dec2016 - fair value measurement for environmental liabilities
TRANSCRIPT
© 2017 Environmental Risk Communications, Inc.
Contact:
John Rosengard(510) 548-5570
www.erci.com
Fair Value Measurement for Environmental Liabilities
December 2016
© 2017 Environmental Risk Communications, Inc.
Elevator Speech on Fair Value MeasurementWhat Since 2006, preferred GAAP basis for pricing assets and liabilities.
Why Build on reasoning why we absorbed liabilities in the past Common sense. Potentially validated by a counterparty, not a regulator. Enables a step-change improvement in productivity. And it might be free. Factor in asset write-up, accelerated and higher
depreciation, deferred tax assets, fuller spectrum of cost recoveries, and avoidable escalation (lifecycle oversight, counterparty default, remedy failure)
How “Think like the competition” when we value an environmental liability. Cleanup projects and budgets ≠ environmental liabilities.
© 2017 Environmental Risk Communications, Inc.
Outline
Fair Value Definition, GAAP Citations
Mandatory and Optional Application
Calculation Options
Examples of Discrepancies
Justification and Path for Adoption
Q&A
© 2017 Environmental Risk Communications, Inc.
Speaker Background: John RosengardWrote Defender™ liability forecasting software package Environmental remediation liabilities (ASC 410-30) Asset retirement obligations (ASC 410-20) Due diligence on acquisitions and divestitures Watch list for future reserve increases (sites & portfolios) Decision analysis on individual sites Pollution remediation obligations (GASB49) Counterparty (PRP) default tracking
ERCI supports Corporate remediation teams PRP groups Port authorities The engineering/consulting and legal partners Their internal and external auditors
Member of ASTM E2137 workgroup, tech contact E2173
MBA, Northwestern; BS, Georgetown
John RosengardFounder/CEO, [email protected], CA
© 2017 Environmental Risk Communications, Inc.
Fair Value Measurement
Preferred Method Asset AND Liabilities at FVM Market-based inputs Price of problem, not cost a possible solution
Present value (companies) or current value (governments)Expected value of multiple outcomes Remedy failure No time limit Counterparty risk
Three “approaches” Income: impact to your income, defined by spending plan Market: transfer to unrelated third party today, orderly market Replacement Cost: “replace service capacity of asset” (problematic for our use)
Hierarchy of Inputs (next page)
Issuer Date ReferenceFASB Sep 2006 ASC 820IASB May 2011 IFRS 13GASB Feb 2015 GASB 72
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Fair Value Hierarchy
Level 1 (preferred): currently quoted price, active market, identical liabilities
Excavated soil “Class C waste”, trucked to landfill for $84.50/ton 500 sediment samples tested for PCBs under USEPA Method 8082A (SW-846) 80,000 kilowatt hours/year to run groundwater pump/treat system
Level 2: some observable inputs, less-active market, similar liabilities
Site soils are 50% sand/50% gravel; lookup bulking factor is 1.15, rule of thumb is 20% over-excavation, therefore target volume = 130 truck trips to the landfill.
Transportation costs last estimated when diesel was $3.648/gallon (7/2/2012). Peer PRP has credit score of 920 and therefore a 35% probability of default in ten years.
Level 3: unobservable inputs, little (if any) market, unique liabilities Regulatory approval of the remediation plan may take four years; during that delay, the
groundwater plume may expand 0%-25%, depending on rainfall
© 2017 Environmental Risk Communications, Inc.
Why is this important?
Environmental liabilities are settled through spending SIC 495305 - Waste disposal - hazardous SIC 871120 - Engineers - environmental SIC 811121 - Environmental attorneys SIC 179502 - Demolition contractors
Treating an entire liability as Level 3 (unique) creates a bubble Market prices don’t factor in Experience, efficiency, and competition don’t matter Peer spending is irrelevant
“Commoditization of spending” is how your core business thrives Economies of scope: doing more with less Economies of scale: apply your learning curve and purchasing power
© 2017 Environmental Risk Communications, Inc.
