self-insurance as a demonstration of
financial responsibility. The three coverage criteria and two test options are depicted in Figure
8.1:
Figure 8.1: Coverage Criteria and Tests for Qualifying for Self-Insurance
TNW > k-,
TNW> [Current Value of Costs] x k2
Domestic Assets > min {[Total Assets] x k3, [Current Value of Cost] x k2}
Financial Ratio Test Bond Rating Test
Under 40 CFR 144.63, the coverage criteria parameters for Class I Hazardous wells were set at:
ki = $10M
k2 = 6
k3 = 90%
Although these parameters have applied to Class I Hazardous wells for 30 years, Class VI GS
wells may require more stringent parameters based on the long time periods and large costs
associated with GS. The purpose of this analysis is to reevaluate the ki parameter for the
minimum tangible net worth (TNW) threshold, explore alternative TNW thresholds, and
recommend a TNW threshold for Class VI GS Wells.
Options
In theory, the TNW threshold can be any (non-negative) number, which would yield a continuum
of policy options. The evaluation of a continuum of policy options would require a proposed
regulation and it is beyond the scope of this evaluation; therefore we evaluated 3 discrete options
for the TNW threshold:
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 83
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A. ki = $0: Drop the TNW criterion
B. ki = $10M: Preserve the status quo (i.e., utilize the Class I Hazardous threshold for Class
VI wells)
C. ki = $100M: Increase the status quo by a factor of 10
Objective for Setting TNW
By definition, for any particular owner or operator, independent third-party instruments
always pose a lower risk of failure than self-insurance. This is because when an independent
third-party instrument is in place, both the independent third party and the owner or operator
must fail in order for the financial liabilities to be passed onto the public. In contrast, with self-
insurance, only the owner or operator must fail for the financial liabilities to become the public's
responsibility. Self-insurance is always riskier to the public, but it remains desirable to owners
and operators because it is their lowest cost option. Self-insurance can also be desirable to the
public because it encourages growth of the GS industry by lowering the cost of doing business.
The TNW criterion, like the other criteria and tests, should not hinder the growth of the GS
industry by excluding prospective owners or operators for entry and it should not expose the
public to excessive risk. Therefore, this analysis identifies a TNW value that assures that the
risk born by the public from a self-insured owner or operator is no greater than the riskiest
scenario under independent third-party instruments 19° To determine the appropriate TNW
value, this report evaluates results from an economic model calibrated to data on GS activities
and the owners or operators expected to participate.191
190 This is a departure from the assumption made by other programs.
191 This analysis excludes other criteria for qualifying for self-insurance; these additional criteria would further control the risk of instrument
failure.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 84
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Calibrated Model
Our quantitative model examines the risks to the public under self-insurance against a baseline
level of acceptable risk. The baseline is the risk to public when the riskiest owner or operator (i.e.
an undercapitalized owner or operator that can barely afford to enter the industry) uses an
independent third-party instrument to demonstrate its financial responsibility. A parsimonious
model was designed to capture the following details:
the timing, structure, overhead costs, and failure of independent third-party instruments
the magnitude, timing, and uncertainty of environmental liabilities
the hazard of financial insolvency and how this changes with the owner or operator's size
the role of tangible net worth in driving an owner or operator into insolvency
the effects of environmental liabilities, as well as other leveraging liabilities, on tangible
net worth and hence on insolvency
the stochastic growth of tangible net worth due to the owner or operator's activities both
inside and outside of the GS industry
the timing and structure of GS operations, as well as the risk and return on GS activities
the characteristics of owners or operators (chiefly the distribution of their size and hence
risk) that will participate in the GS industry
The model divides time into 91 periods corresponding to 1 year of the pre-operation phase
during which the owner or operator secures a financial responsibility mechanism, 40 years of the
operation phase, and 50 years of the post-operation phase during which the owner or operator
continues monitoring the site and tending to any stochastic GS events (e.g. emergency and
remedial responses and corrective action). The unit of analysis is the owner or operator.192 The
return on the owner or operator's investment in GS is accrued only during the operating phase.
