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Mar 31, 2008

Environmental exposure: new regulations for climate risk disclosure?

As activists petition the SEC to make climate risk material to company disclosure, investors and regulators take an increasing interest in how companies calculate their exposure to environmental risk

Last year, companies could still dismiss the idea of reporting about climate change and other environmental risks as too insubstantial to bring to investors’ attention. This reporting season, the conversation has shifted dramatically. Not only are companies expected to address how their business affects the environment, but the best are committing to concrete action and reporting on them publicly.

American Electric Power (AEP), the largest user of coal in the western hemisphere, has been widely praised for the candor of its environmental reporting. ‘We could make our sustainability report what I call ‘greenwash’, with all the birds and trees we saved, but what people really care about is whether we recognize we have issues – and what we are doing about them,’ says Dennis Welch, AEP’s senior vice president for environment, safety and health.

The Nobel Peace Prize for Al Gore’s work on climate change, record-setting heat waves and hurricanes, and a raft of increasingly credible legislation have all brought environmental issues to companies’ attention, says Jeffrey Smith, head of the environmental practice group at Cravath Swaine & Moore. Mindy Lubber, president of Ceres, says the widespread devastation of property by Hurricane Katrina showed businesses that ‘the financial impacts of climate change can be as real a financial risk as inflation and inventory backlogs.’

Nor are conversations about climate change just being aired in the usual boardrooms – energy producers, auto makers and chemical companies: Bank of America has a $20 bn climate change program and Citigroup a $50 bn one. ‘The climate change problem is greater than any other we’ve seen,’ says Lubber. ‘It’s going to call for a major disruption of our energy and transportation systems over the next decade or two – that means we need to ramp up activity now.’

When AEP committed to environmental improvements last year, the board decided to hold management accountable for sustainability. ‘In year two of our reporting, it’s looking at what we achieved versus what we said we’d achieve,’ says Welch. AEP has identified improvement metrics tied to specific risks; for each environmental risk identified in the sustainability report, an individual officer is held accountable for meeting objectives.

For instance, last year AEP committed to becoming carbon-neutral throughout its fleet of 6,000 to 7,000 vehicles and aircraft, buying or creating carbon offsets when necessary, explains Welch. This goal was accomplished by late fall 2007. AEP fell short of its goal of spending an additional $1 mn on forestry in 2007, however. ‘We made the decision not to pay exorbitant amounts of money for planting trees to offset emissions until the ethanol market calms down,’ Welch says.

Todd Arbogast, director of sustainable business for Dell, also embraces environmental disclosure. He notes that Dell reports on the impact of its facilities and operations; on greenhouse gas emissions by region, impact and source; and on expected reduction initiatives. These disclosures are made within Dell’s sustainability report and through the Carbon Disclosure Project.

What makes useful disclosure?
But which environmental risks should firms disclose? Lubber says most companies are adept at reporting litigation risks, but they’re far less forthcoming about regulatory and physical risks. She believes the increasing likelihood of new fuel economy standards in the next three to four years is a regulatory risk that cries out to be explained to investors.

Another imminent risk is the melting of permafrost and the impact that will have on oil pipelines, according to Miranda Anderson, vice president for investor analysis at David Gardiner & Associates, an energy and climate consulting firm based in Washington, DC. When formerly frozen ground becomes swampy, pipelines are no longer supported; Anderson says estimated costs for bolstering and repairing those pipelines run to $2 mn per mile. ‘Those are the kinds of physical risks investors need to know companies are evaluating,’ she adds.

Which regulatory risks a firm discloses depends upon its operations and where those operations are based. Companies with subsidiaries in countries that have signed the Kyoto Protocol need to address those commitments, says Beth Young, senior research assistant at the Corporate Library. Similarly, firms with operations in California might discuss the California Climate Action Registry.

‘The regulatory noose is tightening,’ observes Smith, noting that companies facing capital expenditures to comply with new laws should start informing investors how much these expenditures might be. Last fall, investors led by Ceres petitioned the SEC to clarify that climate risk is material and therefore worthy of disclosure.

Russell Read, chief investment officer for the $250 bn CalPERS pension fund, says: ‘Five or 10 years ago, the greenhouse gas footprint was not material to investors. Five or 10 years from now, investors and regulators will be placing values on companies based on what their footprints are. It’s inconceivable that a greenhouse gas footprint will not become material in the valuation of these firms.’

