Expert Commentary

Fixed-Price Contracts Using Cost-Cap Alternatives for Environmental Cleanup

Until 2011, the vast majority of fixed-price contracts to clean up brownfields and other contaminated property relied on cost-cap (also known as stop-loss) insurance to protect against risks of cost overruns. Although all four of the commercial insurers offering cost caps exited the market in 2011, cost-cap alternatives were invented of necessity and now support fixed-price contracts with terms that are in many ways preferred to cost caps.


Environmental
February 2016

This article discusses fixed-price contracts (FPCs) that have been accomplished using cost-cap alternatives (CCAs), even where the most rigorous form of regulatory review is required. It focuses on two FPCs done by the Air Force but also discusses CCAs created by private parties using captive insurance.

The History and Recognized Benefits of FPCs

The first FPCs were performed in the late 1990s with the emergence of cost cap. FPCs enabled cleanups at hundreds of sites—from multi-party Superfund sites to "brownfield" sites involving just a few parties (e.g., seller, buyer, remediation contractor). They carried strong financial incentives for cleanups to be done thoroughly, expeditiously, and on budget. They also brought assurances that sufficient cleanup funds would remain available throughout the cleanup.1

A broad study of FPCs by the Army found that, with FPCs, cleanup schedules were met or beaten; work quality was "from good to going beyond requirements;" and, perhaps counterintuitively, cleanup costs were, on average, over 21 percent below independent estimates made prior to the cleanup.2

The Environmental Protection Agency (EPA) Inspector General called for the EPA to use FPCs more frequently for its own cleanups, noting as an example the costs of one FPC that were less than half those of a time-and-materials (T&M) contract for similar work done in the same county.3 States, too, have endorsed FPCs.4

The Need for Insurance, and the Evolution of Its Type and Availability

Contractors with meaningful balance sheets have been unwilling to give cost guarantees for significantly sized cleanups (e.g., >$5 million) unless insurance or other risk transfer vehicles are available to reduce roughly two-thirds of the cost overrun risks. Until 2011, cost-cap insurance was used to protect against these risks. Cost caps were combined with pollution legal liability (PLL) insurance, which protected (and is still available to protect) against overruns from unknown pollutants, private tort claims, and other risks (e.g., business interruption, natural resource damages).

Among the cleanups requiring the greatest assurances of cost certainty are those involving transfers of military bases before the cleanup is complete. Under the Superfund or Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) statute, transfers of such properties that are on the National Priorities List (NPL) require a Finding of Suitability for Early Transfer (FOSET) by the EPA administrator and by the governor of the state in which the property is located. The administrator and governor must be satisfied that the transfer will not delay or otherwise hinder the cleanup.

Through mid-2011, every privatized FOSET of an NPL property relied on cost cap to meet this highest standard for regulatory approval. Since 2011, the Air Force has successfully obtained FOSET approvals by relying on the CCAs described next.

Emerging Use of the Cost-Cap Alternative to Support FPCs

To transfer over 700 acres at the former McClellan Air Force Base near Sacramento, California, the Air Force and other parties involved in the transfer (the county, developer, and contractor) created and used a CCA. The transfers allowed the buyer/developer to begin the development of the property even while cleanup was underway. Following the success of a 2013 transfer involving 5,284 acres, the Air Force used the same CCA to transfer another 207 acres in 2015.

Already, 15,000 people live and work within the former base where these transfers were made, and the county estimates that when development is complete, it will have some 35,000 jobs and generate over $6.6 million per year in local property tax and $1.1 million per year in local sales tax revenue.5

In at least two ways, private parties can implement CCAs more easily than the Air Force. First, CERCLA's strict FOSET requirements do not apply to transfers by private parties. Second, and more significantly, private parties are more likely to have access to captive insurance to create a CCA.

The Mechanics of a CCA

While FPCs and accompanying CCAs must be customized to fit the needs of the parties and transaction involved, they do have certain elements in common. Briefly, for a fixed price, an FPC contractor typically agrees to assume all environmental regulatory liabilities up to an agreed cap of 150–200 percent of the agreed fixed price.

For easy math, let's assume an agreed fixed price of $10 million with a guarantee up to $20 million. If the contractor completes the cleanup at less than $10 million, it still receives the full $10 million … a significant "carrot." However, if the cleanup cost exceeds $10 million, significant "sticks" apply, as the contractor must absorb a significant (typically 20 percent … in our hypothetical, $2 million) deductible and then a significant "co-pay." In all, the contractor assumes risk of roughly 32 percent of any overruns up to a $20 million cap. The cost cap covered (and now CCAs cover) the rest.

