Environmental liability can seriously threaten a company's financial health, not to mention its reputation. Financial risk management, whilst commonly used to deal with business risk, has only recently been applied to environmental risk exposure. Beverly La Ferla discovers how, through mechanisms such as insurance or self-financing, environmental risk can be effectively managed and minimised.
Times are a-changing. Criticism has been levelled at the financial community that not enough notice is being taken of environmental issues which have the potential to significantly affect corporate performance. Coupled with a number of well-reported contamination incidents which has lead to the introduction of strict liability and increasing awareness that liability should encompass damage to the so-called ‘un-owned environment’, environmental risks have started to demand greater attention.
The publication of a White Paper on Environmental Liability earlier this year attacks the issue with vigour. As defined in Environmental Risk Management by Paul Pritchard (see iem under cover, this issue), ‘environmental risk’ is a measure of the potential threats to the environment, and combines the probability that events will lead to degradation of the environment and the severity of that degradation. Liability, in terms of financial obligations, may come from the realisation of environmental risks.
The White Paper aims to explore how the European community deals with such liability by implementing the ‘polluter pays’ principle in the hope that future environmental damage can be avoided altogether.
Lack of understanding
Traditionally, there have been many problems with environmental reporting. The lack of understanding of environmental issues by senior executives of large companies, the failure of the media to communicate environmental risks, the inaccurate estimation of risk and clean-up, and the unavailability of systems to identify and track environmental costs, to name but a few.
The increasing need to address such issues during the 1990s witnesed a number of developments, including the introduction of the Financial Reporting Standard 12 (FRS12) – which requires companies to recognise certain liabilities for remediating contaminated land – the introduction of an EC Directive on Integrated Pollution Prevention and Control (IPPC), and the Turnbull Report, which provided guidance on how to put the Combined Code (which requires the identification of environmental business risks amongst others) into effect.
The increasing interest in environmental risk assessment has also seen the expansion of the discipline from a mainly academic perspective to becoming a leading issue for discussion in both government and company boardrooms. This has been due to the potential commercial implications that environmental issues can have on companies that are now required to clean up after themselves.
With the potential for environmental risk comes insurers willing to insure against that risk. And with them comes people to advise you on which policy to buy. Jim Finnamore, head of the Environmental Finance Group at WSP Environmental, admits that future environmental risks are rarely assessed in detail, despite their significant effects on the financial performance of a company. “Technical solutions,” he says, “such as remediation, are not 100 per cent failsafe and insurance deals with this level of uncertainty in the residual risk by providing peace of mind for companies.”
Financial risk management is already used to deal with business risk but has only recently been applied to environmental risk exposure. “There is a real need to bridge the gap between technical environmental risk management and financial risk management, and this,” explains Finnamore, “is what WSP is doing.” The sands are a-shifting – from a purely commercial slant to incorporating environmental issues too.
Risk management includes policies, processes and practices which are implemented by businesses to protect their economic interests. This means, in effect, reducing their risk of experiencing financial loss via several different methods. The potential risk posed by a particular activity could be abated by:
“Companies are realising that environmental issues are becoming an increasingly important part of their overall business risk exposure. To address this, a combination of technical and financial risk management usually provides the most cost-effective business solution,” Finnamore explains. “The optimum combination depends on, amongst other aspects, a company’s specific risk exposure, its business operations, its cash position and the liquidity of its assets. It’s all to do with costs and benefits – the cost of controlling or transferring the risk versus the benefit of reducing, and increasing confidence in, the company’s exposure to residual risk.”
Insurance can also come from several different sources. Companies can take out insurance on part of their risk – the ‘transferred risk’ – and opt to use their own funds for the other part – the ‘retained risk’ – should that risk be realised.