Stochastic GS events can occur in either of the later periods, certain costs (operational and post-
operational) occur in both of the later periods, and the costs of independent third-party financial
responsibility instruments are paid for in the first period alongside other initial costs.193 During
each period, there is some risk that stochastic GS events or external shocks (i.e. losses/windfalls
from the owner or operator's activities in other markets) will decrease the GS owner or
operator's TNW to the point that the owner or operator becomes insolvent.
To evaluate the model's chief outputs, an Excel workbook performed hundreds of Monte Carlo
realizations (scenarios) on every uncertain variable for every year. The model can simulate the
distribution of its variables, including risk to the public, for each possible TNW. The model
parameters were empirically calibrated to "realistic" values found during careful research. The
greatest sources of uncertainty in these model parameters are the stochastic GS events, the
magnitude of the resulting damages, and the price paid to the owner or operator for each ton
sequestered.194
192 For simplicity, all decisions in the model (e.g. participation in the market, the riskiness of the other profit-making investments in the owner or
operator's portfolio of activities, the amount of dividends to offer to shareholders, etc...) are treated as exogenous -occurring outside of the
model and hence independent of what occurs inside the model.
193 By forcing the owner or operator to pay upfront( in-full) for the 91 years, we circumvent the problem of owners or operators evading liabilities
falling in the post-operation phase. Like several other assumptions, this simplifying assumption is made to keep the model tractable. In reality, the
financial assurance of owner or operator owners or operators will be reviewed periodically, owners or operators may be somewhat allowed to pay
as they go, and financial conditions may dictate a change in instruments or even a complete shutdown in the middle of the operations phase.
194 The risk of leakage into the atmosphere is not explicitly set aside in this model; it is subsumed in the damages from a stochastic GS event.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 85
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Results
Over the course of the 91 year span of the model, no more than 1 emergency and remedial
response events are expected for any single owner or operator. However, based on industry
failure rate data, only 61% of insurance owners or operators are expected to survive the 91 years
due to their other liabilities (a compounding of the 0.6% failure rate of insurance companies, a
hazard which is presumably constant over time). In contrast, just over 97% of trust funds are
expected to survive the entire 91 years modeled. However, the upfront cost of using trust funds
as a form of financial responsibility are so high that it is very unlikely that an owner or operator
would choose to use a trust fund over insurance.195 Consequently, both certain and uncertain
costs get coverage from third-party insurance providers in this model. The owners or operators
that survive this 91 year stretch tend to exhibit exponential growth in their tangible net worth and
their risk steadily falls, along with their expected returns (i.e., their expected growth rate).
A. ki = $0: Drop the TNW criterion
If the GS activity costs for which the owner or operator must demonstrate financial responsibility
are sufficiently high, then the criterion requiring TNW to exceed 6 times that current cost (k2 =
6) makes the TNW threshold of $10M used for Class I Hazardous wells irrelevant. For example,
the current value of costs in our baseline scenario when using independent third-party
instruments is $48M rendering both the $10M and $100M candidate thresholds irrelevant
because both are smaller than 6x$48M = $288M. Moreover, all of the owners or operators
actively involved in demonstration projects have TNW values that are orders of magnitude above
these candidate thresholds (the smallest has a TNW of just over $2,800M or 28 times the size of
the larger threshold). However, there are two good reasons for keeping the TNW criterion. First,
the owners or operators involved in the demonstration projects are the heavily capitalized firms
that can afford to take a risk on these experimental demonstration projects as part of their
research and development. But in the future, there may be lightly capitalized owners or operators
entering the GS market, and such higher-risk firms should not be allowed to self-insure. Second,
the $48M figure in our baseline scenario is a central estimate, but there is considerable
uncertainty around that figure. Real costs could vary by orders of magnitude. Hence, depending
on the actual cost estimates, a $100M or even $10M TNW threshold could separate out lightly
capitalized owners or operators.
