Financial Value and Environmental Leverage Points (Peter ...

04/12/23 1

Financial Value and Environmental Leverage Points

State-EPA Innovations Conference25 January 2006

Denver, CO

Peter A. Soyka President

1/25/06

Copyright © 2006 Soyka & Company, LLC2

Introduction & Context• Why should I care about financial value as an

environmental regulator?• How does this topic affect my organization and

its programs?• How might it in the future?

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Introduction & Context (cont’d)

“The Social Investment Forum Foundation wants to make sure that concerned Americans know that they have until January 13, 2006 to voice concerns about a controversial Environmental Protection Agency proposal that would severely weaken the access of investors and communities to information on polluters through the Toxics Release Inventory (TRI) data. With just 10 days to go before the January 13, 2006 comment period deadline, the EPA has received more than 10,000 emails and letters opposing the controversial TRI changes. Read more here”

(Source: http://www.savetri.org/index.cfm)

http://www.socialinvest.org/

http://www.savetri.org/010406SIFEIPrelease.cfm

http://www.savetri.org/index.cfm

http://www.savetri.org/index.cfm

1/25/06



DECEMBER 12, 2005 • Editions: N. America | Europe | Asia | Edition Preference

LOW CARBON LEADERS Who the Judges Picked

Top Companies of the DecadeSingle-Year Percentage LeadersIndividual AchieversBest Management PracticesFinancial Services LeadersGovernments in ActionMethodology SLIDE SHOWS

Reprints/Permissions Conferences Investor Workshops Research Services

SPECIAL REPORT BATTLING GLOBAL WARMING

Business Gets Serious About Emissions

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• Companies will increasingly compete on fuel efficiency

• Companies will compete around:

– New vehicle types (Hybrids)– New powertrain technologies– Lighter vehicle structures– Smaller vehicles

• Strategies around fuel efficiency will likely impact valuations

(Source: World Resources Institute, November 2005)

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“Goldman Sachs will increase our commitment to systematically incorporate environmental, social and governance criteria into fundamental analysis of companies. We believe that companies’ management of environmental and related social risks and opportunities may affect corporate performance.”

(Source: Goldman Sachs Environmental Policy Framework

November, 2005)

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• How can we design programs to more effectively take advantage of financial drivers?– What do financial stakeholders care about?– How can we speak their language?– What environmental program features are likely to appeal

to them?– What do we really know about the financial impacts of

environmental programs and performance?– What are some of the important trends?– What are the implications for our programs and activities?

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Introduction & Context (cont’d)• Organization of session

– Finance & financial markets– Traditional & emerging valuation techniques – Environment & Finance-established linkages– Events & trends to watch– Implications for environmental agency managers

• Participation and questions are welcome!

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• Focus on publicly traded firms in U.S.

• Many principles apply to privately held companies and public sector organizations

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Financing the Organization

Where Does the Money Come From?

–Bank Loans–Commercial Paper–Bond Issue–Stock Issue

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Financing the Organization

How Do We Control Risk?

– Internal Controls– Insurance–Hedging

• Derivatives

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Financial Data• Management Accounting

– Internal focus– Provides basis for planning, budgeting,

transfer pricing, etc.– Allows management to evaluate operations

• Financial Accounting– External focus– Allows investors to value the firm– Allows investors to evaluate management

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Financial Statements

• Financial statements appear in–the Annual Report–the SEC 10-K and 10-Qs

• Three primary financial statements–Balance Sheet–Income Statement–Cash Flow Statement

• “Stock” versus “flow” measures

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Investors & Investing

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Investors & Investing

• Institutional Investors own 50% of total equity

• Many Indexed Investments

• “Universal Owner”

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Equity Ownership

Total Holdings at Market Value $15.62 trillion

Mutual Funds $3.26 trillion 20.8%

State and Local Pensions $1.09 trillion 6.9%

Private Pensions $1.53 trillion 9.7%

Insurance $1.14 trillion 7.3%

Other Institutional $0.70 trillion 4.5%

Total Institutional $7.72 trillion 49.4%

Household $6.13 trillion 39.2%

Rest of World $1.67 trillion 10.7%

(Source: Federal Reserve 2004 Third Quarter Data. Posted Dec. 9, 2004)

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Fiduciary Duty

• Prudent Investor Rule– Reflects Modern Portfolio Theory– Diversified portfolio required unless

imprudent– Prudent Man Standard of Care (ERISA)

• Care, skill, prudence (loyalty), diligence

(Source: UNEP-FI, Freshfields Bruckhaus Deringer. “A legal framework for the integration of environmental, social and governance issues into institutional

investment.” October 2005)

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Investment Analysis

• Risk & Return

• Portfolio Theory

• Investment Evaluation Methods

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Risk & Reward (Return)

– Futures

– Options

– Stocks

– Bonds

– Commercial Paper

– U.S. Gov’t Securities

Ris

k

Rew

ard

Pote

nti

al

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Sources/Types of Investment Risk

