Environmental risk rating for the financial sector

J. C/mrw-

Prod.

Vol. 4, No.

I, pp. 17-20,

1996

Copyright 0 1996 Ekcvicr Science Ltd Printed in Great Britain. All rights reserved 0959-6526/96

PII: SO959-6526(%)00007-8

ELSEVIER

Environmental sector*

risk rating

$1.5.00 + 0.00

for the financial

Nicholas E. Costarast The Netherlands

institute

for MBA-Studies,

Utrecht,

The Netherlands

Environmental risk is difficult to measure due to uncertainties in its extent, timing and the definition of terms. This has led to the need for environmental risk quantification tools as an aid in a manager’s decision making process. Environmental risk rating (ERR) should give a reliable and predictive link between environmental and financial performance. The rating could then be used by the financial sector to set terms and pricing of products, by discriminating between companies’ environmental performance. This paper considers some of the issues in the development of ERR and its benefit for the financial community as well as the environment. Copyright 0 1996 Elsevier Science Ltd Keywords:

environmental

risk rating;

environmental

liability;

industry

standards

Introduction

Some development issues

Financial institutions play a fundamental role in business activity by controlling access to capital and insurance. Meanwhile, business activity, as a principal user of input resources, is seen as a major contributor to environmental destruction with accidents such as Bhopal, Seveso, Exxon Valdez and Chernobyl highlighting the impact. Gradual pollution, though not as dramatic, can have equally far reaching implications both financially and for the environment. As an example, the high levels of CO2 emissions are linked to global warming which the insurance sector regards as leading to natural catastrophies. The financial implications of the recent spate of hurricanes, droughts and floods are estimated to have cost insurance companies $36 billion. The financial community recognises the need for environmental risk quantification tools. As the positive link between environmental and financial performance is becoming more accepted, the ability to define environmental exposures and manage the risks will result in a competitive advantage. Various environmental risk rating (ERR) products are being developed by several organisations to address this need, not only to improve financial performance, but also to encourage awareness of and commitment to improving the environment.

Legislation is a principal driver of improved environmental performance for the business community. Within the European Union (EU), the policy document Towards Sustainability sets out the legislative influence on industry. The problems associated with packaging waste, recycling, environmental liability and the Environmental Management and Audit Scheme are just a part of the agenda of this document. As a result, proactive corporations can anticipate future legislation and be guided by the change from ‘command and control’ instruments to market instruments in their planning strategies. Legal, financial and commercial risks have risen as a direct consequence of the increased level of legislation and regulation. This has, in turn, led to a demand for a general improvement in environmental management systems and the quantification of environmental risks.

*This article is based on an MBA dissertation ‘Environmental Risk Rating: A study of the development of an environmental risk rating tool for the financial sector’, published by Environmental Auditors Ltd., 1996. tpresent address: 7 North St., Bromley, Kent BRI ISD, UK

Environmental risk assessment Environmental risk can be considered as having three components-the hazard, the control mechanism and the receptor. The hazard is related to the nature and quantity of the materials and/or process that describe the risk source. The controls are those factors that affect the potential pathways of the emissions and can be physical (e.g. bunding) or managerial (e.g. procedures, training). The nature of the target and its sensitivity to the hazard is the final component (see Figure I). Environmental risk assessment can then be represented by’:

J. Cleaner Prod.,

1996, Volume

4, Number

1

17

Environmental

risk rating for the financial

sector: N.E. Costaras

Environmental risk = hazard x probability x consequence To arrive at the risk rate, the criteria for determining risk grades must be established. The next step is to ‘score’ each criterion (or risk factor). A weighting is then given to each risk factor dependent upon its perceived relative importance in assessing risk, to give the final rating. The design of the different rating products is very dependent on the target market. Those environmental rating systems that have been developed principally for the banking and insurance sector consider two elements3: l l

How large are the company’s environmental liabilities and costs? How able is the company in dealing with them managerially and financially?

These elements show the impact on the profit and loss account and identify the company’s sensitivity to environmental factors from pollution, regulatory risk, consumer action etc. Table 1 shows the products currently available on the UK market.