Change in Mindset
Probable and Reasonably Estimable: Entire project estimate treated as unique (“level 3”)
Study
RI/FS, RD
Remediation and OM&M
Fair Value Measurement: Each estimate has combination of level 1, 2 and 3 components
11
1
11
1
1
1
1
1
22
22
22
22
22
22
222
22
2
1
12
3
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Fair Value Reserve Calculation Example
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
$3.5
$4.0
VendorQuote
RemedyFailure
ProjectManagement
CounterpartyDefault
Fair Value
Vendor QuoteGroundwater P&T System$2M install, $3 M O&MLess 50% in cost sharing= $2.5M
Remedy Failure80% status quo OK20% expand remedy (+$4M, less 50%)= [(80% x 0) +(20% x $2M)] = $0.4M
Project Mgmt10% add-on= $0.3M
Counterparty60% no defaults25% one PRP default, +$1M15% two PRP defaults, +$2M= [(60% x 0) + (25% x $1M) + (15% x $2M)] = $0.6M
$2.5
$3.8
+$0.4+$0.3
+$0.6
© 2017 Environmental Risk Communications, Inc.
Fair Value Reserve Calculation Example
$ millions Probable and Reasonably Estimable
Fair Value Measurement
Study $0 $0Remediation $2.5 $2.5Remedy Failure $0 $0.4Project Management $0 $0.3Counterparty Risk $0 $0.6Total Reserve $2.5 $3.8Increment to “upper end of range”
$4.0• remedy failure $0 to $2.0• counterparty risk $0 to $2.0
NA
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Five Types of Environmental Liabilities
Asset Retirement Obligations
Commitments Contingencies Guarantees
Liabilities
Your company and four others sign a consent order to complete the RI/FS for a CERCLA site
An asset sale agreement includes a buyback promise if a buyer finds contamination
Leasing property indefinitely on premise that study and possible remediation are deferred
Financial assurance to regulator
Asbestos removal
Lead-based paint removal
Mine closure
Stormwater line decommissioning
Oil well plugging and abandonment
Environmental Remediation Obligations
CERCLA past cost reimbursement to USEPA
Deminimis cash out
Outcome from Litigation
FASB: ASC 410-20GASB: GASB 83IASB: IAS 37
FASB: ASC 410-30GASB: GASB 49IASB: IAS 37
FASB: ASC 440GASB: Note disclIASB: IAS 16
FASB: ASC 450GASB: GASB 10IASB: IAS 37
FASB: ASC 460GASB: GASB 70IASB: IAS 39
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Comparison of Estimate PurposePurpose Time
HorizonInflation and Discounting
Fair Value
Expected Value
Present Value
Asset retirement
Life of asset
Per GAAP Mandatory Mandatory Mandatory
Remediation Reserve forecast
Company policy
Per policy Per policy Per policy Per policy
Budgeting 1-5 years No No No NoCash out Infinite Best practice Yes Yes YesInsurance claim Per policy
limitsPer policy limits
Per policy limits
Per policy limits
Per policy limits
Due diligence Infinite Best practice Yes Yes YesFinancial assurance
As required
As specified No No No
Commitment Infinite Per GAAP Yes Yes YesContingency Company
policyPer policy Per policy Per policy Per policy
Guarantee Infinite Per GAAP Yes Yes YesRemedialalternatives
30 years Per EPA guidance
No No Yes
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Quiz: Name the Source of This Disclosure
ARO
ERL1 ERL3
ERL2
Didn’t apply fair value Applied it
© 2017 Environmental Risk Communications, Inc.
Liabilities Repriced at Fair Value
Date Event12-31-2008 GM environmental reserve: $297 million6-01-2009 GM files Chapter 116-30-2009 GM updates their reserve to $536 million
10-20-2010 $773 million for first six settlements12-14-2010 +$25.0 million settlement = $798.0 million
3-3-2011 +$28.2 million settlement = $826.2 million3-7-2011 +$50.6 million settlement = $876.8 million
3-29-2012 +$23.8 million settlement = $900.6 million6-29-2012 +$39.2 million settlement = $939.8 million
11 settlements = 3.2x reserve, three years$297 million >>> $940 million
Source: USEPA press releases
© 2017 Environmental Risk Communications, Inc.
