Addressing Industrial Air Pollution in Kazakhstan

Annex E. Means of evidencing financial provision

This annex provides details on ways in which financial provision may be made.

Cash deposit

Characteristics

With a trust fund, payments would be made into the trust until full provision has been made for the resource user’s obligations. A charge over the contents of the trust would secure the funds in the event of the resource user’s bankruptcy.

With escrow accounts and cash deposits, funds are deposited with a third party, often a bank. They are only to be available to the competent authorities where certain conditions specified in the underlying agreement between the resource user and the competent authorities are satisfied.

Strengths

• It ensures ready availability of private funds to undertake the works required of the resource user; access is immediate upon presentation of relevant documentation.

• Funds and assets are segregated from the general body of the resource user’s assets (i.e. “ring-fenced”). This means they are likely to be beyond the reach of its creditors should it subsequently enter into bankruptcy or deteriorate financially.

• It redresses the risks associated with the non-renewal of products from third-party providers, such as insurers or banks, i.e. where products must be renewed on a regular basis, there is the prospect that deterioration of a resource user’s financial strength may mean the bank is no longer willing to provide a guarantee.

• Determining the level of cash or other assets deposited with the third party by a risk assessment of the resource user’s activities provides a strong economic incentive for the resource user to operate safely to ensure full recovery of the cash or assets upon termination of the activity.

Weaknesses

• Where the balance does not accrue fully until the final payment has been made and there is no other supplementary/complementary financial provision in place then the value of the “deposit” may be insufficient to cover the necessary costs should it be needed in the event of bankruptcy prior to full capitalisation.

• It sterilises funds and assets during the operational phase of the activity in the sense that they are “locked in” and inaccessible to the resource, e.g. assets are unable to generate debt finance from a bank.

Charge on assets (trust funds, escrow accounts and cash deposits)

Characteristics

A charge (or security) in favour of the competent authorities is taken over an asset (or assets) belonging to the resource user (or, potentially, a company or companies affiliated to them). This could be done ex ante (i.e. before the resource user is allowed to commence activity) or ex post (i.e. after the occurrence of environmental damage).

In both cases, the competent authorities would need to exercise the power of sale conferred by the charge to recoup the funds secured by it.

Assets such as real estate are particularly ripe for such a charge. Other valuable assets, such as heavy machinery, stock or vehicles, may also be suitable where there is a buoyant secondary market for their resale.

Strengths

• Charges on assets provide a secure means of evidencing financial provision in the event of the resource user’s entry into bankruptcy or its financial deterioration. If the financial condition of the resource user deteriorated and it later succumbed to bankruptcy proceedings, a competent authority with a charge over heritable property (i.e. real estate) would have direct recourse to that asset if full payment had not been made. There would be no need to compete with the company’s other creditors. A first-ranking fixed charge affords competent authorities the greatest protection as the competent authorities would be paid prior to i) satisfaction of any other charge secured over the asset; and ii) the company’s general creditors. Consequently, where the resource user was unable (or unwilling) to undertake the works itself, the existence of the charge, or the potential to take one, could give the competent authority comfort to undertake the works itself.

• Charges over assets result in sufficient financial provision where there is adequate value in the asset to bear the full costs associated with the environmental obligations (e.g. as determined by the direct method of assessment under the Kazakh Environmental Code).

• Funds can be released from an illiquid asset (i.e. real estate) and dedicated to financial provision for the resource user’s potential environmental liabilities.

• The value of the asset subject to the charge will not, generally, be impacted by the financial deterioration/bankruptcy of the resource user.

• Lenders could combat the prospect of their charges losing priority by requiring borrowers to hold environmental impairment liability insurance throughout the period of the loan. In essence, the private sector could mandate that resource users hold insurance as opposed to it being mandated by the state.

Weaknesses

• The competent authority must exercise the power of sale conferred by the charge and find a purchaser to realise the funds. Therefore, its ability to recover its costs will be dictated by prevailing market conditions and, perhaps most importantly, demand for that particular asset; the less marketable the asset, the lower the prospect of a prompt sale at a price which it was expected to achieve (and vice versa).

• The specialist nature of certain industrial premises may result in the market being narrower and less active than other sectors of the commercial property market. This means it may take some time for the property to sell, delaying the time in which value may be realised from the asset. Thus, charges over assets may not result in the secured funds being available when required.

• Prioritising the charge in favour of the competent authority over a charge in favour of a third party, such as a commercial lender, is a decision that a debt owed to society is to be prioritised to a debt owed to the resource user’s creditors. This may be controversial where there is a creditor whose charge, having been overreached by a competent authority’s charge, no longer secured the entire debt owed to it.

