Illustration By Greg Tucker
Investors wanting a glimpse of the future should observe companies' changing responses to environmental issues. Pressure for corporate transparency, changing public attitudes, and emerging global environmental issues are forcing companies to integrate environmental issues into core corporate strategies. British Petroleum has restyled itself as Beyond Petroleum, a positioning strategy prompted partly by concerns about global climate change. Home Depot and Lowe's have made commitments to sell only sustainably harvested timber in the near future. What, if anything, do these trends portend for investors?
Changing environmental attitudes have already accelerated growth in socially responsible investments (SRI), which typically screen out companies with poor track records on environmental, labor, and human rights issues. There are currently 175 screened mutual funds, up from 55 just five years ago, and as much as one out of every $8 under management is now invested under some form of socially responsible screen.
| Quantifying Green: Because It Matters |
|---|
|
With the rise in socially responsible investing, the investing landscape is changing. The consideration of factors that seldom, if ever, entered into the decision of whether to invest in a particular company or industry has become more common and can produce dramatic results, such as the end of apartheid in South Africa. Now the question of whether to consider environmental im- pacts in the valuation of a corporation is attracting interest. This article's authors--Robert Repetto and Duncan Austin--are the winners of this year's Moskowitz Prize for outstanding research in the field of socially responsible investing, awarded by the Social Investment Forum. Their research examines this issue within a particular industry--pulp and paper production--although the study could have been done equally well for other industries. World Resources Institute, under whose aegis the report was produced, is a research center in Washington, D.C., whose mission is the promotion of sustainable development. Repetto, visiting professor at the Yale School of Forestry and Environmental Studies and a senior fellow at WRI, comments that the economics program at WRI seeks to harmonize environmental protection with economic progress. "One of the thrusts of that," he says, "was to provide the right kind of incentives for business so that doing what was profitable was also doing what was in the public interest, and vice versa." Part of the authors' research explored the incentives that businesses respond to. Another had to do with businesses' concern with maximizing shareholder value and managing financial market reactions. Also considered was the influence that capital markets wield over corporate behavior. "Consequently," says Repetto, "unless financial markets could adequately recognize and respond to the actions that management took within a business to protect the environment, there was an incentive failure. Prudent managers would not be adequately rewarded, and reckless ones would not be adequately penalized. So this made us want to give them the tools and information to adequately evaluate companies' environmental exposures and performance." He feels this approach will aid companies in "managing their environmental issues in a proactive, forward-looking way that does more to integrate them into strategic planning, as opposed to operating in a reactive, compliance-based mode." This could lead, he theorizes, to companies reviewing their own disclosure policies without waiting for SEC action to insure that they are fulfilling their obligation to disclose known risks and uncertainties that could have a material financial effect. Austin, a senior associate at WRI, says there are two major reasons capital markets are largely silent on environmental issues. First is the preconception that considering environmental issues within a business strategy is not fiscally significant. Second is the difficulty of quantifying those issues in financial terms that analysts can use. "We sought to address that, and say that there are ways capital markets can take environmental issues into account." Eliminating those issues can pave the way to translate corporate behavior into a financially measurable statistic. In addition to the question of whether companies adequately report environmental factors, there is also the issue of whether the SEC adequately enforces existing disclosure regulations. Conversations with the SEC, says Repetto, indicate it is receptive to studies such as Pure Profit (the paper that won Repetto and Austin the Moskowitz Prize) and that there is considerable material there for SEC consideration.--Marlene Y. Satter |
Growth in SRI comes partly from evidence that environmental factors can improve investment performance--demonstrated by the good performance in recent years of the Domini Social Equity Fund and other screened portfolios. Earlier, mainstream investment professionals felt comfortable ignoring environmental issues, relying on the Prudent Investor rule and notions of fiduciary responsibility to justify their focus on maximizing risk-adjusted returns. This view implies that superior corporate environmental performance means diverting resources from profitable core activities to provide public goods that shareholders cannot appropriate themselves.
