Environmental Insurance as a FASB Fix
August 2005
Insured Fixed-Price Cleanups (IFCs) provide
the most certain, most accurate, and often the lowest-cost means of addressing
the Financial Accounting Standards Board's (FASB's) recent pronouncement with
respect to environmental Asset Retirement Obligations (AROs).
by Michael
O. Hill*
Hill & Kehne,
LLC
FASB Interpretation No. 47 (FIN 47) was issued last March to remove a widely
perceived loophole with regard to environmental and other AROs. FIN 47 makes
clear that companies must typically expense for AROs even before the assets’
retirement and despite uncertainties as to the timing and/or method of cleanup
or other settlement. Examples given are: (i) an asbestos-contaminated factory
cannot simply be "mothballed" without adequate reserves to cover the eventual
cost of removing the asbestos; and (ii) reserves must be established today for
the eventual disposal of still-in-use, creosote-soaked utility poles.
As stated by the Wall Street Journal:
- The issue seems technical, but the response … has been one of shock.
That is because FASB's guidance is likely to require these companies to
immediately expense hundreds of millions of dollars to record the cumulative
effects of the accounting change on their income statements….
Wall Street Journal, "Getting Rid of Factories Is about To
Get Tougher", at C3 (March 18, 2005).
As mentioned above and explained more fully below, IFCs are typically the
most certain and most accurate—and often also the lowest-cost—means to address
AROs. At one site, an IFC lowered a company's costs to $5M from an estimated
$15M–$20M. Half of this reduction came from the efficiencies and incentives
inherent in the IFC itself; half came from the IFC's enabling of grants and
tax incremental financing facilitated by the hosting municipality. Thus, companies
and municipalities as well should consider the use of IFCs to address environmental
AROs and to get Brownfields redeveloped.
Background of FIN 47
FIN 47 provides FASB's clarification of its 2002-issued Financial Accounting
Statement 143 (FAS 143). Titled Accounting for
Asset Retirement Obligations, FAS 143 applies to "legal obligations associated
with the retirement of long-lived assets...." In a nutshell, it tells companies
that they must reserve for environmental and other liabilities associated with
the eventual retirement of manufacturing facilities or parts thereof.
The following key provision of FAS 143, however, has been widely seen as
a loophole:
- An entity shall recognize the fair value of a liability for an asset
retirement obligation in the period in which it is incurred if a reasonable estimate of the fair
value can be made.
FAS 143, at ¶ 3 (emphasis added).
Until now, numerous entities have seized upon the word "if" to defer recognition
of obligations until it is probable the assets will be retired "as of a specified date using a specified method or when the asset is actually retired." FIN 47, at 1 (emphasis
added).
FIN 47 was written to close this perceived timing and uncertainty loophole
and require that most environmental and other AROs be immediately expensed.
It cites as examples items as remote and uncertain as the eventual disposal
of utility poles, kiln bricks, and other assets now in active use. While FIN
47 is not limited to environmental AROs,
its likely focus in the environmental arena is underscored by the fact that
all four of its "illustrative examples" concern environmental obligations. (The
first two were the utility poles and the kiln bricks; the third and fourth concerned
asbestos-contaminated factories still in use. FIN 47, App. A.)
The Relationship between IFCs and FIN 47
The following excerpt shows a possible causal connection between IFCs and
FIN 47:
- An [ARO] would be reasonably estimable [and thus must be expensed] if
… an active market exists for the transfer of the obligation....
FIN 47, at 2.
An active market for the transfer of environmental AROs has emerged over
the past decade and now clearly exists. There are now almost 20 remediation
contractors (Contractors) and a smaller number of Brownfield redevelopers (Developers)
who will, for an insured and/or otherwise guaranteed fixed-price, accept transfer
of environmental AROs. AIG, Ace, XL, Zurich, and a number of other insurers
(Insurers) have provided the financial backing necessary for this market. FIN
47 makes clear that industrial and other entities in most cases must estimate and reserve for environmental
AROs where an IFC or other market exists for their transfer. Finally, where
additional capital is required (particularly to go beyond cleanup and to redevelopment),
companies may turn to various well-heeled and experienced environmental investor/developers.
In appropriate circumstances, these entities also offer sale-leaseback options.
The Mechanics of an IFC
The mechanics of an IFC are fairly simple. Under the traditional cleanup
model, a Contractor is hired to perform the cleanup but the risk of cost overruns
is borne largely if not entirely by the site owner or other entity(ies) originally
responsible for the cleanup (Owner). Under an IFC, the Contractor guarantees
a fixed price to cover all environmental
regulatory costs, regardless of whether those costs increase due to unknown
pollutants, regulatory changes, or other causes. The guarantee is typically
backed not only by the Contractor's own indemnification but also by a site-specific
insurance policy. Thus, the Contractor and Insurer assume the risk of overruns before the Owner, and the Owner need pay
nothing more unless all three of the protections set forth below were to fail.
IFCs provide Owners with three protections against cost increases:
- Commutation Account. The estimated
cleanup costs are placed in an escrow, commutation, or similar account that
is typically (though not always) held by the Insurer. The funds are paid
to the Contractor only as it accomplishes
the cleanup. The Insurer is financially motivated to monitor the cleanup
closely and pay out the funds only as earned because, as shown below, the
Insurer provides the second layer of protection in the event the cleanup
account is depleted.
- Insurance Policy. An insurance policy
that typically doubles the amount of the estimated cleanup costs. Thus,
if the cleanup is estimated to cost $10M, the policy ensures that the Contractor
has at least $20M of outside funding to complete it.
