January 01, 2013

Insuring Fracking Risk: Can Conventional Insurance Tools Manage Unconventional Risk?

Matthew Jokajtys

Hydraulic fracturing of subterranean shale formations to extract natural gas, or “fracking,” is a process that sometimes lends itself to hyperbole in these polarized times. Proponents hail it as a lifeline for economically depressed rural regions, touting well-paying jobs and cleaner burning fuel for electricity generation. President Obama has called America the “Saudi Arabia of natural gas” and encouraged expanding its use in cars and trucks. Obama: US Saudi Arabia of Natural Gas, U.S. News & World Rep., Jan. 26, 2012. Skeptics decry fracking as an environmental disaster in waiting. They link existing operations to a variety of serious health impacts and cite threats to drinking water supplies from undisclosed chemical constituents of the fluid used in the fracking process.

However, as the battle over fracking plays out everywhere from kitchen tables in the shale gas rich regions all the way up to the federal government, it is increasingly apparent that shale gas is here to stay. In its 2012 Annual Energy Outlook, the U.S. Energy Information Administration (EIA) estimates that the United States contains one of the largest technically recoverable reserves of shale gas in the world. See U.S. Energy Info. Admin., Annual Energy Outlook 2012 with projections to 2035. By 2035, the EIA estimates that shale gas will account for nearly half of U.S. natural gas production and more than double the share of electricity produced from natural gas. Id. at 92. The impacts on energy and environmental issues will be tremendous.

Specifically, the EIA predicts that increased production of shale gas will drive a revolution in electricity generation in the United States. As the share of natural gas in electricity generation increases, it will displace a significant share of coal-generated electricity in the US, decreasing coal’s share of total generation from 45 percent in 2010 to 38 percent in 2035. Id. For an energy source that some environmental groups have called “America’s dirtiest energy source,” such a decrease should be big news. Nat. Resources Def. Council, Coal Not Clean (2012), available at www.nrdc.org/energy/coalnotclean.asp.

While many would applaud such a reduction in coal-fired power in this country, there are a variety of potential environmental, health, and safety risks associated with increased fracking operations. Most notably is the fear that these operations could contaminate drinking water supplies with either the fluid used in fracking operations or even with natural gas—the flaming taps so vividly displayed in the movie Gasland. One 2011 study by researchers at Duke University’s Nicholas School of the Environment documented methane contamination of drinking water in active fracking areas. The researchers at Duke matched the gas geochemistry from drinking wells to that of gas coming from deep underground via production wells, rather than the gas that naturally seeps to the surface on its own over time. The highest concentrations that the Duke team observed from samples in the study were significant enough to raise concerns of a possible explosion risk. See Osborn, et al., Methane contamination of drinking water accompanying gas-well drilling and hydraulic fracturing, PNAS Early Ed. (2011).

This publicity and uncertainty surrounding fracking have raised questions about the availability of insurance for managing fracking risk. In July 2012, Nationwide Mutual Insurance Company (Nationwide), one of the largest in the world, caused a stir when it announced that it would not cover fracking exposures under its personal or commercial lines policies. See Esch, Mary, US Insurer won’t cover gas drill fracking exposure, Associated Press, July 12, 2012. Nationwide subsequently explained in a press release that while it was not cancelling policies “[f]racking-related losses have never been a covered loss under personal or commercial lines policies.” Nationwide, Nationwide statement regarding concerns about hydraulic fracturing (July 13, 2012). While Nationwide’s announcement has yet to be tested by any large claim or coverage litigation, it has intensified a broader debate about the risks associated with fracking.

The purpose of this article is neither to defend nor support fracking as a natural resource extraction technique. Rather, it is to provide a survey of the associated hazards; describe a variety of risk management tools provided by the private insurance market; and look ahead to the role insurance can play in the future as our understanding of the process and its risks evolves. Like any set of tools, those for managing fracking risk demand a level of understanding and expertise in order to be designed and operated properly. Attorneys, whether focusing on environmental, tort, insurance coverage, or defense—or the plaintiff’s bar—will need a thorough understanding of these tools as fracking litigation is expected to grow in the near future.

