‘green money’ in the bank: firm responses to environmental financial responsibility rules

MANAGERIAL AND DECISION ECONOMICS

Manage. Decis. Econ. 18: 491–506 (1997)

‘Green Money’ in the Bank: Firm Responsesto Environmental Financial Responsibility

RulesJames Boyd*

Resources for the Future, 1616 P. St., NW, Washington, DC 20036, USA

Financial responsibility rules are an increasingly common form of environmental regulation.Currently, the operators of landfills, underground petroleum storage tanks, offshore rigs, andoil tankers must demonstrate the existence of adequate levels of capital as a precondition tothe legal operation of their businesses. Environmental financial responsibility ensures thatfirms possess the resources to compensate society for pollution costs created in the course ofbusiness operations. In addition to providing a source of funds for victim compensation andpollution remediation, financial responsibility is thought to motivate better decision-making,particularly regarding the management of long-term risks. This article describes firms’strategic responses to financial responsibility rules and their implications for the promise offinancial responsibility as a complement to conventional environmental regulation. © 1997John Wiley & Sons, Ltd.

INTRODUCTION

Financial responsibility rules are a relatively newand increasingly common form of environmentalregulation. Currently, the operators of landfills,underground petroleum storage tanks, offshorerigs, and oil tankers must demonstrate the existenceof adequate levels of capital as a precondition tothe legal operation of their businesses. The rationalefor environmental financial responsibility is similarto that for the use of minimum reserve requirementsin the regulation of financial services. Banks andinsurers are required to reserve capital in order toabsorb unanticipated costs that threaten their abil-ity to honor contracts with borrowers or policyholders. Similarly, environmental financial respon-sibility ensures that firms possess the resources tocompensate society for environmental costs theycreate in the course of their business operations. Inboth cases, financial responsibility is thought tomotivate better decision-making, particularly re-

garding the management of risks. This articledescribes firm responses to financial responsibilityregulation. In so doing, the article sheds light onboth the promise of financial responsibility as acomplement to conventional environmental regula-tion and a set of weaknesses associated with itscurrent implementation.

The paper is organized as follows: The Section‘Financial Responsibility as a Complement to Tra-ditional Environmental Regulation’ reviews argu-ments for the use of financial responsibility and itsrelationship to other forms of environmental regu-lation. Having laid out the benefits of financialresponsibility in theory, the analysis provides apractical description of rules that currently applyto the owners and operators of regulated facilitiesunder the Resource Conservation and RecoveryAct (RCRA). The Sections ‘Financial Responsibil-ity in Practice: the Case of Landfill Regulations’ and‘Difficulties Posed by Retroactive Liability’ in turn,describe financial responsibility rules as they applyto waste landfills and underground petroleum stor-age tanks. The way in which firms respond strate-gically to the rules has important implications forthe ultimate success of financial responsibility as aform of environmental regulation.

* Correspondence to: Resources for the Future, 1616 P. St.,NW, Washington, DC 20036, USA. E-mail: [email protected]

Contract grant sponsor: US Environmental ProtectionAgency, Office of Research and Development

CCC 0143–6570/97/060491-16$17.50© 1997 John Wiley & Sons, Ltd.

492 J. BOYD

FINANCIAL RESPONSIBILITY AS ACOMPLEMENT TO TRADITIONALENVIRONMENTAL REGULATION

US environmental policy relies on two basicforms of regulation to deter environmental haz-ards: command and control regulation and liabil-ity law. Command and control regulations includereporting requirements, the mandated use of par-ticular technologies, and specific limits on emis-sions or releases. In contrast, liability law makesfew specific requirements of polluters. Instead, itmotivates desirable environmental behaviour byimposing on polluters the social costs of theiractivities. In practice, the two forms of regulationare complementary. For instance, two major USenvironmental statutes RCRA and CERCLA (theComprehensive Environmental Response, Com-pensation, and Liability Act) both establish regu-lations that feature command and control—andliability-based forms of deterrence. However, li-ability law and command and control regulationcan also be viewed as substitutes. Both can beused independently to deter environmental risks.

One way in which to contrast the two forms ofregulation is to think of command and control asan ex ante intervention. For instance, a firm thatis not in compliance with regulations may beprohibited from operating or face penalties for afailure to comply. By contrast, liability is an expost intervention, in that it imposes penalties onlyafter a firm has already created a social cost. Thisdifference in approach has important conse-quences for the relative desirability of the rules.Due to its ex ante nature, command and controlrequires the regulator to balance the socialbenefits of more stringent standards against theprivate costs of complying with them. This pre-sents several difficulties. First, it requires the regu-lator to have detailed information on firmcompliance costs—information it is unlikely tohave or be able to get firms to reveal. Second, thestandards that result are often inflexible. Cross-in-dustry standards necessarily involve some inflexi-bility because the regulator must monitor thecompliance of many firms. Firm- or technology-specific standards, while more flexible, are morecostly to derive and monitor. But any standardsthat constrain a potential polluter’s ability toreduce risks in the least costly manner implycompliance costs that are excessively high.

In its ideal form, liability law resolves theseproblems. By imposing the costs of pollution onthe polluter, liability law allows polluters them-selves to balance the social benefits and privatecosts of pollution reduction. In this way, pollutionreduction decisions are made by the party withthe best information on how to reduce risks,allowing them to do so in a flexible way andremoving the need for government monitoring offirm decisions.1 Unfortunately, the use of liabilityas a regulatory mechanism suffers from a weak-ness related to its ex post nature. Becausepenalties are imposed only after pollution is cre-ated, there is the possibility that the firm will notexist legally or will be in a financial condition thatdoes not allow it to compensate society for theenvironmental costs it has created. This is themotivation for financial responsibility rules. With-out financial responsibility, liability can fail as asystem of environmental deterrence and compen-sation. With financial responsibility, liability lawrepresents a desirable substitute to command andcontrol regulation.

Insolvency and Deterrence

In general, liability for environmental damages is‘strict’ in the common law and under the majorenvironmental statutes such as RCRA and CER-CLA. By contrast to negligence-type liabilityrules, strict liability places the full burden ofenvironmental costs on the pollution generator,independent of the safety or precaution taken bythe defendant. In principle, strict liability leads tothe internalization of otherwise externalized costs.When costs are internalized, firms are led to makeefficient environmental risk reduction decisions.However, strict liability fails to induce efficientprecaution when firms are potentially insolvent,and thus unable to meet the financial obligationsimplied by their liability. Environmental tortclaims are considered debts that can be dischargedin either Chapter 7 or Chapter 11 bankruptcyproceedings. Insolvency truncates the penaltiesthat are borne by tort defendants, thereby reintro-ducing the possibility of externalized social costs.This means that when firms are ‘undercapitalized’relative to the scale of harm they may generate,they do not expect to bear the full social costs ofpollution and may therefore not take efficientprecautions against risk.2

© 1997 John Wiley & Sons, Ltd. Manage. Decis. Econ. 18: 491–506 (1997)

493‘GREEN MONEY’ IN THE BANK

It is important to emphasize that the merepossibility of bankruptcy is sufficient to weakenliability’s ability to deter. The corollary to thisstatement is that bankruptcy need not already beobserved for it to have an effect on firm incen-tives. From the standpoint of ex ante decision-making, bankruptcy occurs only with someprobability. Nevertheless, this is enough to bluntthe incentive to make costly investments in riskreduction. Probabilistically, costs are externalizedand so the incentive to avoid or reduce such costsis weakened. Also, it is important to note thatincentive problems arise even when liabilities orregulatory penalties are not the sole or even pre-cipitating reason for potential bankruptcy. Iffirms foresee the possibility of bankruptcy for anyreason, they will rationally expect the truncationof future penalties.

