# Underground Injection Control (UIC) Class VI Program

Research and Analysis in Support of
UIC Class VI Program Financial Responsibility Requirements and Guidance

December 2010Office o f Water (4606M)

EPA 816

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December 2010 http://water.epa.gov/drink/Contents

1. Introduction .................................................................................................................. ........... 5

2. Summary of April and May 2009 Financial Responsibility Webcast Discussions ................ 6

3. Research and Analysis on Financ ial 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 Responsib ility Instrument Selection ............................................... 59

I. Introduction .................................................................................................................. ..... 59

A. Summary ..................................................................................................................... 5 9

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 Recogni zed 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 cap ital requirements .................................................................. 76

C. Minimum capital standards pr escribed by the appropriate Federal banking agency .. 76

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 2D. Successful completion of the new compre hensive stress test for banks ..................... 77

IV. Ability to pass the bond rating when applicable ............................................................... 77

A. Financial ratios consistent w ith the bond rating test requir ements 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 Descript ion of Geologic Sequestration (G S) Financial Responsibility (FR) Model..................................................................................................................... ............... 90 Appendix C. Calibration of GS FR Model 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 w ith the third party’s financial stability

determination?................................................................................................................. .............. 17

Table 3.3: Under what conditions are the full esti mated costs not covered? Does the mechanism manage uncertainty in cost? ................................................................................................... ....... 18

Table 3.4: What factors drive the costs associated with the secu ring/maintaining the instrument?

What is the relative cost of the inst rument to the owner or operator? .......................................... 19

Table 3.5: What is the historic al use of the instrument? For environmental obligations? ............ 20

Table 3.6: Under what scenario is the instru ment best or most commonly utilized? ................... 21 Table 3.7: Which conditions may lead to instru ment 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/l ess 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 th e specific weaknesses of an instrument be minimized by combining it with another mechanism? ................................................................. 27 Figure 4.1: GS Proj ect Activities ............................................................................................. ..... 59

Table 4.1: Instruments Best Suited for GS Activities ................................................................... 60

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 3Table 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 Thre sholds for Self-Insurance ......................................................... 87

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 41. Introductio n

This document provides some of the supporti ng 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 intend ed to provide insight for the Program’s Directors, Geologic Se questration (GS) well owners oroperators, independent thirdparty providers, and the genera l 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 af ter 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 cost s of GS are not passed along to the public. This

docum ent describes the following researc h, analysis, and stakeholder input:

• Summary of Financial Respons ibility W ebcast Discussions

• Research and Analysis on Fina ncial Responsibility Instruments

• Rationale for Financial Respons ibility Instrum ent Selection

• Presentation on Financial Responsibility to Grou nd Water Protection Council

• Rationale for the Selection of Third Pa rty Stability Evaluation Recomme ndations

• Rationale for the Selection of Self Insurance Test Requirements

• Evaluation of Minimu m Tangible Net W orth

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 52. 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 wa s to encourage information sharing on potential financial mechan isms that well owners and operators could use to meet the financial responsibility requirement s for GS projects. EPA used the information gathered through the webcast series to inform its decisions as it devel oped guidance related to financial responsibility for GS wells. The webcasts addressed the following topics:

• Trust Funds, Letters of Credit, and Surety Bonds with Standby Tr ust Agreem ents (April 28, 2009)

• Insurance (May 20, 2009)

• Self-Insurance : Financial Test a nd C orporate 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 Ag ency cannot implement some of the financial

assurance mechanisms described in these we bcasts 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 webcas t 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 · Small operators commonly use them with standby trusts. · May be easier to obtain than other instruments. · Used regularly and they work fairly well.

Standby Trusts · 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.

Letter of Credit · In areas with many Class II wells, banks may be accustomed to issuing them. · Typical for small ope rators in at least one Region. · Three participants said they are freq uently used during permitting because they are easy for operators to obtain and administer. · Work fairly well and are less of a burden for implementation.

Surety Bond · In areas with many Class II wells, banks may be accustomed to issuing surety
bonds. · May be use d 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 6Insurance · Commercial scale implementation will reassure mainline carriers who fear losses, so that they will start to ac cept risk of GS projects.
· FutureGe n, which was sited but then canc elled, proposed insurance as a financial mechanism. Similarly the state of Texas chose insurance, which eliminated the

issue of which events are cove red 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 ot her programs; there is a lack of evidence to suggest it should not be an acceptab le instrument in the UIC program. Appropriateness of instruments for different project phases

Trust Fund · At least one state is con sidering trus t funds for longer-term phases of GS.

· It make s sense that trust funds would apply to construction and operation, but it is not clear that they would apply to closure. · Two parti cipants said that for the short te rm 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 app licability 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 woul d be more appropriate than insurance for closure and postclosure.

Letter of Credit · It makes sense that letters of credit wo uld apply to construction and operation, but it is not clear that they would apply to closure.

· For the sho rt 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).

· Unce rtain 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 l ong term bec ause 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 op eration, but it is not clear that they would apply to closure. · Uncertain long-term (closure and monit oring) applicab ility 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 postclo sure.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 7Insurance · Differences exist between coverage of liabilities versus performance, as in plugging and closure. The proposed rule may fall into the category of performance-bas ed liability.

· When combin ing an insurance policy with other FA mechanisms like a surety bond for a singl e activity, which mechanism would kick-in first if a GS owner/operator

fails?

· Insuranc e 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.

· Insura nce could be used successfully dur ing 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 longterm nature of GS such as final care of a plugged well.

Financial Test and Corporate

Guarantee · 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-insuran ce mechanisms are great wh ile 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.

Other · Interest exists in mechanisms for long-term phases.

· Which is sues 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 exp erience under RCRA to define which mechanisms apply to which phase.

· A forfeiture bond would be more appropriate than insurance for closure and postclosure. · 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 requi re 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 · Third-party mechanisms such as trust funds are acceptable.
Standby Trusts · Standby trusts are acceptable with letters of credit and surety bonds.

Letter of Credit · Third-party mechanisms, including letters of credit are acceptable.

Surety Bond · Surety bonds stand “head and shoulders” above other options.

· Surety bonds are less inconvenient than letters of credit and trust funds.

Insurance · Insurance can be categorized into more than two options. Instead of just captive and third-party, there are three choi ces: single, captive, and group.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 8Other · 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 · There is concern about the regulatory word ing for trust funds. A trust fund should be fully funded before it is accepted by EPA.
Standby Trusts · Standby trusts are only needed for DI programs.

Letter of Credit · Letters of credit are sometimes tied to a bond.

Insurance · Specific re quirements should not be wri tten into the GS rule. Because of the

economic downturn , insurance companies have suffered losses in investment portfolios. · Two parti cipants 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 cy cl e where insurance may be used.

Financial Test and Corporate

Guarantee · 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

sho uld provide Income and Bank Statement s (including where the actual figures came from and if they differ from what is published) and attest to their validity.

· If financial tests ar e allowed, the criteria should be set conservatively so that only the very strongest companies qualify.

Other · Will the final GS rule include the type of detailed FA requirements now spelled out
for Cla ss I hazardous wells in 40 CFR 144 Subpart F or will guidance provide

more detail? · How long wi ll the proposed post-injection site care requirement be? How often are particular instruments used?

Standby Trusts · They are used less often and may be more typical for small operators who use

them with surety bonds.

Surety Bond · Often used in DI 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 · Does U.S. Dept. of Treasury hav e an approved list for sureties ? · Regions sho uld 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

s urety rating service.

Surety Bond · Bond ratings may not be a good measure du e to recent failure of several AAArated 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 9Financial Test and Corporate

Guarantee · Captive insurance has the potential for “smoke and mirrors.” · At least one Region has not had a business failure in cases where a Class I or Class II UIC owner/operator relied on these mechanisms.
· A Class I operator in MI used a financial test for FA but the Region did not adequately re view the financial test and later the company went bankrupt.
· A Class I operator received a permit in December, and they were bankrupt by the following September. · Most compan ies favor the financial te st and corporate guarant ee, 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 10 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.

Other · 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 owne r/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 ensu re that the numbers can be duplicated.

The Fo rm 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 · Banks are not always willing to offer these agreements and their availability may vary across the nation. · Standby trusts are not easy to obtai n 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.

Letter of Credit · 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.
Surety Bond · Not as available as once were, but more available than letters of credit.

Insurance · 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 insure rs 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 du ring 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.

Financial Test and Corporate

Guarantee · 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 · Trust funds have high “hassle factor.”

Letter of Credit · Letters of credit have high “hassle factor.”

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 10Surety Bond · 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.

Financial Test and Corporate

Guarantee · States “get stuck” with self-insur a nce since Federal Law allows it.

· Financial tests do n ot accurately reflect company health.

Other

· 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 beginni ng. See case with Zurich and EPA. · UIC 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 s hould 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 · A certificate shows evidence of a pol icy, but does not ensure conformance to regulations.
· One com pany 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 under stand 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.

Financial Test and Corporate

Guarantee · ORCR said that they do not specify how companies must prepare their financial

statements.

Other · Operators should use language from fo rms that the Region provides. Region experience comes from CO2 companies who submitted financial statements.
· Guidan ce on specific language to use in mechanisms should be provided.

· IL uses language from RCRA for UIC. Development of guidance

Trust Fund · Two participants said that EPA should dev elop 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 s hould be more guidance on the transfer of ownership, including an emphasis on the resp onsibility of the present operator to notify the Region about transfer of ownership. · Two partici pants 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 a n 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 dev elop FR language for Class II guidance since it is currently lacking. Language used in Class I FR is inappropriate for Class II due to differences in authority.

Letter of Credit · EPA should develop strong guidance on letters of credit.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 11Surety Bond · EPA should develop strong gui dance on surety bonds. · Companies with a bond or trust agreement are held liable until a new company steps in.

Insurance · 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.

Financial Test and Corporate

Guarantee · Some Regions need to turn to a specialist in their financial mechanism evaluations

to assure that the information is corr ect. One Region has an expert who works specifically on financial responsibility for Class I wells. · The financial statement could leave taxpay ers 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

outsid e 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

assuranc e training to regions and states, which has been a large undertaking. · EPA should consider the multiplier requ irement, whi ch 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 w ould be important for corporations to take the lead in ensurin g that the information provided to EPA is

clear and concise.

Other · 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 includ e a system to determine plugging costs.
· Guidance should no t be modeled too closely on the Class II guidance. Guidance is not easily tied to enforceme nt, and it would be better to have requirements in a regulation.
· Class II guidance could not have same leve l of detail as the Cla ss I regulations regarding FR because of statut ory authority constraints. Issues regarding pay-in periods

Trust Fund · Pay-in periods are allowed because th ey give small operators opportunity to manage FR over time with limited capital. · At least one state is looking at pay-in peri ods for long-term FR over the life of the project.

Letter of Credit · There is an existing enforcement case in volving pay-in period with letter of credit.

Other · 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 projec t cost for large corporations. · Is there any experience with failures d uring the pay-in period? · One Region does not allow pay-in periods longer than 2-3 years. They also set requirem ents in an administrative or der or other enforcement action. Legal Issues

Letter of Credit · States and EPA do not have legal res ources to use letters of credit.

Insurance · Owners could use a disclosed docume nt endorsement to substantiate which documents are disclosed and that they are acceptable to all parties.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 12Other · 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 providi ng the financial assurance.

Costs

Letter of Credit · Letters of credit can tie up $500,000 to $1,000,000.

Insurance · 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 need ing to rely solely on the work of underwriters. Regulators have a limited ability to evaluate the appropriateness of costs for corrective action, emer gency response, and closure.

Financial Test and Corporate

Guarantee · There is concern that large companies woul d not want to tie up a lot of money in a

financial mechanism and will instead want to submit financial statements.

Other

· The cost of well plugging should be based on contractor’s cost for remediation. Ability of mechanisms to manage risk

Insurance · Utility companies may utilize captive insuranc e, 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 t han 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 prob lems 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 insuranc e is less reliable, but a standby trust agreement may provide a mechanism for the insurer to pay for correc tive action in the event of bankruptcy.

Financial Test and Corporate

Guarantee · 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

proc ess takes a lot of time.

Other · There are differences in mechanisms based on the risk covered and the willingness of third parties to cover that ri sk. Rating systems and standards

Trust Fund · The need to constantly monitor the company, plus other complications, indicate why trust funds are a simpler approach to demonstrating financial responsibility.

Letter of Credit · 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 13Insurance · For group insurance, states and the federal government should build off of the IRS’

criteria. · EPA should loo k at how insura nce is financed for various organizations

– whether it is rated or unrated , and vari ous measurements. · EPA should, at least, consider captive insurance. · EPA should not propose eligibility requirements for insurers. Participant believes

the market will drive the sele cti on of financially viable insurers. · Even the most stringent or specific criteria would not restrain market forces. In New York, where there is a robust insuranc e 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 th e 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-à-vis post-injection site care

timeframe. · The regulator nee ds 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 ra tios may give a sense that a company can meet their FR obligations. Ho wever, 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 14Research and Analysis Supporting Financial Responsibility Requirements and Guidance 15 3. Research and Analysis on Financ ial Responsibility Instruments

This chapter includes two sections. The first section contains matr ices summarizing EPA’s research and preliminary analysis related to th e 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 responsibil ity webcasts held in spring 2009; 1 and publicly available litera ture, including peer-reviewed j ournal 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 estimat ed costs not covered? Does the mechanism manage uncertainty in cost?

4. What factors drive the costs associated w ith the securing/maintaining the instrument?

What is the relative cost of the in strument to the owner or operator?

5. What is the historical use of the in strument? For environmental obligations?

6. Under what scenario is the instrume nt 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 mech anisms? 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 sp ecific weakness of an instrument be minimized by combining it with another mechanism?

