Today the financial world is up in arms over "toxic assets," the bad loans and securities that have wreaked so much havoc on bank balance sheets. But few investors understand the true magnitude of the threat that toxic liabilities — environmental liabilities, that is — pose to the financial health of some U.S. businesses. In large part that's because accounting rules enable companies to conceal the full extent of these costs, encouraging minimal disclosure — even when management knows the total bill will be far higher.
It's no secret that many companies have expensive toxic liabilities — asbestos, heavy-metal pollution, oil and gas leaks, contaminated groundwater, and more. Since the 1970s, Superfund and other laws have required companies to clean up their environmental liabilities and undo the damage they caused. Nor is the primary accounting guidance for toxic liabilities new. FAS 5, the accounting standard governing so-called contingent liabilities, such as pending litigation and environmental hazards, went into effect in 1975; Statement of Position 96-1, which tells firms how to apply FAS 5 to mandated environmental remediation, was issued in 1996. In brief, companies with toxic liabilities must take a one-time charge to earnings and create a reserve of funds devoted to environmental remediation. As a cleanup progresses, the reserve should shrink.
Yet companies are regularly topping up their environmental reserves with new accruals. Some reserves are even growing. In a recent study of 24 oil, gas, and chemical companies, the vast majority reduced their reserves less than 50 cents for each dollar spent on cleanup, says environmental attorney Greg Rogers, a CPA and president of consulting firm Advanced Environmental Dimensions. (See "The Truth about Reserves" at the end of this article.)
As a result, investors are left in the dark about the full extent of toxic liabilities. Rogers compares environmental reserves to a bathtub full of water: once the environmental problems are resolved, the tub should be drained. But by adding new accruals each year, companies are effectively leaving the faucet on. "What we don't know is the true capacity of the tub, the cost to fully resolve these liabilities," says Rogers, whose study attempts to estimate those costs using publicly available data.
Whatever a never-ending cleanup bill implies about actual damage done to the environment, such recurring drains on cash flow certainly hurt investors. "Unlike nearly every other income-statement line item, there is very little if any visibility into the annual charge for 'probable and reasonably estimable environmental liabilities,'" complained JPMorgan analyst Stephen Tusa, who downgraded Honeywell for this reason in 2006.
"It's Scandalous."
Companies typically cite three reasons why their legacy cleanup reserves never drain: the difficulty of estimating cleanup costs, new discoveries of contamination, or new costs acquired through mergers. At some companies, however, those claims are belied by the steady rate at which they funnel money into environmental reserves, suggesting, critics say, that managerial discretion plays a large part in reserve calculations. (One company, ConAgra, paid $45 million in 2007 to settle Securities and Exchange Commission charges that it used environmental reserves as a "cookie jar.") At best, the explanations mean that companies are themselves blind to a major internal drain on cash.
Despite what companies say, it isn't difficult to accurately estimate the future cost of environmental liabilities, asserts Gayle Koch, a principal with The Brattle Group in Cambridge, Massachusetts. Koch says her firm regularly does so for both corporate and government clients. "Companies estimate liabilities all the time for insurance recovery, to get insurance, for mergers and acquisitions, and in divestitures," she says. "Transactions go forward based on those estimates." The problem isn't the estimates, she says, but the disclosure.
"I've been in court cases where I've seen detailed cost recovery with very detailed distributions of costs," says Koch. "And those same companies will disclose in their annual reports [only] the known minimum cost."
Sanford Lewis, an attorney with the Investor Environmental Health Network (IEHN), an advocacy group, agrees that companies can and do produce accurate estimates of environmental costs — for internal use. A company that tells investors that it expects liabilities of $200 million during the next 5 years may advise its insurer to expect liability claims of $2 billion over a 50-year period, wrote Lewis in a recent report. "It is happening, it's scandalous, and investors should be outraged," Lewis told CFO.
Increasingly, lawsuits, bankruptcy proceedings, regulatory investigations, and independent research are revealing that companies often know far more about the cost of their environmental liabilities than they tell investors. For example, New York Attorney General Andrew Cuomo is currently investigating whether Chevron misled investors — including New York State's pension plan — about the extent of its liability in a $27 billion lawsuit tied to "massive oil seepage" in Ecuador. Chevron is widely expected to lose the case in Ecuador but fight payment in the United States, and Cuomo has demanded that the company disclose estimates of potential damages and its cash reserves.
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