Growth strategy and M&A Environmental issues impacting strategic decisions

Deloitte Forensic Center

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Environmental challenges: The new paradigm

Business concerns over operational and financial risks are becoming more tangible as access to emerging markets, key raw material inputs, operating permits, and capital loans are being influenced by environmental and social performance. Over the past several years, momentum has been building due in part to:

• Global trends associated with population growth, consumption, emerging markets, and local infrastructure development requirements

• Recognition of natural resource constraints that are driving supply and demand imbalances, such as energy, water, and agricultural commodities

• Increasing regulatory activity including new regulations, stringent conditions for granting permits, alignment of regulatory agencies to increase coverage of inspections, and taxes

• Catastrophic events resulting in unprecedented environmental and economic damages

• The financial and economic crisis and its implications on the drive for transparency and governance by environmental and financial regulators, investor groups, and shareholders

Corporate boards and senior management are being challenged to better identify, understand, assess, price, and manage the risks associated with their companies’ operations. Given the developing regulatory environment and global dynamics, it is difficult to predict or control how environmental performance expectations will evolve amongst regulators and stakeholders. However, companies should be positioning themselves to anticipate the drivers of regulatory and stakeholder expectations, to consider their alignment to business priorities, and to evaluate the company’s readiness to respond to the implications of environmental performance as it relates to operations, brand image, compliance structures, and even company valuations.

As companies develop their plans for growth in an unsettled economy, environmental issues are playing a bigger role in determining strategic growth options, capital allocation decisions, and the ability to carve-out or sell an entire business or its assets. In this article, we discuss how regulatory and enforcement trends are evolving, their potential impact on business strategy, operations and entity valuation, and what companies can do to align their management of environmental exposures with their strategic decision making.

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Regulatory activity may be broadly described as responsive to stakeholder demands in the areas of natural resource scarcity, producer responsibility and transparency, and governance. In response to investor coalitions that were concerned that disclosures of environmental risk were inadequate, the U.S. Securities and Exchange Commission (SEC) and the U.S. Congress have issued mandates directed at more rigorous corporate governance practices. These have resulted in expanded disclosure obligations and new measurement requirements, which have evolved from historical costs to fair market values, including those associated with environmental liabilities.

This regulatory activity may have operational implications, some with lead times longer than product development cycles. Examples include requiring companies to:

• Eliminate or substitute for harmful or toxic materials used in products and services

• Manage production waste or the collection and recycling of products at the end of their life

• Install pollution control equipment so costly that some entities have decided to retire assets rather than invest to meet the compliance requirements

Additionally, regulators have stepped up enforcement activity and stringency. Historically, there were circumstances where the cost of noncompliance was not significant, reducing the incentive for compliance. Now, regulators are focusing on sectors and companies with a history of noncompliance, issuing significant penalties, and taking injunctive measures.

Regulators are also using the permit approval process, for both new developments and renewals, to achieve environmental performance objectives. In recent years, certain companies have been precluded from entering into geographic markets or have been unable to pursue new project development due to increased stringency in agencies’ processes for granting permits.

A company’s environmental strategy should not be merely a reactive response to financial or regulatory threats. As environmental expectations and performance requirements develop, companies can move from short-term risk avoidance and regulation compliance to long-term development of brand, and competitive and operational advantage. Proactive environmental management presents an opportunity for companies to differentiate themselves as leaders in the industry, the environment, and society, supporting long-term business success.

Regulatory and enforcement trends

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Strategic shift and the macro landscape

Many of the elements that drive environmental risk — such as regulation, public sentiment, and resource constraints — are usually outside the entity’s control. Companies are increasingly questioning whether their infrastructure is sufficient to manage environmental risks and opportunities, both inside and outside of their four walls. Major incidents have demonstrated that liabilities associated with environmental performance may not be limited to the actions of company employees, but may extend across the supply chain and encompass the activities of business partners as well. When assessing the applicability of their environmental infrastructures, companies should consider if they have the right roles, responsibilities, policies, and procedures in place to manage environmental risk internally and externally — across the value chain.

The regulatory environment and determining potential liability are two common concerns for executives. Boards and management should consider the efficacy and desirability of their current environmental practices. This involves weighing the force of these drivers against their impact on the company’s business priorities, its environmental footprint, operational considerations, and the cost of compliance. Specific considerations include whether outsourcing certain activities remains a useful practice or presents excessive risk if management may ultimately be held accountable for the results.

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Implications for business strategies

The significance of the above changes may require boards and management to explore some thought-provoking questions including a rethink on their core strategy, assessing the effectiveness of established accountability, determining whether their current environmental risk management infrastructure is sufficient to manage the business, and if there is an effective platform for assessing and valuing environmental risks and opportunities.

