ENVIRONMENTAL FINANCIAL ASSURANCE: CURRENT COVERAGE, INSTITUTIONAL CHALLENGES, AND ALTERNATIVE FINANCIAL GUARANTEE ARRANGEMENTS by José Carlos Lopes da Costa MSc, Simon Fraser University, 2013 MSc, London Guildhall University, 2000 A DISSERTATION SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY in The Faculty of Graduate and Postdoctoral Studies (Mining Engineering) THE UNIVERSITY OF BRITISH COLUMBIA (Vancouver) April 2020 © José Carlos Lopes da Costa, 2020ii The following individuals certify that they have read, and recommend to the Faculty of Graduate and Postdoctoral Studies for acceptance, the dissertation entitled: Environmental Financial Assurance: Current Coverage, Institutional Challenges, and Alternative Financial Guarantee Arrangements submitted by José Carlos Lopes da Costa in partial fulfilment of the requirements for the degree of Doctor of Philosophy in Mining Engineering Examining Committee Scott Dunbar, Professor, Department Head, Norman B. Keevil Institute of Mining Engineering, UBC Supervisor Dirk van Zyl, Professor, Norman B. Keevil Institute of Mining Engineering, UBC Supervisory Committee Member Nadja Kunz, Assistant Professor, Norman B. Keevil Institute of Mining Engineering, UBC Supervisory Committee Member Alan Russell, Professor Emeritus, Civil Engineering, UBC University Examiner James Tansey, Associate Professor, Sauder School of Business, UBC University Examiner iii Abstract Mining activities provide comprehensive socio-economic benefits to a nation. There are, however, varying degrees of environmental risks and financial liabilities related to mining. Governments expect mine operators to rehabilitate the environmental condition of disturbed lands once they complete their extraction activities. In the event of insolvency or bankruptcy, regulators also require them to establish that they possess adequate, financial assurance to ensure that mandatory reclamation and closure requirements are performed in accordance with the approved mine closure plans before initiating their mine operations. Such an approved ‘hard’ financial assurance instrument is typically held by the government or in trust by a third-party in escrow until the end of mining and only released when closure and reclamation operations are completed, which in some cases could be decades into the future or sometimes never. Financing these obligations come with a set of other challenges. Requiring a mining company facing both financial difficulties and unsettling market conditions, an epidemic of current times, to take on tens of millions or even hundreds of millions of dollars in ‘hard’ financial liabilities only increases the possibility of its financial collapse and potential reclamation failure. The dissertation focuses on the evaluation of a proposed structured finance mechanism that is expected to offer greater access to required funds from the capital markets and one that aims to assist government regulators with their regulatory compliance, oversight, and enforcement efforts. Even though securitisation has demonstrated the ability to take an illiquid asset or group of such assets, and through financial engineering, transforming it into a marketable financial security for sophisticated investors to invest in, it has yet to be applied to the securitisation of financial assurance requirements. The available financial assurance funding tools and options are also assessed. The dissertation is expected to deepen the discussion surrounding seeking more effective and readily accessible environmental financial assurance instrument solutions for the iv resource extractive industries. No literature evidence seems to exist to support any earlier study on the prospect of such a financial assurance-backed securitised mechanism. It is therefore of interest to investigate its potential. v Lay Summary Government regulatory agencies mandate mine operators, before initiating their operation activities, to establish that they possess adequate financial resources, through receipt of acceptable listed forms of financial assurance. Such a request is demanded from a mine operator in the event of bankruptcy or insolvency, to ensure that mandatory reclamation and closure obligations are adequately performed following the approved mine closure plans upon completing their mining economic activities. The dissertation focuses primarily on the question of whether financial assurance backed securitised instruments could be suitable alternatives to the growing issues surrounding financing constraints for mining companies. The analysis deepens the discussion surrounding the use of effective and accessible financial assurance instruments within the extractive industries, particularly as it relates to mining but not exclusively. The dissertation constitutes a timely and unique addition to the literature on financial assurance from both a funding and regulatory perspective. vi Preface The academic research described herein was conducted under the principal supervision of Dr Scott Dunbar at the Norman B. Keevil Institute of Mining Engineering, University of British Columbia. To the author’s knowledge, this work is original, except where acknowledgements and references are made to previous work. Neither this nor any substantially similar dissertation or thesis has been or is being submitted for any other degree, diploma or other qualification at UBC or any other academic institution. vii Table of Contents Abstract .......................................................................................................................... iii Lay Summary ................................................................................................................... v Preface ............................................................................................................................vi Table of Contents ............................................................................................................ vii List of Tables .................................................................................................................... x List of Figures .................................................................................................................. xii List of Abbreviations ...................................................................................................... xiv Acknowledgements ....................................................................................................... xvi Dedication ................................................................................................................... xviii Chapter 1: Introduction ..................................................................................................... I 1.1 Research Problem, Purpose, Objective, Scope, and Methodology ......................... 14 1.1.1 Statement of the Problem .................................................................................... 14 1.1.2 Research Purpose, Objective, and Scope ............................................................. 16 1.1.3 Methodology and Research Questions ................................................................ 20 1.2 Academic and Industry Significance...................................................................... 24 1.3 Dissertation Outline ............................................................................................. 28 Chapter 2: Literature Review .......................................................................................... 29 2.1 Review of Mine Reclamation Security .................................................................. 36 2.1.1 Surety Bonds: Limitations and Challenges ........................................................... 37 2.1.2 Setting the Surety Bond Amount .......................................................................... 41 2.2 Role of Securitisation in Modern Economy ........................................................... 42 2.3 Local Contemporary Issues ................................................................................... 47 2.4 Along Comes Financial Engineering ...................................................................... 54 2.4.1 Innovation through Securitisation ........................................................................ 60 2.4.2 Fuzzy Logic and Alternative Methods ................................................................... 61 Chapter 3: Issues in the Use of Financial Assurance ........................................................ 65 3.1 Funding Mine Closure .......................................................................................... 65 3.2 Current State of Reclamation ............................................................................... 70 3.2.1 Little Money, Inadequate Enforcement ............................................................... 71 viii 3.2.2 Response from Industry ....................................................................................... 82 3.2.3 Effectiveness of Mine Reclamation and Funding ................................................. 86 3.2.4 Endangered Surety Bond Market ......................................................................... 89 3.3 Financial Assurance Rules .................................................................................... 95 3.3.1 Underperformed Obligations and Unrecoverable Liabilities ............................... 95 3.3.2 Scale and Scope of Unrecovered Environmental Costs........................................ 97 3.3.3 Benefits of Assurance ........................................................................................... 97 3.3.4 Alternatives to Assurance ..................................................................................... 98 3.4 Politics and Costs of Assurance ............................................................................ 99 3.5 Scope of Assurance Rules .................................................................................... 100 3.5.1 Appropriate Coverage Levels ............................................................................. 100 3.5.2 Determining the Required Assurance Levels ..................................................... 101 3.5.3 Auditing Self-Estimated Assurance Requirements ............................................. 102 3.5.4 Adequacy of Coverage Levels ............................................................................. 104 3.5.5 Confiscation Concerns Arising from Assurance .................................................. 104 3.5.6 Liability Limits and Assurance Coverage Requirements ..................................... 105 3.6 Security of Assurance Mechanisms ...................................................................... 106 3.6.1 Compliance Evasion ............................................................................................ 106 3.6.2 Assurance Evasion through Bankruptcy ............................................................. 107 3.6.3 Assurance Provider Insolvency ........................................................................... 107 3.6.4 Defences, Exclusions, and Cancellation .............................................................. 108 3.6.5 Monitoring, Administration, and Record-Keeping ............................................. 108 3.6.6 Self-Demonstration and Corporate Guarantees Issues ...................................... 109 3.7 Financial Assurance for Reclamation Regulations and Policies ............................. 112 3.7.1 Financial Assurance as a Complement to Liability and Regulation .................... 114 3.7.2 Regulatory Efficiency .......................................................................................... 116 3.7.3 Issues and Policies in the Use of Financial Assurance ........................................ 121 Chapter 4: EFA Securitisation Framework Model and Results......................................... 124 4.1 Conceptual EFA Securitised Framework: Defining Possible Attributes .................. 126 4.1.1 Method ............................................................................................................... 131 4.1.2 The Model ........................................................................................................... 137 ix 4.1.3 Discussion of Results .......................................................................................... 156 4.1.4 Sensitivity Analysis of the Hierarchical FIS Model .............................................. 163 4.2 Discussion and Analysis ....................................................................................... 168 4.2.1 Research Limitations .......................................................................................... 171 Chapter 5: Conclusions, Contributions, and Future Work ............................................... 174 5.1 Conclusions ........................................................................................................ 175 5.2 Contributions to Knowledge................................................................................ 180 5.3 Recommendations for Future Work .................................................................... 182 References .................................................................................................................... 186 Appendices ................................................................................................................... 247 Appendix A: Mine Reclamation Securities in British Columbia for 2014 ..................... 247 Appendix B: Funding Mechanisms for Mine Reclamation .......................................... 250 Appendix C: Issues Surrounding Financial Assurance ................................................. 260 Appendix D: Regulators, Policy, and Enforcement ..................................................... 270 Appendix E: Commonly Used Financial Assurance Instruments ................................. 280 Appendix F: Framework for Securitisation ................................................................ 281 F.1 Modus Operandi: The Securitisation Process ........................................................ 281 F.2 Securitisation: Benefits and Drawbacks ................................................................ 285 F.2.1 Originator and Investors: Benefits ................................................................. 285 F.2.2 Originator and Investors: Drawbacks ............................................................ 286 F.2.3 Government: Benefits and Drawbacks .......................................................... 286 F.3 Requirements for a Successful Securitisation: Structuring and Execution ........... 287 F.3.1 Financial Infrastructure Stability .................................................................... 287 F.3.2 Strong Investor Demand ................................................................................ 289 Appendix G: Financial Assurance Securitised Structure ............................................. 292 Appendix H: Mamdani Fuzzy Inference System ......................................................... 305 H.1 Example – Mine Reclamation Success .................................................................. 310 Appendix I: Fuzzy Membership Function Ranges of Magnitude ................................. 321 Appendix J: Input Combinations and Rules................................................................ 334 x List of Tables Table 4.1: Financial Metrics .................................................................................................. 136 Table 4.2: Description of the Mamdani-Type Fuzzy Inference System Model ..................... 153 Table 4.3: Input Combinations and Rules for the Variable ‘Stakeholders’ ........................... 155 Table 4.4: Hierarchical Levels Scores .................................................................................... 156 Table A.1: 2014 Mine Reclamation Securities in BC for Metal and Coal Mines Summary ... 247 Table E.1: Evaluation of Commonly Used Financial Assurance Instruments ....................... 280 Table I.1: Fuzzy MF Ranges of Magnitude for the ‘Credit-Strength’ Linguistic Variable ...... 322 Table I.2: Fuzzy MF Ranges of Magnitude for the ‘Expected Mine Life’ Linguistic Variable. 322 Table I.3: Fuzzy MF Ranges of Magnitude for the ‘Financial Health’ Linguistic Variable ..... 323 Table I.4: Fuzzy MF Ranges of Magnitude for the ‘CSR/ESG Ranking’ Linguistic Variable ... 324 Table I.5: Fuzzy MF Ranges of Magnitude for the ‘Originator’s Degree of Experience’ Linguistic Variable ......................................................................................................... 325 Table I.6: Fuzzy MF Ranges of Magnitude for the ‘Pooling Arrangement’ Linguistic Variable ...................................................................................................................................... 325 Table I.7: Fuzzy MF Ranges of Magnitude for the ‘Diversification’ Linguistic Variable ........ 326 Table I.8: Fuzzy MF Ranges of Magnitude for the ‘Vehicle Structure’ Linguistic Variable.... 327 Table I.9: Fuzzy MF Ranges of Magnitude for the ‘Credit Enhancement’ Linguistic Variable ...................................................................................................................................... 327 Table I.10: Fuzzy MF Ranges of Magnitude for the ‘Legal Framework’ Linguistic Variable . 328 Table I.11: Fuzzy MF Ranges of Magnitude for the ‘EFA Obligations Value’ Macro Variable ...................................................................................................................................... 329 Table I.12: Fuzzy MF Ranges of Magnitude for the ‘EFA Obligations Life’ Macro Variable . 329 Table I.13: Fuzzy MF Ranges of Magnitude for the ‘Stakeholders’ Macro Variable ............. 330 Table I.14: Fuzzy MF Ranges of Magnitude for the ‘Collateral’ Macro Variable .................. 330 Table I.15: Fuzzy MF Ranges of Magnitude for the ‘Transaction Architecture’ Macro Variable ...................................................................................................................................... 331 Table I.16: Fuzzy MF Ranges of Magnitude for the ‘EFA Obligations’ Macro Variable ........ 332 Table I.17: Fuzzy MF Ranges of Magnitude for the ‘Deal Structure’ Macro Variable .......... 332 xi Table I.18: Fuzzy MF Ranges of Magnitude for the ‘EFA Obligations-Backed Securitisation Outcome’ Macro Variable ............................................................................................. 333 Table J.1: Input Combinations and Rules for the Output-Crisp Value, ‘Stakeholders’ ......... 334 Table J.2: Input Combinations and Rules for the Output-Crisp Value, ‘Collateral’ .............. 335 Table J.3: Input Combinations and Rules for the Output-Crisp Value, ‘Transaction Architecture’ .................................................................................................................. 336 Table J.4: Input Combinations and Rules for the Output-Crisp Value, ‘EFA Obligations Value’ ...................................................................................................................................... 337 Table J.5: Input Combinations and Rules for the Output-Crisp Value, ‘EFA Obligations Life’ ...................................................................................................................................... 337 Table J.6: Input Combinations and Rules for the Output-Crisp Value, ‘Deal Structure’ ....... 338 Table J.7: Input Combinations and Rules for the Output-Crisp Value, ‘EFA Obligations’ .... 339 Table J.8: Input Combinations and Rules for the Output-Crisp Value, ‘EFA Obligations Backed Securitisation Outcome’ ................................................................................................ 340 xii List of Figures Figure 2.1: Categorisation of Tax Issues Affecting Securitisation ........................................... 43 Figure 4.1: Framework of the Analysis ................................................................................. 138 Figure 4.2: Hierarchical Mamdani Fuzzy Logic System Model .............................................. 140 Figure 4.3: Membership Functions Applied .......................................................................... 154 Figure 4.4: Surface Viewer: ‘Mechanism Outcome’ as It Is Affected by the Two Macro-Area Inputs: ‘EFA Obligations’ and ‘Deal Structure’ .............................................................. 161 Figure 4.5: Box-Plots of the Single-Asset EFA Obligations Portfolio ..................................... 164 Figure 4.6: Box-Plots of the Multi-Asset EFA Obligations Portfolio ...................................... 165 Figure F.1: Securitisation Process ......................................................................................... 283 Figure F.2: Actors of Securitisation ....................................................................................... 284 Figure G.1: Basic EFA-Backed Securitisation Process ........................................................... 293 Figure G.2: The Originator .................................................................................................... 293 Figure G.3: Transferring the Pool of EFA Obligations ........................................................... 295 Figure G.4: Securities Issuance ............................................................................................. 295 Figure G.5: Credit Enhancement(s) ....................................................................................... 296 Figure G.6: Creating Security and Managing Risk(s) ............................................................. 296 Figure G.7: EFA-Backed Securitisation Process Flow ............................................................ 297 Figure G.8: Multiple-Tranche EFA Securitised Structure ...................................................... 298 Figure G.9: EFA Tranches ...................................................................................................... 299 Figure G.10: EFABS Cash Flow Modelling ............................................................................. 300 Figure G.11: Cash Flow Schematic for an EFABS .................................................................. 303 Figure H.1: Basic Structure of a Fuzzy Logic System ............................................................. 308 Figure H.2: Structure of the ‘Mine Reclamation Success’ Mamdani Fuzzy Inference System ...................................................................................................................................... 310 Figure H.3: Basic Structure of the ‘Mine Reclamation Success’ Problem ............................. 310 Figure H.4: ‘Mine Reclamation Success’ Memberships ........................................................ 311 xiii Figure H.5: Fuzzifying the Input Variable ‘Financial Assurance’ ........................................... 313 Figure H.6: Applying the Fuzzy Operator .............................................................................. 314 Figure H.7: Applying the Implication Method ...................................................................... 315 Figure H.8: Applying the Aggregation Method ..................................................................... 316 Figure H.9: Applying the Centroid Method for Defuzzification ............................................ 317 Figure H.10: Relationship Between the Variables ................................................................ 318 xiv List of Abbreviations ABS Asset-Backed Security AUM Assets Under Management BC British Columbia CAC Command and Control CAD Canadian CCSP Crown Contaminated Sites Programme CDO Collateralised Debt Obligation CDO² Synthetic CDO CDS Credit Default Swap CE Credit Enhancement CERCLA Comprehensive Environmental Response, Compensation, and Liability Act CLN Credit-Linked Note CLO Collateralised Loan Obligation CMBS Commercial Mortgage-Backed Security CRA Credit Rating Agency CSR Corporate Social Responsibility EFA Environmental Financial Assurance EFABS EFA-Backed Security EIM Economic Incentive Mechanism ESG Environmental, Social, and Governance FA Financial Assurance FABS FA-Backed Security FDI Foreign Direct Investment FEH Factor Endowment Hypothesis FIS Fuzzy Inference System FL Fuzzy Logic ICR Interest Coverage Ratio IFC International Finance Corporation IMCC Interstate Mining Compact Commission IMF International Monetary Fund MBS Mortgage-Backed Security MEM Ministry of Energy and Mines MF Membership Function NGO Non-Governmental Organisation OAGBC Office of the Auditor General of British Columbia OBS Off-Balance Sheet OECD Organisation for Economic Co-operation and Development OTC Over the Counter xv PHE Pollution Haven Effect PH Porter Hypothesis PHH Pollution Haven Hypothesis PPP Polluter Pays Principle R&C Reclamation and Closure R&D Research and Development RMBS Residential Mortgage-Backed Security RMCE Regulatory Monitoring, Compliance, and Enforcement SCC Supreme Court of Canada SIB Social Impact Bonds SPV Special Purpose Vehicle SRI Socially Responsible Investing UNEP United Nations Environment Programme UNEP FI United Nations Environment Programme Finance Initiative US United States of America USD US Dollar US EPA US Environmental Protection Agency xvi Acknowledgements Working on my PhD and writing this dissertation has been a great pleasure, and a real labour of love, for me. The only regret that I have is that I did not further my studies a bit sooner as intended. The years of financial industry knowledge and experience gained, coupled with my educational background; however, benefited my research efforts. I am grateful for the respect, guidance, and advice provided to me by Dr Scott Dunbar, Dr Dirk van Zyl, Dr Nadja Kunz, and others at UBC’s Keevil Institute throughout my efforts to produce and improve this dissertation and all through my studies in the PhD programme. I wish to extend special thanks to Dr Dunbar for his assistance and guidance with my research efforts over the years. I am also thankful to Dr Knud Sinding for his input in the early stages of my research since it helped shape it. A special thanks goes out to Carmen Jensen as well for the chance encounter that brought me to UBC to pursue my PhD studies. My sincere appreciation also goes out to a number of my colleagues1 from the Segal Graduate School of Business at Simon Fraser University (SFU) for their insights and support over the years. As well, to Dr Ana Maria Fuertes from Cass Business School, City, University of London, and to Brian Eales from London Metropolitan University for their inspiration since I was their student. I owe a debt of gratitude to everyone else who helped me progress through the PhD programme or who helped me improve my dissertation. From proof-reading, editing, offering valuable advice and guidance, I appreciate the support provided by them. Thank you to the many dedicated people at CAIA (Chartered Alternative Investment Analyst) Association, CIM (Canadian Institute of Mining, Metallurgy and Petroleum), 1 Especially Dr Christina Atanasova, Elsie Christopher, Dr Andrew Gemino, Dr Brenda Lautsch, Dr Kamal Masri, Dr Jijun Niu, Dr Jan Simon, and Dr Mark Wexler. xvii CIM MES (Management and Economics Society of CIM), and PRMIA (Professional Risk Managers’ International Association) as well who have inspired me over the years. A special thanks are also due to my parents (Manuel Ferreira da Costa and Maria Irene Lopes da Costa), family, and friends2 who encouraged my academic pursuits. I am forever thankful to my wife, Silvia Piccioni, most importantly, and above all, for her encouragement and support over the years while I endeavoured to pursue my career and academic ambitions. Muito obrigado à todos vocês! Boa saúde! 2 In particular, Tony Birch, Bill Carbonneau, Mike Church, Byron Jung, Mark Richards, Jaspal Singh, and Susannah Skerl. xviii Dedication This dissertation is dedicated to all concerned mining stakeholders around the world. I hope that in some small way it will be of benefit to their ongoing mine reclamation and closure efforts and struggles. It is also dedicated to all mature students, like me, who must continuously worry about the many little things while trying to achieve big things. Anyone who stops learning is old, whether at twenty or eighty. Anyone who keeps learning stays young. The greatest thing in life is to keep your mind young. — Henry Ford Ancora imparo. — Michelangelo di Lodovico Buonarroti Simoni (Michelangelo) — José Carlos Lopes da Costa (Carlos da Costa) I Chapter 1: Introduction We are seeing that surety bonding is becoming more expensive and less available. — Anna Zubets-Anderson Vice President – Senior Analyst, Moody’s Investors Service The mining sector is an essential contributor to the Canadian economy (MAC, 2018). The Mining Association of Canada cites that mining contributed CAD$97 billion3 to the country’s Gross Domestic Product (GDP) in 2017 (MAC, 2018). The industry accounted for 19 percent of the value of goods exported that year. Canada’s value of mineral production was CAD$43.9 billion in 2017. Extractive sector companies as well reported payments of more than CAD$9.3 billion to the government that year. The metals and mining sector is also central to the world’s economy. The global top 40 mining companies, which represent a majority of the entire industry, reported $600 billion of revenue in 2017 (Statista, 2018). Activities in the mining sector range from exploration, production, and project decommissioning. Such actions are accompanied by various types and levels of environmental risk and, if not well managed, can result in a substantial expenditure to the public. Environmental risks related with such projects can include the release of toxic and hazardous substances; effects on vegetation, wildlife, and fisheries (biological resources); and the impact of climate change that exacerbates the effects of mining on water and wastewater quality, flows, and containment controls. The result of such catastrophes may require substantial financial commitments or investments to decommission and ensure reclamation of a mine site or facility as history has illustrated various times in Canada and around the world (Sheldon et al., 2002; Poulin and Jacques, 2007; Otto, 2009). 3 In Canadian (CAD) dollars. Hereinafter, unless otherwise stated, all dollar-denominated values are expressed in US dollars (USD). 2 Environmental reclamation provides the right to reclaim property in the event of default, fraud or other irregularities. Mining and metals companies’ exposure to fraud and corruption4 is now more prevalent as a result of cost-cutting measures in the sector and expansion into new territories. Fraud and corruption in the mining, oil, and gas industries keep some developing nations poor and props up brutal regimes. There is a growing global sentiment that governments and corporate entities must end the confidentiality and bring deals, profits, and environmental costs into the open. Governments and regulators possess a selection of tools and options to manage such risks, including: • strategic environmental assessments; • environmental assessments of proposed projects; and • regulations and laws to control the release of pollutants during operations, and for the reclamation and deactivation of mine sites at the end of their operating lives. These tools also include environmental liability limits and various forms of regulatory approved ‘hard’ and ‘soft’ financial assurance5,6. While such instruments are accessible to government and regulators, the responsibility is on mine operators to meet the financial costs associated with mine closure, reclamation, and any damages resulting from accidents. Synonyms such as ‘rehabilitation,’ ‘restoration,’ and ‘re-cultivation’ are often used to denote ‘reclamation.’ Although they are used interchangeably, differences between them exist (Lima et al., 2016). The objective of reclamation is to return affected areas as near as 4 From Kazakhstan to Angola to Uganda, investigations by Global Witness (2019) show how secrecy in this extractive sector entrenches corruption and props up kleptocratic regimes. Experts estimate that in Nigeria alone a staggering $400 billion of oil revenue has been stolen or misused since 1960. 5 Financial assurance (FA) and environmental financial assurance (EFA) are interchangeably used in the dissertation. 6 Financial assurance instrument forms, two forms of guarantee: ‘hard’ security (e.g., cash deposit, letters of credit, bond, and trust), typically held in escrow, and ‘soft’ security (e.g., corporate guarantee, FA discounts, financial test, and other permitted forms). 3 possible to their ecological and economic value; however, it does not aim to return them to the original state (UNEP, 1983; UNDP, 2018; Teck, 2019). From industry’s perspective, the goal of reclamation is to enhance and conserve biodiversity, care for the environment, and turn lands where mining has ensued over to new and productive uses (Teck, 2019). Munshower (1983) defines reclamation as follows: Reclamation includes all aspects of the environment; it is not restricted to soils and vegetation. Although the disturbed area cannot be returned to its exact pre-mining condition, it can be rehabilitated. It can be returned to a useful function in the ecosystem of which it is a part. In all cases, however, the most economical means of attaining the reclamation goals is to develop a suitable reclamation plan prior to actual land disturbance. As can be understood from this statement, reclamation is not considered a simple post-mining operation since best management practices are expected to be progressive and incorporated within all stages of mining. It commences with pre-mining planning, continues through the exploitation stage and also lasts through operations, and ends with post-mining land use. To eliminate the damaging impacts of mining, mine reclamation and closure (R&C) responsibilities, from planning to implementation, is significant to the mining industry, communities, and countries. Ken Bocking, Principal at Golder Associates Inc., points out that mine closure, and even environmental reclamation, is a relatively new concept in Canada (Hiyate, 2018). “I started (in mine closure) in 1992. Why? Because that’s when the law came in Ontario,” Bocking said. “Until that time, basically mines would live out their useful life, and then many of the operators just walked away.” Mine operators now need to possess a well-thought-out, approved closure plans and are required to deposit government-approved FA upfront, and held in escrow by the regulator or a third-party, so that there is adequate funding in place for approved R&C obligations, as outlined in their closure planning if they abandon such responsibilities. However, the industry has not implemented closure at many Canadian mine sites: “There’s not very many mines that have been completely closed to the point 4 where the company can walk away, and the land can be returned to the Crown,” Bocking noted (Hiyate, 2018). “So, I think that’s where it needs to go next.” The significant growth in overall clean-up cost liabilities signals an urgent need for reform in the mining sector (Hiyate, 2018). “It’s the single most important thing that our industry does,” said Douglas Morrison, President and CEO of the Centre for Excellence in Mining Innovation, at the Progressive Mine Forum in Toronto, Canada, in late October 2018 (Hiyate, 2018). “Nobody in the public could care less what our productivity levels are, what the return on investment is. They absolutely care what we do with our waste streams – wastewater and solid waste. This is where our industry interacts with the public.” “The reality is when you look at mine closure in the overall life cycle of a mine, it’s actually the longest phase of a mine,” said Steven Woolfenden, Director of Environment for IAMGOLD Corp. (Hiyate, 2018). “I’m managing some legacy sites that are 30, 40, and 50 years old, and there is no end to that management – it will be in perpetuity.” The cost, he added, is often underestimated. Woolfenden goes on to state, “Most people really don’t pay much attention to it because when you do the costing on mine closure, it’s pushed so far out and discounted so much that it doesn’t really impact it. But when you get there, and you actually have a closed mine, it costs you a lot of money.” Financing such mandatory R&C commitments has a particular set of challenges, including: • uncertainty of their actual costs; • the types of standard, non-standard or unacceptable forms of EFA to the regulator; • ‘hard’ financial guarantee (financial assurance) is typically held by the government or in trust by a third-party in escrow until the end of mining and only released when closure and reclamation operations are completed, which in some cases could be decades into the future or sometimes never; • insufficient financial assurance funding; 5 • inconsistencies and unclear regulations7, inadequate enforcement of laws; • cessation of treatment of polluted mine drainage due to corporate dissolution or bankruptcy; and • unplanned ongoing treatment obligations of mine discharge water (Miller, 2005; Sassoon, 2008). Such regulatory vagueness and incompleteness often lead to higher R&C costs and different regulatory interpretation. Environmental financial assurance is a mechanism that governments and regulators utilise to help shield taxpayers from the possible financial liabilities of environmental protection, clean-up, closure, and reclamation, in accordance with the approved reclamation plan, for a variety of natural resource development projects of the public and private sector in the possible event of bankruptcy or insolvency by the company in question. Such financial security is characteristically required from projects associated with the deterioration of public infrastructure facilities (e.g., transportation, water, power and energy, telecommunications, and health) and other ‘white elephant’ infrastructure8 (e.g., abandoned Olympic venues, World Cup stadiums, and shopping centres worldwide), industrial hazardous waste, municipal solid waste, the transport of oil & gas, energy projects, nuclear, and mining. Absolute cost limits are applied in specific sectors to cap or limit the total financial amount that a corporate entity may be liable for in the event an adverse incident arises, without proof of fault. These absolute liability caps are applied in Canada and other countries (Boyd, 2001; Sassoon, 2009). Such a financial guarantee is a critical component of the reclamation and post-closure process since it can be used to cover the expenditures of mandatory R&C obligations should 7 Regulatory bodies and regulations around the world display considerable heterogeneity (Richer La Flèche et al., 2016). 