1 EPA. 2009. Webcasts on Financial Responsibility Instrument s for Geologic Sequestration (G S) Wells. EPA 815-D-09-001. ( http://www.epa.gov/safewater/uic/pdfs/meetings_ui c_summarywebinars_fina ncial_responsibility.pdf ).Research and Analysis Supporting Financial Responsibility Requirements and Guidance16I.Summary MatricesThe following matrices summarize research and analysis on financial responsibility instruments for geologic sequestration wells.A.General Financial ConsiderationsTable 3.1: How is the financial stabilityof a third party provider determined?Type of thirdpartyFinancial Regulator(Non-environmental)Non-governmentRatingRelative Ease ofMonitoring Third PartyKey ConsiderationsTrust FundBanks,savings andloans, creditunionsStateorFederalDepends on chartertype of institutionCredit ratingagencyEasier•Third party must be regulated andexamined•Third party must be in good standingStandby TrustLetter of CreditSurety BondInsurancecompanyStateorFederalListed on TreasuryCircular 570Harder•Third party must be listed on TreasuryCircular 570•Third party must be in good standingInsurance StateHardest•Third party must be regulated andexamined•Third party must be in good standing•Captive insuranceinherits the risk ofself-insuranceFinancial Testand CorporateGuaranteeN/A – By definition, no third party is involvedEscrow AccountBanks,savings andloans, creditunionsStateorFederalDepends on chartertype of institutionCredit ratingagencyEasier•Third party must be regulated andexamined•Third party must be in good standingResearch and Analysis Supporting Financial Responsibility Requirements and Guidance17Table 3.2: What weaknesses are associated with the third party’s financial stability determination?StabilityDemonstration’sRelative Ability toPredict Third-partyBankruptcy orInsolvencyFederal FinanceRegulatorState FinanceRegulatorNon-governmentRatingKey ConsiderationsTrust FundStrongVariable ReviewPeriodExaminations arelikely to be infrequent,or based oncomplaintsVariable ReviewPeriodExaminations arelikely to vary bystate and beinfrequent, orbased oncomplaintsVariable ReviewPeriodCredit rating agenciesmay be reluctant tolower credit ratings ofclient companies•Government examinations andnon-government ratings shouldbe frequent•Accuracy and value ofexaminations and ratingsdiminish over time•Third-party institution’s financialcondition can change quicklyStandby TrustLetter of CreditSurety BondStrongestAnnual ReviewInstitutions reviewedand listed (andunlisted) annuallyInsuranceWeak None•Captive insuranceinherits therisk of self-insuranceFinancial Test andCorporate GuaranteeN/A – By definition, no third party is involvedEscrow AccountStrongVariable Review PeriodExaminations are likely to be infrequent orbased on complaintsCredit rating agenciesmay be reluctant tolower the creditratings of clientcompanies•Frequency of governmentexaminations and nongovernment ratings•Accuracy and value ofexaminations and ratingsdiminish over time•Third-party institution’s financialcondition can change quicklyExaminations arelikely to vary bystateResearch and Analysis Supporting Financial Responsibility Requirements and Guidance18Table 3.3: Under what conditions are the full estimated costsnot covered? Does the mechanism manage uncertainty in cost?Adverse Conditions/Risks Leading to Inadequate Coverageof Estimated CostsKey ConsiderationsOwner/operatorfailsInvestmentRisk(Marketvolatility or mismanagement)Third-partyLitigation(leading toinadequatefunds)CostUnderestimationby Owner/operatorPolicy Exclusionsor PaymentLimitationsImposed by ThirdPartyTrust Fund X XX•Owner/operator could become insolvent before trust fully funded•Pay-in period should be short and/or include an enforcement order to ensurethat trust is fully funded•Risk level of investment portfolio is important•If trust fund fully funded at its inception, then coverage based on costestimation will be adequateStandby TrustN/A - Not a stand-alone instrumentLetter of CreditX•Incentive to underestimate costs to lower amount of credit held as liability•If letter of credit obtained for full amount of covered activities then coveragebased on cost estimation will be adequateSurety BondX X•Litigation delays have negative effects on environmental results and lead toinadequate funds to cover activities•If estimates increase on a surety bond,RCRA requires the Company to makeup the shortfallInsuranceX X•Incentive to underestimate costs or seek one policy for multiple facilities tolower premiums•Drawing on insurance policies may require litigation for abandoned facilitiesor the bankrupt companies•Boilerplate language proposed by Director can minimize exclusions•“Cap policies” could guard against expenses beyond original estimates•UIC Class I requires guarantee thatfunds available when coverage beginsFinancial Testand CorporateGuaranteeX X X•Only financially strong companies can/should be selected to use thismechanism•Decision for coverage must be based on highly accurate financial information•Insurance underwriters do risk analysis to determine appropriate costs forpolicy; owner/operator attests to accuracy of information they provideEscrowAccountX X•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 costestimation will be adequateResearch and Analysis Supporting Financial Responsibility Requirements and Guidance19Table 3.4: What factors drive the costs associated with the securing/maintaining the instrument? What is the relative cost of theinstrument to the owner or operator?FeesCollateral/DepositsPremiumsEstimate ofCosts as %of Total CostLogistics of ClaimPaymentKey ConsiderationsTrust Fund X~2% (total)Third party usesfund to meetobligations,otherwise assetsreturned to theowner/operator afterit meets obligations•Cost is full cost of environmentalobligation; funded by owner or operatorwith third-party administration•Annual costs determined by pay-in schedule (if any); can be limited (2-3years in one EPA Region) and enforcement actions are taken ifnecessary•Fees vary by institution, fund amount, what other services from sameinstitution used, investment activity, and trustee involvementStandbyTrustXNo dataavailable•Cost is typically an annual fee; feesvary by institution, fund amount, whatother services from same institution used, investment activity, trusteeinvolvementLetter ofCreditX X1.5 - 2%(annual)•Cost based on small percent of face value, paid on an annual basis;interest fees at market rate if credit drawn•Financial health of purchaser determines whether collateral and/ordeposits required•Letter of credit is classified as an accounting liability; relative cost mayinclude limits to borrowing powerSuretyBondX0.5 - 15%(total)Surety seeksreimbursement frompurchaser for claimspaid•Cost is a function of credit-worthiness of purchaser; emphasis onprequalification•Typically, premium paid based on face value of bond prior to projectstart; premiums often on a sliding scale•Each state has provisions for when to release a bondInsurance X XNo dataavailableTypically pay claimsfor both solvent andinsolvent clients•Cost is premium established by underwriter’s assessment of site-specificrisks; price reflects greater likelihood and range of possible claims•May be fee for initial risk assessmentFinancialTest andCorporateGuarantee<0.5% (total)Ability to fulfillobligations is basedon financial health attime payment isneeded•Cost is limited to securing an accountant’s review of financial statementsprepared for other purposes•Least expensive option for owner/operator; based on assessment ofcompany worth; does not require third-party backing or setting fundsasideEscrowAccountX1 - 2% (total)•Cost is full cost of environmentalobligation; funded by owner or operatorwith 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 tocover administrative costs defined inagreementResearch and Analysis Supporting Financial Responsibility Requirements and Guidance20Table 3.5: What is the historical use of the instrument? For environmental obligations?Used under RCRAsince 1982 (includingClass I Hazardous)Listed inClass IIGuidanceOther Non-UICProgramsKey ConsiderationsTrust FundXXX•Under UIC, funds may be deposited into the trust in phases; either overthe term of initial permit or over remaining operating life of injection well(whichever is shorter)•EPA has administered trusts under other environmental statutes such asCERCLAStandby TrustNot a stand-alone instrument, but historically used with letterof credit and surety bond for Direct Implementation programsLetter of CreditXXX•Used in some State Revolving Fund programs•Used for other environmental programsSurety BondXXX•Used under Surface Mining Coal and Reclamation Act of 1977•Banks may be accustomed to issuing bonds in areas with many Class IIwells•Bonds may be used often because they are easy for operators to obtainand administer•Used regularly in direct implementation programs•Used frequently in permittingInsurance X No X•Used for environmental risk management since 1957 Price-Anderson Act•Not listed in Class II Guidance, but not prohibited•Nuclear project licensees requiredto obtain maximum amount of privateliability insurance available on the market, and licensees are strictly liablefor “extraordinary nuclear occurrences”Financial Testand CorporateGuaranteeX X X•Used for other environmental programs•Controversial•Historically justified to minimize the sum of costs to public and industryEscrow AccountNoNoX•Used for ground water discharge and wastewater system permits in MA,MI, and TN; preferred mechanism for MADEP over letters of credit whichare less secure•Magnitude of dollar amount in escrow and time period held in escrow arelikely significantly shorter than for some GS activities•Used in environmentalliability court cases•Certificate of Deposit (cash holdingsimilar to escrow account) has beenused by MT and MI UIC programsResearch and Analysis Supporting Financial Responsibility Requirements and Guidance21Table 3.6: Under what scenario is the instrument best or most commonly utilized?Size of FirmType of Activity(certain vs. uncertain)Key ConsiderationsTrust FundVariesSmall operators benefit frompay-in periodCertainFull amount set aside•Low uncertainty depends on pay-in period; Director mustmonitor payments into the trustStandby TrustNot a stand-alone instrument, but typically used with letter ofcredit and surety bond for Direct Implementation programsLetter of CreditVariesFirm must be financiallyhealthyCertain and uncertainIn short term, given credit limitnot exceeded•May be appropriate for company with good financialhealth/creditworthiness•Bank takes risk of project failure, but bank could fail; firmmay provide deposit/collateral to secure•Risk of shock to creditworthiness; may affect ability toborrow, but less impact on cash flow than trust fundsSurety BondVariesRequires demonstration ofsignificant cash flow whichmay limit small operatorsCertainPerforms 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 yearsfrom closureInsuranceVariesCost of policies driven bymarket and site-specificfactors, which will dictate sizeof participating firmsUncertainDesigned for uncertain riskswith a known probability ofoccurring•Occurrence policies better for long term; allows claims tobe filed after end of policy if cause of claim occurredduring policy period); not preferable for insurers•Long-term policy may be difficult to obtain, and risk ofinsurance firm solvency•Insurance on certain activities is conceptually similar to asurety bondFinancial Testand Corporate GuaranteeLargeCompany must have high networth; financially stableCertain and uncertainHigh financial assurance risk•Evaluation of actual financial strength can be difficult•Company net worth must be significant (i.e., sufficient toexclude under-capitalized firms); financial health andstability are key•Overall gives less protective coverageEscrow AccountVariesMust be able to make onetimepayment to accountCertainFull amount set aside•Typically used (in non-GS scenarios) as short-termmethod to compel buyer to finalize transaction•Certificate of Deposit (cash holding similar to escrowaccount) has been used by MT and MI UIC programsResearch and Analysis Supporting Financial Responsibility Requirements and Guidance22Table 3.7: Which conditions may lead to instrument failure (e.g., cancelation or non-renewal, breach of contract, misrepresentation, theagency does not take action)?Owner/operatorFailureFailure ofThirdParty2Cancellationor NonrenewalInaccurateAssessment ofOwner/operatorHealthKey ConsiderationsTrust FundX3•Partially fails if not fully funded at time that is needed•Low risk that firm that administers trust could go out of businessStandbyTrustX X•May fail if allowed to close (i.e., maintenance fees not paid)•Low risk that firm that administers trust could go out of businessLetter ofCreditX X•For Class I hazardous wells under RCRA, letter must be irrevocable and issuedfor 1 year minimum, 120 day notice for cancellation•Could fail if change of bank ownership could transfer to a trust; requires goodrating for new bank for financial demonstration•Not insured by FDICSuretyBondX X X•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 adequatelydiversified in terms of reinsurance•Inadequate bond ratings and risk of assuror financial failure may causeinstrument failureInsuranceX X X•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 failif parent company becomes insolvent•Class I hazardous wells must contain provision to allow transfer of policy to asuccessor owner or operator with consent of insurerFinancialTestandCorporateGuaranteeX N/A4X•Failure may be caused by bankruptcy of entity that has passed a CorporateFinancial 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 becomeautonomous from parent companies must put new financial assurance in placeEscrowAccountX•Partially fails if not fully funded at time that is needed•Low risk that firm that administers trust could go out of business2Including lack of third-party independence from covered activity3Primacy 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 trustee4Independent auditor could beconsidered third partyB.Considerations for GSTable 3.8: Do states prohibit the use of certain mechanisms? Howaccessible is the instrument in states where GS is likely to takeplace?AllowLikelyto AllowProhibitLikely Level ofAccessibilityKey ConsiderationsTrust FundXHighBased on firm’s abilityto contribute cash orcash equivalents•A preferred method for states;secure and readily availableStandby TrustXUnknown•Must be combined with letter of credit or surety bondLetter of CreditXHighAt least one regionagrees they are one ofmost commoninstruments•Not known to be prohibited in states where GS likely to takeplace: CO, IL, KS, KY, LA, MI, MS, MT, NM, NY, ND, OK, PA,TX, UT, WA, WV, and WYSurety BondX XMediumHistorically available;potentially difficult tosecure in future•WA specifically allows use for GS facilities•May be difficult to secure in future due to increased costs andrisks of unknown obligations; access also limited by phase,site characteristics, or accuracy of costsInsurance XSomeprohibitcaptiveinsurancefor RCRAHighPrivate insurance usedin 26 states forenvironmental risks•Not all insurance products available in every state•Captive insuranceis prohibited for RCRA financial assurancein AL, NY, TX, and VA; allowed in CA, CT, MO, OH, and WAFinancial Testand Corporate GuaranteeXSomeprohibitHighAccessible but testmust be set atappropriate level•At least one state (MT) has banned financial test for UICdemonstrations•Some states do not allow use for mining reclamation; notallowed under BLM 3809 regulation or on federal landsadministered by USFS•Some firms may meet financial tests immediately prior to filingfor bankruptcy protectionEscrow Account XUnknown•Escrow accounts are typically used for transactions andholding money over a short period of time•Some states set maximums on the length of time that a lendercan request the money to be held in escrowResearch and Analysis Supporting Financial Responsibility Requirements and Guidance23Research and Analysis Supporting Financial Responsibility Requirements and Guidance24Table 3.9: What factors make the instrument more/less easy for the Director to review or use?InstrumentRegulated byFinancialIndustryRegulatorRelative Level of EffortRequired to Review/UseRisks to DirectorKey ConsiderationsTrust FundXLow or MediumReview trust fund balancewith cost estimateSome vulnerability toinsolvency of trustee•Liquid assets are easy to use and review•Trust funds are regulated under state andfederal regulatory regimes•Some primacy states may be able to act thetrustee and establish individual or pooled trustfundsStandby TrustN/A - Not a stand-alone instrumentSometimes difficult to obtainLetter of CreditXLowLess frequent monitoringLitigation to obtain funds•Can only be altered with agreement ofpurchaser, provider, and beneficiary•Level of effort for initial review is greater thanthat for long-term monitoring•Automatic renewals reduce administrativeburden•Reliant on federal or state review of third partySurety BondXLowMay be more convenientto review and use•May be less liquid but more convenient thanletters of credit and trust fundsInsurance XHighComplex evaluation dueto different stateregulations and lack oftransparencyVariation in quality, eligibility,and transparency of insurancecompany•Owners/operators influenced by marketfactors•Company objectives, methodology, andevaluations could be considered proprietarybusiness information•Insurance policiesare regulated under stateregulatory regimesFinancial Testand Corporate GuaranteeX5HighRegular financialmonitoring for solvencyCorporate financial auditingnot an in-house strength ofUIC program•Solvency determinations require extensivecommitment to monitoring and verification•Option for third-party auditsEscrow AccountXMediumReview bank statementsto compare with costestimateInstrument not yet tested forGS project magnitude•Some risk of insolvency of trustee dependenton economic climate•MA DEP: instrument easy to review relative toletters of credit5Independent auditor is regulatedResearch and Analysis Supporting Financial Responsibility Requirements and Guidance25Table 3.10: What is the likely total administrative burden/complexity of the review for the Director (i.e., EPA or the state regulator)?Level of AdministrativeBurdenImplementationSteps NeededKey Considerations

Initial Demonstration A nnual Valuation Readjustment Withdraw TerminationTrust FundLowLess frequent monitoringX X X X•Director is unlikely to have challenges accessing funds since funds are liquid and set aside/dedicated tospecific activity•Annual valuation/re-adjustment to ensure fund provides total coverage and firm meets schedule duringpay-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, thismay increase the initial burden but decrease the annual valuation burdenStandbyTrustLowLess frequent monitoringX X X•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 trustLetter ofCreditMediumLess frequentmonitoring; potential forre-demonstration and/ornegotiation and litigationX X X X X•Annual valuation needed to ensure total coverage•Initial demonstration depends on Director’sreview of financial institution’s solvency•May be issued for short periods, therefore manyopportunities for non-renewal; may need frequent redemonstration if finances fluctuate over time•Withdrawal depends on third party; may require negotiation or litigationSuretyBondMediumAnnual evaluation;potential for redemonstration and/ornegotiation and litigationX X X X X•Annual valuation needed to ensure bond provides total coverage•Initial demonstration depends on Director’sreview 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 litigationInsuranceHighPolicies complex due tosite-specific variationsand differences by stateX X X X X•Initial demonstration depends on Director’s reviewof financial institution’s solvency; possible redemonstrations to avoid cancellation of policy or if finances fluctuate over time•Withdrawal depends on third party; may require negotiation or litigation•Agency capacity for reviewFinancialTest andCorporateGuaranteeHighEvaluations and reevaluations are frequentand data intensiveX X X•Director must perform initial and annual review of financial condition (e.g., financial statements andcalculations/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 reviewEscrowAccountMediumNo history of use forlarge magnitude projectsX X X X•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 withappropriate provisions for obligation and timeframeResearch and Analysis Supporting Financial Responsibility Requirements and Guidance26Corrective Action andPhased Corrective ActionInjection WellPluggingPost-injection SiteCare and Site ClosureEmergency andRemedial ResponseKey considerationsTrust FundBestFully-funded trust minimizes the risk to the public for well definedactivities. Beyond third-party failure and cost escalation, risk is limited toinvestment portfolio risk (typically low)Funds will be available butthere may be too littlemoney (public pays) or toomuch money (inefficientuse of funds)••Strength of trust fund is based onbeing fully funded (i.e., 100% ofestimated costs set aside)Most costly to owner or operatorbecause funds must be set aside inadvanceStandbyTrustN/A - Not a stand alone instrumentLetter ofCreditBestBeyond third-party failureand cost escalation, riskstems from theappropriateness of thedefined credit limitMay be unreliable for longer time periods,but some regions have had success overperiods of time up to 20 yearsAppropriate for emergencyand remedial response inconstruction and operationphases but may beunreliable or unavailablefor post injection site careperiod because ofuncertainty and risk overlong time periods•••Perform well so long as the credit limitis not exceededRisk of exceeding the limit is notpooled across owner or operatorRisk of third-party failure is higher thanfor a suretySuretyBondGoodBeyond third-party failureand cost escalation, riskstems from theappropriateness of thedefined credit limitSurety providers are unlikely tounderwrite bonds over longer timeperiods where there is considerableuncertainty, however some regions havehad success over periods of time up to 20years••Perform equally well so long as thecredit limit is not exceededBlanket bonds(multiple sites under asingle bond) present a much higherriskInsuranceCan be used for either short-term or long-term applications dependingon the terms of the policy; likely best and most readily available in theoperational phases because the activities and timeframe are welldefined (operator is making money and can pay premiums)BestIdeal for activities withuncertain frequency andcosts to diversifyingenvironmental risk andhandling the numerouspossible scenarios•••Timing is a significant issue as insurersprefer to restrict the scale, timeframe,and predictability of exposuresBest applied to operational phases.Captive insuranceinherits the risk ofself-insuranceFinancialTest andCorporateGuaranteeGood, but provides no financial recourse if owner or operator failsPerforms well when used for uncertain and certain risks; however, high financial assurance risk to thepublic••Equivalent to a waiver of third-partyinstruments for large and historicallyfinancially stable firmsPrimary reason to allow self-insuranceis for public policy, not for financialresponsibilityEscrowAccountGoodHistorically utilized for welldefined short-term costsTrust funds may be preferred over themid and long term, funds in escrow wouldlikely generate less interestLikely to perform poorlywhen used for uncertainrisks; funds do notrespond to contingenciesbeyond cost estimate••Never used in UIC programMay not require a pay-in period like atrust fundTable 3.11: Which GS phase(s) is the instrument best suited for?Research and Analysis Supporting Financial Responsibility Requirements and Guidance27Potentially Effective CombinationWeaknessMinimized ThroughCombinationKey ConsiderationsTrustFundLetterofCreditSuretyBondInsuranceEscrowAccountTrust FundX X XLong-term costuncertaintyAssociated withemergency andremedial response•Trust fund could be used for response activities up to athreshold value, then an alternative instrument could be usedonly when costs exceed the threshold•Additional administrative burden may be undesirableStandby TrustNot considered a stand-alone instrumentLetter of Credit XXChanges in financialmarkets or firm’scredit & long-termcost uncertaintyAffects cost andavailability•Letter of credit has a fixed value; response activities mayexceed that value•Trust fund may split up potential costs for post-injection site careand site closure; insurance may help manage long-term costuncertainty•Additional administrative burden may be undesirableSurety Bond(Note differences inpayment bond vs.performance bond)XLong-term costuncertaintyAssociated withemergency andremedial response•Surety bond has a fixed value; response activities may exceedthat value•Trust fund could be used for response activities up to athreshold value, then a payment bond could be used only whencosts exceed the threshold•Additional administrative burden may be undesirable•Payment bonds, trust funds, letters of credit, and insurancecan be combined for a facility if together their value is at leastequal to estimated costs•Performance bonds, financial tests, and corporate guaranteescannot be combined with other instrumentsInsurance XXHigh premiumsAssociated withwell-definedactivities•Firms lower premiums by utilizing trust fund or escrow accountto cover activities up to pre-established value; insurance used tocover uncertain costs•Provides additional stability and lower risk•Additional administrative burden may be undesirableFinancial Testand Corporate GuaranteeThe primary driver for utilizing the financial test and corporate guarantee is to avoid the use of other third-party mechanismsEscrow Account X X XLong-term costuncertaintyAssociated withemergency andremedial response•Escrow accounts only desirable for short-term activities•May be desirable to utilize another instrument or combination ofinstruments instead of escrow accountsTable3.12: For each individual GS phase, can the specific weaknessesof an instrument be minimized by combining it with anothermechanism?Research and Analysis Supporting Financial Responsibility Requirements and Guidance 28 II. 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, a nd carries no citations.