B. ki = $10M: Preserve the status quo threshold used by Class I Hazardous wells
A TNW threshold of $10M results in the public bearing a risk from self-insured owners or
operators that can be nearly 14 times higher than the risk from owners or operators that have just
enough capital to afford the independent third-party financial responsibility instruments (which
cost $2.6M, up-front). Therefore, the threshold of $10M clearly fails to accomplish the purpose
of financial responsibility because it exposes the public to excess risk in the baseline scenario.196
195 For a trust fund, the owner or operator would be required to pay the current value (i.e. undiscounted) of all liabilities plus administrative
overhead into a trust. For an insurance contract, the owner or operator could pay only the present value (i.e. discounted) plus the insurer's mark-
up over actuarial fair cost.
196 Allowing an owner or operator with $10M in TNW to self-insure would obviously be riskier if that same owner or operator couldn't even
afford the independent third-party FR instruments.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 86
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Again, this baseline risk is determined from the riskiest owner or operator that can afford
independent third-party instruments and is heavily dependent on uncertain cost estimates.
Likewise, the risk of allowing an owner or operator with $10M in TNW to self-insure also
depends on this uncertain cost estimate.
C. ki = S100M: Increase the status quo by a factor of 10
A TNW threshold for self-insured owners or operators of $100M results in a risk to the public
from a self-insured owner or operator that is roughly equal to the baseline risk from an owner or
operator which is barely able to afford the independent third-party financial responsibility
instruments (which cost $2.6M, up-front).197 Therefore, the threshold of $100M should assure
that the risk born by the public from a self-insured owner or operator is no greater than the
riskiest scenario where independent third-party instruments are used. As mentioned above, this
finding is highly sensitive to the cost estimates and should not be taken as a certainty.
Context
Although a ten-fold increase in the TNW criterion could be seen as a dramatic increase, it should
be put in context. The scale of GS operations (as well as the owners or operators likely to run
them) dwarf the smaller-scale projects for which the $10M TNW criterion was originally set by
the UIC program 30 years ago. The TNW criterion should be judged by the scale of the cost
estimate. A TNW criterion of $100M is small in comparison to $288M, which is the TNW value
equal to six times the cost estimate for covered activities (6 x $48M). Figure 8.2 places the scale
of $100M in context by comparing the TNW criteria in the space of tangible assets versus total
liabilities, as well the participants in demonstration projects.
Figure 8.2: Chart of Criteria Thresholds for Self-Insurance
o
I
$1,000,000
$100,000 -
$10,000 -
$1,000 -
$100
$10
$1
GS Demonstration
Firms
She// Typical Threshold for
Financial Ratio Test*
tatoilHydro
RWEDEANorge
TNW>6*Cost
TNW>$100M
TNW>$10M
$3 $30 $300 $3,000 $30,000
Liabilities (in Millions)
$300,000 $3,000,000
*Typical Threshold for Financial Ratio Test - To plot this threshold in this space, we have assumed that 90% of total assets are tangible (and the
fraction of total assets that are current equals the fraction of total liabilities that are current). The plotted points are the actual (Liabilities,TNW) of
the GS demonstration owners or operators; their tangible assets range from 88% of their total assets (for RWE DEA Norge and StatoilHydro,
both headquartered in northern Europe) to 99% of their total assets (for Sonatrach headquartered in Algeria).
197 The limited simulation produces a flat risk profile between S75M and S165M as a result of a finite number of realizations. With a larger
simulation, that flat interval would narrow, presumably around S100M.
Research and Analysis Supporting Financial Responsibility Requirements and Guidance 8 7
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Appendix A: Costs to the Owner or Operator for each Mechanism
Trust fund: Funds must be paid into the trust to cover the total estimated costs of the GS activity.
Additionally, the owner or operator pays a fee for the administrative services provided by the
trustee. Overhead costs will be case specific, but are estimated at 2 percent of the total cost of the
activity. Annual costs will be determined by the trust fund's pay-in schedule if a pay-in period is
allowed.