8 A white elephant is an idiom for a valuable but burdensome possession. When applied to finance, it is used to describe anything that is expensive to maintain, unprofitable, and impossible to sell. In other words, white elephant is the name given to undesirable investments that are more trouble than they are worth. 6 the mine operator be unable or unwilling to do so. The mining sector is vulnerable to significant technical risks and fluctuations in metals prices, and many companies have gone bankrupt or insolvent, sometimes before mine reclamation or closure activities are completed. Because closing a mine can often cost tens to hundreds of millions of dollars, regulators require a dependable source of funds to pay for the environmental reclamation of a mine site as well as the required oversight by government officials. Since closure obligations are the responsibility of the mine operator, these costs are not included in the budgets of regulatory agencies, nor are they expected to be (Miller, 2005). Regulators need FA that is readily accessible to ensure that mine reclamation occurs. Should a company default on its closure commitments, these liquid funds would be required immediately to maintain and operate mine facilities, such as water treatment plants. The financial assurance should be protected (on an arm’s length basis) from frivolous legal challenges and the prying reach of opportunistic individuals and regulatory agencies. Given the large size of most FA, a surety provider stands to gain financially by collecting interest on the surety bond amount while unsuccessful legal challenges are debated in the courts (Alter and Houston, 2009). Finally, the reclamation liability cost estimate, upon which the environmental financial assurance is based on, must be accurate and up to date. Unfortunately, errors in these computations, whether legitimate or not, have required millions of dollars of taxpayer funding to close bankrupt mines. Demanding financial sureties for large mines is an accepted practice in developed countries9, although opinions differ regarding the form of financial assurance. Governments have employed several financial vehicles to meet FA requirements. These instruments commonly take two types: independently guaranteed EFA and financial assurance guaranteed by mining companies. Because mine operators can and do go bankrupt, non-governmental organisations and governments require ‘hard’ forms of FA, in-full and 9 Countries such as Australia, Canada, South Africa, and the United States of America (US). 7 up-front, that are independent of the mine operator, usually in the form of cash deposits, letters of credit, surety bonds, bank guarantees, trust funds, insurance, or some combination of these instruments. These funds are deposited held, in escrow, in advance of a mining activity and are until the end of mining and released when reclamation operations are completed (Gerard, 2000). The financial coverage provided by such instruments could be based on the relative risk of the mining activity and the potential loss of the environmental services. However, the mining industry, along with other sectors, such as energy, has found it increasingly difficult to obtain such surety coverage for mining operations (Learn, 2016). Legislation and regulations identify the variety of financial security instruments that are permitted. Government regulators hold or have access to these escrowed funds during the lifetime of a project. The responsibility for restoring land that has been mined to a natural or economically usable state (mine reclamation) rests principally with the host jurisdiction. The environmental financial obligations stemming from mining projects can run into tens or hundreds of millions, and in some instances, billions of dollars due to post-closure issues (CCSG Associates, 2001). EFA is an appropriate safeguard since it makes available the necessary funding requirements for future environmental liabilities to be funded for by a mine operator. The escrowed funds provide for financial expenditures stemming from projects with long lifespans where risks related to decommissioning and their associated costs may not be realised for several decades into the future. In conjunction with a sound regulatory, oversight, and enforcement framework, they can act as a potent stimulus to industry to minimise environmental impacts as a core part of its operations. Post-closure issues have often been overlooked in mine closure planning, especially at the mine planning stage. These issues are usually categorised as monitoring and maintenance, water treatment, and catastrophic events (US EPA, 2011). Monitoring and maintenance issues include geotechnical inspections of tailings dams and waste rock facilities, long-term 8 water quality sampling, and minor repair work such as re-grading the slopes of dams and waste dumps and re-vegetation where initial seeding or planting have failed. If water treatment is necessary, extensive financing will be required after the mine has closed. Long-term water treatment along with water treatment plant replacement activities can significantly increase the cost of mine closure, which is why some advocate not allowing the development of mines that require perpetual water treatment (Stantec Consulting, 2016). If a mine operator were to abandon its mine site without providing adequate funding for continuous water treatment, governments would be forced to pay treatment costs. Financial assurance is not generally required for catastrophic events such as floods, earthquakes, tailings dam failures10, or the sudden onset of acid mine drainage after mine closure (US EPA, 2011). These adverse exposures can include major environmental accidents costing billions of dollars for compensation, containment, and clean-up (e.g., the Mount Polley mine disaster (2014) in British Columbia (BC), Canada; the Samarco (Brazil’s Samarco Mineração S.A.) dam collapse disaster (2015) in Bento Rodrigues, a sub-district of Mariana, Brazil; the Texas Silver Mine11 storage ponds spill12 (2016) in southern Queensland, Australia; and the recent Brumadinho dam collapse13 (2019) in the state of Minas Gerais, Brazil). Where similar incidents have occurred, taxpayers have often been responsible for a large part of the clean-up costs. The BC First Nations Energy and Mining Council recently called on the British Columbia provincial government to close a policy gap that permits mining companies not to provide 10 Following January 2019’s tailings dam disaster at Vale S.A.’s Córrego do Feijão mining complex, the Responsible Mining Foundation released a statement highlighting the results of its 2018 Responsible Mining Index report related to miners’ tailing dams. As per the report, many of the world’s leading mining companies are reluctant to acknowledge how effectively they are addressing the risks of tailings dam failure and seepage (RMI, 2018; Ruiz Leotaud, 2019). 11 Not to be confused with the Texas silver mine, Rio Grande Mining Co., in Shafter, Texas, that was acquired by Vancouver-based Aurcana Corp. in 2008. 12 An internal government document disclosed it could cost up to AUS$10 million to rehabilitate the mine site (Willacy, 2016b). The government holds just AUS$2 million from the former owners in financial assurance for the site. 13 Vale’s (Vale S.A.) second dam disaster in Brazil in less than four years is a blow to the mining industry (Lewis, 2019a). Brazil is still grappling from the 2015 collapse of a larger dam, owned by the Samarco Mineração S.A. joint venture between Vale and BHP (Lewis, 2019a). 9 EFA to pay for the costs of such mine disasters (Hoekstra, 2019). FA is already required in Canada for pipelines, tankers, offshore drilling, rail lines, and nuclear power plants. Following the devastating Brumadinho tailings impoundment failure, a group of 96 institutional investors (representing more than $10.3 trillion assets under management (AUM)), led by the Church of England Pensions Board and Sweden’s public pension fund, wrote to 683 extractive companies seeking greater disclosure on the management of tailings storage facilities (Church of England, 2019a; Church of England, 2019b; Jamasmie, 2019). Such religious organisations and institutional investors are the most prominent shareholders of public, corporate entities. These institutional investors are important actors in corporate governance and in prompting company management to improve performance (Wagemans et al., 2013). Controversy surrounding monitoring is generally related to several issues (MEM, 2016): • monitoring data is almost always collected by the mine operator; • mine operators consider some of the monitoring data to be confidential14, especially information that is not explicitly required by regulatory authorities (e.g., in practice the details of reclamation liability costing are kept confidential unless a corporate entity releases it independently); and • the public is usually not permitted to access the mine site to collect samples. 14 For instance, the Mining Act, R.S.O. 1990, Chapter M.14 (the Mining Act) and its regulations offer the framework for the Ministry of Northern Development Mines to support and regulate safe, transparent, and environmentally responsible mining practices in Ontario (MNDM, 2018). Part VII of the Mining Act and Regulation 240/00 set out the prerequisites for FA to be provided, along with the Certified Closure Plan, in a separate appendix with the Closure Plan. Part VII also sets out the constraint that commercial or financial information provided to support the amount or form of financial assurance is to be kept confidential. Confidentiality only applies to the background and supporting materials used to ‘establish’ the FA (MNDM, 2018). Details about the amount or type of FA are not confidential (MNDM, 2018). The idea behind the confidentiality provision seems to be to protect the underlying financial information that would be explicitly needed to establish the corporate financial test form of FA (MNDM, 2018). The posting does not include the following confidential information (MNDM, 2018): i) liability cost estimates comprising of actual quotes from identified contractors or vendors used to support cost estimates for reclamation work and ii) financial information related to proprietary technology or processes used in reclamation. The other types of EFA do not require similar potentially sensitive information about the company’s financial status. The Ministry of Northern Development and Mines oversees support of economic development in the Northern Ontario region and for mining in the Canadian province of Ontario. 10 Nevertheless, mine operators typically seek to comply with the monitoring requirements specified by regulatory agencies (Garcia, 2008). All stakeholders consider compliance with monitoring requirements to be necessary. A regulatory framework and the financial assurance established according to regulations are utilised to manage and monitor environmental risks of extractive activities. For mining, financial assurance provides a contingency fund to cover the inherent economic liabilities associated with mine decommissioning and reclamation, in accordance with the approved reclamation plan. The magnitude of the environmental reclamation that needs to be carried out will impact the amount of EFA required and the cost of the work that needs to be completed. For example, ecological land reclamation15 would usually be considerably more expensive than merely containing mine waste in tailings ponds and would consequently require higher levels of environmental financial assurance. Financial assurance is an illustration of the polluter pays principle (PPP) in action since during the planning stage a mining company must cover all expected financial costs associated with reclamation, environmental protection, and longer-term protection of a closed mine site (Gerard, 2000; Ambec and Ehlers, 2016; Cooter and Ulen, 2016). Sound management of EFA requires some additional critical information, such as the term of the mine operator’s licence or permit, the calculation of the approved financial assurance amount, the type of allowable FA mechanism, and the security’s expiry date. These details are crucial for monitoring the continuing adequacy of the EFA in place. In the absence of such material, regulators will be unaware if the financial securities held are appropriate and enough to cover the total expenditures associated with decommissioning the facility and its 15 The goal of mine reclamation is to return affected areas as near as possible to a natural or economically usable state. It does not aim to return them to the original state (UNEP, 1983; Government of British Columbia, 2019). 11 surroundings to conditions comparable with those that existed before mining operations were initiated. Timely inspections are necessary to ensure that EFA held is adequate. Despite many environmental regulators throughout the world having established adequate systems to obtain environmental financial assurance, there still exist areas for continued development. Many mine operators within a host territory often do not have requirements that are essential for the ongoing management of financial assurance. Notwithstanding the economic benefits that mining brings to a country, the adverse environmental impacts of the industry due to such inefficiencies can be significant. In British Columbia, Canada, through its Mines Act, owners, agents, or managers of a mining project must submit plans for the environmental reclamation of the watercourses, land, and cultural heritage resources affected by mining activity as a requirement to obtain a Mines Act permit prior to the initiation of mine construction and production (OAGBC, 2016). Regardless of this regulatory approach, adequate reclamation of lands is not always pursued by mine operators (the National Orphaned and Abandoned Mines Initiative (NOAMI) database is littered with examples). Such a scenario can occur at abandoned mines, where mineral claims have returned to the government upon approval of all regulatory requirements but where additional work may still be required at the disturbed lands to avoid pollution, human health risks, and property damage. A 2006 study undertaken by Castrilli (2007) considered a levy on industrial production as a funding approach that could help solve orphaned/abandoned mines clean-up problems; similar to the OSM (Office of Surface Mining) levy on coal production. Castrilli studied several jurisdictions that implemented this mechanism or were considering it. The standard characteristics of these programmes include the establishment in law of a government entitlement to impose a tax or fee on an industry sector, which the funds would be deposited into a dedicated fund reserved solely for orphaned/abandoned mine clean-up. 12 The supply of financial assurance providers has declined in past years due to multiple factors in the surety industry, the casualty insurance industry and broader property, and the mining industry itself (Learn, 2016). Citing sharp price increases, reclamation surety companies have withdrawn from the market over the past years and, as a result, mine operators claim that obtaining the suitable EFA required for operations has become significantly costlier. Subsequently, the mining sector has proposed that the government expand the selection of FA offerings that it is willing to accept; though, those proposals, usually ‘soft’ security, could potentially have the government and, consequently, taxpayers bearing higher default risk (Hein et al., 2016; Learn, 2016; Harmon, 2017; Richards, 2017; Lavoie, 2018). In some circumstances, for instance, such as mine sites where the company’s financial strength materially exceeds the estimated liability, a regulator may accept less than full security. As disclosed in the latest available reclamation liability cost estimates data (see Appendix A) to the BC government, for instance (MEM, 2016). The regulator reviews the liability status of such mine sites and reduces bonding liability shortfalls over time, as determined by regulator analysis. Such ‘financial strength materiality’ consideration allows the chief inspector the discretion to accept less than the full value of the financial surety required for reclamation and closure commitments. A discrepancy of such monetary significance not only places the public at considerable financial risk, but it also provides an economic, competitive advantage (subsidy) to large mining corporate entities over their competitors who paid in full. A disappointing performance by Canadian mining companies over the last few years has also taken a toll on the entire global industry, which makes matters even worse (Friedman, 2019). Many executive leaders are reporting that traditional avenues of finance have dried up, with North American investors fleeing to better-performing sectors, such as cannabis and technology (Hoffmann, 2019). “It is clear that the industry as a whole is not in good shape,” Barrick Gold Corporation’s (Barrick Gold) chief executive officer, Mark Bristow, told analysts in May 2019, describing mining as antiquated (Friedman, 2019). The contraction of Canada’s mining industry was outlined at a recent conference (Hoffmann, 2019). Oreninc, a 13 research and advisory firm, tracked approximately 1,400 Canadian-listed mining companies, with market valuations of less than CAD$1.5 billion and more than CAD$100 million, and observed that they are raising less money and forging fewer deals (Hoffmann, 2019). The State of Mining Finance 2019 report, produced by Oreninc and the Prospectors & Developers Association of Canada, also paints a gloomy picture of mining and exploration companies’ capacity to attract financial capital, citing metal price weakness in 2018 as a leading driver behind the growing decline (Els, 2019; PDAC, 2019). The potential for corporate entities to default on FA needs to be addressed with greater detail. Historically, such EFA defaults have occurred in mining situations throughout remote, lightly populated regions of northern Canada where the abandonment of industrial extraction sites without reclamation has been common, if not the norm (Foote, 2012). As Foote (2012) denotes, Samis et al. (2005), for example, reported on fifty northern Canadian lakes that were either entirely or partially eliminated, or approved for elimination, during the 1985-2000 era because of placer mining, diamond mining, or oil sands operations. The legacy of abandoned/orphaned mine sites, with the accompanying environmental liability, the financial costs of clean up, and human health concerns are a serious concern facing Canada and other jurisdictions around the world (Tremblay, 2006). One of the objectives of the dissertation is to produce new knowledge surrounding financial assurance. It introduces a structured finance-based EFA-backed securitised mechanism which is inspired by available forms of creative alternative financing — commercialising life settlements (life insurance policies) (Anderson, 2009), biomedical research innovations, student loans, and intellectual property assets through financial securitisation16 techniques, for example. The proposed securitised mechanism is essentially a customised asset-backed security (ABS), with elements of a mortgage-backed security (MBS) structure, backed by a pool of underlying exposures that are homogeneous in terms of asset type (FA obligations). 16 Securitisation permits originators of financial assets to obtain liquidity and relatively cheap finance, diversify their investor base, secure off-balance-sheet financing, and replace the risks associated with the ownership of financial assets with income from servicing arrangements and residual interests. 14 1.1 Research Problem, Purpose, Objective, Scope, and Methodology 1.1.1 Statement of the Problem We securitise auto loans, credit cards, student loans, life settlements, mortgages, intellectual property assets, and even cancer drugs (to name a few). Why not securitise financial assurance obligations as well? While governments hold millions of dollars in financial assurance securities, estimates for total liability are often much more substantial. In British Columbia, the government holds approximately CAD$900 million in financial securities; however, estimates for total liability are CAD$2.1 billion, which could result in a potential funding shortfall of approximately CAD$1.2 billion (OAGBC, 2016). Because of this deficit and the risk that mine sites are orphaned or abandoned before proponents fulfil their reclamation requirements, the Government of British Columbia stands to benefit from considering alternative and sound approaches to the collection of financial assurance from the mining industry. Similarly, in 2016 the Department of Environment and Heritage Protection of the Queensland Government (DEHP) commissioned an enquiry by the Business Centre Coal into the suitability of the FA system in the Australian state’s coal mining sector. DEHP published the Report of the Targeted Compliance Program: Financial Assurance for Queensland Coal Mines (TCP 15-009). It found that AUS$4.54 billion is held in EFA in the coal sector (Horn, 2016; Willacy, 2016a). By examining the FA held at 15 mine sites across Queensland, the TCP report observed a shortfall that if extrapolated to all coal mines in Queensland would total AUS$3.2 billion. The 2016 report also found that 19 percent of the EFA put forward by the industry was incorrect and too low (Horn, 2016). Queensland senator, Larissa Waters, claimed mining companies had been dodging their responsibilities (Horn, 2016). 15 Since the recent global financial crisis of 2007-2009, mine operators have found it increasingly more problematic to satisfy financial guarantee obligations required by regulators with the typical FA mechanisms of choice because of surety providers’ large-scale departure from the minerals and metals markets. The troubled surety bond market and the corresponding implications for the mining industry received widespread attention. Anna Zubets-Anderson, a senior analyst at Moody’s, comments that “We are seeing that surety bonding is becoming more expensive and less available.” (Learn, 2016). Besides the poor track record surrounding reclamation collection from mine operators – conflicting, incomplete, and vague environmental regulation can lead to unnecessary higher R&C costs and contradictory interpretation of financial reclamation requirements. Such ineffectiveness and inadequateness can also leave little room to determine optimal levels of financial reclamation for each mine site (Berger et al., 2011). While governments across the world use multiple techniques to manage environmental risks, the focus of the dissertation is financial assurance securities. It investigates if a more effective EFA mechanism can be devised, through innovative social-based17 structured finance, that can handle the costly shortcomings of both the current FA offerings and the governmental regulations surrounding environmental clean-up. The alchemy of structured finance (in practice, most references to structured finance imply securitisation – the terms are often used interchangeably), generally, relies on the principle that there is an arbitrage in risk-reward tranching and that the sum of the parts is different from the whole. If markets are efficient, market prices reflect the true value of the underlying pool of asset(s). If something gets underpriced, there is a profit opportunity. The incentive provides the arbitrage mechanism to make sure that prices rise/fall to the correct level. The purpose of permitting such arbitrage opportunities, provided by inefficient pricing 17 EFA-backed securitisation can be considered a form of social finance since EFABSs (EFA-backed securities) would be designed to generate financial returns while including measurable positive social and environmental impact. Social finance is a technique for managing money that provides a social dividend and an economic return (Varga and Hayday, 2016). 16 of EFABSs, along with greater transparency on FA requirements, could become a more efficient deterrent effect on mine reclamation and closure negligence rather than relying on just governmental regulation to ensure standards continually being met (a conceivable, capital markets’ response, complement to regulatory oversight and enforcement). The usage of market instruments rather than relying on regulation sounds modern and flexible, and hence politicians increasingly argue that environmental policy should be market-oriented instead of merely relying on top-down regulation by government (Faure et al., 2006). Economic instruments (or market-based instruments) are currently prevalent, at least in the literature, but increasingly at the policy level as well (i.e., carbon financial instruments were traded on the now-defunct Chicago Climate Exchange, which was linked to carbon trading measures under the Kyoto Protocol). Many policy analysts interested in environmental policy have, for several years now, advanced the increasing use of these market-based instruments, more particularly as a reaction to regulation (Faure et al., 2006). Regulation is, in that respect, often referred to as a ‘command and control’ (CAC) approach. 1.1.2 Research Purpose, Objective, and Scope If we knew what it was we were doing, it would not be called research, would it? — Albert Einstein The purpose of the dissertation is to deepen the discussion regarding the application of EFA instruments in the mining sector, predominantly, where a mining project’s life followed by reclamation efforts extend well into multiple decades or even in perpetuity. Vagueness about reclamation success and the open-ended nature of the regulatory demands can be disconcerting. Such economic liabilities translate into stock values and place significant pressures on regulatory bodies in government to relax environmental regulations. 17 Financial assurance is required for mining, petroleum and gas, and other activities (e.g., infrastructure, nuclear, chemicals, and livestock farming). When assessing such EFA requirements, regulatory authorities are expected to take into consideration the amount of risk that environmental impairment will result; the probability that action will be necessary to rehabilitate, restore or protect the environment; and the environmental record of the holder of the lease. Adequate, flexible, and suitable FA are necessary elements required for greater mine closure efficiency. It offers a level of confidence to stakeholders that sufficient financial resources to meet closure requirements will be accessible; however, there is a pressing need to guarantee that it is applied promptly and that it is transparent, effective, and satisfactory to all concerned stakeholder parties, and consistent. Although most stakeholders agree that systematic monitoring and enforcement is critical to ensuring that mining projects proceed in compliance with the legal framework, and thus that the risks and opportunities of projects are distributed appropriately, these central activities are frequently neglected (Marshall, 2001; World Bank, 2005; Marcin and Ruder, 2007; OAGBC, 2016). In part, at times due to the lengthy time-horizon associated with mine R&C requirements related to a specific mining project18. Regrettably, regulatory monitoring and reporting requirements often tend towards being static, especially when a mine project’s lifecycle is lengthy. Such oversights need to reflect their evolution both in terms of the mining operations as they unfold and any environmental site reclamation activities as they are implemented. Lacks in capacity, transparency, and government monitoring incentives all contribute to inadequate monitoring, compliance, and enforcement practices. Amendments to regulations after a permit have been granted presents a problematic circumstance as well in the sense that mining operational parameters19 all depend on a financial calculation incorporating compliance cost. 18 The lack of importance for mine site reclamation in the early stages of a mining project can be likened to the ‘retirement problem’ or ‘funeral dilemma,’ as outlined in concepts and methodologies from the behavioural and social sciences. 19 Mine cut-off grade reserves, mine design, and mine planning. 18 One can argue that a mining company contributes to its liabilities over time due to ongoing mining operations, and it removes obligations by executing reclamation initiatives. The concern is who is keeping track of such information as it relates to continuous regulatory monitoring and reporting activities? The principal-agent dilemma (agency problem) involves the government (the principal) and the mine operator (the agent) (Miller, 2005a). One dilemma is that lax regulatory policy and challenges undermining monitoring, compliance, and enforcement requirements create a lower cost and, therefore, higher accounting profits and government revenues, but also more significant long-term environmental impact. Stringent policy, conversely, substantially prevents mines from being developed at all due to high compliance cost. Another concern is that government may be tempted to make reclamation and closure obligations stricter after the mine has been established. Such actions can impact the economic calculations upon which the mine development decision was based. Any regulated industry is at risk of engendering the concept of regulatory capture (Stigler, 1971). Conversely, regulation surrounding reclamation finance depends significantly on input from the activities to be regulated. Such a problem needs to be addressed in any plan to develop alternative EFA instruments for dealing with long-term mine closure issues. Existing environmental management guidelines and policies invariably refer to the need to remediate, reclaim, rehabilitate, restore, or some combination thereof, of the mining site after closure (Lima et al., 2016). The use of words like ‘remediation,’ ‘reclamation,’ ‘rehabilitation,’ and ‘restoration’; however, are used interchangeably in the scientific literature, government reports, and policy documents (Li, 2006). Surety bonding, as an EFA example, is often used to impose contractual and regulatory provisions. Typically, an agent (or a third-party) posts a bond as an assurance of compliance, 19 and it is released when the undertaking is satisfied. For instance, in the mining industry regulation regularly requires post-mining site reclamation. The surety is posted to ensure this is satisfied. If compliance is incomplete or insufficient, the company forfeits the financial bond, and the collected proceeds are employed to finance reclamation efforts. Despite the promise of surety mechanisms for environmental reclamation issues (Costanza and Perrings, 1990), standard forms of FA mechanisms (e.g., cash, irrevocable letters of credit, and surety bonds) entail trade-offs that limit their scope and effectiveness (Shogren et al., 1993). The utilisation of surety bonding to mid- and long-term, and in general, environmental reclamation and closure projects have been narrow and the success mixed (Boyd, 2002). Therefore, investigating the potential effectiveness of alternative EFA mechanisms to regulate mid- and long-term mining projects are expected to be of significant interest to public policy and stakeholders – it is the focus of the dissertation. Structured finance may save the day – a bold statement to make but one that the dissertation investigates. An alternative EFA-securitised20 framework is presented, one that will not necessarily shift the financial assurance obligations surrounding mine closure to other parties (such as consulting and advisory providers or credit rating agencies (CRA)) to manage and oversee but rather to ease the financial burden by spreading the initial upfront deposit costs in a similar manner as a mortgage or loan does while incorporating an asset-backed securitisation framework around it. The investigation of a possible FA alternative, flexible with time horizon, which could conceivably overcome regulatory oversight and enforcement shortcomings, and the restrictions surrounding trust funds and other conventional EFA instruments is expected to spawn further research initiatives. Since such a securitised mechanism would be customised financial solutions and their numbers could be small, and too costly to provide sufficient statistical evidence, a 20 Securitisation is a form of off-balance sheet (OBS) financing which comprises of pooling of financial assets and the issuance of financial securities that are repaid from the cash flows generated by these assets (Baig and Choudhry, 2013). 20 traditional empirical analysis cannot be implemented. The dissertation, thus, offers a conceptual framework that was tested based on some specific and relevant parameters21. The utilisation of fuzzy logic (FL) as a modelling tool is fitting since it is, in part, conceptually easy to understand, flexible, tolerant of imprecise data, it can be built on top of the experience of experts, and based on natural language. The framework is tested by applying a fuzzy inference system (FIS) methodology approach. The FL methodology is applied to attempt to infer and study the potential key attributes leading to the possible success of securitisation deals possessing FA obligations as their underlying pool of assets. The model attempts to understand from the observed data and the fuzzy logic analysis if the likelihood of success of an EFA-backed securitised mechanism is feasible, conceptually, through the possible identification of some key attributes. 1.1.3 Methodology and Research Questions Securitisation markets are a key funding channel for the economy, increasing the availability and reducing the cost of funding for households and companies by opening up investment opportunities to a wider investor base, diversifying risk across the economy and freeing up bank balance sheets to lend. — Jonathan Hill European Commissioner for Financial Stability, Financial Services and Capital Markets Union Eurofi Financial Forum 2015 As complexity rises, precise statements lose meaning, and meaningful statements lose precision. — Dr Lotfi Zadeh Professor Emeritus, EECS, UC Berkeley 21 Using the latest available reclamation liability cost estimates data, which was obtained from the 2014 Mine Reclamation Securities in BC for Metal and Coal Mines report (see Appendix A). 21 Credit constraints continue to be particularly critical for resource extraction companies due to ongoing economic restrictions (McGee, 2018). While the rules on regulatory capital requirements under the Basel III Accord do not seem to have a significant positive impact on lending conditions for mining, oil & gas companies, the ongoing situation of credit markets continues to exert its negative effect in the long run for these industries. Such restrictive market conditions are due to the contraction of financial resources for resource-based projects which impact EFA obligations requirements (Chiesa, 2018). The lack of funding from the credit markets for such capital-intensive companies is particularly critical. There has been a rising interest in new financial tools that may help ease financial constraints on FA obligations, at least in principle. The question of whether tools based on financial assurance obligations may be effective alternatives to the problem of financing constraints for mining companies engaged in progressive reclamation activities appears to be significant and of considerable interest for both regulators and researchers. One way to leverage such obligations could be to securitise them. EFA-backed securitisation can be considered a form of social finance since it would be designed to generate financial, inflation-adjusted, returns while including measurable positive social and environmental impact. Social finance is an approach that sees social and economic issues as two sides of the same coin (Varga and Hayday, 2016). It can be described as an investment made to achieve (i) a beneficial and quantifiable impact on society and the environment; and (ii) an economic return (Echenberg, 2015). The appetite for social finance is growing across the world (US SIF Foundation, 2016; Responsible Investment Association, 2017). Publications in the field of FA obligations outstanding, as it relates to mining, have been constrained by the lack of available public data and by the high level of secrecy surrounding such required financial obligations by mine operators (MEM, 2016). 