CCAs Done without Captive Insurance

With a cost cap no longer available to cover the required 68 percent of overruns, the Air Force, the county, the developer, and the contractor created a CCA that, in lieu of insurance policy text, used a customized, four-party contract with terms purposefully similar to a cost cap text. In lieu of a commercial insurer holding the indemnifying funds (in our hypothetical, $6.8 million), the funds are held in an escrow fund.

CCAs Done with Captive Insurance

CCAs can also (and in many ways, better) be supported through the use of insurance provided by captive insurance companies. Although still largely an emerging concept in the environmental field, captive insurance has been, for decades (and increasingly is), routinely used in other areas (e.g., general liability, workers compensation), and captive insurers are owned by the vast majority of large (e.g., Fortune 1,000) companies and many smaller entities (private and public) as well. Though less common, group captives and risk retention groups are oftentimes formed to provide coverages to groups of companies or other entities facing risks for which commercial insurance is expensive or otherwise difficult to obtain.

Captive insurance offers many advantages over commercial insurance, including increased ability to customize coverage to what is needed (e.g., longer terms, higher limits, and with specific risks expressly covered or excluded; lower premiums; a more efficient claims process; direct access to reinsurance; and, in some cases, tax advantages).6

To obtain approval from regulators or other stakeholders who are unfamiliar with captive insurance, on at least one occasion, a post-2011 FPC relied on "fronting" by a commercial insurer for insurance provided by a captive insurer. In a nutshell, the commercial insurer issued a policy on its own "paper"—thus providing the stakeholders with familiarity as well as an added layer of protection (akin to that of a "guarantor" of the captive).

Advantages of CCAs over Cost Caps

Regardless of which particular structure is used to create a CCA, FPCs done with a CCA offer significant regulatory and private advantages over cost caps. These advantages include the following.

  • CCAs Avoid Delay and Uncertainty with Respect to Policy or Similar Risk Transfer Terms. When owners and others seeking FPC bids can show bidding contractors the CCA and other risk transfer terms as part of the bid package, the contractors can bid without fear of unknown terms and unnecessary delay. The work can begin literally the day the contractor's bid is accepted, with risk transfer terms in place that read exactly as the contractor expected them to read.
  • CCAs Can Provide Better Terms. Particularly in the last 5 years of their availability, cost caps were rarely offered for policy periods longer than 10 years or limits above $25 million. CCAs can extend well past those limits.
  • CCAs Have a Better Claims Process. With cost caps, claims made for cost overruns had to be submitted to the insurer, which, of course, not only had a financial disincentive to pay but sometimes also had a remote, if not difficult, relationship with the insureds. While captive insurers also have a financial disincentive to pay, their claims personnel are often on closer, more cordial terms with the insureds, thus facilitating the claims process. CCAs that do not use captive insurance—but instead use a process that was used post-2011 at McClellan—can use a preselected and mutually acceptable third party (typically a small consulting firm with personnel having significant FPC experience) to determine the validity of a claim. Such a third-party would have no financial stake in the outcome; moreover, it would typically work closely with the owners and the contractors from the start of the process, thus facilitating communication in the event of a claim. For these reasons and others, the CCA claims process can operate with far less friction and cost.

Conclusion

In sum, FPCs remain possible today and offer all of the policy and private benefits that the US government, states, and private entities came to expect during the years of cost-cap policies. In fact, FPCs backed by CCAs are, in many ways, superior and can facilitate cleanups that otherwise may take years just to begin.


1 This article is adapted, with permission, from a longer one by Mr. Hill (with greater detail and citation) that can be found at 70 Chem. Waste Litig. Rptr. 955 (Oct. 2015). It is presented here as a precursor to a March 2016 article explaining how FPCs can be used to enable courts and creditors to know early on how much to set aside in an industrial bankruptcy to provide statutorily-required assurances of cleanup of the debtors' properties.

2 USAEC, Tracking Performance on the Army's Performance-Based Contracts, at 4, 24, 31 (2006).

3 EPA IG, EPA Should Increase Fixed-Price Contracting for Remedial Actions, Rept. No. 13-P-0208, at 14 (March 28, 2013).

4 See, e.g., D. Harnish, From the State's Perspective, National Environmental Enforcement Journal, Vol. 18, No. 8, p. 11 (Sept. 2003) ("The [FPC] approach has the potential to reduce transaction costs and expedite cleanups at other sites throughout the country.").

5 Air Force Press Release, http://www.afcec.af.mil/news/story.asp?id=123332596.

6 For more information on captives, see IRMI resources at http://www.irmi.com/risk-finance-captives-resources, www.vermontcaptive.com (website by the State of Vermont, the leading US captive insurance domicile, with over 1,000 licensed captive insurance companies), and www.vcia.org (website of the Vermont Captive Industry Association).


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