Letter of credit: The owner or operator pays fees to obtain letters of credit and may be required
to set aside substantial collateral to secure the instrument. The annual fee for a standby letter of
credit is estimated at 1.5 to 2 percent of the total cost of the GS activity. If letter of credit is
utilized, the interest rate is typically at the market rate (prime plus a percentage determined by
the bank), estimated at 4 to 8 percent. The financial health of the purchaser will determine the
interest rates, and whether collateral or deposits are required. Letters of credit are also classified
as an accounting liability, and their relative costs may include limits to borrowing power.
Additional overhead costs may be incurred to maintain a standby trust, if required.
Surety bond: The owner or operator pays annual premiums to a surety company and generally is
required to provide substantial cash collateral. Premiums average 2.5 percent, although the costs
could range from 0.5 percent to 15 percent of the total cost of the GS activity, depending on the
financial solvency of the owner or operator and the risk associated with the project's activities.
Financial institutions emphasize prequalification. Typically, the premium would be paid based
on the face value of the bond; premiums are often based on a sliding scale rate and need to be
paid up front.
Insurance: Costs for the owner or operator can vary based on the type of insurance.198 Finite or
fully-funded policies (which resemble trust funds and therefore limit risk to the insurer) present
higher costs to the owner or operator than do conventional insurance policies. The cost of
insurance is a premium established by the policy underwriter's assessment of site-specific risks.
The price reflects the likelihood of a range of possible claims. Insurance may also have a fee for
an initial risk assessment.
Financial Test and Corporate Guarantee: The financial test and the corporate guarantee are the
lowest-cost options for companies because they do not have to set aside funds for future
payments or pay fees or premiums to third parties. Therefore, total costs are estimated at less
than 0.5 percent of the GS activity cost. These instruments are based on an assessment of
company worth and do not require backing by a third party or the company to set funds aside.
Escrow account: Funds must be paid into the escrow account to cover the total estimated costs of
the GS activity. Additionally, the owner or operator pays a fee for the administrative services
provided by the escrow agent. Fees are estimated at less than 2 percent of the total cost of the
activity, depending on the amount of money held in escrow. Fees are paid to a third-party
administrator annually, and depending on how the account is managed (entirely liquid, or some
198 Captive insurance, where the insurer is an owner or operator's parent or sibling firm, inherits the risks of self-insurance because the insurance
company is not owned by a third party. Captive insurance is excluded from this discussion.
Appendix A: Costs to the Owner or Operator for each Mechanism 8t
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low-risk investments) it may accrue interest to cover the administrative costs defined in the
escrow agreement.
Appendix A: Costs to the Owner or Operator for each Mechanism 89
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Appendix B. Technical Description of Geologic Sequestration (GS) Financial Responsibility
(FR) Model
Core Model
The model divides time into 91 periods corresponding to 1 year of the pre-operation phase
during which the owner or operator secures a financial responsibility mechanism, 40 years of the
operation phase during which the firm evens profits from injecting CC>2, and 50 years of the post-
operation phase during which the owner or operator continues monitoring for an tending to any
emergency and remedial response (ERR) events. The following table illustrates the timeline:
Year
Phase
GS Activities
Period 0
Pre-operation
Securing Financial Assurance
Instrument(s)
Period 1
Period 40
Operation
GS injections, monitoring, responding to
ERR events
Period 41
Period 90
Well Plugging (year 41 only)
Post-operation
Site-care
(monitoring and responding to ERR
events)
At each point in time t, the owner or operator inherits an initial tangible net worth (TNW) of At
199
from its past activities, in the form of At assets and no liabilities. To leverage these assets, the
owner or operator then borrows additional capital, which shows up as liabilities in the firm's
balance sheet:
The owner or operator invests its assets and its borrowed capital, At + Lt, in productive activities
that consume the capital in the process. The investment in the productive activity returns
stochastic revenue:
199 Although we do not explicitly introduce optimization decisions made by firms in this model in order to remain parsimonious, the model is
consistent with the standard sort of investment model sketched by Hubbard (1998) and presented in corporate finance textbooks (e.g. Tirole
(2006) or Ross, Westerfleld, and Jaffe (2008)).