Liability and Capital Investment in the Absenceof Financial Responsibility Rules

Liability-related insolvency is most popularly as-sociated with product liability cases. Some of themore celebrated examples of product failures thathave resulted in firm bankruptcy include siliconebreast implants, the drug DES, the DalkonShield, and Johns Manville’s asbestos products.3

In the environmental arena, many firms have beenbankrupted by liabilities that dwarf their assets,including petroleum underground storage tankoperators, landfills, and firms deemed responsiblefor Superfund clean-ups. The costs of remediatingpolluted properties and water sources and com-pensating injured third parties are often obviouslylarger than firms’ ability to pay.

To compound this problem, an additionalsource of concern is that firms actively seek toreduce their capital exposure to liabilities by di-vesting themselves of assets. In industries whereliability costs are potentially significant, firms’business organization and capital investment andretention decisions may be influenced by the de-sire to externalize liabilities. For instance, in orderto avoid ‘deepening their pockets’ firms mayavoid retained earnings, choose to not verticallyor horizontally integrate, or shelter assets over-seas.4

To investigate the impact of liability on capitalinvestment decisions, Ringleb and Wiggins (1990)explored the rate of small firm incorporation as afunction of the riskiness of a given industry. Their

evidence suggests that liability has a direct impacton enterprise scale. They compared the number ofsmall firms in 1967—a period before the routineuse of strict liability for tort claims—to the num-ber of such firms in 1980, when the use of strictliability was routine and expected. Their analysissuggests that the incentive to avoid liability led toa 20% increase in the number of small corpora-tions in the US economy between the two periods.This type of evidence has lent urgency to policyreforms, such as financial responsibility rules, thataddress the problems associated with judgement-proof defendants.

The Practical Benefits of Financial Responsibility

Financial responsibility rules are most desirablewhen the scale of possible environmental costs islarge relative to the value of the firms creatingrisks. Not only notorious catastrophes, such as oiltanker spills, signal the need for financial respon-sibility. Smaller risks, such as tank leaks at fillingstations, can in aggregate lead to far greater levelsof externalized environmental costs due to the farshallower pockets of firms using this type of tech-nology.5 Financial responsibility is also particu-larly appropriate when dealing with latent risks.Latency is a common characteristic of environ-mental hazards where risks materialize only overa period of years or decades. This creates the needfor financial responsibility since, without it, thefirm may cease to exist as a legal entity longbefore environmental costs are discovered. In thiscontext, financial responsibility is used to ensurethat existing commercial enterprises reserve capi-tal that will be available for compensation evenafter the firm dissolves.

In concrete terms, financial responsibility en-sures that the expected costs of environmentalrisks appear on a firm’s balance sheets and in itsbusiness calculations. If new investments implypossible future environmental costs, financial re-sponsibility increases the relevance of these coststo the firm’s decision-making. Financial responsi-bility can be demonstrated through either self- orthird-party insurance. The ability to self-insurerequires relatively deep pockets and implies thatthe firm will directly internalize expected environ-mental costs. Shallower-pocketed firms often can-not self-insure and must therefore acquire rightsto financial assets from third parties such as banksand insurers. When third parties provide capital


494 J. BOYD

in this way they are obviously concerned with thelikelihood that their capital will be consumed byfuture liabilities.6 As a result, there is a strongincentive for the providers of capital to monitorenvironmental safety in order to guard againstmoral hazard. In order to guard against adverseselection, capital providers can also base the costof their capital (e.g. their premiums) on observ-able attributes of the firms to whom they providecapital. For instance, more favorable capital costscan be offered to firms with meaningful risk man-agement and safety programs. Moreover, financialcoverage may simply be denied to firms which failto demonstrate acceptable levels of safety. Inthese ways, the capital markets that arise to sat-isfy demand for financial responsibility in turncreate financial incentives to reduce environmen-tal risks.7

A Cautionary Note: Biased Estimation ofProbabilities and Losses

It deserves emphasis that liability and full costinternalization promote efficient risk reductiononly if the damages imposed by the legal systemclosely approximate the true social damage. Thecalculation of social costs presents numerouspractical difficulties in environmental cases. Evenif damages are calculated purely on the basis ofsocial cost (e.g. damages are not influenced by adesire for retribution) the penalties imposed mayover- or under-reflect social costs. However, forsimplicity, and as a natural benchmark, this paperassumes that damages are equal to the social costimposed by the polluter.

In the absence of governmentally-providedstandards or information on risks, strict liabilityand financial responsibility, by forcing cost inter-nalization, leaves the burden of risk assessment tofirms themselves. This is often viewed as one ofthe principal justifications for strict liability. Afterall, firms themselves should be expected to haveaccess to better information than the government,regarding the risks posed by their products. Deci-sion-sciences research offers a cautionary note,however. For instance, individuals routinely un-derestimate the probabilities or scale of low prob-ability events. They also frequently underestimatethe potential consequences of a product or envi-ronmental catastrophe.8 This has the potential toaffect markets for financial coverage by creating adivergence between managers and financial mar-

kets’ estimation of the marginal benefits of risk-reduction.9

The Design of the Rule

Financial responsibility rules require the definitionof a minimum level of coverage, a description ofalternative financial mechanisms that can be usedto satisfy the rule, and a mechanism to monitorcompliance. Ideally, firms should be able todemonstrate recoverable assets sufficient to inter-nalize the costs of the most catastrophic hazardtheir businesses can create. Thus, even if there isonly a small probability of a loss of large magni-tude, optimal deterrence requires that the firminternalize that full cost.10 It is a misconception tothink that assets sufficient to internalize the ex-pected level of harm are adequate. A firm withassets equal to the expected level of harm will bydefinition externalize costs—and be under-de-terred—whenever the harm exceeds the expectedlevel.

Compliance with coverage requirements can bedemonstrated either through evidence that thefirm has adequate wealth (e.g. cash, capital assets)or has purchased a claim on the assets of a thirdparty that can be used to finance liabilities. Inpractice, these claims can take the form of in-surance coverage, letters of credit, or suretybonds. Monitoring compliance is relativelystraightforward. In the case of self-insurance, in-formation such as that contained in routine finan-cial audits is usually sufficient to demonstratecompliance. In the case of third party coverage,evidence of a contract with a licensed capitalprovider is sufficient.