• Information on captive insurance is grouped wi th 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?

Tru st Fund & Standby Trust

• Trust funds and standby trusts are typically provided/administered by regulated financial institutions, such as commercial banks, sa vings 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 b ecause oversight is usually already in place. 7
The stability of the institutions could be in ferred 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.

L etter of Credit

• Letters of credit are typically provided by re gulated financial inst itutions, 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 inst itution (1) is regula ted 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.

Su rety Bond

• A surety bond is usually issued by an insu rance company, however, surety bonds are not insurance. The surety becomes liable only wh en the owner or operator fails to comply

with requirements. 12 The financial strength of the su rety bond provider may be relatively

6 U.S. EPA. 2009. RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Trust Fund. United St ates 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 Assu rance Rules Fulfilling Their Pr omise?

Resources for the Future. Discussi on 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)(1) or U. S. EPA. 1990. Federal Financial Responsibility Demonstrations for Owners or Operator s of Class II Oil- and Gas-Related Injection Wells. Un ited States Environmental Protection Agen cy. EPA 570/9-90-003. Available online at: www.epa.gov/R5water/ui c/ftp/ffrdooc2.doc

9 U.S. EPA. 2009. RCRA Subtitle C Financial Assurance Instrument Fact Sheet: Letter of Credit. United States Environmental Prote ction Agency. Available online at: http://www.epa.gov/waste/hazard/tsd/td /ldu/financial/documents/loc-fs.pdf

. 10 Boyd. 2001.

11 For example, see 40 CFR 144.63(d)(1) 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 29 easy to monitor because oversight is usually already in place. 13 However, the same difficulties in oversight that apply to insu rance (e.g., complex finances obscuring credit ratings) may apply to surety bonds. 14 The stability of these inst itutions could be inferred by whether or not the institution (1) is listed on U.S. Department of the Treasury, Circular

570 15 (consistent with Class I requ irements and Class II guidance 16 ) and (2) is in good standing with its respective federal or st ate regulator (depends on state vs. national charter)

. The financial institution’s standing may be inferred by the number (and frequency) of enforce ment act ions taken by the regulator.

• Circular 570 is published a nnually and lists firm s qualif ied to write surety bonds, provides information on admitted reinsurers, pools and associations, Lloyd's syndicates and surety underwriting limitations. 17

I nsurance

• Insurance is typically issued by an in surance company. Under Class I Hazardous requirements, the insurance comp any 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 Standa rd & 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 contract s that they hold. 19 However, the financial st ability of independent third-party insurance providers may be diffi cult to determine because reinsurance or fronting may further obscure the financial st ability of an insurance policy or provider. 20

F inancial Test and Corporate Guarantee

• N/A

E scrow Account

• Like trust funds and letters of credit, es crow accounts are typically administered by regulated financial institutions, including co mmercial 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 wh ether or not the institution (1) is regulated and examined by a federal or state agency, a nd (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 th e number (and frequency) of enforcement actions taken by the regulator.

13 Boyd. 2001.

14 U.S. EPA OIG. 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)(1) or U. S. EPA. 1990. Federal Financial Responsibility Demonstrations for Owners or Operator s 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/ui c/ftp/ffrdooc2.doc

17 U.S. EPA. 2009. United States Environmenta l Protection Agency RCRA Subtitle C Financia l Assurance Instrument Fact Sheet: Suret y Bond.

Available online at: http://www.epa.gov/waste/hazard/tsd/td /ldu/financial/doc uments/sbond-fs.pdf

. 18 40 CFR 144.63(e)(1)

19 Sources available online at: http://www.ambest.com/about/ ; http://www3.amb est.com/ratings/default.asp ; http://www.insure.com/article s/interactiv etools/ratingslookuptool/sandp/define.jsp ; http://www.standardandpoors.co m/ratings/insurance/en/us

20 U.S. EPA OIG. 2001.Research and Analysis Supporting Financial Responsibility Requirements and Guidance 30 21 U.S. EPA. 1996. Subtitle C and D Corporate Fi nancial Test Analysis Issue Paper: Assess ment of Financial Assurance Risk of Subt itles C and D Corporate Financial Test and Third-Pa rty Financial Assurance Mechanisms. March, 18, 1996. Available online at: http://www.epa.gov/osw/nonhaz/municipa l/landfill/financial/famc/paper10.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, Lett ers of Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009)

25 Treasury Department. 2009. Department of the Treasury's Listi ng of Approved Sureties (Department Circular 570). Available onli ne at http://www.fms.treas.gov/c570/notes.html

. 26 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologi c Sequestration Wells: Trust Funds, Lette rs of Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009) 2) What weaknesses are associated with the third-party's financial stability

determination?

T rust Fund & Standby Trust

• A trust fund and standby trust may be vulnerabl e 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 revi ew institutions seeking credit more frequently.

o No hard and fast rule for how often rati ngs 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 F or institutions seeking credit regularly, this may mean several reviews each year.

o Although the ratings are public, the re ports providing more detail are by subscription only.

L etter 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

S urety Bond

• A potential weakness associated with the Circ ular 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 a nd 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 su rety bonds were “head and shou lders” above other financial mechanisms, but they also may be less conveni ent than trust funds a nd letters of credit. 26Research and Analysis Supporting Financial Responsibility Requirements and Guidance 31 27 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologi c Sequestration Wells: Insurance (May 20, 2009).

28 Source online at: http://www.insure.com/articles/interactiv etools/ratingslookuptool/sandp/define.jsp

29 U.S. EPA OIG. 2001. I nsurance

• Ratings and other measures of financial hea lth 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 financia l health of an insurance company nor do they address the performance or appropriate ness of specific policie s for a given purpose. They also do not consider deductibles, pena lties 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 cred it 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, th e 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. Financ ial stability of independent third-party insurance providers may be difficult to dete rmine. 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

F inancial Test and Corporate Guarantee

• N/A

E scrow Account

• Like a trust fund or letter of credit, an es crow account may be vulnerable to bankruptcy of the financial institution pr oviding financial assurance. Lim iting 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 inst rument? How well does the mechanism handle
uncertainty in cost?

T rust Fund

• Trust funds are funded with the amount of mo ney 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 tr ust over time through the use of a pay-in period. Thus, incompletely funded trusts ar e relatively common. However, when a payin-period is allowed, if a firm becomes insolvent before a trust is fully funded, the actualResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 32 30 Boyd. 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 Environmenta l Protection Agency RCRA Subtitle C Financia l Assurance Instrument Fact Sheet: Suret y Bond.

Available online at http://www.epa.gov/waste/hazard/tsd/td /ldu/financial/doc uments/sbond-fs.pdf

36 U.S. EPA OIG. 2001. Page 19.

37 Northern Kentucky University and Univer sity of Louisville. 2005. Brownfields Insuran ce for Public Sector-led Development Proje cts: Experience and Methods. http://www.brownfield stsc.org/pdfs/bf_case_studies_report.pdf

38 U.S. EPA OIG. 2001. amount of available coverage will be inadequate. 30 Accordingly, shor ter 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 a ssures that at least 100 pe rcent of the invested funds will be available when needed). The mo derate 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 f und will not be fully funded when the facility

becomes insolvent. 33

Standby Trust

• N/A. Standby trust funds are not cons idered stand alone instruments.

Le tter of Credit

• The amount of credit required for letters of cr edit depends on the cost estimate of covered events. Owners or operators may have an in centive to underestimate costs in order to lower the amount of credit they hold as an accounting liability. 34

S urety 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 financia l assurance mechanisms to ma ke 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 co mply with the terms of the bond. The delays and resources spent on litigation have negativ e effects on environmental results, resulting in inadequate funds available to pay for bot h performance of covered activities and any litigation fees. 36

I nsurance

• In the process of procuring insurance, ow ners or operators wi ll typically approach potential insurers with information about thei r 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 offe r to the owner or operator. 37 Owners or operators as insured

entities have an incentive to underestimate co sts in order to lower premiums or other

payments. 38 However, at the time that the owne r or operator applies for the insurance policy, they will often be required to attest to the accuracy of the information that theyResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 33 39 Northern Kentucky University a nd University of Louisville. 2005.

40 U.S. EPA. 2009. Summary of EPA Webinars on Financial Res ponsibility for Geologic Sequestration Wells. Available online at: http://www.epa.gov/safewater/uic/pdf s/meetings_uic_summarywebinar s_financial_responsibility.pdf

41 U.S. EPA. 1988. FINANCIAL ASSU RANCE. Available online at: http://yosemite.epa.gov/osw/rcra.nsf/ ea6e50dc6214725285256bf00063269d/e4c040961 571e0778525670f006bc76a!OpenDocument

. 42 U.S. EPA OIG. 2005. Continued EPA Leader ship Will Support State Needs for Informa tion and Guidance on RCRA Financial Assurance

. Report No. 2005-P-00026. http://www.epa.gov/oig/reports /2005/20050926- 2005-P-00026.pdf

. 43 Boyd. 2001.

44 Northern Kentucky University a nd University of Louisville. 2005.

45 U.S. EPA OIG. 2001. Pages 10-11. have provided – any false information or omi ssions can result in the cancellation of the policy by the insurance compa ny. 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 th e “face amount” of the policy mu st equal at least the current cost of closure or post-clo sure, i.e. the policy mu st 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 wa ste 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 regula tor for cleanup costs instead of providing direct acce ss to the funds. States have also expressed concern that drawing on an insurance policy may require litig ation, especially if the facility has been abandoned or the company is in bankruptcy. 42

• Exclusions may be included to reduce the in surer’s risk exposure and, correspondingly, the customer’s cost of coverage. Howeve r, these voluntary coverage limitations are inappropriate for the purposes of environmen tal assurance. Covera ge limitations, though potentially desirable for the customer and in surance provider, unde rmine the ability to

recover costs and ensure future environm ental obligations. Th erefore, many state programs rely on the use of boilerplate e ndorsements that must accompany instruments used to demonstrate coverage. These endor sements require the in surer to acknowledge the scope of coverages required by regulat ion and rule-out any coverage limiting

exclusions. 43

• Specific insurance policies called cost cap polic ies could help to guard the insurer against expenses that are beyond the originally estimat ed costs for the project. Cost cap policies can be used for a remediation project where th e insured pays for a percentage of the clean up costs (called a self-insur ed retention) and the insurer paying the excess costs. 44

F inancial Test and Corporate Guarantee

• EPA OIG discovered cases in which corporati ons that were successful in a Corporate Financial Test in one year la ter became financially unstable. A firm using the financial test to satisfy obligations cannot guarantee it will have funds for cl osure and post-closure

in the event that it becomes insolvent. For conducting closure and pos t-closure, the public

bears the risk of the firm’s insolvency. 45Research and Analysis Supporting Financial Responsibility Requirements and Guidance 34 46 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

47 Boyd. 2001.

48 Communication with Jeff Green, Wealth Management Group at Citizens Bank.

49 U.S. EPA OIG. 2001.

50 U.S. EPA. 1983. Service Charges on Standby Trust Funds. 530-SW-83-001J. Available online at: http://yosemite.epa.gov/osw/rcra.nsf/ ea6e50dc6214725285256bf00063269d/AB6301907BF C7CC08525670F006BBA6A/$file/12147.pdf

. 51 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

52 Boyd. 2001. • 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 test s should be followed to be sure that only the strongest companies are selected to use this mechanism. 46

E scrow Account

• An escrow account, like a trust fund, woul d be funded with th e amount of money estimated to pay for the full cost of cove red events. Depending on the terms of the agreement, an escrow account could be fully funded at its incepti on, 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%) savi ngs 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. Th erefore, the total cost of the trust fund is

the full cos t of the environmental obligati on for which financial assurance is being demonstrated plus the overhead costs asso ciated 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 fo r the fund (until the tr ust is fully funded)

. 49

• Trustee’s fees can be expected to vary depe nding 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 a nd type of investment activity and trustee

involvement. 50

• During the FR webcasts, participants mentione d 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 li mited by EPA (2-3 years in one region) and enforcement action taken if companies fail to comply. 51

• A fter obligations are fulfilled, trust assets are returned to the firm. It is essential that regulators monitor payments into the trust. 52Research and Analysis Supporting Financial Responsibility Requirements and Guidance 35 53 U.S. EPA. 1983. Service Charges on Standby Trust Funds. 530-SW-83-001J. Available online at: http://yosemite.epa.gov/osw/rcra.nsf/ ea6e50dc6214725285256bf00063269d/AB6301907BF C7CC08525670F006BBA6A/$file/12147.pdf

. 54 U.S. EPA. 2009. Notes from Webcasts on Financial Responsibility for Geologic Sequestration Wells. Unpublished notes from April 28, 2009

webcast.

55 Boyd. 2001.

56 Communication with Jeff Green, Wealth Management Group at Citizens Bank.

57 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

58 U.S. EPA OIG. 2001. Page 22.

59 U.S. EPA. 2009. United States Environmenta l Protection Agency RCRA Subtitle C Financia l Assurance Instrument Fact Sheet: Suret y Bond.

Available online at: http://www.epa.gov/waste/hazard/tsd/td /ldu/financial/doc uments/sbond-fs.pdf

. 60 Communication with Paul Patalano, DeSanctis Insurance Agency. Standby Trust

• Trustee’s fees can be expected to vary depe nding 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 a nd 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.

L etter of Credit

• Banks may require collateral or deposits be fore providing a letter of credit, depending on the purchaser’s financial healt h. Letters of credit are typical ly priced as a small fraction of their face value and are granted for annua l terms. Typically, letters of credit are automatically extended after one year, subjec t 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 acc ounting liability, and lim its the holder’s borrowing

power. 58 Therefore, the relative cost may includ e more than the actual cost of securing

the mechanism.

Surety Bond

• The cost of obtaining a surety bond is a func tion of its credit wort hiness (or financial solvency). The Surety generally places emphasi s on prequalification. With either type of surety bond, the Surety retain s the right to pursue reimburse ment from the Company for funds paid on its behalf. Similar to a bank with a Letter of Credit, th e Surety provides the Company with its financial backing. In retu rn for the Surety's guarantee, the Surety generally receives a premium ba sed 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)

. 60Research and Analysis Supporting Financial Responsibility Requirements and Guidance 36 61 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09).

62 Gerard, D, E.J, Wilson. 2008. Journal of Environm ental Management 90 (1097-1105). Available online at https://www.researchgate.net/journal/0301-4 797_Journal_of_Environmental_Management

63 Boyd. 2001.

64 Boyd. 2001.

65 U.S. EPA OIG. 2001.

66 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologi c Sequestration Wells: Insurance (May 20, 2009). • 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 mechanis ms could help keep prices down. 61

• As compared to insurance, surety bonds or letters of credit pr ovide 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 potenti al costs, and underwriters coul d refuse to write the policy or else require substantial co llateral. 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 a llow 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 cr edit, 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 cam e 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 princi pal bears ultimate respons ibility 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 obl igation. In cases where the regulatory requirement and the bond’s language are in c onflict, 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-sp ecific 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. 66Research and Analysis Supporting Financial Responsibility Requirements and Guidance 37 67 Porter, Winston. 1986. Liability Regu lations. EPA. Available online at: http://yosemite.epa.gov/osw/rcra.nsf/ ea6e50dc6214725285256bf00063269d/1d2a50fa09eea3148525670f006c0081!OpenDocument

68 Boyd. 2001.

69 U.S. EPA. Unpublished. Analysis of Outcom es of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comme nts 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 “Fin ancial Assurance for Closure and Post Cl osure Guidance Manual” or U.S. EPA. 19 90.

