Environmental bonds and public liability for resource extraction site cleanup

Margaret Insley

No 24004, Working Papers from University of Waterloo, Department of Economics

Abstract: Governments have been left with large liabilities for cleanup at natural resource extraction sites after firms have declared bankruptcy. This research studies the impact of different forms of financial assurance on a firm's optimal actions over the full life cycle of a hypothetical natural gas well, in a world of uncertain natural gas prices, when firm bankruptcy may shift cleanup costs to the government. A firm's stochastic optimal control problem is described by an HJB equation with the natural gas price modelled as a stochastic differential equation. The impact of financial assurance is examined in relation to firm investment decisions, the cleanup liability imposed on government and resource taxation revenue. A Cash Deposit and Surety Bond are contrasted with the case of no financial assurance requirement. The "fair" fee (assuming the absence of arbitrage opportunities) is determined for the Surety Bond issued by a third party. Numerical results demonstrate that in the presence of distortionary taxes, there is a trade off between indemnifying the government against cleanup costs versus maintaining government tax and royalty revenues. A numerically plausible case is presented in which the total value of the natural gas well (to the firm and the government) is not increased by the imposition of a strict form of financial surety.

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