How could surety bonds affect the green building sector?

Posted on November 8th, 2012 by
   

Using surety bonds to reinforce green building practices is a relatively new idea within the construction industry. The issue was thrown into the spotlight after the Washington, D.C. Council passed its well-intentioned — but ultimately flawed — Green Building Act (GBA) back in 2006. The GBA was revolutionary because it required publicly funded projects to gain Leadership in Energy and Environmental Design (LEED) certification.

According to the U.S. Green Building Council:

“LEED provides building owners and operators with a framework for identifying and implementing practical and measurable green building design, construction, operations and maintenance solutions…LEED certification provides independent, third-party verification that a building, home or community was designed and built using strategies aimed at achieving high performance in key areas of human and environmental health: sustainable site development, water savings, energy efficiency, materials selection and indoor environmental quality.”

The intention behind the GBA’S LEED certification requirement was to ensure contractors build environmentally sound structures. To reinforce the requirement, the law contained a provision that required contractors to provide green performance bonds for their projects. If a contractor were to build a public structure that failed to qualify for LEED certification, the district could make a claim on the bond, and the funds collected would be put into a district fund. But before we discuss the inherent problems with the idea, let’s review the surety bond process.

How do surety bonds typically work?

Each surety bond that’s issued functions as a special type of insurance policy. When surety bonds are used in the construction industry, they’re typically called “contract bonds” or “construction bonds.” There are also dozens of individual contract bond types contractors must purchase; the most common are bid bonds, payment bonds and performance bonds. Regardless of the exact bond type and its contractual language, every contract bond works in the same basic way.

By requiring a contractor to provide a bond, the project owner acts as the bond’s obligee. The contractor acts as the bond’s principal, who purchases a bond to ensure a project will be completed according to contract. The insurance company that issues the bond acts as the surety. Although backed by insurance companies and not banks, surety bonds actually function more like lines of credit. When an insurance company issues a surety bond, it’s saying that the bonded contractor will be able to pay for claims in the event that a certain task is not fulfilled.

So what was the problem with green performance bonds?

When the GBA was passed back in 2006, insurance companies immediately spoke out against its green performance bond requirement. First of all, no such surety product existed. The Council had developed a new bond requirement without consulting surety experts and insurance companies. And, based on the wording used in the GBA, surety professionals and insurance carriers alike considered the new bond type far too risky to underwrite.

Traditional performance bonds require contractors to complete projects according to contractual terms. Common ones include completing the project by a certain date with a certain production quality. Green performance bonds would require contractors to complete projects according to contractual terms that include LEED certification. Under the GBA, a building’s ability to qualify for LEED certification was the sole responsibility of the contractor.

As such, insurance underwriters weren’t willing to risk backing bonds that guaranteed this because so many other people — such as architects, suppliers and subcontractors — could also affect the final product. Under the GBA, however, they wouldn’t be held financially accountable for whether the environmental standards were met. As such, many assumed the claim rate for green performance bonds would be far too high.

Although passed in 2006, the GBA was not scheduled to go into effect until January 1, 2012. Surety professionals and insurance companies protested its green performance bond requirement through 2011. Finally, on December 6, 2011, the D.C. Council passed emergency legislation to give contractors more options for meeting the financial responsibility aspect of the law. Simply put, contractors no longer have to file a green performance bond to comply with the GBA.

What does this mean for other green building markets?

The Washington, D.C. Council made a statement by establishing more stringent green building regulations for contractors. As with any sort of industry regulation overhaul, significant changes tend to ripple throughout the industry until they reach all parts of the country. By setting higher expectations for green building, the Washington, D.C. Council will likely inspire other cities and states to follow similar procedures when establishing new laws. Whether surety bonds will be used to enforce these laws at some point remains to be seen.

Danielle Rodabaugh is the director of educational outreach at SuretyBonds.com, a nationwide surety bond producer that helps contractors fulfill their bonding requirements. Danielle writes to help leading industry professionals better understand surety bond intricacies, including those related to emerging green building practices. You can keep up with Danielle on Google+.

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