22 A wide range of issues limits the suitability and diffusion of EFA-backed securitisation. First, they are complex instruments of financial engineering, which involve high structuring costs. Second, estimating the value and risk profile of a portfolio of FA assets would be a challenge for the development of these proposed solutions. Lack of generally accepted methodologies for the valuation of R&C costs and the high degree of uncertainty to which financial assurance value is subject to would strongly affect the confidence in FABS22 instruments. To the author’s knowledge, no other research has been conducted on such securitised instruments. The dissertation provides a unique approach that adds value to the research landscape surrounding the search for more effective and readily accessible financial assurance instrument solutions for the resource extractive industries. Securitisation financing, in general, is a challenging area of study. In particular, literature and available data on FA-backed securitised financial instruments are non-existing. The research in this field could be constrained by the limited number of such securitisation deals (if any), by the lack of existing data, and due to the high level of secrecy surrounding existing transactions. Consequently, a conceptual framework was developed and tested. It was explored by using a fuzzy set model that includes key attributes leading to the potential success of securitisation deals having financial assurance obligations as their underlying pool of assets. The framework consists of a set of independent crisp inputs that are converted to linguistic variables that are assumed to explain the possible outcomes that such a securitised offering may have in the mining sector. Through simulation, the model is tested on two portfolio samples based on the latest available reclamation liability cost estimates data (see Appendix A). It highlights the potential for securitisation for each observed FA obligations portfolio. The model attempts to infer from the observed data and the FL analysis if the likelihood of success of an EFA-backed securitised mechanism is feasible, conceptually, through the possible identification 22 FABS (FA-backed security) and EFABS are interchangeably used in the dissertation. 23 of some key attributes. There is, however, no evidence available on this topic that directly supports or refutes the observed conclusions outlined in the dissertation. The securitisation-based conceptual framework provides the basic structure from which the research questions – and, therefore, the methodological approach to answer the questions – are drawn. Critical issues that the dissertation addresses include: • Can securitisation provide a reliable, regulatory approved, financial assurance funding source to the mining sector, among others, for reclamation and closure obligations in the advent of diminishing surety providers? • Can environmental financial assurance obligations potentially be securitised? • Can key attributes be identified that may influence the likelihood of success of a financial assurance-backed securitised mechanism? The dissertation addresses whether obstacles exist that could hinder EFA-backed securitisation from becoming a successful means of financing reclamation requirements as it has proved to be for other unmarketable, and even intangible, assets. An explanation as to why financial assurance-backed securitisation remains an untapped niche market could be due to what can be described as an integrated risk analysis. That is, there exists a set of interdependent (therefore, combined) risks that are present in such a securitisation process (e.g., underlying asset risk, legal risk, regulatory risk, commercial risk, credit risk, counterparty risk, and country risk) that would dictate its overall market success. Securitisation works to diversify such residual risks once the underlying assets have been pooled. If the associated risks of each pooled asset are not highly correlated, tranching allows the issuer to exploit the risk diversification effect of pooling to create a highly-liquid and low-risk security. Despite the analysis undertaken, the market potential for EFA-backed securitisation will remain uncertain until case studies have been completed, and conclusive results are 24 observed. Future case studies in multiple jurisdictions are being planned to examine the possible likelihood of such market potential. 1.2 Academic and Industry Significance Regulatory monitoring, compliance, and enforcement (RMCE), which are essential to ensuring that mining projects advance in accordance with the legal framework, are often neglected even more so in some jurisdictions with slow economic growth (Dean et al., 2009). Structured finance can potentially play a role in strengthening RMCE requirements through the adoption of new and innovative forms of FA instruments which would possess built-in monitoring, compliance, and economic enforcement mechanisms that are both cost-effective and efficient. The author is optimistic that the dissertation could spawn a sound financial mechanism for a new form of, inflation-hedging, financially innovative tool that could be well-received by concerned stakeholders, including institutional investors (Deacon et al., 2008; Canty and Heider, 2012; Perrucci and Bénaben, 2012). The proposed EFA-backed securitisation mechanism is an enhanced, hybrid-form, of a general trust fund (e.g., Mine Rehabilitation fund, Abandoned Mine Land fund, or Abandoned Mine Reclamation fund) that is incorporated into an ABS framework (with some features similar to an MBS). Such financial innovation could also positively impact the effectiveness of regulatory legislation (to govern how RMCE are conducted) and possibly lead to tax code updates, and securities regulation reform in some jurisdictions, and the creation of employment opportunities. It could also provide greater data exposure surrounding reclamation monitoring and liability costing to stakeholders. More importantly, it could ensure timelier reclamation should a mine operator be unable or unwilling to perform the required environmental R&C actions by promptly providing the necessary funding. 25 The importance of the global financial sectors in influencing the environmental and social quality of resource-related project initiatives is already broadly recognised. Almost two decades have passed since the World Bank included provisions to guarantee that any project financed by the Bank or the related International Finance Corporation (IFC) anywhere in the world must consist of appropriate standards of mine reclamation and closure responsibilities, including the nature and amount of financial assurance in its Pollution Prevention and Abatement Handbook (Peck, 2011). After the financial crisis of 2007-2009, the term financial engineering mutated into a curse for many financial market participants. Securitisation unfairly became ‘taboo’ for many investors, credit agencies, and regulators alike. Despite the allegations of the overuse and misuse of securitisation, stemming from manipulation, fraud, and other abuses, in the commercial, industrial and residential market, and in other markets, it is an essential and indispensable structured finance technique for financing significant ventures. Fusing portfolio theory with securitisation, in the extractive industries, could spawn into some viable mid- to long-term EFA alternatives. Such a structured finance method can be utilised to assist in funding something as crucial as reclamation obligations when standard forms of FA with their inherent limitations, including monitoring, compliance, and enforcement, may not always be the appropriate option. If the life expectancy of a mining project and the required amount of time needed to effectively clean-up and reclaim the mine property is several decades, or more, into the future, this is especially so. Similar to an MBS, the proposed financial assurance securitised mechanism is a collection of a type of asset (financial assurance) combined into a group, divided in tranches of different credit quality and therefore of varying subordination, and evaluated using weighted average characteristics. The size and diversification of each financial assurance pool are expected to decrease investment risk for the investor to the point where the expected, inflation-26 adjusted, returns are predicted to outweigh the risks for the high-quality23 and to, some extent, the mezzanine tranches as well. These appealing features should attract the attention of many types of sophisticated investors, for both their social financing, returns potential, principal protection features, and inflationary hedging properties. Anticipated investors for such an EFA securitised mechanism offering could include insurance companies, pension funds, money managers (including exchange-traded funds, ethical funds, and the like), sovereign wealth funds24, and sophisticated individual investors. Such investors, with access to sizable amassed fortunes, are continuously seeking new investment opportunities with acceptable levels of risk and return to enhance their alpha returns25 from their pool of diversified investments. The proposed securitised mechanism would be considered socially responsible investing (SRI) (i.e., socially conscious, sustainable, ‘green’ or ethical investing). By its definition, it is an investment strategy which seeks to consider both social/environmental good and financial return to bring about a positive change in the context of successfully meeting specific environmental reclamation, closure, and long-term liabilities objectives in the metals and mining sector but not necessarily exclusively (OECD, 2006; Marlowe, 2014). There is a growing interest in such social investments, among institutional investors and others, globally (Berry and Junkus, 2013; Marlowe, 2014; Auer and Schuhmacher, 2016). 23 All the combined tranches in a securitised mechanism make up what is referred to as the deal’s liability structure or capital structure. They are commonly paid sequentially from the most senior to most subordinate (and typically unsecured), although specific tranches with the same security may be paid simultaneously. In this context, it relates to circumstances where two or more securities are uniformly managed without any act of preference. The senior (high-quality) tranches possess the highest credit quality with the lowest yield. Subsequently, the mezzanine tranches are next in line with lower credit quality and higher yield, while the subordinate (subprime) or equity tranches receive residual tranches and are of least credit quality with the highest yield. For instance, senior tranches may be rated AAA, Aaa, AA+, Aa1, AA, Aa2, or A, while a junior (subordinate), unsecured tranche may be rated BB or Ba2. 24 Two of the top 15 sovereign wealth funds (SWFs) worldwide, with a combined value of over $7.09 trillion (as of November 2018), by AUM, are i) Government Pension Fund Global — Norway ($1.06 trillion) and ii) China Investment Corporation — China ($941.4 billion) (Statista, 2019). Preqin (2018) states that SWF assets jumped (13 percent year-on-year) to $7.45 trillion in March 2018 — a size comparable to that of the entire alternative assets industry. 25 The active return, in excess of a specific market index, of an investment. 27 The tranched issuances within the proposed EFA securitised mechanism, which could be viewed as a next-generation form of social impact bonds (SIB), would each possess a different risk profile and financial return (Herrera, 2015). A feature for such transactions would entail higher usage of credit ratings by issuers. The ratings offer a market signal as to the credit quality of the particular asset. For instance, such a SIB tranched EFA obligations-based issuance could possess the following tranches and interest rate pay-outs: senior tranche (A%), mezzanine tranche (A% + B%), and equity tranche (A% + B% + C%) (listed from least to most risky). With a tranched SIB, if the SIB issuer were unable to pay the owed interest to the investor, the equity tranche holders would consequently take the first loss, followed by the mezzanine, and then senior tranches. Such a tranched SIB-based securitised mechanism could expand the potential social impact investor base since they would provide a more extensive array of risk profiles (and thus, interest rates) in the same issuance. Such features could make the mechanism appealing to social investors. One of the crucial factors to the possible success of the proposed EFA-backed securitised instrument will be the use of an additional layer of RMCE that will rely on early indicators of potential failure of a mining company. Empirical research on environmental enforcement confirms that effective monitoring helps to discourage regulatory violations (Cohen, 1998). Multiple independent third-parties will be investigated to determine if such impartial (non-political) entities can provide value to the good governance (transparency and accountability) process at a reasonable cost to assist regulators in the surveillance responsibilities. These entities include consulting and advisory providers, credit rating agencies, and agencies of the United Nations, such as the United Nations Environment Programme (UNEP), through their United Nations Environment Programme Finance Initiative (UNEP FI) (Peck, 2011), and the Bank’s Oil, Gas and Mining Unit. Another objective of the dissertation is to investigate if the proposed enhanced, positive-sum, reclamation mechanism framework can indeed be developed for market use given the findings of the research (Klein, 1991; Wright, 2000; Wright, 2006). 28 1.3 Dissertation Outline The dissertation contains five chapters, references, and appendices. The first chapter briefly describes the background to the analysis presented in the dissertation and outlines the framework within which it is set. It describes the government requirements for EFA for environmental risks in approved mine R&C requirements, its significance, and the scope of the dissertation. The second chapter provides a literature review of the general concepts underlying financial assurance and the limitations and challenges regarding mine reclamation security. A short discussion is also presented on how financial innovation can play a part in ongoing efforts to mitigate environmental risks. The third chapter offers a background surrounding the regulatory approved funding mechanisms available to mine operators for reclamation efforts, and it outlines key issues that concern various stakeholders relating to EFA. The section also provides a brief insight into some of the critical institutional arrangements for mine closure planning and characterisation of current mining reclamation security (financial assurance) regulation for many mining jurisdictions around the world. The fourth chapter includes a framework overview of the proposed FA-based securitised mechanism. It also describes and explains the methodologies applied, and it discusses the benefits and drawbacks of asset-backed securitisation, which the EFABS mechanism is partially based on, to critical stakeholders. Several critical potential determinants leading to the possible success of securitisation deals having financial assurance obligations as their underlying pooled asset are also studied. A conceptual framework is proposed and tested by applying a Mamdani fuzzy inference system-based methodology. In the fifth and final chapter, conclusions, contributions, and recommendations for future research are presented. Finally, the references are then listed, and appendices are located at the end of the dissertation.29 Chapter 2: Literature Review You never let a serious crisis go to waste. — Rahm I. Emanuel Former Chicago Mayor Mining activities characteristically involve the displacement of large volumes of rock and soil, resulting in various degrees of environmental degradation. Mine reclamation entails restoring these disturbed areas to a previous natural resource setting, such as forest or agricultural land uses while minimising environmental impacts. Financial assurance for mandatory reclamation and closure requirements, which is held in escrow, is designed to serve as an insurance policy, of a sort, to provide adequate funding, when required, to government regulators to deal with clean-up, closure, and reclamation expenditures, in accordance with the approved R&C plans, if a mine operator is unable or unwilling to fulfil such duties (Peck and Sinding, 2009; Malone and Winslow, 2018). Multinational companies must conform to increasingly rigorous domestic regulations and may adopt voluntary practices that exceed regulations. There is some confusion that free-market policies applied to attract mining investment have led economically developing nations to weaken their environmental regulations. The subject is still heatedly debated (Gallegos and Regibeau, 2004). There continues to be no consensus among researchers whether environmental law adversely or favourably impacts a company’s behaviour. Some of them argue that mining companies are low-cost seekers and, consequently, minimise activities when they are up against strict environmental standards (i.e., pollution haven hypothesis). Others stress the role of clean natural resources and pioneering technologies in the production process (factor endowment hypothesis (FEH) and Porter hypothesis (PH)) (Gallegos and Regibeau, 2004). According to this view, environmental regulation should govern a company’s activities. Consequently, the relationship between these aspects will 30 produce different results, such as a cleaner environment in the host country than anticipated by the pollution haven hypothesis (PHH). Empirical research has determined that strict environmental policy is just one determinant in location decisions, and a negligible one, compared to other country factor endowments such as quality of infrastructure and the accessibility to low-cost country sourcing (Jaffe et al., 1995; Tole and Koop, 2010). Geology is a dominant factor that influences it. PHH expects that rigorous environmental regulation in developed countries lead to the repositioning of pollution-concentrated production away from high-income nations toward economically developing nations, where regulations are comparatively weaker. If these lower regulatory standards in developing nations can be considered as an additional source of comparative advantage, it is reasonable to be troubled that governments could try to attract foreign direct investment (FDI) by aggressively undercutting each other’s regulations, and consequently turning developing nations into pollution havens (Neumayer, 2001; Zeng and Eastin, 2011). Conversely, capital or export inflows can also be discouraged by stricter environmental regulations (Taylor, 2005). FEH deviates from PHH by hypothesising that factor endowments, and not just differences in environmental legislation and regulations, are the core incentives for trade patterns (Temurshoev, 2006). Trading economies will specialise in production where comparative advantage is evident – this infers that nations, where capital is abundant, will export capital intensive (dirty) products. Conversely, countries, where access to capital is limited, will witness a decrease in pollution levels given the reduction of the pollution-producing industries. The impacts of open-trade on the environment are contingent on the distribution of comparative advantages across countries (assuming resource endowment). The Porter hypothesis assumes that stringent regulations have the potential to encourage efficiency while promoting innovation that supports greater competitiveness (Porter and van der Linde, 1995). 31 Substantial empirical research has been carried out in seeking for confirmation for pollution haven practice amongst companies (Neumayer, 2001; Zeng and Eastin, 2011). These studies have come up with different conclusions. Dean et al. (2009) examined pollution haven behaviour by assessing the determinants of location preference for equity joint ventures in China. The study results concluded that weak environmental standards attract highly-polluting industries funded through Taiwan, Hong Kong, and Macau. Chung (2014) also found evidence for the pollution haven effect (PHE) in the pattern of Korean FDI over 2000-2007. A similar finding was observed when Korean imports were analysed. Eskeland and Harrison (2003) examined the pattern of FDI in four developing countries and found minimal indication to support PHH. Levinson and Taylor (2008) observed that environmental policy and regulation had a revealing impact on trade flows that adheres with the PHH, after taking into consideration unobserved endogeneity and heterogeneity of pollution reduction cost measures. In contrast, Costantini and Mazzanti (2010) illustrated that environmental policies, coupled with innovation activities, promote competitive advantages of green exports. They also trigger greater efficiency in the production process, consequently turning the concept of environmental protection initiatives as a production expenditure into a net benefit. In the last two decades, a growing number of countries have become increasingly aware of environmental issues, and many of them have taken adequate measures to regulate and to protect their environment (United Nations, 2015). Voluntary standards have also been employed by mine operators to achieve and maintain their social licence to operate (SLO). Since the 1990s economically developing countries have implemented environmental regulations and established administrative structures to enforce these laws; regulatory and legal reforms have enhanced environmental rights and legal protection of the environment 32 in Latin American and African countries (United Nations, 2015). National courts of justice ultimately enforce the implementation of such regulations. At the global level, environmental standards have also been strengthened. Environmental treaties include the United Nations Conference on Environment and Development (1992); the Control of Transboundary Movements of Hazardous Wastes within Africa and the Bamako Convention on the Ban of the Import into Africa (1993); the International Convention to Combat Desertification in those Countries Experiencing Serious Drought or Desertification (1994); the European Convention on Access to Information, Public Participation in Decision-Making and Access to Justice in Environmental Matters (1998); the United Nations Conference on Sustainable Development (2012); and the United Nations Sustainable Development Summit (2015). The perceptions of mining companies working abroad also dispel the belief that environmental regulations are more stringent in developed countries than in developing nations. According to the Fraser Institute, a Canadian public policy think tank, more mine operators avoid investing in Latin America due to constraints or uncertainties from environmental regulations than would avoid investing in Canada for this reason (McMahon and Cervantes, 2012). Nevertheless, regulatory uncertainty is an issue since environmental regulations that lack clarity and stability can bring about different understandings, higher compliance costs, and increased political interference (World Bank, 2005). The primary approaches to environmental policies and regulation are direct regulation, via command and control, and market alternatives (economic incentive mechanisms (EIM)). Under CAC, the authority (regulator) will specify how polluters are to behave. In contrast, Oates (1996) defines economic incentives as a system (i.e., EIM) through which the authority creates economic incentives for abatement activity but leaves polluters free to decide their responses to these inducements. 33 The basic concept of CAC is that it is the task of the regulator to gather the information required to decide upon actions to control pollution, and then to demand potential polluters to take specified actions. Thus, the difference between the two methodologies is mostly defined based on the amount of government involvement regarding the specific conduct of polluters. Both CAC and EIM have been discussed in the literature (Baumol and Oates, 1988; Oates, 1996; Hackett, 2006; Castellucci and Markandya, 2012; Máca et al., 2012; Steinberg and VanDeveer, 2012; Wiesmeth, 2012; Callan and Thomas, 2013; Phaneuf and Requate, 2017). Cornwell and Costanza (1994) compare CAC and EIM approaches, and some aspects have been adapted to the mining sector. The command and control approach consists of creating and enforcing laws and regulations, and of setting objectives, standards, and technologies that agents must comply with. The economic incentive mechanism offers incentives that promote the desired behaviour while permitting companies the ability to act on their knowledge of their mitigation and production costs. Such a mechanism decentralises the decision-making process to protect mine sites and their disturbed surroundings. It also relies on performance objectives instead of a pre-established course of action. Regarding government intervention, Ogus (1994) categorised several regulatory instruments concerning the degree of intervention. The least interventionistic instruments are economical and information provision instruments, while the most interventionistic instrument is prior approval. Between these two extreme instruments lie environmental standards. The classification of the economic incentives approach typically embraces the use of pollution taxes and subsidies, deposit-refund systems (e.g., financial assurance), marketable emissions permits, and liability rules. 34 Economic analysis specifies that current methods of environmental protection, mostly based on CAC strategies, are ineffective and frequently provide disincentives for costs reduction (Cornwell and Costanza, 1994). The central reasons are: • increasing reservations in calculating closure costs; • costly and lengthy litigation processes; • homogeneous treatment of mine operators; • significant information burden on the regulatory agency (selecting the best technology and enforcing penalties for noncompliance); • the minimal motivation for the development of innovations that can encourage improvements and cost reductions; • regulatory avoidance rather than regulatory compliance; and • the ambiguous statutory language that permits companies to build convincing legal arguments that show that mounting requirements are unattainable. The regulatory approach of the CAC instrument has been subject to criticisms as well. They can be summarised as follows (Faure et al., 2006): • A traditional command and control system focuses on a permit or licensing system. Within this system, permits traditionally set emission standards, in the oil & gas sector, but these often disregard the effect of the aggregate level of emissions on the environmental quality of the receiving environmental medium. • It requires high levels of information and enforcement costs. If the controls are too strict, costs will be too high. If conversely, the level of control is too low, the damage costs for society as a result of environmental pollution will be too high. • It has often been argued that the CAC approach has, in many cases, failed to generate adequate inducements for polluters to decrease their pollution levels. • It cannot equalise the marginal pollution costs of pollution control among different polluters that produce the same pollution. The reason has to do with the fact that a command and control approach is often too general and too unspecific. 35 • Under a CAC approach, polluters will only pay the prevention costs required to comply with the regulatory standard. However, polluters under this method will not necessarily be required to pay for the costs of residual damages associated with the pollution that they have produced in conformity with the standard. Considerable disadvantages in the traditional CAC approach thus exist, which can be summarised by the fact that the regulatory standard is often too general and not flexible or differentiated enough. An optimal environmental policy would require flexible, market-based, instruments, such as the proposed FA-backed securitised mechanism. It, on the one hand, will provide more flexibility (taking into consideration the individual prospects for optimal pollution abatement by each polluter) and, alternatively, it will offer optimal incentives towards environmental technological innovation and not merely compliance with a regulatory standard. The legal structure governing mining activities in most provinces and territories, in Canada, and states, in the United States, are, in most instances, well defined by statutes and regulations. Mining in these jurisdictions and other countries presents progressively complex cost and compliance issues. Government enforcement regimes, worldwide, tend to be costly, and host governments, which have many social or geopolitical matters to address and enforce, cannot, at times, be relied upon to act against the mining industry in the name of environmental standards (Marcin and Ruder, 2007). Lack of proper monitoring, compliance, and enforcement capabilities can impede the willingness of a mining company to improve its environmental performance standards even in well-established mining jurisdiction such as BC, Canada (Marshall, 2001; Marcin and Ruder, 2007; OAGBC, 2016). The view of environmental surety bonds as a form of financial assurance is rooted in the theory of ‘materials-use fees,’ first developed in the early 1970s. Several economists advocated programmes where governments would collect a materials-use fee from the industry when they could be found responsible for releasing harmful substances into the 36 environment (Solow, 1971; Bohm and Russell, 1985). The cost would be refunded to parties who can verify that they had disposed of materials, with the generosity of the refund varying according to the chosen disposal method (Solow, 1971). As this early work on the topic suggests, the collection of EFA by regulators is grounded in the PPP, in turn, underpinned by the notion of strict liability, which holds that agents responsible for damages compensate all other affected parties (Becker and Stigler, 1974; Cropper and Oates, 1992; Gerard, 2000; Ambec and Ehlers, 2016). 2.1 Review of Mine Reclamation Security A methodology to evaluate mine reclamation FA was developed by the Environmental Law Alliance Worldwide (ELAW). ELAW (2010) comments that the following three factors are essential in suitable financial assurance: • reclamation and closure plans should contain a commitment by the mine operator to pay for reclamation and closure expenditures during the active phase and the closure phase of the mining project; • it is essential to make available this financial commitment before the commencement of any mining activities and in an irrevocable form; and • the mine closure plans should indicate an adequate amount of funds that the mine operator would pledge, in escrow, to pay for reclamation and closure expenditures (these costs would be updated periodically to reflect any changes in site conditions or requirements in the order or approval, and, subsequently, the posted financial assurance requirement would be adjusted accordingly). 37 2.1.1 Surety Bonds: Limitations and Challenges There are several possible complications associated with surety bonding (Shogren et al., 1993; Boyd, 2002; Mooney and Gerard, 2003; Boyer and Porrini, 2008). Shogren et al. (1993) list moral hazard, liquidity constraints, and legal restrictions on contracts as possible shortcomings related to performance bonds in environmental regulation. Collecting financial assurance through environmental bonds mitigates the adverse impacts of resource depletion, providing enforcement through market-based incentives leading to low-cost land reclamation (Bohm and Russell, 1985; Peck and Sinding, 2000). The literature also includes a countervailing perspective; however, stressing the restrictions and key trade-offs associated with EFA policies. A summary of the various limitations and critiques follows. Bonding is expensive, both in terms of the associated transaction costs and of the liquidity constraints imposed on companies at the onset of the project. Jose et al. (1996), Nobanee et al. (2011), Al-Shubiri and Aburumman (2013), and Takon (2013) all discussed the cash conversion cycle and the continual requisite for free cash flows to ensure the liquidity of a mine operation. A perception of such applies to mining given the substantial amount of initial cash outlay on capital costs that are accumulated and the expectation of early positive cash flows by investors, and subsequently by mine operators. If the company cannot guarantee positive cash flows on the onset of a project, its riskiness would rise, which would then increase its cost of capital. As is the case with liability, surety bonding becomes more expensive as complexity increases, hence restricting its effectiveness. If the costs of monitoring, compliance, and enforcement are minimal and the mine operator poses an insignificant default risk, then mandatory, hard forms, FA requirements may perhaps be a real cost to such companies. One consequence if bonding is costly is that there could be less of the regulated mining activity and possibly fewer corporate entities involved within the host jurisdiction. 38 A surety bonding obligation can also tie up the operating capital funds of a company, imposing liquidity constraints on them. Such restrictions become more binding as the deposit amount increases. The use of a third-party provider, such as a surety provider, is one method to reduce but not eliminate the liquidity constraint (Gerard, 2000). A possible drawback on the reliance of liability rules and bonding as deterrence mechanisms is the potentially long latency period between the mining company’s operational activities and the potential harm afflicted (e.g., a spill or leak of a cyanide-containing solution, toxic substances, and the realisation of the leakage) (Shavell, 1986; Ringleb and Wiggins, 1990). Two issues could subsequently arise. For long-term horizons, this is an issue since the responsible party may become insolvent before the damage arises. For surety bonds, the limitation of having financial capital tied up for such long periods is a concern. As is the case with liability rules, the lengthy expectancy period between the company’s operational activities and the potential harm can present complications for bonding mechanisms. Not only is it conceivable that responsible parties will become insolvent before the damage arises, but the bonding obligations could also tie up considerable, and possibly much-needed, financial capital indeterminately. Due to increasing ambiguity as time horizons expand, financial assurance providers are less likely to underwrite surety bonds over time horizons where there exists considerable uncertainty. Mining projects require clearly defined time frames and levels of responsibility. The refundability of the bonds is an effective means to encourage socially efficient environmental outcomes only if it reflects the social cost of misbehaviour (Gerard, 2000). Risk-pooling policies such as insurance have emerged as a potential complement to surety bonding as part of a broad environmental policy (Poulin and Jacques, 2007). Similarly, a policy mix of an environmental bond and a modified Pigouvian tax has been advocated to help achieve both risk-sharing and efficiency objectives (Farzin, 1993; White et al., 2012). 39 Concerns regarding the imposition of liquidity constraints on mine operators also give rise to the possibility of utilising insurance as either a complement or substitute to surety bonds (Shogren et al., 1993; White et al., 2012). Some researchers suggest that the availability of insurance products would relieve the liquidity constraint connected to bond rules (Shogren et al., 1993). In the absence of private options for insurance26, a jurisdiction-sponsored institution providing insurance products might be considered an alternative FA mechanism for addressing the liquidity concerns implicit to an environmental surety bonding scheme. A further constraint of environmental bonds is that they often reflect minimum R&C costs (Peck and Sinding, 2009). Under circumstances of imperfect monitoring, the practical value of a surety bond should be set to reflect both the value of evasion and the possibility of detection (Shogren et al., 1993). In other words, this model of environmental policy holds that, when set at an adequate level, such financial assurance bonds can escalate the costs of dodging to a level that brings into line company behaviour with social preferences for environmental quality (Shogren et al., 1993). When these bonds are set too low relative to the gains from avoidance on environmental responsibilities, the costs of doing so would not be adequate to penalise poor performance in reducing environmental reparations. Parties liable for environmental damages would then be able to shift the related risks to the rest of society at a low cost (Costanza and Perrings, 1990). In conjunction, uncertainty restricts the ability of decision-makers to request the appropriate surety bond level from relevant parties where the range and probability of the future effects of present actions are unknown. It is not possible to calculate an expected value for the outcome of those actions (Costanza and Perrings, 1990). Coming up with a fair estimate of reclamation liability ex-ante is problematic, particularly with the continuing possibility of catastrophic environmental events. 26 Likely due to information asymmetries and self-selection bias (Akerlof, 1970). 