Pricing risk to the environment works best when it’s fair

Pollution

Our latest report Responsible Risk explains how putting a price on risk to the environment can make disasters less likely. The report shows how we can use economic tools to strengthen companies’ incentives to manage environmental risks posed by their operations. In this blog, I’ll discuss why when it comes to risk pricing, one size shouldn’t fit all. The fairer that we can make risk pricing, the better it will work. That means that firms with bigger risks should pay more.

Risk pricing 101

First, let’s start with a quick explainer on environmental risk pricing.

We can put a price on risk to the environment using a policy tool called financial assurance. Financial assurance requires companies to promise or commit funds against their environmental risks. It can come in a variety of forms, including bonds, insurance, and industry funds.

When there is a risk that a company will cause environmental harm (whether from an explosion, a spill or leak, or something more gradual like site contamination), governments can require financial assurance from that company. Doing so: 1) ensures funds are available for clean-up or compensation (which they otherwise might not be if, for example, the company went bankrupt); 2) gives companies an economic incentive to manage and reduce risk; and 3) keeps the cost of doing these things low by harnessing market forces and giving firms flexibility in determining how to manage their own risk.

Not all risks are created equal

Specific companies and specific operations pose unique risks. Take mining as an example. Mines’ risk to the environment will differ depending on the production technologies and processes they use, how they manage their wastes, and the ecological sensitivity of the area they’re located. The risks might also be financial in nature. For example, the risk of a mine site not getting cleaned up will be greater when a company is thinly-capitalized and has only one operation.

Treating all mining companies the same ignores the fact that their risks are unique. Not only is this unfair to the companies that pose lower risk, it also dilutes the risk-reduction incentives that financial assurance provides.

Less risk, more reward

When we price environmental risk, the amount of financial assurance we require should be proportional to the actual level of risk. This not only means requiring less financial assurance from less risky operations, but also rewarding companies when they demonstrably reduce risk (for example, by returning some of their cash assurance or lowering the premiums they pay into an industry fund).

We should want to make risk pricing fair for its own sake. But even if fairness wasn’t a big priority, we should still want to do it, for three reasons:

  1. First, by making financial assurance requirements case-specific, we make it more likely that the financial assurance we’ve required will be enough to cover the costs of potential damage (compared to, for example, when financial assurance is based on industry-average risk).
  2. Second, because posing less risk means paying less, fair risk pricing creates a powerful economic incentive for companies to innovate and to find new ways to reduce risk.
  3. Third, it creates these incentives where they’re needed most. The bigger a given company’s risk, the more they stand to gain by reducing it, and the more powerful the incentive they have.

Of course, making risk fair cuts both ways. Companies that pose higher risk should have to pay more. Not only does this create strong incentives to reduce risk where they’re most needed, it can actually help screen out excessively risky projects, since projects that can’t afford the cost of their risk won’t proceed.

You can’t manage what you don’t measure

Making financial assurance fair means understanding a company or operation’s unique risks. To do this, governments need to carry out detailed risk assessment and monitoring that can give them a strong (and current) understanding of companies’ risks. This will help policy-makers craft fairer, more effective financial assurance policy.

Where precise estimates of risk aren’t possible (or are too costly), governments can use proxies for risk to risk-differentiate companies. For example, they can distinguish less risky operations from riskier ones by looking for adoption of a best-practice technology or risk management system.

To return to the mining example, the Mining Association of Canada’s Tailings Management Protocol could serve as a proxy for prudent risk management. In requiring financial assurance for mining disasters (which we currently don’t do, as we’ll discuss in a future blog), we could lessen the requirements for companies that have adopted the protocol. This would give mining companies that haven’t adopted it an incentive to do so, which can help lower the risk of a tailings dam failure.

Fair’s fair

In risk, estimation is the name of the game, so perfect risk differentiation will never be possible. But the more we can do it, the better.

If we want risk pricing to reduce the risk of disasters, we should make it fair.

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