6 Financial Instruments
This chapter examines the management of the different financial liabilities associated with:
- the surface restoration of UOG sites ("restoration liabilities");
- the decommissioning of UOG wells ("decommissioning liabilities");
- monitoring of UOG wells after decommissioning but prior to surrender of the PEDL, and any requirement for repair of wells due to failure that occur during this period ("aftercare liabilities"); and
- repair of any well failures in the future after licence surrender ("long-term repair liabilities"),
by means of use of appropriate financial instruments.
Financial instruments are required to ensure that restoration, decommissioning, aftercare and long-term liabilities are adequately funded to ensure that the environment is protected whilst minimising risk to the public purse. The financial instruments required under the present licensing and planning regimes (as set out in Chapter 3) are assessed and any gaps in financial coverage identified and considered together with potential improvements to the regulatory regime that may be considered by the Scottish Government.
Management of financial liabilities for surface restoration is the responsibility of the local authority under the legal agreements attached to planning permissions for UOG development (see Section 3.4) and will be on a wellsite by wellsite basis.
Management of financial liabilities associated with failure of wells after decommissioning, but while a wellsite is licensed, is the responsibility of the licensing authority (currently the OGA but in future under a Scottish licensing authority) under the petroleum licensing system and will be on a licence by licence basis.
6.2 Key Issues
The following issues influence the size and timing of financial liabilities and how they are managed:
- the unique nature of wells;
- post-decommissioning well failure; and
- financial strength of licence holders.
6.2.2 Unique Nature of Wells
Unless drilled in close proximity to another well, it is likely that the rocks through which a well passes will be site specific. This means that construction and abandonment plans will need to be specifically tailored to the geological situation of each well.
In addition, as described in Chapter 2, some UOG wells may penetrate rocks above the target shales or coal that contain gas/oil or fluids under pressure. Because of this, these wells present a greater potential risk of well leakage if no allowance for the presence of hydrocarbons or fluids under pressure is made during well construction and abandonment. These wells may therefore have additional engineering requirements (and therefore additional funding requirements) during abandonment and decommissioning, to prevent the well providing a pathway for leakage.
Wells which prove to be dry or otherwise non-viable at the initial testing stage will also require decommissioning at the end of testing and may require more conservative well abandonment designs than production wells for the reasons set out in Section 2.5.
6.2.3 Well failure Post-Decommissioning
As discussed in Chapter 2, there is a small probability that a well that has been decommissioned according to best practice will fail. Should a failure occur, it is most likely to happen in the period after decommissioning, when monitoring and aftercare are ongoing.
However, there is also a low possibility that a well that has been properly decommissioned and which has shown no indications of failure during the post-decommissioning monitoring period could fail in the longer term i.e. over a period of several decades.
6.2.4 Relative financial strength of Licence Holders
It is clear that not all licence holders will have the same degree of financial strength and represent different levels of risk in relation to the certainty that future restoration, decommissioning and aftercare costs will be covered.
6.3 Uncertainty around Size of Liabilities
Despite the similarities to conventional oil and gas, the UOG industry is a new industry within Scotland and the rest of the UK. The lack of a significant number of completed UOG wells in Scotland means that there is uncertainty around the costs of decommissioning and this is exacerbated by the fact that the decommissioning plan for each well will be specific to that well. The variation in the uncertainty associated with decommissioning and aftercare financial liabilities through the lifecycle of a well is illustrated in Figure 7 and explained below.
Liabilities will be held by the holder of the licence, which may be a single operator, or a consortium of operators, each of which shares joint and several liability. Licence holders can prepare cost estimates for well abandonment using oil and gas industry guidance ( OGUK, 2015c). These guidelines are applicable throughout the whole development life cycle of wells: including at the field design stage, for annual financial reporting and for planning of decommissioning. Licence holders can also prepare cost estimates for surface restoration using standard estimating methods.
With time, industry data on the actual costs of decommissioning will also become available which will enable estimates of individual well decommissioning costs to be improved reviewed, updated and refined on a periodic basis that will reduce the level of uncertainty in decommissioning costs.
6.3.2 Prior to Drilling
Until well consent is given by licensing authority and drilling begins, decommissioning liabilities are minimal. At this stage, the design for decommissioning of any well will be preliminary. The estimates of decommissioning, aftercare and long-term repair liabilities will have relatively large ranges and therefore any provision for liabilities at this stage should include significant contingency sums.
6.3.3 At Completion of Drilling
As drilling commences and progresses, sub-surface decommissioning liabilities will increase both with depth and as the well passes through particular rocks ( e.g. pressurised formations). However, the real information obtained in drilling enables the engineering design for decommissioning to be refined and more accurately costed. This in turn enables the decommissioning liability to be estimated with a higher degree of certainty and a lower range. Similarly, restoration, aftercare and long-term repair liabilities can also be better estimated.
6.3.4 At Completion of Drilling and Testing - Dry Wells
In the case of wells that are dry, or otherwise non-viable, decommissioning will occur once the well is completed and tested. The size of the decommissioning liability will be the cost of the approved the well abandonment plan for decommissioning. The estimates of aftercare and repair liabilities will remain the same as at the completion of drilling, as no additional information will have been obtained from the operation of the well during production.
Figure 7: Variation in Decommissioning Liabilities with
6.3.5 During Production
For wells put into production, information on the integrity of the well will be gathered during production, including monitoring for signs of leakage by detection of SCP and monitoring of groundwater quality. As the industry expands, information from other wells will also become available. This will allow more refined estimates of decommissioning costs to be calculated, as well as after-care and long-term repair liabilities. However, estimates will only be refined if they are updated when new information is received, therefore it would seem prudent to create a regulatory requirement to carry out a periodic review of liability estimates.
6.3.6 End of life wells
Once production ceases at a well, the well abandonment plan for decommissioning will be finalised subject to approval by the licensing authority and the HSE, and to contractual agreement with any service companies employed to carry out the works. At this point, the cost of decommissioning and therefore the associated liability will be crystallised at the contracted amount, plus the cost of any variations and/or delays. At the same time the cost of surface restoration will also be finalised.
Once a well is decommissioned, it will enter a period of monitoring and aftercare prior to surrender of environmental authorisations. The purpose of the monitoring is to ensure that emissions from the well are do not exceed agreed standards.
If a well leaks and emissions to air and/or groundwater are above agreed standards and repair of the well may be required (dependant on the proximity of and risk to sensitive receptors, such as local residents and watercourses). The cost of any such repair will be dependent on the nature of the well failure.
Licence holders for UOG developments have a responsibility to repair leaking decommissioned wells and therefore they have a responsibility to make a financial provision for such repair costs. As with decommissioning costs, the maximum cost of repair will be dependent on the depth of the well, the hydrocarbon bearing potential of the strata through which the well passes and the local geology. However, this information will be known at the time of decommissioning and it is therefore possible for licence holders to estimate the of costs repair conservatively at the time of decommissioning.