Strategic flexibility may be required to incorporate health, safety and environment (HS&E) not only into the context of risk mitigation and management, but also into a company’s evaluation of its economic imperatives. For instance, some oil and gas companies may need to reassess the scope and viability of their U.S. offshore operations, as it may become uneconomic for some companies to operate there given the potential for increased insurance and regulatory costs. Others, however, may find opportunities to buy assets from those with less substantial balance sheets.

It is also important to develop protocols and decision points to identify and respond to changes in the risk profile or the environment. It is imperative for HS&E processes and procedures to be dynamic, with a mechanism for noting changes during operations that are indicative of an increasing likelihood of an operational incident occurring.

Today, leading companies are tackling this dilemma by employing dynamic modeling to support decision making and to assess the effectiveness of operations. This method can enable companies to consider multiple projects in light of alternative scenarios and strategic responses. It can also provide the ability to capture risk factors and interdependencies across several projects and time horizons.

Targets of environmental enforcement activities may be increasingly disadvantaged in the marketplace.

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Financial implicationsFrom the financial and capital planning perspective, challenges emanating from environmental exposure include potential asset impairment and shortened economic lives. Expected profitability may be lowered by unforeseen costs or cash flow risks such as the cost of additional capital equipment to reduce pollution, volatile commodity prices, and potentially increased operating costs arising from new mandatory procedures. Companies may want to revisit their funding mechanisms to assess their financial flexibility in case of an unanticipated obligation because of regulatory or enforcement actions.

Companies should also consider bringing enhanced transparency in reporting environmental liabilities and disclosing their environmental objectives and performance to their stakeholders; not doing so may have significant impact on share price and market value.

On the other hand, companies that choose to address the environmental opportunity through a disciplined and structured approach may reap the rewards of increased returns (such as energy and water operational efficiencies) and tax incentives.

M&A strategyEnvironmental issues can have a significant impact on strategic growth options and the ability to carve-out or sell an entire business or its assets. Companies looking for acquisitions should be aware that environmental value opportunities will vary by sector, geography, and business. Also, before going on an acquisition drive, an evaluation of priority markets and strategic assets can help determine specified rate of return requirements and where environmental performance may influence deal multiples and create performance synergies.

Those looking to make divestitures may want to address issues related to environmental exposures that can have a significant impact on positioning a business for sale. Companies can mitigate these risks by enhancing the management of exposures, segmenting products, services, operations, and facilities within their portfolio by risk profile, creating processes designed to monitor and mitigate risk and future exposures for each site, and engaging in proactive stewardship of key assets. Such an approach can equip companies with more readily accessible information relating to risk management efforts and help resolve issues identified during the prospective buyer’s due diligence.

An important question companies should be asking today more than ever is how do environmental risks and opportunities impact key valuation metrics and deal structure?

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Assessing environmental risks

Applying an enterprise-wide perspective to the assessment and monitoring of the HS&E control framework and performance allows systemic or intangible issues — such as managerial tone and operating culture, or issues associated with reporting structure and information flow — to be more easily identified. Integration of environmental and financial controls framework provides for common risk assessment and management approaches.

For many companies, this is likely to be a complex undertaking. Merely determining the factors that shape HS&E risks and performance requires assessing the influence of multiple constituencies. These constituencies can include shareholders, regulators, vendors, customers, joint venture partners, employees, and the general public, among others. A broad perspective is necessary to understand the far-reaching effects of environmental risks and performance across a business or over the entire lifecycle of an investment. Once these impacts are identified, companies can consider how their strategic priorities and operating models may need to change in light of them. In particular, they might want to take a lifecycle view to environmental exposures and valuing them according to their true lifecycle costs.

Today, the markets are increasingly demonstrating a similar approach to environmental exposures — where contaminated property, exposure to increased operating costs due to regulatory requirements, and dependency on natural resources are increasing the cost of capital or are being factored into the attractiveness of investment opportunities. Such an approach may significantly increase the focus on those sustainability activities that create a higher return on invested capital or create more value.

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Potential actions to consider

To help accomplish their strategic growth objectives and align management of environmental exposures with their company’s overall strategy, executives should consider:

• Identifying the impact of environmental performance on strategic growth, access to capital markets, and competitiveness (cost efficiency)From an investor’s standpoint, the issues and opportunities presented by environmental exposures are not only becoming a factor in strategy development and influencing buy/sell decisions transacting; they have become integral to managing the day-to-day operations of the companies. Applying a strategic, structured approach that balances growth aspirations as well as sustainability considerations may help boards give appropriate priority to different projects and assist management in allocating time efficiently. It may also position the business to meet both public expectations and government requirements for environmental exposure. Equally important, such an approach may provide a foundation to use sustainability as a business growth driver, where leading sustainability practices are applied across various business units both locally and globally.