72 For example, see 1982 RCRA guidance entitled “Financial Assurance fo r Closure and Post Closure Guidance Manual” or U.S. EPA. 1 990. • 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 greate r likelihood and range of possible claims. Consequently, insurance is usually priced w ith much greater sensitivity to the risks presented by the insured than other mechanisms such as bonds. 68

• During the FR webcasts, a particip ant expressed concern that with captive insurance companies were more likely to use “smoke a nd mirror” tactics to obtain approval because they could use company data as pr oof for their fina ncial stability.

F inancial 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

E scrow Account

• Like trust funds, escrow accounts are funded by the owner or operator and thus are not technically purchased, but instead are administ ered 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 co st (included in the escrow agreement) associated with the account that is paid to the third-party admi nistrator on an annual basis. The costs to establish the account average around $5,000, and some financial institutions may have a minimum th reshold (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?

T rust Fund

• Trust funds have been used to demonstr ate financial responsibility under RCRA since approximately 1982 and have been recommende d in guidance for Class II wells since

1990. 71

S tandby Trust

• Standby trust funds are not considered stand al one instruments, but have been used as a component of financial res ponsibility demonstrations unde r RCRA since approximately 1982 and have been recommended in guida nce for Class II wells since 1990. 72Research and Analysis Supporting Financial Responsibility Requirements and Guidance 38 73 For example, see 1982 RCRA guidance entitled “Fin ancial Assurance for Closure and Post Cl osure Guidance Manual” or U.S. EPA. 19 90.

74 U.S. EPA OIG. 2001. Page 57.

75 Gerard, D, E.J, Wilson. 2008. Journal of Environm ental Management 90 (1097-1105). Available online at https://www.researchgate.net/journal/0301-4 797_Journal_of_Environm ental_Management

76 For example, see 1982 RCRA guidance entitled “Financial Assurance fo r Closure and Post Closure Guidance Manual” or U.S. EPA. 1 990.

77 U.S. EPA. Unpublished. Analysis of Ou tcomes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells.

78 U.S. EPA. Unpublished. Notes from EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Trust Funds, Lette rs of Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009)

79 U.S. EPA OIG. 2001. Page 59.

80 For example, see 1982 RCRA guidance entitled “Financial Assurance fo r Closure and Post Closure Guidance Manual” or U.S. EPA. 1 990.

81 U.S. EPA. 2009. Summary of EPA Webinars on Financial Res ponsibility for Geologic Sequestration Wells. Available online at: http://www.epa.gov/safewater/uic/pdf s/meetings_uic_summarywebinar s_financial_responsibility.pdf

82 For example, see 1982 RCRA guidance entitled “Financial Assurance fo r Closure and Post Closure Guidance Manual” or U.S. EPA. 1 990.

83 U.S. EPA OIG. 2001. L etter of Credit

• L etters of credit have been used to dem onstrate financial responsibility under RCRA since approximately 1982 and have been r ecommended in guidance for Class II wells

since 1990. 73

• Letters of credit are widely used for RCRA financial assurance. 74

S urety 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 demonstrat e financial responsibi lity under RCRA since approximately 1982 and have been recommende d 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 th ey are ea sy for operators to obtain and administer. They are frequently used during permitting. 77

• Surety bonds are used regul arly, especially in direct implementation programs. 78 Widely

used for RCRA financial assurance. 79

I nsurance

• Insurance has been used to demonstrat e financial responsibility under RCRA since approximately 1982. However, it was not reco mmended in guidance for Class II wells in

1990. 80

• Insurance has been used for environmenta l risk management since the 1957 PriceAnderson Act, which contained financial requi rements for nuclear pr ojects. Licensees are required to obtain maximum amount of priv ate liability insura nce available on the market, currently $300 million (or show proof of comparable resources); licensees are strictly liable for “extrao rdinary nu clear occurrences.” 81

F inancial Test and Corporate Guarantee

• Financial tests have been used to demonstr ate financial responsibi lity under RCRA since approximately 1982 and have been recommende d 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 we ll financial responsibility in the past, but have been used by the courts and by states for two financial respons ibility purposes: first,Research and Analysis Supporting Financial Responsibility Requirements and Guidance 39 84 Communication with Alan Slater of the MA DEP.

85 Boyd. 2001. in many environmental liability court cases, fi rms 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 remedi ation period, which would typi cally 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 fina ncial mechanism for environmental activities when securing so me 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 repl acement of its privat ely owned wastewater treatment facility (e.g., at a mixed use reside ntial/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 fo r a capital reserve acc ount as an alternate financial mechanism. As a second exampl e, in Nebraska, the Department of Environmental Quality requires th at waste tire haul ers provide financial assurance for the removal, closure, and abatement of waste tire s and materials. The waste tire hauler may

use an escrow account as the financial a ssurance 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 dem onstrate financial responsibility under Nebraska

law. In either exam ple, the magnitude of th e 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)?

S urety Bond

• Typically, bonds are used to guarantee performance of a known, future obligation. Bond agreements typically assume that the princi pal bears ultimate respons ibility 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 us e of claims-made policie s (those that provide coverage for claims presented to the insu red and reported to the insurer during the coverage period) be accompanied by additional safeguards to provide assurance over long timeframes. For example, regulations ma y require that the c overage period of a claims-made policy be extended beyond th e policy’s cancellation date. OccurrenceResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 40 86 Boyd. 2001.

87 Boyd. 2001.

88 U.S. EPA OIG. 2001.

89 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

90 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

91 U.S. EPA OIG. 2001. policies cover claims arising even after th e policy period has ended, providing the cause

of the claim occurred duri ng the policy period. Insurers like to avoid occurrence coverage, as a way to reduce the scale and e nhance 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 contamin ation) tend to be assured via

insurance coverage. 87

Fi nancial Test and Corporate Guarantee

• Under RCRA , firms must have a net worth greater than $10 million. 88

• During the FR webcasts, participants indica ted that a $10 million threshold seemed low relative to a GS project for coverage under se lf-insurance. Many agr eed that third-party mechanisms provide more protection than self-insurance. Regulators who use selfinsurance have found that additional time is re quired to regulate due to the need to follow details about the company’s financial hea lth, and there are sometimes multi-level companies who have different responsibili ties within the company regarding selfinsurance. 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 informati on available to characterize how an escrow account is most commonly utilized for envir onmental 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 characteri zed as a “better” long-term investment for the firm.

7 ) Under what conditions does the instrument tota lly 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 prov iding financial assura nce be financially independent from the activity being covered. 91Research and Analysis Supporting Financial Responsibility Requirements and Guidance 41 92 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents 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)

97 U.S. EPA OIG. 2001. RCRA FA review. http://www.epa.gov/oig/repor ts/2001/finalr eport330.pdf

98 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

99 Boyd. 2001.

100 Boyd. 2001.

101 U.S. EPA OIG. 2001. Standby Trust

• The standby trust may fail if it is allowed to close prior to being funded and is therefore

not available when needed.

Le tter of Credit

• A letter of credit could fail when a bank ch anges ownership and th e 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 a ssurance is not put in place. 94

• EPA OIG recommends that the third party prov iding financial assura nce 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 i rrevocable and issued for a period of at least 1 year. The letter of credit must provide th at the expiration date will be automatically extended for a period of at least 1 year unl ess, at least 120 days before the current expiration date, the issuing institution notifies both th e 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 Ad ministrator have r eceived the notice. 96

Surety Bond

• If a surety issues a la rge number of bonds to facilities in one corporation, the surety bond risk might not be adequately dive rsified in terms of reinsurance. 97 A surety bond could fail if bond ratings are wrong. 98

• Many bonds are “penal bonds” that authorize th e forfeiture of an entire bond amount for failure to perform as agreed. As a result, ev en 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 worri some form of confiscation, and more a penalty used to motivate complia nce with performance standards. 99

• Despite regulations that typically guard agai nst the possibili ty of assuror insolvency by requiring U.S. Treasury certifi cation of bond issuers, assure r provider bankruptcies are relatively common, and there is no insurance against an a ssuror’s financial failure. 100

• Refusal of issuing entity to honor bond requirements. 101Research and Analysis Supporting Financial Responsibility Requirements and Guidance 42 102 U.S. EPA. 1996.

103 40 CFR 144.63(b)(8) or (c)(8)

104 U.S. EPA. 2009. United States Environmenta l Protection Agency RCRA Subtitle C Financia l Assurance Instrument Fact Sheet: Suret y Bond.

Available online at http://www.epa.gov/waste/hazard/tsd/td /ldu/financial/doc uments/sbond-fs.pdf

105 U.S. EPA OIG. 2001.

106 Boyd. 2001.

107 40 CFR 144.63(e)(8)

108 U.S. EPA. 2009. Summary of EPA Webinars on Financial Res ponsibility for Geologic Sequestration Wells. Available online at: http://www.epa.gov/safewater/uic/pdf s/meetings_uic_summarywebinar s_financial_responsibility.pdf

109 Boyd. 2001.

110 Marcia Williams. 1987. EPA Guidance On Excl usions For Pre-Existing Conditions In RCRA TSDF Insurance Policies. Available onlin e at: http://yosemite.epa.gov/osw/rcra.nsf/ ea6e50dc6214725285256bf00063269d/bc5ce94e 1913f2b88525670f006c1844!OpenDocument • The overall assurance risk for EPA's sure ty 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 Re g ulator 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 occu r, however, during 120 days beginning on the date of the receipt of the notice of cancellation. 103

• If the Company fails to provide alternate fi nancial assurance and r eceive written approval of the new mechanism by the Regulator within 90 days, the Regulat or can direct the Surety to pay up to the amount guaranteed by the bond into th e standby trust fund. 104

• EPA OIG recommends that the third party prov iding financial assura nce be financially independent from the activity being covered. 105

I nsurance

• Instruments should not be easily withdraw n by providers if costly environmental problems develop. In most situations, insu rers 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, term inate, or f ail to renew the policy except for failure to pay the premium.” 107

• UIC Class I Hazardous Wells the policy “mus t contain a prov ision allowing assignment of the policy to a successor owner or opera tor” that depends on the consent of the

insurer. 108

• One concern associated with insurance is th at the policy may feature “exclusions” that weaken coverage. For this reason, regulators must carefully verify that policies fully cover the kinds of claims subj ect to assurance requirements. In general, contract law offers protections against the use of exclusi ons that are not volunt arily 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 pr e-existing conditions ex clusions that would invalidate the purpose of the policy and/or are based on suspected rather than known preexisting conditions. Pre-existing conditions ex clusions m ust be specifically based on

factual information known at the tim e the contract was entered into. 110

• During the FR webcasts, one concern was that if an insurance co mpany feels that the owner/operator did not disclose all of the ava ilable information about the project, then the policy is void from the beginning. There is a court case involving Zurich North AmericaResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 43 111 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologi c Sequestration Wells: Insurance (May 20, 2009)

112 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

113 U.S. EPA OIG. 2001.

114 Boyd. 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 Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09) and EPA. UIC does not have a provisi on for cancellation with notice for fraud. 111
Webinar participants indicated that insuran ce companies can cancel for non-payment of premiums, and non-payment would likel y occur in the case of bankruptcy 112

.

• EPA OIG recommends that the third party prov iding financial assura nce 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 wh en its strength is most needed—upon the insolvency of the parent. Some, but not al l, 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 policie s 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 insuran ce 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

F inancial Test and Corporate Guarantee

• The problem with corporate guarantees is th at there exists no financial instrument dedicated to environmental obligations. The degr ee to which a firm’s assets are obligated

to other liens or cr editors 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 faciliti es with multiple obligations in multiple jurisdictions. Adding up all these obligations and accounti ng for them properly is crucial for assessing a firm’s ability to internaliz e 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 pa ssed 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 receivi ng TARP money, so it may not be a good

measure anymore. 119

• If a company is bankrupt, some alternativ e mechanism to pay would be necessary, and

financial tests are difficult to conduct on mu lti-level companies because it may not be clear which level of the company is res ponsible. Other drawbacks cited by webcast participants included the timeframe and n eed 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 usedResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 44 120 U.S. EPA. Unpublished. Notes from EPA Webcast on Financial Responsibility for Geologic Sequestration Wells: Self-Insurance: Fi nancial Test and Corporate Guarantee (May 26, 2009)

121 U.S. EPA. 1984. Parent Company Guarantee For Newly Independent Company. Available online at: http://yosemite.epa.gov/osw/rcra.nsf/ ea6e50dc6214725285256bf00063269d/a78bf6cc0 672f5e08525670f006bbda8!OpenDocument

122 Based on DOE Regional Carbon Sequestration Part nership (RCSP) sites and other known sites.

123 Kuipers, Jim. 2003. Putting a Price on Pollu tion – Financial Assurance for Mine Reclam ation and Closure. Mineral Policy Center . MPC Issue Paper No. 4. March 2003. http://www.earthworksaction.org/ pubs/PuttingAPriceOnPollution.pdf

124 Kuipers. 2003 within a framework of industry-wide pooling of resources, could work. A participant noted that self-insurance may be suffici ent 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 fina ncial test or corporate guarantee must be designed to be very conservati ve in selecting co mpanies for self-insurance so that only the strongest companies are a llowed to use self-insurance. 120

• If a subsidiary uses a Corporate Guarant ee from its parent company to provide RCRA financial assurance and the subsidiary subse quently becomes autonomous from the parent company, the Corporate Guarantee no l onger 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 provid ing financial assurance through the escrow account should be financially independe nt from the activity being covered.

B. Considerations for GS

8) Do states prohibit the use of certain mech anisms? 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 w ith other cash /cash equi valents – 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, th ey 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 ar e the most practical way to assure financial responsibility. 124Research and Analysis Supporting Financial Responsibility Requirements and Guidance 45 125 Based on DOE Regional Carbon Sequestration Part nership (RCSP) sites and other known sites.

126 Based on DOE Regional Carbon Sequestration Part nership (RCSP) sites and other known sites.

127 State of Washington. 2008. Proposed Rule (Washington Administ rative Code, Chapter 173-218, Underground Injection Control Progra m)

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 Part nership (RCSP) sites and other known sites.

130 Source online at: http://www.gao.gov/ne w.items/d07152.pdf

131 U.S. EPA OIG. 2001.

132 Based on DOE Regional Carbon Sequestration Part nership (RCSP) sites and other known sites.

133 Kuipers. 2003. L etter of Credit

• G S 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 W Y )

. 125 It does not appear that any of these states will prohibit the use of Letters of credit.

Su rety 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 W Y )

. 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 readil y accessible for environmental obligations. However, there is a potential due to increas ed costs and risk of unknown environmental obligations, that surety bonds may become more difficult to secure as an assurance mechanism. An example of increased difficu lty in securing surety bonds is what has occurred regarding mining reclamation and that mining reclamation and closure bonds are considered high-risk. The increased ri sk for mining reclamation occurred due to uncertainty about bond duration, co ncerns about enforcement, along with realization that cleanup and closure of modern mines is sign ificantly more expensive than initially projected. 128 There is a potential that access to su rety bonds may be limited in certain GS situations and may be dependent upon the si te characteristics a nd accuracy of cost projections.

I nsurance

• 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 W Y )

. 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 st ates 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 assu rance in under Sub title C in the following states: AL, NY, TX, and VA . It is allowed in CA, CT, MO, OH, and W A. 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 W Y )

. 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 Cor porate 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. 133Research and Analysis Supporting Financial Responsibility Requirements and Guidance 46 134 Kuipers. 2003

135 Mahan, Jeff. RCRA Financial Test and Corporate Guarantee. Depa rtment of Toxic Substances Control. Sacramento, California. http://www.dtsc.ca.gov/LawsRegsPolicies/Regs/ upload/HWMP_FR_FinanT estCorpGuarantee.pdf

136 U.S. EPA OIG. 2001.

137 Boyd. 2001.

138 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents 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, Lett ers of Credit, and Surety Bonds with Standby Trust Agreements (April 28, 2009) • Financial test and corporate guarantee can be readily access ible 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 signi ficant financial resources in the future. 135

Escrow Account

• Because of their use in transactions a nd 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 mortga ges) can ask to be put in escrow.

9 ) What factors make the instrume nt more/less easy for the re gulator 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 CF R 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 in solvency of a financia l institution acting as

trustee. 137

S tandby Trust

• Standby trust funds are not considered stand alone instruments, how ever, see discussion

on trust funds above.