40 Another shortcoming of common financial assurance mechanisms in some jurisdictions, where regular updates of FA are mandatory, is that they do not sufficiently deal with time value of money (TVM). The average life of a typical mining project is often well in the decades, and the importance of having a nominal EFA returned at the end of the mine production period is insignificant from a mine operator’s standpoint (Igarashi et al., 2014). The concern boils down to one of investing the financial assurance obligations in an interest-bearing security or bank account, so that accrued interest is accessible to cover the increasing costs of reclamation efforts over time (Otto, 2009; OECA, 2015). TVM should not be confused with inflation (Rudawsky, 1986). Under inflationary conditions, the value of future income will be less than that of the same revenue at present, due to a general rise in the price level. Nevertheless, the inflationary effect does increase and magnify the time value of money. Changes in price levels do not create the TVM; they only influence its magnitude for any given time frame. A more economically rational system would require an FA mechanism, at the start of mine development, such as the interest-bearing securitised one that is proposed in the dissertation. The proposed system would offer some appealing options for increasing the incentive of mine operators to perform the R&C obligations. One possibility is to share the accrued interest on the mechanism between the host jurisdiction and the mining company. The influence of private interest in environmental law has been addressed, specifically in the literature concerning the issue of instrument choice. The selection of FA instruments that can be utilised to control environmental pollution was specified, indicating that the research suggests under what kind of circumstances a particular type of policy instrument would be optimal. In practice, these ‘economic prescriptions’ are not always followed. The effect of lobbying on instrument selection has also been analysed in many papers (Hahn and Noll, 1983; Hahn, 1989a; Hahn, 1989b). Hahn points out that policy instruments are seldom used in the way that is suggested by economic theory. 41 Bearing in mind the advantages and disadvantages of the various approved FA instruments, it can be concluded that there is no single instrument that can be used for all circumstances. The proposed financial assurance-based securitisation mechanism would be just another tool that government regulators worldwide would possess at their disposal. More importantly, it may be more efficient to use a hybrid system that combines more than one instrument. In such instances, Oates and Baumol (1996) concluded that the protection of the environment could be best pursued by using a combination of various regulatory instruments, namely the grouping of CAC and EIM measures. 2.1.2 Setting the Surety Bond Amount Setting the amount of the surety bond is a central dimension of bonding requirements. Due to the costs involved on the side of the mine operator and the probable public liabilities, it is often a contentious issue. Gerard (2000) proposes a simple model to demonstrate that companies with deep pockets can be expected to abide by regulatory requirements even if the financial sum of the bond posted is less than the expected compliance costs. In many instances, regulators and corporate entities cooperate on several projects, and the frequent interactions and reputation effects, especially in today’s world of increasing active mobile social users, act as a check on opportunistic behaviour. Furthermore, since companies are responsible for reparations or risk reduction, then defaulting on a surety bond will only result in ensuing litigation. A consequence of these liability rules and reputation effects is that the mine operator’s financial position should be a factor in determining if a bond is appropriate. Another result is that rather than setting surety bond amounts at the worst-case scenario, compliance can be encouraged even if bond requirements are lower than expected R&C costs. 42 2.2 Role of Securitisation in Modern Economy It is widely agreed that when used appropriately, securitisation can increase the availability of credit and reduce the cost of funding. As a funding tool, it can contribute to a well-diversified funding base. As a risk transfer tool, it can also act to improve capital efficiency and allocate risk to match demand. — European Securities and Markets Authority, June 2016 Securitisation usually only thrives in economies with developed capital markets. Constraints on lack of information about the borrowers, transferability, and freedom of the parties to design both the terms and form of transfer of the loans are not conducive to creating markets in loans and ABS instruments (Hu, 2011; Buchanan, 2017). Securitisation arose due to the inefficiencies of the bank-dominated money markets (Hu, 2011; Buchanan, 2017; Deku and Kara, 2017). Benefits from securitisation include protection from interest rate risk and sometimes repayment risk, increased liquidity, and a more efficient flow of capital from investors to borrowers. It may allow institutions to attract long-term funds more economically than would be possible with more conventional financing tools. Additionally, securitisation can offer the originator with a new source of fee income from originating and servicing the securitised assets (Hu, 2011). Furthermore, most banks (i.e., originator) pay corporate income taxes, but securitisation vehicles (i.e., SPVs) do not – a further source of revenue. Tax issues, however, would arise for such securitisation transactions, these include: i) whether the transfer of assets from the originator to the SPV will be treated as a sale or a loan; (ii) the degree to which the SPV itself would be taxed; and (iii) the degree to which the investors who purchase the financial assurance securities will be taxed. The tax consequences of the transaction would be especially important for the originator. By understanding the tax treatment of the transaction, all parties involved would be able to make informed choices as to whether structuring such a securitisation deal would be worth the time, effort, and expense. 43 In general terms, the tax issues on securitisation can be broken down into five main categories, which in turn can be separated into those issues in the originator jurisdiction(s) and those in the issuing SPV jurisdiction(s). This is illustrated in Figure 2.1, showing a traditional (though simplified) securitisation structure. Figure 2.1: Categorisation of Tax Issues Affecting Securitisation The tax analysis in the originator will commonly seek to ensure that tax neutrality (at worst) is obtained as a result of the securitisation transaction. To summarise the main elements observed in Figure 2.1: 1. Sale of Assets: In many securitisation structures, the originator sells the assets to an SPV, at an arm’s length, potentially giving rise to corporate income tax, VAT, and transfer tax implications. These are largely issues in the home jurisdiction of the 44 originator and, certainly in respect of commonly securitised assets, should be broadly well-known and manageable. Often (though not always) they are issues for the originator which do not affect the rating process. 2. Withholding Tax on Income Stream: In many jurisdictions withholding tax may potentially arise on the income produced by the underlying assets (or secured on the underlying assets where the funds reach the originator in secured loan form in structures, such as whole business securitisations for example where there is no actual sale of underlying assets). This depends on several factors including the nature of the income, and the status of the originator, the SPV, and the source of the underlying income (e.g., mortgage borrowers in the case of a mortgage securitisation). This (potential) withholding tax cost is a key determinant of the securitisation structure as a whole and to the type of assets commonly securitised. Where withholding tax is not imposed by a particular jurisdiction, or at least not in respect of the relevant asset class, the location of the securitisation SPV, including whether to locate onshore or offshore, is left to be determined by other factors. Issuing SPV Jurisdiction: In the issuing SPV, the main focus is on the reliability of cash flows, including taxation (or, typically, its virtual absence), so as to maintain the integrity and the rating of the SPV. These factors are, of course, driving factors behind the ability to raise cheaper finance than would otherwise be available. 3. Withholding Tax on Investor Return: Commercially, interest paid on the notes issued by the SPV must not carry withholding tax. This is generally achieved fairly readily but depends on the tax jurisdiction of the SPV, the nature of the bonds issued, double tax treaties, and specific withholding tax exemptions. 4. Taxation Within the Issuer: The securitisation SPV will typically be a corporate entity in its own right (and therefore, in many jurisdictions without a special securitisation regime, a corporate taxpayer). Given the need for a high degree of certainty regarding the tax liability of the special purpose vehicle, the offset of income and 45 expenditure should be clear and predictable. Canada, for example, has complex offset rules and, where such difficulties are encountered, one option for Canadian originators would be to locate the securitisation SPV in a jurisdiction with more straightforward offset rules or indeed in a tax favoured jurisdiction. This has often not been possible, mainly for withholding tax reasons. 5. Profit Extraction: Regardless of the ability, or otherwise, to effectively offset expenditure against income in the SPV, the structure should allow the originator to extract profit from the special purpose vehicle in a tax-efficient way. There are various means of doing this with perhaps the most common being the payment of deferred consideration by the SPV to the originator in respect of the original acquisition of the securitised assets. One key purpose of the EFA-securitised mechanism is to offer additional sources of funds for financial assurance financing while encouraging lower interest rates and longer-term EFA financing. Under such a structure, as the financial assurance holders make their periodic payments, these funds are channelled to the investors. The mine operators are generally unaffected by, and may even be unaware of, the securitised transaction. Environmental protection regulation, in combination with effective supervision and enforcement stemming from the efforts of the regulators and features of the proposed securitised mechanism, is expected to reinforce or enhance trust in the financial assurance system within which the relationship between the regulator and mine operator arises, by enhancing trust in the regulatory context. In this regard, such trust is complementary to the confidence of environmental law and regulation. Securitisation may also increase the liquidity of a portfolio by making it possible to package and sell these otherwise sometimes low-liquid pooled assets in an established secondary market (Davidson et al., 2003). Greater diversification may be attained since an investment institution can hold the same dollar value of a particular type of investment. 46 Protection from interest rate risk exposure is also beneficial to long-term institutional investors, such as mutual funds, pension funds, and insurers (Hu, 2011). Securitisation offers a more efficient flow of funds from investors to companies that require financial resources for the development of their new and existing projects or services. Many institutional investors prefer to invest in long-term instruments, such as 10- to 100-year high-quality market (HQM) corporate bonds, since they characteristically generate a consistent and healthy income stream (Girola, 2007; USDT, 2007; Girola, 2011; Federal Reserve Bank of St. Louis, 2017). Securitisation links the long-term funds of corporate entities with relatively long-existing assets, thus permitting more capital to flow into the markets. Sherris and Wills (2008) discussed that longevity risk is one of the remaining frontiers challenging modern financial markets. The authors considered how financial markets and financial product innovations can be efficiently and effectively utilised to mitigate the risk and to reflect on lessons from the insurance-linked securities market that could be used to fund such a risk in the financial markets successfully. Securitisation may offer a comparatively inexpensive funding source when a company’s overall credit rating is lower than the one on its receivables (Hu, 2011). For instance, a publicly-traded mining company with experienced leadership guidance seeking investment to conduct exploration work in an area with proven results may be rated BB by Standard and Poor’s. The bonds issued by the company are backed by a well-structured portfolio which could possess a stand-alone credit rating of A1 (one of the top scores that a CRA can assign to an issuer or insurer). The mine operator would subsequently reduce its borrowing cost rate considerably by securitising its assets (Baig and Choudhry, 2013). 47 Securitisation can, therefore, be characterised as a form of financial innovation that better (efficiently and effectively) utilises the markets, especially in an unstable economic environment (Sassoon, 2009). 2.3 Local Contemporary Issues The notion that reclamation sureties are not adequately assessed in BC and companies don’t have to put up full reclamation sureties upfront, as they have to do in Alaska and many other countries in the world, means BC can’t continue saying it is world-class in terms of their mining sector. — Heather Hardcastle Director, Salmon Beyond Borders Over the past few decades, increasing recognition has been observed that mining activity can bring adverse environmental, community, and social impacts. Such opinions have emerged in research studies, industry and stakeholder accounts, and government reports, each of which point with wavering force to the toxic legacy of mine sites (OAGBC, 2002; Keeling and Sandlos, 2009; Keeling, 2010; OAGBC, 2016; Keeling and Sandlos, 2017). In BC, Canada, the Office of the Auditor General of British Columbia (OAGBC) raised the issue of mine reclamation in a 2002 report relating to the management of contamination on provincial lands. The 2002 report pointed to contaminants remaining on former mining sites on private and public areas in the province. It argued that the extent to which these substances are found in soil and water sometimes threatens both environmental sustainability and human health. OAGBC (2002) suggested that the province identify a leading ministry to oversee a government framework for managing contaminated sites; develop a process of collecting information enough to decide where scarce resources should be allocated for R&C obligations; and establish a management accountability framework to measure progress in managing contaminated mine sites (Stewart and Johnstone, 2007). 48 The province, in response, established the Crown Contaminated Sites Programme (CCSP), a system of managing tracts of land needing environmental reclamation (Stewart and Johnstone, 2007). As per the recommendation of the Auditor General, the CCSP is now overseen by the Ministry of Forests, Lands, and Natural Resource Operations, which manages the reclamation of contaminated provincial lands for which government is liable (CCSP, 2016). Where poor mine site reclamation is deemed to pose substantial risks to either human health or environmental sustainability, mineral claims may return to the government before the discharge of the conditions of a mining permit (CCSP, 2016). These are the mine sites managed under the CCSP. Contaminated sites include abandoned and orphaned mines but may also consist of ones contaminated by other causes (CCSP, 2016). However, the Office of the Comptroller General Public Accounts 2016/17 report points out that mining sites encompass the majority (about 75 percent) of contaminated sites in the programme (OCG, 2017). In 2015, the CCSP drew CAD$192 million from consolidated revenue to remediate lands and carried CAD$508 million in liability for contaminated sites (CCSP, 2016). Despite this policy framework, inadequate reclamation efforts of mine sites have remained a concern and have resurfaced as a topical issue in the province triggered by single events27. It has also invigorated apprehensions over the severity of the environmental risks associated with mining. Such catastrophic events have spurred widespread discussion concerning the long-term environmental management practices at mine sites, including an independent review which concluded that similar circumstances, as the Mount Polley mine disaster, should be expected to recur every five years in the province (IEEIRP, 2015). The BC First Nations Energy and Mining Council concluded that 35 First Nations communities stand to be affected by similar tailings breaches in northern BC alone (FNEMC, 2015). According to 27 Such as the 2014 Mount Polley mine spill, which is considered one of the biggest environmental disasters in Canadian history and one of the largest dam failures in the world in the past fifty years (Hoekstra, 2018). 49 some observers, this event prompted a more cautious approach to the permitting process on the part of the mines branch at the province’s Ministry of Energy and Mines (MEM). On May 3, 2016, the Auditor General of British Columbia, Carol Bellringer, issued her audit (Fry, 2016; OAGBC, 2016). It looked at whether the MEM and the Ministry of Environment’s compliance and enforcement activities of the mining sector are shielding the province from significant environmental risks. In her report – An Audit of Compliance and Enforcement of the Mining Sector – she stated (Fry, 2016; OAGBC, 2016): Almost all our expectations for a robust compliance and enforcement programme were not met. ... The compliance and enforcement activities of both the Ministry of Energy and Mines and the Ministry of Environment are not set up to protect the province from environmental risks. Significant gaps in resources, planning, and tools in both ministries are observed in the findings. For instance, the departments possess inadequate staff levels to handle a growing number of permits, and staff work with incomplete and cumbersome data systems. Consequently, monitoring and inspections of mines were unsatisfactory to make certain mine operators observed the requirements. Furthermore, some companies have yet to provide the government with adequate FA deposits to handle possible R&C costs if a mine operator fails to cover its financial guarantee obligations (OAGBC, 2016). The province is underfunded by over CAD$1.2 billion, a liability that could potentially fall to BC taxpayers28. Much of the FA securities held by the regulator are illiquid, and if companies seek restructuring under the Companies’ Creditor’s Arrangement Act, RSC 1985, the held assets may not be accessible for mine site reclamation (Allan, 2016). Reviews of current policy conclude with several recommendations for reform. These include the creation of a pooled reserve fund; an extension of EFA for the risks of unexpected events; a general escalation in the FA requirements demanded of mine proponents; the creation of an independent 28 Underfunding for the clean-up of mines rose to CAD$1.273 billion in 2015, increasing the level of financial risk to taxpayers above what it was the previous year (Hoekstra, 2017). 50 compliance and enforcement branch at the MEM; and increased organisational transparency concerning the mine permitting process (Allan, 2016; OAGBC, 2016). Besides the poor reclamation record, the lack of practical reclamation standards of the mining industry has become increasingly problematic (OAGBC, 2016). The Health, Safety and Reclamation Code for Mines in British Columbia (BC Ministry of Energy and Mines, 2017) establishes permitting, reclamation and closure standards for surface mine operators to reclaim and restore the land, but it has been criticised as being vague and inadequate (OAGBC, 2016). Vagueness and inadequacy as they pertain to: • particular code definitions; • the uncertainty of R&C costs; • incomplete definitions of outcomes; • unforeseen challenges that crop up in the mining project plans; and • lack of agreement surrounding the completion of reclamation activities given that uncertainty defines every mining project since no two projects are identical. Conflicting, incomplete, and vague environmental regulation can lead to unnecessary higher R&C costs and contradictory interpretation of financial reclamation requirements. Such ineffectiveness and inadequateness can also leave little room to determine optimal levels of financial reclamation for each mine site (Berger et al., 2011). Moreover, if mine operators wish to minimise the possible shock stemming from inadequate allocated funds, these companies should do more to mitigate such vagueness. They are likely to undertake only the level of reclamation that is required by law, even when greater reclamation efforts would produce more net benefits to society (Berger et al., 2011). Given the scope of mining in BC, Bellringer’s report highlighted the seriousness of more regulatory enforcement. The environmental risks of extraction are growing in the province, but compliance and enforcement are declining (Fry, 2016). The risks are material as 51 evidenced by the Mount Polley mine disaster, which occurred during the 2016 audit. “To avoid such failures, business, as usual, cannot continue,” says Bellringer (Fry, 2016). Since the Auditor General’s 2016 report being released, BC has tried to increase the amount of financial assurance it holds, says an Ecofiscal study (Ecofiscal Commission, 2018). “However, the province still holds only CAD$1 billion in financial assurance against a CAD$2.1 billion clean-up liability,” it says. “Financial assurance in British Columbia is stronger in theory than in practice,” says the Ecofiscal report, which observed that the broad authority given to the Chief Inspector of Mines to set the amount of FA that companies must post before digging, is used more to boost economic activity than to deal with compensation or to discourage corporate entities from selecting environmentally-risky choices. “In practice, the government has not required stringent assurance. As a result, the province does not hold sufficient financial assurance to cover its potential reclamation liabilities,” it says (Lavoie, 2018). The province of Québec stands out as possessing the most stringent EFA requirements in Canada and, according to a recent Fraser Institute annual survey of mine operators, is also one of the top jurisdictions in the country and globally for mining as it has simultaneously modified rules and regulations to encourage investment (Stedman and Green, 2018). Lead researcher, Jason Dion, stated every jurisdiction has its pros and cons, but BC’s FA choices are inconsistent with the PPP (Ecofiscal Commission, 2018). Dion said it is a choice the province has made since the initial stages of mine construction are very capital intensive, implying projects may be less viable if BC demanded ‘hard’ financial assurance in full and up-front. Such methods of bonding are costly ex-ante for the mine operators. In September 2010 an environmental think-tank stated that Albertans could be on the hook for billions of dollars to pay for oil sands clean-up, signalling the obligation works out to as 52 much as CAD$6,300 per person. In their report (Landry, 2010), the Pembina Institute pointed out that inadequate information exists about the exact cost of land reclamation. It warned that a fund set aside to cover for clean-up and reclamation supposedly might be significantly underfunded. It also states (Lemphers et al., 2010): Alberta requires all oil sands mine operators to post a security deposit to fund reclamation in the event an operator is unable or unwilling to pay for reclamation, ... However, because of the lack of transparency about the true costs of reclamation, the public doesn’t know if the current security deposits are adequate. The Pembina Institute report further remarks that the Alberta government has placed around CAD$820 million aside in its Environmental Protection fund for nearly 69,000 hectares of disturbed land, a dollar amount that appears low (Lemphers et al., 2010). On July 6, 2015, Alberta’s Auditor General, Merwan Saher, stated Alberta might not be demanding oil sands companies to provide sufficient funds to guarantee their massive mines are cleaned up at the end of their life (Weber, 2016). “If there isn’t an adequate programme in place to ensure that financial security is provided by mine operators ... mine sites may either not be reclaimed as intended, or Albertans could be forced to pay the reclamation costs,” states a report by Saher (Weber, 2016). Alberta Environment Minister, Shannon Phillips, in response, said the government agreed with Saher’s concerns and accepted his recommendations. The Mine Financial Security Programme was instituted in 2011 and as of 2016 holds security deposits from eight oil sands mines and nineteen coal mines (Weber, 2016). The fund holds CAD$1.6 billion to cover about CAD$21 billion in future liabilities (Weber, 2016). In the last 50 years, Alberta’s oil sands companies have only received reclamation certificates for about 0.1 percent of the total land disturbed (Lothian, 2017). Industry reports it has put reclamation efforts into about seven percent of land affected by tailings — but it has not yet received final regulatory certification to confirm that. 53 A recent report by the Alberta Liabilities Disclosure Project (ALDP), a coalition of Alberta landowners, researchers and former regulators, suggests the financial liabilities surrounding cleaning up all of the old and unproductive oil & gas wells in Alberta is several times more than the Alberta Energy Regulator which had estimated clean-up at around CAD$18.5 billion (Montgomery, 2019). The ALDP cost estimate for remediation is as much as CAD$70 billion to clean up more than 300,000 orphan oil & gas wells in Alberta (Bakx, 2019; Graveland, 2019; Jones, 2019). The number of wells in the province scheduled to be remediated is approximately 3,000. There are, however, more than 100,000 unproductive oil wells that will need to be cleaned up. Alberta’s oil & gas liabilities have been mounting for decades, with reported estimates ranging from CAD$58 to CAD$260 billion (ALDP, 2019). Only CAD$1.5 billion is held in securities to shield Albertan taxpayers from the likelihood of being left to pay the financial expenditures (ALDP, 2019). “Fiscally and environmentally, this is a ticking time bomb,” stated lead researcher Regan Boychuk (Graveland, 2019). Could mining be headed for the same problem? Alberta’s Auditor-General recently launched an investigation into the growing problem of orphan wells as the province struggles with underfunded environmental liabilities in the oil & gas industry that have climbed into the tens of billions of dollars (Jones, 2020). The Alberta energy regulator will soon unveil sweeping changes to how it regulates its old oil & gas infrastructure, including a complete overhaul of an environmental liability rating scheme it now considers a ‘flawed system’ (Morgan, 2020). The liability management ratios are a faulty measure because they allowed companies in good financial health to avoid posting security bonds and other security for environmental remediation. However, when their finances begin to deteriorate, they are asked to post surety bonds and security — precisely at a time when they have a difficult time finding the needed funds to do so. When deliberating on financial assurance issues, one should not only look at traditional assurance offerings but also at other forms of financial security. One of the intentions of the 54 dissertation is to provide further analysis of different financial arrangements that could become a conceivable substitute or complement to alternative forms of regulatory approved ‘hard’ financial assurance securities. Consideration should be given to innovative types of financial security, provided they meet specific criteria that protect a host government’s interests and objectives. 2.4 Along Comes Financial Engineering You have reclamation obligations growing for an industry and companies that are actually contracting. — Anna Zubets-Anderson Vice President – Senior Analyst, Moody’s Investors Service Securitisation is no more evil than a shovel but if you hit someone in the head with a shovel, they still die. — Sean Sheerin Senior Quantitative Policy Analyst, Federal Reserve Bank of New York An alternative FA-backed mechanism that is expected to satisfy the requirements of R&C is presented. Specifically, the dissertation examines the potential application of a securitised mechanism that is flexible and robust enough to possibly address short-, mid-, and long-term financial and regulatory requirements surrounding mine reclamation. Despite the promise of mainstream financial assurance mechanisms for environmental issues (Costanza and Perrings, 1990), such instruments entail trade-offs that limit their scope and effectiveness (Shogren et al., 1993; Cornwell and Costanza, 1994; Weersink and Livernois, 1996; Mooney and Gerard, 2003). The application of FA instruments such as surety bonding to environmental projects has been narrow, and the success mixed (Boyd, 2002). Consequently, examining the potential effectiveness of an alternative EFA 55 mechanism within the framework of regulating mining projects is of direct interest to public regulatory policy in mining and other extractive resource industries as well29. Securitisation arises when a financial institution (e.g., bank) transforms its illiquid assets (e.g., mortgage assets on its books), traditionally held until maturity, into marketable securities (Baig and Choudhry, 2013). In a typical securitisation transaction, the originating bank assigns a pool of financial assets with fixed or practically fixed cash flows to a special purpose vehicle (SPV), a bankruptcy-remote entity that in turn finances the purchase through the issuance of securities backed by the pool. The transfer of assets must meet the requirements of a true sale, where the transferor (e.g., the originating bank) relinquishes control over the financial assets and can consequently eliminate the assets from its balance sheet. The implication is that the money raised in the securitisation transaction does not need an offsetting liability to be presented on the originator’s balance sheet — the cash merely depicting the proceeds of the sale of the pool of financial assets to the SPV. Securitisation thus provides an originator with a diversified means of funding, usually at a lower borrowing cost30. To reduce credit risk for investors, thus increasing the credit rating of the ABSs, and to mitigate adverse selection complications arising from issuers having more information regarding the credit quality of the underlying pooled assets than do the investors, the SPV obtains credit enhancements (CEs) (Baig and Choudhry, 2013). They usually come from the originating financial institution (e.g., bank) and can comprise of both contractual and non-contractual arrangements. Examples of explicit recourses, or contractual agreements, include retaining interests in the transferred assets such as subordinated securities and 29 Although the dissertation mainly focuses on the mining industry, such an EFA-backed securitised mechanism possesses promising implications in other sectors such as oil & gas, chemicals, nuclear, infrastructure, and livestock farming. 30 Securitisation enables an originator to raise funds at a lower cost than if it, with its associated risks, had borrowed the funds. The originator accomplishes this cost-saving for two reasons. The first reason is that by not having to borrow from a bank intermediary (or other financial institution) of funds, it avoids the bank’s profit mark-up. It also accomplishes a cost-saving since the interest rate payable on the securities issued by an SPV is generally lower than the interest rate that would have to be paid on corporate securities issued directly by an originator. The interest rate savings reflects the creditworthiness of financial assets sold to SPVs in securitisation transactions which should be easier to understand and value, if not safer, than the actual creditworthiness of originators with all their related business and other risks. 56 credit-enhancing interest-only strips and furnishing standby letters of credits to the securitisation structures. Implicit recourses, or the non-contractual arrangement, include (Kothari, 2006; Hu, 2011; Buchanan, 2017): (i) selling assets to the SPV at a mark-down from the price detailed in the securitisation documentation; (ii) purchasing assets from the SPV at an amount more significant than fair value; (iii) swapping performing assets for non-performing ones in the SPV; and (iv) funding CEs beyond contractual requirements. The provision of implicit recourse breaches the true sale condition, but it allows issuers to preserve their reputations for consistent credit quality over recurrent sales. The literature explains that securitisation offers a means of diminishing bank risk (Greenbaum and Thakor, 1987; Pavel and Phillis, 1987; Hess and Smith, 1988). Such financing innovation has been both acclaimed as the engine of the advancement of society and criticised for being the cause of the weakness of the economy (Segoviano et al., 2013). Only the inventiveness and credit requirements of the parties to any securitisation place limits on what can be securitised. An example is the efforts of MIT Sloan School researchers and the Dana-Farber Cancer Institute. In examining the problem of medical research risk, such studies (e.g., investigations to search for cancer treatments) are unusual investments in that they are usually costly, often costing several hundreds of millions of dollars, and many of these projects end up not being profitable at all. Those that do make money may earn a great deal of it, but the financial returns would be realised only many years later, typically ten years or more. Fernández et al. (2012) and Fagnan et al. (2013) outlined financial engineering techniques to facilitate such medical research. They suggested a large fund with the proficiency to appraise projects and select a large, diversified group of projects over a long period. The large size of the proposed fund and diversification could be keys to success. An assorted group of research ideas (portfolio) is essential since a group of projects with comparable methods may all fail or succeed, making the portfolio very risky. The issue lies finding suitable project methods that are unrelated enough to create uncorrelated outcomes. 57 Fagnan et al. (2013) and Fagnan et al. (2014) contended that such a cancer megafund would differ from a standard venture capital fund in both funding methods and size since a significant fraction of the funding would need to come from the long-term bond market. Financial instruments, such as bond insurance (credit default swaps (CDSs)) and tranching (securitisation), could structure the risk to different types of investors, and thus attracting a more extensive range of investors. Their study showed how securitised consumer healthcare expenses loans could spread the cost of medical therapies over several years, offering more patients access to costly medical treatments while generating positive returns to investors (Dana-Farber Cancer Institute, 2016; Montazerhodjat et al., 2016). If financial engineering can distribute the monetary risk of medical research, then it can play a part in curing cancer. A similar argument can be made for the proposed EFABSs. Securitisation has become an essential method for financial institutions31, corporate entities, and governments to pool assets and sell them to investors (Watson and Carter, 2006; Slaughter and May, 2010). The history of securitisation has revealed that this form of financing has expanded to new categories of assets, not only home mortgage financings from where it originated in the 1970s in the United States (Stone and Zissu, 2012; Deku and Kara, 2017). With new types of assets successfully securitised during past decades, the question arises whether such a form of financing can be utilised for any or all assets that are capable of accumulating revenues over time. Securitisation issuance in the United States alone, including agency and non-agency MBSs and ABSs, totalled $2.2 trillion in 2016 (SIFMA, 2017a). It amounted to $1.2 trillion in the first half of 2017 (SIFMA, 2017b). Morgan Stanley Investment Management estimates that the global securitised market is nearly $9.8 trillion in size, with the US securitised market 31 Including the IFC, a member of the World Bank Group. 58 representing 86 percent (Morgan Stanley, 2018). Putting it into perspective, Canada’s GDP in 2018 was $1.65 trillion; leaving Canada placed 10th in the ranking of GDP of the 50 countries observed by the International Monetary Fund (IMF) (IMF, 2018). Moreover, the notional amount of outstanding over the counter (OTC) derivatives contracts was $542 trillion at end-June 2017 (BIS, 2017) while the notional principal of exchange-traded futures and options amounted to $33.7 billion at end-December 2017 (BIS, 2018). Further statistics show that securitisation provided $13.1 trillion in financing and funded more than fifty percent of US household debt in 2019 (SFA, 2020). Through securitisation and structured finance, more families, individuals, and businesses have access to essential credit, seamlessly and at a lower price. Slaughter and May (2010) and the Economist (2014) comment that securitisation continues to demonstrate its usefulness to the world of business, as also observed by student loan asset-backed securities (SLABS). SLABS are securities consisting of numerous student loans pooled together. They deliver scheduled coupon payments much like an ordinary bond. The selling of student loan asset-backed securities allows lenders to move their credit risk to several investors. In theory, this permits for a more efficient loan market and creates better means for students to finance their education. Student loan finance and the assessment of related risk evolved dramatically since the 1980s (Maurice and Goyal, 2012). Historically, student loan financing relied in no small extent on tax-exempt public financing sources (Maurice and Goyal, 2012). Today, tax-exempt issuers are equally likely to access taxable markets as they are tax-exempt funding sources as the demand for financing has increased over time, and tax-exempt cap allocation (the amount of volume capital that was approved) has not risen to meet the needs for all issuers. Often the same issuer will tap both markets in the same transaction. Whether taxable or tax-exempt, the risk profile is essentially the same for the Family Federal Education Loan Programme backed student loan financings (Maurice and Goyal, 2012). 