From the November 2002 issue of Investment Advisor • Subscribe!

November 1, 2002

A Question of Balance

In considering companies as possible investments,

Over the last 12 months, a series of financial and accounting scandals has caught financial advisors and the investing public quite unaware. Unanticipated revelations by Enron, Tyco, and others have led to sharp drops in stock price, company collapses, and the loss of billions of dollars in investment holdings. In the aftermath of these events, many advisors are questioning how much they in fact know about the companies they invest in on behalf of clients. Even "safe bets"--as Enron and WorldCom were generally perceived--may no longer be as secure as previously assumed.

These scandals should have raised numerous doubts. Can advisors trust companies' disclosure statements? Are advisors looking broadly enough at factors that might affect business performance? Are the traditional frameworks for determining company value too narrow? Put simply, are there other issues waiting in the wings that might yet blindside advisors and their clients?

One area that advisors almost certainly don't know enough about is companies' environmental performance. Despite the relevance of environmental issues for shareholder value, mainstream financial advisors traditionally have not thought systematically about environmental pressures or sought to anticipate the environmental liabilities or risks that might confront companies. Advisors probably do not see or buy much research on the topic. Nor do companies' disclosure statements prompt them to think much about these trends. Discussion on forthcoming environmental issues is largely absent from corporate reports.

Yet, given notions of fiduciary responsibility that bind advisors, and given the new wariness about company disclosure statements, a more systematic appraisal of environmental risks and opportunities seems warranted. Shocked out of their complacency by recent events, advisors who are reviewing their approach to company evaluation would do well to look carefully at environmental trends, the financial implications of which can be massive. Previous neglect and poor understanding of these trends is strange, and potentially hazardous, given the degree to which such trends will challenge or benefit companies. Many industries face a growing tide of environmental pressures capable of influencing the bottom line. In view of the increasing profile and relevance of environmental issues for business, wider concern over their outcomes ought to be a part of every advisor's consideration. Consider the following:

o In a poll of attendees at the World Economic Forum in 1999 to determine which issue presented the biggest challenge to business in the 21st century, it was an environmental issue--climate change--that topped the list.

o Environmental preferences are emerging in the marketplace and forcing companies to respond. BP and Shell have made well-publicized investments in renewables, and have publicly backed the Kyoto Protocol--the international framework for addressing climate change. Toyota and Honda are both marketing new hybrid-electric vehicles with superior fuel efficiency and cleaner emissions profiles. Kinko's has bought electricity from renewable energy sources, such as wind and solar power, at more than 75 of its retail stores. Many other companies, including Dupont, General Motors, and Johnson & Johnson, have made public commitments to reduce energy use or emissions associated with their operations.

o Environmental compliance can place a considerable burden on company finances. In 1998, industrywide environmental expenditures in the oil and gas industry amounted to $8.5 billion, more than twice the net income of the top 200 oil and gas companies. Similarly, the emergence of environmental liabilities has often led to significant price drops in certain stocks.

o More shareholders are caring more about corporate environmental performance. Last year, a record 64 shareholder resolutions were brought before companies that dealt exclusively with management's handling of environmental issues. Of that number, 18 dealt exclusively with climate change. At Eastman Chemical, for instance, a resolution asking management to report on, and take steps to reduce, greenhouse gases attracted 29% of the shareholder vote--an unprecedented level of support for a resolution on climate change, and an indication of the pressures for change that are facing management.

Quantifying the Risk

Fortunately, it is possible to assess how pending environmental issues might affect companies. In a recent study, Changing Oil: Emerging Environmental Risks and Shareholder Value in the Oil and Gas Sector, we assessed how two key environmental issues could affect the future financial performance of 16 leading oil and gas companies. While most advisors would regard oil and gas companies in general as solid investments, an impressive array of environmental pressures facing the industry raises interesting questions about the future performance of some companies in the industry.

Two environmental issues uppermost in the minds of industry experts that we consulted were, first, pending policies to curb greenhouse gas (GHG) emissions that contribute to global climate change; and, second, restricted access to oil and gas reserves located in environmentally sensitive areas.

Although some industry analysts may be familiar with traditional regulatory pressures facing the industry (e.g., ever-tightening clean air regulations), the climate and access issues are markedly different. Measures to protect the climate will succeed only by lowering demand for fossil fuels, the industry's core products, while maintaining access to reserves is the basis of sustained value in the industry. Moreover, neither issue is easy to dismiss. More than 180 nations have been involved in the drafting of the Kyoto Protocol, the international framework seeking to limit GHG emissions. Similarly, public concerns about access issues have proven resilient to recent changes in political and economic fortunes. Barely months after the events of September 11th pushed energy security concerns to the fore, the U.S. Senate still voted to prohibit industry access in the Arctic National Wildlife Refuge.

Figure 1 (page 54, Range of Financial Consequences of Climate Policies) reveals the possible implications of the climate and access issues for the stock prices of the companies in our sample. The dots for each company indicate the most likely impact for shareholder value if the climate and access risks were to be priced into today's stock prices. The vertical lines indicate the full range of possible shareholder value implications, reflecting the impossibility of predicting the future with any certainty.