New evidence, though, suggests that good environmental performance can translate directly into superior financial performance, a reality many progressive companies have already grasped. Prudent investors may no longer be justified in dismissing environmental issues. It could be in their interest to know much more about companies' environmental exposures and performance, and to demand much closer analysis of the impact these factors have on companies' financial prospects and risks.
Making the Link between Environmental and Financial PerformanceIn a recent study, Pure Profit: The Financial Implications of Environmental Performance, we found evidence that companies best positioned to deal with pending environmental issues are likely to have better financial performance. A case study of 13 leading U.S. pulp and paper companies found environmental issues likely to materially affect the value of stockholder equity, the firms' competitive position within the industry, and their financial risks. These issues were not adequately disclosed in the companies' financial reports, nor adequately researched by analysts following the industry.
The pulp and paper industry faces many environmental issues. It depends on forest harvests and recycled paper for raw materials; is one of the most energy-intensive industries; emits many toxic and conventional pollutants to air, water, and land; and is one of the largest contributors to the solid waste stream. The industry faces an enormous range of environmental and natural resource regulation and litigation, and must allocate significant fractions of investment and operating outlays to environmental control programs.
To determine how these issues might affect business, the study developed a methodology for quantifying in monetary terms a company's exposure. This methodology, like financial analysis and asset markets, is forward-looking. It is transparent, conceptually similar to methods used by managers and financial analysts to evaluate conventional business risks. The approach is based on developing scenarios about impending environmental issues, and identifying how companies are financially exposed under each scenario. The methodology can be seen as iterative, since scenario details, probabilities, exposures, and likely financial impacts change over time. The underlying analysis can readily be updated as new information emerges.
| TABLE 1. PENDING ENVIRONMENTAL ISSUES WITH POTENTIALLY MATERIAL FINANCIAL IMPLICATIONS FOR THE PULP AND PAPER INDUSTRY | ||||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| ||||||||||||||||||||||||||
Table 1 (page 94) provides a brief description of the most significant environmental issues confronting the industry and for which scenarios were developed. Scenarios--and occurrence probabilities--were developed with the help of company representatives, regulators, consultants, and others familiar with the industry. Even among large multi-plant firms, the scenarios would have substantially different financial implications. For some firms, the financial impact of a particular scenario would be significant; for others, it would be insignificant, or even positive. Companies have positioned themselves differently on these issues, mainly through decisions taken in years past for broader business reasons. Where mills and forestlands are located, which products they turn out, and what technologies are embedded in the capital stock are historical factors that largely determine companies' exposure to impending environmental issues.
For each company, each scenario's financial impact on revenues, production costs, investment spending, and owned asset value was estimated and expressed as a percentage of current market value. This process was repeated for all the issues in Table 1, generating a series of scenario-specific financial impacts.
Though the methodology estimates financial exposures to individual issues, investors will likely be interested in the implications of all risks combined. One way to assess overall exposure is to combine individual scenarios in an overall risk assessment. Experts were asked to assign probabilities to each scenario. Such probabilities were used to estimate a most likely financial outcome for each company, and a probability-weighted range of possible outcomes. Figure 1 (page 96) illustrates the most likely outcome (indicated by a dot) and the variance of outcomes (indicated by a line) for the 13 companies. Several key findings are apparent:
Environmental issues are financially material. The most likely outcomes reveal that, though several companies will be largely unaffected, at least half the companies in the group face financial losses equivalent to at least 5% of total shareholder equity. Three other companies face losses approaching or exceeding 10% of shareholder value.
Environmental issues create much more financial uncertainty for some firms than others. The variance of possible impacts, indicated by the line, is as low as 1%-2% of share value for three companies in the group, and as high as 8% for two others. The former group is hedged against environmental risk; its future earnings will not be highly sensitive to the outcome of the issues. The latter companies are greatly at risk: their earnings will depend heavily on the way these issues develop.