59 Issuers consistently employ the same securitisation financing techniques, or repackaging of student loans, as a dominant financing vehicle. In April 2018, Social Finance, Inc. (SoFi), a fintech company, from San Francisco, California (Ryabkova, 2017), announced that it had just completed $2.6 billion in loan securitisations in the first quarter of 2018, a 35 percent increase over the previous-year period and its largest-ever quarterly ABS issuance volume (SoFi, 2018). Ashish Jain, SVP of Capital Markets at SoFi, noted, “Volatility returned to the credit markets this quarter, but investors continued to show a strong appetite for our securitisations, which allowed us to compete for several large transactions. We are especially pleased that our investor base has continued to expand as more institutions recognise the strength of SoFi as a top ABS issuer of prime consumer credit.” With this positive quarterly performance, SoFi remains a top-ten ABS sponsor, ranking seventh among all sponsors as of March 31, 2018, behind Sprint, General Motors, Ford, Santander, Ally Financial, and Citibank, and first among all online lenders (SoFi, 2018). SoFi plans to capitalise on its niche of loaning to ‘not rich yet’ borrowers with student debt (Wiltermuth, 2017). These examples provide a strong incentive to pursue the underlying research surrounding financial assurance-backed securitisation given the similarities of both mechanism forms, and that of others stemming from other unmarketable and intangible assets. Specifically, these financing innovations are a catalyst for the research focus of the dissertation on FA-backed securitisation. The development of such a securitised mechanism can be considered a viable and perhaps significant disruptive financial innovation akin to what blockchain32 or smart contracts may become unless suppressed by ill-considered regulatory or legislative actions (Vora, 2015). Financial innovations regularly respond to regulation by circumventing regulatory restrictions that would otherwise limit activities in which the public wishes to 32 Applying blockchain, a form of distributed ledger technology, in securitisation, offers opportunities for reinvention. The substantial space in the financial industry is at an early stage in the advancement of blockchain for structured finance, but blockchain, together with smart contracts, promises to transform many activities in the securitisation lifecycle (Cohen et al., 2017; Deloitte, 2017). 60 engage (Calomiris, 2009). As such, financial innovation disseminates into forward-thinking financial capital markets around the world – its adoption is expected to grow. The understanding of the dynamics that fuelled the last wave of financial innovation is premised on the development of the financial sector. Financial innovation became the primary tool for banks and corporations to fund their operations and to be competitive on a worldwide scale. In recent times, these theorems have found fertile soil in the unrestricted utilisation of new structured finance schemes, and in the general euphoria that permeated financial markets, characterised by excessive liquidity, low-interest rates, and a willingness to innovate to satisfy high demands. 2.4.1 Innovation through Securitisation Amore et al. (2013), Beck et al. (2016), and Lauretta (2018) demonstrated that there exists a strong relationship between finance and technological innovation. Research studies on the US subprime mortgage crisis of 2007, such as those of Mian and Sufi (2009), Keys et al. (2010), and Dell’Ariccia et al. (2012), suggest the cause was the association between the lax lending standards and the securitisation process of the time. Financial engineering and its toolkit of derivatives received a bad reputation during the financial crisis. Along with financial products such as MBSs and collateralised debt obligations (CDOs), derivatives allowed savers—including individuals and pension funds—to purchase payments on mortgage securities from investment banks that acquired the rights to those loan payments from mortgage lenders. Many analysts faulted the housing bubble and/or the severity of the subsequent crisis on lax regulation and the misuse of these financial instruments, rightly or wrongly. Both fans and foes of financial engineering must acknowledge that this discipline, like other financial tools, multiplies one’s power to do 61 harm or good. It, however, solves economic issues with mathematical techniques, which commonly involves trading and distributing risk. Mallick and Sousa (2013) expressed how fluctuations in financial distress conditions can describe output fluctuations. Other researchers have highlighted the presence of the finance-growth nexus (Greenwood et al., 2010; Creel et al., 2015) and revealed that financial innovation coupled with deregulation had fostered a rapid development of the financial system but consequently amplified economic instability and complexity (Dosi et al., 2013; Grydaki and Bezemer, 2013; Brunnermeier and Sannikov, 2014). There are few academic studies expressly focused on the concept of financial innovation; the studies from Levine (2005), Klein and Olivei (2008), and Lerner and Tufano (2011) outline and model financial innovation using an approach that correspondences with the concept of innovation applied in the industrial sector. From the studies, it is evident that researchers focused their attention primarily on a more general and vaguer concept of financial innovation, examining its influence on financial depth and its ensuing effects on economic growth. Thus, further study is required since the role of financial innovation remains unclear and not adequately modelled. 2.4.2 Fuzzy Logic and Alternative Methods Since EFABSs would be considered customised financial assurance solutions and their numbers are expected to be small, and costly, to support statistical evidence and inference, a traditional empirical analysis could not be implemented. Therefore, a conceptual framework was developed and tested on the latest available reclamation liability cost estimates data (see Appendix A) to the BC government (MEM, 2016). Two cases of securitisation transactions based on this data were referred. 62 The theoretical framework consists of a set of independent crisp inputs that are converted to linguistic variables which are assumed to explain the potential outcomes that a FABS may experience. The identification of possible key attributes of failure and success of an EFABS, and their level of influence compared to the other variables observed, was based on: • the analysis of existing literature, on financial assurance obligations information derived from the mentioned reclamation liability cost estimates data; • discussions with industry specialists in structured finance and the mining sector; and • personal, professional experience. Several attributes leading to the probable success or failure of securitisation deals having EFA obligations as its underlying pooled asset are studied. The Mamdani-type FIS-based methodology is applied to explore such a potential. The degree of success of financial assurance-backed securitisation deals is measured by one concluding crisp output value generated by the applied Mamdani model. The level of success is in part based on the selected input-crisp values. Fuzzy logic has been employed in many applications such as industrial control, engineering, military operations, medicine, pattern recognition and classification, reliability, economics, management, and business studies to model systems which are difficult to define precisely (Zadeh, 1976; Wang and Hwang, 2007; Minola and Giorgino, 2008). Mamdani (1977), Sugeno (1985), Bojadziev and Bojadziev (1997), Tanaka (1997), and Von Altrock (1997) demonstrated that it could be applied to industrial, business, and financial applications. A Fuzzy logic method is a useful tool to represent and analyse qualitative information and to deal with complex phenomena (Minola and Giorgino, 2008; Nounou et al., 2013). Furthermore, it is an appropriate methodology for investigating several problems characterised by unreliable data, imprecise measures, ambiguous language, and unclear decision rules (Karadogan et al., 2008). 63 It is worth mentioning that alternatives to FL models exist that employ more traditional probabilistic methods. These approaches include decision trees, which represent a traditional approach to decision-making that deals with uncertainty and has been widely utilised in financial applications (Chambers and Lu, 2007; Han et al., 2014). Decision trees are major components of philosophy, finance, and decision analysis. Decision tree analysis is often preferred due to its simplicity, descriptive, transparency, and predictive power. Fuzzy decision trees, in particular, combine the leverage of such classic decision trees along with the benefits of FIS systems, which include the ability to deal with uncertainty and imprecision in data. To exploit the advantages of path-based modelling utilised by decision trees to determine the degree of potential success of EFA-backed securitisation, without bearing the computational cost of calculating billions of paths, a method of randomly sampling from all available paths exists. These paths could also have been simulated using a Monte Carlo technique as an alternative to fuzzy logic. Monte Carlo methods involve randomly selecting paths to approximate the results of a full path-wise evaluation. Such methods were introduced by Hertz (1979) to finance. Boyle (1977) pioneered the use of simulation in financial derivative valuation. These alternative models to the observed Mamdani FIS type have been applied in the literature, but they possess some limitations. Monte Carlo simulation is only useful in circumstances where data and analytic models are unavailable. Rubinstein and Kroese (2016) explained that the utilisation of such a simulation method is appropriate when: • the observed system is too complicated; • it is too expensive or impossible to obtain data; • it is difficult to validate the mathematical experiment; and • the analytical solution is challenging to obtain. 64 Decision trees also possess certain inherent limitations (Zorman et al., 1997). They include: • the dependability of the information in the decision tree depends on feeding the precise internal and external data at the onset; • a small change in the data (i.e., computing probabilities of different possible branches – it requires a higher degree of accuracy) can cause a significant change in the structure causing instability; • the decisions contained in the decision tree are based on expectations, and unreasonable expectations can lead to errors and flaws in the decision tree; • decision trees are prone to errors in classification, owing to differences in perceptions, and the limitations of applying statistical tools; • computing probabilities of different possible branches, determining the best split of each node, and picking optimal combining weights to prune algorithms contained in the decision tree can be problematic; and • data that is perfectly divided into classes and uses only elementary threshold tests may require a large decision tree. A comparison of these models is expected to be examined in future studies. 65 Chapter 3: Issues in the Use of Financial Assurance Progress is impossible without change. — George Bernard Shaw 3.1 Funding Mine Closure Mining is a short-lived activity, with mines operating from anywhere between a few years to several decades. An essential measure of the mining industry’s ability to contribute meaningfully to sustainable development is its long-term environmental performance, which involves timely and detailed planning for mine closure and beyond. What happens after a mining operation is closed, and the impact this has on the local community and environment, influences the competitiveness of the mining operation. An essential component of this planning in some host mining jurisdictions is the consideration of how closure measures will be funded and who should fund it remains a topical issue since the need for financial assurance is explicit. Funding R&C obligations have consequently become a necessary cost and the foremost concern regarding mine decommissioning and reclamation. The nature of the various expenses surrounding mine closure is discussed by du Plessis and Brent (2006) who considered existing mine closure cost calculation models in South Africa. The cost of mine closure can vary immensely as a World Bank and IFC publication points out (Sheldon et al., 2002). Funding these environmental costs is a growing concern in mine closure and continues to play a fundamental role in feasibility and investment into the extractive industries. The issue lies on whom should the responsibility of these environmental expenditures fall on? 66 Various models have been introduced throughout the world, and the choice is dependent on the legislative provisions of the host jurisdiction where mining operations are carried on (Sheldon et al., 2002). There are three primary sources of such funding: host state, third-parties, and the mining company itself (Sheldon et al., 2002). The first model is where the obligation of the mine closure expenditures rests on the host country through taxing its citizens or the mining companies themselves (Mathews, 2016). Jurisdictions are seldom the source of such funding obligations as such costs ultimately rest on the taxpayer, which may upset investors due to the unreliability or the possible corruption of the host nation (Mathews, 2016). In the second one, a mining R&C fund is established in a jurisdiction where its local mining companies contribute to it to meet the EFA requirements (Government of Western Australia, 2013). A mine operator would pay a contributory payment to the fund throughout the life of its local mine. It would not only pay to its reclamation and closure requirements but in effect also to the R&C obligations of other member mines. The underpinning of such a fund is the PPP since mine operators are often described as being raiders of resources generally due to the absence of sustainable legacies left behind after mine closure (Tilton, 1995; Cordato, 2001). It is now a common practice in modern mine closure planning to possess details of the estimated mine R&C costs and the type(s) of financial assurance vehicles the mine operator will utilise for environmental reclamation and mine closure purposes (Robertson and Shaw, 2006; Heikkinen et al., 2008; Pavlović and Tomislav, 2012; Holmes et al., 2015). The financial assurance instrument(s) of choice is determined by the government regulators of the jurisdiction within which mining operations are carried on (Frilet and Haddow, 2013). 67 Increasing environmental concerns has led governments to tighten regulatory controls, and the selection of approved FA suitable for mine R&C plans requirements. The question of reclamation and funding is a crucial one for the mining industry, government authorities, the general public, and other stakeholders, and one that Appendix B examines. Mine operators, today, often try to predict rather than engage in costly R&C obligations determination exercises since they can at times ‘walk away’ from a mine operation after minimal closure activities. Such an abandoning scenario, however, does not appear to be valid for a single modern major mine. In every instance, mining company officials and regulators have failed to acknowledge the hard realities of mine reclamation (e.g., acid drainage is a particularly costly and challenging problem to rectify). Operators cannot simply ‘walk away’ from mines that are generating acid drainage. Even where mines do not possess acid drainage issues, clean-up is often more complicated than estimated and takes longer than projected, becoming extremely costly. In response, where mining activities occur, many governments have enacted regulations that in some form require reclamation and closure plans to address issues associated with existing mining operations. All these regulations comprise, at least nominally, of a financial assurance provision. Existing regulatory methods have been verified during the past decade. As newer mines have reached the closure phase — with some companies defaulting or otherwise going bankrupt — regulatory agencies have occasionally been forced to conduct reclamation and closure tasks, to comply with current environmental regulations, and to incur costs for performing those activities. In general, existing financial assurance is lacking, as demonstrated by these experiences with modern mines: • the magnitude of disturbance and contamination, and in particular the long-term threat of pollution of water resources, is more significant than previously predicted; • the potential is real for bankruptcies, insolvencies, and other circumstances that lead to a default on required reclamation and closure obligations; • costs associated with such defaults are much higher than expected; 68 • regulatory agencies’ costs for conducting R&C tasks at a mine are usually higher than projected by mining companies; and • as a result, financial assurance is generally inadequate, or in some cases, the intended funds are unavailable (as in the case of self-guarantees). The relative scarcity of surety bonds for mine operations is an effect of historically underestimating risk for many modern large-scale mines. Such a problem could have a severe impact on the environment, and as well to a government’s budget. Further discussion is found in Appendix C. In addition to these governmental responses, there has been a market response, which is discussed in Section 3.2.4. Another necessary aspect that should be taken into consideration when estimating reclamation and closure costs is to understand for whom the assessment is being prepared (Brodie, 2013). Freeman (2010) proposed a broad definition of what constitutes a stakeholder, and he remarked that “any group or individual who can affect or is affected by the achievement of an organisation’s objectives.” Estimation for internal use assumes that the work would be performed under the guidance of the mine manager, which would maximise the use of existing equipment and staff, and thus the unit cost for all required R&C work would be completed at the lowest permissible total price. Brodie (2013) cited that the moderately low cost to the high productivity of equipment and familiarity of the workforce working on the mine site is expected to lead to a low contingency expenditure. No capital cost relating to the use of equipment would be administered in this circumstance since it would be regarded as a sunk cost. Closure and environmental cost estimations by the mine operator is generally prepared and submitted by the company in support of its proposal for providing financial assurance security (Brodie, 2013). According to regulations, costs based on third-party contractors performing all the work should be included, with no concession for salvage value. The 69 contingency cost for FA purposes would be like the internal estimate as both cost valuations were based upon the expectations that mine development would proceed as planned. Estimation by the regulator reflects its adverse anticipation that the company could abandon the mine site. The assessment is prepared when the regulatory agency addresses the degree of uncertainty in the mine closure plans. The contingency cost in such a circumstance may be higher as very few mines are developed precisely to the initial plan’s specifications without any revisions. There are also plans based on technological advancements, which could yield different results than projected (Brodie, 2013). According to Brodie (2013), the worst-case approximation is usually developed when non-governmental organisation (NGO) stakeholders want to thwart the mine development due to the explanation that financial constraints surpass the company’s security. Grant Thornton (2003) observed that most countries use the worst-case-scenario approach rather than the most probable scenario method when determining the amount of financial assurance. Posted financial assurance signals to regulators that a company possesses the financial capacity to meet its environmental obligations, thus reducing the environmental risk exposure of regulators should it default or go bankrupt. Traditionally, however, there has been an ongoing disagreement between the government and the industry regarding the level of EFA requirements (Hawkins, 2008; Malone and Winslow, 2018). While most governments recognise the benefits that mining brings to an economy and their country, they want to make sure that local mine operators are financially capable of closing and remediating the mine and its surrounding disturbed lands (Brodie, 2013). Regulators believe that the more FA they have access to, the higher the likelihood to minimise taxpayers’ burden due to possible bankruptcy losses by ensuring that a dependable third-party has access to enough funding that is segregated from the rest of the mining operations. Such precautionary measures are taken in the event of bankruptcy and the subsequent right to seized assets by creditors who are stakeholders or shareholders of the bankrupt entity. 70 Nonetheless, mine operators argue that both the EFA security and the further regulatory burden can result in a rising cost of doing business and the exposure taken by the regulatory agency and government in the event of a bankrupt company can be reduced by less costly measures (Brodie, 2013). Further discussion is found in Appendix D. 3.2 Current State of Reclamation The legacy of mining, globally, is a two-sided coin. On one side, the mining industry has provided significant employment opportunities to many, social services (e.g., built schools, hospitals, sewage treatment facilities, public transit, senior residences, and community centres) in areas surrounding a mine, and generated secondary economic activity, tax revenues and paid royalty, and helped in satisfying the worldwide insatiable appetite for mineral resources. Conversely, it has produced many orphaned mine sites; led to long-term environmental threats and devastating disasters – some of the most publicised environmental catastrophes are linked to this industry (it created and imposed short- and long-term clean-up and R&C responsibilities onto the taxpayer’s shoulders). Much of the damaging legacy is derived from mines that were approved under previous environmental regulatory eras. Existing mines that were and are being developed or continued under the current regulatory environment have also contributed to this legacy. In many mining jurisdictions throughout the world, little consideration is still given to R&C responsibilities of mine sites let alone to long-term environmental reclamation efforts. Disappointedly, reclamation often begins at the end of mining, when the company may not have the necessary funds or incentive for mine reclamation and closure responsibilities. Without an adequate, approved form of FA, the R&C cost obligations go unfulfilled. Environmental degradation is a result of such negligence. 71 As global public awareness strengthens along with participatory engagement, it is increasingly important that the credibility of reclamation practices, environmental regulation and its enforcement, and the type(s) of financial assurance instruments deployed be established and reliable. Such views relate not only to the environmental policies and actions of these practices but also to how society perceives environmental clean-up and reclamation (Peck and Sinding, 2009). Environmental reclamation is an increasingly significant feature of the public ongoing perception and perspective of the mining industry. The extent of reclamation activity appears to be directly interrelated to a society’s aspiration to find other land uses from altered landscapes (Cao, 2006). Existing mining practices are reliant on these environmental practices to preserve the integrity of the surrounding countryside and the various types of life disturbed due to ongoing mining operations. There is also a continuing necessity to examine how effective current reclamation practices and financial assurance fit into a mining regulatory framework, especially when a mining project’s life is often long-lasting. 3.2.1 Little Money, Inadequate Enforcement Impacts on Company Decision-Making Financial responsibility makes sure that the expected costs of environmental risks appear on a company’s financial statements. If new investments imply potential future environmental costs arising, financial obligation raises the impact of such expenses to its decision-making. To self-insure, mine operators must be comparatively deep-pocketed, which suggests that they will internalise expected environmental liabilities. Shallower-pocketed companies usually cannot self-insure and must consequently purchase rights to financial assets from third-parties. When these parties, such as banks and insurers, arrange for capital in this way, they are concerned with the prospect that future costs will consume their money. As a 72 result, there is a strong incentive for the providers of capital to observe environmental safety to shield themselves against moral hazard (Fanga and Moscarini, 2005). To protect against adverse selection, financial funds providers can also base the cost of their capital (e.g., their premiums) on visible attributes of the companies to whom they provide the funds (Faure, 2007; Dionne and Harrington, 2013). For example, more favourable capital cost rates can be supplied to mine operators with solid risk management and safety programmes. Additionally, EFA coverage may be denied to companies which fail to exhibit adequate levels of safety. By these means, the capital markets that fulfil the demand for environmental financial responsibility generate incentives to decrease environmental risks. Mine Reclamation and Closure The global trend in the past few decades demonstrates that governments from mineral-rich countries require mine operators to develop a timely mine R&C closure plans (Otto, 2009). These companies are usually expected to reclaim their sites themselves. Within these regulations, mine operators are also directed to establish adequate FA (Otto, 2009). The following reasons justify the need for financial assurance (Otto, 2009): • mine closure implies that no further revenue will come from the mine; • premature closure can arise due to unanticipated volatility on mineral prices or other circumstances, or in the company becoming insolvent or going bankrupt; and • inadvertent events may adversely impact the environment; even far-after reclamation is duly completed as per required by the regulations. 73 Government regulatory agencies set multiple conditions and requirements based on the amount of FA required for mine R&C obligations. For instance (Miller, 2005): • various jurisdictions in Australia decide the necessary amount of financial assurance on a case-by-case basis, and in Texas, such financial requirements are established by the mine’s permit conditions; • in India, a fixed sum per hectare of a mining site is required, and Botswana and Suriname need funding from a company for closure as an ongoing expenditure; and • Ontario, New Brunswick, and Arkansas demand EFA to cover the entire cost of mine R&C, while Québec requests monetary funds to cover 70 percent, Nevada requires 40 percent, and Ghana expects between 5 to 10 percent of the projected clean-up costs to be handed over at the start of a mining project. Financial assurance is designed to function as an insurance policy to supposedly offer adequate funding to the government to cover the reclamation expenditures if a company is incapable or reluctant to perform its reclamation obligations (Peck and Sinding, 2009). These reclamation liability cost estimates and the collected EFA funds, regrettably, often fall short of actual R&C costs (Chambers, 2005). For example, the British Columbia Auditor General’s 2016 report stated there is a shortfall of over a billion dollars in BC (Hoekstra, 2016). The Ministry of Energy and Mines estimated its financial security deposits for major mines were under-secured by more than CAD$1.2 billion. The latest information available to the BC government (see Appendix A) comes from 2014 data (MEM, 2016). The data offers the first public mine-by-mine breakdown, as BC legislation permits such reclamation estimates information to be kept confidential by companies (MEM, 2016). Inflation adjustments are also not compulsory, and a no-victim-compensation scheme is not required (MEM, 2016). The BC government asked the mines to provide the breakdown, which they agreed to do. It shows the provincial government possesses financial securities of CAD$450 million from Teck Resources Ltd. (Teck Resources) against total reclamation costs of nearly CAD$1.187 billion. That leaves an underfunded liability of CAD$736 million. 74 Minister Bill Bennett (BC Minister of Energy and Mines and Minister Responsible for Core Review) stated most of the CAD$1.2 billion the government failed to collect was from Teck Resources and Barrick Gold, both of which are large multinational, public, corporate entities with plenty of financial resources. “Those companies aren’t going anywhere,” he said. Such an attitude of ‘too big to visualise’ implies that British Columbia could be subject to the mining equivalent of the financial moral hazard that is ‘too big to fail’ (Goodlet, 2010; Gormley et al., 2015). Such companies enjoy the ‘too big to fail’ status. In the 2007 financial crisis, many kinds of prominent financial institution failed or were saved only by government intervention: investment banks – Lehman Brothers and Bear Stearns; large financial conglomerates – Royal Bank of Scotland and Citigroup; smaller retail banks – Sachsen Landesbank and Northern Rock; public agencies – Freddie Mac and Fannie Mae; America’s largest insurer – American International Group; diversified banks – Fortis; and specialist lenders – Hypo RE. Taxpayers were held footing the bills. ‘Too big to fail’ is too senseless of an idea to keep. The main objective of regulation is to protect the public, not endorse the interests of a particular company or even industry. Moreover, it is impractical for government regulators to avert business failure and undesirable to seek that purpose (Moosa, 2010). Teck Resources was one of the worst-hit companies when coal prices plunged in the global commodity price shocks during the second half of 2014. Its shares peaked at CAD$62.22 apiece in January 2011 and fell to CAD$3.65 in January 2016. The diversified natural resources public, corporate entity lost CAD$2.5 billion in 2014, driven mainly by impairment charges. Barrick Gold shares plummeted to a 25-year low, as low as $7.82, on the New York Stock Exchange, on July 2015 as falling gold prices put pressure on the mining sector (Owusu, 2015; Rocha, 2015). Gold’s tumble posed problems for debt-laden Barrick Gold. 75 Mining companies often face the correlated market and credit risks associated with the cyclical nature and volatility of commodity pricing. Such cyclicality and variability have long been recognised. The recent 2014 commodity downturn, however, was different. It was longer and more painful than past cycles due to multiple reasons, including a structural shift in the demand for coal, copper, and other base metals. When Moody’s (2016) downgraded Teck Resources’ rating to B3 on February 23, 2016, it noted that “This rating action reflects Moody’s view that there has been a fundamental downward shift in the mining sector with the downturn being deeper and the recovery longer than previously expected, resulting in increased credit risk and weaker metrics for Teck as well as the global mining sector.” All four credit rating agencies33 downgraded Teck Resources to non-investment grade, junk bond status, during the 3rd quarter of 2015 (Thomson Reuters, 2015). A decrease in share value and non-investment grade credit rating can make it increasingly difficult for a company to raise capital and arrange credit facilities. Moreover, when a public, corporate entity drops down to a non-investment grade, junk bond status, they are often referred to as ‘fallen angels.’ As many institutional investors, such as insurers and pension funds, are barred from owning sub-investment-grade debt, money managers would have to dump their holdings of these fallen angels, leading to a sharp fall in their bond prices. As a result, downgraded issuers such as Teck Resources could struggle to find buyers for their pending and future bond and stock issuances. A form of systemic risk34 that may arise from such a potentially massive business failure is far from theoretical given the interdependency of Teck Resources’ R&C efforts due to the company’s multiple mining operations (Allan, 2016). These funds generated from one ongoing mine project are expected to cover the R&C closure costs of another one. Allan (2016) suggests that the overall success of R&C efforts by Teck Resources is co-dependent 33 Moody’s Investors Service (Moody’s), Standard & Poor’s, Fitch Ratings, and DBRS. 34 Systemic risk became a key contributor to the worldwide financial crisis and global recession of 2007-2009. The term ‘too big to fail’ is frequently used to describe companies which pose a systemic risk and as such, receive preferential treatment from the government, which often leads to ‘moral hazard’ situation. 76 on the ‘domino’ business success of the pool of mine operations that it possesses. Equally concerning is the potentially anti-competitive nature of such a permitted form of ‘soft’ security. It could inversely impact the competitiveness of small and midsize mining projects that are required by regulation to demonstrate ‘hard’ financial assurance for mine closure. Barrick Gold has put up financial security of CAD$6.5 million on total estimated reclamation liability costs of CAD$218 million (MEM, 2016). In another instance, the BC government has an underfunded liability of CAD$73 million on estimated reclamation costs of CAD$79 million for Switzerland-based Glencore. Imperial Metals has a CAD$10.5 million underfunded responsibility on total reclamation costs of CAD$29.5 million. Peace River Coal possesses a CAD$67 million underfunded liability, and Thompson Creek Metals has a CAD$29.2 million underfunded liability. In releasing her 2016 BC Auditor General report, Carol Bellringer stated the shortfall implies taxpayers could be on the hook if a company cannot pay for cleaning up a closed mine (MEM, 2016). It concluded that in addition to an unfunded reclamation liability, British Columbia had assumed responsibility for reclaiming abandoned mines, putting taxpayers on the hook for a further CAD$275 million. The Auditor General’s team also examined the Imperial Metals’ Mount Polley tailings dam failure35, which happened during their two-year review (Fry, 2016). Bellringer said their examination differed from other investigations as it did not focus on the mechanics of how the dam failed, but whether it was related to compliance and enforcement (Fry, 2016). She said they determined the province’s regulators did not ensure the mine was built to design specification, noting an independent engineering panel appointed by the government of BC found that had it been built to specifications, it would 35 The BC First Nations Energy and Mining Council recently called on the BC provincial government to close a policy gap that permits mining companies not to provide financial assurance to pay for the costs of a mine disaster (Hoekstra, 2019). “BC has a polluter-pays policy under its Environmental Management Act, but that’s not the reality on the ground,” said Allen Edzerza, the mining lead for the BC First Nations Energy Council. 77 not have failed. “To avoid such failures, business, as usual, cannot continue,” says Bellringer. Her report also stated that CAD$730 million of the underfunded liability is for mines that require water treatment, which contravenes the Ministry’s policy of needing full security on mines that require long-term water treatment (OAGBC, 2016). The report mentions that Québec and Alaska require total funding of project reclamation from miners. Some of the explanations for the discrepancy in mine closure expenditures relate to the inability or the strategic reluctance of effectively forecasting financial expenses deep into the future at times (Chambers, 2005). Mining companies calculate the liability cost estimates with the viewpoint that they will be the ones dealing with the clean-up and reclamation obligations. Conversely, environmental regulatory agencies approach the same matter believing that they might need to take responsibility for such mine closure efforts due to the inability or unwillingness of the mining entity. Consequently, the requirement for financial assurance can be viewed as an effective economical monitoring, compliance, and enforcement mechanism. These opposing viewpoints can, and often do create significant discrepancies in the assessment of mine closure costs (Chambers, 2005). In some jurisdictions, financial institutions have offered FA for mine abandonment and closure in the form of a surety bond or insurance policy36. Due to the number of mines that any individual insurer is capable of insuring versus the adverse possibility of a high payout, many insurance providers ceased covering this form of activity (Chambers, 2005). The increasing lack of assurance coverage led to the use of cash or its equivalent, which can be desirable from a regulator’s perspective. However, such financial instruments can significantly impact a mining company’s balance sheet, cash flow, borrowing capacity, and even its credit rating (Miller, 1998). 