The current edition of the Cato Institute’s Regulation magazine has an interesting article about the role of legal liability in protecting the environment.
In “Does Private Insurance Reduce Environmental Accidents?” economists Haitao Yin, Howard Kunreuther, and Matthew White document the decline in leaks from underground fuel tanks when gas stations are required to carry private clean-up and liability insurance. The authors explain that “the price structure for market-based insurance gives tank owners economic incentives to invest in equipment that reduces the chance of accidental fuel tank leaks.”
What works for gas stations works for other industries, as well. Making potential polluters responsible for the adverse effects of their operations by requiring them to carry insurance that is adequate to cover any damages that occur accomplishes two things: It creates incentives for them to take care (thereby reducing the risk of adverse events) and it ensures that if something does go wrong, there will be sufficient funds to repair the damage and to compensate those who have been harmed. In short, this simple accountability mechanism internalizes costs and risks, making the world both safer and more just.
Following is an excerpt from the article:
Many of the risks faced by firms and individuals are spread across the economy through government assurance programs. Prominent examples include bank deposit insurance, pension benefit guarantee funds, and hazardous material cleanup funds. A salient feature of these government assurance programs is the absence of risk-based pricing: they do not charge insured individuals a premium commensurate with the specific risk that each one poses. As a result, the programs protect beneficiaries from adverse events at a subsidized price. The absence of an actuarially-based pricing structure may exacerbate moral hazard, raising the frequency of adverse events by lessening incentives for risk-reducing efforts.
An example of this can be found in government-managed assurance programs for gas station fuel leaks. In the late 1980s, new federal regulations 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. Michigan, Illinois, and Indiana soon created state assurance programs to subsidize firms’ costs of complying with the new federal regulations. Although the risk of an underground fuel tank leak varies greatly with a tank owner’s operating and investment decisions, the price to participate in these state cleanup assurance funds did not vary with the individual station’s risk. Consequently, station owners could have costly tank leaks and their consequential damages covered at state expense, while facing little program-related incentives to take care to prevent such leaks.
By the mid-1990s, Michigan’s and Illinois’ assurance funds became insolvent. However, they took different approaches to their insolvency crises. While Illinois raised its gasoline excise tax to restore its program’s solvency, the Michigan legislature terminated its state assurance program. 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 assurance funds, the price structure for market-based insurance gives tank owners economic 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. At an average cleanup cost of $125,000 per release, this represents an aggregate cleanup cost savings for that state on the order of $400 million.
These findings have a practical policy implication. The U.S. Environmental Protection Agency estimates that 6,300 new underground fuel tank releases occur each year in the United States. For the more than 30 states that presently operate state assurance fund programs, risk-based pricing mechanisms similar to private insurance markets may reduce the costly burden of future accidents and alleviate ongoing solvency crises.
To read “Does Private Insurance Reduce Environmental Accidents?” in full, click here.