Insured Fixed-Price Contracts as a Means To Quantify Costs and Obtain Funds
To Clean Up Contaminated Sites: The Kenosha Model
April 2003
The two largest hurdles to cleaning up contaminated
sites are knowing how much the cleanup will cost and getting the cleanup funds.
Using the Kenosha model, insured fixed-price contracts (IFCs) are often the
best way to quantify and obtain cleanup funds. The financing of the Kenosha
IFC was obtained from the owner and former owner, through Brownfield grants
from the government, and from bonds floated through Tax Incremental Financing.
With their cost certainty, IFCs enable communities to turn contaminated and
nonproductive eyesores into clean properties at what may be the lowest possible
cost.
by Michael
O. Hill
Marsh Inc.
Generally, the two largest hurdles to cleaning up contaminated sites are:
(1) knowing how much the cleanup will cost; and (2) getting the cleanup funds.
This article discusses why insured fixed-price contracts (IFCs) are the best
way to quantify the cost and, in many cases, to obtain cleanup funds. The cleanup
now underway at a 115-year-old closed industrial site in the City of Kenosha,
Wisconsin ("the City"), provides a clear picture of how to use IFCs.
The mechanics of an IFC are fairly simple. Under the traditional cleanup
model, contractors (hereafter, the "Contractor") give an estimate of the cleanup
costs, but the risk of cost overruns are borne by the city or other entity ("the
City") that is paying for the cleanup. By contrast, under an IFC model, the
Contractor gives a fixed price that is backed up by insurance (the "Insurer")
to cover cost overruns, and the Contractor and Insurer assume the risk of overruns.
While the City does not have absolute protection against further cost increases,
it has the best protections currently available, as set forth more fully below.
Those protections include:
- an "Experience Account" into which the estimated cleanup funds are deposited
and paid out only as the cleanup is accomplished;
- insurance that typically doubles the amount of the cleanup funds available;
and
- an indemnity from a Contractor who is highly motivated to complete the
cleanup at or below the estimated cost because the Contractor would be required
to cover any costs above the amounts not provided by the Experience Account
and the insurance.
Cost Certainty
The first and most obvious benefit of an IFC is that the costs are quantified
with the greatest certainty possible. As noted, the cleanup costs are placed
in a separate Experience Account. This Account is managed not by the Contractor
but by the Insurer. Several large insurance companies including AIG, Chubb,
Zurich, Ace, and others provide these policies. The Insurer has a fiduciary
obligation to the City to pay out the funds only as the cleanup progresses.
Even apart from this fiduciary obligation, the Insurer is financially motivated
to limit the payouts because the Insurer wants the Contractor to complete the
cleanup before the Experience Account is depleted and insurance is tapped into.
Even if the Experience Account is depleted, the City still has available
to it insurance funds that typically cover costs up to twice the amount of the
Experience Account. Thus, if at the beginning the Contractor (with the Insurer’s
necessary buy-in) has estimated the cleanup to be $10M, insurance will provide
funding to cover costs up to $20M.
Finally, even if the Experience Account and then the insurance are depleted,
the City will have a right of indemnity against the Contractor for any additional
costs. How deep the Contractor’s pockets are will vary from case to case. With
the Kenosha cleanup, the contractor is a publicly traded company with assets
of over $200 million. As noted above, IFCs do not provide the City with absolute
certainty. However, this triple-protection method provides more certainty than
any other.
Types of Funding
There are three basic funding sources for environmental cleanups, as follows.
- Potentially Responsible Parties (PRPs). The most traditional funding source is the current or past property owner(s)
and any other PRPs. Unfortunately, sometimes the PRPs are gone or do not
have sufficient funds to pay for the project, and oftentimes their duty
to pay does not extend to the entire cleanup. (As an example, while the
PRPs may be unquestionably required to remove all pollutants, they may not
have to demolish buildings or otherwise prepare a site for redevelopment).
- Brownfield and Other Grants. A second
and increasingly available funding source includes Brownfield and other
government grants (both federal and state).
- Tax Incremental Financing (TIF). Finally,
a third funding source is Tax Incremental Financing (TIF), through which
a city or other entity issues bonds that are repaid through the increased
property taxes generated as a result of the cleanup.
