The Environment Canada Policy Research Seminar Series

Dr. Robert Repetto November 17, 2003

On November 17, 2003, the Environment Canada Policy Research Seminar Series hosted Dr. Robert Repetto, who delivered a thought-provoking presentation entitled "Protecting Investors and the Environment Through Financial Disclosure". The following is a summary of his presentation.

In recent years, financial markets have paid greater attention to environmental issues. If channeled effectively, these emerging concerns could provide a key means of promoting environmentally friendly company behaviour.

Business managers closely monitor the way their companies are perceived in financial markets since a company's stock price will reflect these perceptions. Business decisions detrimental to the environment could result in future financial costs (e.g., clean-up costs, fines) which will ultimately be borne by shareholders. It has become evident that environmental risks can have large financial consequences for companies. For example, financial settlements resulting from the 1989 Exxon Valdez oil spill amounted to more than $U.S. 1 billion. To protect shareholder value, managers must control the financial risks a company faces, including those associated with potential environmental liabilities.

Investor Concerns

Mainstream investors have become highly concerned about the environmental risks facing the companies in which they hold shares since these risks could affect the returns on their investments. Such environmental risks could include not only costs associated with direct environmental damage, but also unresolved lawsuits, and the costs of compliance with future environmental regulations, including measures to address climate change.

This heightened importance of investor perceptions of the environmental performance of companies is being integrated into the mechanisms of financial markets. This is evident by the emergence and rapid growth of Socially Responsible Investing options in which pension and mutual fund managers screen the companies they include in their investment portfolios based on social or environmental criteria.

Insurer Concerns

Like investors, property insurers have been paying closer attention to the potential site clean-up costs for commercial properties. With disclosure rules expected to tighten in the future, property insurers are insisting that information be provided regarding the risk of incurring contamination costs.

Correspondingly, a pseudo price is effectively placed on contamination risks. Insurance companies are also paying close attention to the policy arena emerging around greenhouse gas emissions and other issues surrounding climate change.

Information Disclosure as a Policy Tool

With these new developments in financial markets, how can policy makers channel investor concerns into positive outcomes for the environment? Investors have the right to know how to accurately value companies. The disclosure of information about publicly traded companies has always been central to the efficient operation of capital markets. Unless market valuations accurately reflect the financial risks that companies face, securities will be mispriced and investors endangered.

The rules surrounding the reporting of risks facing a company should be consistent, whether due to, say, high debt loads, anticipated declines in customer demand, or high potential environmental clean-up costs. Permitting companies to withhold risk information runs counter to security trading rules and prevents investors from appropriately valuing companies.

Mandatory information disclosure, that is, requirements to provide information, could hold great potential as a policy tool to promote environmental protection and market efficiency. Among its advantages, information disclosure would reduce information asymmetries in the market which could potentially trigger financial market failures. Information disclosure for environmental risks might be perceived as a form of eco-labeling for investment. It would harness consumer choices and values to lead to more efficient and environmentally friendly company behaviour in a fashion analogous to eco-labeling requirements for organic foods or the energy efficiency of products.

The U.S. Environmental Protection Agency's Toxic Release Inventory provides an example of the effectiveness of information disclosure as a public policy instrument. It provides information to the public on toxic chemical releases and other waste management activities by covered industry groups. Citizen activists and community organizations educate their citizens or residents about toxic chemical releases using this information, often combining it with a call to action. Some community organizations have used this information to initiate discussions with local industries or to call on local and public interest organizations to lobby for their causes.

Linking Information to Environmental Performance

Information disclosure requirements need to be further developed, particularly in the financial community. Evidence generally indicates that markets reward companies with more transparent disclosure practices. To ensure sound use of disclosure requirements as an instrument for environmental policy, we need to analyze the link between disclosure and environmental performance in greater detail.

What type of information should companies be required to disclose? Legally, all material information must be promptly disclosed. Information is deemed to be "material" if it will likely affect the opinion of a reasonable investor regarding a company's financial value and the integrity of its management. There is no financial threshold in determining material information. At the same time, even a financially insignificant matter can be material if it reflects the integrity or competence of management. Within every company's portfolio, there is the overarching disclosure requirement to disclose all information necessary to make statements not misleading. Doing otherwise may result in government penalties or civil lawsuits.

In the U.S., the Securities and Exchange Commission (SEC) has identified disclosure requirements that apply specifically to environmental information. It is stipulated that, in Management's Discussion & Analysis, information must be disclosed if it will potentially have material impacts, even if there is uncertainty that the information will in fact have material effects. Examples of material environmental uncertainties that must be disclosed include proposed environmental regulations that may have financial impacts or unresolved environmental lawsuits. All of these must be disclosed, even though it is not certain that they will have material financial impacts, just possible.

Empirical Evidence

Some recent studies examined some environmental issues facing the oil and gas sector, including clean fuel regulation, marine transport risks and hazardous waste programs. Two main issues were examined: climate change and the adoption of the Kyoto Protocol, and constrained access to oil and gas reserves. In comparing the studies, there were significantly different results. A wide range of financial impacts would result in the case of full adoption and implementation of the Kyoto Protocol. However, only two companies disclosed climate change policies as a possible risk to future earnings in their SEC filings. Only three more mention climate change in their annual reports, with no mention of the financial implications that would result from climate change activity. Seven companies reported on their GHG emissions, but only in supplemental reports. In the electric utilities sector, few companies discussed the financial impacts of multi-pollutant cap-and-trade bills or carbon control.

Conclusion

With the increasing investor demand for environmental information, markets are rewarding companies that possess superior disclosure policies in their financial portfolios. However, despite the strong demand by the market, there are still areas where disclosure policies and practices can be further improved. For instance, there is the need for more clarification and guidance from securities agencies. In addition, there is the possibility for close liaison between the securities and environment agencies of governments, such as EPA and SEC cooperation in the United States. Such cooperation could enhance information provided to investors, stability of companies, and environmental stewardship.