36 Also, for abandoned oil wells. Such wells can contaminate water and soil, leak greenhouse gases, and put nearby residences at risk of harmful gases and explosions, according to a study by the C.D. Howe Institute, All’s Well that Ends Well: Addressing End-of-Life Liabilities for Oil and Gas Wells (Dachis et al., 2017). 78 Another issue relates to the actual mine closure standards necessary to meet regulatory requirements. That is, what level of environmental reclamation is required to fulfil a regulator’s expectations to obtain a closure certification? Through the integration of observable criteria for the mine closure expectations with the financial assurance requirements, which should be agreed upon by all stakeholders, future surprises are expected to be limited. Such decisions are best developed early in the mining operations planning and development stage, so stakeholders will possess all the pertinent information needed to make the necessary choices (Miller, 1998). Including EFA requirements into licenses and new permits is straightforward; however, how do regulators handle mine sites that have been abandoned some time ago and those mines that are still productive but mature? According to Mackasey (2000), placing the same financial assurance expectations on such established mines may prove financially burdensome and harmful to its very existence. Robertson et al. (1998) observed that the interest of a mining company in the jurisdiction where its mining operations exist usually comes to an end with the execution of a mine closure plans. Such a blueprint is often concentrated upon objectives such as resource extraction optimisation, attainment of planned environmental goals and termination of ongoing financial obligations as rapidly and as cost-efficient as possible (Laurence, 2003). It is said that a mine operator often possesses a shorter perspective than that of the environmental impacts for which it is responsible for (Strongman, 2000). Mine owners, strategically, strive to avoid dealing with financial obligations as far into the future as legally permitted since they dislike possessing unresolved liabilities on their balance sheets. They attempt to avoid dealing with their reclamation costs for as long as they are legally allowed to offer them the opportunity to dispose of their mine sites at a suitable time for them (Strongman, 2000). Such a procrastinated stance is in stark contrast 79 with the plans of the succeeding land caretakers and related stakeholders since they are far more concerned about continued sustainable use of the land (Strongman, 2000). In August 2013 the IMCC (Interstate Mining Compact Commission) surveyed outstanding obligations related to bonding across the United States (IMCC, 2013), and it was observed that some mining companies in various states reported difficulty in obtaining financial assurance in the form of surety bonds for their mine operations (Kuipers, 2000). It is correct to remark that EFA is progressively costly37, and cash equivalents are even pricier than surety bonds; however, the explanations provided by mine operators for this upsurge pricing trend do not necessarily explain the issue(s). Financial assurance providers that offer financial guarantees are responding, as anticipated in a market economy, to higher and more complex levels of risk. Events have shown, repeatedly, that the total disbursement, timeframe, and magnitude of reclamation have been significantly underestimated by the environmental regulators who determine the bonding amounts (Kuipers, 2000). Because of the increasing magnitude of bankruptcies (Els, 2016), surety providers have been forced to make substantial payouts in recent years, which could explain why the industry increased its overall rates. Agents of financial assurance providers outline that mine reclamation surety bonds are often riskier than other forms of investments that they hold in their portfolios (Kuipers, 2000). Such surety bond returns are highly skewed with limited upside. As a result, it is much more challenging to diversify risks in a bond portfolio than in an equity portfolio. When a mining company borrows money from an FA provider, it obligates itself to repay the financial assurance loan at a future agreed upon date, and if it cannot meet this obligation, the debt holders gain control over the corporate entity. These holders would have a claim on the company’s assets, and this claim is enforced by the legal system. In a way, debt 37 British Columbia Mines Minister, Bill Bennett, referring to the Auditor General Carol Bellringer’s 2016 report, an Audit of Compliance and Enforcement of the Mining Sector, pointed out that financial security for reclamation costs in the province had doubled in the last decade (Fry, 2016; Hoekstra, 2016). 80 holders and equity holders own the company together, but the debt holders’ investment typically has a limited upside and downside while the equity holders’ investment has unlimited upside and downside. A payoff of such signifies that the creditors (e.g., surety provider) are short a put option written on the assets of the borrowing company (Merton, 1974). Companies with higher debt ratios may be tied to higher defaults and thus, greater credit risk (Merton, 1974). The Merton Model, a structural model, based on the Black-Scholes option pricing model (Black and Scholes, 1973), describes such scenarios – it can be used for equity valuation and credit risk management (Merton, 1974). Merton expresses owning equity stock in a company as equivalent to simultaneously owning a European call option and selling a put option on the company’s assets, with the strike price being the value of the company’s debt. Merton sees default as arising from the value of the company’s assets falling short of the amount of debt at maturity. Overall, the global speculative-grade corporate defaults rose by more than 30 percent in 2016 and reached the highest level since 2009, stated Moody’s Investors Service in their report, entitled Corporate Default and Recovery Rates, 1920-2015, which covered more than 20,000 corporate issuers (Els, 2016). According to Moody’s, in 2015, companies defaulting on corporate bonds or loans compared to 2014 close to doubled, with the total value jumping to $97.9 billion. What is different compared to the global financial crisis of 2007-2009 is that defaults in this credit cycle are uncommon in that they are sector-specific (Els, 2016). Oil & gas represented for 32 percent of all defaults and metals & mining around 14 percent, the second-largest contributor among non-financial sectors (Els, 2016). Metals & mining also suffered the highest default rate in 2015 at 6.5 percent, followed by oil & gas at 6.3 percent. 81 In its 2013 annual report, Molycorp Inc. (Molycorp) stated that the US Environmental Protection Agency (US EPA) declared its plan to launch a new FA programme for hard rock mining, extraction, and processing facilities under the Federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) of 1980 (commonly referred to as the Superfund law). Such a strategy may require mining companies to establish additional financial bonds or other forms of sureties (Molycorp, 2013; US EPA, 2016). At that time, Molycorp could not predict the effect of any such requirements on their operations, and those of mining companies, in general. Asset Retirement Obligations38 for accounting purposes can be, and frequently are, larger than the number of financial surety bonds placed with local regulatory authorities (Molycorp, 2013). The Superfund law is a United States federal law intended to clean up sites contaminated with hazardous substances and pollutants (US EPA, 2016). It sanctions federal natural resource agencies, primarily the EPA, US states and Native American tribes to recuperate natural resource damages caused by hazardous substances; however, most states usually use their versions of CERCLA. Financial assurance may identify parties responsible for the contamination, and may either require them to clean up the mine sites or it may take on the clean-up on its own using the Superfund trust fund and expenditures recovered from polluters by requesting the US Department of Justice to intervene. It should be mentioned that Molycorp, in the summer of 2015, filed for bankruptcy with a plan to restructure its outstanding debt of $1.70 billion after the dive in prices for its products plunged (McCarty and Casey, 2015; Miller and Zheng, 2015). Molycorp emerged as the property of Oaktree Capital Management and was subsequently reorganised as Neo Performance Materials (Topf, 2015; Brickley, 2016). 38 Asset Retirement Obligation cost estimate is a legally defined term meant for financial reporting by the US and some other jurisdictions (Parshley et al., 2009). Such assessments must be prepared each year as part of the annual financial reporting requirements and must be adjusted to reflect any increases stemming from new development work or reductions resulting from completed mine closure work that occurred in the fiscal year. 82 When Pegasus Gold Inc., located in Montana, filed for bankruptcy in 1998, the cost of the clean-up fell on the US taxpayer. The expenses kept growing (Jacobson and Custer, 2017; Preston, 2017; AbandonedMines.gov, 2018). To stop such future abuses, the Obama administration moved to mandate hard rock mining operations to demonstrate they possess the financial capacity to clean up future pollution. The administration rule was meant to support cash-strapped Superfund clean-ups of areas polluted by hazardous waste and was aimed at minimising the prospect of taxpayers having to foot the clean-up bill in such disastrous circumstances in the future. Now the Trump administration, cheered by many mine operators, moved to transfer the financial liability of cleaning up back to federal and state agencies (Jacobson and Custer, 2017; Preston, 2017). Critics claim that the US president’s EPA rule change exploits taxpayers for mine clean-up. In early December 2017, Scott Pruitt, EPA administrator, dropped the Obama-era rule, asserting modern mining practices, in addition to other US state and federal requirements, made the financial responsibility rule unnecessary. He stated, “Additional financial assurance requirements are unnecessary and would impose an undue burden on this important sector of the American economy and rural America, where most of these mining jobs are based.” (US EPA, 2017). 3.2.2 Response from Industry Miller (1998) states that the mining industry agrees that financial assurance is about the protection of stakeholders’ interests through environmental regulation. They are also aware that dropping or volatile commodity prices and unanticipated technical difficulties can render a viable project uneconomic. For a single-mining corporate entity with finite financial resources, the outcome can be disastrous. 83 The consensus is that most of the industry agrees that if the reclamation expectations and regulations for mine abandonment and closure are adequately defined, and a company possesses an established track record as an accountable mine operator, FA should not be required. He goes on to mention that mine operators would prefer financial assurance that could be attained at nominal or no cost (Miller, 1998). In place, it would include financial statements and financial strength/stress tests, asset pledges, or corporate self-guarantees – examples of ‘soft’ forms of financial assurance. Mining companies specified that a corporate guarantee should be an acceptable form of EFA in circumstances where (Miller, 1998): • there is a low probability of default; • clean-up and reclamation expenditures are established by an acceptable third-party; • the reclamation process is expected to be short-term; and • the company possesses the financial capacity to meet all its mine closure financial obligations sufficiently. In circumstances where the above conditions cannot be met, then ‘hard’ FA instruments such as cash or its equivalent should be required – this might include newly established mining companies or ones with a restricted record of performance (Miller, 1998). The mining sector agrees that no single FA method exists that best suits all mining operations circumstances and environmental regulators should possess a toolkit with various forms of financial assurance instruments at their disposal for mine reclamation closure purposes (Miller, 1998). Having such a selection that could be tailored for specific needs based on the length of time needed to retire a mine site, the probability of a company defaulting on their reclamation obligations, and the extent and type of closure activity accomplished to date serves the collective interest of all stakeholders (Miller, 1998). 84 An SMI-CSRM (Sustainable Minerals Institute’s Centre for Social Responsibility in Mining at The University of Queensland) paper concluded that the financial liability of financially assuring mine R&C obligations should be measured and analysed in relation to the overall tax burden to boost much-needed mining investment and to permit rational and efficient exploitation of mineral resources (Dondo, 2014). The cost of the required FA would need to be evaluated considering the overall tax burden for mining investments. Internalising costs in the companies will decrease the tax base and consequently the state revenues, but it may also impact the country’s ability to attract investments. The research was conducted from the Argentine context, where large scale mining is a relatively recent development in the nation. Dondo (2014) further remarks that government regulators should also be aware of the relationship between resource efficiency and higher costs, since raising capital expenditure can increase the cut-off grade of the mining projects, resulting in smaller mines or shorter life, or leaving some projects unfeasible (Peck and Sinding, 2009). Remediating Abandoned Mine Sites Governments absorb most of the financial expenditures associated with classifying and remediating abandoned mine sites, but it is taxpayers who ultimately pay the costs. Over the last 30 years, most Canadian provinces and territories, along with the country’s federal government, have made attempts to have fitting reclamation and closure plans in place and to make sure sufficient funding for reclamation is available when a mine is permitted (CCSG Associates, 2001). Unfortunately, mine sites are seldom, if ever, returned to their natural or economically usable state. Consequently, financial assurance is often insufficient or inaccessible when it is required. There are a limited number of innovative programmes for recovering the R&C costs from mining companies that benefited from not providing adequate funding for reclamation. 85 However, these still need considerable government investment (CCSG Associates, 2001), and, at present, have only a voluntary commitment from the mining industry. There is some support from mining companies in the reclamation of old and abandoned mine sites where they wish to search for new mineral deposits, as in the Sullivan underground zinc-lead-silver mine in Kimberley, BC, and the Kam Kotia mine site located 35 kilometres northwest of Timmins, Ontario. There are also mine sites such as the Faro mine, in Yukon, and Yellowknife, Northwest Territories, where the federal government accepted financial responsibility for previous perpetual environmental liabilities to entice interested parties in re-mining the site. The reworking of tailings is not a new concept. Leonida (2015) comments that the abandonment and closure of mining areas are seldom as a result of the overall consumption of a reliable resource, but instead due to diminishing financial returns based on metal prices, or political, social, and environmental restrictions resulting to an unprofitable scenario per resource unit. Miners have traditionally reworked earlier mine wastes as commodity prices have changed or new technologies have been developed, in an attempt to recover commodities lost to former inefficiencies, or due to other economic drivers. However, the reclamation of mine tailings to help in restoration has only recently been considered a possible answer as the pressure on the mining industry for proactive mine closure planning has risen. Nevertheless, even if the ore potential can be established and the technology will recover adequate amounts of metal, there may still be little motivation to re-mine many old mining districts. Concerns include new mining ventures being held financially accountable for past mining legacy, not counting any further disturbance, and the sheer remark of metal value from such old sites could result in legal action from bankruptcy trustees or property owners who will lay claim to any recovered ore value. The Canadian Broadcasting Corporation (CBC) News reported on May 2012 that Canada’s environmental commissioner’s 2012 report identifies four mine sites as possessing the 86 highest reported financial liabilities in the country – although it does not reveal the exact financial details, which is said to be classified information (CBC News, 2012). In Canada, there has been a minimal investigation into how the expenditures of remediating abandoned mine sites can be internalised to the mining companies and principal persons that have primarily profited from their mining activities (CCSG Associates, 2001). Clark et al. (2000) stated that complete mine closure for orphaned mine sites, currently operating mines, and new mines remain the main obstacle for practically every mining country in the world. To take on the obligation to close abandoned mines and to ensure that current operating and new mines are properly closed usually involves the assistance of a diverse group of stakeholders, new and advanced methods of financing mine closure, and significant changes in government policy and legislation in most mining countries to guarantee post-mining continual development. In recent years the legacy of orphaned mines, their related environmental, financial obligation and social issues, and the prospecting development options for nearby communities has led to increased social awareness on mine closure planning (Smith and Underwood, 2013). In many jurisdictions’ regulatory requirements, mining practice and procedures have advanced to reflect the concerns of stakeholders, and some mine operators have implemented organisational practices and policies and have implemented various forms of technologies (including biotechnology) that enables resource extraction to occur while reducing environmental impact (Smith and Underwood, 2013; Shore, 2014). 3.2.3 Effectiveness of Mine Reclamation and Funding Each provincial government, in Canada, regulates its respective mining industry, and they have all established and passed regulations and legislation for the supervision of provincial 87 mining activities and site closure. The Canadian federal government has also established acts and regulations that oversee mine closure and is accountable for these mining activities on First Nation Reserves and in the Northwest Territories and Nunavut. These jurisdictions all demand that mine closure plans are developed, and adequate funds are easily accessible for mine reclamation purposes by the company before mining operations commencing (Mackasey, 2000). Progressive R&C work is completed by the mine operator in accordance with the approved closure plans, which must be continuously amended and approved by the appropriate government agencies (Mackasey, 2000). Each level of government in Canada has legislation in place to offer reclamation financial assurance in the event a mining company is incapable of doing so (Mackasey, 2000). If an operator declares bankruptcy before the closure of its mining operations, the overseeing government agency will employ the security deposit funds to cover the costs associated with clean-up and reclamation and for the mine site closure (Noble, 2006). If the operator correctly handles its R&C obligations, the security deposit is refunded to them (Noble, 2006). That way, even if the corporate entity goes insolvent, the taxpayer is sheltered from having to cover such mine closure expenditures. According to Munso (2009), for one single project, abandoned mine R&C costs can reach several hundred million dollars or even much more. For instance, for the abandoned Faro mine in Yukon, the reclamation cost of its toxic tomb is expected to top well over CAD$1 billion (Giovannetti, 2017) and the poisonous dust buried under Yellowknife’s Giant Mine that is costing taxpayers over CAD$2.37 billion to remediate (Thomson, 2018). As part of Canada’s federal budget for 2019, the Canadian government outlined its CAD$2.2 billion abandoned mine sites remediation programme in the Northwest Territories and the Yukon, naming 89 sites that will receive tax funding to clean up these sites over the next 15 years (Parizot, 2019) – this list includes Faro mine39. 39 The mines that will secure funding are the Cantung, Giant, and Great Bear Lake mines in the Northwest Territories (Parizot, 2019). In addition, the Clinton Creek, Faro, Ketza River, Mount Nansen, and United Keno Hill mines in the Yukon. 88 There are some mining operations, which are abandoned, where the mine owner(s) merely disappear(s) from the country. For example: • the owners of Nunavut’s first and only diamond mine, Jericho mine, vanished after the company went bankrupt. Nunavut diamond mine owners owe CAD$2 million for clean-up costs (CBC News, 2013). • South Africa’s Department of Mineral Resources (DMR) holds a list of 6,000 derelict and orphaned mines, which became the government’s responsibility over the years when the former owners vanished. While the DMR slowly rehabilitates these mines – at a rate of about ten per year – mining companies continue to discreetly walk away from their operations once they have become economically unprofitable (Olalde, 2016). Encouraged by the mining industry and other interested groups, governments are keen to endorse local economic development through mineral extraction and to keep regulations to a minimum – often viewed as a method to attract investment (CCSG Associates, 2001). Substantial tax breaks and subsidies are also established to entice mining operations to continue, even when their operators do not believe it to be an economically viable strategic decision to do so. Such actions are widely cited as an example of regulatory capture (Haselipa and Hilson, 2005; Grant, 2011). The Faro mine, in the Yukon, is a case in point. Proper mine reclamation cost assessments are essential pieces of information that permit a mine operator and the jurisdiction regulatory agency supervising mining operations the capability to decide the amount of the financial assurance that should be put forth before mining operations commence. Such material information should be periodically reviewed by both the agent (mining company) and the principal (regulatory agency) and updated regularly, and this financial veil of secrecy should be lifted for public knowledge and information in the stakeholders’ interest. It should also be made easily accessible within a company’s annual report for all interested parties to review. 89 It is also difficult to discover the cumulative reclamation, long-term site monitoring, and financial R&C costs of ongoing mining companies. In particular, how reclamation liability cost estimates are calculated since the discrepancies in some instances are mind-boggling (OAGBC, 2016). For example, and as earlier noted, in the BC Auditor General’s 2016 report, the 2014 data shows the provincial government holds financial securities of CAD$450 million from Teck Resources for its various coal mines and its large Highland Valley Copper mine against estimated reclamation costs of CAD$1.187 billion (OAGBC, 2016). That leaves an underfunded liability of CAD$736 million. Barrick Gold, which possesses several shuttered metal mines in BC, including the Eskay Creek gold and silver mine in northern BC, has put up the financial security of CAD$6.5 million on total projected reclamation costs of CAD$218 million. Such a low-ball value signifies that the regulator holds an underfunded liability of CAD$212 million (97 percent of the total reclamation cost). Such material regularly must be pieced together from annual reports and other sources if it indeed is documented. Notes of material to the financial statements may exist, but they are not necessarily easy to locate and may be vague or incomplete. 3.2.4 Endangered Surety Bond Market Since the recent global financial crisis, operators in the mining industry, and other sectors, including oil & gas, have found it progressively problematic to satisfy financial guarantee obligations required by regulators with the typical financial assurance mechanisms of choice because of surety providers’ large-scale departure from the natural resources markets. The latest financial credit crunch and the tightening of the surety bond market have prompted such extractive companies to seek and post substitute forms of financial collateral. Such a turn of events has had negative consequences for the mining and energy sectors (Learn, 90 2016). The troubled surety bond market and the corresponding implications for the mining industry received widespread attention. These problems stemmed from the convergence of several events, which include the most recent financial crisis and the subsequent commodities market crash. The ensuing erosion in financial capital, due to such circumstances and stemming from tighter lending regulations, triggered longer-term conservatism in the underwriting market, which is still felt today by many mine operators in the form of higher premiums. The assurance industry has recognised that surety bonds are now comparatively high-risk investments – especially when dealing with mine operators with multi-decade projects in their portfolios. Consequently, many are either limiting or cancelling their existing bonds with mining and oil & gas companies and refusing to issue new ones. The last market correction of 2007 has increased the surety industry’s rates and made it more risk-averse. Another concern, according to Robert Duke, general counsel of The Surety and Fidelity Association of America, is that selling surety bonds to mine operators is already a niche market in which perhaps only a few dozen financial companies operate (Learn, 2016). The shortage may get worse, as Anna Zubets-Anderson, a senior analyst at Moody’s, said, “You have reclamation obligations growing for an industry and companies that are actually contracting” (Learn, 2016). Zubets-Anderson goes on to mention, “We are seeing that surety bonding is becoming more expensive and less available.” Bob Kenney, president of First Surety Corp., indicated the market for surety bonds is also tightening for many in the broader energy sector (Learn, 2016). The Supreme Court of Canada (SCC) released its verdict in Orphan Well Association, Alberta Energy Regulator v. Grant Thornton Limited and ATB Financial on January 31, 2019, which could tighten access to much-needed debt financing even further. The case concerned the receivership and bankruptcy of Redwater Energy Corp. (Redwater Energy). The dispute in 91 Redwater Energy centred on the renunciation of uneconomic oil & gas wells, pipelines, and facilities that are subject to provincial abandonment and remediation liabilities. The company’s receiver (and later trustee in bankruptcy) challenged the applicability of the provincial regulatory regime administered by the Alberta Energy Regulator. It argued, among other things, that the provincial regulatory regime frustrated the legislative purposes of the federal Bankruptcy and Insolvency Act and that dual compliance with federal and provincial legislation was not possible. It also indicated that preventing receivers from renouncing uneconomic assets, including oil & gas wells, would result in receivers and trustees refusing to take on such mandates and would frustrate statutorily mandated efforts to realise on oil & gas assets of insolvent companies. The SCC’s decision could have profound effects on lending to oil & gas companies at a time when the industry is experiencing severe setbacks (DeSereville, 2019; Maerov et al., 2019; Morgan, 2019; Restructuring Roundup et al., 2019). In reaching its verdict, the SCC noted that the effect of its judgment is to enforce the supremacy of the polluter pays principle; such a goal is equally laudatory and sacrosanct (Collins et al., 2019; Johnson, 2019; Restructuring Roundup et al., 2019). The case has been one of the most closely watched by the Canadian oil & gas industry in decades. Such a verdict implies that super-priority administrative claims would take precedence over all other administrative claims, including seniority debt, when a corporate entity is insolvent. The priority of creditor rankings under the Bankruptcy and Insolvency Act in Canada classifies all kinds of claims against a debtor. It prioritises them according to specific rules depending upon, among other things: when the claim arose, whether it is unsecured or secured and whether it should be entitled to some especially elevated status of the payment in accordance with various policy considerations and particular interest concerns identified by the Office of the Superintendent of Bankruptcy Canada (Department of Justice, 2019; ISED, 2019). Secured claims possess the highest priority so long as the value of 92 collateral securing a claim is larger than the face amount of the obligation, the secured creditor’s rights will be relatively unchanged by a bankruptcy case. Unsecured claims fare worse except in rare situations where unsecured creditors receive a pro-rata distribution from a bankruptcy estate that contains inadequate assets to satisfy all creditor claims. Government regulators may now contend that regulatory obligations have been leapt to a super-priority status (DeSereville, 2019; Maerov et al., 2019; Morgan, 2019; Restructuring Roundup et al., 2019). Where those financial obligations surpass the value of the estate, and the transfer of assets is subject to regulatory control, it is uncertain whether those assets could be sold in a bankruptcy process. It is therefore uncertain whether there would be a point to a bankruptcy process in those circumstances. Such an SCC decision may have profound repercussions, possibly limiting the capacity of oil & gas producers to establish credit and impairing the effectiveness of the bankruptcy system where debtors have significant regulatory obligations (DeSereville, 2019; Maerov et al., 2019; Morgan, 2019). Secured lenders, such as banks, may soon be unwilling to advance monetary funding to any oil & gas company for fear that the regulator may in effect confiscate the secured lenders’ interest in their borrower’s assets (Collins et al., 2019; Johnson, 2019; Krüger et al., 2019). Consequently, credit for all corporate entities in the affected industries could become costlier and less accessible, stunting economic growth and causing more financial failures and distress (Krüger et al., 2019; Restructuring Roundup et al., 2019). The Redwater Energy verdict is expected to generate increased financial difficulties for junior and intermediate producers in an already challenging credit market (Restructuring Roundup et al., 2019). Borden Ladner Gervais LLP (BLG) expects that trustees40 are likely to be prevented from disclaiming uneconomic assets and selling economic ones (Krüger et al., 2019). Instead, trustees will now be obligated to sell assets in bundles or perform abandonment and 40 Receivers and trustees are referenced as ‘trustees’ (all the stakeholders, they include the Crown, Alberta’s Orphan Well Association (OWA) and Energy Regulator (AER), producers, receivers, lenders, surface rights holders, and bankruptcy trustees) in the upstream oil & gas production sector (Collins et al., 2019). 93 reclamation obligations as conditions of selling economic assets. Where environmental liabilities exceed the total valuable assets, BLG expects fewer asset sales in ongoing engagements, as well as fewer appointments of trustees and receivers by creditors in the first instance. Moody’s Investor Services says high court support for the Alberta Energy Regulator’s ability to force a bankruptcy trustee to pay out well-abandonment obligations before paying back creditors is credit negative for energy companies (Kilpatrick, 2019). Such an impact may well extend beyond the regulated oil & gas industry to other sectors such as mining (DeSereville, 2019; Lewis, 2019b; Maerov et al., 2019; Morgan, 2019). Moody’s also states the ruling is credit negative for banks and other creditors but adds it is unclear how it will affect different industries and provinces going forward (Kilpatrick, 2019). SCC’s verdict in Orphan Well Association, Alberta Energy Regulator v. Grant Thornton Limited and ATB Financial could add strength to the arguments raised in the dissertation in favour of the application of securitisation to meet the regulatory requirements surrounding financial assurance. Securitised mechanisms are typically made bankruptcy-remote (under the control of an arm’s-length trustee, the SPV). The SPV is usually set up in a manner that ensures that it is operationally distinct from the originator (Hahn et al., 2015). The Canadian federal government also unveiled a new piece of legislation, Bill C-69, the Impact Assessment Act (an overhaul of the Federal Environmental Assessment Act). The C.D. Howe Institute (C.D. Howe) has warned this controversial legislation, which the Canadian government introduced in 2018 to overhaul federal environmental assessments for major mining projects, threatens to dampen investment in the already depressed natural resources sector even further (Bishop and Sprague, 2019; C.D. Howe Institute, 2019; Webb, 2019). Investment in Canada’s mining and oil & gas sectors are disproportionately down compared with other jurisdictions (Bishop and Sprague, 2019). C.D. Howe blames Canada’s sclerotic regulatory regime. 94 Morgan (2018) comments that the proposed legislation under consideration lacks clarity and decisiveness since it does not define guidelines and rules. Instead, it uses terms left to the interpretation of the reader, which could potentially adversely impact the reclamation success of a given site. It will force stakeholders into massive financial spending commitments before even applying to the regulator for consent, all due to lack of absolute clarity of rules or requirements. Bill C-69 will permit the government to serve some role as the regulator, thus sanctioning political influence into a decision that should be made by a regulator. The Environment Minister would ultimately have the final say on any approval of a pipeline (Morgan, 2018). The Fraser Institute also warned that oil & gas and mining projects would be needlessly exposed to political risk, which in turn could limit the ability of proponents to finance projects on a cost-effective basis. Canadian Senator and lawyer, Douglas Black, also questioned if Bill C-69 is an attempt to kill the oil sands in Alberta (McNeil, 2018). Martha Hall Findlay, president of the Canada West Foundation, said, “In all of my involvement for decades now, I’ve never heard the phrase ‘sovereign risk’ associated with Canada, and that is now a regularly used term.” (Bennett, 2019). C.D. Howe further argued that Bill C-69 is flawed and stated that the legislation for impact assessments must specify considerations for assessing projects that can be scoped and applied with reasonable consistency and predictability (Bishop and Sprague, 2019). It also commented that legislation must preserve the role of independent and expert lifecycle regulators in leading assessments. The Fraser Institute has further stated that eliminating the existing test for public involvement will throw the door open for interventions from groups far from any future project, potentially adding a considerable amount of time for taking testimony on a proposed project (Green, 2018a; Green, 2018b). The Institute also warned that Bill C-69 95 would mean environmental assessments could take longer and be more subjective and political, which might potentially lead to conflicting, incomplete, and vague environmental regulation. 3.3 Financial Assurance Rules A key mining standard of environmental law and regulation is that pollution costs are expected to be borne by their creators (Vagstad and Kirsch, 2002). Regulations and laws give this principle form by demanding polluters to pay for property, natural resource damages, and health and unperformed reclamation requirements. Regrettably, many environmental obligations, despite being well defined in theory and law, are not always met (OAGBC, 2016). Outright abandonment, insolvency, and bankruptcy are disturbingly common techniques by which polluters evade responsibility for environmental costs. Financial assurance rules are intended to address this policy issue. These rules require probable polluters to demonstrate, before the fact, their financial resources are adequate to deal with environmental damage that may arise in the future. Thus, EFA acts as a central complement to liability rules, reclamation and closure obligations, and other environmental and closure compliance requirements (Miller, 2005). 