Optimal timing of hazardous waste clean-up under an environmental bond and a strict liability rule

Abstract

Inadequate site clean-up and restoration by resource extraction firms leave a toxic legacy which must be dealt with by governments. This study compares the impacts of an environmental bond and a strict liability rule on a firm's incentives for cleaning up hazardous waste during resource extraction and upon termination. The firm's problem is modelled as a stochastic optimal control problem that results in a system of Hamilton Jacobi Bellman equations. The model is applied to a typical copper mine in Canada. The resource price is modelled as a stochastic differential equation, which is calibrated to copper futures prices using a Kalman filtering approach. A numerical solution is implemented to determine the optimal abatement and extraction rates as well as the critical levels of copper prices that would motivate a firm to clean up the accumulated waste under each policy. The paper demonstrates that an environmental bond provides strong waste abatement incentives, implying that the waste is more likely to be cleaned up under the bond than the liability. The strict liability rule imposes sunk costs on a firm upon termination which would motivate it to remain inactive as a way to escape clean-up costs. However, the environmental bond raises funds ex ante for future clean-up costs and thus encourages site restoration.