As with decommissioning liabilities, the after-care and long-term repair liabilities need to be reviewed periodically and be subject to approval. However, once a well is decommissioned, the maximum liabilities for after-care and long-term repair are unlikely to vary significantly with time (except to allow for inflation and for reduction in future monitoring costs as each year passes) before the environmental authorisation can be surrendered.
6.4 Financial Instruments Available
The financial instruments which could be used to ensure that adequate funds are available to cover both decommissioning and restoration liabilities for UOG developments are:
- shareholder funds;
- parent company guarantees;
- letters of credit/secured debt;
- payments into escrow; and
- mutual funds.
All these instruments are available to the licensing authority for financial provision for the management of sub-surface liabilities associated with well leakage on a licence-by licence basis. Parent company guarantees, bonds and payments into escrow have also be used by local authorities for financial provision for the management of surface restoration liabilities in other industries and can be similarly used for UOG development on a wellsite by wellsite basis. These financial instruments and their applicability are summarised in Table 4.
Table 4: Summary of Financial Instruments
Parent Company Guarantees
Letters of Credit
The financial instruments also to cover the following liabilities:
- anticipated decommissioning liabilities (foreseen liabilities); and
- costs of accidents/failures (unforeseen liabilities).
These are generally covered by different types of financial instrument.
In addition to the above, licence holders have access to environmental liability insurance which includes cover for pollution arising from plugged and abandoned wells ( UKOOG, pers.com.).
6.4.2 Shareholder Funds
At their simplest, shareholder funds can be described as the net assets of the company. However, this definition includes things such as money owed but not received (and which ultimately may not be received), or the right to earn money in the future from Public Private Partnership contracts. For the purposes of demonstrating that a company has sufficient shareholder funds to cover decommissioning and repair liabilities, the assets under consideration should be restricted to realisable assets (including cash, fixed property (although some caution is required because property is not always realisable into cash), retained earnings, bonds, shares in other companies etc.).
The net assets (and therefore the realisable assets) of a company change year on year. Where an licence holder is allowed to rely on shareholder funds to cover its decommissioning and repair liabilities, there will always be a level of uncertainty that sufficient funds will be available at the point that they are needed in the future. Consequently, shareholder funds should be re-validated at least annually (see Section 6.5).
6.4.3 Parent Company Guarantees
Parent company guarantees are guarantees issued on behalf of a subsidiary company by the company considered to be its parent. The effect of the guarantee is to make the parent company liable for particular obligations of the subsidiary company if the subsidiary fails to carry out those obligations.
In usual practice, the parent company is considered to be the company that owns or has a controlling interest in the subsidiary. However, this enables the immediate parent company to be a holding company. If the holding company has no assets other than the subsidiary, parent company guarantees issued by it would be worthless. Consequently, if the subsidiary is part of a group structure with multiple layers, parent company guarantees will only be acceptable if they are issued by a company higher in the group that has substantial assets, i.e. one which is not simply a holding company and where the parent company's core business is independent of the subsidiary. In some cases, guarantees will only be acceptable if they are issued by the ultimate parent company i.e. the company that controls the group.
Where parent company guarantees are used, the company issuing the guarantee is required to show it as a contingent liability on its balance sheet. This can reduce the ability of that company to borrow money in the future. Where a parent company has entered into debt arrangements that contain "negative pledges", it may be prevented (by the terms of those arrangements) from issuing parent company guarantees. Consequently, entities seeking to use parent company guarantees to cover their future liabilities will generally seek to provide them at the lowest level possible, particularly if issuing them at the ultimate parent company level complicates the ability of the group to finance itself.
Where a company is not a true subsidiary, i.e. it is not in the control of one parent (for example the company is a joint venture company owned by two or more other companies), it is still possible to provide parent company guarantees from each of the companies that own it. In such cases it is common for the party being guaranteed (who would be the licensing authority in the case of UOG development) to ask each of the owners to provide a joint and several guarantee. This makes each of the owners responsible for all the liabilities of the subsidiary, rather than just the proportion of the shareholding in the subsidiary that they own. In many cases, the owners will be reluctant to agree to joint and several liability and this could effectively prevent a licence holder with more than one parent from offering parent company guarantees.
Parent company guarantees are only good as long as the guarantor itself remains in robust financial health. For example, in the past, high profile failures of energy companies such as Enron and TXU Europe, and more recently Scottish Coal, have shown how rapidly financial health can deteriorate.
In the case of Enron, fraud and illegal use of off-balance sheet vehicles had disguised the extent of liabilities. In the case of TXU Europe, falling wholesale electricity prices and wholesale coal prices undercut the trading operations of the group, which had entered into long-term purchase contracts with power stations and coal producers at higher prices. In the case of Scottish Coal, falling coal prices, caused by a fall in demand for coal from British power station corresponding with a surge in US coal exports, meant that its revenues were no longer sufficient to meet all of its liabilities.
In all three cases, parent companies guarantees became worthless and triggered further insolvencies in companies that were reliant on those guarantees. In the case of Scottish Coal, the administrator was not able to find buyers for seven of Scottish Coal's opencast coalmines, resulting in the liability for restoration being orphaned.
If parent company guarantees are used to cover UOG well decommissioning liabilities, they would have to be match the maximum duration of the liability; that is until the licence is surrendered. In addition, they should explicitly state that they are governed by the law of Scotland and can be validly executed under the laws Scotland.
From an industry point of view, parent company guarantees would be a low cost way for UOG operators to show that their decommissioning and repair liabilities are covered.
6.4.4 Letters of Credit/Secured debt
A letter of credit is usually a letter issued by a bank to a recipient guaranteeing that the recipient will be paid a sum of cash provided certain conditions are met. Letters of credit are typically used in:
- the construction industry, to guarantee that construction firms and equipment suppliers will be paid provided that they have met the terms of a construction contract; and
- international trade, to guarantee that a manufacturer of goods in one country is paid by a purchaser in another.
Using the example of international trade, the purchaser of goods makes an arrangement with a bank for the bank to pay the manufacturer. The bank will only issue a letter of credit where it is certain that the purchaser will re-pay it (the bank). The level of security that the purchaser is required to give to the bank will depend on the relationship between them, but could range from the purchaser paying the bank up-front, to the bank and the purchaser agreeing a term loan (which allows the purchaser to repay the bank over a number of years) backed by assets pledged as collateral. The bank will charge the purchaser and/or the manufacturer a fee for issuing the letter of credit. Whatever the re-payment arrangement between the bank and the purchaser, this will not normally be visible to the manufacturer. From the manufacturer's point of view, the credit-worthiness of the bank becomes the key issue, rather than the credit-worthiness of the purchaser.
Letters of credit could be used to cover decommissioning and repair liabilities in the UOG industry. In this case, they would be more complicated than the international trade example as a licensee would not be paying for goods but using the letter of credit to guarantee that the decommissioning work would be carried out. There would have to be clear definition of the purpose of the letter of credit (to provide funds to the licensee to carry out the work or to provide funds to the licensing authority to procure decommissioning works in the event of a licensee default, or both) and the circumstances in which it could be used.