Appendix B. Technical Description of TNW Mode I
90
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Where Pt is the productivity of the capital. The owner or operator will survive only if it remains
200
solvent. Let St be a binary variable indicating if the owner or operator is solvent at the end of
period t. The solvency condition is given by:
Where 1 { } is an indicator function equal to 1 when its argument is true and TO is the interest rate
that lenders charge the owner or operator (which will be made a function of the firm's credit risk
below). If the owner or operator's revenue is sufficient to pay off the principal and interest on its
liabilities, then the remainder of the firm's revenue is reinvested as next period's initial net
worth:
Survival is uncertain because the productivity of the owner or operator's working capital, Pt, is
stochastic. The distribution of productivity is log-Cauchy, yielding a closed-form for the
probability of failure:201
Where 8 is the median productivity and yis Vz of productivity's interquartile range.202 A critical
stylized fact for this model to capture is that smaller owners or operators experience productivity
shocks with a higher median and greater volatility than larger firms.203 In order to make the
model sufficiently flexible to capture this stylized fact, we let the median and volatility of
productivity shocks vary with the firm's size:204
8-
200 This solvency condition should be interpreted as a level of tangible net worth below which the firm is unwilling, or unable, to finance a
continuation of its operations. Instead, bankruptcy is either the better option or the only option. In general, the solvency threshold would depend
on the transactions costs of bankruptcy, as well as short-term options for financing the cash flow shortage (and these financing options depend on
a variety of financial variables).
201 Because a normal distribution is convenient for many models of investment returns, e.g. the classic option-pricing model of Black and Scholes
(1973), it is often used in models of investment returns and even in models of credit risk, e.g. Hillegeist et al. (2004). However, it is well known
that the normal's kurtosis is inadequate for modeling investment returns. In the context of this sort of dynamic model, a sufficiently large
probability of failure is only possible by giving the normal such a large variance that most firms grow at an implausibly high rate. Following the
suggestion of Mandlebrot and Hudson (2004), we employ the Cauchy distribution which has much fatter tails while concentrating more
probability mass around the median.
202 Note that the central tendency (median) and variability (volatility = IRQ/2) are measured in different units from the normal distribution, for
which practitioners usually refer to mean and variance. For the Cauchy distribution, the tails are so fat that the mean and variance do not actually
exist. Although they may appear quite different on the surface, the Cauchy and Normal distributions are closely related. Both the Cauchy and the
Normal are particular members of a broader parametric class of distributions known as Stable Distributions for which the distributional family is
closed under convolution. See Nolan (2009) for more on Stable Distributions.
203 In addition to being a presupposition of there being a TNW requirement for self-insurance, documented empirical evidence of this stylized fact
dates back at least as far as Hall and Weiss (1967).
204 Without allowing 8 and yto vary by firm size, the empirical relationship between At and Lt (coupled with the observed survival probabilities
and growth rates) would rigidly box this model into a corner where it would fail to allow sufficient variation in productivity shocks by firm size.
Appendix B. Technical Description of TNW Model 91
-------
Where the second equation comes directly from the Capital Asset Pricing Model (CAPM), rF is
the long-run rate of return on a "risk-free" asset, rm is the long-run average (across the market)
rate of return on private capital, and (3 is the mark-up in the owner or operator's interest rate due
to its riskiness relative to the market.205 Describing the relationship between (3, y, and A
introduces three additional parameters: 61 describes how volatility changes with the owner or
operator's risk factor (its (3), 62 describes the elasticity of (3 with respect to the firm's size, and 63
determines the firm size at which (3 is I.206
Self-Insurance
At time 0, the owner or operator must make a financial responsibility demonstration. If its TNW
exceeds the minimum threshold, then the owner or operator can use self-insurance to make a
financial responsibility demonstration that is good enough to cover the lifetime of the site.207 We
assume that a self-insurance demonstration is (virtually) costless for the firm.208 From period 1 to
period 40, the owner or operator can inject Q tons per year at a certain cost of Ct in the CAPM, and its failure risk.