The Fracking Process

Though only reaching widespread notoriety in the past few years, fracturing subterranean shale formations to release the natural gas contained within has been practiced since the forties. The first step in the fracking process is to locate the gas rich shale formations known as shale “plays.” Shale plays are geographic areas containing layers of rock located up to six thousand feet below the surface that have natural gas trapped within them. U.S. Dep’t of Energy, Office of Fossil Energy, Nat’l Energy Tech. Laboratory, Modern Shale Gas Development in the United States: A Primer (2009), at 17. Because of their low permeability, the gas is difficult to extract without breaking up the rock in the formation. Natural geological activity has been fracturing these formations and creating natural gas seeps for as long as the formations have existed, but it was not until hydraulic fracturing that an economically feasible way was discovered to extract and collect the gas for use.

Hydraulic fracturing occurs after drilling down to the shale play and lining the well with steel casings that are cemented together to protect groundwater and prevent the loss of natural gas as it travels up to the surface for production. At its most basic, hydraulic fracturing involves inserting charges into the well at the level of the shale play and detonating them, fracturing the formation. A fluid containing water, a variety of chemicals, and a proppant such as sand is then pumped into the well, which helps expand the fractures and release the natural gas. The chemicals in fracking fluid serve a variety of purposes, such as reducing friction between the fluid and the well, and the proppant helps to prop open the fissures and allow the gas to escape. The natural subterranean pressures force the gas up the wellbore and to the production site.

As technology has advanced, drilling companies have developed techniques to drill not only vertically to the level of the subterranean shale play, but also horizontally along the shale play for up to two miles underground. Drilling companies are also now able to drill up to eight wells on one roughly three-acre drilling “pad,” substantially increasing the volume of shale to be fracked while minimizing drilling pads across the landscape. This technique exposes more subterranean shale to fracking, thus extracting larger amounts of natural gas more efficiently than traditional techniques.

Managing Fracking Risk

The latest advancements in fracking techniques have been a game changer in terms of altering the estimates of total recoverable reserves of shale gas in the United States, but they have also dramatically altered the hazards associated with fracking. As public awareness and trepidation surrounding fracking has grown with its increased use in the heavily populated Northeastern United States, many fracking skeptics are demanding that safeguards be put in place or that the practice itself be banned until its impacts are better understood.

The regulatory environment for fracking compounds the skeptics’ concern. At the federal level, the EPA position on fracking is still evolving, and there are key areas in which fracking is exempt from regulation, including the Safe Drinking Water Act and the Clean Water Act. Given the current legislative gridlock, it seems unlikely that major legislative action on fracking will occur in the near future. For example, the Fracking Responsibility and Awareness of Chemicals, or FRAC Act, was introduced in 2009 and designed to revoke the fracking exemptions from the Safe Drinking Water Act and compel public disclosure of the chemical constituents of fracking fluid. However, neither the House nor the Senate acted on their respective versions. See S. 1215 (111), Fracturing Responsibility and Awareness of Chemicals (FRAC) Act.

At the state and local levels, regulations can vary widely. For example, New York has had a moratorium on fracking since 2008 while it conducts an environmental review of the process. There is some precedent to indicate that municipalities may regulate fracking through their land use and zoning powers. See Anschultz Exploration Corp. v. Town of Dryden (Sup. Ct. Tomkins Co., 224 Feb. 21, 2012), and Cooperstown Holstein Corp. v. Town of Middlefield (Sup. Ct. Otsego Co., Feb. 24, 2012). New Jersey has banned even fracking wastewater from entering its borders. In contrast, Pennsylvania has recently reaffirmed that the oil and gas industry is not required to disclose to constituents the contents of fracking fluid if they are deemed a trade secret, along with a raft of other regulations, in its Act 13 of 2012.