• The competent authority’s charge would deplete the pool of assets available to unsecured creditors upon the resource user’s entry into bankruptcy proceedings. There may be policy concerns associated with this.

• Prior-ranking charges will inhibit the protection afforded by the measure in that there may be insufficient equity in the asset to accommodate all charges.

• The value of the asset could decline, decreasing the security afforded to the competent authority.

Risk transfer (insurance, letters of credit, bank guarantees and surety bonds)

Characteristics

Insurance

It enables risk-averse parties to transfer the prospect of a large financial liability for environmental damage to an insurer for a comparatively small fee. The insurer charges a premium – the fee paid for the risk of loss to be removed – for coverage that reflects the level of risk posed by the resource user to the pool.

Letters of credit, bank guarantees and surety bonds

A third party (the “provider”) agrees to meet a predetermined level of the resource user’s environmental obligations; the risk of those obligations not being fulfilled by the resource user is transferred to the provider. The trigger for this to occur may vary between the measures.

They are likely to be granted for annual terms. However, they may be extended automatically subject to the purchaser’s continuance as a low credit risk and adherence to the contractual terms.

Strengths

Insurance

• Where an insured risk materialises and the insurer meets the claim of the policy-holder, this will, within the confines of the policy’s terms, provide a source of private funds through which environmental damage may be remediated. Where this occurs, insurance implements the remedial function of the Polluter-Pays Principle.

• Where an insurance premium can be adjusted to accurately reflect changes in the environmental risks associated with engaging in a particular activity (i.e. differentiated), it may provide market-based incentives for resource users to adopt safer practices.

Letters of credit, bank guarantees and surety bonds

• The provider will, typically, be subject to direct liability under the instrument and will be required to meet its contractual obligations even if the resource user becomes bankrupt. They are, therefore, secure in the event of the resource user’s bankruptcy.

• As the guarantee is provided by an independent financial institution as opposed to the resource user or a company affiliated to it, there is no connection between the resource user’s financial health and that of the provider.

• The funds will also, presuming that the provider does not refuse to pay out for a particular reason, be available when required.

• When coverage of the product is sufficient to meet the costs associated with the obligations required by the resource user, public funds need not be used to undertake them.

• The specified level of funds will be available from the outset, avoiding the dangers of waiting for funds to accumulate.

Weaknesses

Insurance

• Under traditional liability insurance, insurers will only cover an insured risk where liability can be established. Difficulties in establishing causation, for example, may prevent liability insurance from providing funds for remedial measures. Even where liability can be established, insurers are also unlikely to cover all costs for all activities. Limits and sub-limits to indemnity, deductibles, conditions, exclusions, specific policy periods and triggers mean that insurance does not ensure coverage of an insured’s losses.

• Intentionally caused harms, criminal activity and intentional violations of statutes or regulations are often excluded from all liability insurance policies. This means a typical insurance policy may not cover the intentional emission of pollution to air, in contravention of the emission limits in a permit. Such exclusions are understandable from the insurer’s perspective as they provide a crucial means to reduce moral hazard. However, resource users under significant financial pressure may intentionally cut corners to reduce operating costs. In such a situation, there is significant scope for coverage under the policy to be refused.

• Coverage is determined ex ante under the insurance contract, while restoration requirements are controlled ex post by competent authorities. Therefore, the policy may not cover certain restoration requirements.

Letters of credit, bank guarantees and surety bonds

• Guarantees are usually renewed annually. Therefore, there is the risk each year that guarantees may not be renewed. If this occurs, the financial provision may fall away. This leaves the resource user to find an alternative means of evidencing its capacity to bear its environmental liabilities. This may prove troublesome where its financial strength has weakened. However, the terms of the instrument could, in theory, require the provider under contract to pay out where the product is not renewed.

• The price accorded by measures such as surety bonds and bank guarantees bear no relation to the resource user’s environmental risk; they are priced according to the risk of the resource user becoming insolvent (i.e. its financial risk). These measures do, however, motivate the resource user to remain financially strong so as to benefit from lower price products from third parties. While, in itself, this should be viewed as a positive thing, it creates no substantive motivation to reduce environmental risk.

Financial test (self-insurance, self-bonds and parent company guarantees)

Characteristics

With this category of measures, which includes self-insurance, self-bonds and parent company guarantees, a resource user (or a company with whom it is affiliated, such as its parent company) must meet specified criteria to show its financial net worth or credit rating.

The assumption is that large, profitable companies are able to bear their environmental liabilities without the need to involve unaffiliated third parties, such as financial institutions.

Strengths

• Where a surplus exists between the funds available to the resource user (or the party which has satisfied the financial test) and the costs associated with the environmental obligations to which it is subject, these measures will enable the resource user to meet those obligations in full.