3.3.1 Underperformed Obligations and Unrecoverable Liabilities Theoretically, polluter cost internalisation is practically undeniable as a guiding principle for environmental regulation (Gerard, 2000; Boyd, 2001; Miller, 2005; OAGBC, 2016). Cost internalisation by responsible parties yields the most equitable means of casualty remuneration, where the alternatives are no compensation provided by public funds or simply no compensation. Polluter cost internalisation also encourages prevention, risk 96 reduction, and innovations to diminish environmental harm. Because of that, with few exemptions, most environmental regulations make polluters responsible for damages stemming from commercial activities that harm public health or that cause property or ecological disasters. The relevance of cost internalisation in law and regulation does not always correspond by its successes in practice (Gerard, 2000; Boyd, 2001). Even the most certain legal requirements can vaporise when presented to an absent, insolvent or bankrupt polluter. Consider the inferences of bankruptcy. In the US bankruptcy code, debtors are sheltered from creditors by the automatic stay provision of which implies that both public and private environmental claims can be discharged in bankruptcy (Howard, 2015). Outstanding environmental liabilities are only partially recoverable upon bankruptcy occurring if they are retrievable at all. To compound the matter, companies may deliberately increase the prospect of insolvency by divesting themselves of capturable assets to externalise costs. In industry sectors where liability costs can be high, a corporate entity’s business organisation and its decision-making strategies regarding capital investment and retention decisions may be influenced by the incentive to externalise liabilities (Howard, 2015). For example, it might shelter assets overseas through a shell company such as an SPV legal entity, where it serves as a vehicle for business transactions without the shell entity itself having any significant assets or operations. Environmental cost recovery can also be crushed if a polluter has legally dissolved its operations before the realisation of performance or liabilities of obligations; however, there are limits to such a strategy. A liable company that is sold does not instantly escape liability since they will be transferred to the purchasing company. If assets are retired over time or sold piecemeal, however, such environmental costs can more effectively be externalised. This prospect is enhanced by the nature of many environmental obligations and risks, which frequently materialise only over a period of years or possibly decades. Company closure can 97 be a questionable tactic to avoid future requirements. Regardless of the strategy used to circumvent liability and reclamation obligations, the absence of a solvent defendant defeats the capability of victims or governments to collect compensation. Insolvency undercuts an environmental law’s ability to discourage environmental injuries in the first place. 3.3.2 Scale and Scope of Unrecovered Environmental Costs Non-recoverable environmental obligations are more than an imaginary likelihood. Over the past decades, countless numbers of environmentally damaging mining operations have been orphaned or have avoided liability by declaring insolvency. 3.3.3 Benefits of Assurance Reclamation obligations and liability rules lead to polluter cost internalisation, in theory; however, liability, many administrative requirements, and any other after-the-fact obligations or penalties suffer from a significant fault. Since the financial commitments or damages arise only after environmental damages have occurred, polluters can escape cost internalisation through prior dissolution or bankruptcy declaration (Faure and Grimeaud, 2000; Boyd, 2001; Miller, 2005). Financial assurance rules are meant to counter this weakness. Moreover, EFA essentially safeguards that the expected financial costs of environmental risks appear on a company’s financial statements. Financial assurance can also foster timely, relatively low-cost public access to compensation, which can be favourable when a swift response allows for the minimisation of environmental damages. When assurance is held by a public trustee, such as a regulatory agency, it reduces the public transaction costs related to collecting payment. Even when liability is confidently established, the prospect of postponement, appeal, and uncertainties 98 associated with penalty collection can muddle the actual transfer of funds from defendants to victims and resource trustees. Specific financial assurance instruments permit practically instant access by regulators to reserved funds – this shifts the responsibility of the regulator to the accuser. Instead of the regulator having to substantiate that reparation is due and seek the funds, the burden falls to the polluter to establish that they are not legally liable (Faure and Grimeaud, 2000). 3.3.4 Alternatives to Assurance Perhaps the most substantial incentive for financial assurance requirements arises from the contemplation of the alternatives. Since R&C costs never cease to exist, someone must ultimately pay but who…? Two choices exist, the extension of environmental costs to polluters’ business partners or the externalisation of these costs to society. The externalisation of such costs to society is objectionable since it undermines deterrence and the capacity to compensate victims (Faure and Grimeaud, 2000; Monti, 2002). The extension of liability to corporate partners is a more difficult circumstance, but it too highlights the desirability of EFA. The law regularly extends financial liability to the business partners of absent or bankrupt defendants. The incentive for extending liability is identical to that for financial assurance, as seen in the insurance industry where compensation and deterrence are served by the internalisation of financial costs (Faure and Grimeaud, 2000). Corporate entities exposed to their business partners’ financial obligations will diligently monitor those partners’ safety. Such partners also provide a source of compensation that can be sought out if required. Under CERCLA, an acquiring company takes on the liabilities attached to a property possessed by the seller (Price, 1984; Buckley, 1990). Accountability is also extended from mine operators of disposal facilities to the original generators of the waste (Price, 1984) and 99 legal responsibility can be applied without reference to fault or the liable mine operator’s proportional contribution to the environmental damage. Financial assurance is preferable to extended liability for a multiple of reasons. Foremost, the extension of financial responsibility does not ensure cost internalisation given there may be no business partners from whom to seek reparation or if such partners may themselves be in receivership. Secondly, joint or multiple environmental obligations entail significant transaction costs related with ex-ante contracting between mutually liable entities and the resolution of ex-post claims for contribution among jointly responsible offenders (Price, 1984; Buckley, 1990). Lastly, extended liability can impact production decisions (Price, 1984). 3.4 Politics and Costs of Assurance Regulated communities typically oppose new or strengthened financial assurance rules (Peck and Sinding, 2009). New regulations produce dismal expectations of higher insurance rates, the possible departure of insurers and surety providers from the market, and the potential demise of extractive companies who are unable to meet new financial assurance requirements (Faure and Grimeaud, 2000; Boyd, 2001). Amendments to mining regulations have often prompted opposition based on their adverse impact on small mine operators (Boyd, 2001). Should such uncertainties call into question FA’s social desirability? It should be mentioned that much resistance can be accredited to an underlying cynicism and distress of increased financial liability as opposed to fear of financial assurance requirements themselves (Faure and Grimeaud, 2000; Boyd, 2001; Dondo, 2014). 100 3.5 Scope of Assurance Rules Financial assurance is an elegantly simple concept where its central purpose is to protect public finances in the event a mining company becomes bankrupt or fails to carry out its legal commitments related to the normal activities of its project(s), including mine decommissioning and reclamation. EFA requires operators to demonstrate the availability of financial resources to conduct closure and environmental activities. Such simplicity highlights a set of crucial design issues. Issues of the proper scope of financial assurance requirements relate to the obligations and liabilities that are covered by EFA and the dollar value of coverage or bonding that must be demonstrated. Tension often arises between the objective to maximise the scope of FA, to maximise deterrence and compensation, and the need to reduce compliance costs by minimising EFA requirements (Faure and Grimeaud, 2000). Issues surrounding the effectiveness of a regulatory approved EFA mechanism is also often questioned by concerned stakeholders (Marcus, 1997; Faure and Grimeaud, 2000). One approach for liable parties to decrease their financial burden and their financial risks is to reduce the amount of security they provide as financial assurance. A significant obstacle inherent in environmental regulation is that they require regulators, who usually possess limited enforcing resources, to monitor and ensure the financial mechanisms’ security is financially adequate over long periods (Marcus, 1997). 3.5.1 Appropriate Coverage Levels To internalise costs and subsequently to ensure environmental obligations are sufficiently performed, financial assurance regulations need to provide a mine operators’ capacity to internalise costs in the future. Financial coverage requirements should be satisfactorily high enough to validate the performance of the required obligation or internalisation of future 101 environmental expenditures. An opportunity cost will arise if coverage requirements are greater than the required levels since they would be excessive given that a company’s capital would be tied up without it yielding any additional social benefit (Grimeaud, 2000). Conversely, coverage requirements lesser than the required levels are also detrimental since they would not ensure cost internalisation, and thus yield an insufficient level of deterrence and compensation (Grimeaud, 2000). As in insurance economics, FA rules mandate coverage up to some finite dollar value, even if there is no actual upper limit to the likely damages arising from an operation (Zweifel and Eisen, 2012). 3.5.2 Determining the Required Assurance Levels Regulators and corporate entities rarely know with confidence what actual costs will ultimately be since such reclamation liability cost estimates are subject to negligent, deliberate, or inadvertent error. Financial obligations related to pollution disasters are even more challenging to predict. Given such uncertainties, the calculation of the necessary financial assurance amounts can be problematic. A variety of approaches are utilised to determine coverage requirements. In some circumstances, these obligations are determined on a case-by-case basis, which considers the specific risks posed by a mining operation. In other situations, greater procedural formality is imposed via established estimation approaches. To further complicate matters, cost estimates frequently change considerably over time (EY, 2017). EFA amounts must also be adjusted accordingly for cost inflation, expansion of operations, and changes in a mine site’s environmental conditions (Cheng and Skousen, 2017). The Pennsylvania Department of Environmental Protection points out that a surety bond, in general, is not a suitable financial instrument for safeguarding the long-term treatment of a post-mining pollution discharge since it is finite and fundamentally incapable in keeping up 102 with inflation (PA, 2007). In Pennsylvania, every five years, when a mining permit is renewed, the permittee must make available additional financial assurance to keep pace with inflation and changing site conditions. Due to the general term and given it is highly improbable that the bond will ever be released, many permittees will be unable to obtain the obligatory assurance to meet their legal obligations. As a substitute to bonds, Pennsylvania’s Surface Mining Act permits the Department of Environmental Protection to establish alternative FA mechanisms that meet the objectives and purposes of the bonding programme. One alternative tool created by the Department is a trust fund (PA, 2007). Accordingly, the estimation of required coverage amounts places a substantial burden on the regulator to assess the quality of the values and estimation methods. Under some regulatory programmes, a fixed schedule of requirements is imposed across an entire industry (Boyd, 2001). Overall, though, regulatory agencies may possess a high degree of difficulty in determining suitable financial assurance levels (Boyd, 2001). Several legal cases highlight the procedural challenge. For instance, in Leventis et al., v. South Carolina DHEC, et al., the Sierra Club persuasively argued that the state environmental agency neglected to estimate and assess acceptable clean-up, closure adequately, and reclamation financial assurance amounts for a hazardous waste disposal facility (Boyd, 2001). 3.5.3 Auditing Self-Estimated Assurance Requirements While regulators can perform cost estimation themselves, such evaluation is time-consuming and costly. In some circumstances, mine operators are asked to develop their environmental liability cost estimates as a basis for their EFA obligations. Absent of adequate oversight, these valuations may prove to be low. After all, low-balling assessments of future environmental requirements is a good approach for companies to minimise their costs of financial assurance. A low approximation translates into lower coverage obligations and, therefore, lower compliance costs. Therefore, audits, ideally 103 conducted at regular intervals, by certified third-parties, as the dissertation is proposing, are imperative to ensure that adequate financial assurance is put in place. It should be noted that an advantage of fixed assurance schedules is that they minimise this auditing burden. Absent of a suitable audit process, it is ill-advised to permit mine operators to assess the amount of their EFA obligations. There is evidence that companies regularly underestimate R&C requirements while conforming to assurance regulations (US EPA, 2001). One US EPA study found that 89 of 100 facilities submitting landfill liability cost estimates miscalculated their closure expenditures and thus posted low levels of EFA (US EPA, 2001). Furthermore, the US EPA (2001) report stated that the total amount of the under-estimates was substantial, estimated at $450 million, just for those 89 facilities. Because the usefulness of financial assurance rules hinges in large part on having enough financial guarantee funding, and since the level of EFA is often based on liability cost estimates, verification of such estimates should be an essential regulatory priority. The US White House released its fiscal 2019 budget in February 2018, where it outlined the administration’s budgetary priorities. It included cuts to programmes like Medicare and food stamps, and leaner budgets across federal agencies, including the US EPA (Davis, 2018). It also cut several programmes and shifted many environmental responsibilities to the states. Moreover, funding to the states has been reduced. Among the programmes that were cut or modified at EPA and other agencies is the elimination of thousands of federal EPA jobs and environmental projects at the state level, educational institutions, and government contractors; cuts in funding for Superfund clean-ups; and increased funding for fossil fuel development on public lands and waters (Dennis et al., 2018). 104 3.5.4 Adequacy of Coverage Levels The best test to determine if coverage levels are adequate is the degree to which mine operators’ EFA obligations are met over the decades. Because many current financial assurance rules are somewhat recent, and cover obligations that arise over decades, it is challenging to draw definite conclusions concerning the sufficiency of coverage levels for longer-term projects since overall patterns of cost recovery have not been identified yet. Financial assurance levels are an exception since such an obligatory funding commitment mechanism has been required for decades, and there is enough evidence that mining surety bond levels have been inadequate and continue to remain so. A finding that is of interest observed that reclamation standards, which regulate bond amounts and the conditions for the release of bonds, were not well documented and are commonly subjective and problematic to measure (US EPA, 1997). Such an observation highlights the significance of standardised, audited reclamation liability cost estimates and performance standards. Another issue relating to the sufficiency of surety bond amounts arises from the usage of trust funds as an EFA mechanism (GAO, 2005). If a fund is fully funded at its inception, then coverage should be satisfactory, provided that the required coverage amount is acceptable. Some programmes, however, permit mine operators to pay funds into a trust fund over time. Note that if an operator becomes insolvent before a trust is fully funded, the actual amount of available coverage will be subsequently deficient. Partly funded trusts are common (GAO, 2005). 3.5.5 Confiscation Concerns Arising from Assurance Some mining advocates have raised concerns that EFA may enhance a regulator’s ability to confiscate private property (Shogren et al., 1993; Tan, 2007). It should be mentioned that 105 many surety bonds are so-called ‘penal bonds’ where they authorise the forfeiture of the whole bond amount for failure to perform as agreed (US EPA, 2010). Consequently, even though the performance failure may have a comparatively small cost associated with it, a more considerable bond sum can be collected by the government (US EPA, 2010) – this is by design, though, and is agreed upon mutually by the parties before the fact. Consequently, penal bond collections represent less a worrisome form of confiscation, and more of a penalty used to encourage compliance with performance standards. 3.5.6 Liability Limits and Assurance Coverage Requirements Financial assurance requirements, even if based on sound estimation procedures, may be surpassed by the final costs of reclamation or liability. If so, the mine operator’s liability may be limited to the assured amount since the company may have no other accessible funding to cover environmental claims. Legally, conversely, its obligation is not generally defined by the amount of required FA (Auditor General of Canada, 2012). It would be liable for any environmental damages it causes, regardless of the amount of mandatory assurance. From a public policy perspective, the alternative of liability limits reflects a trade-off. For one thing, truncated impairment awards reduce uncertainty, which can be anticipated to decrease the costs of assurance and thus may encourage the development of markets for third-party assurance products. Furthermore, from a regulated company’s perspective, liability limits discipline the regulator’s pursuit of claims the polluter operator may feel are unsupported. Consequently, liability limits may encourage political resistance to FA requirements. Conversely, these benefits to the regulated community must be weighed alongside the downside of capped liability. Specifically, that environmental costs above the limit will be uncompensated by responsible parties. 106 3.6 Security of Assurance Mechanisms Financial assurance rules should be judged on their capacity to offer adequate compensation when environmental obligations come due (Faure and Grimeaud, 2000; Halland et al., 2015). It is consequently essential to comprehend the manners in which the efficiency, or security, of FA can be derailed. In some instances, companies may blatantly fail to abide by coverage requirements (Faure and Grimeaud, 2000; Boyd, 2001; Miller, 2005; Halland et al., 2015). In other situations, third-party FA providers may themselves be incapable of delivering on financial obligations due to their insolvency (Halland et al., 2015). The financial mechanisms utilised to establish compliance may be flawed, by design or negligent regulatory oversight (Halland et al., 2015). In this respect, self-bonding is a particularly perplexing compliance mechanism (Hein et al., 2016; Harmon, 2017; Richards, 2017). Lastly, government regulators may neglect to oversee EFA instruments effectively, and therefore, permitting secured funds to be released prematurely (Halland et al., 2015). 3.6.1 Compliance Evasion A feature of financial assurance regulations is that they create an incentive for third-party assurance providers to monitor the performance and environmental safety of the mine operators whose financial obligations they underwrite or guarantee (Faure and Grimeaud, 2000; Boyd, 2001). Such a measure can lessen some of the enforcement liability on regulatory agencies. An enforcement burden that is not relieved, though, is the requirement to guarantee that companies conform to the EFA requirements themselves. Like any regulation, FA requirements require monitoring and penalties mechanisms to encourage compliance (Faure and Grimeaud, 2000). 107 3.6.2 Assurance Evasion through Bankruptcy Financial assurance rules decrease the risk that corporate entities with environmental obligations will be insolvent when the requirements come due. In some instances, though, EFA is imposed, or higher amounts must be posted, while a company is already insolvent (US EPA, 2001) – this creates a clash between bankruptcy law and FA requirements. Boyd (2001) offers an illustration, environmental clean-up costs, once it is insolvent, could be a dischargeable entitlement under the bankruptcy code. With the code as a buffer, mine operators have attempted to elude EFA requirements by appealing that assurance-related costs are dischargeable obligations (Boyd, 2001). Nevertheless, courts have held that financial assurance costs, including the mandatory posting of FA or increased assurance amount to cover R&C costs, are not money rulings under the bankruptcy code and fit within the regulatory powers’ exception to the automatic stay (Boyd, 2001). 3.6.3 Assurance Provider Insolvency Sureties, insurers, and banks can themselves become insolvent, thus jeopardising the accessibility of EFA instruments. Regrettably, there is no insurance against an underwriter’s financial failure unless they possess reinsurance. Regulations typically guard against the likelihood of insurer insolvency by securing ratings for the underwriter, necessitating US Treasury certification of bond issuers or, at least, requiring some form of licensing for financial institutions who offer EFA (US EPA, 2010). Nevertheless, assurance provider insolvencies are common (US EPA, 2010). A concern when underwriters become insolvent is that their former customers must seek out FA elsewhere and on short notice at times. For financially healthy clientele this is not usually an issue. When mine operators in need of EFA are undergoing financial difficulties of their own, though, a replacement can prove problematic. In some instances, new assurance 108 may not be accessible. When a financial assurance provider fails abruptly, and a company with FA obligations is in financial distress, regulators face a severe dilemma (US EPA, 2010). Officially, non-compliance with EFA regulations is grounds for an injunctive action, which could include mining operations closure. Such a penalty can be a prevailing compliance motivator if a corporate entity is financially healthy. When it is near insolvency, though, closure yields no real environmental benefit, since it starves the mine operator of cash flow that could be employed to finance monetary obligations, improve its capability to secure alternative assurance, and evade bankruptcy (US EPA, 2010). 3.6.4 Defences, Exclusions, and Cancellation For EFA to be capable such instruments should not contain exclusions or defences that might hinder the host regulator’s ability to collect financial obligations (Boyd, 2005; US EPA, 2008). It is also critical that such financial instruments not be quickly withdrawn by providers if substantial environmental costs develop. In most circumstances, insureds and insurers willingly settle on coverage exclusions and cancellation terms (Boyd, 2005). 3.6.5 Monitoring, Administration, and Record-Keeping Host regulators must supervise FA instruments in a variety of ways (US EPA, 2001). First, the initial establishment of an approved assurance mechanism must be confirmed, typically by inspection of a coverage contract from an approved underwriter (US EPA, 2001) but, equally important, the continuing soundness of financial assurance contracts must be established. Regulatory rules themselves can assist in simplifying the regulator’s responsibilities and for instance, necessitating letters of credit to renew themselves automatically thus relieving regulators of one of the duties – the necessity to validate annual renewals. Sound 109 bookkeeping and monitoring of instruments are critical to ensuring that the EFA contracts will be binding and offer adequate funding in the future. An issue is the release of financial assurance funds by providers without regulatory approval (US EPA, 2001). Regulations, in such an instance, requires the government regulator to be the sole recipient of the financial assurance (US EPA, 2001). Changes in trust agreements or bank accounts can arise over time, FA providers themselves can restructure or merge, and records need to be updated to reflect changes in the EFA instruments (US EPA, 2001). Minimally, administrative procedures and regulatory requirements need to place prominence on essential record-keeping to facilitate the legal and financial maintenance of FA instruments (US EPA, 2001). The fact that regulators are characteristically not contract lawyers, accountants or even financial assurance experts complicates such an undertaking. Another burden that government regulators face is the decision to release EFA funds after a mine operator’s reclamation, closure, post-closure, and other requirements are satisfactory met. Such a decision entails engineering and scientific expertise instead of financial judgement; however, the administrative challenge is evident. The quality of R&C efforts can be problematic to evaluate (US EPA, 2001). Mine operators possess the right to challenge a regulatory agency’s decision of if their posted FA should be released. Litigation over such issues is frequent in some instances, and it adds to administrative costs (US EPA, 2001). 3.6.6 Self-Demonstration and Corporate Guarantees Issues Self-assurance and corporate guarantees permit selective mine operators to pass a set of accounting tests as an alternative to having to secure suitable financial assurance. When a company self-guarantees, its financial status is utilised to fulfil the criteria. When a corporate guarantee is applied, the corporate parent’s financial condition is employed. Almost all FA programmes permit self-assurance and corporate guarantees as methods of 110 compliance (Miller, 2005). To the regulated community, self-guarantee is inexpensive, and, therefore, a desirable form of compliance since no coverage needs to be purchased, or no dedicated funds need to be kept back (Miller, 2005). Consequently, regulatory agencies and governments may be pressured to relax self-guarantee standards to permit more operators to conform in this nearly costless manner. Self-guarantee is desirable when utilised by the wealthiest, most ecologically responsible, and most financially stable companies since it avoids the cost of purchased EFA. Regrettably, it can be unexpectedly problematic to differentiate between such entities and their less stable and scrupulous counterparts. The main issue surrounding self-assurance and guarantees is that there exists no FA instrument devoted to environmental obligations. In concession of self-assurance’s dangers, regulations feature a set of defences designed to guarantee the company’s capacity to absorb future costs. For instance, corporate entities must pass one of two assessments – a bond rating test or a set of financial ratio tests based on the sum of net income plus depreciation, depletion, and amortisation to total liabilities; current assets to current liabilities; and total liabilities to net worth (Boyd, 2001). Furthermore, there is a domestic assets test, a tangible net-worth test, a net working capital test, and a net working capital and tangible net worth to estimated closure and post-closure costs ratio test. Such a daunting set of accounting challenges suggests that many mining companies would not qualify for self-guarantees. A regulator’s task is similarly daunting. Interpretation, verification, and monitoring of such financial litmus tests over time entail either substantial in-house accounting expertise or reliance on third-party audits. Regulations regularly require independent accounting reports; however, this is not iron-clad protection since accounting fraud is relatively common, and representative among smaller mine operators and those experiencing financial distress which could lead to insolvency – precisely the kind of company and condition that can pose the most severe financial assurance complications (Boyd, 2001). 111 Accounting standards for environmental liabilities and other financial obligations are also not satisfactorily standardised (Boyd, 2001). There tends to be a significant inconsistency in the manner EFA obligations are recognised for accounting purposes. It can also be very challenging to fully evaluate the degree to which a company’s assets are pledged to other creditors or liens. From a bookkeeping perspective, it is difficult to evaluate all the environmental obligations attached to a single company. Mining companies often operate multiple operations with multiple commitments in various host jurisdictions. Consequently, summing up all these requirements and accounting for them properly is fundamental to the goal of evaluating a corporate entity’s capacity to internalise costs years in the future (Boyd, 2001). In brief, EFA accounting is problematic not only for regulators untrained in its intricacies but for accountants themselves. Another concern is that a company’s financial status can rapidly worsen and if this materialises the regulator may not even be informed of a financial crisis for many months. Self-guaranteeing also raises another issue since it involves no specific financial asset to which a regulatory authority can lay claim in the event obligations are not performed. Certain EFA instruments may not always be easily converted into compensation. Nonetheless, these instruments are more likely to yield liquid sources of payment (US EPA, 2001) – mainly true if the regulating agency is made the sole recipient of the FA instrument. The purchased coverage will also tend to be regarded by courts as explicitly committed to liability or reclamation requirements, and therefore more probable to be recoverable for regulatory agencies. The assets claimed by a self-guarantee company are much more fleeting. Assets that are not expressly dedicated to FA requirements in a legally binding capacity would be sought in competition with other creditors should they be in place and possess material value upon obligations becoming due. Financial assurance rules are intended to discourage environmental damage and to provide compensation when environmental problems cause injury while assuring that corporate entities will be able to meet their future environmental R&C obligations. EFA is alluring in 112 theory since it helps allocate costs to the parties best able to plan for and reduce them – the potential polluters themselves. FA is enticing in practice since it accomplishes its goals at comparatively low cost and without significant commercial disruption. It is significantly desirable when observed relative to the alternatives: charges imposed after-the-fact on offending companies’ commercial partners or abandoned to society. Compared to such alternatives, financial assurance leads potential polluters to a transparent, in-advance understanding of their future environmental obligations. EFA’s value as a deterrent is enhanced further when companies must purchase FA from third-parties since availability and coverage rates will be determined by the entity’s environmental track record and expectations of future environmental performance. The extensiveness of operations and risks covered by current regulations is an illustration of FA’s practicality. Markets for EFA coverage offer a wide variety of financial instruments that can be personalised to the requirements of individual corporate entities, facilities, and regulatory requirements. If there is to be a critique of FA requirements, it could be that they do not go far enough. It is clear, for instance, that much of the held EFA by government and third-parties has not been sufficient to safeguard a sufficient level of mine reclamation. In other programmes, more exposure to cost recovery over more extended periods is required to determine whether the scope of FA requirements is acceptable. The security of specific assurance instruments is also deserving of continuing examination. Self-guaranteeing assurance, captive insurance arrangements, trust funds with lengthy pay-in periods, and claims-made insurance policies may hamper cost recovery – principally the recovery of costs that arise only after a period of possibly many decades. 3.7 Financial Assurance for Reclamation Regulations and Policies Regulation is frequently predicated on international standards, benchmarks, and policies, and these regulatory influences are themselves often conditioned by contending political, 113 social, economic, and philosophical concepts (Schiavi and Solomon, 2007). Formal regulation is a product of benchmarks, standards, and policies and has mostly been included in the legal jurisdictions of both developing and developed countries. Regulation, as it relates to environmental R&C efforts, is no different. Regulation surrounding reclamation and closure efforts of mine sites includes oversight of the abandonment notification of approval, reclamation inspection and certification, and liability management. Such guidelines are currently partitioned, depending upon the kind of operation activity and whether the mine site is on private versus public lands (Lefsrud, 2017). Such a partitioning result in differences in the regulatory agency possessing authority, the relevant legislation and regulations, the approval/review process, and access to the regulatory-acceptable financial instrument(s) to terminate or transfer liability. The objective of regulatory policies is to fundamentally take suitable measures to mitigate environmental risk and increase the efficiency of reclamation activities for mining operations in a host jurisdiction. However, many observers have expressed how regulations are narrowly focused, out of date and inefficient, which can slow the advancement of mining projects (Lefsrud, 2017). The consensus is that the regulatory efficiency for managing industrial developments needs to be amended (Lefsrud, 2017). There are many limitations of the common law in promoting prevention, including the likelihood of spotting the harm, the latency period between cause and effect, the appointment of blame, and the probable judgment-proof nature of the corporate entities (Shavell, 1986). A review of the limitations of liability in handling risks is instructive for the advancement of an understanding of the practicality of financial assurance mechanisms. The first concern is the capacity to detect and assign blame for the environmental harms caused (Faure and Grimeaud, 2000). If there are complications with the storage facility, such as a surface leak in a remote area, then the impairment could be problematic to detect, making it improbable that any party would sue for damages. 114 Another challenge to liability is that companies responsible for injection and storage could lack the necessary funds to address any complications that arise (Faure and Grimeaud, 2000). In such instances, a company’s assets are the upper bound on liability and the deterrent effect of debt will be inadequate. In this circumstance, the entity is said to be judgment-proof, and ex-post damage awards will not offer adequate deterrence against the risky activity. Shavell (1986) describes the confines of liability in internalising external costs. Ringleb and Wiggins (1990) contend that large companies form subsidiaries, such as SPVs, to protect the assets of the parent company from environmental and safety liabilities (Klee and Kornhauser, 2007). If a company becomes insolvent, there will be no funding available to continue mine site monitoring and maintenance or to address any complications that arise. In circumstances where they become insolvent due to the financial obligations arising from some unfortunate environmental or safety mishap, this can be a critical issue. A third difficulty with liability is the time horizon between cause and effect (Shavell, 1986; Ringleb and Wiggins, 1990; Faure and Grimeaud, 2000). Given the time horizons for appropriation, there could be an extended latency period before any surface leaks or underground seepage ensue – this presents several complications. First, a responsible party may no longer be in the position to deal with the damages by the time that problems arise (Faure and Grimeaud, 2000). Additionally, since problems may only occur after some extended period, companies might lack the motivation to take necessary measures to guarantee the long-term integrity of the storage facility (Faure and Grimeaud, 2000). 