The figure reveals that these environmental issues are materially significant and could lead to losses of up to 6% of shareholder value. As relevant for advisors, the financial impacts are materially different across the industry. Each company has a unique asset base with differences in the oil-to-gas ratio of reserves and production, in the geographic location of their reserves and sales, and in the distribution of assets among business segments. These generate different exposures to climate and access issues and imply distinct financial consequences. Despite the significance of our findings, we do not believe that these impacts are priced into current market valuations.

The Methodology

How were these financial impacts determined? In recent years, World Resources Institute (WRI) has developed a new analytical approach that allows advisors to evaluate environmental information in the same way that they assess conventional business drivers. One of the main reasons that environmental risks and opportunities have been neglected by investment professionals is a lack of environmental information that can be translated into financial terms.

The methodology has much in common with traditional shareholder valuation frameworks in that it is explicitly forward-looking and uses scenarios to frame future possibilities. The methodology traces a link between external environmental influences and fundamental business drivers, such as sales volumes or asset values, and expresses final impacts in terms of percentage changes in shareholder value. To account for the subjective nature of predicting the future, uncertainties are handled in a systematic and transparent way so that advisors can come to different conclusions if they have different opinions about how future uncertainties may be resolved or wish to alter forecasts on the basis of new information.

The steps in the methodology are:

1. Identifying salient future environmental issues;

2. Building scenarios around each salient issue;

3. Assigning probabilities to scenarios;

4. Assessing company exposures for each scenario;

5. Estimating financial impacts contingent on scenarios; and

6. Constructing overall measures of expected impact and risk.

Steps 2 to 5 were repeated for both of the environmental issues examined here. Steps 1 and 6 frame the overall analysis. In formulating scenarios and assigning probabilities, we consulted with oil and gas company representatives, and with others familiar with the industry, in order to tap a broad range of perspectives. In order to ascertain companies' exposures to different scenarios, and the subsequent financial impact, we compiled a database of company information, comprising information from company annual reports and from industry information sources such as John S. Herold and IHS Energy.

For this study, we applied WRI's methodology to 16 prominent oil and gas companies, including the integrated "super majors" and smaller upstream or downstream producers, to illustrate the financial impacts of environmental risks and opportunities across the sector. Our company sample consisted of Amerada Hess (AHC), Apache (APA), BP (BP), Burlington Resources (BR), ChevronTexaco (CVX), ConocoPhillips (COP), Eni (E), Enterprise Oil (ETP), ExxonMobil (XOM), Occidental Petroleum (OXY), REPSOL YPF (REP), Royal Dutch/Shell Group (RD), Sunoco (SUN), TotalFinaElf (TOT), Unocal (UCL), and Valero Energy (VLO).

In the following sections, we outline how the financial impacts of the two environmental issues were determined for each company.

Climate Change In discussions with industry experts, climate change emerged as the single most important environmental issue facing the oil and gas sector. The combustion of fossil fuels--the industry's main products--is the chief cause of increased atmospheric concentrations of GHGs, which are considered to be driving climate change. To mitigate the impacts of climate change, the Kyoto Protocol seeks to reduce GHG emissions in developed countries to 5.2% below their 1990 levels by 2010. While several companies have made well-publicized efforts to reduce GHG emissions from operations, the industry's main vulnerability comes from the impact that policies could have on sales of gas and, particularly, oil (which emits more GHGs per unit of energy). Ninety percent of the GHG emissions associated with the industry result from final combustion of fuels by end users.

Following Russia's recent declaration of support, the Protocol will likely come into force in the near future, but almost certainly without the participation of the United States (and possibly Australia). Even without U.S. participation, U.S.-based companies will be affected by the Protocol. Changes in the global oil market, transmitted by price, will be felt throughout the industry. In addition, many U.S.-based companies have extensive assets abroad that could be impacted. For example, about 25% of ExxonMobil's petroleum products are sold in Europe, where several countries have already ratified the treaty and are implementing measures to reduce GHG emissions.

To assess the possible financial implications of climate policies, we modeled several different scenarios, ranging from no action to widespread adoption of the Protocol. The results show that future climate policies could create "most likely" financial impacts for companies spanning from a 5% loss in shareholder value to a slight gain. [See Figure 2 above, Potential Financial Impacts.]

Perhaps the most likely scenario is that Canada, Europe, Japan, and Russia will adopt the Kyoto Protocol, while the United States pursues its own (more limited) measures to reduce GHG emissions. Under this scenario, Burlington Resource's shareholder value could increase slightly while Enterprise, Occidental, and Repsol YPF could lose about 4% of shareholder value. In some scenarios, two companies with significant natural gas assets--Apache and Burlington Resources--could benefit from a substitution away from coal and toward natural gas in electricity markets.