L etter of Credit

• L etters of credit require re gulators 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 w ith the bank and the amount of liquid assets the company

has 138 because a letter of credit can only be al tered with the agreement of the purchaser, the provider, and the beneficiary. The cred it provider does not generally pay out on claims. Rather, the purchaser indemnifies th e bank, making the bank liable only if the purchaser defaults. 139 During the initial demonstrati on, 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 indi cated that EPA and States do not have legal resources to use letters of cr edit; he noted that surety bonds are a much

better choice for that reason. 140

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,Research and Analysis Supporting Financial Responsibility Requirements and Guidance 47 141 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comm ents by instrument. (Version 10-21-09)

142 U.S. EPA OIG. 2001.

143 Boyd. 2001.

144 U.S. EPA. 2009. United States Environmenta l Protection Agency RCRA Subtitle C Financia l Assurance Instrument Fact Sheet: Suret y Bond.

Available online at http://www.epa.gov/waste/hazard/tsd/td /ldu/financial/doc uments/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. especially with a change of ownership. In this respect, the mechanism may be less attractive compared to others due to conve nience or applicability. An EFAB member commented that surety bonds stand “head and shoulders” above ot her 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 postclosure only when the owner or operator fail s to comply with closure or post-c losure 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 regulat or 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 ad minister, and are freq uently used during permitting. Under most programs, surety co mpanies must be certified by the U.S. Treasury Department to qualify as an acceptabl e source of assurance. Surety bonds, like letter of credit, cannot be can celled 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 Regulat or must send a written notificat ion to the surety tha t the company ha s failed to perform in accord ance with the requirements of the Bond. 144 On the other hand, the state may ha ve to litigate to obtain th e 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.

I nsurance

• During the FR webcasts, participants noted that insurance companies currently go through site-specific consultation and a met hodology to estimate costs. Over time, insurers gain the ability to perform rigorous cost estimations. However, participants were concerned that for GS, insurers would be es timating costs for something that has never existed. In a future paper, EFAB will anal yze failures and identify what works in th e field, what works in the insurance industr y, and how to handle proprietary business

information. EFAB intends to give a set of ope rating principles set fo rth in a paradigm so that it’s mathematically certain that it will work. 145

• Insurance can be difficult to evaluate and monitor 146 for a regulator. Since insurance is primarily regulated by states, differences in state regulations contribute to the complexities regulators would face in evaluatin g insurance policies. For group insurance, states and the federal government could bu ild from IRS criteria based on how insurance

is financed for various rated and unrated or ganizations. Since regulat ors are not privy to an insurance company’s site-specific eval uation of its insurance policy objectives, regulators may have a difficult time understand ing 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 insuranceResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 48 147 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

148 Boyd. 2001.

149 U.S. EPA OIG. 2001.

150 Boyd. 2001. commissioner established criteria that ha ve 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 interpre t 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 responsibilit y. Federal regulations (applicable to RCRA ) allow fi nancial test requirements to be me t 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 or iginal company. After ev aluating the test or guarantee, a regulator would need to conduct at least annual update s to try to predict whether a company will remain solvent, so regulators would have to take the time necessary to evaluate the test s and keep updated in order to predict future problems with the company. Self-demonstration requires the government to m onitor the firm’s financial condition over time. Accordingl y, regulators must regularly a udit 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 beca use 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 fina ncial 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 invol ve interpretation, verification, and monitoring of the financial tests over time requiring eith er significant in-hous e accounting expertise or reliance on third-party audits. 150

E scrow Account

• Escrow accounts are relatively secure, while remaining liquid, and would be managed by a single bank, making them easy to evaluate. Ho wever, there is less incentive for a firm to use an escrow account over a trust fund, b ecause the interest accrued over time will be limited when compared to a trust fund. Furt hermore, escrow accounts have not yet been used for environmental liability projects with a magnitude comparable to a GS project.Research and Analysis Supporting Financial Responsibility Requirements and Guidance 49 151 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comm ents by instrument. (Version 10-21-09)

152 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comm ents by instrument. (Version 10-21-09)

153 Communication with Alan Slater, MA DEP. 1 0) 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?

T rust Fund

• Webcast participants indicated that trust f unds may have a lower administrative burden than other instruments because they do not requ ire 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 valua tion during the pay-in-period, if it is allowed, (3) ensuring that the fund’s valuation matches re vised cost estimates (annual valuation and periodic readjust ment), 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 l ong as the Director is confiden t in the respective state or federal regulator’s review of the third-pa rty. 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 th e trust fund would be a one-time occurrence, taking plac e either to fulfill unmet oblig ations, 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 lette r of credit or surety bond the to tal administrative burden would include (1) ensuring the fund’ s existence as a standby (annua l valuation), and (2) the termination of the standby trust. The burden a ssociated with the termination of the trust

fund would be a one-time occurr ence, taking place either to fulfill unmet obligations, or to reimburse the owner or operator.

Let ter of Credit

• Webcast participants said that letters of cred it 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 si nce switched to us ing escrow accounts. 153

• The total administrative burden fo r a FR demonstration using a letter of credit is driven by (1) the initial demonstration, (2) ensuring that th e letter of credit’s valuation matches revised cost estimates (annual va luation and periodic readjustme nt), 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 isResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 50 154 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells. Comm ents by instrument. (Version 10-21-09)

155 Marcia Williams. 1987. EPA Guidance On Excl usions For Pre-Existing Conditions In RCRA TSDF Insurance Policies. Available onlin e at: http://yosemite.epa.gov/osw/rcra.nsf/ ea6e50dc6214725285256bf00063269d/bc5ce94e 1913f2b88525670f006c1844!OpenDocument

156 U.S. EPA OIG. 2005. fulfilled. The initial demonstration would requ ire a review of the submitted paperwork,

but no review of the trustee’s financial conditi on, as long as the Director is confident in the respective state or federal regulator’s review of the thir d-party. The burden associated with returning the letter of credit if the owner or operato r fulfills its obligations is minimal. However, if the Director needs to draw on the letter of cr edit, 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 th e 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 ag reement, there may be a need for redemonstrations by the owner or operator if their financial condition fluctuates greatly before the environmental obligation is fulfille d. The initial demonstr ation would require a review of the submitted paperwork, but no review of the trustee’s financial condition, as long as the Director is confiden t in the respective state or fede ral regulator’s review of the third-party. The burden associated with th e cancellation of the bond if the owner or operator fulfills its obligations is minimal. Ho wever, if the Director needs to draw on the surety bond, the funds or the completion of ob ligations come from th e third-party itself (funds are not set-aside); acce ssing the funds may require negotiation or litigation.

I nsurance

• OSW guidance suggests EPA or authorized states conduct periodic reviews of basic policy language to ensure that only accep table pre-existing condition exclusions are

used. 155

• Insurance language can be complex, and regulat ors 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 demonstrati on, (2) ensuring that the policy’s coverage is adjusted along with revised cost estimates (periodic readjust ment), and (3) the cancellation or use of insurance. The insurance company can cancel th e policy; therefore, there may be a need for re-demonstrations by the owner or opera tor if their estimated costs or financial condition fluctuates greatly be fore the environmental obligat ion is fulfilled. The initial demonstration would require a review of the submitted insurance policy, but no review of

the trustee’s financial conditi on, as long as the Director is confident in the state regulator’s review of the thir d-party. The burden associated with reviewing the insurance policy may be substantive due to variations among policies (i.e., site specific policies,Research and Analysis Supporting Financial Responsibility Requirements and Guidance 51 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 insura nce policy, the funds or the completion of obligations come from the third-party itself (funds are not set-asid e); accessing the funds may require negotiati on or litigation.

F inancial Test and Corporate Guarantee

• Corporate financial tests must be reeval uated and re-administered on a particular schedule, creating administration costs for regulating agencies a nd regulated entities. 157

• The total administrative burden fo r a FR demonstration using a financial test is driven by (1) the initial demonstrati on, and (2) annual reevaluations . The initial demonstration would require a review of the submitted fina ncial statements and calculation in a direct review of the owner or operators financ ial condition. Therefore, unlike third-party mechanisms, it is the Director reviewing the financial conditi on of the owner or operator instead of a third-party. The burden associated with review ing the owner or operator’s financial condition may be substantive to ch eck that financial cal culations ( ratios ) and other financial documents (bond ratings, or a nnual statements) are complete and accurate.

There is no additional burden if the owner or operator fulfills its ob ligations. 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.

E scrow Account

• The total adm inistrative 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 de monstration. The regulat or would need to work closely with the owner or operator and the escrow agent to ensure that the in strument was established with provisions that work for the type of GS activity and timeframe required.

1 1) Which GS phase(s) is the instrument best su ited 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 owne r or operator failing (for cer tain environm ental activ ities). To the extent there is a pay-in period, thes e strengths are diminished because the owner or operator could fail prior to the trust becoming fully funded.

• For well-defined activities lacking “environmenta l risk” (i.e., certain to occur) such as well plugging, post-injec tion 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 risk iness of the trust’s investment portfolio), (2) risk from the failure of the trustee firm, and (3) risk of cost

escalation.

157 U.S. EPA OIG. 2001.Research and Analysis Supporting Financial Responsibility Requirements and Guidance 52 158 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

159 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

160 U.S. EPA OIG. 2001. • For activities with uncertain frequency and costs, such as emergency and remedial response, trust funds may perform poorly be cause the pool of funds in a trust does not respond to contingencies outside thos e embedded into the cost estimate.

• For activities that continue ove r the long-term (i.e. post-injec tion site care, site closure, and emergency and remedial responses in the post-injection site car e 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 webc ast participants indicated that trust funds

were less ris ky than insurance policies that require the owner or operator to continue paying premiums in order to continue coverage.

o Ho wever, two webcast participants expre ssed concern that trust funds may not be

the best instrume nt 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 wh ich 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 th at unnecessarily raises GS costs).

S tandby Trust

• Standby trusts are not considered stand alone instruments. Th ey are used exclusively for the short term fulfillment of environmental obligations.

L etter of Credit

• During the FR webcasts, participants discu ssed the appropriateness of instruments for various project phases and noted that letters of credit would appl y to construction and operation, but probably are not suited for cl osure or the monitoring phase. It was

uncertain whether the letter of credit woul d still be useable after 40 or 50 years. 159

• Widely used for RCRA financial assurance during hazardous waste landfill closure and post-closure care. 160

• 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 bu rden of determining creditwo rthiness 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 heal th 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 ove r the long-term (i.e. post-injec tion site care, site closure, and emergency and remedial responses), letter s of credit may be less effective than other instruments because they are granted fo r an annual period, upon which the creditorResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 53 161 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

162 U.S. EPA OIG. 2001.

163 Gerard, D, E.J, Wilson. 2008. Journal of Environm ental Management 90 (1097-1105). Available online at https://www.researchgate.net/journal/0301-4 797_Journal_of_Environmental_Management

164 Boyd. 2001. reconsiders extension (although th ere 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) app licability if these instrument s 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 under write bonds over longer

time horizons where there is considerable unc ertainty. GS projects that intend to use surety bonds should be able to “clearly delin eate timeframes and levels of responsibility.” Bonding for GS projects is likely to be an e ffective financial mech anism if transaction costs are low and with “well-defined ag reements and agreed upon definitions of compliance and non-compliance, a high proba bility 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 offeri ng letters of credit, surety companies are more focused on pooling the risk of failure ac ross 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 uncerta in environmental activities, surety bonds may not handle the numerous scenarios fo r environmental obligations as well as

insurance because their struct ure of contingency payments is different than it is for

insurance.

• For activities that continue ove r the long-term (i.e. post-injec tion site care, site closure, and emergency and remedial responses), sure ty 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 ope rator’s sites ar e covered under a single bond (as if it were a singl e site), are inferior because they do not cover the full scale of the owner or operat or environmental obligations and hence present a much higher risk of the public paying for the owne r or operator’s envir onmental obligations. 164

I nsurance

• For activities with uncertain frequency and costs, such as emergency and remedial response, insurance is the id eal instrument for diversif ying environmental risk andResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 54 165 Boyd. 2001.

166 Boyd. 2001.

167 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents 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 Fi nancial Services Group. Available online at: http://www.zurich.com/NR/ rdonlyres/E2B5B53E-11DB47AF-91E4-01ED6A2BDCA3/0/ ClimateRiskChallenge.pdf

169 U.S. EPA. 2009. Notes from Webcasts on Financial Responsibility for Geologic Sequest ration Wells. Unpublished notes from May 2 0, 2009

Insurance webcast. handling the numerous scenarios possible in this GS phase. Moreover, insurance companies internalize much of the admini strative burden of overseeing owners or operators by creating the incentive for reduc ing 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 in stance, insurers prefer policies that cover claims made during the covera ge period (preferable the peri od of time during which the owner or operator is paying premiums) and av oid 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 th at shorter terms with finite policies will be easier to obtain, while longer-term po licies that cover broader areas will be more expensive and ha rder to obtain.

• During the FR webcasts, participants suggested that insurance probabl y works best in the operational phases of a GS project because th e 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 busine ss at the end of the operational phase. 167

• The insurance company Zurich has develope d what they call the Geologic Sequestration Financial Assurance plan which covers cl osure and post-closure costs, and a CCS liability plan which covers po llution event liability, business interruption, control of well, transmission liability, and geomechanical liability. 168

• During the FR webcasts, a participant said th at insurance probably works best for the operational phases of a facility. During the injection operations, the activities are not unusual technological activities (with the excep tion of sequestering the carbon dioxide). According to the participant, insurance beco mes problematic during site closure and postclosure care. The partic ipant wondered how an insurer ensu res financial responsibility for that period of time. He suggested that a forfeiture bond, surety bond, or trust fund would be more appropriate. Another participant agr eed that insurance woul d be a viable option through well construction. 169

• For well-defined activities lacking “environmenta l risk” (i.e., certain to occur) such as well plugging, post-injection site care, and site closure, insu rance 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 owne r or operator’s parent firm. However, because the insurance company is not owned by a third party, captive

insurance inherits the ri sks of self-insurance.Research and Analysis Supporting Financial Responsibility Requirements and Guidance 55 170 U.S. EPA. 1996.

171 U.S. EPA. Unpublished. Analysis of Outc omes of EPA Webcasts on Financial Responsibility for Geologic Sequestration Wells: Comm ents by instrument. (Version 10-21-09)

172 U.S. EPA OIG. 2001.

173 Kuipers 2003, and Boyd. 2001. F inancial 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 ha ving to pay for the environmental obligations of a owner or operator) is an order of magn itude higher when self-i nsurance is used than when a third party instrument is used. 170

• During the FR webcasts, participants stat ed 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. 172

• Self-insurance FR demonstrations are equivalent to a waiver of third-party instruments for large and historically financ ially stable firms. If the fi rm’s net worth is large enough and its risk of failure low enough, the governme nt effectively guarantees the fulfillment

of environmental activities in event of the owner or operator’s failu re. For this reason, self-insurance is a very cont roversial means for demonstrat ing financial responsibility.

• The financial test and corporate guarantee coul d 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 financia l responsibility. Therefore, the primary reason to admit self-insurance is to promote GS as a matte r of public policy. Wh en a self-insured company fails the fundamental purpose of FR–e nsuring that the pollu ter 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-ins urance, the cost of risk-pooled private FR instruments (i.e., in surance) 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-i nsurance with a comparative a dvantage and may also inhibit the development of robust third-party instrument markets, especially in the early years of commercial GS activity.

E scrow Account

• Escrow accounts perform almost exactly like tr ust 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 overs ight), 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 likelyResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 56 174 U.S. EPA OIG. 2005.

175 U.S. EPA OIG. 2005. 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 ak in to standby trusts.

1 2) For each GS phase, can the specific weakne sses of an instrument be minimized by
combining it with another mechanism?

T rust Fund

• Trust funds, letters of credit, surety bonds guaranteeing payment, and insurance can be combined for a facility if together their va lue is at least equal to the closure or postclosure cost estimate. Surety bonds guaran teeing 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 s ite care and site closure. However, the uncertain frequency and costs associated with emergency and remedial response may not match the trust fund’s relati vely fixed value (i.e ., response activities may be more or less than estimated cost s) and may occur with an unknown timing. The unknown timing of response activities could crea te 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 re sponse 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 th is approach the owner or operator uses the trust fund as set-aside financing to cove r lower-cost ac tivities, and purchases risk assurance (l etter of credit, su rety bond, insurance) to make up the difference for high cost activities. However, from the Director’s perspective, the additional burden and complication from revi ewing 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 va lue is at least equal to the closure or postclosure cost estimate. Surety bonds guaran teeing performance, financial tests, and corporate guarantees cannot be combined. 175

• Le tters of credit may work most effectively for well-defined activities, near term activities, and phases such as corrective act ion or injection well plugging. However, the longer-term nature of post-inj ection site care and site closur e and the uncertain frequency

and costs associated with em ergency and re medial response may not match value of the letter of credit. Changes in financial mark ets 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 cr editor’s perspective. For response activities,Research and Analysis Supporting Financial Responsibility Requirements and Guidance 57 176 U.S. EPA OIG. 2005.

