Does Private Insurance Reduce Environmental Accidents?

July 11, 2012

In 1988, new federal regulations from the Environmental Protection Agency (EPA) required gas stations and owners of underground fuel tanks to demonstrate they are financially capable of cleaning up underground fuel leaks and compensating third parties for consequential damages. Specifically, the EPA's ruling necessitated that owners maintain minimum coverage of $1 million per leak occurrence, say Haitao Yin, an associate professor at Shanghai Jiao Tong University (China), Howard Kunreuther, a professor in the Wharton School at the University of Pennsylvania, and Matthew W. White, the senior economist for ISO New England Inc.

States responded by subsidizing the cost of compliance. For tank owners that satisfied minimal technical requirements, the state would provide financial coverage for the occurrence of leaks, paid for in large part by a marginal increase in the state's motor taxes. This assurance system, however, resulted in significant moral hazard.

  • Tank owners were required to pay only a small fraction of the cost of obtaining similar coverage in the private sector, prompting near-100 percent participation.
  • Furthermore, the fees that states collected from tank owners were flat, regardless of the risk posed by an individual owner.
  • As a result, tank owners had no individual incentive to prevent leaks through regular manual checks or to invest in equipment that would reduce the frequency of leaks, such as bolstered tank casings that were more resistant to corrosion.
  • Additionally, at an average cost of $125,000 per leak, many states' assurance programs were unable to keep up with cost; both Michigan's and Illinois' programs were insolvent by the mid-1990s.

Instructive, however, was the state of Michigan's response to the insolvency of its assurance program. While Illinois raised its gasoline excise tax to continue its program, the Michigan legislature terminated its program altogether.

  • Tank owners in Michigan subsequently had to purchase commercial cleanup and liability coverage in order to comply with the federal financial responsibility requirements.
  • In contrast to state funds, the price structure for market-based insurance gives tank owners incentives to invest in equipment that reduces the chance of accidental fuel tank leaks.
  • After Michigan's policy change, the number of underground fuel tanks with accidental releases dropped by more than 20 percent, relative to surrounding states that maintained state assurance fund programs.
  • This reduction corresponds to more than 3,000 avoided fuel tank releases in Michigan over the following eight years, amounting to $400 million in savings over that time period.

Source: Haitao Yin, Howard Kunreuther and Matthew White, "Does Private Insurance Reduce Environmental Accidents?" Regulation Magazine, Summer 2012.

For text:

http://www.cato.org/pubs/regulation/regv35n2/v35n2-5.pdf

 

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