• Embedding environmental considerations in capital planning and budgetingBusiness concerns over operational and financial risks are mounting since environmental and social performance is impacting access to emerging markets, operating permits, and investment capital. Availability and price volatility associated with key raw material inputs such as natural gas and water are presenting commodity risks, and businesses are achieving cost savings through reducing their outputs (such as wastes and by-products) as well as their dependence on inputs.

The importance of weighing environment-related risks and opportunities in capital planning decisions is intensifying. Influencing factors include the changing global economic environment and corresponding demand and supply imbalances, as well as high-profile events — from product recalls to industrial accidents. A refreshed approach to capital budgeting decisions when investing in technologies and processes that reduce consumption and waste can help improve overall return on investment in environmental policies.

• Factoring environmental issues into strategic buy/sell decisionsForward-looking business leaders understand that environmental issues may present an opportunity for both risk management and value creation. They also know that there are infrastructure constraints that extend beyond the scope of a company that is looking to restructure its business by acquiring or carving off some of its assets. Which environmental risks or opportunities can affect a company’s value? Which should be targeted first? Where are the early successes and differentiators, and where are the significant risks that should be managed or mitigated? Answering these questions can help companies not only leverage the competencies, but redefine performance expectations of the new entity as a result of M&A. Certain externalities may only be addressed through collaboration with non-traditional business partners including the government, supply chain partners, and even competitors. Business sectors that are engaged in joint ventures that seek to reduce contractor-related risks might consider implementing environmental and social contractor performance requirements in advance of formal regulatory requirements.

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Conclusion

Environmental and the broader sustainability performance is an important business issue that is increasingly impacting strategic business decisions. There is a compelling financial, regulatory, and marketplace opportunity to evolve a company’s business models to mitigate environmental risk and enhance opportunity. Significant value can be attributed to proactive and effective environmental performance and this is likely to increase given the new price on risk. For companies, there is a very real opportunity to seize a leadership position in environmental performance management that enhances overall business performance.

Deloitte Forensic CenterThe Deloitte Forensic Center is a think tank aimed at exploring new approaches for mitigating the costs, risks and effects of fraud, corruption, and other issues facing the global business community.

The Center aims to advance the state of thinking in areas such as fraud and corruption by exploring issues from the perspective of forensic accountants, corporate leaders, and other professionals involved in forensic matters.

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Deloitte Forensic Center

The following material is available on the Deloitte Forensic Center website www.deloitte.com/forensiccenter or from dfc@deloitte.com.

Deloitte Forensic Center book:• Corporate Resiliency: Managing the Growing Risk of Fraud

and Corruption– Chapter 1 available for download

ForThoughts newsletters:• International Business Partner Due Diligence: How Much

is Enough?• Internal Investigation Costs: Securing Elusive Insurance

Coverage• The Tone at the Top: Ten Ways to Measure Effectiveness• Visual Analytics: Revealing Corruption, Fraud, Waste,

and Abuse• Anti-Corruption Practices Survey 2011: Cloudy with a

Chance of Prosecution? • Fraud, Bribery and Corruption: Protecting Reputation

and Value• Ten Things to Improve Your Next Internal Investigation:

Investigators Share Experiences• Sustainability Reporting: Managing Risks and Opportunities• The Inside Story: The Changing Role of Internal Audit in

Dealing with Financial Fraud• Major Embezzlements: How Can they Get So Big?

• Whistleblowing and the New Race to Report: The Impact of the Dodd-Frank Act and 2010’s Changes to the U.S. Federal Sentencing Guidelines

• Technology Fraud: The Lure of Private Companies• E-discovery: Mitigating Risk Through Better Communication• White-Collar Crime: Preparing for Enhanced Enforcement• The Cost of Fraud: Strategies for Managing a Growing

Expense• Compliance and Integrity Risk: Getting M&A Pricing Right• Procurement Fraud and Corruption: Sourcing from Asia• Ten Things about Financial Statement Fraud - Third edition• The Expanded False Claims Act: FERA Creates New Risks• Avoiding Fraud: It’s Not Always Easy Being Green• Foreign Corrupt Practices Act (FCPA) Due Diligence in M&A• The Fraud Enforcement and Recovery Act “FERA”• Ten Things About Bankruptcy and Fraud• Applying Six Degrees of Separation to Preventing Fraud• India and the FCPA• Helping to Prevent University Fraud• Avoiding FCPA Risk While Doing Business in China• The Shifting Landscape of Health Care Fraud and

