The BP Gulf of Mexico oil spill highlights the debate over the correct way to deal with environmental and other externalities. Under current law, polluters are seldom required to pick up the full cost of environmental pollution. Strangely, much of the right wing would like to continue this policy with the result that gains are private and losses are socialized.
The BP Gulf oil disaster is only the latest event that highlights the crony capitalism so prevalent under current law and regulatory apparatus. Under our current legal regime, private companies time and time again are able to offload their costs to taxpayers. This regime is supported by a whole host of legal protections including liability caps, favorable regulatory case law ("administrative law") and other protections under the common law that have developed over the years. In addition, since this operating regime is underpinned by a mountain of case law developed over many years, the moral imperative against privatized gains/socialized losses now merely causes a political firestorm before the inevitable is resolved in favor of the private parties responsible for causing losses. And then the outrage subsides.
Do not believe for a moment that the BP Gulf disaster is an exception just because the company has pledged to fund a $20 billion escrow account. The event is far from over, but there are already signs that liability will be apportioned in such a way that some significant portion will be covered by the government - the problem in this case and many others is that there is a belief that once BP is bankrupt and the shareholders have absorbed all the losses they can, that there are no other assets to attach. In fact, however, shareholders' claim on the assets represents only a portion of the company's balance sheet - bondholders and other creditors (trade creditors, unsecured creditors and employees) represent the rest. As the global financial crisis is demonstrating, debtholders, both secured and unsecured, seem to represent a privileged class deserving of loss protection under the law (and even shareholders, including management, did not feel the full force of losses).
The U.S. government has made attempts towards polluter pays legal mechanisms, the best known of which is the Environmental Superfund (Comprehensive Response, Compensation and Liability Act of 1980, or CERCLA). The Superfund is designed to clean up hazardous waste sites that endanger public health or the environment. It authorizes the EPA to identify the parties responsible for contamination and compel them to mitigate the pollution. Where responsible parties cannot be found, such as when they have gone bankrupt, the EPA is authorized to undertake cleanup itself using a special trust fund. This trust fund was originally funded by a dedicated tax on the petroleum and chemical industries, but the tax lapsed in 1995 and the fund was subsequently funded out of general revenues during the Bush administration (socialized losses).
The Environmental Superfund has many positive aspects, but is not comprehensive enough because there are too many instances where the polluting party has disappeared and then the cleanup cost falls on the taxpayer. Unless right wing conservatives acknowledge that they favor crony capitalism, or Corporatism, they should agree that the cost of doing business should not be subsidized, or backstopped by government. And so there are several reforms that the government could undertake to ensure as much as possible that polluters bear the cost of their activities and hence reduce the chance that government has to step in:
- Under present law environmental liabilities are treated similar to unsecured debt under bankruptcy, which means that they fall behind secured creditors in priority for liquidation purposes; the recovery amount remaining after secured creditors are made whole is apportioned pro rata among unsecured creditors. Under a bankruptcy scenario, the funds left over after secured creditors are made whole may not be sufficient to cover environmental liabilities. A change in the law to prioritize environmental liabilities over secured and unsecured creditors would increase the probability that there would be sufficient funds recovered for any environmental liabilities.
- The bond market community will not like the above proposal, but when the dust settles under a reformed bankruptcy regime bond investors will realize that they must force companies to carry sufficient amounts of environmental liability insurance to cover any contingencies. While I believe the market would impose an environmental insurance requirement on companies, it would be wise for the government to impose such a requirement in law to ensure that extra layer of protection is available to minimize the possibility that costs fall back to taxpayers.
The current and reform bankruptcy regimes are laid out below.
Priority in Bankruptcy - Current Regime:
a) providers of financing under bankruptcy (interim creditors)
b) secured creditors
c) unsecured creditors (trade creditors, other unsecured creditors, environmental liabilities, employees)
d) shareholders
Priority in Bankruptcy - Reform Regime
a) providers of financing under bankruptcy
b) environmental liabilities and liabilities to employees (wages, salaries, pension and healthcare benefits)
> [Environmental Liability Insurance Cushion]
c) secured creditors
d) unsecured creditors
e) shareholders
You will notice that liabilities to employees are higher under the reform regime. Under current law promised benefits to employees can be cut or even extinguished, which is inefficient because rank and file employees seldom have much power to influence key corporate decisions. It is a topic for another post (see stickyfeet blog).
- the law should require that environmental liability insurance is structured to ensure that bondholders share in losses arising from environmental contingencies. In other words, there should be a rather high "co-payment" requirement in case insurance kicks in (for eg., the "co-pay" requirement could require bondholders to absorb losses along with the insurance company up to 50% of secured creditors' claims, with insurance kicking in thereafter, and liability returning to secured creditors up to the remaining bond value only when insurance is exhausted). This requirement would encourage bondholders to play closer attention to management activities, instead of sleeping soundly under the umbrella of insurance. The added regulatory benefit is obvious: there would be two additional pairs of eyeballs on management - bondholders and insurance executives. Bondholders and insurance providers would become much more active on boards and supervisory committees and would also be incentivized to act as a check on management (we would go some way towards solving the agency problem so inherent with current boards and corporate governance).
- The Environmental Superfund covers a limited number of environmental contingencies. It should be expanded to cover a greater number of pollutants and other negative externalities. In addition, a dedicated tax for funding the Superfund needs to be introduced again, this time on a risk-weighted basis - there are still thousands of hazardous waste sites that remain polluted and the cleanup status is in limbo because the Superfund's trust is depleted; there will also be extreme situations where the government will be called to step into the breach because environmental liabilities may exceed the value of company assets plus the environmental insurance.
- environmental legislation also needs to move to the next stage, which means North America ought to join our European counterparts and begin legislating cradle to cradle recycling policies. What cradle to cradle recycling means in practice is that companies and industries must plan not only the design, manufacture, sales and servicing of their products for the market, but they must also plan and execute the collection and recycling of their products for when they are ready to be disposed of. Cradle to Cradle policies are the environmental gold standard, while the bankruptcy reforms are the safety net to catch those companies that will inevitably screw up before they impose costs on taxpayers.
The above reform regime still cannot really deal with pollutants (environmental externalities) such as greenhouse gases whose impact is difficult to attribute to a specific source and where the impact is dispersed. And that is the argument for either a GHG tax or cap-and-trade, both of which at their core simply demand that polluters pay.
I can hear the baying and crying from Corporatists that these policies will increase the cost of doing business. Except for some limited administrative costs, it will do no such thing. Requiring polluters to pay simply internalizes to companies costs that are now born by government and society. If you are a good capitalist, you should favor removal of pollution subsidies.
StickyFeet blog
Inside the box thinking. And Plotting. Because all the nutters are outside.
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