Obtaining natural gas from shale formations has quickly become a vital part of the United States’ future energy plans, not only because of the estimated volume of gas, but also because of the use of horizontal drilling and hydraulic fracturing. Hydraulic fracturing (also known as ‘fracking’ or ‘fracing’) has been used for decades in the oil fields and involves the injection of highly pressurised fluids and proppants into shale or other non-porous hydrocarbon formations in order to increase production from oil and natural gas wells. In this article, Barclay Nicholson from our Houston office takes a look at the risks posed by hydraulic fracturing and the insurance policies bought by oil and gas companies to manage those risks.
In spite of its potential long-term economic benefits, fracking attracts substantial criticism, mainly for the chemicals used in the process and for the ‘flowback’ or ‘produced water’ generated at the end of the process. Concerns have been raised about the reduction of citizens’ water supplies due to the large volume of water used in the fracturing process, the alleged chemical contamination of aquifers that supply drinking water, the appropriate disposal of or recycling of the flowback or produced water, and earthquakes allegedly caused by fracking.
Lawsuits against the oil and gas companies are being filed across the US with lessors and neighbouring landowners asserting causes of action for negligence, negligence per se, trespass, nuisance, strict liability, toxic tort, breach of contract, premises liability, and violations of environmental statutes and seeking compensatory damages for personal injuries and for damaged real and personal property as well as punitive damages. The oil and gas companies will turn to their insurers for assistance – but, will the insurance companies cover these claims and damages?
As with any oil and gas operation, there are environmental risks associated with the development of oil and gas from shale plays. Even where best practices are used, there can still be incidental releases of fluids. With hydraulic fracturing, some risks include:
- Extensive use of water resources which may affect municipal water supplies.
- The possibility of spills, leaks and overflows from ‘frac tanks’ and/or specially constructed ponds or pits that hold the water, fracking fluids, chemicals, mud, drill cuttings, and flowback water.
- Insufficient cementing of the vertical casings.
- The impact on near-by ground water and drinking water resources.
- The potential for a blow-out or loss of well during the drilling phase.
Prudent operators will minimise these risks by following best practice for storage, use of fluids and construction of the well bore. Proper contingency and spill plans should be in place to quickly handle any releases and protect workers and others near the well site. All employees will be trained in correct response techniques and how to use any specialised equipment that may be needed.
Given these risks, operators will want to manage the financial risk through insurance policies, including commercial general liability insurance (including excess and umbrella coverages), environmental site liability insurance, operator’s extra expense policy, and directors and officers’ insurance.
Commercial general liability insurance
Most companies carry Commercial General Liability (CGL) insurance which covers third-party claims against the insured for personal injury and/or property damage caused by an occurrence during the policy period. An occurrence may be a single event (i.e. an earthquake or a spill of produced water) at a specific point in time or a series of events over a period of time. Many of the claims for hydraulic fracturing-related damage, such as ground water contamination, fall into this latter category.
In the 1970s, with environmental issues coming to the fore, insurers added a pollution exclusion to the CGL policy, only providing coverage for ‘sudden and accidental’ pollution incidents. The focus of the pollution exclusion is on the discharge that leads to the loss:
“This insurance does not apply to bodily injury or property damage arising out of pollution or contamination caused by oil or arising out of the discharge, dispersal, release or escape of smoke, vapor, soot, fumes, acids, alkalis, toxic chemicals, liquids or gases, waste materials or other irritants, contaminants or pollutants into or upon the land, the atmosphere or any water course or body of water; but this exclusion does not apply if such discharge, dispersal, release or escape is sudden and accidental.”
With the passage of the Superfund legislation in 1980 and the possibility of new loss exposures, the insurance industry quickly amended the CGL policies to include a ‘total and absolute’ exclusion for claims arising from the release of contaminants.
This insurance does not apply to:
- ‘Bodily injury’ or ‘property damage’ which would not have occurred in whole or part but for the actual, alleged or threatened discharge, dispersal, seepage, migration, release or escape of ‘pollutants’ at any time…(a) at or from premises owned, rented or occupied by the named insured; (b) at or from any site or location used by or for the named insured or others for the handling, storage, disposal, processing or treatment of waste;…(c) which are at any time transported, handled, stored, treated, disposed of, or processed as waste by or for the named insured,…
- Any loss, cost or expense arising out of any:
(a) Request, demand, order or statutory or regulatory requirement that any insured or others test for, monitor, clean up, remove, contain, treat, detoxify or neutralise, or in any way respond to, or assess the effects of ‘pollutants’; or
(b) Claim or suit by or on behalf of a governmental authority for damages because of testing for, monitoring, cleaning up, removing, containing, treating, detoxifying or neutralising, or in any way responding to, or assessing the effects of, ‘pollutants.’
A ‘time-element’ provision can also be attached to the pollution exclusion, requiring that the pollution condition be discovered and reported within a specified, limited time period. For example, the policy may require the insured to discover a pollution discharge within 30 days of its commencement and to report the incident to the insurance company within 60 days of the commencement of the release.
This ‘time-element’ provision can provide some coverage for pollutant releases that can be immediately discovered, such as a blow-out or a spill; but, the risk of undiscovered contamination requires operators to find additional insurance coverage. And, it should be remembered that a failure to notify the insured of the release within the specified deadline can result in denial of coverage.
What the policy considers a ‘pollutant’ will determine whether the exclusion applies to alleged contaminants from hydraulic fracturing:
‘Pollutants’ means any solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals or waste. Waste includes materials to be recycled, reconditioned or reclaimed.