Secured debt is similar to a letter of credit, in that a bank will provide a line of credit to fund a particular purpose. Using the international trade example again, the bank does not have any dealings with the manufacturer; it simply agrees to provide funds to the purchaser to buy the goods from the manufacturer. This debt is secured by assets put up by the purchaser as collateral. The bank can seize the assets if the line of credit is used and the resultant debt is not repaid. The bank will charge the purchaser arrangement fees, interest on debt drawn down, and commitment fees on any undrawn debt.
In theory, secured debt could be used in the unconventional oil and gas industry where a licensee has a) assets other than the well itself and b) cash flow from other activities that will be used to repay the debt (if the debt is actually drawn down) after the well is decommissioned. There are a number of possible variations to this, from scheduled term loans to lines of credit that will only be drawn upon if the licensee has insufficient liquid funds to pay for decommission when the well ceases to be viable.
In practice, for both letters of credit and secured debt, the licensing authority would have to examine the terms of the instrument carefully to ascertain:
- whether or not assets used by the licensee as collateral have also been used to pass financial strength tests (which would be double counting);
- the extent to which pledged assets are ring-fenced;
- the circumstances under which funds will be made available;
- whether or not the funds will be available to the licensing authority if the licensee fails to decommission the well;
- the transparency (to the licensing authority) of the arrangements between the institution and the licensee (for example, the licensing authority having the right to be informed if the licensee defaults on the terms of the instrument); and
- the creditworthiness of the institution issuing the instrument.
From the licensing authority's point of view and provided that the instrument is correctly and transparently structured, and the licensing authority has the right to draw down funds (if the UOG operator fails to decommission the well), it would reduce the risk that an UOG operator (or its parent company) does not have sufficient funds available to pay for decommissioning. However, it does not remove all risk; if the institution issuing the instrument becomes impaired or insolvent in the future, there would a risk that the instrument will not be honoured in its entirety.
From an industry point of view, letters of credit and secured debt would be more costly than relying on shareholder's loans and parent company guarantees, but will avoid the opportunity cost of making a direct up-front provision (such as holding cash on account) to cover decommissioning liabilities. If UOG development is permitted in Scotland, in the early years of the industry the fees/interest charged for such instruments are likely to be higher than those charged to other industries, but will likely fall, as the first wells are successfully decommissioned.
Bonds come in many different forms. Most commonly known as performance bonds and surety bonds, they are usually provided by banks or insurance companies to cover liabilities. Bonds issued by banks are often called "bank guarantees".
Bonds all have the same form in that they do not guarantee that the work covered by the bond will be completed. Instead, they guarantee that the party insured by the bond ("the client") will receive funds (up to the value of the bond) in the event that the party being guaranteed (the "contractor") fails to honour its contractual obligations.
The contractor is required to pay premiums to the bond issuer for the bond. The size of the premium is dependent on the amount of the bond, the type of bond required and the perceived risk (that the contractor may not complete its obligations). In the event that the bond is called upon, the bond issuer generally has subrogation rights that permit it to recover damages from the contractor.
Bonds typically (but not exclusively) operate for just the period in which the provider has contractual obligations and expire at either the practical completion of the work or at the end of the rectification period specified in the contract. It is common for bond issuers to require that a breach of contract is first upheld by a court or an adjudicator before the bond is honoured. This in turn requires the client to prove that it has suffered a loss as a result of the contractor's breach of contract. Thus, if bonds are being used, it is better that they are "on-demand" bonds, which require the party granting the bond to pay out on a claim without looking into the circumstances of the claim. If a claim is made when it should not be, the bondsman will still pay out and then the operator would have to try to recover the sum from the licensing authority.
Bonds are used to guarantee that mining, oil and gas, and landfill companies, for example, will restore sites to an agreed state once extraction has ceased. These are also called restoration bonds, reclamation bonds and reinstatement guarantees. Within the UK, bonds have been successfully used by both SEPA and the Environment Agency to manage financial liabilities.
The party being insured under these bonds is usually a government agency or the relevant regulator and the party being guaranteed (contractor) is the extraction or landfill company. Exact requirements for the bonds vary from country to country, but generally the bond issuer will require a legally approved restoration plan, which includes a detailed cost estimate and timetable for the work to be carried out. The bond amount required by the government agency or regulator is usually equal to the detailed cost estimate plus a contingency sum. Typically, the bond is not released back to the bond issuer until the government agency or regulator is satisfied that the restoration has been successful, which is usually at the end of the after-care period.
Some hybrid bonds are structured in an 'endowment' format so that funds are built up over the productive life of the mine, well site or landfill site, which the operator (contractor) then draws down to restore it. The government/regulator can only call upon the bond if the licensee cannot carry out its obligations.
The bond amount can either be 'fixed' or 'rolling'. The former relies on a sum estimated at a particular point in time, the latter allows for the amount to be varied at prescribed intervals depending on what has actually occurred (and is occurring) on the site.
Within Scotland, restoration bonds were used by the opencast coal mining industry (as well as parent company guarantees). When operators of certain sites became insolvent in 2013, the restoration bond provision was found to be inadequate and that the approach to framing and structuring bonding requirements had varied among planning authorities. The Scottish Government's Opencast Coal Task Force has recommended actions to ensure that this situation does not occur in future (Scottish Government, 2015c).
Bonds could be used to warrant UOG well decommissioning and after-care liabilities. . As yet, there is no liquid market for UOG decommissioning bonds, but given the size of the overall bond market in the EU, it would seem reasonable that a liquid market would appear if UOG development were permitted in Scotland. In such a case, the premiums would most likely be high to start with, up to perhaps 25% of the bond value.
As with opencast coal, the effectiveness of bonds will depend on the accuracy of the assessment of the decommissioning liability and the suitability of the bond for its purpose. Learning from the experience of the opencast coal industry, this indicates that in order to use restoration bonds for UOG wells:
- decommissioning and repair liabilities must be accurately estimated, regularly updated, be verified by an independent well engineer and correspond to the decommissioning design approved by the HSE;
- the bonds must be rolling bonds where the bond value can be periodically adjusted ( i.e. the amount used at well consent is not a fixed amount);
- the bonds must survive insolvency of the licensee (or its parent);
- the licensing authority must be adequately staffed by persons in possession of the necessary knowledge and skills to ensure that bonds are of an appropriate type and quantum; and
- the licensing authority must ensure licence conditions are adhered to and that licensees cooperate with and give full disclose to the independent well engineer.
Providing the foregoing are achieved, from the licensing authority's (and local authority's) point of view bonds would increase the certainty that funds will be available for decommissioning and repair, subject to the bond issuer remaining solvent. The licensing authority/local authority will therefore need to monitor the financial strength of the bond issuer as well as the licensee. From an industry point of view, bonds will be more expensive than use of shareholders' funds or parent company guarantees (and probably more expensive than letters of credit/secured debt in the early years).
6.4.6 Payments into Escrow
An escrow account is an account held in trust by a third party or "trustee" (usually a bank) on behalf of the parties to a transaction or contract. Funds in the account remain the property of the depositor, but may only be drawn down with the agreement of the trustee and for the specific purposes of fulfilling the depositor's contract obligations (in this case to cover decommissioning). Once the depositor has carried out all contract obligations, any remaining funds are released back to the depositor.