177 U.S. EPA OIG. 2005. it may be possible to utilize in surance to manage the uncertainty associated with cost. However, from the Director’s perspective, the additional burden and complication from reviewing more than one inst rument 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 va lue is at least equal to the closure or postclosure cost estimate. Surety bonds guaran teeing performance, financial tests, and corporate guarantees cannot be combined. 176

• Surety bonds may work most effectively for we ll-defined activities and phases such as corrective action, injection well plugging, and post-injection s ite 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 re medial response it may be possible to combine a surety bond with a trust fund to spl it up potential costs. Th at is, use the trust fund for response activities up to a pre-estab lished value (that the owner or operator can afford to set aside) and then use the su rety bond for response ac tivities with more predictable costs. By pursuing this approach, the owner or op erator uses the trust fund as set-aside financing to cover low-cost activit ies, and purchases a surety bond to make up the difference for high cost ac tivities. However, from the Director’s perspective, the additional burden and complication from revi ewing 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 va lue is at least equal to the closure or postclosure cost estimate. Surety bonds guaran teeing performance, financial tests, and corporate guarantees cannot be combined. 177

• Insurance is likely to be most suitably matc hed to manage the uncertain frequency and costs associated with emergency and reme dial response. However, the well-defined activities and phases such as corrective act ion, injection well pluggi ng, and post-injection site care and site closure may also be mana ged by insurance. Owners or operators could lower their insurance premium payments by set ting money aside in a trust fund or escrow account to pay for activities up to a pre-estab lished 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 revi ewing more than one instrument may be

undesirable.

Financial Test and Corporate Guarantee

• N/A. The primary driver for utilizing the fina ncial test and corporat e guarantee is to avoid the use of the other third-party mechanisms.Research and Analysis Supporting Financial Responsibility Requirements and Guidance 58 E scrow Account

• Escrow accounts may work most effectively fo r near-term activities and phases such as corrective action or emergency and remedial response during injection. The longer time periods associated with a ll other GS phases m ake escrow accounts a relatively undesirable mechanism. Although any of the in struments could be combined with an escrow account over the long-term, it may be mo re desirable from both the perspective of the owner or operator, and th e regulator, to simply utilize another instrument (or combination of third party instruments such as insurance, surety bonds or letters of credit).4

. Rationale for Financial Responsibility Instrument Selection

I. Introduction

The rule “Federal Requirements Under the U nderground Injection Cont rol (UIC) Program for Carbon Dioxide (CO 2 ) Geologic Sequestration (GS) Wells” es tablishes a new Class VI well with specific requirem ents for th e underground injection of CO 2 for the purpose of GS. The rule contains specific provisions for owners or opera tors of GS wells to demonstrate and maintain financial responsibility for corr ective action on wells in the Area of Review (AoR), injection well plugging, post-injecti on site care and site closure, a nd emergency and remedial response. Figure 4.1 shows the various phases of a GS project; the activities for which financial responsibility must be demons trated are shown in bold.

Figure 4.1: GS Project Activities

*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 cons truction) are not activities for which financial responsibility must be demonstrated.

EPA will describe the types of financial instrument s that owners or operators can use to meet the requirement in GS Class VI Guidance entitled “F inancial Responsibility f or Class VI Wells.” This paper provides EPA’s rationale for ma king decisions on the financial instruments

recommended for Class VI financial responsibilit y demonstrations. The intended audience is GS well owners or operators, EPA and stat e regulators, and the general public.

A. Summary

EPA based its decision ma king with emphasis on USDWs protection on an analysis of (1) the potential for instrument failure, and (2) reso urce implications for owne rs or operators and Directors (see a summ ary of EPA’s research a nd 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 fina ncial tests and corporate guaran tees. Based on the analysis of these instruments, Table 4.1 indicates the re lative suitability of the various financial responsibility demonstrations for each project activity.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 59Table 4.1: Instruments Best Suited for GS Activities

Corrective Action Injection Well Plugging Post-injection Site
Care and Site Closure Emergency and Remedial Response

1 . Trust fund

2. Letter of credit

3 . Surety Bond

4. Escrow Account

5. Financial test and corporate guarantee* 1. Trust fund

2. Letter of credit

3. Surety Bond

4. Insurance

5. Financial test and corporate guarantee* 1. Trust fund

2. Insurance

3. Financial test and corporate guarantee* 1. Insurance

2. Letter of Credit**

3. Surety Bond**

4. Financial test and corporate guarantee*

*Financial tests and corporate guarantees pres ent the lowest direct costs to owners or operators but the highest risk to the pu blic. Therefore, the reason to allow financial responsibility demons trations 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:

• T he historical precedent and c ontext for using trust funds, lette rs of credit, surety bonds, insurance, escrow accounts, and financial te sts and corporate guarantees for financial responsibility demonstrations.

• T he factors leading to instrument failure, wh ich ultimately result in costs to the public.

• T he resource implications, to the owner or operator and the Director, associated with utilizing the financial responsibility instruments.

• A dditional information explaining which instru ments EPA recommends for particular GS activities and why.

II. 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 escr ow accounts were specif ically 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 wast e activities, including Cl ass 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 Mi chigan UIC programs and were perceived by the states to have similar functionality. Although standby trusts are not c onsidered stand-alone instruments, they have historica lly been combined with letters of credit and surety bonds when EPA is the Director instead of a state (i.e., for direct implementation prog rams) and are discussed

below in this context.

III. Potential for Instrument Failure

EPA understands that all financial responsibility instruments have some risk of failure and acknowledges that the purpose of requiring fina ncial responsibility de monstrations is to

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 60Research and Analysis Supporting Financial Responsibility Requirements and Guidance 61 178 EPA recognizes that primacy states may have the ability to es tablish individual or pooled trusts, in which case there is no ri sk of third party

failure because the state itself is the trustee.

179 The failure of a third-party audit (i.e., inaccurate audit) c ould contribute to the collapse of the financial test and corpora te guarantee
instrument. minimize the risk that costs will be transferre d to the public. Although th e extent of the risk varies among instruments, adverse conditions re sulting from owner or operator failure, market volatility, third-party li tigation, 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, inst rument failure can be minimized along with the associated financial (e.g., clean up or enfo rcement costs), environmental (e.g., ground water contamination), or social (e.g., en vironmental justice) impacts.

The total failure of financial responsibility inst ruments 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 thir d party failure as financial inso lvency leading to unfulfilled requirements, or the outright abando nment of environmental obligations.

A

. Owner or Operator Failure

For all instruments except financia l tests and corporate guarantees, the risk of instrument failure is partially mitigated by the fact that the fund or liability is he ld by a third party. Therefore, for third-party instruments, both the owner or operato r 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 te st and corporate guarantee immediat ely fails. If the trust fund or escrow account is not yet fully funded due to a pa y-in period, financial insolvency of the owner or operator at the onset of the GS project or ove r 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 ar e therefore affected by third-party failure. 179 This failure may occur as a result of bankruptcy of the instrument admi nistrator or issuer, cancellation of the account or policy due to non-payment of fe es or premiums, or a change in third-party ownership. However, EPA notes that third-party failure must coin cide 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, letter s 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. Furthe rmore, the third party may terminate an account or policy based on changes to the owner or opera tor’s financial status, or for other reasons. Therefore, in the event of can cellation or non-renewal, EPA re commends 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.Research and Analysis Supporting Financial Responsibility Requirements and Guidance 62 180 Because the costs of the activity are paid for by trust funds and escrow account s, or the owner or operator is reimbursed, est imated costs are paid (i.e., set aside) upfront. However, when demonstrations ar e made with surety bonds and lette rs of credit, activity costs a re paid for by the owner or operator and the secured financial responsibility instrume nt is only used in the event that the owner or operator cann ot complete the activity. 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 financia l health of an owner or operator has been inaccurately assessed by the Director. EPA recogni zes 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 in strument 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 Ow ner or Operator and the Director

EPA recognizes that all third-part y instruments require the owner or operator to pay fees (upfront or annual fees) or monthly premiums to secure and maintain the instru ments (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 activ ity for instruments like trust funds and escrow accounts. Letters of credit may also require a cas h or hard asset collateral in addition to the premium. Therefore, EPA anticipates that the cost s that owners or operators will incur to obtain financial assurance will vary by in strument type. For third-party instruments, the costs paid by the owner or operator include the overhead cost n eeded to secure and maintain these instruments with the third party. Additionall y, 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 cas es the third party may seek reimbursement from the owner or operator. EP A recognizes that logistical aspects of the instruments have differing resource implications for the owner or operator and the Director.Table 4.2: Regulatory Risk, Oversight Effort, and Costs to Owners or Operators

Total Cost to the Company* Estimated
Overhead Cost

as a Percent of
Total Cost Relative

Financial Risk

to the

Government* Oversight and

Enforcement

Effort Needed*

Trust Fund High ~2% (total) Low Medium Low

Letter of Credit High 1. 5 - 2% (annual) Low Low

Surety Bond Medium High 0.5 - 15% (total) Medium Low Medium Low

Insurance Medium** No data available Medium Medium

Financial Test and Corporate Guarantee Low <0.5% (total) High High

Escrow Account High 1 - 2% (total) Low Medium Low

* Except for information on escrow accounts, relative ranki ngs are based on U.S. GAO. 2005. Environmental Liabilities ( http://www.gao.gov/ne w.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 inhe rits the risk of self insurance.

The Director’s goal in reviewing a financial responsibility demonstr ation 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 Dire ctor for an initial re view, reevaluations, and monitoring will vary among instrument s. During the initial review of the financial responsibility demonstration, For third-party instruments, the Dire ctor should consider th e stability of the thirdparty financial institutions to minimize the risk of instrument failure. In the case of financial tests and corporate guarantees, the Director needs to eval uate the stability of the owners or operators themselves. See Chapter 6 “Director’s Ex amination of Third Party Stability.”

A. D irector’s Review and Monitoring

EPA acknowledges that the initial review of the financial re sponsibility de monstration, reevaluations, and monitoring take time, regardless of which instrument is proposed. Trust funds, letters of credit, surety bonds, and escrow acc ounts require the lowest total oversight and

enforcement burden for the Director. Insurance and financial tests and cor porate guarantees have the highest levels of administrative burden. In surance policies will be complex due to sitespecific variations and differen ces within states. Financial tests and corporate guarantees are data-intensive and require fre quent evaluations and re-evalua tions for solvency. Financial auditing and review of financial mechanisms are resource intensive processes that require access to specific expertise or traini ng for which additional capacity may need to be developed within the UIC program.

V. Re commendations 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 financia l responsibility demonstrations can be characterized as environm ental obligations that are either relatively well-define d 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 cer tainty and sequencing.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 63• C orrective 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 du ring the AoR phase will be well-defined. However, the extent of future corrective ac tion 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 w ithin a 20 to 30 year period

.

• I njection well plugging , as described at 40 CFR 146.92, is relatively well-defined in

terms of when it will occur a nd 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.

• P ost-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.

• Em ergency and remedial response activities, as described at 40 CFR 146.94, in contrast

to the three activities describe d above, are relativel y 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 th e characteristics of the instruments an d the characteristics of GS project activities, EPA recommends the following financial instrument s as “best” or “good” for Class VI financial responsibility demonstrations (Table 4.3).

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 64Table 4.3: Instruments Best Suited for GS Activities

Corrective Action

and Phased
Corrective Action Injection Well Plugging Post-injection Site
Care and Site
Closure Emergency and Remedial Response

Trust Fund Best May be too little or too much money

Letter of Credit* Best May be unreliable for longer time periods (>20 years) Most appropriate for ERR during operation

Surety Bond* Good Best May be unavailable over longer time periods (>20 years)

Insurance Not ideal for operational phases Best

Financial Test and Corporate Guarantee Good, but provides no financial reco urse if owner or operator fails

Escrow Account 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 de scribed 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, a nd post-injection site

care and site closure demonstra tions. These activities are relati vely 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. Alt hough the cost of the instrument is essen tially the full cost of the activity, the owner or oper ator recovers this cost (in the form of reimbursement) following the fulfillment of the activity. In addition, costs to th e Director are relatively low. For activities with uncertain frequency and costs, su ch as emergency and remedial re sponse, the trust will likely not have the right amount of funds—too little money is a partial failure of the instrument that must be borne by the public and too much money repr esents an inefficient use of funds that unnecessarily raises GS costs.

B. Letters of Credit

Letters of credit are best suited for corrective ac tion and injection well plugging demonstrations. Letters of credit perform equally well for certain and uncertain e nvironm ental 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 opera tor, and risks faced by the owner or operator.

Costs to the Director are low when automatic re newals take place and no litigation is needed. For

activities that continue over th e 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 lin e of credit. Moreover, their application over longer time periods (i.e., greater than 20 years) is uncertain. T her efore, letters of credit may not be effective for post-injection site care and site closure.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 65Research and Analysis Supporting Financial Responsibility Requirements and Guidance 66 181 Captive insurance, where the insurer is an owner or operator’s parent or si bling firm, inherits the risks of self-insurance be cause the insurance company is not owned by a third party. Captive insurance is excluded from this discussion. C

. Surety Bonds

Surety bonds are good for corrective action and in jection well plugging demonstrations. Surety bonds perform equally well for certain and uncerta in environmental activities—as long as the limits are not exceeded. The cost to the owner or ope rator 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 th e long term (i.e., post-injection s ite care and site closure, and emergency and remedial responses), surety providers are unl ikely to underwrite bonds over longer time periods where there is considerable uncertainty.

D

. Insurance

Insurance policies are best suited for emerge ncy and remedial response dem onstrations. Insurance is the ideal instrument for diversifyi ng environmental risk a nd handling the numerous possible scenarios associated with emergency and remedial response. 181 However, because insurance policies may cover a wide range of contingencies with wi de 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, insu rance 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 a nd hence are just as reliable. The difference between the two financial responsibility instruments is th at escrow accounts have a lower cost to set up, less oversight (trust funds cost more to set up because resource s are spent on establishing stronger oversight), and their funds are kept in a highly liquid form (a simple interest beari ng 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 f und. Therefore, escrow accounts are likely only to be used for the shor test-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 guar antees may be useful or “good” for corrective action, injection well plugging, post-injecti on site care and site closure, a nd emergency and rem edial response. While offering the lowest cost to owners or operators, self-insurance represents the highest financial risk to the public. Addi tionally, the Director at the st ate or Regional level may need a high level of financial expertis e 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 publicResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 67 182 U.S. EPA OIG. 2005. State support. http://www.epa.gov/oig/reports /2005/20050926-2005-P-00026.pdf worthwhile to f acilitate the realization of br oader 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 financia l assurance are better suited to certain GS activities, E PA 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 singl e activity (e.g., well plugging). EPA recognizes, however, that Directors may be reluctant to allow combined de monstrations due to the likely additional burden in their review process. In ge neral, trust funds, letter s 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 re spective GS activity. Sure ty bonds guaranteeing performance, financial test s, and corporate guarantees cannot be combined for an activity

. 182Research and Analysis Supporting Financial Responsibility Requirements and Guidance 68 5. Presentation on Financial Responsibili ty to Ground Water Protection Council

On January 27, 2010, a short presentation was used to receive state i nput on EPA’s initial analysis on Financial Responsibil ity (FR) instruments for Geologi c Sequestration (GS) in the proposed Class VI UIC well class. A total of 48 participants representi ng EPA Headquarters and Regional offices, and S tate Underground Injectio n Control (UIC) programs attended the meeting.

I. 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 allo wable for FR demonstration and why an

instrument should not be allowed for a demons tration. The benefit of being specific in the

rule is that when an instrument is denied la ter 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 tr ust fund is administered by a state instead of a bank, it

reduces the likelihood of failure. In additi on to using a state administered trust fund to cover anticipated (estimated) cost s, 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 exam ple 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 seve ral 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 instru ment 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, rega rdless 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 in strument language could do a better job of specifying that funds can onl y be released upon the Director’s

authorization.

• Montana no longer accepts CD s from out-of-state banks.

o Michigan has faced problems with CD s 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 fina ncial institutions have failed. In these cases, alternative instruments were successfully identified and implemented.

o In an effort to minimize insurance fail ures, Texas passed a statute allowing FR demonstrations with insurance; but sin ce 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 in struments may not be available under state law. For example, in Montana, financia l 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 usingResearch and Analysis Supporting Financial Responsibility Requirements and Guidance 69 cash (CD or escrow account) over all other instruments, including a trust fund, is that all the state needs to do is say “rel ease the money.” In all other cases, the state may need to prove that the obligati on 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 th ere 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 stat e 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 th e instrument will be very different. The bond may have a face
value of $10k for Class I well, but that Cl ass VI bond values may be much higher.

o EPA added that it was asked to consid er 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 guidan ce 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 applic ations. Indeed, guidance specifying how to implement each instrument would be beneficial.II. Presenta tion

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 70Research and Analysis Supporting Financial Responsibility Requirements and Guidance 71Research and Analysis Supporting Financial Responsibility Requirements and Guidance 72Research and Analysis Supporting Financial Responsibility Requirements and Guidance 736

. Director’s Examination of Third Party Stability

This chapter describes EPA’s rationale for gui dance recommendations on the examination of third party stability. Because the failure of the third parties prov iding trust funds, standby trusts, letters of credit, insurance, and escrow acc ounts 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 re gulated by a non-EPA state or fe deral 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 Tr easury’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, th e stability determinations for surety bond providers may require the lowest effort. Alternat ively, the third party’s standing may be inferred by the number (and frequency) of enforcement actions taken by the fi nancial 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 gua rantee, bond ratings and credit ra tings can be used for third parties. Most financial institutions acting as th ird parties are likely to be evaluated by credit rating agencies and have publicly available ra tings (although detailed reports explaining the rationale for the rating may not be public). Cr edit ratings are review ed 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 pr oviders must either

• Pass financial strength requireme nts 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 guideli nes for owners or operators a nd the Directors, EPA can make recommendations on each component of the Rule requirements: (1) financial strength requirement based on credit ratings, (2) mini mum rating, (3) minimum capitalization, and (4) bond rating. Described below are several options fo r interpreting each of these requirements. The selected option, and the rationale for choosing this option, is also noted for each component.