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
Environmental: $0.5 B(Probable and reasonably estimable)
Dividend proxy: $1.9 B
Pension proxy: $1.4 B
Refinance proxy: $2.5 B
Market Value/Fair Value Zone
Source: 10-K Reports, $ billions.
Is “Book Value” vs. “Market Value” an Issue?
2016 data from US-based company, noting the valuation methods in place for remediation and pension liabilities; if the identical remediation cash flows were evaluated with actuarial pension or other approaches, market value would be 3x to 5x higher.
© 2017 Environmental Risk Communications, Inc.
Example of Fair Value Volatility2014: @ $100/barrel
Takeaway: an asset that is operating profitably in 2014 can justify a small (present value) ARO:-Indefinite “date of settlement”-Unknown future cleanup levels-Unknown future source (soil, GW)
Decommissioning or sell off an unprofitable asset in 2016, the ARO is revalued using:-Immediate settlement-Based on current cleanup regs-Based on today’s source knowledge
six mon
ths
Fair value of ARO
Fair value of operating asset
Fair value of ARO
Fair value of operating asset
2015: @ $50/barrel
$5MM ($.5MM)$2MM
($3MM)
© 2017 Environmental Risk Communications, Inc.
ERCI’s FAQ on Fair Value Measurement
Statement ERCI’s ReplyFVM applies to valuing assets, like our pension plan investments
FVM applies to liabilities, too. And not just financial instruments.
Our reserve policy generally treats Remediation Liabilities (ASC 410-30) as Contingencies (ASC 450)
Not mandatory, but FVM applies to Contingencies, too.
Our environmental reserves pass audit every year
Common outcome, but what are the root causes of recent reserve increases? What do we know nowthat we didn’t know before?
Auditors never ask for this; our reserves are immaterial
A statement like “all Obligations, Commitments, Contingencies and Guarantees are at/near market value” needs reliable evidence.
Some answers are privileged and confidential
Balance compartmentalization, privilege with business needs.
© 2017 Environmental Risk Communications, Inc.
Divestitures: due diligence can uncover surprises Acquisitions: discounts must be reserved at close,
and THEN quickly reevaluated during “purchase accounting window” for fair value
Reserve is not current market value of liability “Don’t know what accounting does with our numbers” Multiyear budget ≈ reserve, which defaults to ≈ liability “I can’t explain the number in our SEC 10-K (20-F) report”
Reserve policy is pivot point; if FVM isn’t required. Or if auditors never ask….
ERCI Observations on FVM
© 2017 Environmental Risk Communications, Inc.
Useful to decisions and decision makers; eliminates surprisesGAAP Compliant: “relevant”, “faithful representation”GAAP Compliant: comparable, verifiable, timely, understandableFocuses spending on liability reduction (not deferral or remedy)Helps manage knowledge lossImproves execution on acquisitions and divestituresIdentifies portions of portfolio with long-term recoveries at risk (cost recoveries; counterparties)
Why Transition to Fair Value Measurement
© 2017 Environmental Risk Communications, Inc.
Objective: comply with the duty to display the obligation to management, and possibly to disclose
Build consensus for a Pilot Project Environmental, Legal, Audit, Treasury/CFO, Board
Conduct a Pilot FVM Evaluation Project Single division, plant, or asset type; <25% of company 90-day effort; use an FVM term sheet template;
Numerical: soil and groundwater volume, cleanup goal(s), unit costs Timeline: deadlines, constraints Scorecard: Level 3 answers moved to Level 2; Level 2 to Level 1
For validation, perform “market testing” on select site(s) Ask a vendor to validate a market price to take over a liability Compare terms and lifecycle costs
How to Efficiently Transition to FVM (1 of 2)
© 2017 Environmental Risk Communications, Inc.