Motivating Cost Internalization without FinancialResponsibility

When a firm is insolvent or otherwise judgement-proof, the common law often extends liability toother firms with whom the injurer had contractualrelationships. Retailers, for instance, may be liablefor reselling a product that causes injury if themanufacturer is unable to compensate victims.The underlying motivation for ‘extending’ liabilityin this way is cost internalization. By extendingthe reach of liability, there is an increased incen-tive for firms to monitor and demand greatersafety from those with whom they trade.11

Compared to financial responsibility rules,however, this method of fostering cost internaliza-



tion can introduce distortions of its own. Ex-tended liability can distort the pattern of transac-tions between risk-generating firms and those withwhom they contract. This happens since deep-pocketed firms have an incentive to avoid transac-tions with more shallow-pocketed firms whoseliabilities they may inherit. When transactions areavoided, gains from trade are lost. This can in-crease production costs. Moreover, the possibilityof being exposed to another firm’s liability isinherently more uncertain, perhaps uninsurable,and thus more costly.12

Financial Responsibility in Practice

Current US environmental policy requires finan-cial responsibility for the owners and operators oflandfills and underground petroleum storagetanks under RCRA. The next sections detail theimplementation of financial responsibility rulesunder this statute and highlight a set of practicalissues that can blunt the regulations’ effectiveness.Described first is a set of potential weaknesses inthe rules implemented under the landfill provi-sions of RCRA. Of the several allowable mecha-nisms for demonstrating financial responsibility,some are likely to lead to less cost internalizationthan others. The analysis explores the impact ofthe different mechanisms on firm incentives andsuggests ways in which the law can be strength-ened. Financial responsibility as it has been imple-mented for underground storage tanks is explorednext. Under this program, financial responsibilityhas evolved into a system of publicly-financedliability coverage. As is explained, this signifi-cantly reduces the ability of financial responsibil-ity to deter environmental risks.

While not discussed in detail, it is worth notingthat financial responsibility is also required underthe Oil Pollution Act of 1990.13 The OPA requiresfinancial responsibility for tankers, offshorepipelines, and oil and gas terminals. Its provisionsare very similar to those under RCRA.

FINANCIAL RESPONSIBILITY INPRACTICE: THE CASE OF LANDFILL

REGULATION

In 1993 the EPA issued financial responsibilityrequirements for municipal and other ‘non-haz-ardous’ landfills. This section analyses the likely

impact of the Subtitle D financial assurance re-quirements on the safety investments and operat-ing decisions made by municipal solid waste(MSW) landfill owner-operators. Subtitle D’s re-quirements are the outgrowth of an increasedrecognition that wastes, even those classified as‘non-hazardous’, can lead to significant environ-mental risks.14 The principal risk presented by anylandfilling operation is due to the leaching ofcontaminants into groundwater. Off-site soil andgroundwater damage can lead to health risks andreduce the value of neighboring real estate. Air-borne pollutants and underground methane build-up also contribute to the overall risk of a landfillsite.15

Landfill Risks and the Desirability of FinancialResponsibility Rules

The nature of landfill risks can impede the abilityof liability-based laws to accomplish their goals ofcompensation and deterrence. First is the ‘latency’of losses. Environmental damages may develop orbe detected only after years of operation, or afterthe landfill has closed. Second, the scale of reme-diation and damage costs can be large relative tothe value of the firms operating them.

When landfilling results in environmental dam-age, or the threat of environmental damage, liabil-ity can be imposed on owner-operators throughthe application of common law principles RCRA,and CERCLA. Under the common law, thirdparties such as neighboring property owners canrecover damages due to the increased risk ofdisease, the costs of medical monitoring, andproperty damage.16 RCRA liability is primarily acodification of existing common law public nui-sance remedies in which liability derives from theexistence of an ‘imminent and substantial endan-germent’ posed by the facility.17 There is a right tocitizen suit and liability can be applied to remedialactions at both active and inactive sites.18 RCRAliability is joint and several, meaning that any onedefendant can be held liable for the full amount ofdamages if responsibility for the harm is indivisi-ble among multiple parties. CERCLA liabilityalso applies to MSW landfill operations. CER-CLA defines potentially responsible parties(PRPs), which generally include owner-operators,transporters, and generators of waste. All PRPsare jointly and severally liable. Liability is as-sumed if there is a release or threatened release of


496 J. BOYD

a ‘hazardous substance’ from the site or if therelease or threatened release causes the plaintiff(typically the federal government) to incur costs inresponse to the release.19 Roughly 25% of allSuperfund sites involve municipalities or MSW, aproportion that is expected to increase overtime.20 Like RCRA, CERCLA can be applied toboth active and inactive (abandoned) sites.21 Un-like RCRA, CERCLA does not have an exemp-tion for ‘household’ waste. This has raised thepossibility of widespread municipal liability underCERCLA.22

The scale of these liabilities can be huge. ForRCRA subtitle D actions, the EPA estimates thatthe costs of closure, post-closure and correctiveaction will range between $1 and 29 million for atypical landfill.23 CERCLA liabilities add millionsmore to the potential costs of site remediation.24

Moreover, since liability is joint and several underboth CERCLA and RCRA, total liability costsmay be even greater due to the transactions costsassociated with litigation among potential co-de-fendants. Because the scale of liability costs is solarge, owner-operators can be bankrupted by li-ability and other enforcement actions. When thishappens remediation costs must be borne by otherPRPs or the government.25

Subtitle D, in addition to its financial assuranceprovisions, includes design criteria that requirelandfill liners, leachate collection, and groundwa-ter monitoring systems. For several reasons, thesetechnical requirements alone cannot be relied onto guarantee efficient landfill risk reduction. First,design and operating safety regulations requireenforcement activities to ensure compliance. Theexisting record on enforcement and complianceunder RCRA, however, is weak. For instance, theearliest Subtitle D provisions required states toenforce groundwater and methane monitoringand surface water control standards. The require-ments went into effect in 1979. A 1988 EPAreport, however, found only 36% of landfills mon-itoring groundwater, 7% monitoring methane,and 15% with surface water controls.26 Second,even if enforced, specific technical requirementscannot be all-inclusive. By contrast, financial re-sponsibility requirements create an incentive toreduce risks broadly, in whatever way the opera-tor feels is in its best interest.

Financial responsibility also deters the con-struction and operation of landfills with negativenet social value. Moreover, because dedicated

funds are available for remediation and closure,the legal transactions costs associated with appor-tioning responsibility among generators andtransporters can be reduced or eliminated. Inde-pendent of whether efficient investments in safetyare made, when environmental costs are external-ized via bankruptcy, landfills with negative netsocial value may be constructed and operated. If alandfill creates social value V and all environmen-tal costs E are internalized, then only landfillswhere V\E will be constructed and operated.This is efficient. However, if a fraction of the costsE are borne by the government or third parties,then landfills may be operated even though VBE,which is clearly inefficient. Externalized environ-mental costs also mean that the price of tippingfees charged by landfill operators may not reflectthe full social costs of disposal. In turn, thisartificially low price of disposal distorts the incen-tive of MSW generators to reduce their produc-tion of waste.

The Alternative ‘Allowable Mechanisms’ forDemonstrating Financial Responsibility

The FRRs mandated under RCRA are likely toimprove the overall efficiency of the landfill mar-ket. However, because of ‘loopholes’ in the regu-lations, financial responsibility rules are unlikelyto eliminate the possibility of inefficient opera-tion, safety, and closure decisions. To understandthese loopholes, it is necessary to describe thevarious allowable mechanisms for demonstratingfinancial responsibility compliance.