Restricted Access to Oil and Gas Reserves Another important environmental issue facing oil and gas companies is their ability to access reserves in ecologically sensitive areas of the world. As conventional sources of oil and gas become exhausted, the search for new reserves often brings companies into regions that are remote, pristine, or close to existing communities. Intrusion into these new areas may result in vociferous environmental and social controversy. In developed countries, NIMBY ("not in my back yard") attitudes can markedly restrict industrial development and impinge on the industry's plans for additional infrastructure. Residents of developing countries are also becoming more vocal in their opposition to oil and gas projects through informal networks of community leaders, local nongovernmental organizations (NGOs), and international environmental or human rights organizations. Such opposition can raise operating costs, constrain production, or block access to reserves. As one example, Shell reported that community opposition in Nigeria had resulted in them being able to produce at only 40% of capacity in 2000.

Companies' exposure to future resource accessibility pressures differs markedly. To assess this, we mapped company reserves around the world against areas identified by the World Wildlife Fund and the World Conservation Monitoring Center as environmentally significant. It transpires that Apache, ChevronTexaco, ConocoPhilips, TotalFinaElf, Repsol YPF, Occidental, and Unocal have a larger than average share of their upstream reserves in areas identified as ecologically important. Burlington Resources, ENI, ExxonMobil, and Shell have relatively few reserves in environmentally sensitive areas, while none of Enterprise's reserves lie in these areas.

As with the climate issue, we modeled several future scenarios concerning access to environmentally and socially sensitive reserves, including formal commitments by governing bodies and corporations, increased NGO networking pressure, or the weakening of this issue due to national security or oil supply concerns. We found that future access policies could create "most likely" financial impacts for companies averaging a 2% loss in shareholder value across several different scenarios. Non-integrated producers were the most affected. Apache, Occidental, and Unocal had a "most likely" loss of 3% in value. [See Figure 3 above, Range of Consequences of Restricted Access.]

One likely scenario is that communities living in or near environmentally sensitive areas will increase their opposition to oil and gas development, either through a political process or other means, such as protests and sabotage. Under this scenario, Enterprise was unaffected while Apache, Occidental, and Unocal lost more than 3% of shareholder value.

Not enough disclosure?

Advisors relying on companies to forewarn them about environmental pressures risk being caught unprepared. Few companies have disclosed the degree to which they are financially exposed to these issues, and no company has attempted to quantify the financial implications for its shareholders.

Of the companies examined in our study, only three--BP, Conoco, and Phillips--made any reference in their latest 10-Ks (or 20-F equivalent) to climate change as an issue that may affect future operations. Three other companies--Enterprise, ExxonMobil, and TotalFinaElf--refer to the issue in their annual reports, but do not elaborate on any possible implications for their business. The remaining 11 companies do not mention climate change in the principal materials prepared for investors.

None of the sample companies attempt to quantify the possible financial implications of climate change and policy responses. BP, Conoco, and Phillips come closest. In their separate reports last year, Conoco and Phillips both state that expenditures under the Kyoto Protocol are hard to predict but "could be substantial." In contrast, BP notes that the Kyoto Protocol could lead to "some" reduction in the use of fossil fuels; however, "the impact of the Kyoto agreements on global energy (and fossil fuel) demand is expected to be small." Though better than others, even these disclosures fall short of quantitative estimates of financial impacts that advisors would find useful in evaluating potential investments for their clients.

These sector-specific findings on climate change disclosure are mirrored in other industries. A report published this year by Friends of the Earth (Survey of Climate Change Disclosure in SEC Filings of Automobile, Insurance, Oil & Gas, Petrochemical, and Utility Companies) finds that only a quarter of a sample of firms in those sectors inform their shareholders of the relevance of climate change for future business performance.

Reporting of access issues is more difficult to monitor, mainly due to the piecemeal nature and the variety of ways financial consequences may be felt (e.g., lawsuits, asset losses, increased operating costs). Most companies report political risks inherent in overseas operations, particularly in developing regions of the world, yet describe community investments as corporate stewardship rather than as a risk-mitigation policy.

Furthermore, in regions that are highly dependent on natural resources for survival, the link between social unrest and environmental quality is rarely made. Only Repsol specifically links environmental and social policies in sensitive areas with the goal of preventing disruptions and losses in oil and gas operations. Despite the fact that access issues have always been at the heart of the upstream oil and gas business, their financial significance goes largely unmentioned in annual reports.

Lack of disclosure on these issues is curious given the efforts expended by the industry to prevent implementation of the Kyoto Protocol and to attempt to secure access to reserves in remote areas.

Ask for More

Few advisors and in- vestors have heeded the financial relevance of current environmental trends. Even industry analysts familiar with traditional regulatory pressures will find in the issues reviewed above fundamental new drivers for corporate value.

While environmental issues have not always been easily translated into financial terms, the approach used above establishes a means by which environmental risks and opportunities can be integrated into conventional shareholder valuation frameworks. Moreover, this approach could readily be transferred to several other sectors where climate pressures in particular will be important--for example, autos, petrochemicals, and utilities. As a framework, it could also be used to assess many other environmental issues.

As advisors take stock of the implications of Enron and other disclosure failures for the way in which they evaluate companies, prudence would seem to demand a careful review of pending environmental trends. Advisors seeking to avoid environmental "surprises" from the companies they recommend should press for greater disclosure from companies themselves, and look to verify that information with independent analysis and research.

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