Estimating and Disclosing Environmental Liabilities

© 2014 Environmental Risk Communications, Inc.

Contact:

John Rosengard(415) 336-5085

www.erci.com

Estimating and Disclosing Environmental Liabilities

February 2015 Call: (914) 339-0033Code: 443-350-915


Today’s Webinar Outline

Speaker Background

GAAP Framework

- ASC 410, GASB 49

Fair Value Measurement

Non-Performance Risk of Counterparty Default

Best Practices

Q&A


Speaker Background: John Rosengard

21 years at ERCI; founder/creator of Defender software suite

14 US corporate remediation teams [>60 audits]

3000 unique liabilities

200 decision analysis projects

4 US port authority remediation teams [>10 audits]

Counterparty credit tracking system

MBA, Northwestern; BS, Georgetown

…not an attorney or an engineer or a CPA


Elevator Speech

Environmental liabilities are significant and growing

Legacy and ongoing releases to soil, GW, sediments

More GAAP standards than ever

More environmental regulations than ever

More raw data than ever

Counterparties defaulting regularly

Reliably stating environmental liabilities is a challenge

Fair value is the trend

Legacy behaviors brought deferral, not extinguishment

We decided long ago that the dangers of excessive and unwarranted concealment of pertinent facts far outweighed the dangers which are cited to justify it. – John F. Kennedy, April 27, 1961


Legacy Behaviors: Liabilities not 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 million10-20-2010 $773 million for first six settlements12-14-2010 +$25.0 million settlement = $798.0 million3-3-2011 +$28.2 million settlement = $826.2 million3-7-2011 +$50.6 million settlement = $876.8 million3-29-2012 +$23.8 million settlement = $900.6 million6-29-2012 +$39.2 million settlement = $939.8 million

11 settlements = 3.2x reserve, three years

Source: USEPA press releases


$0.0$0.1$0.2$0.3$0.4$0.5$0.6$0.7$0.8$0.9$1.0

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Legacy Behaviors: Deferral v. Extinguishment

Source: Honeywell 10-K Reports

Spending = $3.3 billion over 18 years


FASB Conceptual Framework

Source: FASB Statement of Financial Accounting Concepts No. 8, September 2010

Enhancing Qualitative

CharacteristicsFundamental Qualitative

Characteristics

Objective of Financial Reporting

Information

Useful to Decisions

Relevant

Predictive value

Confirmatory value

Faithful Representation

Complete

Neutral

Free from error

Elements of Financial

Statements

Comparability

Verifiability

Timeliness

Understandability

Recognition

Measurement

Presentation

Disclosure

Cost Constraint

Materiality Constraint


High Level View of Environmental Liabilities

ObligationsASC 410

CommitmentsASC 440

ContingenciesASC 450

GuaranteesASC 460

Liabilities

Consent order to study and remediate a site

Promise to study and/or buy back a site if

contamination is found

Settlement to share past costs at a closed

landfill

Financial assurance instrument (LOC) to

regulator for performance of RCRA

monitoring

Asset retirement obligations


Key GAAP Sources

FASB: ASC 410, 440, 450, 460, 820

GASB: GASB Statements 18 & 49; draft on Fair Value

IASB: IAS 37, IFRS 13

SEC Regulation S-K (17 CFR 210 to 230)

Sarbanes-Oxley Act (2002)

Dodd-Frank Act (2010): Title IX, Subtitle I

PCAOB AU 336 (2011+)

PCAOB Audit Standards 5, 12, 15 (2011+)

ASTM E2137-06 Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters (2002, updated 2011)

ASTM E2173-07 Standard Guide for Disclosure of Environmental Liabilities (2002, updated 2011)

There is no substitute for reading these yourself

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High Level View of GAAP

Domain FASB GASB IASBFor… US Corporations Government

AgenciesNon-US Corporations

Environmental Obligations

ASC 410Oct1996

GASB 49Nov2006GASB 18Aug 1993

IAS 37Sep1998IFRIC 1

Fair Value ASC 820 -Sep2006

GASB 72Feb 2015

IFRS 13 –May2011

Commitments ASC 440 Note disclosure IAS 16Contingencies ASC 450 GASB 10 IAS 37Guarantees ASC 460 GASB 70 IAS 39Nonperformancerisk of counterparty default

ASC 820-10-35-17 and ASC 410-30-30-7

GASB 72¶ 62

IFRS 13:42


ASC 410 Environmental Obligations & AROs

July 2009 Codification of GAAP

AICPA SOP 96-1 Environmental Remediation Liabilities

FAS 143, FIN 47 Asset Retirement Obligations

…and others

Obligations are distinct from commitments, contingencies and guarantees

Recognition benchmarks (3 for ARO, 6 for EO)

Preference for “expected value” basis Weighting different outcomes (such as technology) Factoring in remedy failure Adding in corporate overhead, working capital Including nonperformance risk of counterparty default …and a risk transfer premium