Despite the differences in the regulatory environment, the concerns relating to fracking are similar across jurisdictions. Perhaps the most feared hazard of fracking is the contamination of drinking water, either through surface spills, improper disposal, or underground migration. While fracking fluid is roughly 99.5 percent water, the latest multi-well fracking techniques can require millions of gallons of fracking fluid, implicating thousands of gallons of chemicals in the multimillion-gallon fracking operations. Such large volumes of water could prompt lawsuits to enforce water access rights in more drought-prone areas of the country, or to redress water contamination from “sudden and accidental” events like surface spills or more gradual events, such as well contamination.

Additionally, like any industrial activity, fracking carries with it the hazards of bodily injury, property damage, assorted types of environmental degradation, and the cost of business delays associated with the previously mentioned hazards. Explosions, equipment malfunctions, or other accidents could give rise to claims for first or third party bodily injury or property damage. Notably, some have even made connections with earthquakes and fracking operations, such as the earthquakes observed in northern Texas, Ohio, and even Blackpool, England.

To address these risks, the fracking industry turns to a variety of insurance products. Private insurance has a number of benefits, principal of which is the use of risk-based pricing to encourage the use of best industry practices and other risk-reducing behavior through premium reductions for policyholders.

In its 2012 Energy Market Review, the international insurance broker Willis cites a number of carriers who are willing and able to underwrite fracking risks, as well as some of the techniques insurers use to price these risks. See Willis, Energy Market in Review: All Fracked Up? Just how concerned should energy insurers be about hydraulic fracturing? (April 2012). Coverage for fracking risks comes in three types—the Comprehensive General Liability (CGL) and associated excess coverage, environmental liability coverage, and Operator’s Extra Expense (OEE) coverage—which are purchased by the operators of fracking projects for coverage against first and third party liability resulting from fracking related losses.

The standard CGL policy provides business organizations occurrence based coverage for third party bodily injury and property damage liability arising out of those activities designated as “covered operations” under the policy. Claims that trigger coverage under a CGL policy are most likely to stem from a sudden and unexpected incident at a discrete time and place, like a construction accident, rather than a long-term latent issue like groundwater contamination. In fact, many basic CGL policies contain a specific “pollution exclusion” that would preclude coverage for “Bodily Injury, Property Damage or Personal Injury or Advertising Injury arising out of the actual, alleged or threatened discharge, dispersal, seepage, migration, release or escape of Pollutants anywhere at any time.” See Stanovich, Craig F., The CGL Pollution Exclusion, IRMI Online (March 2003).

This basic coverage can be modified via endorsement to include or exclude underground resources and equipment hazards, which cover property damage to the gas resources underground and any equipment inside the well underground. The coverage provided and the premium charged for a CGL policy is usually a function of the extent of an insured’s operations, such as the number of drilling pads to be covered and the exposure for third party liability. Such third party exposure could have implications for fracking operations in the Marcellus Shale region that are increasingly encroaching on populated areas.

Next, environmental liability policies can provide coverage for fracking related losses on two levels: contractors’ pollution liability for those organizations involved in the drilling, fluid injection, recovery, treatment, and disposal; and pollution legal liability for longer term, more gradual exposures. These policies are designed to provide coverage for first or third party claims for bodily injury, property damage, and remediation costs incurred as a result of a pollution incident resulting from a “covered operation” (i.e., fracking) or located at a covered site, such as a well pad or leasehold held by a gas company.

Rather than a sudden accident like that covered under the CGL policy, an environmental policy is designed to address more latent hazards, like groundwater contamination and resulting bodily injury. Coverage under these policies can vary widely, providing coverage only for specific types of pollution conditions with specific timing requirements for discovery and reporting to the insurer. Environmental policies can also provide coverage for legal defense costs associated with actual or alleged pollution conditions, which can account for 40 to 60 percent of the cost of a remediation. Russek, Karl J. & Hazelton, William P., Global Environmental: Debunking the Myth, Not Just Third-Party Insurance, ACE Progress Reports, April 2010. Given the controversy surrounding fracking, coupled with an active and litigious plaintiff’s bar, some industry observers have expressed concern about whether environmental liability products will be available for fracking operations in the future.

