Bonding Requirements for Natural Gas Producers

Hydraulic fracturing and other recent technological advances have dramatically increased the availability of natural gas, providing large benefits to the U.S. economy. At the same time, however, these new forms of drilling raise a number of potential environmental concerns, in particular, about contamination of groundwater and the increased scope for large-volume surface spills.

How do we continue the development of this valuable resource, while ensuring environmentally-safe drilling? In a new Hamilton Project discussion paper, I highlight bonding requirements as an important policy tool. The paper will be available June 13th as part of a one-day conference “New Directions for U.S. Energy Policy” at Stanford. The complete schedule and registration information is available here.

Bonding requirements help address a misalignment of incentives that leads natural gas producers to underinvest in environmental protection. Revenues from drilling are realized immediately. Environmental damages, however, may not become evident for many years. And by the time damages are well understood, producers may no longer exist or may not have the resources to finance necessary cleanups or to compensate those who have been affected.

The tort system is designed to recover damages. However, bankruptcy laws limit producers’ liability significantly. This is particularly true here because the industry is composed primarily of small and medium-sized companies.  As of March, there were over 100 different companies actively drilling deep horizontal wells in the United States, with no single company representing more than 10% of the market.

Bonding requirements are not a new idea. Since the 1920s, the U.S. Bureau of Land Management has required natural gas producers operating on public lands to post a bond prior to drilling. If environmental damages occur, the bond is used to reclaim the site. If no environmental damages occur, the company gets the bond back with interest.

This approach makes sense, but current requirements are inadequate given modern drilling techniques. The current minimum bond amount—$10,000—was set in 1960 and has never been updated for inflation. This is not enough to pay even for routine site reclamation expenses, and is negligible compared to the cost of damages when accidents occur.

Adjusting for inflation would increase the minimum bond amount to $60,000. This would be a good start, but evidence supports an even larger increase. Advanced drilling techniques involve larger and riskier drilling operations than the shallow vertical wells for which the legislation was originally designed. And the large quantity of chemically treated water used in hydraulic fracturing introduces new risks that are not present in traditional drilling.

The proposal goes on to discuss state-level bonding requirements and the treatment of “blanket” bonds that, under current legislation, allow producers to post a single, larger bond for a large number of wells. Modernizing the existing system of bonding requirements would be an effective complement to traditional regulation, helping to ensure that standards are followed even when it is impractical to have regulators on the ground at all drilling sites.

About Lucas Davis

Lucas Davis is an Associate Professor of Economic Analysis and Policy at the Haas School of Business at the University of California, Berkeley. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.
This entry was posted in Uncategorized and tagged , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s