Compensation funds versus financial responsibility

A very important problem connected with liability policy instrument is the limit of a firm’s financial resources compared with the amount of the dam­ages that could derive from an environmental accident.

In the United States this problem arose in cases of smaller firms involved in risky production activities (Ringleb and Wiggins, 1990). From an eco­nomic point of view, this is a problem of internalization in the sense that some of the losses of the victims may go unclaimed under conventional strict liability; moreover in some cases, firms facing considerable liability risks may reduce their capital using ‘judgment proofness’ as an evasion strategy (Van’t Veld et al., 1997).

Among internalization instruments, there is one that uses a compensation fund. Usually funds are created in connection with a regulatory system to cover environmental damage, contaminated site costs and victim compensa­tion amounts. The fund can be financed by a taxation system or by a firms’ contribution system.

The most important application of this instrument is the one by CERCLA, which enabled the Environmental Protection Agency (EPA) to clean up con­taminated waste sites directly by utilizing funds from the Hazardous Substances Response Trust Fund, commonly known as the ‘Superfund’. The Superfund was created to provide the federal government with the financial resources necessary for cleaning up contaminated sites and facilities. The fund is financed through a combination of federal appropriations, industry taxes and judgments entered against responsible parties. CERCLA authorized the EPA to target specific contaminated sites across the country and to rank those sites through a national priority list (NPL), which generally determines the order in which the various sites will be cleaned up.

So on the one hand, as in the US experience, compensation funds as environmental policy instruments prove to be an efficient kind of emergency tool when a quick intervention is necessary. On the other hand, in the imple­mentation of these public-oriented instruments many problems can arise from a distributional point of view, because the existence of a public fund gener­ates social costs connected with taxation sources that make income distribution problems relevant (Lewis, 1996). Moreover from a law and economics point of view, the literature shows that this system can result in a lack of motivation by firms to adopt preventive measures (Porrini, 2001).

We can also analyse another kind of instrument as an alternative to solve the judgment-proof problem: financial responsibility. By this, we consider all the tools that require polluters to demonstrate ex ante sufficient financial resources to correct and compensate for environmental damage that may arise through the activities of a firm. In its common application, financial responsibility implies that the operation of hazardous plants and other busi­ness is authorized only if firms can prove that future liability claims will be financially covered, for example, letters of credit and surety bonds; cash accounts and certificates of deposit; self-insurance and corporate guarantees. Letters of credit and surety bonds are purchased from banks or insurance companies: they are paid to a third-party beneficiary, often the government, under certain circumstances such as the failure of the purchaser to perform certain obligations. Cash accounts and certificates of deposit place cash or some other forms of interest-bearing security into accounts that are made payable or assigned to a regulatory authority. Self-insurance is purchased by companies with relatively deep pockets to satisfy coverage requirements by demonstrating sufficient financial strength. A corporate guarantee allows another firm, such as a parent corporation, to satisfy the coverage require­ment and financial guarantors must themselves agree to cover the liabilities of the firm (Boyd, 2002).

While a market for assurance coverage has developed in the United States to provide a wide variety of financial instruments tailored to individual firms and regulatory needs, in the European Union this kind of instrument has a corresponding importance but relatively little diffusion.⁶ However, this does not exclude the possibility that financial responsibility instruments have already been provided within the individual member states, and in fact some national enforcement has occurred.⁷

These experiences show that financial responsibility may be complemen­tary, sometimes mandatory, to the legislation on liability assignment of environmental damage. It is usually required as an integral part of some kind of ex ante regulation, to ensure that the damaged natural resources are made good. In its different applications, it has a common motivation: to ensure the future internalization of the costs caused by the polluter in order to indemnify the victims and discourage different forms of environmental deterioration.

In the presence of informational issues, financial responsibility can also be seen as a solution to asymmetric information problems that can arise in the relationship between firms and the financiers (Porrini, 2002). First, given the contractual relationship between the financial institutions and the firms, there is a strong incentive for the financial institutions, insurance companies or banks, to check that the firm is taking adequate preventive measures (Feess and Hege, 2000). Second, the firm itself is motivated to take precautions because financial responsibility ensures that the expected costs of environ­mental risks appear on the firm’s balance sheet and in its business calculation.