206 In practice, we will calibrate 63 so that it is the mean of the logged distribution of firm size across the GS industry, with the assumption that the
distribution is log normal with mean |I and standard deviation o. This assumption is standard in the literature on the distribution of firm sizes
within an industry - see Cabral and Mata (2003).
207 The TNW requirement is a necessary condition for using self-insurance but not a sufficient condition. There are more conditions, referred to as
financial tests, which further control the public's risk exposure due to self-insurance. Likewise, the director has some discretion in allowing third-
party assurance mechanisms and that is also not included in this simple model. Moreover, these requirements are revisited periodically. However,
the model becomes increasingly complicated if these details are included.
208 EPA recognizes that self-insurance is not without cost. Self-insurers may utilize captive insurers or seek other means of diversifying risk that
are costly. However, the demonstration of self-insurance itself is assumed to be a minor cost.
Appendix B. Technical Description of TNW Model 92
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Where the parameters (a, P) produce a skewedness in-line with expert judgment, while
satisfying:
We model the uncertain costs of CA events as the simple product of the occurrence of a CA
event that year, MtCA, and a constant cost for that event, ACA:
UtcA = ^CAMtCA
For years 41 through 90, the owner or operator does not earn any revenue from injection but is
still obligated to pay for certain costs at the site, Ct>4o, as well as any costs from ERR events.
If the owner or operator fails for whatever reason, be it from an exogenous productivity shock or
an ERR event, then the public must pay for the dissolved firm's environmental obligations. We
assume that if an owner or operator fails during years 1 through 40, another operator or owner
will continue to operate the plant for the remaining operable years.209 The public will not pay for
post-operation expenses until year 41. The expected discounted risk to the public of a self-
insured owner or operator is given by:
90 ( i Y
E(D | Self) = Z [E(DERRMtERR)CNP,+ACAE(MtCA) + Ctl{t > 40}]fr(St = 0 | At)
Where D on the left hand side is the expected damages (risks to the public) and r* is the socially
optimal discount rate, which is necessary in order to sum liabilities that are spaced over time.
Third-Party Instruments
If the owner or operator's TNW is beneath the minimum threshold, then it cannot use self-
insurance to make its financial responsibility demonstration. Instead, in period 0, it must
purchase third-party instruments for demonstrating financial responsibility over the course of the
lifetime of the site. The simplest third-party instruments to model are those that pay out so long
as the third-party is solvent, regardless of whether the owner or operator has failed. Hence, we
use insurance for the uncertain costs due to ERR and CA events as well as for the certain costs in
the post-operation phase. The cost of these instruments is actuarially fair, plus a percentage
markup over that actuarial fair cost: 21°
i
K1N = 0 + *)l __ [E(DERRMtERR)CNP,+&CAE(MtCA) + Ctl{t > 40J]
These third-party instrument providers can, themselves, fail. We have modeled the failure of
third-party instrument providers as a (statistically independent) constant hazard rate over the
209 This assumption lowers the financial risk to the public substantially. Without this assumption the TNW would need to be increased by a factor
of 10 to equate risk.
210 This model of insurance is extremely simplified. For instance, the model has no caps on claims, no annual premiums, no copay, no deductible,
no exceptional clauses, etc.
Appendix B. Technical Description of TNW Model 93
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horizon of the model. In order for the public to bear the risk, both the third-party instrument
provider and the owner or operator must fail. Once again, we assume that the public will not pay
for post-operation expenses until year 41. Hence, the expected discounted risk to the public of an
owner or operator with a third-party instrument is given by:
90 ( i Y/
E(D | 3rd) = £ ((\-qy[E(DERRMtERR)CNPV+ACAE(MtCA) + Ct\{t > 40J])Pr(^ = 0 | At)W
(=o V1 + r J
here q is the probability of an insurance provider surviving the year. As can be seen from these
two equations for risk, third-party instruments pose a lower risk than self-insurance for any given
owner or operator. However, because risk is decreasing in the owner or operator's size, there
exists a level of TNW above which the risk to the public is lower than the riskiest firm that can
afford the cost of third-party instruments. 2n
References
Black, Fischer and Scholes, Myron. 1973. "The Pricing of Options and Corporate Liabilities".
