Option Coverage Techniques for Environmental Projects

Abstract

Environmental firms are faced both with the prospect of liability claims that may arise long after activities at a project have been completed and the impact of catastrophic events that can severely threaten a firm’s financial resources. The inadequacy in most cases of site-specific data, the lack of scientific understanding of the complex processes’ interaction at a contamination event, and the limited cost-effective technological solutions that exist compound the problem. This condition has led many environmental firms to explore alternatives for risk management through the use of innovative insurance policies, training and selection of specialized staff for high-risk projects, careful screening of potential projects and customers, self-funded risk pools, partial involvement in projects as members of a consortium, and option payments. Payment of a one-time amount for the option to limit a firm’s maximum liability to a fixed amount has been used in many cases to facilitate financial transactions, mergers, and acquisitions and to set well-defined limits to future risks. This study focuses on the alternative of option payment as a method for managing risk. Two general methods to evaluate the maximum option amount are presented and illustrated with the use of a hypothetical numerical example. Consideration of an option alternative makes management teams sharply aware of future unknown remediation or liability costs and guides them in bracketing the range of these costs. Correspondingly, according to an environmental firm’s risk tolerance, limits can be set on future potential liabilities and optioning out of payment.