Regulatory Compliance• Some of the Leading Practices in FCPA Compliance• Monitoring Hospital-Physician Contractual Arrangements to

Comply with Changing Regulations• Managing Fraud Risk: Being Prepared• Ten Things about Fraud Control

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Deloitte Forensic Center

Notable material in other publications:• How to Perform Due Diligence on International Business

Partners, WSJ Professional, April 2012• More Clues on SEC Whistleblower Office, Compliance

Week, February 2012 • Anti-Corruption Practices Survey Highlights Challenges

Facing Companies, Business Crimes Bulletin, January 2012• Execs Not Confident In Corporate Anti-Corruption

Programs, FinancialFraudLaw.com, January 2012• 10 Ways to Measure the Tone at the Top, WSJ

Professional, January 2012• So You Want to be a Multinational?, ChiefExecutive.net,

December 2011• Execs Lack Confidence in Anti-Graft Programs, Compliance

Reporter, November 2011 • Bounty Hunting: Will New Regulations Create a New

Incentive for Whistleblowers?, Perspectives (University of Illinois), November 2011

• The Hidden Risks of Doing Business in Brazil, Agenda, October 2011

• Use of Third Parties’ Seen as Leading Source of Corruption Risk, Ethikos, Sept/Oct 2011

• Smaller Companies Lag Behind in Anti-Corruption Programs Despite Escalating Enforcement Activity, EmploymentLawDaily.com, September 2011

• High Tide: From Paying For Transparency To ‘I Did Not Pay A Bribe’, WSJ.com, September 2011

• Executives Worry About Corruption Risks: Survey, Reuters, September 2011

• Whistleblowing After Dodd-Frank — Timely Actions for Compliance Executives to Consider, Corporate Compliance Insights, September 2011

• Corporate Criminals Face Tougher Penalties, Inside Counsel, August 2011

• Follow the Money: Worldcom to ‘Whitey,’ CFOworld, July 2011

• Whistleblower Rules Could Set Off a Rash of Internal Investigations, Compliance Week, June 2011

• Whistleblowing After Dodd-Frank: New Risks, New Responses, WSJ Professional, May 2011

• The Government Will Pay You Big Bucks to Find the Next Madoff, Forbes.com, May 2011

• Major Embezzlements: When Minor Risks Become Strategic Threats, Business Crimes Bulletin, May 2011

• As Bulging Client Data Heads for the Cloud, Law Firms Ready for a Storm, and More Discovery Woes from Web 2.0, ABA Journal, April 2011

• The Dodd-Frank Act’s Robust Whistleblowing Incentives, Forbes.com, April 2011

• Where There’s Smoke, There’s Fraud, CFO magazine, March 2011

• Will New Regulations Deter Corporate Fraud? Financial Executive, January 2011

• The Countdown to a Whistleblower Bounty Begins, Compliance Week, November 2010

• Deploying Countermeasures to the SEC’s Dodd-Frank Whistleblower Awards, Business Crimes Bulletin, October 2010

• Temptation to Defraud, Internal Auditor magazine, October 2010

• Shop Talk: Compliance Risks in New Data Technologies, Compliance Week, July 2010

• Many Companies Ill-Equipped to Handle Social Media e-discovery, BoardMember.com, June 2010

• Mapping Your Fraud Risks, Harvard Business Review, October 2009

• Use Heat Maps to Expose Rare but Dangerous Frauds, HBR NOW, June 2009

This article is published as part of ForThoughts, the Deloitte Forensic Center’s newsletter series edited by Toby Bishop, the director of the Deloitte Forensic Center. ForThoughtshighlights trends and issues in fraud, corruption and other complex business issues. To subscribe to ForThoughts, visit www.deloitte.com/forensiccenter or send an email to dfc@deloitte.com.

AuthorsKathryn Pavlovsky is a principal in the Forensic & Dispute Services practice of Deloitte Financial Advisory Services LLP. Ms. Pavlovsky may be reached at kpavlovsky@deloitte.com.

Tron Allen is a senior vice president with Deloitte Corporate Finance LLC. Mr. Allen may be reached at trallen@deloitte.com.

Charles Alsdorf is a director in the the Business Valuation practice of Deloitte Financial Advisory Services LLP. Mr. Alsdorf may be reached at calsdorf@deloitte.com.

This publication contains general information only and is based on the experiences and research of Deloitte Financial Advisory Services LLP and Deloitte Corporate Finance LLC practitioners. Deloitte Financial Advisory Services LLP and Deloitte Corporate Finance LLC are not, by means of this publication, rendering accounting, auditing, business, financial, investment, legal or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.

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