The Journal of Political Economy, Vol. 81, No. 3, pp. 637-654.
Cabral, Luis M. B. and Mata, Jose. 2003. "On the Evolution of the Firm Size Distribution: Facts
and Theory". The American Economic Review, Vol. 93, No. 4, pp. 1075-1090.
Campbell, John Y.; Hilscher, Jens; and Szilagyi, Jan. 2008. "In Search of Distress Risk". The
Journal of Finance, Vol. 113, No. 6, pp. 2899-2937.
French, Craig. 2003. "The Treynor Capital Asset Pricing Model". Journal of Investment
Management, Vol. 1, No. 2, pp. 60-72.
Hall, Marshall and Weiss, Leonard. 1967. "Profitability and Firm Size". The Review of
Economics and Statistics, Vol. 49, No. 3, pp. 319-331.
Hillegeist, Stephen A.; Keating, Elizabeth K.; Cram, Donald P.; and Lundstedt, Kyle G. 2004.
"Assessing the Probability of Bankruptcy". Review of Accounting Studies, Vol. 9, pp. 5-34.
Hubbard, R. Glen . 1998. "Capital-Market Imperfections and Investment". Journal of Economic
Literature, Vol. 36, No. 1, pp. 193-225.
Mandlebrot, Benoit and Hudson, Richard. 2004. The (Mis)behavior of Markets: A Fractal View
of Risk, Ruin, and Reward. New York: Basic Books.
Nolan, John P. 2009. "Stable Distributions: Models for Heavy Tailed Data." Draft available for
download from the American University Department of Mathematics and Statistics.
211 We should note that this model is quite simplified, by necessity. What it fails to address could potentially alter the recommended TNW
requirement. For instance, the model does not explicitly model the optimizing decisions made by firms, including the decision to participate in
GS. Also, many heterogeneous aspects of both GS activities and GS firms have been neglected entirely here. Importantly, the probability of a
third party's failure is not likely to be independent of all other shocks. Finally, this model neglects the effect of allowing self-insurance on
markets: it exacerbates the competitive advantage of larger firms and it skims the third party insurance market's risk pool of the least risky firms.
Appendix B. Technical Description of TNW Model 94
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Ross, Stephen A.; Westerfield, Randolph W.; and Jaffe, Jeffrey. 2008. Corporate Finance, 8
edition. New York: McGraw-Hill/Irwin.
Tirole, Jean. 2006. The Theory of Corporate Finance. Princeton: Princeton University Press.
,th
Appendix B. Technical Description of TNWModel 95
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Appendix C. Calibration of GS FR Model Parameters
The set of parameters to be calibrated appear in the following table:
Description
Quantity of CO2 sequestered by GS Operation
Certain Costs of GS During Operation (all costs other than
ERR)
Average cost of an ERR event
Expected number of ERR events per site
Certain Costs of GS After Operation
Price paid per ton of CO2 sequestered by a GS Operation
Overhead cost for trust fund
Overhead cost for insurance
Average rate of return in private capital markets
Average rate of return on risk free asset
Interest rate on trust fund investments
Interest rate used by insurance investments
Socially optimal discount rate
Liabilities as a fraction of Assets, given unitary elasticity
Leveraging Elasticity Parameter
Insolvency rate for insurance
Insolvency rate for trust funds
Baseline Average Insolvency rate for Owners/Operators
Elasticity of Beta to TNW
Beta Risk Factor
TNW level with unitary Beta Risk Factor
Mean ln( Assets) of owners or operators in Industry
Standard Deviation of ln( Assets) of owners or operators in
Industry
Parameter on the stability distribution (2 = normal, 1 =
Cauchy)
Parameter
Q
Ct<41
A
X
Ct>40
P
KTF
KIN
rm
rF
TTF
TIN
r*
bo
bi
1-qiN
1-qiF
1-qoo
61
e2
e3
n
G
a
To describe how these parameters are calibrated, we take them one block at a time.