Finally, Operator’s Extra Expense policies are designed to provide the oil and gas industry coverage for the costs associated with regaining control over a well after a blowout. Coverage can include re-drilling costs, as well as addressing any associated clean-up costs. The coverages and premiums associated with OEE policies are heavily dependent on the specific operations seeking coverage. Insurers require technical data on the well itself, the components used in the drilling and extraction process, and the experience of the drilling operator.

Looking Ahead

As the body of research on fracking, its impact on the environment, and the public response grows, the market for products to manage fracking risk will evolve. With the recent announcement by Nationwide, some have raised concerns that fracking will become all but uninsurable in the future and leave the costs of any bodily injury, property damage, or environmental impairment on the shoulders of the responsible operators—or even the taxpayers or the victims of fracking losses themselves. Looking to the future, what can we expect to see in terms of market and policy responses to this risk?

The first path is the status quo. If legislators continue to be deadlocked, it will be up to the market to shape the products that are available in the future based on the science of fracking, the lawsuits filed, and claims made against policies. However, with the Nationwide announcement, some fear that more insurers will decide to decline to underwrite fracking risk, or that pricing of risk will inflate premiums to unsustainable levels.

A second option could be statewide funds like those created to address contamination of underground storage tanks. As part of the amendments to the Solid Waste Disposal Act, Congress directed the EPA to enumerate certain regulations to require owners and operators of underground storage tanks to demonstrate their fiscal responsibility to respond to any releases from their tanks and compensate those who are affected by any release. Owners and operators are able to demonstrate this responsibility in a variety of ways, including surety bonds, paying into a state trust fund for leaking underground storage tanks, or obtaining insurance.

Pennsylvania’s Act 13 is one example of a statewide fund that assesses a drilling impact fee based on the age of a well and the average price of natural gas. The Pennsylvania Public Utility Commission is charged with distributing the funds to state agencies, with the remainder to counties or local governments with fracking wells within their borders to offset part of the cost of environmental conservation initiatives, remediation of fracking-related contamination, emergency preparedness, and provision of social services.

However, the fate of Act 13 is currently in doubt. On July 27, the Commonwealth Court of Pennsylvania struck down zoning provisions that were considered to be a key part of the law. The court also struck down the Section 3215(b)(4) waiver for certain setback requirements in the Act. See Robinson Township v. Commonwealth of Pennsylvania, No. 284 M.D. 2012. At the time of this writing, Governor Tom Corbett’s administration has already announced that it will be appealing the decision directly to the Pennsylvania Supreme Court, and it has requested a hearing during the Court’s October 2012 session in Pittsburgh.

A third option could leverage the versatility of the private insurance markets with the assurance of government regulation. Precedent for such a program can be found in the leaking Underground Storage Tank (UST) programs developed in the eighties and nineties in response to growing concern over groundwater contamination and insolvency of tank owners and operators. Specifically, Michigan developed a program in the nineties that required gas station owners and operators to obtain private environmental liability insurance after its original state assurance fund went bankrupt. Trade groups for gasoline retailers originally railed against this insurance requirement, arguing that many gas stations would go out of business because environmental liability insurance was expensive and hard to come by in the eighties and nineties. Yin, Haitao, et al., Risk-Based Pricing and Risk-Reducing Effort: Does the Private Insurance Market Reduce Environmental Accidents?, J.L. & Econ. (May 2011), at 5.

Despite these dire predictions, USTs with “accidental release dropped by more than 20 percent relative to surrounding states that maintained state assurance fund programs” without the risk-based pricing that private insurance employs. Id. at 2.

Whatever route is eventually taken by regulators, the discussion about how to most efficiently and effectively manage fracking risk is not merely academic; it is a discussion with tremendous impacts for the communities in which fracking takes place. These communities range from small towns in Pennsylvania and New York to towns and cities all over the world. As interest in fracking and prices for natural gas grow, countries around the world are identifying potentially lucrative shale plays within their own borders. The developments in fracking risk management we see here today have the potential to affect the globe.

Matthew Jokajtys

Mr. Jokajtys is a Manhattan-based attorney specializing in environmental law.