If conventional insurance is not available, other financing solutions such as captive insurance, alternative risk transfer or accrual funds can be set up. The principle of captive insurance is similar to normal insurance except that captives are owned by the company wishing to purchase the insurance which ensures that the risk is kept ‘in-house’, rather than being transferred to the insurance company. This brings significant advantages when insurers are unable to offer policies to companies with known liabilities, and stems from the principle that if your house was on fire, no underwriter in his right mind would let you take out a home insurance policy. Thus, the possession of contaminated land excludes the owner from insuring against contamination.
Taking out captive insurance can be effective in dealing with situations like this and brings other advantages too, such as not having to pay management fees, retaining capital and flexible payment terms (see IEM Sept 1998 for more information on captives).
The combination of insuring for some risk and retaining the rest adds up to an Alternative Risk Transfer (ART) programme which allows the costs of risk to be minimised and spread through time. Too much diversion of capital to deal with retained risk diverts resources from other areas of business, but too little can lead to the inability to pay for environmental damage when it occurs. The correct combination can lead to significant savings should the pendulum swing either way.
WSP, as an environmental consultancy, specialises in financial risk analysis, using economic models to generate ‘aggregate financial risk profiles’ for companies. These profiles show the complete financial exposure to which a business is faced as a result of environmental issues. This in turn enables a company to make more informed decisions on its risk management strategy. For example, a hypothetical company may be in a position to pay for risks less than £5m itself, take out captive insurance for risks greater than this but less than £5.5m, and insure conventionally for potentially catastrophic risks that will cost greater than £5.5m.
The financial models also show the relative contributions of various parts of the business to the overall risk. This is shown in the form of a ‘risk footprint’. WSP calculates financial impacts pre- and post-implementation of control measures, as well as giving the costs of such measures. In some cases, the financial costs of risks can be dramatically reduced by installing suitable, low-cost, control measures (e.g. bulk storage) while in other cases, control measures are unnecessary (e.g. air conditioning).
“This allows our clients to see where capital expenditure can be targeted to obtain maximum risk reduction for least cost,” says Finnamore. “What we’re doing is translating technical data into financial terms, qualitative into quantitative.”
There are three main stages to the process:
Such assessments are, as yet, a relatively new product on the market and are expected to take off during the next few years. However, the benefits of having one far outweigh any possible doubts that might be lurking. Besides equipping companies with the confidence to operate in the present without fearing environmental officials will be knocking at their door, such assessments also provide awareness of what risks companies will expose themselves to in the future and their competitive advantage in a relentless marketplace.
Budgets are spent more efficiently, risk is dealt with more effectively and environmental management programmes are given outstanding seals of approval.
Perhaps even more important is a company’s reputation. Rating systems make or break reputations, and that is exactly what SERM aims to do.
Credit rating for the environment (IEM, March 1998) explained the SERM system in detail, but it is sufficient to note that SERM offers a company an independent overview of their ability to manage the physical hazards arising from their operations. This is then translated into an alphabetical rating on a 27-point scale running from AAA+ to C- which can be understood by the financial community.
Companies listed on the stock exchange, in fact all 1,600 of them, have been rated by SERM not only in environmental terms but also using health & safety, social and ethical criteria. The ratings will soon be publicly available. Jonathan Barber, SERM’s managing director, hopes they will be ready by the New Year.
“And next year,” he relishes, “we are setting our sights on the world. We hope by 2002 to have rated the top 5,000 companies worldwide.”
Establishing a link between environmental and financial performance is the key. Edwards, in his recent book The link between company environmental and financial performance, notes that research in the US has concluded that companies are not paying a financial penalty for improved environmental performance.
In fact, business is likely to improve through greater efficiency, less waste and their environmentally-friendly reputation. Take BlueLine Office Furniture who have become the first furniture manufacturer to obtain raw materials exclusively from sustainably managed forests (see Business News).
As Barber notes: “The SERM figure is not a risk rating but a sustainability rating – we want the bad boys to go out of business and the good ones to stay in.”
With environmental risks meaning big money, companies can’t afford to ignore them and this, in combination with the public becoming increasingly aware, has made environmental issues a hot potato. Be careful you don’t burn your fingers.