Sources

– Interest Rates– Market– Inflation– Business– Financial– Liquidity– Exchange Rate– Country (Political)

Types

–Systematic

–Non-Systematic

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Portfolio Theory

• Risk = Volatility in Returns

• Non-Systematic Risk Can be Diversified Away

• Market Participants Assumed to be Diversified

• Relevant risk of a security is impact on portfolio risk

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Investment Evaluation Methods• Fundamental Security Analysis• Taking it from the Top; Examine

– Economy/Market– Sector/Industry– Company

• At the Company Level, Apply– Present Value Analysis– Multiplier Analysis (e.g., P/E Ratios)– Other Techniques (e.g., EVA)

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Investment Evaluation Methods

• The Economy/Market• Attributable for ¼ to ½ of variability in company earnings

• Business Cycles– Stock prices lead economy– Change in investor confidence affects required ROR

• Considerations– Stage of Economic Cycle– Inflation– Interest Rates– Expected Corporate Profits (overall)

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Investment Evaluation Methods• Sectors/Industries• Standard Sectors

– Interest-Rate Sensitive– Consumer Durables– Capital Goods– Defensive

• Industry Analysis– Growth– Defensive– Cyclical– Interest-Rate Sensitive

• Considerations– Economic Conditions– Industry Life Cycle Stage

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Company Evaluation Methods

“What do the great successes of the past 20 years tell us? It’s the company, stupid.”

-- Peter Lynch

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Company Evaluation Methods

The Investor’s Big Question:– Should I Add, Remove or Hold this Security?

–Is it Priced Correctly?–What’s It Worth?

•Present Value Analysis•Multiplier Analysis (e.g., P/E Ratios)

–Hidden Value or Risk - What Are the Clues?–What Might Change in the Future?

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Traditional Evaluation MethodsReward Factors

–Profitability

–Cash Flow

–Efficiency/ Productivity

–Growth

Risk Factors

– Capital Structure

– Liquidity

– Cash Flow

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Traditional Evaluation Methods

Factors–Profitability–Cash Flow–Efficiency/ Productivity–Capital Structure–Liquidity–Growth

Ratio– Return on Equity (ROE)– Cash Flow/Total Liabilities– Sales/Assets– Debt/Total Capital– Current Ratio– P/E : Growth

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Trends

– Growth in sales

– Growth in earnings

– Growth in market share

– Changes in volatility

– Changes in industry structure

– Technology & innovation

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Other Indicators

– Share Price Appreciation

– Price/Earnings Ratio

– Bond rating

– Yield

– Total Return

– Stock Beta

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Traditional Evaluation Methods• Required Conditions-Data that are…

– Timely– Accurate– Consistent– Comparable– Reliable– Meaningful

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Emerging Evaluation Methods

• Alternative (Proprietary) Frameworks– EVA

– Balanced Scorecard

• Intangibles

• “Values-Based” Investing

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Market Value of Intangibles• Intangible Value Drivers Produce Out-performance

– “As recently as the mid-1980's, financial statements captured at least 75% on average of the true market value of major corporations. In the intervening years, however, that figure has dropped to a paltry 15% on average.”

(Baruch Lev, Intangibles: Management, Measurement and Reporting: Washington, D.C. Brookings Institution, 2001.)

– Ergo, roughly 85% percent of a company's true market value cannot be explained by traditional financial analysis. The disconnect between companies' book value & market capitalization is at an all-time historical high

(See, Low et al.)

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Market Value of Intangibles

–Strategic Environmental Management

–Human Capital–Stakeholder Capital–Sustainable

Governance(Source: Innovest Strategic

Value Advisors Web Site, 2005)

– Customer– Leadership and Strategy– Transparency– Brand Equity– Environmental & Social

Reputation– Alliance & Networks– Technology & Processes– Human Capital– Innovation– Risk

(Source: GEMI, Clear Advantage: Building Shareholder Value, 2004)

Most powerful intangible value drivers:

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Values-Based Investing (SRI)

–Mature Concept but Growing Rapidly–Now Significant Fraction (~12%) of Equity Capital Invested; Substantial Factor in Fixed Income Also

–Evolution from “Sin” Emphasis to Broader (& More Sophisticated) Perspective

–Emergence of Niche Information Providers–Involvement of Major Mainstream Players–Track Record of Comparable Performance (or Better)

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Vs. “Mainstream” Investing

Institutional Investors– Universal Owners– Dislike Divestment– Focus on Engagement– Rely on Fund Managers

• Not yet formally screening fund managers for approach to the environment

• INCR proposes doing so on climate change• State of Connecticut is considering a broader question in

RFP’s– Conservative Interpretation of Fiduciary Duty

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Mutual Fund Voting Policies

(Source: “Unexamined Risk,” Ceres 2004)