Many policies do not define ‘pollutants’ so the courts may need to decide what is or is not covered. Some US state courts have determined that natural gas is not a pollutant. Fracking fluid is made up of 99.5 per cent water and sand, with the remainder 0.5 per cent consisting of proppants, chemicals and other agents to open the fractures and release the shale gas. Causally connecting such small percentages of alleged contaminants to hydraulic fracturing operations may be difficult, if not impossible, since many of the gases and substances released throughout the process occur naturally.
The insurer may raise the policy’s ‘expected or intended’ exclusion provision as a defence. Did the insurer expect or intend the pollution to occur? If the insured drilled next to a drinking water source, should not the pollution have been expected? For the exclusion to be inapplicable, the insured must have acted without any intent or expectation of causing any injury, however slight. Depending on the insurance policy, this exclusion will either appear in the definition for ‘occurrence’ (describing it as an accident) or in a provision foreclosing coverage for harm that was intended or expected. For example, ‘occurrence’ may be defined as:
[A]n accident or event including continuous repeated exposure to conditions, which results, during the policy period in personal injury or property damage neither expected nor intended from the standpoint of the insured.
The governing principles relating to ‘expected’ or ‘intended’ vary by state and may be determined by specific policy language; but coverage will be precluded if the insured knew that:
- the damages would flow from its intentional act;
- the harm was more likely than not to occur;
- the injury or property damage was reasonably anticipated;
- the injury was practically certain, and/or
- the harm was the natural and probable consequence of the intentional act.
Courts have applied objective and subjective standards (or a combination of the two) to assess the insured’s prior knowledge of the harm.
Operator’s extra expense insurance
Operator’s Extra Expense Insurance (OEE) is a specialised policy available to oil and gas well operators that provides coverage for perils identified within the policy terms, such as a blow-out or loss of the well. The policy may provide for reimbursement of costs incurred when regaining control of a well blow-out, re-drilling expenses, damages paid to third parties for harm caused by seepage and pollution and costs for remedial clean-up measures. It may also provide coverage for damage to third-party equipment under the operator's care, custody or control. Generally these OEE policies contain ‘time-element’ restrictions, as described above.
Environmental site liability
Environmental Site Liability (ESL) is a form of pollution specific insurance that covers third-party claims for bodily injury or property damage caused by pollution at or escaping from the specific location covered by the policy. ESL policies respond to losses arising from pollution conditions that migrate beyond the boundaries of the insured’s property.
‘Pollution conditions’ means the discharge, dispersal, release or escape of smoke, vapours, soot fumes, acids alkalis, toxic chemicals, liquids or gases, waste materials or other or other irritants, contaminants or pollutants into or upon land, the atmosphere or any watercourse or body of water.
Generally these policies are claims-made, which allows coverage for pollution events that took place before the policy period began (which may be limited by a retroactive date) as opposed to the occurrence-based CGL policies which only cover events within the specific policy period. Also unlike an OEE policy the ESL policy is not limited to named perils. Thus, ESL policies fill in gaps left by the CGL and OEE policies.
ESL policies treat multiple claims arising from a single pollution incident as one claim, subject to one limit of liability and one deductible. An ESL policy may also provide coverage for offsite clean-up, civil fines and government penalties, defence costs and business interruption costs. However, the policy will exclude coverage for known pre-existing conditions, deliberate non-compliance with environmental laws, nuclear liability, acid rain, war, and products and completed operations.
Directors and officers’ insurance
Directors and officers’ (D&O) insurance protects a company’s directors and officers from certain types of liability for claims arising from alleged mismanagement or other negligence in the performance of their duties. Generally there are three types of coverage within a D&O policy: coverage for individual directors and officers in situations where the company cannot indemnify them; coverage for the company when it does indemnify the directors and officers; and coverage for the company when it is a defendant (usually for securities-related claims).
In recent years, oil and gas company shareholders have actively sponsored resolutions relating to hydraulic fracturing, seeking more information and disclosures about the environmental risks associated with the operation. These shareholders may file class actions or shareholder derivative lawsuits, alleging failure to disclose, misrepresentation or mismanagement of the risks associated with hydraulic fracturing, resulting in lost revenues, loss of market share, stock price declines or damage to the corporation’s reputation. In addition, there is the increased possibility of regulatory investigations for misleading or faulty disclosures.
What is considered a ‘claim’ under a D&O policy controls whether the policy will apply in specific circumstances. A lawsuit is certainly covered by most D&O policies – but what about administrative or regulatory proceedings, such as US Securities and Exchange Commission subpoenas or requests for information? The precise definition of ‘claim’ in the policy and the nature of the issue involved will determine if coverage is provided.
D&O policies often exclude: pollution claims; claims ‘for’ or ‘arising out of’ bodily injury and property damage (which are covered by the CGL policy); fines, penalties, and taxes; intentional or criminal acts; and punitive, treble or exemplary damages.
A UK perspective
The London market has written fracking risks for some time and wording exists which will be appropriate as a basis for the UK and other non-mature markets. Insurers considering underwriting fracking risks in the UK can use the experience of the US as a basis for pricing the risks but should also take into account that, in the UK, environmental risks are expected to pose greater issues due to the regulatory background and population density. The EU Environmental Liability Directive imposes potentially very significant duties to remedy environmental damage. Given this additional exposure, fracking risks written in the UK may include further cover such as additional environmental liability cover, bespoke OEE cover and earthquake cover.
Many insurers and reinsurers are reluctant to cover hydraulic fracturing risks, mainly because there are many unknowns and conflicting information surrounding the process. Insurers need to understand and quantify the risks in order to price a policy’s premium. Insurers must consider the high cost of defending hydraulic fracturing lawsuits with class action allegations, discovery issues and complex claims requiring expert testimony. Until operating, regulatory and legal liability issues become clearer and best practices are adopted, insurers are unlikely to provide coverage for all the risks associated with shale gas development and hydraulic fracturing.
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