The Subtitle D requirements for non-hazardouswaste disposal facilities require owner-operatorsto demonstrate financial responsibility for closure,30 years of post-closure care, and known correc-tive actions.27 The rule requires an itemized esti-mate, in current dollars, of the cost of hiring athird party to perform these activities assuming‘worst case’ assumptions. The estimate is revisedannually and financial responsibility must reflectany changes to the estimate (positive or negative)over time. There are several allowable mecha-nisms for demonstrating financial responsibility.Multiple mechanisms can be used simultaneously.

Corporate and Local Government FinancialTests This mechanism is the most straightfor-ward and allows ‘deep-pocketed’ corporations orgovernments to satisfy the requirement by demon-strating their financial strength. In the case of



corporations, the diversity and depth of the firm’sassets and debt, as well as the value of futureincome are particularly relevant. The requirementis most likely to be satisfied by large, diversifiedcorporations. The proposed local government testis based on a bond rating requirement. If theminimum acceptable bond rating is not met, addi-tional tests involving liquidity and debt serviceratios may be used. Governments are prohibitedfrom using this test if they are in default on anygeneral obligation debt or if they operate at anymore than a 5% annual revenue deficit for 2 ormore fiscal years. Assuming the requirements aresatisfied, at most 43% of the government’s annualrevenue can be claimed as funds to satisfy thefinancial responsibility requirement.

Trust Funds The trust fund mechanism requiresannual payments into a site-specific trust over thelifetime of the landfill’s operation. Given a totallevel of required coverage COV and Y years ofoperation, annual payments of (COV−BAL)/Yare required, where BAL is the balance of fundsalready held in trust. Following the post-closureperiod any remaining funds left in trust revert tothe owner-operator. Note that full financial re-sponsibility is achieved under this mechanism,only after the end of the landfill’s operation.Thus, premature closure can result in incompletecost internalization when this mechanism is used.

Annual payments into a trust fund are desirableif they reflect funds needed to internalize addi-tional social costs created by the landfill’s opera-tion over time.28 If, however, the spreading ofpayments over time implies that the firm’s capitalreserve may be inadequate to internalize all poten-tial costs, then the firm will not be adequatelydeterred.

Letters of Credit Financial responsibility can bedemonstrated if the owner-operator is in posses-sion of a letter of credit from an approved finan-cial institution (usually a bank). Letters of creditare a promise to pay from a third party institu-tion. The credit issuer will typically require anowner-operator to provide collateral for 100% ofthe face value of the letter. The collateral require-ments make this mechanism unavailable, or unde-sirable to most owner-operators. First, real estatehas little collateral value since landfill propertyhas few alternative uses and may be valueless inthe event of environmental damage. And the liq-uidation value of capital investments such as

heavy machinery is limited. In any event, owner-operators able to satisfy the collateral require-ments are likely to be able to satisfy the corporatefinancial test. In addition, letters of credit can berevoked by the issuer as long as 120 days notice isprovided to the state and owner-operator.

Surety Bonds Like letters of credit, surety bondsmake the issuer liable in the event that the owner-operator is unable to satisfy its obligations. How-ever, surety bonds feature a ‘sinking’ fund, orannual repayments of the principal to the bondissuer. These payments are deposited in a trustuntil the coverage period (the post-closure period)ends. Because of the annual installments made tothe sinking fund, surety bonds typically do notrequire as much collateral as letters of credit. Inpractice, the use of a sinking fund requires anability to demonstrate significant cash flow. As aresult, surety bonds will only be available tolandfills that are many years from closure. As inthe case of letters of credit, the surety can cancelthe bond by providing 120 days notice of cancel-lation.

Insurance Financial responsibility can bedemonstrated through purchase of an insurancepolicy with a face value equal to the total level ofrequired coverage. The insurer is liable for the fullamount and, significantly, is prohibited from ter-minating or failing to renew the policy unless theowner-operator fails to pay its annual premiums.In addition, the law requires insurers to transferthe policy to any successor owners or operators.

The alternative mechanisms differ in importantrespects. The fact that letters of credit and suretybonds can be withdrawn by their issuers raises thepossibility that financial assurance may not existwhen an environmental loss is detected and reme-dial actions ordered. Similarly, the trust fundmechanism does not provide full financial assur-ance until the end of the landfill’s operating life-time. By contrast, the insurance mechanismrequires a guarantee of lifetime coverage at thetime a policy is purchased. Below, firm investmentdecisions are modeled under three different sce-narios: no financial responsibility requirement,financial responsibility fulfilled via the insurancemechanism, and financial responsibility satisfiedvia a trust fund. This analysis allows for both anormative comparison of the different financialmechanisms and a descriptive analysis of strategicfirm responses to the mechanisms.


498 J. BOYD

A Model of Landfill Safety, Start-Up andClosure Decisions

The model below more formally describes landfillowners’ start-up, closure and safety decisions inthree alternative regulatory environments. First,firm decisions are modeled given no financial re-sponsibility requirement. Then compliance withfinancial responsibility is imposed. In the first casewith financial responsibility, the requirement mustbe satisfied via the purchase of insurance. In thesecond, firms can comply through the demonstra-tion of a trust fund. In practice, firms are allowedto choose whichever mechanism they prefer. Byisolating decisions under the specific mechanisms,however, it becomes clear that the insurancemechanism requires a greater level of cost inter-nalization. As a consequence, firms are likely tocomply via other means. This weakens the deter-rent value of financial responsibility.

To capture the possibility of premature closure,the model features two periods of operation inwhich waste can be accepted and revenues earned.These periods are followed by a post-closure pe-riod. For notational simplicity, a zero discountrate is assumed.

The model employs the following notation: I,expected income per period; C, operating costsper period; b, expected closure and post-closurecosts; D, damages incurred due to remedial ac-tion; s, safety investment; p(s), the per periodprobability of a remedial action; and A, the valueof assets recoverable in the event of liability.

Landfill operation entails the risk of environ-mental damage. If damage occurs, the firm isliable, i.e. required to undertake remedial actionto restore soil or groundwater quality. To reducethe likelihood of environmental damage (and itsown liability), the firm can invest in safety s. Theprobability of a loss p( · ), is decreasing in s. Theprobability of a loss is p( · ) in each period, butonce a loss has occurred and remedial require-ments satisfied, it is assumed that no further losscan occur.29 Denote the probability of a lossoccurring at some time during the three periods asG(s). A loss, if it occurs, creates a social cost D,the costs of remediation and compensation toinjured third parties

Figure 1 describes the costs and income associ-ated with operation in the three periods. In eachperiod the firm operates it earns revenue I and hasoperating costs C.30 Following operation, the

landfill requires closure and post-closure care at acost b. Closure costs are assumed to be indepen-dent of the number of periods the firm operates.

A denotes the value of assets that can be recov-ered by plaintiffs in the event that the owner-op-erator is liable. Recoverable value is most likely tocome from the salvage value of relatively immo-bile capital assets such as machinery. Cash assetsmay not be recoverable since they can be dissi-pated in anticipation of liability. A is equal to 0 if,knowing it will soon be liable for environmentaldamages, the firm is able to convert or sell itsassets, distribute the value to the firms owners anddissolve. So profit of I−C earned in period 1 willnot necessarily increase the firm’s assets in period2. Also, the recoverable value of land on which alandfill is located is probably close to zero in theevent of environmental contamination. Therefore,the value of real estate holdings in general will notcontribute to A.

