Bio Intelligence Service, European Commission (DG ENV) Final Report November 2009(55) ; Pages 68-73 :
Alternative Financial Security Instruments
1) Assessment of stakeholders
2) Overview of different instruments
2.1) Financial test and corporate guarantee
2.2) Trust funds
2.3) Letters of credits – Bank guarantees
2.4) Surety bonds
2.5) Escrow agreements
2.6) Governmental schemes
3) Alternative Financial Security Instruments versus Environnemental Insurance
As discussed above, when it comes to financial security instruments to cover ELD
related liabilities, MS as well as operators largely concentrate on insurance as opposed to
alternative products. Among operators, for example, more than fifty percent stated that they
were not aware of financial security instruments other than insurance to cover ELD-related
liabilities. The perception seems to be that alternative instruments would need to be developed
especially for ELD-related liabilities, as was the case for insurance products, though in fact
many of these instruments already exist and can be used for this kind of risk with no or
limited adaptation efforts. Furthermore, financial security instruments other than insurance
have the potential to cover a number of the gaps and limitations discussed above. However, in
many cases, these instruments are less easily available to SMEs than to larger companies as,
for example, they might require the operator to set aside substantial amounts of money (as for
escrow agreements) or be directly linked to the net working capital of a company (as for
corporate guarantees). Availability of these kinds of instruments to SMEs can be expected to
decrease further in times of economic crisis.
1) Assessment of stakeholders
MS named bank guarantees as the most interesting alternative to insurance products.
However, only three MS were in a position to name providers of this kind of instrument
(compared to 13 who were in a position to name three providers of ELD related insurance
products). Furthermore, only a limited number of MS could assess whether this kind of
alternative financial security instrument was readily available in their country to all types of
companies (including SMEs). Out of those who did answer this question four MS were of the
opinion that these instruments were indeed readily available (Bulgaria, Estonia, Netherlands
and Sweden) compared to two MS that were not (Czech Republic and Hungary). Among
operators, more than fifty percent stated that they were not aware of any financial security
instruments other than insurance to cover ELD-related liabilities. Among those operators who
were aware of other forms of liability cover, most named bank guarantees as well as parent
company guarantees as the most important ones. Insurers and brokers also mentioned bank
guarantees as the most pertinent alternative to insurance to cover ELD-liabilities, followed by
self-insurance.
2) Overview of different instruments
There exist a large number of different instruments that could be of interest in the
context of ELD-liability cover. The choice of instruments discussed below is largely based on
the most commonly used alternative security instruments in the USA as well as those most
frequently named by stakeholder groups of this study as pertinent alternatives to insurance in
the European context.
2.1) Financial test and corporate guarantee
The financial test and corporate guarantee are available only to larger regulated
companies or regulated companies with a large parent or other affiliate. The financial test
generally includes criteria to determine a minimum level of the regulated company’s net
working capital or net worth, a minimum level of its current assets to its current liabilities, a
minimum ratio of net income or tangible net worth to the estimated costs of complying with
required works, a minimum rating for the company’s bonds by a recognised rating company,
and the location of a substantial proportion of the company’s assets in the relevant
jurisdiction. The net worth of a company is its total assets minus its total liabilities, that is, the
equity of shareholders in the company. The working capital is the company’s current assets
minus its current liabilities. A company that has an investment grade bond rating in the USA
may satisfy one criterion of the financial test by using tangible net worth. A company that
does not have investment grade bond rating must satisfy the criterion by evidence of its net
working capital. The data provided by the regulated company must be supported by a report
from an independent auditor. A corporate guarantee enables a company with a large parent or
other affiliated company to provide the above evidence regarding its parent or other affiliate
on behalf of the regulated company.
A governmental authority’s acceptance of the above mechanisms is based on its
satisfaction that the regulated company’s, or its affiliate’s, financial strength sufficiently
minimises the likelihood that public funds will be required to pay to remedy environmental
damage or other harm caused by the regulated company. Another reason in respect of very
large regulated companies is that the third party from which the company would obtain
financial security could be less financially viable than the regulated company itself.
Companies that satisfy the financial test or corporate guarantee can do so at low cost because
they do not have to purchase a financial security mechanism from a third party. The
competent authority, however, must regularly monitor the company’s financial position to
ensure its continued financial viability and its potential failure. As discussed above, the
continued use of the financial test and corporate guarantee in the USA has been questioned
and enforcement of them has increased.
