A Market Approach to Regulating the Energy Revolution: Assurance Bonds, Insurance, and the Certain and Uncertain Risks of Hydraulic Fracturing

Despite the recent drop in oil and natural gas prices, fossil fuels continue to flow out of U.S. wells at astounding rates. In just a few years, the United States has transitioned from a position of substantial dependence on foreign fuels to the status of a leading producer of both oil and gas. This is due largely to the combination of horizontal drilling and hydraulic fracturing deployed in shale formations around the United States. This rapid transition has greatly benefited parts of the country economically but also shows the perils of resource booms and the busts that follow. The current yet temporary lull in the drilling of new wells is a good time to reflect on the long-term consequences of our country’s becoming a major “petrostate.” One of these consequences is the threat of long-term pollution—something that industry and regulators tended to ignore during the rush to drill new wells. This has allowed the boom to continue without needed environmental safeguards like adequate bonding and insurance to cover the cost of pollution clean-up. To compound this problem, states are increasingly preempting local government regulations that have been the first to impose adequate bonding and insurance safeguards.

In the past few years, thousands of new oil and gas wells were drilled and hydraulically fractured in United States, and they will continue to be in coming years. Although dropping oil and gas prices have somewhat slowed domestic drilling activity, production and drilling continue at a high rate. In March 2015, there were 1,109 rotary drilling rigs operating in the United States, and most of these rigs move from site to site to drill multiple wells.   Nearly all new natural gas wells are hydraulically fractured, as are many oil wells. These wells are scattered throughout the country, from Pennsylvania, West Virginia, and Ohio to North Dakota, Arkansas, Louisiana, and Texas, among many other states. They are located in a variety of environments, near or far from sensitive environmental resources and human populations. And many of these wells will produce oil and gas for decades. Fracking is also expanding to offshore wells. Few of these wells—either offshore or onshore—are subject to bonding and insurance requirements that would ensure adequate clean-up if pollution were to occur.

During the drilling and fracturing process, numerous accidents can happen that can cause long-term pollution of the site or the nearby environment. Sometimes diesel leaks from tanks on site that store fuel for site construction, drilling, and fracturing equipment. Drilling fluids and muds and wastes from drilling are stored on site in pits or tanks, and these can overflow or leak. Hydraulic fracturing fluids trucked to the site sometimes spill during transport or when they are being transferred from a truck to a tank on site. After a well is hydraulically fractured, the “flowback” (used fracturing fluid) can spill when being transferred from the well to tanks or pits, or can leak from tanks and pits. And over the life of the well, natural “produced water” comes out of the well, which has low levels of radioactivity. This produced water sometimes leaks from tanks or pits or contaminates underground water when improperly disposed of.

All of these spills, leaks, and other accidents can contaminate soil, surface water, or underground water resources. And some are very difficult to clean up—particularly in underground aquifers. All told, there is a possibility that several decades from now there will be thousands of sites with low, moderate, or even high levels of pollution that need cleaning up. By this time, well operators might have abandoned the site and gone out of business, and the communities experiencing the pollution might lack the resources to conduct clean-up themselves. Something must be done to better incentivize safe, lower-risk operations that avoid contamination incidents at well sites and to cover the costs of clean-up.

One way to force companies drilling and fracturing wells to internalize the costs of pollution and engage in lower-risk operations—drilling fewer wells, drilling wells farther from sensitive environmental resources and human populations, using lower-toxicity drilling and fracturing materials, and/or implementing technologies that reduce the risk of spills, for example—is “command and control” regulation. But conditions at well sites vary, and the most effective and efficient means of preventing risk in a variety of environments and climates can be difficult and costly for regulators to identify and enforce. Indeed, in this case industry might have the best available information on the cheapest yet most effective risk reduction measures yet might not want to share all of this information with regulators due to concerns about costly regulation.

Another way to force drilling companies to reduce risk is to rely largely on liability—a solution proposed by Thomas Merrill and David Schizer. While tort actions have an important role to play in forcing risk internalization, the exact source of pollution can sometimes be difficult to pinpoint, and individuals often lack adequate incentives to file lawsuits even where causation is easily established. Further, by the time individuals sue, the well operators who caused the contamination might be judgment proof, leaving no available money to remedy the pollution-based problem.