Variable Level 1/2/3 inputs: site-specific conditions, KPIs, unit costs
FVM Level
Income Impact
A. Lifecycle cost projection 12 years pump & treat, 10 gpm from 5 wells, three pore volumes of 19 acres
2 -$5.5 million
B. Contingencies for changes to scope, schedule and vendor
25% cost increase for fourth pore volume, doubling well count (to 10) in years 8-12
2 -$1.2 million
C. Premium for full/partial strategy failure
Additional ten years pump & treat for fifth and sixth pore volume
3 -$3.8 million
D. Premium for project management 12 years oversight, legal, contracting, cost recovery work 2 -$2.8 million
E. Premium/discount for counterparty risk
Successor owner has diesel generator onsite; credit rating 620
1 -$1.5 million
F. Premium/discount for your company’s own ability to pay
Fortune 200, credit rating 1085 1 +$0.5 million
G. Insurance for cost cap, etc Self-insuring all cost escalation, reopeners 3 +$0.0 million
H. Income for brownfield Ground lease $500K/yr to 2025 2 +$5.0 million
I. Recovery - current/future costsAsserted and unasserted claims
50% recoverable under Federal contract20% recoverable from legacy owner
2 +$7.4 million+$3.0 million
J. Recovery – sunk costsAsserted and unasserted claims
50% recoverable under Federal contract20% recoverable from legacy owner
1 +$0.5 million+$3.0 million
K. Value of deferred tax assets 30% of items A through F 1 +$4.3 million
Fair Value Components Total OutflowsInflows
Net
-$14.8 million+$23.7 million
+$8.9 million
Fair Value Term Sheet (Reserve = A to F)
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How to Efficiently Transition to FVM (2 of 2) Conduct Post-Pilot Evaluation, make final decision
Develop business case for analyzing full portfolio Confirm cost/benefit for level 3, 2 and 1 answers Determine governance and frequency of deep-dive updates
Niche valuation experts or internal staff Three to five year cycles to bridge staff turnover, knowledge loss issues
Develop key performance indicators, phase-in schedule Implement, refine transition plan
Review 20%-33% of portfolio annually (3-5 year cycles) Rebuild forecasts, especially after major transactions Confirm type and approach for each liability (GAAP terms are obligation,
commitment, contingency, guarantee) Reclassify funding type as needed (ARO, OPEX, CAPEX, reserves)
Rebuild exit strategies Reduce the liabilities (“work it down”) Evaluate captive insurance (“fund it, isolate it”)
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Best Practices in FVM Train everyone to use ASC 820, GASB 72, IFRS 13 Project managers Key external consultants Corporate leadership, asset managers, property managers Auditors Counsel
Build term sheets Use term sheets to build watch lists, even for sites with
no budgets -30%/+50% accuracy Pro/con of projects and current strategies (“what has to go
right” “what can go wrong”) Factor in strategy failure (starting over), in-kind services Include sites that are “done”, “new”, “sold”, “never studied” Include counterparty risk (% allocation grows)
© 2017 Environmental Risk Communications, Inc.
Presenting Fair Value Measurement Metrics
$ millions 2017 2016 2015A. Portion at Level 1 $21 $13 $8
% of total 15% 10% 5%
B. Portion at Level 2 $28 $19 $16 % of total 20% 15% 10%
C. Portion at Level 3 $91 $94 $136 % of total 65% 75% 85%
D. Sum $140 $125 $160 % of total 100% 100% 100%
Metric #1: this dollar value keeps dropping
Metric #2: this share keeps dropping
© 2017 Environmental Risk Communications, Inc.
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
Source: 10-K Reports, $ billions.
Can Progress Be Monitored? ASC 410-30 Example
“likely” accounting definition
Takeaway: while a “probable and reasonably estimable” reserve policy may show spending does not impact the liability, using other metrics may show successful liability burndown.
© 2017 Environmental Risk Communications, Inc.
Summing Up Fair Value Measurement
What is at Risk Misallocating capital (people, money, reputation, attention) Not complying with GAAP
What Can Improve Is there a large gap between book and fair value? Do cost recoveries capture full life-cycle costs? Does spending match liability reductions? Are we discharging booked liabilities at the best rate? Are our asset retirement obligation forecasts appropriate given
the current size of our asset base?
© 2017 Environmental Risk Communications, Inc. 27
Next Steps
Website: www.erci.com
LinkedIn Group – webinar announcements
YouTube page – select webinar recordings
Email [email protected] or call (510) 548-5570 PDF of this presentation (original PPTX format on request)
December 2016 webinars on Calculating Environmental Liabilities Calculating and Managing Environmental Counterparty Risk Presenting and Disclosing Environmental Liabilities Fair Value Measurement for Environmental Liabilities