Payments into escrow give absolute certainty that funds will be available to meet future liabilities provided that the bank holding the funds remains solvent. However, as the money in the account is held on deposit, it will only attract interest. With interest rates below the rate of inflation, with time the money held in escrow may turn out to be insufficient to meet all liabilities. As with mutual funds, the sufficiency of the amount placed into escrow will be dependent on accurate estimation of the size of each liability. Use of escrow accounts is expensive, as the payments into them have to be made up front.
In Scotland, escrow accounts have been used for a variety of environmental purposes. This includes their use at the Polkemmet opencast mine, where tonnage related payments were made into an escrow account controlled by the council to part cover its restoration liabilities. Escrow accounts have also been used for the restoration of wind farms and hydroelectric power stations.
In the case of UOG wells, from the licensing authority's point of view escrow accounts would give certainty that funds will be available, although there will be doubt that the total liability will be covered when it is realised, unless there are regular reviews of the sums held with appropriate adjustments to cover any gaps in likely restoration costs. From an industry point of view, escrow accounts will probably be the highest cost way of covering liabilities.
Escrow accounts may be useful in some circumstances in ensuring that decommissioning liabilities are met. For example, in the case where the licensee of an operating well (or a parent company providing a guarantee) experiences a material negative change in its financial strength, there could be doubts that it will be able to fund the decommissioning of the well once production has ceased. In such a circumstance, it would be useful for the licensing authority to have the power to compel the licensee to place a sum into escrow to cover the estimated decommissioning liability. The licensing authority would hold the money in escrow until such time as it was required to pay for decommissioning, or until such time as the licensee could demonstrate that it (or its parent) had returned to an acceptable level of financial strength.
Escrow accounts are generally unsuitable for covering long-term (post-licence surrender) repair liabilities for two reasons:
- only a small number of wells will realise their repair liabilities and if every well had to make a provision in escrow, the amount of money tied up would in all likelihood damage the viability of the industry; and
- the long-term nature of the repair liability would mean the real value of funds held in escrow would be substantially diminished by the time the liability was realised. unless the escrow sum is regularly reviewed and increased to meet any gaps in likely repair liabilities.
6.4.7 Mutual Funds
Mutual funds (also known as pooled funds) operate on the basis that the individual liabilities are pooled together and the cost of these liabilities (if they are realised) are covered by a single fund. In the case of UOG development, mutual funds are applicable to management of:
- liabilities arising following surrender of the licence; or
- liabilities arising from the decommissioning of orphan wells ( i.e. where the licence holder has gone into liquidation and ceased to exist).
Mutual funds are capitalised by contributions in advance from the parties who have pooled their liabilities. For a mutual fund to work, the contribution from each member has to be proportional to the real liability that it is pooling, and the fund would have to be managed by professionals (authorised by the financial regulator) who would invest it so that its value keeps pace with inflation.
The key advantages of pooled funds are:
- a capitalised fund is provided in advance to meet liabilities; and
- where the liabilities of each member are being accurately calculated on the same basis, it is possible to reduce the amount of contingency included in individual liability estimates. The rationale for this is that if the pool is large enough, the sum of individual cost over-runs and under-spends will tend to cancel each other out.
The key disadvantages of pooled funds are:
- as well as accurate calculation of the size of liabilities, they require an accurate calculation of the probability of the liability occurring. If the probability or the size of liabilities is under-estimated, the fund will be underfunded and some of the liabilities will be orphaned;
- if the fund manager cannot grow the fund at or above the rate of inflation, the fund will ultimately become underfunded and some of the liabilities will be orphaned; and
- they do not guarantee that the work required to discharge the liability will be carried out by the party liable for it, merely that funds will be available to pay for the work.
In the case of unconventional oil and gas well decommissioning, there is a 100% probability that the decommissioning liability will be realised, therefore the key issue is accurate estimation of the size of each decommissioning liability.
From the licensing authority's point of view, mutual funds would provide a high degree of certainty that industry-wide decommissioning liabilities will be covered (subject to the caveats that the regulator has ensured that individual liabilities have been accurately estimated and the fund keeps pace with inflation). However, if the licensee cannot complete decommissioning (for example if the licensee has become insolvent), the regulator will have to procure a contractor to carry out the work. From an industry point of view, mutual funds are unlikely to be attractive: Notwithstanding the possible reduction in the contingency included in the liability estimate, the contributions in advance (and the fund management fee) will make this a relatively high cost way of ensuring that decommissioning liabilities are covered.
In the case of repair liabilities after decommissioning (both during the after-care period and in the long-term after licence surrender), mutual funds could have valuable role to play: it is projected that only a small percentage of wells will fail after decommissioning and realise the repair liability. From a regulatory point of view, the oversight of a single mutual fund will be considerably easier than ensuring that wells continue to have viable cover for their repair liabilities on an individual basis. However, in the case of repairs being needed after licence surrender, it is most likely that the regulator will have to procure a contractor to carry out the repairs. From an industry point of view, pooling liability will probably be cheaper than each licensee making a separate provision to cover its full liability over a period of time measured in decades.
6.5 Financial Instruments in Other Comparable Industries
Landfills continue to produce both leachate and landfill gas for many years after the landfill has closed, ceased taking waste and all the cells within it have been capped. Consequently, landfill environmental authorisations require a long-term after-care period, during which the integrity of the cap (which prevents ingress of air and rain and uncontrolled egress of gas), gas levels, leachate levels, condition of the waste and cap stability are monitored.
Surrender of environmental authorisations for landfills is only possible once completion criteria have been met. These vary according to the type and nature of each landfill, but generally the landfill operator is required to demonstrate that the waste in the landfill is unlikely to present a hazard to the environment and that gas production, leachate production and emissions have stabilised.
Clearly, the circumstances around the decommissioning of landfill sites are different to those of UOG wells; the latter will be decommissioned as soon as practicable and in such a manner that further emission of gas is prevented. In contrast, where electricity is generated by combustion of landfill gas, electricity sales revenue provide an economic incentive to landfill operators to effectively cap (the main cost of decommissioning) and maintain the site.
In order to guarantee long-term after-care liabilities, bonds are the primary financial instruments which landfill operators are required to provide by SEPA as the environmental regulator. The waste management industry is mature and dominated by large companies. As would be expected when dealing with a mature industry where the risks are well understood, there is a liquid market for the supply of such bonds.
6.5.2 Opencast coal mines
Opencast coal mining is a sequential process where the coal deposits are mined in a series of cuts. In each cut the topsoil and sub-soil are removed first (and conserved away from the operational area), then the overburden and then the coal. In the first cut, the overburden is removed and placed in a stockpile outside the excavation area. For all cuts except the final one, once the coal has been extracted the cut is filled by casting the overburden from the next cut into it. The final cut is filled by transporting the material in the stockpile and depositing it in the final cut.
