Expert Commentary

Insured Fixed-Price Contracts as a Means To Quantify Costs and Obtain Funds To Clean Up Contaminated Sites: The Kenosha Model

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.


Environmental
April 2003

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:

  1. an "Experience Account" into which the estimated cleanup funds are deposited and paid out only as the cleanup is accomplished;
  2. insurance that typically doubles the amount of the cleanup funds available; and
  3. 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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