Make-good clauses, skifield restoration, & public finances
Make-good clauses, skifield restoration, & public finances
The Ruapehu ski field bankruptcy shows a potential downside of restoration requirements
Make-good clauses are common features of commercial leases. Want to open a cafe? Typically, you’ll rent an empty shell, and your landlord will want you to hand it back empty. The coffee-machine plumbing that was essential for your cafe business may just get in the way of the next tennant’s business plans.
Make-good clauses also appear in other leases. The Mt Ruapehu ski fields are wholly within Tongariro National Park, which is managed by the NZ Department of Conservation (more commonly known by its acronym DOC). Ruapehu Alpine Lifts (RAL) operates under a “concession” (much like a lease) from DOC. A condition of the concession is that if the ski field ceased to operate then RAL is responsible for removing all skiing infrastructure from the mountain.
RAL is currently in voluntary administration.
The administrators have continued to run the Sky Waka gondola and associated cafe over summer. Further, a $6m loan from the government should allow the field to open for the 2023 winter season. There is a link to an early operating plan for the winter season at the bottom of the 2023 Winter Season Update webpage.
A $100m cleanup
But without a new owner, it is likely the field will face permanent closure. This would no doubt trigger the make-good clause in its DOC concession. Removing skifield infrastructure could cost as much as $100m. RAL is unlikely to be able to contribute much, if anything, to funding this.1
The case for making good
One way to understand make good clauses is to compare them with the polluter pays principle, that is, the party responsible for producing pollution should be responsible for paying for the damage done to the natural environment. While this is generally considered to be a legal rather than economic principle, it reflects the economic idea that an economic agent should “internalise” the costs its actions place on the environment. Internalisation creates an incentive to minimise those costs and, to the extent that some costs are unavoidable, the agent responsible should pay some money towards rehabilitation.
A recent paper by Sara Aghakazemjourabbaf & Margaret Insley2 investigated the problem of mine site rehabilitation when operator bankruptcy is possible. In their paper, bankruptcy could occur opportunistically (e.g. to avoid operator costs) or exogenously (e.g. because of falling commodity prices).
They looked at two policies:
the mine operator is legally liable for site rehabilitation
the mine operator posts a bond in advance that covers the expected costs of site rehabilitation
They found, not unexpectedly, that
when bankruptcy is an option and no bond is required, the firm produces too much waste relative to a benchmark case, resulting in an efficiency loss and a cleanup liability imposed on government. In the presence of bankruptcy risk, a bond ensures that the firm acts optimally and no efficiency loss is imposed on society.
With the benefit of hindsight, requiring RAL to post a cleanup bond would have been perfect. But, without a time machine, that’s not the world we inhabit.
Pursuit of the perfect may undermine the good
RAL’s rehabilitation requirement is of the form of a legal liability, the failings of which are now clear. DOC, and thus the New Zealand taxpayer, is currently up for an estimated $100m of rehabilitation costs.
Unless, of course, a new operator (let’s call them NewSki) takes over the field.
DOC would, quite likely, want NewSki to take over RAL’s cleanup liability. That would get DOC off the financial hook for the cleanup — temporarily at least. DOC cannot be sure that NewSki will not go bankrupt at some time in the future, particularly given that it has happened before.
Alternatively, DOC could require NewSki to post a bond for rehabilitation. That would cover off DOC’s financial liability nicely.
Lastly, DOC could wear the future rehabilitation costs itself. This would leave it no worse off than it is at present. Arguably it would be better off, as rehabilitation could be deferred. NewSki would be unencumbered, but have no (financial) incentive to minimise any future rehabilitation costs due to its own actions.
An unencumbered NewSki is better than no NewSki at all
However, NewSki would be taking over a failed business. That is, almost by definition, financially risky. More upfront costs would make it riskier still. And the more costly and riskier it is to take on a business, the less likely it is to find someone willing to take it on.
A bond is the most costly option for NewSki. But liability is not cost free either. A foreseeable exit cost acts almost identically to an entry cost. An operator with a reputation to protect would be unlikely to take on a business that required bankruptcy to avoid predictable but likely unaffordable exit costs.
So DOC faces a quandary. Its best financial options are, in order: a bond, liability and unencumbered — but only if it actually finds a willing NewSki. But the likelihood of finding a NewSki diminishes across the same options in the reverse order. And, should it not find a NewSki, DOC would be left with the whole cost of rehabilitation, payable almost immediately.
Maybe it’s time to get creative
DOC needs an arrangement with the incentive structure of a bond, but without the upfront costs for NewSki. I think a contract could be worked out along the lines of:
DOC (or more likely, the government) funds a bond to cover the estimated costs of rehabilitation.
After 5 years of operation, NewSki begins to buy out DOC’s stake in the bond. The annual buyout is capped at say $5m or 25% of accounting profits, whichever is lower.
NewSki supplements the bond to cover the future rehabilitation of any new infrastructure they build, net of any rehabilitation costs they incur for the infrastructure it replaces.
This would leave DOC no worse off than the present situation, and possibly a lot better off. And it would be much more attractive for a new operator than a (full) bond or liability. Worth exploring?
By Dave Heatley
As I’m not privy to the details of RAL’s DOC concession, I don’t know whether RAL’s make-good liability ranks ahead of or behind it’s liabilities to its lenders and other creditors. RAL has reported debts to lenders of $45m. I think it is reasonable to assume that whatever the relative ranking of the make-good liability, RAL is able to contribute a small fraction, at most, of restoration costs.
Sara Aghakazemjourabbaf & Margaret Insley (2021). Leaving your tailings behind: Environmental bonds, bankruptcy and waste cleanup, Resource and Energy Economics, Volume 65, 101246, ISSN 0928-7655, https://doi.org/10.1016/j.reseneeco.2021.101246.