2.2) Trust funds
A trust fund is administered by a trustee on behalf of a beneficiary, to which the
trustee owes a fiduciary duty. The beneficiary of a trust fund for environmental liabilities, into
which the regulated company has placed assets, is the governmental entity. The assets may
include a letter of credit. Legislative provisions permitting the use of trust funds as financial
security mechanisms in the USA may specify the express or minimum format of the deed of
trust. They typically require the trust fund to be irrevocable in order to prevent the regulated
company terminating it without the agreement of the governmental entity.
2.3) Letters of credits – Bank guarantees
A letter of credit which may be used as a financial security mechanism for
environmental liabilities is an agreement by the financial institution that issues it to pay
money from it to the governmental entity when requested to do so by the entity. The financial
institution bases a decision to issue a letter of credit on the creditworthiness of the company to
which it is issued. The institution may require the company to provide collateral in the form
of securities, bonds or other monetary instruments for the entire face value of the letter of
credit. In the USA, letters of credit used as mechanisms for financial security provisions in
environmental legislation must generally be irrevocable.
A bank guarantee differs from a letter of credit in that the amount of the guarantee is
only paid if the regulated company does not fulfill stipulated obligations. A problem may
arise if the regulated company cannot obtain financial security mechanisms such as letters of
credit or bank guarantees due to economic circumstances. Indeed, the current economic crisis
has resulted in some US companies that traditionally met financial security requirements by
letters of credit purchasing insurance policies to do so instead because of the difficulty in
obtaining the former.
2.4) Surety bonds
Surety bonds are instruments under which banks and other financial institutions
(including insurance companies), agree to pay a certain amount in case a regulated company
(or other person) does not or is not in the position to pay itself.
Performance as well as payment bonds are used as evidence of financial security for
environmental liabilities. A performance bond covers the cost of completing the specified
works; a payment bond provides the necessary funding to do so. If the surety for the bond is a
lending institution, the regulated company’s borrowing capacity is affected because the bond
is offset against its borrowing facilities. If the surety is, say, a subsidiary of an insurance
company, its decision to issue the bond is based on the regulated company’s creditworthiness
and may include a charge on the company’s assets or the requirement for a guarantor.
Legislative provisions mandating financial security in the USA may set out the express, or
minimum, terms and conditions of the agreement establishing the bond. Typical terms and
conditions provide for the governmental entity to step into the shoes of the regulated company
if it defaults on its obligations to the entity.
The availability of bonds is affected by economic conditions. For example, during the
early 2000s, some surface mining companies in the USA were unable to obtain bonds for
reclamation works due to the withdrawal of sureties from the market. The problem may be
particularly acute for bonds that must be provided for lengthy periods, in some cases over
fifty years, for the post-closure period of a landfill.
2.5) Escrow agreements
Under an escrow agreement, deposits are made with a third party, such as a bank, that
can only be released under conditions pre-determined in the agreement. This kind of
agreement ensures that the necessary means will be available for preventive or remedial
measures, provided that the amount in escrow has been adequately calculated. A disadvantage
of this kind of agreement, as with letters of credit, bank guarantees and bank surety bonds, is
that it requires the operator to set aside a substantial amount of money, which might make this
a difficult option for SMEs.
2.6) Governmental schemes
The legislation requiring financial security for environmental liabilities may, in some
cases, establish or enable a scheme by which regulated companies may meet the requirements
if commercial financial security mechanisms are generally unavailable.
The legislation may, for example, establish a fund into which taxes levied on the regulated
companies themselves or other persons are paid. An example in the USA was the
establishment of state funds during the 1990s to enable owners and operators of USTs to
provide evidence of financial security in respect of environmental damage from their USTs.
Many of the USTs were already leaking and, thus, required replacement under the applicable
legislation, which made the financial security requirements particularly difficult to apply. The
EPA and state environmental agencies were concerned that many small petrol stations would
have to close because, although insurers had developed and offered policies to cover the
financial security requirements, they (obviously) only offered policies to satisfy the
requirements to owners and operators whose USTs had been tested to ensure that they did not
leak.