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Bond Ratings

Economic Risk Industry Risk Market Position Business

Diversification Geographic Dispersion Management

Credit Risk Market Risk Funding & Liquidity Capitalization Earnings Risk Management Financial Flexibility

Business Risk Financial Risk

(Source: Cathy L. Daicoff and James M. Wiemken, Standard & Poor’s Credit Market Services. 10 February 2005)

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Fiduciary Duty-A New Interpretation?• Modern Prudent Investor Rule

– Portfolio assumed– No duty to maximize returns, but to implement a rational &

appropriate strategy– Portfolio to be diversified unless imprudent– Prudence judged at time of investment

• ESG must be considered where relevant to any aspect of investment strategy

• No bar to integrating ESG into fund management, so long as focus is on beneficiaries/fund purposes

(Source: UNEP-FI, Freshfields Bruckhaus Deringer. “A legal framework for the integration of environmental, social and governance issues into

institutional investment.” October 2005)

1/25/06


Climate Change-A Bellwether?• Institutional Investor Summit on Climate Risk- May 2005

–26 investors managing > $3 trillion in U.S. & Europe–Urge publicly held companies in high-risk sectors to report business impacts & response strategies

–Require investment managers overseeing fund assets to describe resources, expertise and strategies for assessing financial risks associated with climate change;

–Evaluate & rank 100 of the world’s largest, publicly-held companies on their actions for reducing risks; share scorecard report with investors later this year;

–Invest $1 billion of capital in the next year in companies with clean technologies –Urge SEC to require companies to disclose financial risks related to climate change

–"Assessing climate change is now an essential aspect of intelligent investing," William C. Thompson Jr., Comptroller for New York City.

• Shareholder Resolutions & Management Responses –Apache, Anadarko, Chevron, Marathon, Tesoro, Unocal report on climate change impacts & mitigation strategies

–Reports issued by AEP, Cinergy, Reliant, Southern & Texas Utilities

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Implications

• Financial Value is…– Revenue growth– Improved profitability– Reduced risk, and/or– New/better information

• How many of our environmental programs explicitly speak to these drivers?

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Linkages Between Environment & Finance

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SEC Rules– Existing SEC rules cover three substantive areas

• accrual in financial statements • disclosure in financial footnotes and SEC filings• estimations for both accruals and disclosures

– Many SEC rules apply only to matters that are “material” to the financial condition of the company

– Generally, a matter is material if a prudent investor would reasonably want to know about it

– The SEC has generally declined to define materiality, relying on established case-law

(Source: Jeff Smith. “Sarbanes-Oxley and EMS.” Cravath, Swain & Moore. July 26, 2005.)

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Sarbanes-Oxley– Emphasis on systems & controls– C-level certification

FAS 143 – Relates to environmentally impaired assets and

systems– Requires recognition of liability using probabilistic

analysis – Disclosure of material liabilities (> $100,000)

(Source: Jeff Smith. “Sarbanes-Oxley and EMS.” Cravath, Swain & Moore. July 26, 2005.)

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Findings from the Literature –P2 proportional to profitability at firm level–Liabilities significant & quantifiable–Beyond-compliance behavior related to

intangible asset value–No penalty for green portfolios–Stock price reactions to environmental

events–Environmental management/performance

affect cost of equity capital

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Meeting Financial Market Expectations

• Meaningful endpoints & linkages• Clear & compelling value proposition• Evidence of senior management control &

engagement• Strategically implemented, effective, validated

systems• Consistent, comparable, credible data• Documented, verifiable performance

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Events & Trends to Watch

• Market reaction to UNEP-FI/Freshfields analysis of “fiduciary responsibility”

• DOL & ERISA

• Evolution of standards of practice under Sarbanes-Oxley

• Shareholder resolutions & corporate responses

• Financial sector behavior

• FASB Rules-Existing & New (e.g., FAS 143)

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Events & Trends to Watch

• Mutual Fund voting policies

• New SEC enforcement posture

• Mandatory disclosure of environmental and sustainability information for listed companies on stock exchanges?

• Climate change -- Beyond Montreal• SRI – consolidation & unification? • Standard(s) for Corporate Social Responsibility (e.g., ISO guidance)

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Key Take-Aways• Think Marketing (“want to, not have to”)• Understand your audience• Explore risk:reward relationships• “Value” = Growth, Greater Profitability and/or Risk

Reduction OR New Meaningful Information• Leverage evolving trends

– Information availability & quality– Changing market expectations & dynamics

• Quantify where possible• Understand & disclose uncertainties

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Key Take-Aways• How does/can your program address…

– Values & Image – Strategy and Tactics– Organizational Development/Strengthening– Innovation, Intellectual Capital Formation & Branding– Quality & Responsiveness– Risk Management– Supply Chains & Alliances– Stakeholder (including customer) Relations– Performance Measurement (environmental & financial)– External Reporting & Transparency

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Questions & Discussion

• Further questions?

• Thank you for your participation!

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Financial Value and Environmental Leverage Points (Peter ...

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