We propose a third approach to reducing the risk of spills and resulting long-term contamination at well sites—one that relies on market mechanisms in addition to the limited command and control and tort-based approaches that are already sparsely deployed. Specifically, to draw from the superior knowledge of industry regarding the most efficient methods of reducing risk while also ensuring that there is a pool of money available for clean-up where industry still fails to avoid spills, we propose that states require all well operators that drill and hydraulically fracture wells to carry mandatory environmental liability insurance and/or to pay higher amounts of bond money before drilling. Under a better bonding regime, each operator would have to post a substantial environmental quality bond with a state regulatory agency before drilling and fracturing a well, providing money that would be available for the state to use if a spill occurred and the operator failed to clean it up. Alternatively or additionally, each operator would have to purchase insurance that would cover the costs of a major long-term pollution event, such as a policy that would provide $5 million per incident (a requirement already in place in a very limited number of jurisdictions).

Insurance requirements—perhaps more so than bonds—would incentivize risk reduction by operators because insurance companies would monitor their clients.   To avoid the threat of large pay-outs, insurance companies would review companies’ safety and environmental records before issuing a policy. In choosing whether or not to issue policies, insurance companies could tailor specific packages toward different clients—oil and gas operators with strong safety records might have to pay lower premiums, for example. Indeed, products are emerging that allow third parties, whether they are governments issuing a bond or insurance companies issuing a policy, to better ascertain the performance of an operator and tailor requirements accordingly. Insurers would also track ongoing operator performance once they issued policies.   Oil and gas operators’ premiums might go up, or their insurance might be canceled, if their performance records declined. Through monitoring and economic penalization of bad behavior, insurers would provide a sort of enforcement function that under-resourced agencies often fail to fully carry out in the command- and-control context.

Insurance and bonding do not solve all of the problems that arise under command and control and tort-based approaches oil and gas production risks.   For insurance or bond money to be used for clean-up, the operators that caused the contamination still must be identified. But unlike with command-and-control or tort-based approaches, a guaranteed pool of money is available if causation can be shown. And causation standards can be loosened, if necessary. For example, the Comprehensive Environmental Response, Compensation, and Liability Act makes all entities associated with a polluted site liable for clean-up costs—those who owned it when a release of hazardous substances occurred or who currently own the site, those who conducted operations at a site during the release, and those who transported hazardous substances to the site, among other entities. Strict liability attaches to these entities once it is shown that a release occurred at the site.

Those opposed to mandatory insurance might argue that it is simply unavailable—that the risks are so high that companies will be unwilling to insure the risks. Recent developments have proven this to be untrue. While at least one insurer indicated that it would not provide policies for companies that hydraulically fracture wells, other companies offer flexible packages that cover a range of drilling and fracturing operations and their associated risks. Further, mandatory insurance in other, risky areas like offshore drilling and nuclear power has worked; policies are available despite projections that they would not be. Other objections might focus on affordability—the concern that small companies will not be able to afford expensive drilling and hydraulic fracturing insurance and will go out of business. In some ways, this might have certain positive effects, as smaller, undercapitalized companies sometimes cut corners and produce more risks. But for the low-risk yet small actors that should not be pushed out of business by expensive insurance, insurance pools, where numerous companies within a certain risk profile pool their money to purchase insurance, can help with affordability.

Despite the seeming feasibility and advisability of mandatory insurance and stronger bonding requirements, few states have implemented them. All states with oil and gas production require operators to post a bond before they drill, but this bond often just covers the cost of plugging abandoned wells and not cleaning up spills—and the bond amounts are often too small to even fully cover the cost of plugging. And it appears that only Illinois and Maryland, along with certain municipalities, have required mandatory environmental liability insurance for oil and gas operators. Given the availability of insurance for oil and gas operators, the real threat of long-term pollution at thousands of sites around the country, and the importance of reducing pollution and providing a pool of money to clean it up, policymakers should seriously consider mandatory environmental liability insurance and better bonding requirements as they continue to modify or implement new oil and gas legislation and regulation.

David A. Dana, Kirkland & Ellis Professor of Law at Northwestern University Law School and Hannah J. Wiseman, Attorneys’ Title Professor at The Florida State University College of Law. The post is based on their article, which is entitled “A Market Approach to Regulating the Energy Revolution: Assurance Bonds, Insurance, and the Certain and Uncertain Risks of Hydraulic Fracturing” and available here.