Appendix C. Calibration of GS FR Model Parameters
96
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1. Of the first block of parameters, Q, Ct<4i, and Ct>4o are taken from the cost model that EPA is
developing to estimate to impact of the GS rule.
Description of certain costs:
Cost
Certain Costs of GS Before
Operation (Ct=o)
Certain Costs of GS During
Operation (all costs other than
ERR/CA) (Ct<4i)
Certain Costs at Well Plugging
(CtMo)
Certain Costs of GS After
Operation (Ct>4o)
Annual Amount (MS)
45.8
4.2
0.8
0.8
Description
One-time costs incurred in the
pre-orientation phase (year 0).
Average annual costs incurred
in the operation phase (years 1
through 40).
One-time costs incurred in the
well plugging phase (year 40).
Average annual costs incurred
in the post-operation phase
(years 41 through 90)
Source: All certain cost estimates are from the EPA's "Cost Analysis for the Federal Requirements Under the Underground Injection Control
Program for Carbon Dioxide Geologic Sequestration Wells" (816-R-10-013).
Our estimate for P (the price paid per ton of CO2 sequestered during the life of a GS operation) is
based on a rate of return equal to 7 percent of total capital costs. The rate of return is set so that
owners or operators get a fair return (equal to rm) on their cost outlays. Given that Q (quantity of
CO2 sequestered by a GS operation) is equal to 1.8 million tons, P is equal to the quotient of total
revenue and sequestered tons of CO2:
P = (l+rm)K/Q
Where K is equal to total capital costs. The estimate for Q is taken from the EPA's cost model.
Both A and k were increased to reflect our best professional judgment of the full range of
damages.
2. The overhead costs of trust funds were taken from the Fall 2009 Tangible Net Worth Issue
Paper. The overhead costs of insurance were assumed to be the same.
3. The long-run interest rates come from OMB's standardized instructions for conducting
economic analyses. Roughly half are 3%, reflecting the long-run average rate of return on
treasury bills and the other are 7%, reflecting the long-run average rate of return on private
capital.
4. The leveraging parameters (bO,bl) get their values from rounding off an estimation of those
parameter values for liabilities regressed on assets using the 4 largest firms involved in GS
demonstration projects (Shell, BP, ExxonMobil, and Chevron) using the data that appears in the
Fall 2009 Tangible Net Worth Issue Paper.
Appendix C. Calibration of GS FR Model Parameters
97
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5. The survival probabilities [q, QTF, qoo] were taken (respectively) from A.M. Best Financial
Strength Rated Insurance Company Impairments, a RCRA issue paper, and from The Dun and
Bradstreet Corporation's Annual Business Failure Record using the oil and gas industry as a
proxy for the GS industry. This third probably is not a direct input to the model but gets used in
the estimation of other model parameters.
6. Because inspection of publicly available estimates of (3 for oil firms hovered around 1 (with
the largest firms being below 1), we set 63 to |i, the mean of the log of the distribution of firm
sizes. Both 61 and 62 were estimated in a multi-step procedure that also involved estimating |i
and G. The first step involved centering the prior distribution on the beliefs of the |l and o
parameters using a method of moments (GMM) matching to the moments for firm failure
conditional on TNW reported in a RCRA issue paper. In the second step, the prior number of
firms in the GS industry was centered on the MLE of the number of firms in the industry using
the 4 largest firms listed in the Fall 2009 TNW Issue Paper as the top 4 order statistics (of draws
from the log normal distribution using the |l and G estimates from the initial GMM procedure).
With flat priors around these center points, Bayesian updating was performed on these prior
distributions using the 4 order statistic data points. This resulted in our final estimates of |l and G.
Given those estimates, we then fitted 61 and 62 using a GMM procedure to fit the mean failure
rate for owners and operators.
Appendix C. Calibration of GS FR Model Parameters 98
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