The point in time at which environmental costsarise is particularly important to the firm’s opera-tion and closure decisions. The model is designedto capture the possibility that, for instance, thefirm will be insolvent in the event that environ-mental damage occurs in period 1. A firm isinsolvent if its current and future value is ex-ceeded by its liabilities.31 More specifically, if cur-rent assets and future income are less than futureoperating, closure, and liability costs, the firm isrendered insolvent and will cease operation.

The Efficient Safety Investment Safety invest-ments are efficient if they minimize the combinedcosts of risk avoidance s and expected environ-mental damage G(s)D. Denote the efficient safetyinvestment s*, where s* solves

mins

s+G(s)D. (1)

Figure 1. Expected liability over lifetime=G(s)D=[1− (1−p(s))3]D.



As will be shown, whether or not the firminvests up to the efficient level depends on thefirm’s assets and future earnings and on the typeof mechanism by which the owner-operator isable to demonstrate financial responsibility.

Safety and Operation Decisions in the Absence ofFinancial Responsibility

To illustrate the potential inefficiencies that canarise in the absence of financial responsibilityrequirements, first consider the financial conditionof a firm given an environmental damage arisingin period 1. Given the need to satisfy damages Din period 1, the firm is insolvent—unable to sat-isfy its liabilities—if the future value of operationplus the value of its assets is less than D. Recallingthat the net value of operation in period 2 is(I−C), a period 1 environmental problem resultsin insolvency whenever

(I−C)+ABD. (2)

Rearranging, a firm with assets such that

ABD− (I−C)

expects to be insolvent if a loss occurs duringperiod 1. In the event of a period 1 loss andbankruptcy, the firm loses the value of period 2operation (I−C) and externalizes costs equal to(D+b)−A.

Now consider the impact of potential insol-vency on the firm’s incentive to invest in safety.While the firm wishes to avoid a period 1 loss inorder to capture (I−C) in period 2, its insolvencyin the event of a loss in any period means that itwill not fully internalize environmental costs.With probability G( · )—the cumulative probabil-ity of a loss in any of the three periods—the firmloses its assets A. If no loss occurs over thelandfill’s lifetime, the firm bears only the post-clo-sure costs b.32 Thus, the firm picks s to minimize

s+G(s)(A−b)+p(s)(I−C). (3)

The second term represents the firm’s expectedliability in excess of the guaranteed post-closurecosts b. The second term reflects the possibility offoregone period 2 profits due to insolvency in theevent of a period 1 loss.

Comparing (3) to (1) implies that the firm’sprofit-maximizing safety choice is suboptimal.33

Being under-capitalized, the firm does not expectto bear the full expected costs its operations can

create and, as a result, it has insufficient incentiveto avoid risks.

Also, in the above example, the firm external-izes an expected social cost G(s)(D+b−A). Aconsequence of this externality is that landfillswith negative net social value may operate. Ifowner-operators can extract profits in the shortterm, then landfills might be opened whose long-term social costs exceed their benefits.

Financial Responsibility Satisfied via theInsurance Mechanism

Now consider the incentives created by financialresponsibility requirements. In particular, con-sider compliance satisfied via the insurance mech-anism. Let the firm be undercapitalized, so thatD\A. And assume that the financial responsibil-ity requirement mandates coverage of D+b (cov-erage for post-closure care and any remedialliabilities). The insurer’s expected liability inproviding this amount of coverage depends on thelikelihood of a loss D. This likelihood is a func-tion of the landfill’s safety.

If insurance markets are competitive, premiumswill be actuarially fair (equal to the insurer’sexpected loss). Over the landfill’s lifetime, then,premiums of G(s)D+b will be collected. Thus,the actuarially fair per period premium is

G(s)D+b

2.

It is significant that the insurer, rather than theowner-operator, is liable in the event of an envi-ronmental loss. This means that the decision tooperate the landfill is independent of whether ornot—or when—a loss occurs. Consider the firm’soperation decision if there is a loss in period 1.Because the insurer is liable, the firm’s liability issimply equal to its period 2 insurance premium.As long as period 2 profits exceed the premium,the firm will not be insolvent. Bankruptcy wouldoccur only if

(I−C)BG(s)D+b

2. (4)

But this is impossible, since the firm was facedwith the same condition before period 1. Giventhat the firm chose to operate in period 1, condi-tion (4) cannot hold.

If premiums can be conditioned on firm safetyattributes, the firm has an incentive to invest in


500 J. BOYD

the level of safety that minimizes the cost of safetyexpenditures and its aggregate premiums. Giventhat full financial responsibility is required, andpremiums are actuarially fair, firms are led tomake the efficient safety investment, as in (1).

Also, with a full insurance requirement, it fol-lows that the social benefits of operation areguaranteed to be greater than the total expectedsocial costs of operation. Thus, there is an effi-cient level of entry.

Compliance via the Trust Fund Mechanism

The trust fund mechanism, as described in theprevious section, requires annual payments intotrust that build up to the full level of responsibil-ity over the landfill’s operating lifetime. Impor-tantly, the schedule of payments implies that thefund’s balance does not fully accrue until the finaloperating period. If a loss occurs before the endof this pay-in period, the trust’s value may beinsufficient to cover existing remediation and clo-sure costs. Thus, the trust fund mechanism doesnot eliminate the possibility of bankruptcy. Forthis reason, the trust fund mechanism can fail toinduce efficient operation decisions and invest-ments in landfill safety.

Assume that the fund requires a final accruedbalance of (D+b). If achieved, this level of finan-cial responsibility allows for the full internaliza-tion of post-closure and remedial action costs.Any remaining balance is returned to the firmfollowing the post-closure period. Since the modelinvolves two operating periods, the firm is re-quired to make payments of (D+b)/2 per period.

As in the previous examples it is necessary toconsider the possibility of bankruptcy. In theevent of a loss in period 1, the firm will bebankrupt if the value of its period 2 net profit andassets is less than its liabilities, or if

(I−C)+ABD+b

2. (5)

The firm’s liabilities are (D+b)/2 since anequal payment was made at the beginning ofperiod 1. Note that bankruptcy after period 1 is apossibility and that if it occurs there is an exter-nalized cost (D+b)/2−A. This means the firm’sinvestment in safety will be inefficiently low.However, the trust fund mechanism leads togreater safety investment than if there was nofinancial responsibility requirement at all.

Early payments into the trust fund (in thisexample the period 1 payment) reduce the poten-tial externality that can be created by an insolventowner-operator. Recall that without financial re-sponsibility, the firm externalizes an expected costG(s)(D+b−A). With a trust fund, the firm ex-ternalizes an expected cost p(s)[(D+b)/2−A ],which is clearly less. While the possibility thatcosts will be externalized means that operationswith negative net social value can still exist, theexternality is lower with the trust fund mechanismthan in the absence of financial responsibility. Ofcourse, the insurance mechanism externalizes nocosts and is therefore clearly preferable since itleads to efficient safety investments and guaran-tees that only operations with positive net socialvalue will exist.