The best practice for open cast coalmines is to restore the site progressively as the excavation front moves away from the first cut. Progressive restoration ensures that the bulk of the cost of restoration is met from the revenues from coal sales. However, even if final restoration is restricted to re-filling the final cut and replacing the soils, this still represents a large financial liability for which a provision must be made in advance.
From the point of view of restoration, the key differences between UOG wells and opencast coal sites are:
- the size of sites to be restored, with wellsites being considerably smaller and less onerous to restore than opencast coal sites; and
- that the decommissioning of a UOG well can only commence once production has ceased, therefore progressive decommissioning funded by production revenues is impossible. Instead, provision has to be made for the full decommissioning cost before production has ceased.
Opencast coal mine operators have used parent company guarantees, restoration bonds and payments into escrow in the past to guarantee that sites will be restored (in accordance with the terms of planning conditions and Section 75 agreements). As discussed in Section 4.2.8, in a large number of cases, the provisions proved to be inadequate when the open-cast coal industry was hit by falling coal prices in 2013 and a number of site operators went into liquidation (Scottish Government, 2015c; Mackinnon, et al., 2014).
Measures are currently being put in place to ensure that such a problem does not occur in future in the opencast coal industry. These measures would be anticipated to benefit other similar industries such as UOG development. These measures include improving the ability of local authorities to monitor operator's compliance with restoration obligations and to ensure that an appropriate level of financial cover for these obligations is in place (Scottish Government, 2015c).
6.6 Current Financial Regime
In common with other regulatory regimes around the world (see Chapter 4), the current licensing system in the UK (including Scotland) has been developed primarily for conventional oil and gas (particularly offshore oil and gas) and UOG development was not a consideration when it was developed.
At present, oil and gas production and decommissioning is primarily regulated by the Petroleum Act 1998 as applied by the Oil and Gas Authority through guidance. Onshore oil and gas is also covered by the Petroleum Licensing (Exploration and Production) (Landward Areas) Regulations 2014.
Under this legislation, licence holders are required inter alia to:
- supply the Minister every 6 month with an abstract of the accounts;
- not abandon any well without the Minister's consent; and
- abandon wells in accordance with a specification approved by the Minister.
The legislation does not require UOG operators to make a specific financial provision for the costs of decommissioning, after-care or repair of well failures after decommissioning.
The existing regime for covering decommissioning costs is included in guidance issued by the OGA for PEDL applicants. A key part of the regime is that PEDLs are issued as Deeds, which binds the licensee to obey the licence conditions regardless of whether or not they are using the licence at any given moment. Where more than one company is named on a licence, each company has joint and several liability for operations conducted under it.
6.6.2 Financial Tests
Each licence holder is required by the OGA currently (and the Scottish licensing authority in future) to pass financial strength tests that are applied at the time that the operator(s) makes a licence application. The tests are re-applied more stringently at the point that a Well Consent application is made. They are also applied to:
- new companies when a licence is assigned; and
- parent companies where the parent is supplying the funding or where a parent company guarantee is relied upon to pass the tests.
In the context of ensuring that surface restoration obligations are fully guaranteed, the local authority will be reliant on the ability of the licensing authority to ensure that the operator satisfies the financial strength tests required by the petroleum licensing system.
It is clear that not all UOG operators have the same financial strength or quality. At the two extremes, there could be companies that:
- have low gearing and appear well capitalised, but which are relatively small and therefore do not have sizeable net cash flows; or
- have high gearing and appear thinly capitalised, but due to their size have large net cash flows.
Each presents a different risk that future decommissions and aftercare costs may not be covered. In the case of the former, future cash flow may be insufficient to fund decommissioning (if the actual cost of decommissioning is significantly greater than estimated at the time well consent is given). In the case of the latter, high gearing could tip the company into receivership in the future, either because of future increases in interest rates, or because of relatively minor (in percentage terms) changes in costs and/or revenues.
The OGA currently has two distinct types of financial criteria that it uses to assess financial strength:
- Financial Viability, which refers to a company's ability to remain solvent; and
- Financial Capacity, which refers to the company's ability to meet specific costs.
Before any company receives a licence, it must have:
(i) positive total net assets (shareholders' funds);
(ii) a current ratio (current assets divided by liabilities falling due in less than 12 months) of at least one;
(iii) gross gearing (total debt divided by shareholders funds) of no more than 75%; and
(iv) interest cover (operating profit divided by net interest payable) of at least two.
The term "liabilities" as used here does not include decommissioning costs if decommissioning is not scheduled to occur within the next 12 months.
The licensing authority may still consider a PEDL applicant to be financially viable if:
- it fails the total net assets test but can demonstrate that the deficit is fully funded ( e.g. by a corporate parent, directors' or shareholders' loans, commercial debt or other lines of credit);
- it fails the current ratio test but can demonstrate (with evidence) that its working capital requirements are financed by adequate short term funding arrangements ( e.g. by a corporate parent, bank overdrafts, directors loans etc.); or
- it fails the gross gearing test but can demonstrate that it will be able to service the debt (both interest and principal repayments).
( OGA, 2015b)
As part of the tests, each company must provide :
- a copy of its most recent published accounts or a pro-forma balance sheet which has been certified by a director and is sufficiently detailed to enable the Financial Viability Assessment to be undertaken;
- cash flow projections, incorporating a debt repayment schedule as appropriate. For onshore applications the projections should cover a period of five years; and
- evidence of any third party funding arrangements ( OGA, 2015b).
An important point to note is that "Well Costs" have to be included in the cash flow projections, but the regulations do not currently specifically require decommissioning costs to be included within the "Well Costs". This appears to be a major omission, as failure to include decommissioning costs could give an entirely false picture of the required of the financial viability of a well.
From the licensing authority's point of view, regular re-testing of shareholders' funds will create additional work (depending on the interval between re-tests). However, if the financial tests are passed, the regulator should have a high degree of certainty that the full decommission costs will be funded for situations where the licence holder is not insolvent. From an industry point of view, being able to rely on shareholder funds to cover decommissioning and repair liabilities is likely to be a low-cost option for doing so.
From the licensing authority's point of view, parent company guarantees will have a similar level of uncertainty to shareholders funds: the net assets of the parent company used to underwrite the guarantee can also change year on year. As a result, the licensing authority's workload would be increased, as it would have to re-test the financial strength of the parent company (or companies) regularly as well as that of the licensee. However, if the parent company continues to pass the tests and the guarantee is absolute, there will be a high degree of certainty the total decommissioning and repair liability will be met. One point to be considered, however, is that if the parent company guarantee is not worth enough towards the end of the period of operation (just before decommissioning starts) then the licensing authority will be vulnerable if the parent company refuses to increase the guarantee or provide a substitute guarantee and just walks away from the site and the liability i.e. the assets from the site have been taken and distributed and there is no money left to deal with restoration. Both independent bonds and independent escrow accounts avoid this potential problem.
The financial capacity test was primarily conceived for offshore oil and gas. The provisions also apply for onshore wells but need to be interpreted for onshore circumstances. Each company must demonstrate adequate Financial Capacity to cover its share of the proposed Work Programme as well as all of its existing commitments (including overseas commitments). The Work Programme includes projected costs of decommissioning ( OGA, 2015b).