I. 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 cat egories 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 ma intains 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-insu rance and third-party provider) is the same--minimizi ng the likelihood that th e provider will be unable to meet its financial obligations.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 74B. Credit rating by any Nationally Recognized Statistical Ratings Organization (NRSRO)

EPA could recommend that thir d-party providers provide a cr edit rating of the Xth highest category (e.g., 3 rd or 4 th highest) as determined by any NRSR O. 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 cr edit ratings are not limited to just two rating agencies (Standard & Poor’s and Moody’s). A pote ntial weakness is that categories may not be consistent among rating agencies (i.e., a 4 th highest rating from one agency could mean “adequate” or “moderate risk” while a 4 th highest rating from another agency may mean “inadequate” or “s ubstantial 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 sp ecific rating agencies along w ith 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 re quirement 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 subm it a comparable rating from any NRSRO as long as the owner or operator can demons trate the credibility of this rating compared to the recommended ratings.

II. Minimum Rating

A

. [SELECTED] Minimum credit rating using the same option chosen for the credit rating requirement

EPA may interpret minimum rating to mean mini mum 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 ra ting or a credit rating plus).

Rationale: Introducing other types of ratings would re quire the Director to have a broader familiarity with financial metrics in order to eval uate 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 a bout the third-party provider or its credit rating, the Director can request add itional information to satisfy part 2 of 40 CFR 146.85(a)(6)(ii) (i.e., minimum rating, minimum ca pitalization, and bond ra ting if applicable).

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 75B. Broader range of minimum rating options

In this option, “minimum rating” co uld 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” financ ial strength rating and thus woul d submit the financial strength rating instead of the credit rating as an indica tion of financial stabil ity. 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 operato r who submits a rating for part 2 of 40 CFR 146.85(a)(6)(ii) would simply be a making differe nt demonstration of third-party stability.

III. Minimum Capitalization

A. [SELECTED] Financial ratios consistent w ith the financial ratio test requirements for self-insurance

EPA could recommend that third- party providers m eet the minimu m thresholds for the following

financial ratios : Debt-Equity, Asse ts-Liabilities, Cash Return on Liabilities, Liquidity, and Net

Profit. Since these ratios are the required capita l 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 fam iliar with thes e 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, mini mum capitalizati on could be specified as meeting capital requirements of annual capital, surplus, and undivi ded 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 woul d require additional rati onale for recommending

thresholds different than thos e required for self-insurance.

C. M inimum capital standards prescrib ed by the appropriate Federal banking agency

The Federal Deposit Insurance Act requires Fede ral banking agencies to establish minimum capital standards for their regulated entities. For example, the Federal Deposit Insurance Corporation (FDIC) requires inst itutions to maintain capital levels that meet both the leverage capital ratio requirement and the risk-based cap ital ratio requirement. The thresholds for these requirements are summarized in the table below.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 76Research and Analysis Supporting Financial Responsibility Requirements and Guidance 77 183 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. <http://app.ny.frb.org/res earch/economists/p eristiani/CAPITAL-RATIOS.pdf>.

184 Enrich, D., D. Fitpatrick, and M. Eckbald. “Banks Won Con cessions on Tests: Fed Cut Billi ons Off Some Initial CapitalShortfall Estimates; Tempers Flare at Wells.” WSJ.com. May 9, 2009. <http://online.wsj.com/ article/SB124182311010302297.html>.

185 Fact Sheet: Financial Stabil ity Plan. U.S. Department of the Treasury. 2009 <http://www.financialstability.gov/docs/factsheet.pdf>.

186 June Oversight Report: Stress Testing and Shoring Up Bank Capital. Congre ssional Oversight Panel. June 9, 2009. <http://cop.senate.gov/docume nts/cop-060909-report.pdf>.

187 Bozzo, Albert. “Most Banks Well Capitalized But May Need More, Fed Says.” CNBC.com. April 24, 2009. <http://www.cnbc.com/id/30385838/Most_Banks_We ll_Capitalized_But_May _Need_More_Fed_Says>. Leverage Tier 1 Risk-Based Total Risk-Based

Well Capitalized >= 5% and >= 6% and >= 10%

Adequately Capitalized >= 4% * and >= 4% and >= 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 thre sholds are in violati on of FDIC requirements because they are considered at risk of insolv ency. Potential benefits of using these capital standards are that they are well-defined, easily a ccessible, 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 legisl ation has been aimed at raising these standards, they may still not be as robust as the standards in Options A or B 183

, 184

.

D. Successful completion of the new comprehensive stress test for banks

This option involves recommending th at third-party providers that are banks pass the new stress tests conducted by the Department of the Treasu ry. 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 pr oviders will have stress test results (it was onl y required of banking institutions with asse ts 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 re gulation 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. Fi nancial ratios consis tent with the bond rating te st requirements for selfinsurance

For self-insurance, the Rule requires a bond rating in the top four cat egories 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 forcredit ratings. It therefore has the same potentia l benefits and weaknesses of Option A for credit ratings.

B. Bond rating by any Nationally R ecognized 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., 3 rd highest or 4 th
highest) as determined by any NRSRO. This opt ion parallels Option B for credit ratings. It therefore has the same potential benefits a nd 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 sp ecific rating agencies and their associated recommended ratings. This option could be broade r than Option A but not as broad as Option B. For example, the Guidance could recommend specifi c 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 reas ons 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 men tion the alternative of a comparable bond rating from any NRSRO. The appropriateness of these a lternate 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 al l third-party providers will have bond ratings).

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 78Research and Analysis Supporting Financial Responsibility Requirements and Guidance 79 188 Report on Financial Assurance. EFAB. March 2010. Page 6.

189 Report on Financial Assurance. EFAB. March 2010. Page 2. 7

. Rationale for the Selection of Self Insurance Requirements

This chapter describes EPA’s rationale for th e 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 ar e 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 preceden t established by the detailed guidance “Federal Financial Responsib ility Demonstrations for Owners and Operators

of Class II Oil- and Gas-Related Injecti on Wells” (EPA 570/9-90-003) as well as rule requirem ents described at 40 CFR 144.63 for Cl ass I hazardous waste injection wells.

EPA chose to follow precedents by selecting of se lf-insurance requirements for Class VI wells so that they closely follow Cla ss I hazardous waste well requirem ents. 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 ow ners or op erators to exceed all five ratio thresholds to

ensure th e demonstration of their financial health and stability in as many ways as possible.

EPA’s approach for the selection of self insuran ce tes t requirem ents is also consistent with the approached recommended by the Environmenta l Financial Advisory Board (EFAB) . When charged with the task of recommending financia l assurance m echanisms for the new Class VI wells, EFAB “recommended use of Class I financ ial assuran ce 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 m echanism for demonstrating financial assurance and should continue to be an alternative for those companies that have investment-grade ratings on their debt.” 189I. Financial Coverage Criteria

Table 6.1: Definitions of Financial Coverage Criteria

Financial

Indicators Requirement Rationale

Net Working Capital (NWC) NWC must be at least six times the sum of the current cost estimates for all required
GS activities. Consistency with

• Cl ass I Haz Regs at 40CFR144.63(f)(i)(B) and 40CFR144.63(f)(ii)(B)

Total Assets 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. Consistency with:

• C lass I Haz Regs at 40CFR144.63(f)(i)(D) and 40CFR144.63(f)(ii)(D)

Tangible Net Worth (TNW) TNW must be at least six times the sum of the current cost estimates for all required
GS activities. Six times threshold is established for consistency with:

• C lass I Haz Regs at 40CFR144.63(f)(i)(B) and 40CFR144.63(f)(ii)(B)

II. Bond Rating Test

Table 6.2: Explanation of Bond Rating Test Requirement Rationale 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. Consistency with:

• C lass I Haz Regs at 40CFR144.63(f)(ii)(A)

• C lass II Guidance

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 80III. Financial Ratio Test

Table 6.3: List of Financial Ratios

Type of

Ratio Financial Ratios Threshold Rationale

DebtEquity Total Liabilities

Net Worth < 2.0 Consistency with:

• Class I Haz Regs at 40CFR144.63(f)(i)(A) This diverges from:

• Long 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.

AssetsLiabilities Current Assets
Current Liabilities > 1.5 Consistency with:

• Cl ass 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.).

Cash

Return

on Liabilities (Net Income + Depreciation + Depletion + Amortization)

Total Liabilities > 0.10 Consistency with:

• Class I Haz Regs at 40CFR144.63(f)(i)(A)

• Cla ss II Guidance

Liquidity (Current Assets – Current Liabilities)

Total Assets > - 0.10 Consistency with:

• Class II Guidance

Net Profit Net Profit > 0 Consistency with:

• Class II Guidance

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 81IV. 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 828

. Evaluation of Minimum Tangible Net Worth

EPA’s final rule creates a ne w Class VI well for the geologi c 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 incl ude corrective action on wells in the Area of Review (AoR ), injection well plugging, post-inj ection site care, site closure, and any emergency and remedial responses. To pr otect the public from the risk of paying for these financial liabilities, the proposed rule co ntains specific provision s requiring an owner or operator to demonstrate and mainta in 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 th e public) that they are unlikely to fail. To demonstrate adequate financial responsibility, EPA requires that the self-insuring owner or operator meet specific fi nancial coverage criteria and pass e ither a bond rating test or a financial

ratio test. The coverage criteria and tests should ensure that owne rs or operators are unlikely to fail and leave the public with a large financial liability. The Di rector 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

Under 40 CFR 144.63, the coverage criteria param ete rs for Class I Hazardous wells were set at:

k 1 = $10M

k 2 = 6

k 3 = 90%

Although th ese 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 k 1 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-ne gative) 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 83Research and Analysis Supporting Financial Responsibility Requirements and Guidance 84 190 In a March 1996 issue paper on self-insurance developed by ICF fo r EPA’s Solid Waste program financial tests were justified on the grounds of minimizing the sum of the costs to the industry (the overhead cost) and the costs to the public (the risk of failure), without an accounting of the transfer of costs from the owner or operator to the public. Th at analysis was based on two EPA Office of Solid Waste documents: “Background Document for Revisions to the Subtitle C Financial Tests For Closure, Post-Closure Care, and Liability Coverage” and “Backgroun d Document: Subtitle D Financial Tests for Closure, Post-Clo sure, and Corrective Action”, (40 CFR Part 254 and 265) and (40 CFR Part 258). The transfer of costs from the ow ner or operator to the public should not be neglected. Such a transfer inherently depletes the natural capital wealth of th e public and increases the financial capital wealth of the polluting firm’s owners. In doing so, it cedes some of the public’s property right to a clean environment, wh ich completely undercuts the explicit purpose of financial respon sibility (ensuring that the polluter-pays principle is upheld).

191 This analysis excludes other criteria for qualifying for self-i nsurance; these additional criteria would further control the r isk of instrument

failure. A. k 1 = $0: Drop the TNW criterion

B. k 1 = $10M: Preserve the status quo (i.e., utilize the Class I H azardous threshold for Class

VI wells)

C. k 1 = $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 financ ial liabilities to be passed onto th e public. In contrast, with selfinsurance, only the owner or operator must fail for the fi nancial liabilities to become the public ’s responsibility. Self-insuran ce is always riskier to the public, but it remain s desirable to owners and operators because it is their lowest cost op tion. Self-insurance can also be desirable to the public because it encourages grow th of the GS industry by loweri ng 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 op erators for entry and it should not expose the public to excessive risk. Therefore, this analysis identifies a TN W value that assures that the risk born by the public from a self-insured own er or operator is no g reater than the ris kiest scenario under independent third-party instruments

. 190 To determine the appropriate TNW value, this report evaluates resu lts from an economic model calib rated to data on GS activities and the owners or operators expected to participate. 191Research and Analysis Supporting Financial Responsibility Requirements and Guidance 85 192 For simplicity, all decisions in the model (e.g. participation in the market, the riskiness of the other profit-making investm ents in the owner or operator’s portfolio of activities, the amount of dividends to offer to sharehol ders, etc...) are treated as exogenous – occurrin g outside of the model and hence independent of wh at occurs inside the model.

193 By forcing the owner or operator to pay upfront( in-full) for th e 91 years, we circumvent the pr oblem of owners or operators e vading liabilities falling in the post-operation phase. Like seve ral other assumptions, this simplifying assumption is made to keep the model trac table. In reality, the financial assurance of owner or operator owners or operators w ill be reviewed periodically, owners or operators may be somewhat allowed to pay as they go, and financial conditions may di ctate a change in instruments or even a complete shutdown in the middle of the opera tions phase.

194 The risk of leakage into the at mosphere is not explicitly set aside in this mode l; it is subsumed in the damages from a stocha stic GS event. Calibrated Model

Our quantitative model examines the risks to th e public under self-insuran ce against a baseline level of acceptable risk. The baseli ne is the risk to public when th e riskiest owner or operator (i.e. an undercapitalized owner or opera tor that can barely afford to enter the industry) uses an independent third-party instrument to demonstr ate its financial responsibility. A parsimonious model was designed to capture the following details:

• the timing, structure, overhead costs, and failu re of independent third-party instruments

• the magnitude, timing, and uncertainty of environmen tal liabilities

• t he hazard of financial insolv ency and how this changes with the owner or operator’s size

• t he role of tangible net worth in driving an owner or operator into insolvency

• t he effects of environmental liabilities, as we ll as other leveraging li abilities, on tangible net worth and hence on insolvency

• t he 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 we ll as the risk and return on GS activities

• the characteristics of owners or operators (c hiefly the distribution of their size and hence risk) that will participate in the GS industry

The m odel divides time into 91 periods corres ponding to 1 year of the pre-operation phase during which the owner or operator secures a financial responsibil ity 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 an y 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 th e later periods, certain co sts (operational and postoperational) occur in both of the later periods, an d 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 ac tivities 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 m odel’s chief outputs, an Ex cel workbook performed hu ndreds of Monte Carlo realizations (scenarios) on every uncertain variab le for every year. The model can simulate the distribution of its variables, in cluding risk to the public, fo r each possible TNW. The model parameters were empirically calibrated to “rea listic” values found during careful research. The greatest sources of uncertainty in these model parameters are the stochastic GS events, the magnitude of the resulting damage s, and the price paid to the ow ner or operator for each ton sequestered. 194Research and Analysis Supporting Financial Responsibility Requirements and Guidance 86 195 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 opera tor could pay only the present value (i.e. discounted) plus the insurer’s markup over actuarial fair cost.

196 Allowing an owner or operator with $10M in TNW to self-insure w ould obviously be riskier if that same owner or operator couldn’ t even afford the independent thir d-party FR instruments. Results

Over the co urse of the 91 year span of the model, no more than 1 emergency and remedial response events are expected fo r any single owner or operator. However, based on industry failure rate data, only 61% of in surance owners or operators are expected to survive the 91 years due to their other liabilities (a compounding of the 0.6% failure ra te 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. Ho wever, the upfront cost of using trust funds as a form of financial responsibil ity 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 provi ders in this model. Th e 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 re turns (i.e., their expe cted growth rate).

A

. k 1 = $0: Drop the TNW criterion

If the GS activity costs for which the owner or op erator must demonstrate financial responsibility are sufficiently high, then the criterion requiring TNW to exceed 6 times that current cost (k 2 = 6) makes the TNW threshold of $10M used for Cl ass I Hazardous wells irrelevant. For example,

the current value of costs in our baseline scen ario when using i ndependent third-party instruments is $48M rendering both the $10M and $100M candidate thre sholds irrelevant

because both are smaller than 6 × $48M = $288M. Moreover, all of the owners or operators actively involved in demonstrati on 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 demonstr ation projects are the heavily capitalized firms that can afford to take a risk on these experi mental demonstration projects as part of their research and development. But in the future, ther e may be lightly capitalized owners or operators entering the GS market, and such higher-risk firm s 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. Re al 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

. k 1 = $10M: Preserve the status quo threshold used by Class I Hazardous wells

A TNW threshold of $10M results in the public b earing a risk from self-insured owners or operators that can be nearly 14 tim es higher than the risk from owne rs or operators that have just enough capital to afford the independent third-pa rty 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 ri sk in the baseline scenario. 196Again, this baseline risk is determined from the riskiest owner or operator that can afford independent third-party instruments and is h eavily dependent on uncertain cost estimates. Likewise, the risk of allowing an owner or ope rator with $10M in TNW to self-insure also depends on this uncertain cost estimate.