The analysis in this section illustrates the desir-ability of financial responsibility requirements,and in particular the desirability of fully-fundedresponsibility at the time of a landfill’s start-up. Itshould be emphasized that the analysis assumedfinancial responsibility for both closure costs andpotential remedial actions D. Current Subtitle Dregulations, however, require financial responsibil-ity for the remedial component of costs only afteran environmental loss has been detected and re-mediation ordered. This is equivalent to requiringdrivers to purchase liability insurance only afterthey are involved in a collision. Defining financialresponsibility in this way does not prevent alandfill owner-operator’s insolvency and the cor-responding inefficiencies suggested by the model.Once a loss occurs, the landfill may have only alimited number of years of operation left. Thus,the firm’s ability to finance remediation (its finan-cial responsibility) through future cash flow maybe limited. Clearly, requiring financial assurancefor a known remedial event may be impossible ifthe landfill is near the end of its operating period.

While not treated specifically, the model alsosuggests that the letter of credit and surety bondmechanisms do not guarantee efficiency. Even ifcoverage is required for both possible remedialevents and post-closure costs, the fact that finan-cial assurance can be withdrawn by the lender orsurety means that an owner-operator may not bein compliance at some point during the landfill’soperation. In fact, if the landfill’s underwritersexpect a future environmental problem they mayhave an incentive to withdraw coverage. Thismakes it more likely that the firm will be unable



to cover its environmental costs in the event of aremedial action being required.

The full benefits of financial responsibility areachieved only by mechanisms which (1) requirecoverage for all possible environmental costs, and(2) require coverage that cannot be withdrawnuntil the end of the lifetime coverage period.These requirements are currently not reflected inthe law.

DIFFICULTIES POSED BY RETROACTIVELIABILITY

Financial responsibility acts as a complement tothe regulation of ‘prospective’ environmental haz-ards. But much environmental regulation has a‘retrospective’ aspect as well. Retrospective envi-ronmental problems complicate the implementa-tion and effects of financial responsibility.

Retroactive Liability

Environmental regulation has been marked in re-cent years by a broad set of reforms. Broadly,these reforms have addressed two distinct socialproblems: how to better deter future pollutionand how to deal with existing pollution that hasaccumulated over decades of relatively unregu-lated economic activity. Retroactive liability arisesout of the need to assign responsibility for pollu-tion costs that already exist. Firms that in atechnical sense polluted legally in the past arenevertheless responsible for the costs of that pol-lution in the present. Thus, many regulated firmsface both historic (existing) and prospective (un-certain) environmental risks.

Financial responsibility is a policy tool gearedtoward prospective deterrence. It leads to costinternalization which fosters more efficient invest-ments in precaution. Financial responsibility isnot an appropriate tool to foster the clean-up ofexisting environmental problems. In fact, the fail-ure of regulation to account for the interactionbetween financial responsibility rules and retroac-tive liability, accounts for several problems associ-ated with financial responsibility regulations. Forinstance, a common complaint from firms thatmust comply with financial responsibility rules isthat pollution coverage is simply not available.34

A reason for this lack of coverage is that insurersexpose their own assets to retroactive liabilitywhen they underwrite prospective liabilities.

In general, retroactive liability increases thecosts of demonstrating prospective financial re-sponsibility, as when it increases the expectedliabilities of third party insurers. It also increasescosts when firms self-insure by consuming assetsthat otherwise could be used as collateral againstfuture liabilities.35

Also, financial responsibility rules do nothingto promote the clean-up of existing environmentalproblems. Firms with the capital to absorb exist-ing risks are already ‘financially responsible’.Firms without adequate capital have no incentiveto demand—and capital providers have no incen-tive to supply—coverage for existing costs. Firmswith existing costs want to externalize as much ofthose costs as possible. And insurers or lenderscertainly want to avoid exposing their capital toknown liabilities.

Because retroactive liability imposes large—po-tentially bankrupting—costs on the private sec-tor, it may be difficult or impossible for smallerfirms to comply with prospective financial respon-sibility rules. The result can be fierce politicalopposition to compliance with financial responsi-bility rules. Below is described the outcome ofpolitical opposition to financial responsibility forunderground petroleum storage tanks (USTs).Opposition has led to the creation of public liabil-ity funds that mimic, but ultimately undermine,the goals of financial responsibility. Failure todistinguish between the goals of cleaning up exist-ing pollution and deterring future pollution hasled to a decidedly undesirable means of regulatingUST risks.

UST Regulation

Regulations governing the use of USTs are acentral component of RCRA. In addition to mon-itoring, construction, and technical requirements,RCRA requires the owners and operators ofUSTs to demonstrate financial responsibility fortank leaks. Specifically, RCRA requires financialresponsibility for remediation and third party li-ability costs through insurance or some otherform of collateral in an amount typically exceed-ing $1 million for each tank system. USTs are atechnology for which financial responsibility isparticularly desirable. The costs of tank leaks caneasily dwarf a typical gas station or distributor’sability to bear such liabilities. Tanks are fre-quently owned by small businesses (from farmers


502 J. BOYD

to ‘mom and pop’ service stations) and liabilitiescan range up to millions of dollars.36 It is in justthis type of situation that liability is most likely tofail as an effective deterrent.

The other important distinguishing feature ofUST regulation is that many tanks have beenslowly leaking for decades. Thus, RCRA financialresponsibility rules have taken effect alongside thediscovery of huge existing liabilities.37 The resulthas been intense opposition to UST financial re-sponsibility rules, particularly from small businessowners.38 In response to opposition, the statesand the EPA have chosen to allow ‘state guaran-tee funds’ (SGFs) to help UST owners complywith RCRA’s financial responsibility rules, more-over 43 states now have SGFs. The typical fund isfinanced through a flat tax on gasoline sales ordeliveries and are therefore a form of publicly-funded financial responsibility. At least two-thirdsof all UST clean-up is paid for with publicmoney.39 Importantly, the SGFs provide coveragefor both historic and prospective environmentalhazards.

SGFs are the political consequence of RCRA’sfailure to account for the huge impact of retroac-tive liability on small firms. While public financingis an economically defensible and perhaps desir-able way to finance the cost of retroactive liabili-ties,40 it is a particularly undesirable form ofprospecti6e financial responsibility. By subsidizingprivate environmental costs SGFs undermine de-terrence. Instead of internalizing future environ-mental costs as financial responsibility is meant todo, SGFs externalize future costs and therebyblunt the incentive to reduce environmental risks.

CONCLUSION

Financial responsibility rules resolve the principleweakness of liability-based forms of environmen-tal regulation: specifically, that defendants willnot be legally available or financially able to bearthe judgements imposed upon them. Because li-ability and financial responsibility promote costinternalization, they create a powerful form ofincentive-based regulation. With the knowledgethat costs will be internalized, potential pollutershave a clear economic incentive to take appropri-ate precautions against environmental damage.Moreover, this method of regulation affords firmsthe flexibility to reduce risks in the ways they best

see fit, and thus, reduces the need for continuousgovernmental monitoring of technology adoptionor other types of firm behavior.