As the OGA decommissioning unit currently only considers offshore decommissioning costs, a separate requirement appears to be needed for onshore decommissioning costs. The projected costs of decommissioning used in this test are those projected by the licensee prior to drilling. There does not appear to be an explicit obligation for licensees to independently validate, update and refine costs if the tests are re-run after a well has been drilled.
OGA "requires evidence of 100% funding cover for all [Field Development Plan], Firm and Contingent Commitments. In the case of Drill or Drop wells in a portfolio, a company must demonstrate 100% funding capacity for the single most expensive net well cost exposure, plus 50% of the cost of the others." ( OGA, 2015b)
The OGA considers that "where a company has a net worth that is so much greater than the cost of a Work Programme, this alone may be enough to assure the OGA that they will be able to raise funding where necessary, or will be able to fund the work from their own internal resources." ( OGA, 2015b)
These two provisions in the regulations clearly envisage that some companies will be passed on the strength of their balance sheets alone. This would appear to have been because of the offshore oil and gas industry, where the market capitalisations of major companies are billions of pounds. This is unlikely to be the case in the UOG industry. It therefore reinforces the need for decommissioning costs to be specifically included in the "well costs/works programme" when the tests are carried out, and that the costs have been validated.
The OGA's current primary financial capacity measure is that a Company has Commitment Cover of 2.00 or better where:
- Commitment Cover = Net Worth divided by the sum of existing and proposed licence commitments;
- Net Worth = Shareholders' Funds less Intangible Fixed Asset.
Logically "licence commitments" should be defined in legislation/regulation to specifically include future liabilities for decommissioning, aftercare and repair of post-decommissioning well failures. It is important to note that currently this is not the case.
There is a general need for flexibility, in order for licensees to be able to put in place funding arrangements that suit them. However, there may be circumstances where the licensing authority should have the power to specify a particular arrangement (such as escrow accounts). This would be to ensure that adequate funds are available to cover decommissioning, aftercare and repair liabilities once production and revenue generation at a well have ceased.
The OGA currently considers that funding arrangements to meet deficits in Commitment Cover can include:
a) Issue of additional share capital, where evidence can be given that the funds are available and have been irrevocably committed to the share issue by the investor(s), or the share issue has been guaranteed/underwritten by a recognised financial institution or stock brokerage (future share issues will not be acceptable without such evidence).
b) Parent company loan supported by a copy of the executed loan agreement.
c) A parent company guarantee using one of two ( OGA) prescribed forms of words. Where an applicant seeks to satisfy the OGA of its Financial Capacity in this way, besides requiring an parent company guarantee, the OGA will apply its financial criteria and documentation/evidence requirements to the parent instead.
d) Directors' loans, which must be confirmed in writing and the Company must also satisfy the OGA about the directors' ability to make such loans from their private resources.
e) Loans from banks or other financial institutions that are evidenced by the provision of a copy of the executed loan agreement. Loan agreements that have been made conditional upon the award of licence are acceptable but letters of intent from a bank or other financial institution are not. If a company will be relying on commercial debt to meet its existing and/or proposed licence commitments, or is a subsidiary of a corporate group which is reliant on commercial debt, the OGA will need assurances that the funding arrangements will remain in place long enough to fund the Work Programme and that the company and, if applicable, the corporate group to which it belongs can meet the interest payments and agreed capital repayment obligations. A debt repayment schedule for the applicant company and, if applicable, for the corporate group should therefore be provided along with summary cash flow projections clearly showing interest charges and capital repayments. If the debt repayment schedule shows any significant redemption of debt within the next 12 months which cannot be met from operational cash flow, details of how the redemption will be funded should also be provided.
f) Future cash flows from existing assets where those assets have proven reserves and are in production, or where production is imminent. The OGA will require detailed financial projections for a period of not less than 5 years. As a minimum, these projections should comprise cash flow forecasts for both the Applicant Company and consolidated cash flow forecasts for any corporate group to which the Applicant Company may belong. Any assumptions made in the compilation of these forecasts should also be provided. Speculative cash flows, for example where assets are not in production and where production is not considered imminent, are not acceptable ( OGA, 2015b).
6.7 Gaps in the Financial Regime
Provided the recommendations of the Opencast Coal Taskforce are implemented across those local authority areas in which UOG development may be undertaken (Scottish Government, 2015c), no specific gaps have been identified in the planning regime where this is used to control surface restoration liabilities under Section 75 planning agreements.
There appears to be a gap in the regulations relating to decommissioning, aftercare and long-term well failure liabilities of onshore wells. This is because currently the OGA decommissioning unit only deals with offshore wells: there is no existing unit to deal with on-shore decommissioning costs.
The definitions of "Well Costs" and "Works Programme" used in the regulations and guidance could be interpreted to only cover the projected decommissioning costs at the time that well consent is applied for ( i.e. before the well has been drilled). They do not make reference to the costs of after-care or long-term well repair liabilities. As demonstrated above, there is a measure of uncertainty regarding the estimates of decommissioning costs prior to drilling.
The legislation and regulations do not include a specific requirement to include decommissioning costs (or aftercare or long-term well repair) in "Well Costs" or "Works Programme" once a well has been completed. Logically the term "licence commitments" used in the regulations and guidance should be defined to explicitly include decommissioning, aftercare and repair liabilities, but as currently worded this appears to be open to interpretation.
Once the a well is completed, the licensing authority has power to require the tests to be re-run if it deems this necessary, but there is no specific requirement to do this at regular intervals. However, if the tests are re-run, there is no specific requirement to refine decommissioning and other liabilities once a well has been completed. Together, these create the possibility that some portion of post-production liabilities could be unfunded.
The current regulations are geared towards companies with the large balance sheets required to operate offshore. If unconventional onshore oil and gas exploration and production is permitted, it will take place on a smaller scale, and most likely, on shorter time scales (from exploration to decommissioning) than offshore conventional oil and gas. It will therefore be accessible to companies with smaller balance sheets, whose financial strength could change more rapidly than the financial strengths of the offshore companies.
6.7.3 Liabilities after Licence Surrender.
The current regulations do not legislate for the cost of repairing leaking wells once the licence has been surrendered. As described in Chapter 2, there is a low likelihood of long-term failure of wells that have successfully surrendered their environmental authorisations. Should any problems occur in a decommissioned well, they would most likely occur during the aftercare and monitoring period (in which case, the costs of repair will be covered by the financial arrangements put in place to cover Repair Liabilities during the aftercare period). Failure of a well after the environmental authorisation has been surrendered, if it occurs, is more likely to occur decades into the future than in the years immediately after surrender.
6.8 Possible Remedies - During Licensing
6.8.1 Guiding Principles
When considering potential remedies the following factors have been taken as guiding principles:
- adequate funding should be available to ensure that wells are timely and securely decommissioned and that any long-term, post-decommissioning well failures are repaired where necessary to protect public health and the environment; and
- the funding of such decommissioning and repairs should fall to UOG operators and not to the public purse.