C

. k 1 = $100M: Increase the status quo by a factor of 10

A TNW threshold for self-insured owners or opera tors of $100M results in a risk to the public from a self-insured owner or opera tor 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 fr om a self-insured owner or oper ator is no greater than the riskiest scenario where independe nt 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 c ould be seen as a dramatic increase, it should be put in context. The scale of GS operations (a s 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 × $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 participan ts in demonstration projects.

Figure 8.2: Chart of Criteria Thresholds for Self-Insurance

*Typical Threshold for Financial Ratio Test – To plot this thres hold in this space, we have assumed that 90% of total assets ar e tangible (and the fraction of total assets that are current equals the fraction of total liabilities that are curre nt). The plotted points are th e actual (Liabilities,TNW) of the GS demonstration owners or operators; their tangible assets ra nge from 88% of their total asse ts (for RWE DEA Norge and Sta toilHydro, both headquartered in northern Europe) to 99% of their to tal assets (for Sonatrach headquartered in Algeria).

197 The limited simulation produces a flat risk profile between $75M and $165M as a result of a finite number of realizations. Wit h a larger simulation, that flat interval w ould narrow, presumably around $100M.

Research and Analysis Supporting Financial Responsibility Requirements and Guidance 87Appendix A: Costs to the Owner or Operator for each Mechanism 88 198 Captive insurance, where th e insurer is an owner or operator’s parent or sib ling firm, inherits the risks of self-insurance bec ause 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

Trust fund: Funds must be paid into th e trust to cover the total esti mated costs of the GS activity. Additionally, the owner or operator pays a fee for the admini strative services provided by the trustee. Overhead costs will be case specific, but ar e 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 obtai n letters of credit and may be required

to set aside substantial collateral to secure the instrument. The annual f ee for a standby letter of credit is estimated at 1.5 to 2 percent of the tota l cost of the GS activity. If letter of credit is utilized, the interest rate is t ypically at the market rate (prime plus a percentage determined by the bank), estimated at 4 to 8 percent. The fina ncial health of the purchaser will determine the interest rates, and whether collat eral 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 averag e 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; prem iums are often based on a slidi ng 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 like lihood 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 part ies. Therefore, total co sts are estimated at less than 0.5 percent of the GS activity cost. Thes e 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 acc ount to cover the total estimated costs of the GS activity. Additionally, th e 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 someAppendix A: Costs to the Owner or Operator for each Mechanism 89 low-risk investments) it may accrue interest to cover the administrative costs defined in the

escrow agreement.Appendix B. Technical Descriptio n of Geologic Sequestration (GS) Financial Responsibility (FR) Model

Core Model

The model divides time into 91 periods corres ponding to 1 year of the pre-operation phase during which the owner or operator secures a financial responsibil ity mechanism, 40 years of the operation phase during which the firm evens profits from injecting CO 2 , and 50 years of the postoperation phase during which the owner or operator continues monitoring for an tending to any emergency and remedial response (ERR) events. The following table illu strates the timeline:

Year Phase GS Activities

Period 0 Pre-operation Securing Financial Assurance Instrument(s)

Period 1

Operation GS injections, monitoring, responding to

ERR events .

.

. Period 40

Period 41

Well Plugging (year 41 only) Post-operation Site-care (monitoring and responding to ERR events) .

.

. Period 90

At each poin t in time t, the owner or operator in herits an initial tangible net worth (TNW) of A t from its past activities, in the form of A t assets and no liabilities. 199 To leverage these assets, the owner or operator then borrows additional capita l, which shows up as liabilities in the firm’s

balance sheet:

The owner or operator invests its assets and its bo rrowed capital, A t + L t , in productive activities that consume the capital in the process. The investment in the productive activity returns

stochastic revenue:

Appendix B. Technical Desc ription of TNW Model 90 199 Although we do not explicitly introduce optimi zation decisions made by firms in this model in order to remain parsimonious, th e model is

consistent with the standard sort of inve stment model sketched by Hubbard (1998) a nd presented in corporate finance textbooks ( e.g. Tirole (2006) or Ross, Westerfield, and Jaffe (2008)).Where P t is the productivity of the capital. The ow ner or operator will survive only if it remains

solvent. 200 Let S t be a binary variable indicat ing 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 r O is the interest rate that lenders charge the owner or operator (which will be made a func tion of the firm’s credit risk below). If the owner or operator’s revenue is suffi cient to pay off the principal and interest on its liabilities, then the remainder of the firm’s reve nue is reinvested as ne xt period’s initial net

worth:

Survival is u ncertain because the productivity of the owner or operato r’s working capital, P t , is

stochastic. The distribution of productivity is log-Cauchy, yi elding a closed-form for the probability of failure: 201

Where δ is the m edian productivity and γ is 1⁄2 of productivity’s interquartile range. 202 A critical stylized fact for this model to capture is that smaller owners or operato rs experience productivity shocks with a higher median and grea ter volatility than larger firms. 203 In order to make the model sufficiently flexible to capture this styl ized fact, we let the me dian and volatility of productivity shocks vary with the firm’s size: 204

200 This solvency condition sh ould be interpreted as a level of tangible net wo rth below which the firm is unwilling, or unable, t o finance a continuation of its operations. Instead, bankruptcy is either the better option or the only option. In general, the solvency th reshold would depend on the transactions costs of bankruptcy, as well as short-term options for financing the cash fl ow shortage (and these financin g options depend on a variety of financial variables).

201 Because a normal distribution is convenient for many models of investment returns, e.g. the cl assic option-pricing model of Bl ack and Scholes (1973), it is often used in models of investment returns and ev en in models of credit risk, e. g. Hillegeist et al. (2004). Howe ver, it is well known that the normal’s kurtosis is inadequate for modeling investment returns. In the contex t of this sort of dynamic model, a suffi ciently large probability of failure is only po ssible 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 ha s much fatter tails while concentrating m ore probability mass around the median.

202 Note that the central tendency (median) and variability (volatility = IRQ/2) are measur ed in different units from the normal d istribution, for which practitioners usually refer to mean and variance. For the Ca uchy distribution, the tails are so fat that the mean and var iance do not actually exist. Although they may appear quite different on the surface, th e Cauchy and Normal distributions are closely related. Both t he Cauchy and the Normal are particular members of a broade r parametric class of distributions known as Stable Distributions for which the distri butional family is closed under convolution. See Nolan (2009) for more on Stable Distributions.

203 In addition to being a presupposition of th ere being a TNW requirement for self-insur ance, documented empirical evidence of th is stylized fact dates back at least as far as Hall and Weiss (1967).

Appendix B. Technical Desc ription of TNW Model 91 204 Without allowing δ and γ to vary by firm size, the empirical relationship between A t and L t (coupled with the observed survival probabilities and growth rates) would rigidly box this m odel into a corner where it would fail to allow sufficient variation in productivity shocks by firm size.Where the second equation com es directly from the Capital Asset Pricing Model (CAPM), r F is the long-run rate of return on a “risk-free” asset, r

m

is the long-run average (across the market) rate of return on private capital, and β 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 β

, γ , and A introduces three additional parameters: θ 1 describes how volatility changes with the owner or operator’s risk factor (its β ), θ 2 describes the elasticity of β with respect to the firm’s size, and θ 3 determines the firm size at which β is 1. 206

Self-Insurance

At tim e 0, the owner or operator must make a fi nancial 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 C t<41 with a high enough price for the firm to net a “fair rate of re turn” on that cost outlay at the end of the year (i.e., 1 + r

m , akin to an electri c power utility).

During these first 40 years, as well as for the ne xt 50 years after that, th e owner or operator is also responsible for any uncerta in costs due to Emergency and Remedial Response (ERR) events and Corrective Action (CA) events. We model the uncertain costs due to an ERR event as the simple product of the occurrence of an ERR event in that year, M tERR , the scale of damages from that event, D ERR , relative to expected total disc ounted costs of the project (C NPV ):

NPV tERR ERR ERR t 

### CMDU =

Let the probability of an ERR event be constant:

ERR ERR t M λ

==

)1 Pr(

Let the damages of an ERR event be Beta distribu ted with mean equal to 80 percent of the owner or operator’s estimated total costs and a maximum of 6 times that total cost:



## [ ] ),(6 )6( }6,0{1 Pr(

1 1 1
βα βα β α

Β − ×∈==

−+ − − dd dd)D

ERR

205 See French (2003) for the development of a basic variant of th e CAPM and the model’s place in the history of economic thought. Campbell, Hilscher, and Szilagyi (2008) demonstrate a conn ection between the stock’s risk, captured by β in the CAPM, and its failure risk.

206 In practice, we will calibrate θ 3 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 μ and standard deviation σ . This assumption is standard in the lite rature 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-i nsurance but not a sufficient cond ition. There are more condition s, referred to as financial tests, which further control the public’s risk exposure due to self-insurance. Likewise, the director has some discre tion in allowing thirdparty assurance mechanisms and that is also not included in this simple model. Moreover, these requirements are revisited perio dically. However, the model becomes increasingly complicat ed if these details are included.

Appendix B. Technical Desc ription of TNW Model 92 208 EPA recognizes that self-insurance is not without cost. Self-i nsurers may utilize captive insurers or seek other means of dive rsifying risk that are costly. However, the demonstration of self-i nsurance itself is assumed to be a minor cost.Where the parameters ( α , β ) produce a skewedness in-line with expert judgment, while satisfying:

8.0 )( 6 )( = + = βα α dE

We model the uncertain costs of CA events as the simple produc t of the occurrence of a CA event that year, M tCA , and a constant cost for that event, Δ CA :

tCACA CA t 

### M U Δ=

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, C t>40 , as well as any costs from ERR events.

If the owner or operator fails for whatever reas on, 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 du ring years 1 through 40, another operator or owner will continue to operate the plan t for the remaining operable years. 209 The public will not pay for post-operation expenses until year 41. The expect ed discounted risk to the public of a selfinsured owner or operator is given by:



## { } 

## [ ] )|0Pr(401)( )( *1 1 )|( 90

0 t t t tCA CA NPV tERR ERR t

t AStCMECMDE

r SelfDE = >+ Δ+ ⎟ ⎠ ⎞ ⎜ ⎝ ⎛

+ = 

# ∑

=

Where D on the left hand side is the expected dama ges (risks to the public) and r* is the socially optimal discount rate, which is necessary in or der to sum liabilities th at are spaced over time.

Third-Party Instruments

If the owner or operator’s TNW is beneath th e minimum threshold, then it cannot use selfinsurance 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 inst ruments to model are those that pay out so long as the third-party is solvent, regardless of whet her 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 instru ments is actuarially fair, plus a percentage markup over that actuarial fair cost: 210



## { } 

## [ ] 401)( )( 1 1 )1( 90

0 >+ Δ+ ⎟ ⎟ ⎠ ⎞ ⎜ ⎜ ⎝ ⎛

+ += 

# ∑

= tCMECMDE

r kK

t tCA CA NPV tERR ERR t

t IN IN

These third-party instrument providers can, them selves, fail. We have modeled the failure of third-party instrument providers as a (statistica lly 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 increa sed by a factor of 10 to equate risk.

Appendix B. Technical Desc ription of TNW Model 93 210 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.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:



## { } 

## [ ] 

# ( ) )|0Pr(401)( )()1( *1 1 )3|( 90

0 t t t tCA CA NPV tERR ERR t t

t rd AS tCMECMDEq

r DE = >+ Δ+

− ⎟ ⎠ ⎞ ⎜ ⎝ ⎛

+ = 

# ∑

= W

here q is the probability of an insurance provide r surviving the year. As can be seen from these two equations for risk, third-part y instruments pose a lower risk th an self-insurance for any given owner or operator. However, beca use risk is decreasing in the ow ner or operator’s size, there

exists a level of TNW above which the risk to the public is lower th an the riskiest firm that can afford the cost of third-party instruments. 211

References

Black, Fischer and Scholes, Myron. 1973. “The Pr icing 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-Mark et 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: Model s for Heavy Tailed Data.” Draft available for download from the American University Depa rtment of Mathematics and Statistics.

Appendix B. Technical Desc ription of TNW Model 94 211 We should note that this model is quite simplified, by necess ity. What it fails to address could potentially alter the recomme nded TNW requirement. For instance, the model does not explicitly model th e optimizing decisions made by firms, including the decision t o participate in GS. Also, many heterogeneous aspects of both GS activities and GS firms have been neglected en tirely here. Importantly, the pro bability of a third party’s failure is not likely to be independent of all ot her shocks. Finally, this model neglects the effect of allowing self-insurance on markets: it exacerbates the competitive adva ntage of larger firms and it skims the thir d party insurance market’s risk pool of the least risky firms.Appendix B. Technical Desc ription of TNW Model 95 Ross, Stephen A.; W esterfield, Ra ndolph W.; and Jaffe, Jeffrey. 2008. Corporate Finance , 8 th

edition . New York: McGraw-Hill/Irwin.

Tirole, Jean. 2006. The Theory of Corporate Finance . Princeton: Princeton University Press.Appendix C. Calibration of GS FR Model Parameters 96 Appendix C. Calibration of GS FR Model Parameters

The set of parameters to be calibrated appear in the following table:

Description Parameter Quantity of CO2 sequestered by GS Operation Q Certain Costs of GS During Oper ation (all costs other than ERR) C t<41 Average cost of an ERR event Δ Expected number of ERR events per site λ
Certain Costs of GS After Operation C t>40 Price paid per ton of CO2 seque stered by a GS Operation P

Overhead cost for trust fund κ TF Overhead cost for insurance κ IN

Average rate of return in private capital markets r m Average rate of return on risk free asset r F Interest rate on trus t fund investments r TF Interest rate used by insurance investments r IN Socially optimal discount rate r*

Liabilities as a fraction of A ssets, given unitary elasticity b 0 Leveraging Elasticity Parameter b 1

Insolvency rate for insurance 1-q IN Insolvency rate for trust funds 1-q TF Baseline Average Insolvency rate for Owners/Operators 1-q OO

Elasticity of Beta to TNW θ 1 Beta Risk Factor θ 2 TNW level with unitary Beta Risk Factor θ 3

Mean ln(Assets) of owners or operators in Industry μ Standard Deviation of ln(Assets) of owners or operators in Industry σ

Parameter on the stability distribution (2 = normal, 1 = Cauchy) α

To describe how these parameters are calibra ted, we take them one block at a time.Appendix C. Calibration of GS FR Model Parameters 97 1. Of the first block of parameters, Q, C t<41 , and C t>40 are taken from the cost model that EPA is developing to estimate to im pact of the GS rule.

Description of certain costs:

Cost Annual Amount (M$) Description

Certain Costs of GS Before Operation (C t=0 ) 45.8 One-time costs incurred in the pre-orientation phase (year 0).

Certain Costs of GS During Operation (all costs other than ERR/CA) (C t<41 ) 4.2 Average annual costs incurred in the operation phase (years 1 through 40).

Certain Costs at Well Plugging (C t=40 ) 0.8 One-time costs incurred in the well plugging phase (year 40).

Certain Costs of GS After Operation (C t>40 ) 0.8 Average annual costs incurred in the post-operation phase (years 41 through 90)

Source: All certain cost estimates are from the EPA’s “Cost Anal ysis for the Federal Requirements Under the Underground Injecti on Control Program for Carbon Dioxide Geologi c Sequestration Wells” (816-R-10-013).

Our estimate for P (the price paid per ton of CO 2 sequestered during the lif e 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 r

m ) on their cost outlays. Given that Q (quantity of

CO 2 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 CO 2 :

P = (1 + r

m )K/Q

Where K is equal to total capital costs. The estima te for Q is taken from the EPA’s cost model.

Both Δ and λ were increased to reflect our best pr ofessional judgment of the full range of damages.

2. The overhead costs of trus t 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 OM B’s standardized inst ructions for conducting economic analyses. Roughly half are 3%, reflec ting the long-run averag e rate of return on treasury bills and the other are 7%, reflecting th e long-run average rate of return on private capital.

4. The leveraging parameters (b0,b1) get their va lues from rounding off an estimation of those parameter values for liabilities regressed on asse ts 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 98 5. The survival probabilities [q IN , q TF , q OO ] 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 thir d probably is not a dir ect input to the mode l but gets used in the estimation of other model parameters.

6. Because inspection of public ly av ailable estimates of β for oil firms hovered around 1 (with the largest firms being below 1), we set θ 3 to μ , the mean of the log of the distribution of firm

sizes. Both θ 1 and θ 2 were estimated in a multi-step pro cedure that also involved estimating μ
and σ . The first step involved centering the prior distribution on the beliefs of the μ and σ 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 sec ond 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 t op 4 order statistics (of draws from the log normal distribution using the μ and σ 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 st atistic data points. This resulted in our final estimates of μ and σ

. Given those estimates, we then fitted θ 1 and θ 2 using a GMM procedure to fit the mean failure rate for owners and operators.