Reporting risk in official filings
Sustainability reports – stand-alone documents that address everything from a company’s environmental record to its engagement with the community – are increasingly popular places for disclosing climate change and other environmental risks. Jonathan Halperin, director of research and advocacy at the Washington, DC-based consulting firm SustainAbility, says clear metrics are critical. To date, companies have excelled at describing initiatives, but have fallen short when identifying whether they’ve met targets.

Some aspects of disclosure are particularly well-suited to the MD&A. A company facing a growing carbon footprint through acquisitions, for example, would want to put such a change in context for investors. Read says investors aren’t looking at raw emissions data so much as a company’s ‘trajectory’ in tackling environmental challenges.

Both Young and Halperin praise internet-based discussions of environmental risk as they lend themselves to regular updating. ‘You can’t just publish something in a report and be done,’ says Halperin. ‘The real question is how you get from once-a-year reporting to quarterly, monthly, daily and real time.’

‘The push has been more disclosure, more disclosure, more disclosure. The unintended consequence? A carpet-bombing effect,’ adds Jennifer Woofter, CEO of Strategic Sustainability Consulting, based in Silver Spring, MD. She hopes firms will begin distinguishing their core issues from the welter of sustainability topics, to help investors make important distinctions.

Young says one of the major differences between climate change and other environmental risks is that ‘climate change has the potential to shake up business models.’ Consequently, she argues that ‘boards need to be looking at these issues and assessing them in a company-specific way.’

Smith believes corporate boards increasingly ‘get’ climate change but finds them ‘justifiably skeptical’ about some of the ways this potential disaster will affect their particular firm. ‘They’re saying, We understand this is a societal issue, but what does this matter to our business? And a lot of the answers to that question haven’t been fully developed yet.’

What lies ahead
Almost everyone anticipates that 2008 will be a watershed year because of the presidential election. ‘Next year we’ll have a new president, Senate and House – and maybe a radically new slate on which to write a climate change agenda,’ says Smith.

When trying to envision what shape federal legislation might ultimately take, Smith believes it’s likely that federal climate change legislation will be modeled after some of the state initiatives currently being enacted. ‘There are literally hundreds of regional, state and local initiatives out there,’ he says. ‘Some are purely political and don’t have any teeth but many are great templates on which to base federal legislation.’

Although finding a way to discuss risks that could profoundly alter a company’s operating model isn’t easy, it’s what business leaders must do. Welch believes a productive dialogue will begin when ‘the majority of companies see you can talk about environmental risks without it bringing you to your knees.’

This article originally appeared in the January 2008 issue of Corporate Secretary.

Building a reporting template
So far, most environmental reporting in the US has been purely voluntary. Ceres’ global reporting initiative, established in 1997, gives companies one template for disclosing environmental and other corporate behaviors.

Another touchstone is the Global Framework for Climate Risk disclosure, created by investors and released in 2006. This framework examines four basic components of reporting: historical emissions data, strategic management of climate risks and emission reduction plans, physical risks posed by climate change, and a quantitative assessment of regulatory risks.

A further gauge is the Carbon Disclosure Project (CDP). Currently 1,300 companies globally report through the CDP and 300 of these participants are based in the US, according to CDP’s CEO Paul Dickinson.

One important benefit of voluntary CDP disclosure is the ability to benchmark a company both inside and outside its industry. Todd Arbogast, director of sustainable business for Dell, emphasizes that the CDP lets Dell’s management team and board compare progress and commitment with its peers.

The variety of templates points to a growing problem: it’s not yet clear how best to calculate emissions data. Russell Read, chief investment officer of CalPERS, encourages companies to view greenhouse gas emissions in terms of efficiency. He suggests companies might measure how many tons of carbon they emit per thousand dollars of sales or profits. But he emphasizes that these metrics will have real value only once everyone makes calculations the same way.

Even without standard measures, many experts believe the impulse to disclose is worthwhile. ‘If firms are factual in their disclosure and careful to express uncertainty where there is uncertainty, I don’t think they can go wrong,’ says the Corporate Library’s Beth Young.

That said, it is possible to disclose environmental risk in a way that leaves a company looking foolish later. ‘You don’t want to establish a track record of fake math that’s hard to crawl back from and later looks like an accounting restatement,’ says Jeffrey Smith, a Cravath Swaine & Moore partner. Instead of swinging ahead of the ball, Smith advocates waiting, watching and swinging true.