Still no closure on disclosure: ambiguity ensures that the debate about what constitutes proper environmental disclosure goes on and on. Companies can protect themselves from uncertainty with sound environmental insurance policies, a writer argues

Risk & Insurance, Nov, 2004 by Peter Gilbertson

Although environmental disclosure is not yet making headlines in the New York Times or the Wall Street Journal, the debate about what constitutes "adequate disclosure" of environmental liabilities is an important corporate governance issue that continues to stump auditors, regulators and institutional investors alike.

For example, a recent report from the General Accountability Office ("Environmental Disclosure--SEC Should Explore Ways to Improve Tracking and Transparency of Information") noted that publicly traded industrial companies have considerable flexibility in how they report environmental liabilities.

In their current form, the SEC's environmental disclosure rules hinge on subjective, imprecise and elusive concepts such as the materiality, probability and estimability of environmental liabilities. As a result of the inherent ambiguity of these concepts within the context of environmental liabilities, critics, including members of the Socially Responsible Investment community, public pension funds and institutional investors, have expressed concern that the information made available in securities filings is not sufficient for proper evaluation of risk.

The scope of environmental risks involved ranges from traditional operational risks and legacy soil and groundwater contamination, to liabilities associated with the retirement of long-lived assets (such as mines or oil/gas drilling facilities) and issues relating to climate change/global warming risks.

To understand the frustration of the critics, and the challenge presented to both the reporting companies and the regulatory agencies, consider that in a citation within the 2002 10-K financial report of a major northeast electric utility, it is noted that the Financial Accounting Standards Board requires disclosure when it is "reasonably possible that a loss has been incurred." Further, consider that FASB defines "reasonably possible" as cases in which "the chance of the future event or events occurring is more than remote but less than likely." As you can see, the definition of "reasonably possible" is not a strong source of clarity for either the party trying to ascertain risk, or for the reporting entity trying to determine what--or what not to--disclose.

For investors, the heart of the matter is financial clarity. Investors seek enough information to gauge the uncertainty associated with the environmental issues of a target company, and determine how prospective returns may be impacted by those variables. As a result, corporations that continue to rely on the ambiguity of the existing rules to avoid explicit disclosure about environmental issues risk shareholder lawsuits. If companies surprise shareholders by reporting previously undisclosed (or underdisclosed) material environmental problems, shareholders may sell their shares and possibly attempt to recover losses through litigation against the corporate directors and officers. Further complicating the matter for public companies, it should be noted that most directors and officer's insurance policies contain pollution exclusions, potentially exposing individual directors and officers to personal liability.

MAKING A CASE

Unfortunately, many companies are missing an obvious and simple solution. Environmental insurance tools that provide efficient funding for risk and/or a mechanism to transfer risk pertaining to environmental liabilities have existed for decades. The problem lies in the fact that there are very few companies who currently reference the use of environmental insurance in their financial disclosures as a means of establishing fiscal certainty.

Companies that address these issues in their financial reports can effectively explain that the use of environmental insurance enables them to cap/contain known or existing liabilities, as well as protect shareholders from unknown contamination and future pollution occurrences. Simply put, investors, regulators and the company itself would all benefit from knowing that if disclosed environmental costs escalate unexpectedly (due to perhaps cleanup cost overruns or changes in government cleanup standards), environmental insurance is in place to cover added expenses.

Aside from these risk management considerations, companies that continue down the path of environmental "don't ask/ don't tell" are overlooking a compelling source of competitive advantage. Let's say a company is looking to the capital markets for growth financing, and they have addressed environmental risk proactively through the use of environmental insurance and disclosed the details in their SEC filings.

This company may enjoy a lower cost of capital and/or more attractive financing terms than peer companies who have not taken such steps. Furthermore, addressing the risk in this way can help facilitate mergers, acquisitions or other transactions, which might otherwise get mired down in a debate regarding the value to place on evironmentally impaired assets. It is also worth noting that major institutional investors, for example CalPERS, are implementing environmental screening mechanisms to identify which companies in their funds have established a poor environmental track record in their state.