The Kenosha Model
The City of Kenosha, Wisconsin, is employing an IFC to obtain cost certainty
and funding from all three of the above sources. Bottom line, the City will
obtain a $10.1M cleanup that will cost the City nothing and will cost the PRPs
only $5.1M.
The Kenosha IFC was contracted for in June 2002 and the cleanup must be completed
by August 2004. The site is a 110-year-old, 31-acre industrial Brownfield in
the heart of the city’s residential section, and the Contractor’s obligations
are to demolish the buildings, remove the pollutants, and otherwise ready the
site to be used as productive and tax-generating commercial property. As of
the March 2003 drafting of this article, the 30 acres of buildings have been
entirely demolished (in 9 months) and the cleanup is otherwise on schedule.
The way the City did this is as follows. Briefly, for $10.1M, the City and
the PRPs entered into an IFC contract with a Contractor. The Contractor agreed
to clean up the entire site, including $4.7M worth of building demolition plus
whatever soil and groundwater cleanup the state requires. The Contractor further
agreed to purchase enough environmental insurance to cover costs up to roughly
twice the estimated cleanup cost. Significantly, following the cleanup the site
belongs to the City.
The funds for the $10.1M were obtained as follows.
- $5.1 million (50 percent) from the owner and former owner (the "PRPs");
- $2 million (20 percent) in Brownfield grants from the government; and
- $3 million (30 percent) from bonds floated through Tax Incremental Financing
(TIF).
A key element to all three funding sources was
the cost certainty provided by the IFC. The IFC cost guarantee helped
persuade the PRPs to contribute toward the cleanup since they knew in advance
the total amount they would need to pay. Working together, the PRP, Contractor,
and Insurer agreed on a price ahead of time that all can live with and that—absent
the unlikely failure of all three protections outlined above—will not change.
Prior to the fixed price offered by the Contractor, the PRPs at the Kenosha
site had received cost estimates of well over $10.1 million. In the end, they
paid only $5.1 million (since the City paid the other $5 million).
In addition to this obvious cost reduction, in many cases PRPs can deduct
the full cost of the IFC in the first year (even though the actual cleanup may
take several years). Another tax benefit is the deduction available for giving
the property in a guaranteed clean state to the City. Taken together, these
two tax benefits could at some sites reduce the PRPs after-tax costs by as much
as half.
PRPs often obtain substantial reserve benefits as well. The Experience Account
and other protections afforded by an IFC enable companies to provide the SEC
with the greatest assurances possible that they have identified and set aside
adequate funds for the cleanup. In the event that the company is left with excess
funds held in reserve, in some cases they can declare those excess funds as
income.
The IFC cost guarantee also helps secure Brownfield and other government
grants, since the grantors are assured that their funds will actually lead to
a cleanup. Again, while this assurance is not 100 percent, it is as comprehensive
as possible.
Finally, the IFC cost guarantee facilitates TIFs. This is because, to float
a bond that is backed by tax incremental financing, the bond issuer needs as
much assurance as possible that the Site will be (a) cleaned up for the estimated
cost; and (b) left in a condition that can be quickly turned to tax-generating
use. In most states, TIFs cannot be used unless the bonds are reasonably expected
to be paid off within a specified period of time (e.g., 12-16 years). Because
IFCs provide the greatest certainty possible with respect to the cleanup costs
and the site condition following cleanup, IFCs vastly improve cities’ ability
to use TIFs.
The Tested History of IFCs
IFCs are by now well-tested. In addition to the Kenosha site, IFCs have been
used to clean up a 3,000-PRP Superfund Waste Oil Site in Maine; a $200 million
Superfund Mining Site in California; a $103 million Brownfield cleanup in midtown
Manhattan; and over 50 other sites. IFCs require no statutory or regulatory
changes, and they are generally favored by regulators because, in most cases,
they add a PRP (the Contractor) who, along with an Insurer, is required to reserve
and maintain twice the estimated cleanup costs, and who is financially motivated
to begin and progress through the cleanup (since the Contractor needs to do
so in order to earn its income out of the Experience Account).
In sum, IFCs provide PRPs the greatest cost certainty possible and, in many
cases, substantial cost savings. IFCs provide governments and other grant sources
the greatest assurance possible that their funds will achieve their intended
purpose. And perhaps most importantly, IFCs enable communities, such as the
City of Kenosha, to turn contaminated and nonproductive eyesores into clean
properties at what may be the lowest possible cost.
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