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.
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.