Responsible Risk: How putting a price on environmental risk makes disasters less likely


Environmental disasters — for example, train derailments, tailings pond failures, or oil spills — are infrequent, but also potentially costly. The economic activity that drives our prosperity comes with risk to the environment. We cannot eliminate that risk, but we can do more to manage it. Putting a price on environmental risk is key to doing so.

From a policy perspective, managing risk means getting incentives right. Firms already want to avoid disasters and environmental damage, given costs to their reputation and their bottom line. But those incentives are sometimes insufficient.

Gaps in existing policies — we call them “liability gaps” — mean that firms are not always held fully accountable. These gaps can shift risk—and any related costs of environmental damage—away from firms and onto taxpayers. For example, firms that declare bankruptcy might be unable to pay the full costs of clean up, leaving society to cover the rest of the bill.

When firms do not bear the full cost of potential environmental damage, they have less incentive to reduce risk. As a result, industrial disasters might be more likely to occur.

Better financial assurance policies— for example, cash deposits, insurance, and industry funds — address this problem by putting a price on environmental risk. They create incentives for firms to reduce risk. They ensure that taxpayers do not end up bearing the costs of environmental damage, should those unlikely disasters occur. And they support economic activity by harnessing market forces to achieve these objectives at lowest cost.

The report today unpacks both the problem of un-priced environmental risk and potential solutions. It identifies five types of liability gaps that can result in firms’ not bearing the full cost of potential environmental damage. It shows how financial assurance can address these gaps, and considers the tradeoffs across different financial assurance tools. And it develops a detailed case study of financial assurance in Canada’s mining sector, evaluating current provincial policies in Yukon, British Columbia, Alberta, Ontario, and Quebec.

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Key Recommendations

Canadian policy-makers should close gaps in existing policies by pricing risk

Policy-makers should make greater use of financial assurance. Increasing the extent to which firms are financially accountable for environmental damage they might cause gives them an incentive to avoid it. In particular, policy-makers should expand policy to price risks that are currently unpriced. For example, in the mining sector, governments should extend financial assurance beyond site remediation to also include damages from potential disasters such as tailings dam failures.

Policy-makers should estimate risk comprehensively to inform their risk-pricing policies

Estimating risk is critical to determining how much financial assurance governments should require. Requiring too much can unnecessarily increase costs; requiring too little can limit the extent to which financial assurance reduces risk and funds cleanup, should a disaster occur. Policy-makers should endeavor to align financial assurance requirements according to firms’ individual risk profiles. High-risk firms should be required to provide more assurance, and low-risk firms less.

Policy-makers should combine risk-pricing instruments when risks are severe

In some cases, individual firms may be unable to provide assurance that can cover the full range of potential costs, especially where high-cost, low-probability outcomes are possible. Similarly, third-party providers of financial assurance may be unable or unwilling to provide coverage for severe events. To address this problem, policy-makers should use tiered financial assurance solutions. In a tiered scheme, firm-level and third-party assurance would provide coverage up to a point. Beyond this threshold, sector-level financial assurance or public insurance would kick in.

Society should share environmental risks only when there is a clear case for doing so

Sometimes risk sharing between private firms and society more broadly can be justified; for example, in natural resource sectors where firms pay royalties to government. Because society shares in the benefits of the economic activity, there is a case for sharing in some of the risks as well. But in other cases, the costs of risk sharing can outweigh the benefits. Risk sharing is an indirect subsidy and can lead to an increased likelihood or severity of costly environmental damage.

Policy-makers should articulate and justify their policy priorities — and then design and implement policies consistent with this vision

Policy-makers should justify their approaches to risk sharing and make the case that they present a net benefit to society. Where policy design trades off risk reduction or full compensation from firms in favour of greater economic activity, policy-makers should demonstrate that the benefits of this approach (e.g. greater production and investment) outweigh the costs (e.g. greater environmental risk and potential social costs). Similarly, where policy design prioritizes greater risk reduction or compensation over economic activity, policy-makers should demonstrate how the benefits of avoided risk exceed the costs of reduced investment.

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