While financial responsibility rules hold greatpromise, analysis of their present implementationreveals weaknesses. First, firms can continue toexternalize environmental costs due to loopholesassociated with allowed mechanisms for compli-ance. Clearly, it is desirable to allow a variety ofmeans for compliance with financial responsibilityrules. Variety allows for compliance to occur atthe least cost and may foster a profusion of newfinancial market products to provide risk coverageand assessment. But, as discussed in Section 3,variety is accompanied by inconsistency in thedegree to which the mechanisms demand costinternalization over the lifetime of a firm’s activi-ties. For instance, the insurance mechanism en-sures full cost internalization from the time thefirm begins operation. In contrast, trust fundsensure full cost internalization only after a periodof years or even decades. Because financial re-sponsibility can be costly for firms to demon-strate, the ability to minimize these costs willalways be appealing. The most direct way tominimize the costs of financial responsibility is touse a method of compliance that externalizes asmuch risk as possible. Only a consistent statutorycommitment to financial mechanisms that pro-mote total cost internalization will guarantee thatthe full promise of this form of regulation isfulfilled.

It is also important to understand the politicalconsequences of financial responsibility rules, par-ticularly the way in which they affect small busi-nesses. Financial responsibility is relatively harder(more costly) for small firms to demonstrate. Thelarger the firm, the more likely it is that self-in-surance, or a corporate parent’s assets, can beused to comply. For large firms, compliance withfinancial responsibility may involve little morethan the preparation of audited financial state-ments. Small firms, by definition, cannot self-in-sure and so must either pay for the involvementof a third-party insurance or capital provider, orpool risks amongst themselves. Both options arecostly for several reasons. Small firms must com-pensate the insurer (or pool) for the ‘actuarial’cost of the insurer’s exposure to liability plus thecoverage’s ‘load’, or mark-up. In addition, thefirm is required to participate in risk assessments,paperwork, and a set of transactions with which it



may be unfamiliar. Smaller firms consequently findit harder to comply with financial responsibilityrules and may in fact be forced to cease operation(General Accounting Office, 1994).41

This burden, particularly if faced by a largenumber of affected businesses, can generate signifi-cant political opposition, as in the case of the USTprogram. In contrast, there has been relatively littlepolitical opposition to financial responsibility fromthe industry regulated under the Oil Pollution Act.This is due, at least in part, to the relative ease withwhich large oil and shipping firms can self-insure.42

When small-firm opposition is particularly strong,compromise solutions—such as the publicly-financed state funds used for UST compliance—should be resisted because they undermine theincentives for precaution toward which financialresponsibility is geared.

Despite the political difficulties, meaningfulfinancial responsibility compliance for small firmsis an important goal. After all, the social benefitsof financial responsibility are likely to be greatestwhen applied to small firms. Perhaps the mostimportant step that can be taken to promotefinancial responsibility is to provide third-partycoverage providers with immunity from theretroactive liabilities of the firms they underwrite.Without this immunity, third-party insuranceproviders will either avoid the financial responsibil-ity market altogether, or raise the price of coveragein order to compensate for the risk of inheritingretroactive liabilities. In either case, the ability ofsmall firms to acquire financial responsibility cov-erage at actuarially fair rates is undermined. Thus,guaranteeing underwriter immunity from theretroactive liability of covered parties is an impor-tant means to promote the prospective, deterrence-related benefits of financial responsibility rules.

Acknowledgements

The author wishes to thank Dan Ingberman, Margaret Walls,Howard Konreuther, and the editor for helpful comments.Research was sponsored in part by the US EnvironmentalProtection Agency, Office of Research and Development.

NOTES

1. For a similar, but more exhaustive, comparisonof command and control regulation and liability-type rules see Cohen (1987).

2. For analyses which have explored or employ thisreasoning see Schwartz (1985), Shavell (1984,1986), Landes and Posner (1987), Kornhauserand Revesz (1990), Polinsky and Shavell (1991),and Boyd and Ingberman (1994).

3. For discussion of such cases see Roe (1984).Hazardous products have the potential to createmassive litigation costs, in addition to the socialcosts of the injuries themselves. For instance, seeViscusi (1991) who documents 275 000 asbestos,210 000 Dalkon Shield, and 125 000 Agent Or-ange cases.

4. Allied Signal’s divestiture of a facility for han-dling Kepone, a highly carcinogenic solvent, is aclassic example. For a description of offshorefinancial havens, or ‘asset protection trusts’ see‘Salting it Away’, The Economist, Oct. 5, 1991, at32.

5. For instance, the environmental costs of theExxon Valdez disaster, while huge, were not ex-ternalized due to the wealth of Exxon.

6. Skogh (1991) describes the benefits from monitor-ing that come when intermediate financial ‘guar-antors’ expose their assets to the liability claimsof the firms they underwrite.

7. Mandatory automobile insurance leads to similar,desirable incentives. With required insurance,drivers pay premiums based on their drivingrecord and may have coverage revoked in extremecases. Because insurance is required, this creates abroad-based, self-enforcing system to deter trafficrisks.

8. See Hogarth (1987) and Kahneman et al. (1982).For an economic analysis of damage assessmentissues see Kaplow and Shavell (1996).

9. Zeckhauser and Viscusi (1990) argue that, withregard to catastrophic events, people underesti-mate the probabilities of disaster, and so perceiveinsurance premiums for coverage against theevents as too high.

10. An exception to this proposition occurs when theunderlying liability rule is negligence-based,rather than strict. Because it conditions damageson the defendant’s actual care, a negligence rulecan induce efficient safety investments even iffirms are somewhat undercapitalized (Shavell,1986; Landes and Posner, 1987). The implicationis that, the level of financial responsibility neededto induce optimal deterrence is lower under negli-gence rather than strict liability. However, giventhat strict liability is the applicable rule in mostenvironmental and product risk contexts, we fo-cus on the use of financial responsibility in con-junction with strict liability.

11. This same motivation underlies academic pro-posals to relax current limitations on shareholderliability. Extending liability to shareholders pro-motes cost internalization and can be expected toyield corresponding benefits in deterrence. Forinstance, see Hansmann and Kraakman (1991)


504 J. BOYD

who advocate proportionally unlimited share-holder liability for corporate torts. A similar ra-tionale is central to the literature on vicariousliability, as in Kornhauser (1982) and Sykes(1984).

12. For a more complete analysis of the effects ofextended liability see Boyd and Ingberman (1996,1997).

13. 33 U.S.C. §2716.14. RCRA’s hazardous waste regulations (subtitle C)

exempt household hazardous waste and small-generator wastes. But these types of sources con-tribute to a vast annual volume of waste capableof creating environmental damage. As a measureof the scale of MSW operations in the US, a 1988EPA estimate placed the annual volume of mu-nicipal waste at nearly 211 million tons. US EPA,1 Report to Congress: Solid Waste Disposal in theUnited States, 11 (1988). A frequently cited esti-mate is that 0.3–0.4% of MSW is composed ofhazardous substances. See testimony in B.F.Goodrich Co. V. Murtha (754 F. Supp. 960, DConn., 1991).

15. See Ferrey (1988).16. Werlein V. United States (746 F. Supp. 887, 1990).17. 42 U.S.C §7002. As an example of enforcement

under this section, see Dague V. City of Burlington(732 F. Supp. 458, 1989) where the city ofBurlington Vermont was found liable for operat-ing a landfill presenting ‘an imminent and sub-stantial endangerment to the public’s health andthe environment’.

18. See United States V Ottati & Goss, Inc. (630 F.Supp. 1361, 1985).

19. CERCLA, §107.20. Superfund Program: Interim Municipal Settlement

Policy, 54 Fed. Reg. at 51 071 (1989). The Officeof Technology Assessment has also estimated thatbetween 17 400 and 34 800 MSW sites may even-tually involve CERCLA response actions.

