Assurance Methods: A Welfare Analysis

Sustainable development requires that exploitation of environmental resources is such that it does not result in permanent damage to the environment. In many instances environmental damage is an external cost of the entity exploiting the resource. Ideally, the entity should be forced to internalize this cost. Various financial assurance schemes have been proposed to ensure that the entities fulfill their financial responsibility to restore the environmental dam-age. Prominent among these schemes are ?environmental bonding requirements?. A main issue with these financial assurance schemes is that many times the amount and duration of environmental damage is uncertain. That is, the cost of restoring the environment in the future may be unknown (or unknowable), and, furthermore, the extent of the damage may not be known for many years into the future. Nevertheless, bonding requirements have to be set in advance and the rules for returning the bond and absolving the entity of responsibility have to be specified ex ante. In practice, a problem of allocation of resources arises. To make sure that all external costs are internalized, in the face of uncertainty, will require a sufficiently (arbitrarily) large bond for a sufficiently (arbitrarily) long period of time. But such a requirement may prove too expensive and may result in not undertaking a project (even if, under certainty, the project may be profitable after internalizing all costs). This will result in a reduction in total welfare. Under present bonding requirements, firms are responsible up to the value of the bond. This results in an asymmetry: if environmental restoration is less than the bond amount, the firm has an incentive to restore and reclaim the bond; if the cost of the environmental restoration is above the value of the bond, the incentive is to forfeit the bond, imposing on the government/ society the excess cost. This also may reduce social welfare, at least on distributional grounds since the firm owners pocket the profits and the taxpayers foot the bill. The presence of uncertainty suggests that a fee based reclamation fund may be welfare enhancing. The thinking can be sketched as follows: All firms undertaking environmentally sensitive projects pay into the proposed fund. The fund examines the risks and sets the premiums at the level of the expected restoration costs (not the maximum!) plus administrative expenses. One advantage of the scheme is that this eliminates the asymmetry. Firms with restoration costs below expected end up subsidizing firms whose restoration costs were underestimated. In other words, the industry ends up internalizing the costs not internalized by the individual firms, instead of the taxpayers.