• As regards the parent company guarantee, it contractually overrides the publicly ordered limitation on the parent company’s liability for environmental liabilities arising from its subsidiary’s activities (i.e. the conferral of limited liability to shareholders under domestic corporate law). It creates a default target for the competent authority should the resource user be unable to meet the requisite costs. This achieves by contract what veil piercing and other liability extending mechanisms (e.g. the interpretation of the relevant statutory language so as to capture the parent) seek to achieve through judicial discretion.

• Self-insurance (i.e. satisfaction of financial tests) motivates the resource user to remain financially strong so as to remain exempt from the need to purchase expensive products, such as insurance, from third parties. This should be viewed positively.

Weaknesses

• When competent authorities accept financial test-based measures as evidence of financial provision, they do not demand that the resource user (or affiliated company) set aside assets or funds to cover environmental obligations. No financial provision in the truest sense of the phrase is actually made; no funds are provided, prepared or arranged in advance of the works. It is a financial illustration of an ability to pay. This means that the resource user (or affiliate’s) assets and funds will be available to its creditors should it enter into bankruptcy; they are inherently insecure as a result.

• The parent company guarantee is a mere unsecured, contractual obligation to pay. The parent company may have suffered financially, perhaps as a result of the resource user’s financial deterioration. This could affect its ability to meet the resource user’s environmental obligations. It is, therefore, neither secure nor guaranteed to be sufficient in the event of the resource user’s bankruptcy.

• Self-insurance (i.e. satisfaction of financial tests) accords no price whatsoever to the resource user’s activities and so to its environmental risk; that is the beauty of it for those resource users large enough to benefit. It creates no substantive motivation to reduce environmental risk.

Compensation funds

Characteristics

The fund will, generally, pay for remediation, compensate claimants and may also permit fund administrators to pursue the offending resource user(s) for reimbursement of remediation/clean-up expenses.

The main source of finance of compensation funds is likely to derive from taxes or charges against resource users engaged in the regulated activity. However, this could be supplemented by public funds.

Funds are typically created to deal with a particular type of environmental hazard such as oil spills or storage of hazardous waste. They could conceivably be used in relation to the environmental damage caused by emission of pollutants to air, as per the Dutch Air Pollution Fund.

There are two main types of funds relevant to the present report:

• Guarantee funds complement civil and/or administrative liability regimes and other financial provision measures by protecting competent authorities against the possible bankruptcy of a resource user (or the provider of their financial provision, e.g. an insurer or a bank).

• General funds, in contrast, may operate as an alternative to liability and insurance.

Strengths

• Where a compensation fund is privately financed, it has the capacity to ensure that private funds can be drawn upon to undertake the necessary remedial measures.

• If the associated costs are high, it may not be possible to recover all of these costs from a single resource user. A compensation fund could assist in providing full compensation to the government of Kazakhstan or a private claimant.

• Improved levels of safety within a particular industrial sector could be achieved through imposing requirements upon resource users who wished to obtain membership of the fund. For instance, they could be required to take preventive measures before being accepted as a member of the fund, e.g. obtain particular certification (e.g. ISO 14000 certified or registered in the EU Eco-Management Audit System [EMAS Programme]). Alternatively, resource users who wished to join the fund could be required to provide evidence of a predetermined level of financial provision, such as insurance.

• Where fund administrators can differentiate the risk associated with the individual resource user through its contributions, then resource users will possess the requisite incentive to improve safety precautions and, consequently, prevent environmental damage arising from their emissions to air.

Weaknesses

• The actual polluter does not pay, or more accurately, does not pay in full. The resource user and the industry covered by the fund share the cost of environmental damage. Thus, they appear to run counter to the true aim of the Polluter-Pays Principle and, consequently, the normative justifications for the frameworks of environmental liability based on it.

• Funds often exhibit bureaucratic inefficiencies, which hinder the ability of claimants to gain compensation readily.

• Fund maintenance may be difficult and the ability to obtain contributions from the relevant industrial sector relies on continued political will.

• If a resource user was permitted to pass its liability on to the fund and carry on as usual, not only would the Polluter-Pays Principle be implemented inadequately but there would be little incentive to reduce the risks, which it exhibited. The fund could, however, be conferred the right to pursue a cost recovery action against the responsible resource user.

• Accurate differentiation may be difficult meaning that there will be a reduced incentive upon resource users to prevent environmental damage. If the contribution is determined by a flat rate or by volume of product produced (e.g. cents per barrel), then large, safe resource users are penalised as smaller, potentially less safe resource users will not contribute in proportion to their prospective loss.

• A failure to differentiate ignores safety precautions by individual resource users, rendering it unlikely that they will be encouraged to exceed legally mandated minimum safety requirements.