21. Chemical Waste Management, Inc. V. ArmstrongWorld Industries (669 F. Supp. 1285) (E.D. Pa.,1987).

22. In Transportation Leasing Co. V. California (21ELR 20 826 (C.D. Cal., 1990), the court ruledthat CERCLA does not expressly exclude house-hold wastes from its definition of hazardous sub-stances. Quoting an EPA directive, the courtargued that, ‘‘communities should recognize thatpotential liability under CERCLA applies regard-less of whether the household hazardous waste(HHW) was picked up as part of a community’sroutine waste collection service and disposed of ina municipal waste landfill…’’ For the directive,see EPA Office of Solid Waste and EmergencyResponse Directive No. 9574.00–1, Clarificationof Issues Pertaining to Household HazardousWaste Collection Programs, (Nov. 1, 1988).

23. En6ironment Reporter, January 7, 1994 at 1591.Conservative estimates put closure and post-clo-sure costs at 15–20% of the total development

and operating costs of a landfill. See Glebs (1988)or ‘Landfill Construction and Operating Costs inMichigan’, mimeo, State of Michigan, Scienceand Technology Division, State Legislature, De-cember 1989.

24. As an example, in the Transportation Leasing casesupra note 11 the clean-up concerned was esti-mated to come at a cost of $650–800 million.Bernstein (1989) estimates, based on municipallandfill clean-up costs in New York and NewJersey, an average remediation cost of $40 mil-lion.

25. A typical example is the Kim-Stan landfill inVirginia. A fish kill alerted state officials to wide-spread contamination from the landfill in 1989.As a result, the state issued $1.5 million in fines.The landfill’s owners subsequently filed forbankruptcy and eventually paid only $100 000 inpenalties. See Solid Waste Digest, Southern, April1994, p. 2.

26. See ‘Expectations Dwindle for Subtitle D’, En6i-ronmental Information Digest, July 1993, p. 35.

27. The financial assurance requirements are delin-eated in 40 CFR 258, subpart G.

28. This is true if increases in the aggregate amountof waste imply an increase in the landfill’s clean-up costs, if there is a leak. In contrast, considerthe damages created by a damaged oil tanker.Financial responsibility payments should not betime-sensitive for this type of technology since thevolume of oil carried by a given ship, and thus themaximum potential damage, are relatively con-stant.

29. This is a simplifying assumption. It is more realis-tic to assume that, given remediation due to apast loss, the probability of future losses is posi-tive, but lower than p(s). However, the assump-tion that the subsequent liability is zerosignificantly simplifies the notation and does notaffect the analysis’ qualitative results. The cumu-lative probability of a loss over the three periods,denoted G(s) can be represented by a geometricprobability distribution. Specifically, G(s)= [1−(1−p(s))3]. The probability of a loss in period 1is p, the probability of a loss in period 2, given noloss in period 1 is p(1−p) and the probability ofa loss in the post-closure period 3, given no lossin periods 1 and 2 is p(1−p)2.

30. The assumption that income I is fixed in eachperiod is reasonable if the costs b and D are notvery sensitive to the number of units of wastedisposed at the facility. The price and quantity ofdisposal set by the owner-operator is in this caseindependent of the ‘fixed’ costs b and D.

31. For a more general treatment of conditions whichdetermine bankruptcy than is offered here seeBulow and Shoven (1978).

32. It is assumed, without loss of generality, that thefirm’s assets are at least as great as the costs ofpost-closure care (A]b).



33. Since condition (2) holds, we know that [(A−b)+ (I−C)]BD. Thus, G(s)[(A−b)+ (I−C)]BG(s)D. And since p(s)BG(s), (3) implies asmaller cost minimizing safety investment than(1).

34. See General Accounting Office (1994).35. Retroactive liability can be inefficient, since mak-

ing firms responsible for historic liability costs canactually weaken the incentive to take precautionsagainst future environmental costs. The retroac-tive application of liability yields no deterrence-related benefit. The decisions that led to theexisting liabilities were made years or decadesearlier. Also, retroactive responsibility for accu-mulated environmental costs reduces firm assetvalues. As a consequence, retroactive liability re-duces the value that firms seek to protect fromfuture environmental costs. This can reduce theincentive to guard against the occurrence of fu-ture costs, see Boyd and Kunreuther (1997).

36. In 1984 Exxon paid an out-of-court settlement toresidents of East Meadow, New York of between$5 and $10 million to settle a leaking UST claim,while Chevron paid about $10–$12 million toavoid a similar suit in Northglenn, Colorado.Also, in Maryland a 1990 sample of ten sitescalculated a per-site clean-up average of $710 000.This includes $3 000 000 in costs associated withthe restoration of one community’s water line.See ‘Report of the Governor’s Task Force onUnderground Storage Tanks’, State of Maryland,1990.

37. USTs are the most common method of petroleumstorage for fuel distributors, municipalities, largefirms, or any other organization which storeslarge amounts of fuel. There are approximately1.4 million such tanks in the United States andEnvironmental Protection Agency estimates ofthe fraction leaking have been as high as 35%. Todate, there have been 185 000 confirmed releases.The total cost of UST remediation is expected tobe between $30 and $40 billion. See ‘USTs: ABusy Decade Ahead’, En6ironment Times,November 1992, p. 31 or ‘The Underground Stor-age Tank Market: Its Current Status and FutureChallenges’, Environmental Information Ltd.,Minneapolis, MN.

38. Contributing to opposition was a front page arti-cle in the New York Times with the headline‘Fuel-Leak Rules May Hasten End of Mom andPop Service Stations’, that included an estimateby the American Petroleum Institute that therules would force the closure of 25% of the na-tion’s service stations (The New York Times, June19, 1989: A1). Around the same time, Congressbacked off of its original mandate to the EPA.Witness the comment by one representative that‘‘It is the small- and medium-sized businesseswhich will be unable to meet the requirementsand, in some cases, will be forced completely outof business… some action may have to be takenby the EPA, and some action may have to be

taken by Congress… I am not going to just sitaround and watch the small businesses be legis-lated out of business by the Federal Government’’(Representative Richard Ray, Nov. 18, 1987,Hearing before the House Committee on SmallBusiness Subcommittee on Energy and Agricul-ture, Y4.Sm1/2: S. hrg. 101–690).

39. En6ironment Reporter 12/25/92, p. 2091.40. Guarantee funds, by absolving firms of historic

liabilities, allow for remediation of existing con-tamination without reducing the firm’s value.Firms left with greater value have a greater incen-tive to take efficient prospective risk reductionmeasures, assuming that they are prospectivelyliable and have to demonstrate privately-providedfinancial responsibility.

41. In a survey of pollution insurance availability, theGAO found serious compliance difficulties forsmall firms. And, not surprisingly, the survey alsofound that ‘‘smaller companies were more likelyto cite the difficulty of meeting the act’s financialrequirements as the reason for closing than largercompanies’’.

42. The oil and gas industry has seen the formationof ‘mutual’ insurance companies to help spreadrisk among the relatively deep-pocketed membersof this industry (Cropw and Knott, 1994).

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‘green money’ in the bank: firm responses to environmental financial responsibility rules

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