Environmental issues will likely create winners and losers. Even though the scenario and probability assumptions are the same for all companies, the most likely outcomes, and the ranges, differ substantially from company to company. These differences are entirely due to differences among companies in their exposures to the underlying environmental issues.
It is improbable that these differences are already factored into company market valuations. Analysts have not conducted similar research themselves due to lack of familiarity with environmental issues; a preconception that these issues will not have a significant impact on profits, certainly not one that would be differential across firms; and a general lack of information on environmental issues that allows these views to persist. The lack of relevant information accessible to investors is a direct consequence of inadequate reporting and disclosure by companies of their financially material environmental exposures.
Implications for investment professionalsThe finding that environmental issues can directly influence future financial performance upends the argument that fiduciary responsibility precludes consideration of environmental issues. Instead, the findings suggest that, where environmental issues are financially material, fiduciary responsibility requires investors to understand the issues and include them within their decision-making.
With environmental issues exerting greater influence on corporate performance and strategy, responsible fiduciaries must develop an understanding of how companies may be exposed to such issues or positioned to take advantage of them.
The above methodology could provide a starting point for developing analytical tools in this area. Although environmental risks are only one of many considerations when investing in a company, financial analysts might use results from this approach as an additional factor in evaluating potential returns and risks from an investment in a company's securities. Similarly, analysts involved in credit ratings might consider potential outcomes from such environmental exposures on a company's earnings, cash flow, and balance sheets, while forming an overall judgment of a company's financial risks. Managers of screened portfolios might use this approach to determine which companies in a sector face the potentially most serious environmental problems.
This approach is broad enough to be applied to other sectors in which environmental factors can be value drivers, and is general enough to encompass not only the costs of meeting environmental standards but also the opportunities afforded by providing solutions to environmental problems.
The findings also underscore the need for improvement in information that companies currently provide to investors. The smooth operation of the capital markets rests on sufficient information being available to investors about opportunities and risks. To that end, the SEC has established a comprehensive set of guidelines and rules regarding what companies should report.
Inadequate reporting on exposure to financially material environmental risks appears to infringe existing SEC rules, thus threatening investors. Having identified the environmental issues in Table 1 that could significantly influence corporate performance, we reviewed 10K, 10Q, and 8K filings made by the pulp and paper companies during 1998 and 1999 to see what, if any, mention was made of these risks. Although companies differed in the thoroughness, few companies adequately disclosed the financial risks or potential competitive impacts arising from exposures to these known environmental uncertainties.
There is a clear gap between the potential financial impacts of impending environmental issues and the almost total absence of any meaningful discussion or disclosure of those risks.
This non-disclosure infringes SEC rules designed to protect investors. Disclosure rules are not confined to reporting current conditions affecting the firm, but also extend to disclosure of any known risks and uncertainties that might have future financial effects. In particular, Item 303 of SEC Regulation S-K requires a Management Discussion and Analysis (MD&A) in which companies must disclose known future uncertainties and trends that may materially affect financial performance.
Figure 1 indicates that the industry faces several known environmental uncertainties reasonably expected to be discussed in the MD&A. This gap is not adequately explained by lack of relevant information; the industry devotes considerable attention to estimating potential impacts of significant environmental issues.
Moreover, despite explicit statements promising vigorous enforcement of disclosure requirements for financially material environmental risks, the SEC's enforcement efforts in this area have been minimal. Of more than 5,000 administrative proceedings initiated by the SEC over the last 25 years, only 3 are based on insufficient disclosure of environmental risks or liabilities. Over the same period, the SEC has brought only one civil action against a company on the grounds of inadequate environmental disclosure, and this dates to 1977.
This lack of transparency conflicts with broader trends. In what has been dubbed "The Information Age," the demand for information and the ability of investors to make use of it is expanding greatly.
Improving the flow of company-specific information on environmental issues would enable financial analysts and investors to evaluate environmental risks and opportunities more accurately.