These two objectives should be met in a proportionate way that results in the least adverse impact on the economic viability of the UOG industry.
6.8.2 Possible Changes to the Existing Regulatory Regime
With the devolution of the OGA's powers to a future Scottish licensing authority, there is an opportunity to adapt the existing licensing regime to the Scottish situation to ensure that the liabilities for decommissioning, aftercare and repair of failed wells (prior to licence surrender) are adequately provided for by licence holders and that they do not fall on the public purse. Recognising that the shorter project lives and smaller scale of unconventional oil and gas compared with conventional oil and gas, and the experience of the Scottish opencast coal industry, the following remedies could be considered:
- define "decommissioning liabilities" to include the cost of decommissioning and aftercare up until licence surrender;
- define "repair liabilities" as the cost to repair a well should emissions post-decommissioning exceed agreed environmental standards;
- require the future Scottish licensing authority to ignore unrealisable assets such as goodwill when considering a company's assets or net worth;
- require licensees to supply evidence and a technical opinion (by the independent well examiner) to support their estimates of decommissioning liabilities and repair liabilities;
- require decommissioning liabilities to be specifically included in "well costs" and "works programme" and shown as a separate line in the cash flow projections supplied by licensees to the licensing authority for the purpose of applying the financial strength tests;
- require UOG operators to provide a commentary to the Scottish licensing authority (in statutory drilling returns) of any material changes in the estimate of Decommissioning Liabilities as a consequence of geological conditions encountered during drilling;
- require the Scottish licensing authority to monitor UOG operators actively, including site inspections at regular intervals.
- give the Scottish licensing authority powers to compel licensees to provide additional financial arrangements prior to well testing, if information gathered during drilling indicates that there could be a material increase in the estimate of decommissioning liabilities;
- require UOG operators to re-submit, with evidence and technical opinion, their estimates of Decommissioning Liabilities and Repair Liabilities once drilling and well testing are complete;
- require the Scottish licensing authority to re-run the financial strength tests on completion of well testing;
- require licensees to update and independently re-validate their estimates of decommissioning liabilities and repair liabilities at least annually, taking into account operating data, evolving best practice and inflation;
- require the Scottish licensing authority to periodically re-run the financial strength tests during gas and oil production (noting that the licensees are already required by existing regulations to resubmit accounts and other financial information on an annual basis) and during the aftercare period; and
- where a
operator fails the tests, the Scottish licensing authority could
be given powers to compel the licensee to provide specific
additional or alternative financial arrangements where, in the
opinion of the licensing authority:
- these are necessary to respond to changes in oil, gas, banking, bond or insurance markets; or
- the financial circumstances of a UOG operator or any other entity which the operator depends on to meet its Licence Obligations including Decommissioning Liabilities and Repair Liabilities have materially and negatively changed or are likely to materially and negatively change as a result of those market changes.
Ideally the specific arrangements compelled by the Scottish licensing authority should be at least sufficient to cover the decommissioning liability and the provision of insurance or payments into a mutual fund to cover the after-care and long-term repair liabilities.
In addition, whenever production has ceased, either temporarily or permanently, until the environmental authorisation has been surrendered the UOG operator could be required to demonstrate (through the financial strength tests) that sufficient funds will continue to be available and "ring-fenced" to cover the latest estimate of Decommissioning Liabilities. Where this cannot be demonstrated to the satisfaction of the licensing authority, the licensing authority could be given the power to call upon funds, guarantees, bonds and insurance policies provided by the licensee and/or its parent company to cover its Decommissioning Liabilities and place their proceeds into escrow.
Whenever production at a well is ceased, either temporarily or permanently, UOG operators could be required to provide insurance policies or other instruments acceptable to the licensing authority to cover the Repair Liabilities of that well.
The UOG operator could also be required to demonstrate to the satisfaction of the licensing authority that the provider of the instrument used to cover the Decommissioning and/or Repair Liability has approved the operator's decommissioning design. In the event that regulatory approval of the decommissioning design occurs after the date on which the instrument is required, the operator could be required to either:
- demonstrate to the licensing authority that the instrument provider has noted and accepted any changes to the decommissioning design (since the instrument was issued) required to gain regulatory approval; or
- provide a new financial instrument compatible with the design that has received regulatory approval.
Where a well fails during the aftercare period, the design of the repair should be subject to regulatory approval.
6.9 Possible Remedies - After Licence Surrender
The current regulations do not legislate for the cost of repairing wells once the licence has been surrendered. As set out in Chapter 2, wells, which are designed, constructed and abandoned to a high standard in a strong regulatory environment, are considered to be at low risk of leakage. Should any problems occur in a decommissioned well, they will most likely during the aftercare and monitoring period. In this case, the costs of repair will be covered by the financial arrangements put in place to cover repairs during the aftercare period. Long-term failure of a well after the PEDL has been surrendered will occur decades into the future (if at all) rather than in the years immediately after licence surrender.
Under the "polluter pays" principle, the licensees at the time of decommissioning should still be liable for the future costs of repair of the well if such a failure occurs. However, there will be a real possibility that at the time of failure, those licensees will have either ceased to exist or will no longer have the financial strength to pay for the repairs. In such a case the repair liability will be orphaned. Such an eventuality could be avoided by simply never permitting licensees to surrender their licences and requiring them to continue to pass the financial strength tests indefinitely. However, such an option would appear unrealistic: it would impose an ever larger administrative burden on the licensing authority as decommissioned wells proliferate (substantially increasing the total cost of regulation); and it would impose indefinite costs on industry, which are unlikely to be proportionate to the risk and which would in all likelihood damage the economic viability of the industry.
In an ideal world, licensees would deal with the long-term liability by buying an insurance product in the market, with the licensing authority as the insured party (to ensure the licensing authority has funds to procure repairs to the well in the event of a failure in the period after licence surrender). In reality, such products do not yet exist. Even if they did, the long-term nature of the liability means that there would be a risk that the insurance provider could withdraw from the market at some point in the future, thereby negating the cover and leaving the repair liability orphaned.
Given the above and the current immaturity of the unconventional oil and gas industry in Scotland, the simplest and most secure way of ensuring that long-term failure liabilities are covered would be an industry-wide mutual fund (see Section 6.4). The fund would be capitalised over time by collecting "premiums" from all licensees. Then, should any well fail after licence surrender, the costs of repair of that well could be borne by the mutual fund under the direction of the licensing authority.
To examine the feasibility of a mutual fund, a number of issues need to be considered:
- the size of the mutual fund;
- failure occurring before the fund is fully capitalised; and
- fund management.
6.9.2 Size of the Mutual Fund.
As there is a low probability of any well failing, a mutual fund would not have to be so large that it could cover the cost of all decommissioned wells failing. Rationally, it should be sufficiently large to cover the costs of repairing a percentage of all wells drilled ("the failure percentage"). As all wells require licensing authority approval of the decommissioning design under an industry wide licensing authority regime, it would seem appropriate to calculate the failure percentage on an industry-wide basis. In the early stages of the industry, the failure percentage should be determined by reference to the long-term failure rate in conventional oil and gas wells, but with an additional margin that reflects differences between conventional and unconventional well drilling and operating practices (and therefore the stresses placed on the well annulus). As the industry matures and experience is gained, the licensing authority would be able to adjust the failure percentage in the light of experience.
