Building value by paring environmental risk: investors will reward companies that act to prevent a rise in environmental liabilities and penalize those who don't, writes an environmental attorney.

• Author: Rogers, C. Gregory
• Position: ENVIRONMENTAL LIABILITY

It started when a market analyst called the CFO of a Texas-based energy company to discuss concerns about the company's outlook. Volatility in reported environmental remediation liabilities was among the analyst's top concerns.

Afterwards, the CFO asked the company's general counsel what could be done to extinguish the company's environmental liabilities. The general counsel, in turn, asked the director of environmental remediation to determine the feasibility and cost of transferring the company's environmental liabilities to a trust or liability buy-out firm. The company had the cash to settle its environmental obligations, but numerous other projects were competing for limited resources.

Expecting that the company would have to pay a 25-30 percent premium to transfer these liabilities to an independent party and remove them from its balance sheet, the remediation manager wondered how he could ever demonstrate a satisfactory return on investment.

There is a conceptual framework for calculating the return on investment for expenditures to extinguish or otherwise cap environmental liabilities. This framework is based on the thesis that financially strong corporations with significant environmental liabilities can generate a positive return on investment by controlling the potential for upward volatility of these obligations.

By investing in mechanisms to extinguish or otherwise cap their environmental liabilities, companies reduce risk to lenders and investors and thereby increase their market capitalization and lower their weighted average cost of capital. This thesis rests on four key assumptions:

1. Investors discount the value of a company's future cash flows and stock price for estimation risk--risk arising from uncertainty surrounding the valuation and future cash flows associated with the company's environmental liabilities (both recognized and unrecognized).

2. Corporations can take steps, other than protracted cleanup, to reduce or eliminate perceived estimation risk to lenders and investors.

3. Investors and lenders will reward companies for perceptible reductions in estimation risk.

4. Incremental investments to extinguish or cap environmental liabilities will result in positive net present values for financially strong companies. For financially weak companies, investors may regard bankruptcy as a better means of resolving outstanding environmental obligations.

Estimation Risk

Estimation risk with respect to preexisting pollution conditions, including both known and unknown conditions, arises from uncertainty surrounding valuations and future cash flows associated with these legal obligations.

The actual value of a company's environmental liabilities may differ from its reported environmental liabilities for a variety of reasons. Pollution conditions giving rise to environmental liabilities can be difficult and expensive to identify, and, even when identified, environmental liabilities and the ultimate cost of remediation are subject to considerable scientific and engineering uncertainty.

Accounting standards provide significant latitude for professional judgment and discretion regarding recognition, valuation and disclosure, thereby compounding the uncertainty around reported numbers. Given this flexibility, some managers may be tempted to manipulate estimates in order to smooth earnings. The ex-CFO of Safety-Kleen Corp., who pleaded guilty to securities fraud in June, is a case in point.

Estimating a company's implicit environmental liabilities can be a daunting task, even for sophisticated lenders and investors. When there is recognized uncertainty, they will regard the company's environmental liabilities as riskier, with this risk reflected in the company's valuation and cost of debt. Moreover, when faced with uncertainty and limited information, analysts will tend to...