Dec2016 - Fair Value Measurement for Environmental Liabilities

© 2017 Environmental Risk Communications, Inc.

Contact:

John Rosengard(510) 548-5570

www.erci.com

Fair Value Measurement for Environmental Liabilities

December 2016


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.


Outline

Fair Value Definition, GAAP Citations

Mandatory and Optional Application

Calculation Options

Examples of Discrepancies

Justification and Path for Adoption

Q&A


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


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


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


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


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


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


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


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


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


Quiz: Name the Source of This Disclosure

ARO

ERL1 ERL3

ERL2

Didn’t apply fair value Applied it


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


$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.


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)


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.


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


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


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)


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)


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”)


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)


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


$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.


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

Dec2016 - Fair Value Measurement for Environmental Liabilities

Documents

Transcript of Dec2016 - Fair Value Measurement for Environmental Liabilities