Monies for the funds were generally raised by taxing petrol introduced into, delivered
or sold in the state and by annual registration fees on the ownership and operation of USTs.
Most funds quickly became insolvent due to the large number of claims to clean up
contamination from USTs. Another major problem was the effect of the funds on policies
offered by insurers to satisfy the requirements due to the lack of interest in such policies
whilst the funds existed. Another problem with funds is that they do not encourage regulated
companies to reduce environmental risks from their operations
3) Alternative Financial Security Instruments versus Environnemental Insurance
As became evident in the discussion above, the difference among alternative financial
security instruments is significant. Their use in covering ELD-related liability in comparison
to insurance products will depend largely on the individual situation of an operator, such as its
sector, its assets, risks, etc. An in-depth comparison of different financial security instruments
to cover ELD liabilities is beyond the scope of this study.
However, this section aims at providing a preliminary and very basic understanding of
the different factors that will play a role in this analysis.
The deciding factors in whether an instrument is appropriate in the context of ELD liability
cover are the following:
– Will the instrument ensure that environmental damage will be remediated or prevented
at the operator’s costs, i.e. will it ensure the effective implementation of the polluterpays
principle that is at the heart of the Directive?
All financial security mechanisms that are obtained from a third party, such as a bank or a
surety company, and all corporate guarantees are subject to the limit specified in the
mechanism or guarantee, a limit that must be determined prior to a potential incident. There
is, therefore, a risk that the pre-determined amount will not suffice for full remediation. In the
case of self-insurance such as financial test, no company can provide that unlimited funds will
be made available because, obviously, no company has unlimited assets. ELD-related
insurance cover will provide the means to remediate environmental damage. However, as
discussed above, this is limited to the activities that insurers are willing to cover, the agreed
liabilities, the agreed level of indemnity, etc. Insurance can therefore be an effective way of
meeting the cost of remediating environmental damage, subject to its limitations.
Alternative financial security mechanisms, such as escrow accounts, surety bonds, letters of
credit and bank guarantees are, as indicated above, subject to the amount of the mechanism.
Further, their use might be limited if operators experience difficulties in obtaining them.
One means to ensure a specified level of financial security for all mechanisms would be to
establish minimum levels of financial security required for ELD liability, as in the USA (see
section 1).
– Will it be available to operators (with a special focus on SMEs) at reasonable costs
and conditions, as required in Article 14(2) of the Directive?
As discussed above, insurance premiums are generally regarded by the different
stakeholder groups as commensurate to the service provided. Furthermore, a reduction in
premiums is not generally seen as a factor that could increase the take-up of ELD-related
insurance products. It should be kept in mind that insurance premiums are tax deductible.
On the other hand, there are a number of alternative financial security products, such as the
financial test and corporate guarantee that are not generally available to SMEs. They might,
however, make financial sense for larger companies, e.g. as no insurance premiums need to be
paid. As discussed (previously), however, any legislative provisions authorising such
mechanisms must ensure their adequacy and continued viability.
– Will the instrument be effective in preventing pollution by providing an incentive to
operators to limit it?
A financial security instrument will only provide incentives to prevent an incident, if the
related charges are linked to the specificities of the operator, such as the risk management
scheme in place or preventive measures that are taken. Insurance premiums, for example, will
depend on these operator-specific issues and can therefore be expected to provide the
necessary incentives.
Funds, however, which are based on the levy of taxes or equal contributions of all
participants irrespective on their individual situation, do not encourage operators to take
measures to reduce environmental risks beyond what is legally required.
It becomes clear from the above, that the decision for insurance or an alternative financial
security instrument (or a combination of these) will need to be made on a case-by-case
basis. Nevertheless, further research into the different instruments currently available in
the EU based on the three criteria outlined above, could significantly facilitate the
decision-making process for operators. In addition, as discussed above, only a financial
security instrument that actually leads to the remediation or prevention of environmental
damage at the operator’s costs will ensure the effective implementation of the polluterpays
principle. Further research into the identification of those instruments can help the
European Commission and/or MS to promote the ones that are most effective in
implementing the ELD and the polluter-pays principle.
55 Bio Intelligence Service, “Study on the implementation effectiveness of the environmental liability directive
(ELD) and related financial security issues”, [Contract Reference: 070307/2008/516353/ETU/G.1]