Requirements and applications An ERR must be seen to be credible and reliable before it will be accepted as a useful risk quantification tool in the financial sector. In order to be credible ERR should lead to competitive advantage and show distinct financial benefits for the user. This will only occur with increased use of the available systems and an acceptance by the financial community of the positive link between environmental and financial performance. Why does the assessment of environmental risk pose a problem? A major difficulty is estimating the extent of environmental liabilities. Because of the imprecise nature of scientific evidence and the subjectivity in evaluating the value of a species, a plant or even human life, the outcomes of regulations are hard to predict. Costs are highly variable and potential environ-

Figure 1 Environmental

18

it would allow liability insurance underwriting by focusing resources for detailed risk evaluation; it provides a measure of exposure to risk for shareholders and other stakeholders; it allows investment fund managers and independent investors to distinguish environmental performance of companies being considered for both general investment opportunities as well as ‘green’ opportunities; it can be used as a portfolio screening tool for bankers to highlight levels of risk and as a resource allocation tool; it will encourage risk improvement programmes to improve ratings;

risk audit elements*

J. Cleaner Prod., 1996, Volume 4, Number

mental risks are difficult to assess, are contingent or cannot be quantified. Further, the timing of any expenditure is unclear and it is not always clear who will be liable. But, for environmental risk assessment, precise measurement may not be required. Indicators, such as the ratings offered by existing credit agencies, could be developed for environmental risk in the financial markets. It is, however, important to keep in mind that different users define and manage environmental risk in different ways. As an example, an emission on a site poses varying financial repercussions to different users. For the banker it could negate the value of an asset as well as leading to failure of the company and the loss of ability to repay a loan; to the insurer it could require covering legal and clean-up costs, while the exposure can be controlled by the setting of deductibles and limiting payouts; for the investor an event can result in the officer being held personally liable as well as loss of returns on the investment; to the corporation it can result in poor publicity leading to loss of revenue as well as fines, expensive insurance and capital, with liability for damages/remediation. However, an environmental rating need not only consider the cost side of the equation, but also, the benefits of good environmental performance. ‘Green’ funds invest in a range of companies that demonstrate a positive commitment to the preservation and protection of the natural environment. Thus, some ERR products measure a company’s performance over the range from ‘reactive’ to ‘sustainable’. Other organisations are looking at the development of performance indicators to show the positive link between environmental and financial performance and using this as a pseudo-rating. These ‘green’ ratings can be seen as a consequence of the EU policy move from ‘command and control’ to market instruments. Environmental risk represents an aggregate of individual risks: regulatory, technological, operational and event risk. It is not only the individual risk that must be understood but the interactions with one another. The challenge is to develop a method of measuring this aggregate environmental risk. There are, nonetheless, significant potential benefits of an environmental risk rating system for the financial community4:

1

Environmental Table 1 ‘Environmental

risk rating for the financial

sector:

N.E. Costaras

risk rating’ products available

System

Methodology

Strengths

Weaknesses

CSFI

Site audit; interviews with management and staff. Industry sector expert opinion; correlation with financial data Questionnaire; correlated with financial database

Detailed with interpretation

Complex; expensive; subjective

Portfolio screening

No site-specific environmental data. Subjective No site-specific information. Little detail. Subjective

SYBERR Ecco-Check Eco-Rating International Loss Prevention Council MAS International Environmental Rating System (IERS) The Safety and Environmental Risk Management Rating @ERM Operator and Pollution Risk Appraisal (OPRA)

0

0

Considers sustainability of products; processes; companies, using IO different criteria Four-level assessment from questionnaire to site audit Modelling of information on processes; management quality; sensitivity of sites, etc. Considers I6 elements as a guide to environmental management Considers hazard potential, risk management and financial strength in a mathematical model Rating of management performance and pollution hazard

it enables the screening of supply chains as part of an environmental standard requirement or to qualify for inclusion into a ‘green’ fund; it can be used in mitigation or aggravation in proceedings against companies and/or their officers and directors as part of a ‘due diligence’ process.

For the rating to be credible requires access to quality information. The current absence of standards, whether in environmental performance measures, costing of the environment, legal judgments or reporting requirements, results in a set of rather subjective measures of performance which are not generally recognised. This situation is expected to change with the creation of a European System of Integrated Economic and Environmental Indices (ESI) and the European System of Environmental Pressure Indices (ESEPI) in the next two to three years’. Even such bodies as the ‘Advisory Committee on Business and the Environment’, the Confederation of British Industry and the One Hundred Group of Finance Directors recognise that reporting of environmental performance should be standardised. Information should also be available through the activities of the ‘Environmental Management and Audit Scheme’, Eco-labelling, Toxic Release Inventory and the Freedom of Environmental Information. At present, however, the many discussion groups have not produced any generally recognised or accepted standards. Properly designed environmental standards can trigger innovations that lower the cost of a product or improve its value6. Financial institutions should embrace the advancement of standards to reduce their risk and promote the competitiveness of their clients. An ERR can be used as a measure to stimulate the application of new technologies that minimise the cost of dealing with pollution once it occurs. More