3.7.1 Financial Assurance as a Complement to Liability and Regulation The necessity for financial assurance requirements stems from the moral hazard debate – if there are high costs of monitoring performance, companies may respond by shirking on their environmental and safety responsibilities. The principal concern is that the public will 115 be burdened with the obligation to remediate environmental damages and safety risks. Liability and assurance mechanisms each offer financial incentives for them to address such effects. Under liability, a damaged party initiates litigation to recuperate monetary damages for any harm caused, and the prospect of a damage award is the motivation to ensure due care. Nevertheless, the deterrent consequence of tort liability is inadequate if the company lacks enough assets to cover damages. In effect, its assets are the upper bound on liability. Financial assurance possesses several distinct differences from reliance on a liability rule: • it is posted up-front contrasted with being settled after-the-fact; • if the corporate entity neglects to comply with its R&C obligations, the forfeited collateral is instantly available to remedy the performance failure; • the FA instrument shifts the burden of proof from the regulator proving that harm was done to the company to demonstrate that compliance criteria were met; and • the public sector is only protected up to the amount of the EFA posted, and not for the full amount of possible reparations. If the company remains solvent, regulators can pursue a remedy through the courts. Public Ownership One of the concerns regarding long-standing mining projects is that in the far distant future it seems doubtful that any legislative or regulatory structure will provide private mine operators long-term reclamation responsibilities in perpetuity (Bocking and Fitzgerald, 2012). It is more likely, however, that there will possibly be some period where these companies are accountable, and subsequently, such long-term obligations are turned over to the public sector. While EFA is regularly required to ensure proper reclamation and closure efforts are achieved, in many instances no long-term monitoring after-the-fact is compulsory, and the financial assurance funds are released upon completion of the work. 116 3.7.2 Regulatory Efficiency Economists, regulators, and industry have different viewpoints in how regulatory efficiency is defined. These perspectives are not mutually exclusive. Economic Perspective Economists describe regulatory efficiency as attaining the anticipated objectives at the lowest possible cost (Arrow et al., 1996; Goodstein and Polasky, 2007). Preferably, the benefits of the regulation surpass the costs. The costs and benefits should be quantifiable to calculate this but if that is not possible best estimates of the costs and benefits should be utilised coupled with the accompanying uncertainties (Arrow et al., 1996; Goodstein and Polasky, 2007). Distributional inequity must also be considered since those who receive the benefits are not necessarily the same as those who bear the costs (Arrow et al., 1996; Goodstein and Polasky, 2007). Regulatory Perspective From the regulators’ viewpoint, efficiency is described as safeguarding the protection of society as paramount while permitting development that benefits the country (McNamara, 2009; Dondo, 2014). To accomplish this, regulators must have a clear direction from the government to guide them to support sound regulatory decision making and adjudication. It also entails that the public understands the government’s position on a resource and environmental policy issues and can offer input to the development of new policy. Internal regulatory efficiency entails access to required data and information to government, industry, and the public. Preferably, the requirement for enforcement should 117 be minimised since constant vigilance and enforcement is equally expensive and resource-consuming (McNamara, 2009). Enforcement has become increasingly more significant as host mining jurisdictions face the difficulties associated with EFA forfeitures and insolvencies be it mine operators or financial assurance providers themselves (McNamara, 2009; Dondo, 2014). Industry Perspective Industry leaders often classify and remark regulations as being a burden that makes their operations inefficient and uncompetitive. The truth of the matter is that well-written environmental protection policies can encourage businesses to be more innovative and efficient (Steen, 2017). Innovative products and processes in response to regulation efficiency can also lead to renewed industrial competitiveness and growth (Steen, 2017). The industry describes regulatory efficiency as possessing a strong understanding of the duties it must meet while offering society confidence that industry is pursuing sound and responsible operating practices (Rajaram et al., 2005; Campbell, 2012). Such efficiency is achieved through transparent, predictable, and effective regulatory policies to allow companies to define their operational strategies adequately. It also entails an application review process with a specified period. Regulatory efficiency would ensure that industry participants can appeal a regulator’s decisions through a timely, formal, transparent, and procedurally fair appeal process. Effective governmental regulation can also lead to innovation performance during low market uncertainty (Blind et al., 2017). They examined the impact of formal standards and regulation on a company’s innovation efficiency in contrasting levels of technological uncertainty. Their findings outlined that formal standards lead to lower innovation efficiency in markets with low uncertainty, while regulations display the contrary effect. In 118 instances of high market uncertainty, Blind et al. (2017) observed that regulation leads to lower innovation efficiency while formal standards had the opposite effect. Munro (2015) contends that the mining industry’s reputation is exposed to two states which may develop in a regulatory vacuum. First, on occasions where there is an alleged regulatory weakness, it attracts rogue mine operators who try to take advantage of lower environmental regulatory thresholds, primarily to save time and reduce costs. This method of mining has produced many environmental scars and health effects throughout Africa. Secondly, Munro (2015) asserts that some mine operators fail, through ignorance, to observe acceptable standards – where there is minimal in-country supervision. These factors place an added burden on mining companies operating in the African continent. Many complications result from Africa’s stage of development and recent history since such factors can destabilise the mining sector’s recovering reputation across the African continent and pose new threats and risks to both the industry and companies. The entrance into the industry of mine operators from countries without a proven history is an additional cause for alarm and growing discontent in host societies (Munro, 2015). Steen (2017) outlined the Porter hypothesis for the relationship between proactive environmental policy and industry competitiveness. Porter and van der Linde (1995) maintained that the environment-competitiveness debate had been framed inaccurately. They contended that appropriately designed environmental standards could prompt innovation that may partly or more than fully offset the costs of conforming to regulation and can even lead to absolute advantages over companies in foreign countries not subject to comparable rules. The hypothesis proposes that strict environmental regulation prompts the discovery and introduction of environmental improvements and cleaner technologies, the innovation effect, making production processes and products more efficient (Wagner, 2003). The cost savings that can be attained are appropriate to overcompensate for both the compliance costs directly attributed to the innovation costs and new regulations. Such 119 savings in funding charges through financial assurance-backed securitisation is expected to be effective if they are higher than the cost of innovation in reclamation efforts, unless external pressure from specific stakeholders arises. The PH is debatable since this opinion defies a long-held paradigm in economics that postulates that, as profit-maximising companies, such entities are already using their resources most efficiently to attain maximum profits, and that regulations confine its options, unavoidably leading to suboptimal returns (Ambec et al., 2013). Interest in the hypothesis has increased rather than contracted over the past two decades, due in part to the prevailing implications of this theory. If well-constructed regulations can be demonstrated to benefit companies, it could become much easier for industry and government to jointly establish environmental regulations that encourage productivity, improve competitiveness, and attain significant environmental targets that benefit a nation. Literature has evaluated different aspects of the Porter hypothesis and has also investigated several environmentally regulated industries to discover what the existing evidence indicates regarding the theory in practice. Some literature proposes that it is difficult to find general theoretical arguments on which to build mechanisms that provide the results of the hypothesis. As a result, its validity could be regarded as an empirical question – this suggests that it is challenging to distinguish between the ‘weak’ form, the ‘narrow’ version, and the ‘strong’ form of the hypothesis (Jaffe and Palmer, 1997). The ‘weak’ version of the PH theory suggests that environmental regulation will inspire certain types of environmental innovations. Environmental regulation encourages innovation; though, it does not extend to competitiveness and profitability. The ‘narrow’ version of the theory emphasises that governments with flexible environmental policies give companies greater motivation to innovate than rigid regulations, such as technology-based standards. Lastly, the ‘strong’ version of the hypothesis proposes that appropriately designed regulation may encourage cost-saving innovation that more than reimburses for 120 the expenditures of compliance. The implication is that environmental regulation indorses innovation, which instigates competitiveness. Using data collected in the recent AUD$200 billion expansion of the Australian oil & gas industry, Steen (2017) provided evidence that the Porter hypothesis relationship does indeed hold. However, it is highly reliant on the maturity of the sector and its stage of technological development. Specific cases of innovation in answer to regulation within the hydrocarbon and mining industries further highlight the central role of regulatory frameworks in the development of these industries. Steen (2017) expressed that: • environmental regulation is essential for novel innovation but so is reputation and technical skill; • regulation should be sensitive to the level of industry technical and development capability; • surpassing compliance and pushing industry standards can be a good business strategy; • service companies are much more likely to introduce innovations of any type; and • industry, environmental, and innovation policies are all connected here. Bare-knuckling between business competitiveness and environmental protection is negligent since good environmental policy benefits environmental protection, and business can make use of environmental performance for competitive advantage. Steen (2017) concluded by discussing the need to connect government policy silos since environmental protection should not just be considered an environmental agency problem. Engaging in discussions between industry and policymakers is equally crucial given well-designed industry policy encourages international competitiveness and productivity while strengthening environmental education and research policy boosts both research and development capabilities and develops workforce skills (Colla et al., 2012). 121 3.7.3 Issues and Policies in the Use of Financial Assurance The mining industry has always considered itself a global industry. Since the 1990s, though, an extraordinary explosion of interest among countries on every continent in using their mineral resources as an engine of development has been witnessed (Connolly and Orsmond, 2011). To do so involves attracting considerable mining investment. Together, companies, governmental regulators, and international institutions have all become more conscience that mining activities should be carried out with due care to the protection of the environment and FA measures are essential instruments to pursue such objectives. Two forms of policy are associated with financial assurance for mine R&C requirements (US Congress, 1994; Peck, 2005): i) there are framework policies which outline the general rules relating to the usage of assurance, and ii) decision rules are governing the selection of specific EFA arrangements to be applied to companies and mining projects. Policy Summary of Mine Reclamation Regulations The analysis describes the current FA regulation in the following mining jurisdictions: • Afghanistan (Renaud, 2017); • Australia (Western Australia) (Kabir et al., 2015; Australian Government: Department of Industry, Innovation and Science, 2016; Morrison-Saunders et al., 2016; Stantec Consulting, 2016); • Canada (British Columbia) (Kabir et al., 2015; Stantec Consulting, 2016); • Chile (Veiga et al., 2000; Bastida and Sanford, 2006; Olivari, 2014; Bastida, 2015; Sanzana et al., 2015; Calmon, 2016; OECD, 2016); • China (Zhao et al., 2015a; Zhao et al., 2015b; Cheng and Skousen, 2017); • Ghana (Twum, 2013a; Twum, 2013b; Morrison-Saunders et al., 2016); • Kazakhstan (Faizduldayeva, 2016); 122 • Kyrgyzstan (Faizduldayeva, 2016); • Mongolia (Hogan Lovells, 2012; Cane et al., 2015; Robinson, 2015); • Mozambique (Morrison-Saunders et al., 2016); • North Korea (Yoon, 2011; Vasey, 2017); • Papua New Guinea (Commonwealth of Australia, 2006; Sassoon, 2008); • Peru (Veiga et al., 2000; Bastida and Sanford, 2006; CCSI, 2016; Calmon, 2016); • Russia (Faizduldayeva, 2016); • South Africa (Sassoon, 2008; Morrison-Saunders et al., 2016); • Tanzania (Morrison-Saunders et al., 2016); • United States of America (Gorton, 2013); and • Zambia (Morrison-Saunders et al., 2016). Similar patterns in R&C objectives are observed in Western Australia, Canada, Chile, South Africa, and the United States. Physical and chemical stability is one of the repeated environmental targets, along with public health and safety. Financial assurance in Western Australia, British Columbia, Chile, South Africa, and the United States covers the full cost of mine closure. Different EFA mechanisms are employed to ensure that the cost of the mine closure will be adequately provided for. When contrasted with international good practise standards of certain countries such as Australia, Canada, South Africa, and the United States, the analysis reveals that the mine closure regimes in some countries are still in their developmental stages and are well below advanced standards. The present level of foreign investment in mining interests in resource-based jurisdictions around the world is influencing the way approved reclamation and closure requirements are approached. Notably, as companies apply more stringent closure policies from their native countries to mine sites in developing nations and as investors increasingly demand 123 that sustainability issues be incorporated into all mining operations, despite a lack of local, suitable environmental regulation and policy (Garcia, 2008). In the absence of well-defined closure regulations, mine operators may choose to use reclamation and closure guidance from international sources such as the World Bank, as well as prominent national and state or province-specific legislation. Although R&C regulations are not equal in all countries, the trend is for increased regulation of mine closure by governmental and lending agencies. Details relating to the financial assurance securitised structure are described in Appendix G. 124 Chapter 4: EFA Securitisation Framework Model and Results Remember that all models are wrong; the practical question is how wrong do they have to be to not be useful. — Dr George E.P. Box Professor Emeritus, University of Wisconsin A key objective of the dissertation is to examine if the financial assurance requirements that mining companies41 are obligated to post, in escrow, before the authorised mine activity is carried out can be securitised in the same manner as other conventional and nonconventional assets42. The response to this question, if found favourable, could benefit the various stakeholders, including government regulators and mine operators, while attracting sophisticated investors (e.g., institutional clientele) and others (via exchange-traded funds (ETFs) and specialised funds) as a potentially cost-effective and readily-accessible source of ‘social-centric’ financing for environmental reclamation purposes for mine operators but not necessarily exclusively. The proposed securitised model43 could alleviate the upfront financial burden that these mine operators face in needing to demonstrate they possess an adequate amount of financial assurance at the initial onset of a mining project when their cash burn rate is often high while access to debt funding is sometimes low. Such a structured finance mechanism could become an alternative, potentially cost-effective, FA supplier in a financial market’s environment where the increasing lack of surety providers is present (Learn, 2016). 41 Although not limited to this sector alone, any industry that requires financial assurance – including oil & gas, infrastructure, nuclear, chemicals (including paint and coatings), and livestock farming. 42 The research refers to it as an EFA-backed structured finance technique or simply EFA-backed securitisation. 43 A viable form of ESG (environmental, social, and governance) financing. 125 Appendix F provides a review of structured finance and securitised mechanisms. It also describes and explains the essential methodologies used to develop the model, and the appendix discusses the observed benefits and drawbacks of asset-backed securitisation to key stakeholders of environmental risks. Securitisation of financial assurance obligations may help to resolve another practical matter, the proper valuation of mine R&C costs. Rethinking the FA challenge might begin by trying to minimise or even eliminate in some circumstances both the high-cost government work and the budget-constrained mine operator from the liability equation. To do this would require that an operator works on an ongoing basis with an independent group of qualified industry parties that may help determine the future value of the R&C costs, oversee the completion of reclamation requirements, and, if required, mediate when required should adverse issues arise within the company (similarly, for reclamation left in default). This party, which would be certified by government and industry, would also undertake the R&C responsibilities of orphaned and abandoned mines from governments. What group of professionals would possess sufficient resources and expertise for such a purpose? The local mining industry, and under the guidance of its respective regulators, of course. Should such a strategic alliance proposal be rejected out of hand just because of the competitive nature of the sector? It is worth mentioning that collaboration does already exist between the government and mine operators on many issues (KPMG LLP, 2017; Warner and Sullivan, 2017; Yakovleva, 2017). Not surprisingly, the opinion that seems to rule is that of common interest. Does this comradery exist regarding issues surrounding reclamation and closure activities left in default? Indeed, it does when the issue is one of growing environmental concern and public image. Once these scrutinised R&C costs, which would then become public knowledge, are packaged into an asset product offering and brought on the capital market in the form of securitised securities, the underlying mine reclamation costs immediately receive a market 126 valuation. These values may serve as a reference guide for many stakeholders and industry rivals who may not possess adequate experience or tools for evaluation of such reclamation and closure expenses due to poor regulation surrounding lack of clarity on what constitutes acceptable closure standards. A tempting thought is to declare securitisation as the ideal method to finance R&C obligations for mining companies (or even oil & gas, and others). It should be regarded as merely another ‘hard’ financial assurance tool in a regulator’s toolbox to assist them in their regulatory and auditing duties. The incentive to make such a bold statement would be that securitising of assets is generally inexpensive compared to a bank loan or issuing corporate debt. It also permits a company to improve its balance sheet (by removing the debt assets from its financial statements). Moreover, it increases the leverage of capital structure (which is sometimes a positive signal to the market, especially if the corporate entity is publicly-traded). Nevertheless, the truth is that so far securitisation of EFA obligations is a promising, but untested (as far as the author is aware), solution for consideration. 4.1 Conceptual EFA Securitised Framework: Defining Possible Attributes Neurosis is the inability to tolerate ambiguity. — Dr Sigmund Freud It is not everything that can be proved, otherwise the chain of proof would be endless; you must begin somewhere, and you must start with things admitted but indemonstrable? — Aristotle 127 Canada, like other financial centres, including the US, has not regulated EFA-backed securitisation in any specific sui generis44 system or integrated it into its capital markets, or regulation under corporate or FA regulations due to their current lack of existence. The absence of regulation concerning EFA-backed securities sparks a fundamental problem for their application. Without specific regulation, their validation by interested parties – regulators, capital markets, mine operators, investors, and others – would be questioned. The uncertainty of the law may also raise doubts about determining whether such a securitised mechanism is worthwhile. Moreover, without specific regulation in place, there would be uncertainty as to whether FA-backed securitisation would be considered part of the securitisation of assets or should it be separated and treated differently from the asset securitisation. Regulatory vagueness surrounding financial assurance valuation would also delay and risk the abandonment of EFA-backed securitisation possibilities. The critical aspects of FA-backed securitisation are the valuation and calculation of reclamation obligations due to the mentioned uncertainties, which is also related to conflicting and vague environmental mine closure regulation. Calculation and valuation are required to determine the feasibility of securitisation and to predict future cash flow (Rosenberg and Weiss, 2003). However, at the practical level, EFA valuation uncertainty is the main practical challenge to structuring an FA-backed securitised mechanism. Another challenge arises since financial assurance-backed securitisation would involve multiple parties, complex interdisciplinary laws, and economic infrastructures. Such an environmental-focused securitisation mechanism would be a problematic area of study since it would require multidisciplinary research and requirements – including reclamation costs valuation, environmental regulations, taxes, credit ratings, securities regulations, capital markets, corporate finance, and other areas. Securitisation involves not only a 44 As per the Black’s Law Dictionary, a ‘sui generis’ system means ‘one that is of its own kind.’ 128 portion of a financial system, but the entire system, not one or several branches of law, but most branches of the law. EFA-backed securitisation would require professionals and practitioners such as the SPV, servicers45, credit rating agencies, credit enhancers46, investment bankers47, insurance companies, appraisers, capital market professionals, financial intermediaries, tax and accounting advisers, auditors, environmental regulators, and many others. It would not merely need the traditional intermediaries, but the finance subsidiaries of mining companies and government intermediaries. The literature surrounding EFA-backed securitisation or even EFA-backed structured finance techniques seems to be non-existent. Published papers in this field could be constrained by several factors, including the lack of available data and by the secrecy surrounding posted EFA amounts and the valuation of reclamation liability cost estimates of mining operations. A variety of issues limits the appropriateness and diffusion of EFA-backed securities, which could reduce both borrowers’ and sellers’ confidence in such a form of tools: • they would be complex instruments of financial engineering, which would involve high structuring costs; • assessing the value and risk profile of a financial assurance obligations portfolio would be a key challenge for the development of these solutions; and • the absence of generally accepted methodologies for the valuation of R&C costs and the high degree of uncertainty regarding the accuracy of somewhat subjective FA values is expected to affect the confidence in such a financial mechanism adversely. 45 The servicer is the entity that collects principal and interest payments from obligors and administers the portfolio after transaction closing. Regularly the originator acts as servicer, although this is not always the case. 46 Credit enhancement is used to improve the credit rating of the issued securities. Therefore, credit enhancement providers are third parties that agree to elevate the credit quality of another party or a pool of assets by making payments, usually up to a specified amount. This is done in the event that the other party defaults on its payment obligations or should the cash flow generated by the pool of assets be less than the amounts contractually required due to defaults of the underlying obligors. 47 Investment banks mainly perform structuring, underwriting, and marketing of the securitisation transaction. 129 Such limitations could be due in part to conflicting and vague regulation (i.e., regulatory incompleteness and vagueness) in some mining jurisdictions and given that uncertainty defines every mining project since no two projects are identical. While leaving this substantive investigation to future work, the research, in part, examines how, and under which conditions, an EFA-backed securitisation transaction can potentially create value for both the issuer and the investors. Like a typical asset-backed securitisation transaction, a successful FA-backed securitisation transaction would be defined as one in which the issuer monetised its diversified portfolio of EFA obligations assets in an efficient, cost-effective manner, with the investors receiving a well-structured, highly-rated investment that provides a favourable risk/return trade-off. Since an FA-backed securitised mechanism would be customised financial solutions, and their numbers could be too small to support statistical evidence, a traditional empirical analysis cannot be implemented. Therefore, the dissertation provides a conceptual framework that was tested based on some specific and deemed-relevant parameters. The structure consists of a set of variables which are assumed to be able to explain the potential outcomes that a marketable EFA-backed security might possess in the extractive industries sector. The identification of specific leading, independent linguistic determinants of failure and success, and their level of influence compared to the other variables observed, of such a mechanism was based on: • the thorough analysis of existing literature; • information derived from Appendix A, financial statement details of each participating publicly-traded mine operator (a subset of the owners list detailed in the appendix), and other data; • discussions with industry experts on structured finance and mining operations; and • personal, professional experience. 130 A Mamdani-type FIS-based methodology approach was adopted to build the framework of the analysis. It should be mentioned that securitisations are expensive due to management and system costs, legal fees, underwriting fees, rating fees, ongoing administration, and other factors. An allowance for unforeseen expenses is usually essential in securitisations, especially if it is an atypical one. Numerical data is scarce, and only ambiguous and imprecise information could be available for such complex systems (Ross, 2010). In terms of the inference process, the other main type of FIS is the Sugeno system. The Mamdani system, however, is more widely employed mostly because of the reasonable results with the relatively simple structure it offers, and the intuitive interpretable nature of the rule base (Zaher et al., 2014; MATLAB, 2018). It is also well-suited to human input, unlike Sugeno, since it is more appropriate for mathematical analysis and is computationally efficient. Since the consequents of the rules in a Sugeno FIS are not fuzzy, this interpretability is lost. Fuzzy logic permits approximate interpolation between input and output situations (Ross, 2010). The Mamdani scheme is a sort of fuzzy relational model where each rule is represented by an IF-THEN relationship. It is also referred to as a linguistic model since both the antecedent and the resulting are fuzzy propositions (Babuška, 1998). The model structure is manually developed, and the final model is neither optimised nor trained. The output from a Mamdani-type model is a fuzzy membership function based on the rules established. Since this method is not solely dependent on a data set, with enough expertise on the system involved, a generalised model for valid future predictions can be attained. Appendix H discusses how a Mamdani FIS can be applied to determine the possible success of mine reclamation for a particular mine site based on two input variables, ‘Financial Assurance’ and Regulatory Transparency and Openness (‘Regulatory Transparency’) adequacy. Figure H.3 demonstrates how these two input variables are taken through the 131 fuzzy reasoning process with three IF-THEN rules. The results from these rules are then combined and transformed into a crisp numerical value to quantify the likelihood of ‘Reclamation Failure’ for a particular mine site. A numerical example is also provided. Results from the Mamdani FIS model highlight that factors related to the quality of the assets, as it relates in part to the credit and financial strength of the participating mine operators, underlying an FA-backed securitised mechanism can reasonably increase the probability of reclamation-completion success. Moreover, a higher quality of financial obligations is likely to decrease the risk of default of reclamation. Finally, the stability of the credit enhancement mechanisms, the adoption of a diversification strategy, and the flexibility of the deal architecture are other central factors in determining the possible success of the proposed financial assurance-backed securitised mechanism. 4.1.1 Method An EFA-backed securitisation space is estimated. The securitisation space is a numerical index related to the potential of mine reclamation success measured with several variables. Along with the uniqueness of financial assurance obligations in comparison to other types of pooled assets used in standard securitisation, to estimate deal potential, a broader range of factors must be considered, they include: • the variables related to FA obligations features; • the financial assurance value; • the financial condition of the observed mine operators (based in part on economic conditions); • the economic size of the deal; and • the key elements of the deal structure. 132 The fact that an FA obligation could be potentially securitisable, as a cash flow generating asset, is not a satisfactory condition to make such a securitisation structure perform successfully. Financial assurance obligations, to be used as the underlying for a financial deal, should possess distinct attributes suitable to guarantee a successful transaction. A conceptual framework was developed and tested to understand what factors may influence the success of an FA-backed securitised mechanism. The unique nature of each EFA obligation within a portfolio implies a case by case assessment of their value and risk profile and, consequently, the design of such a securitised mechanism transaction would not involve a standard process as it happens with ABS deals. Since FA-backed securitised mechanisms would be highly specific and customised financial solutions, some asset-backed examples of securitisation were referred to which some relevant conclusions were drawn. Given some distinct features surrounding environmental financial assurance obligations, in comparison to other physical assets, designing a standard process would be challenging. The cash flow generation streams are the only main resemblance between FA obligations and other asset classes of ABS deals. The initial step of the research was to select suitable candidates to be incorporated within the EFAs portfolio. For simplicity, a subset of the mine operators listed in Appendix A was chosen. The fundamental strategy that would be applied to decrease risk reduction in the financial assurance obligations portfolio is provided by modern portfolio theory as it relates to a combination of diverse assets (Markowitz, 1952). In practice, a low correlated (interrelated, in part, by factors such as the location of the asset, asset type, and the degree of relationship between the price movements of the different assets included in the pool) portfolio of FA assets would originate from the mining sector and other sectors of the economy (e.g., oil & gas, nuclear, chemicals, infrastructure, and livestock farming) since the global pool of suitable mining-related EFA obligations at any given time is limited. 133 EFABSs may eventually offer an attractive alternative to investors who seek to allocate to high levels of credit quality while maintaining a level of diversification difficult to achieve in the corporate credit market alone. Securitisation provides diversification within the asset class and when used in conjunction with some other assets such as FA obligations from different sectors. Under the securitisation process, idiosyncratic (unsystematic) risk contributions from individual financial assurance assets are diversified away. The second level of diversification provided stems from the wide range of economic activity EFABS support. Individual subsectors would retain sensitivities specific to the economic activity they finance and therefore are subject to factors affecting that particular market, encompassing all of those that would be familiar to corporate credit buyers and more. EFABS may also offer a level of diversification when used in a portfolio of broader fixed-income assets. Securitised products such as ABSs and MBSs exhibit a relatively low strength directional relationship with other fixed-income assets, of both high and low credit quality, as measured by correlation. So, a strategic allocation to EFABS could help diversify portfolios containing a variety of fixed-income assets. The low correlation also means the relative value of EFABS to the asset classes fluctuates, providing an opportunity for tactical positioning by an active manager. Long-term investors, such as sovereign wealth funds and pension funds, have also started to account in their investment decisions for systematic risks that may manifest themselves over several decades, and hence they possess a different perspective on risk than short-term investors (Bonnafous et al., 2017; Mercer, 2019). In particular, they have a growing interest in understanding how environmental and climate risks may impact the corporate entities comprising their investment portfolios (specifically, incorporating ESG factor integration and climate change considerations into the investment process). Global water risk, including scarcity, flooding, pollution, and anthropogenic climate change is of increasing concern to investors, companies, regulators, and governments worldwide. An approach towards portfolio risk assessment and portfolio diversification that accounts for 134 the geographical distribution of assets in a portfolio and the associated exposure to climate extremes is one that would be expected to be undertaken when constructing the proposed securitisation mechanism’s portfolio of reclamation obligations. Although an in-depth analysis of just one single case study portfolio might not be necessarily representative of delineating the relevant factors that could influence an EFABS deal outcome, it will nevertheless provide some insights regarding which features could
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UBC Theses and Dissertations
Environmental financial assurance : current coverage, institutional challenges, and alternative financial… Lopes da Costa, José Carlos 2020
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