For the extreme case of a total well decommissioning failure (where hydrocarbons or well fluids are freely migrating between different geological horizons and/or to the surface), the maximum cost of repair of each well will have been estimated in advance. If regulation requires the repair liability to be estimated, the repair liability will be estimated once well testing is complete (and refined and adjusted in each year thereafter). It should therefore be possible for the licensing authority to produce an estimate of the industry-wide maximum repair liability (for all wells that have been completed to date). Again, as the industry matures, better information is made available and more wells are drilled, the licensing authority will be able to adjust the industry-wide repair liability.
Once the failure percentage has been estimated, the licensing authority would be in a position to estimate the size of the mutual fund required. At its most simplistic, this could be achieved by multiplying the industry-wide maximum repair liability by the estimated failure percentage plus a sum to cover the cost of administering the fund.
In reality, should failures occur, they could range from minor failure (emissions marginally raised above agreed limits) to total failure. A failure may therefore not require the full repair liability to be spent in order to repair the well, but this will depend on the nature of the failure and where in the well column the emissions are originating. As the industry matures and better information becomes available, it may be possible to ascribe different failure percentages for different types of failure. If deemed appropriate, this could enable the size of the mutual fund to be adjusted to account for the different failure percentages and the repair costs of different types of failure.
If a mutual fund were established on this basis, UOG operators would be required to populate it with premium payments. The premium for a well should be proportional to the estimated repair liability for that well. At its most basic, the premium should be equal to the repair liability for that well multiplied by the (industry-wide) failure percentage, plus an amount to cover the cost of administration of the mutual fund. If the failure percentage is adjusted in the future, the size of the of the premium will change.
Premium payments could either be lump sums or payments spread over time, but as a minimum the premium should be paid in full before the licence is surrendered:
operators be required to continue to pass the financial strength
tests during aftercare and monitoring, they would have to
continue to demonstrate sufficient assets to cover the Repair
Liability during the aftercare period.
- Where the Repair Liability has been covered by shareholders funds, parent company guarantees or letters of credit, the value of the assets would be greater than the premium. In such cases, the premium could be paid as a lump sum when the assets are "released" at the time of licence surrender.
- Where the Repair Liability has been covered by insurance, the licensing authority could require the licensees to provide additional assets to cover the premium, if the UOG operator wishes it to remain payable at PEDL surrender.
- If a well fails during the aftercare period, the possibility that the cost of repair could equal or exceed the Repair Liability will need to be considered by the licensing authority. Taking into account the margin by which the Licensee passed the most recent financial strength tests, at the time that failure is declared the licensing authority will need to consider whether or not to compel the Licensee to provide additional assets or to pay the premium immediately.
- If licensees are not required to continue to pass the financial tests during the aftercare period, the licensing authority could be given the power to compel payment of the premium at the start of decommissioning.
- UOG operators could be given the option of paying the premium in advance should they choose to do so; if the premiums are deemed to be tax deductible, licensees could be incentivised to pay the premium whilst the well is in production (to offset tax liabilities).
- Where payments are made in advance, UOG operators could remain liable for additional charges (or refunds) in the future, should the licensing authority adjust the industry-wide failure percentage before the PEDL is surrendered.
- Where a licensee elects to pay in advance, it should be given the option to pay the premium in instalments.
6.9.4 Failure Occurring before Mutual Fund is Fully Capitalised.
The principle of a mutual fund is to share the costs of repairing long-term well failures amongst the industry. However, if only a limited number of wells are drilled, it is possible that the fund will not be large enough to pay the repair costs if one or more of those wells fails after licence surrender ( i.e. the failure rate is greater than the failure percentage used to calculate premiums). This liability could be balanced by consideration of:
a) the minimisation of the probability of failure occurring through the robust system of regulation and licensing authority approval of well and decommissioning design; and
b) the size of the liability, which will be relatively small given that only a small number of wells are drilled.
The monetary options for minimising the liability of excesses falling to the public purse are limited. The most realistic one would be to increase the failure percentage (and thus the size of premiums) in the early years of the industry's development. This would however increase industry costs, which may in turn reduce the number of viable wells and therefore be potentially self-defeating.
6.9.5 Fund Management
Any mutual fund would need to be managed over a long period of time. It would need to be invested in such a manner that it grows at rate that keeps pace with both inflation and the increase in the nominal cost of future well repairs.
6.10.1 Whilst Operators are Licensed
It is essential that UOG operators have sufficient funds available to cover liabilities associated with the abandonment and decommissioning of wells. The licensing authority can test the financial robustness of operators during licence applications, if a licence changes hands or before a well consent is issued. The licensing authority also has powers to compel the supply of further financial information once operations commence, and to require a company to "take action" if the licensing authority is not confident that there are sufficient funds to cover its liabilities.
We have identified this as a weakness in the existing provisions in that there appears to be no power to require specific arrangements for onshore well decommissioning and aftercare if a company proves to be failing the financial tests after a well consent is awarded. A relatively simple solution could be to re-apply the financial strength tests regularly for operators and to ensure that the well costs used in the tests include sufficient allowance for the operator's decommissioning and restoration liabilities.
If a company fails the financial strength tests, under the existing regulations the OGA does not have the power to compel operators to make specific further financial provisions. It is clear that both the liabilities for individual wells and the robustness of individual operators will vary. The Scottish Government should consider therefore whether the future Scottish licensing authority needs to be able to compel specific financial provisions to match the individual circumstances These could include provision of Parent Company Guarantees, insurance, bonds or letters of credit or payment into escrow accounts - depending on the reasons for failing the tests.
Post-decommissioning well failure is unlikely, but should it occur it is most likely to happen within a few years after well abandonment and decommissioning. It could therefore be expected that the licensing authority will not accept surrender until all environmental authorisations and restoration obligations have been complied with. During this period, the licensing authority could continue to apply the financial tests and require specific financial action should significant liabilities be identified by the regulators.
6.10.2 After Licence Surrender
The likelihood of long-term failure of decommissioned UOG wells that were well constructed and abandoned is considered to be low.
In the event that a failure does occur after licence surrender, long-term insurance products could cover such risks. Alternatively, a mutual fund could be established to cover the costs of repairing leaking orphaned wells in the future. As an example, an annual levy on consented wells raised through the licence fee could be used for this purpose.
6.10.3 Impact on the Cost of Regulation in Scotland
Should UOG development be permitted in Scotland, there will be increased regulatory costs associated with:
- increased regulatory oversight by the future Scottish licensing authority;
- ensuring that local authorities in which UOG development may occur are resourced to implement the recommendations of the Opencast Coal Taskforce.
There will also be increased regulatory requirements for SEPA should the industry grow and develop.