- Contractor Indemnity. An indemnity
from a Contractor who has two enormous financial incentives to complete
the cleanup at or below the estimated cost: (1) the Contractor receives
or shares with the Owner whatever remains in the Account following governmental
sign-off on the cleanup; and (2) the Contractor is required to cover any
costs above the amounts not provided by the Cleanup Account and the insurance.
The value of this indemnity depends, of course, on the financials of the
Contractor, but several have both assets and revenues of several hundred
million dollars.
Three Specific Advantages of an IFC
IFCs will virtually always bring two, and sometimes three, specific advantages
to addressing an environmental ARO: greater cost certainty; more accurate cost
estimates; and (often) lower costs.
Greater Cost Certainty
While IFCs do not provide Owners absolute protection against further cost
increases, in almost all circumstances they provide the most protection (and
thus the most certainty) available. At least to the author's knowledge, IFCs
have protected Owners from any cost increases
at every one of the hundreds of sites where they have been applied. Particularly
when judged against an historical record where non-IFC cleanups almost typically
involve "change orders" requiring more dollars, Owners are in almost all cases
assured that IFCs provide greater certainty than conventional approaches.
More Accurate Cost Estimates
IFCs also provide more accurate cost estimates. This is because they reflect
strong incentives forcing bidding Contractors toward the true costs. A bidding
Contractor who artificially underestimates ARO costs would risk assuming liabilities
with insufficient funds to cover them. A bidder who artificially overestimates
would, at least in a competitive process, risk losing the competition and thus
wasting the time and costs involved in bidding. Because of these market incentives,
an Owner that has obtained a cost estimate through IFC bidding is almost certainly
in the best position to argue that it has reserved enough while also assuring
itself that it has not reserved too much.
Lower-Cost Solution
Finally, though counter-intuitive, IFCs very often cost less than conventional cleanups. This is
due to the many cost advantages that IFCs offer Contractors: IFCs require fewer
administrative costs; they allow greater flexibility of resource use; they improve
Contractors' long-term planning abilities; and they often reflect leveraging
of otherwise unavailable regulatory benefits/advantages, both formal (e.g.,
an otherwise unavailable Brownfield program) and informal (e.g.,
a responsible party with a "new face"). Although no hard data on these cost
reductions is available, one can reliably state that fixed-price liability transfers
are frequently 10–20 percent lower than conventional estimates:
-
In one example about which I have written previously, a conventionally
estimated $15–$20M cleanup was completed for $10M, half of which came from
outside funding (as discussed below), thus reducing the company's costs
to $5M. Today the site is being developed into tax-generating commercial
and residential properties. See"Insured
Fixed-Price Cleanups as a Means To Quantify Costs and Obtain Funds To Clean
Up Contaminated Sites: The Kenosha Model," Int'l. Risk Mgt. Inst.
(April 2003).
-
In another, a cleanup estimated at $25M was completed for $15M, and today
the property consists of soccer fields and open space. A Tale of Two Sites: How Insured Fixed-Price
Cleanups Expedite Protections, Reduce Costs, and Help the SEC, the EPA,
and the Public, 45 Chem. Waste Litig. Rptr. 907 (May 2003), reprinted with permission by the American
Bar Association's Science & Technology Newsletter (Vol. 3, No. 2, p. 17,
August 2003), and in the National Association of Attorneys General's National
Environmental Enforcement Journal, Vol. 18, No. 8, p. 3 (Sept.
2003).
IFCs Also Facilitate the Obtaining of Outside Funding
In addition to the increased efficiencies, market incentives, and other cost-reducing
mechanisms discussed above, IFCs may also facilitate the availability of outside
funding. This is particularly true when Owners and municipalities work together
for their mutual benefit.
In the first example referenced above, fully half ($5M) of that $10M IFC
was paid for with Brownfield grants and tax incremental financing (TIF). IFCs
enable Brownfield grants because they give grantors greater assurances that
their funds will actually lead to a cleanup. And IFCs facilitate TIFs because
they provide bond issuers the greatest certainty of the cleanup costs. IFCs
can also promote site's developability (and thus tax revenues) following cleanup,
because the cost guarantees can run to future owners as well as past.
Further information on this example and how IFCs facilitate outside funding
can be found in the April 2003 IRMI.com article, "Insured
Fixed-Price Contracts as a Means To Quantify Costs and Obtain Funds To Clean
Up Contaminated Sites: The Kenosha Model."
Conclusion
IFCs are by now well-tested. They have been used at one state and three federal
Superfund Sites; at two of the largest Brownfield redevelopments in the United
States; and at over 100 other sites. IFCs require no statutory or regulatory
changes, and they are generally favored by regulators because in most cases
they add a responsible party (the Contractor), add financial resources (the
policy), and expedite cleanups all while remaining fully subject to government
direction and requirements.
Not until FIN 47, however, has the connection between AROs and IFCs been
so clear. FIN 47 makes clear that, beginning this year, companies must reserve
for AROs despite uncertainties as to the time or method of settlement. IFCs
enable the transfer of environmental AROs despite these uncertainties, and IFCs
are almost always the most certain and most accurate—and often also the lowest-cost—means
to meet this requirement. Thus, companies (and hosting municipalities) should
consider the use of IFCs to address environmental AROs and to get Brownfields
redeveloped.
*Author's Note: As IRMI's new Commentator
in the area of environmental risk management, this is my first in a series of
quarterly articles. I would very much welcome comments on this article as well
as suggestions for future topics. MOH
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