Portfolio screening; discriminates performance within industry sector Gives interpretation with the rating. Can compare companies within a sector Detailed look at the compnay and sites Detailed

Time-consuming; subjective

expensive;

Complex; subjective assessment of probabilities and cost Insufficient statistics to show effectiveness or reliability

Detailed

No site-specific information

Detailed, site and company specific

Complex; subjective, untested

Considers details related to a particular site

Only considers processes requiring pollution permits,

importantly, it can lead management to address the root cause of pollution by improving resource productivity in the first place. An ERR can be applied to create pressure to improve both commercial and environmental performance by: l

l

l l

alerting and educating companies about areas of resource inefficiency; encouraging product and process innovation to minimise waste; creating a demand for environmental improvement; levelling the playing field and allowing benchmarking between companies.

In the absence of recognised standards, performance indicators provide an alternative approach. In America, the Investor Responsibility Research Center (IRRC) uses environment-related performance measures to allow decisions to be made through comparison. These measures have been used to show a positive relationship between environmental and financial performance7. Standardised measures can be used as part of an environmental performance improvement strategy by: 0 tracking performance over time; providing a comparison against other businesses; l allowing benchmarking against the ‘best practice’; l allowing comparison with an ideal (e.g. zero impact). l

Any rating must come with an interpretation. The ERR should define the elements of environmental risk and advise on risk management. In this way the rating could show that, say, 9 out of 10 of the criteria leading to the rating are not as significant as the tenth, which could be focused on with a covenant or warranty attached. This would allow appropriate pricing of banking and insurance terms, not only leading to a competitive advantage for these financial institutions but also

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Environmental

risk rating

for the financial

sector:

N.E. Costaras

providing capital to the better performers in high risk sectors. It will only be through increased use of ERR that confidence in its reliability will grow. The reluctance of the financial community to accept any of the systems is also a reflection of the early stage in their environmental awareness. As awareness improves and the financial consequences of poor environmental performance become more apparent, the development and acceptance of ERR will accelerate.

Conclusion ERR can provide financial institutions with a means of assessing their exposures and so result in improved risk management, leading to competitive advantage. More importantly, by raising awareness of the environmental issues and the associated financial implications, the financial sector can promote improved environmental performance from its clients. Ultimately, with better costing of natural resources, environmental risk should be considered as a normal part of business risk. Currently, however, the scarcity of recognised standards hinders the formation of reliable measures of performance. Without standards, an ERR will not be readily considered as credible, so that it is difficult to see them being accepted as a risk management tool. Nonetheless, even the current very crude indicators are beneficial in raising awareness and lead to the conclusion that there exists a positive relationship between environmental and financial performance. However, it is vital to clarify the assumptions and purposes behind such indicators so that the users of these ratings understand the limits, as well as the benefits, of these tools. Organisations should consider that ‘it is better to be approximately right than precisely wrong’-the longterm consistency in measurement is more important than absolute accuracy. Without this consistency, it is difficult to see how comparisons and benchmarking of companies will be possible.

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Managers must start to consider environmental improvement as an economic and competitive opportunity and not as an inevitable cost. ‘Pollution = Ineficiency’. Environmental risk rating would provide a measure of enhanced resource productivity. The ability to discriminate elements of environmental risk can lead to a better allocation of risk management resources. An interpreted risk rating can define those elements in a company’s process which pose the greatest threat to the environment. This can encourage innovation. The arguments against improving environmental performance are very similar to those used in the quality revolution of the 1980s. At that time managers believed that quality and cost were a trade-off. Viewing defects as inefficient product and process design required a different mentality, Similarly, a commitment to the environment need not be viewed as a cost but rather as a step to improved quality, lower costs and greater competitive advantage. ERR could be viewed as a tool that, by providing a measure of progress, could help in defining a positive relationship between environmental and financial performance and a change in mentality in the business community.

References 1 Department 2 3 4 5 6 7

of the Environment. ‘A Guide to Risk Assessment and Risk Management for Environmental Protection’, HMSO, London, 1995 Pritchard, P., ‘Managing Environmental Risks and Liabilities’, Environmental Practitioner Series, 1994 Lascelles, D. ‘Rating Environmental Risk’, The Centre for the Study of Financial Innovation, 1993 Chipman, N. ‘Risk financing-when all else fails’, Banking on the Environment Conference, July 1995 European Commission, ‘Directions for the EU on Environmental Indicators and Green National Accounting’, COM(94).670 final Porter, M. and v.d. Linde, C. ‘Green and competitive: ending the stalemate’, Harvard Business Review, 1995, Sept.-Or%. House, R. ‘Rating environmental risk’, Institutional Investor, 1995, March