GASB 49 Pollution Remediation Obligations

Issued November 2006

Obligations are distinct from contingencies and guarantees

Recognize based on five “recognition benchmarks”

Update valuation based on five “obligating events”

Current value: no inflation, no discounting

Preference for “expected value” basis Weighting different outcomes (such as technology) Factoring in remedy failure Adding in overhead, working capital Including nonperformance risk of counterparty default …but normally no risk transfer premium


ASC 820 Fair Value Measurement

FASB 157 issued September 2006, ASC 820 in July 2009

Fair Value = “current market price” between similar owners, in an “orderly market”

Level 1 (preferred): quoted price, active market, identical liabilities

Landfill space for Class C waste is $84.50/ton

Level 2: some observable inputs, less-active market, similar liabilities

Operating a 20-gallon/minute groundwater extraction system has an annual utility cost of $8K to $10K

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


Fair Value Fluctuation

six months

Fair value of environmental restoration cost

Fair value of operating asset

Fair value of environmental restoration cost

Fair value of operating asset

@ $100/barrel

@ $50/barrel

Takeaway: an asset that is operating profitably in 2013 can justify a small (present value) cost for restoration:-Indefinite “date of settlement”-Unknown future cleanup levels-Unknown future source (soil, GW)

Decommission or sell off an unprofitable asset in 2015, the environmental costs are:-Settled now-Based on current cleanup regulations-Based on today’s source knowledge

$5MM ($.5MM) $2MM ($3MM)


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


No two EO/ARO/PRO liabilities are alike

$0.0$0.5$1.0$1.5$2.0$2.5$3.0$3.5$4.0

$0.0

$1.0

$2.0

$3.0

$4.0

1 2 3 4 5 $0.0

$1.0

$2.0

$3.0

$4.0

1 2 3 4 5

Implementation Risk Counterparty Risk Reopener Risk

Conditions: typical cleanup on owned site

Conditions: counterparty default triggers liability reversion to us

Conditions: remedy goals redefined by regulator, while counterparty fails

Vend

or Q

uote

Rem

edy

Failu

re

Proj

Mgm

t

Cou

nter

party

Fair

Valu

e

Vend

or Q

uote

Rem

edy

Failu

re

Proj

Mgm

t

Cou

nter

party

Fair

Valu

e

Vend

or Q

uote

Rem

edy

Failu

re

Proj

Mgm

t

Cou

nter

party

Fair

Valu

e


Non-Performance Risk of Counterparty Default

ASC 410-30-30-1(b) Assess the likelihood that other potential responsible parties will pay their

full allocable share of the joint and several remediation liability.

ASC 410-30-30-7 An entity should assess the likelihood that each potentially responsible

party will pay its allocable share of the joint and several remediation liability. That assessment should be based primarily on the financial condition of the participating potentially responsible party. This assessment requires the entity to gain an understanding of the financial condition of the other participating potentially responsible parties and to update and monitor this information as the remediation progresses. The entity shall include in its liability its share of amounts related to the site that will not be paid by other potentially responsible parties or the government.

Key Takeaways: this is not newapplies beyond CERCLA; ASC 410-30-30-7 is the exact same language

as SOP 96-1, ¶ 6.20 (1996)

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FASB: ASC 820-10-35-17 The fair value of a liability reflects the effect of nonperformance risk.

Nonperformance risk includes, but may not be limited to, a reporting entity’s own credit risk. (continues)

FASB: ASC 820-10-35-18 When measuring the fair value of a liability, a reporting entity shall take

into account the effect of its credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled. (continues)

GASB: GASB 72 ¶62 The fair value of a liability reflects the effect of nonperformance risk.

Nonperformance risk includes, but may not be limited to, a government’s own credit risk. Nonperformance risk is assumed to be the same before and after the transfer of the liability. When measuring the fair value of a liability, a government should take into account the effect of its credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled. (continues)

GAAP on Non-Performance Risk

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Who Are Counterparties?

Any party who retained some or all of an environmental liability (EO, ARO, PRO) related to one of your assets Successor property owners or tenants Predecessor property owners or tenants Joint venture partners; working interests PRPs on a multiparty site cleanup; their insurers State or Federal agencies funding “orphan share” allocations

Landfills accepting new waste from your current projects Landfills which accepted wastes from your projects in the past

Any multiparty sites where you are the PRP group “banker” and contracting agent

Contractors on fixed-price contracts Sureties providing financial assurance bonds Banks issuing financial assurance letters of credit Insurers backing your remediation contractors with cost cap

insurance, workmen’s comp, commercial/general and automotive liability coverage


How to Measure Nonperformance Risk

Dun & Bradstreet and Standard & Poors each provide several scores to convey short-term and long-term “ability to pay”. Not all large companies are scored alike (June 2014 scores):

0 10 20 30 40 50 60 70 80 90 1001 FSS Class 2FSS Class 3FSS Class 45


Nonperformance Risk Calculation

Five PRPs, all have 20% share

$10 million in future costs over ten years

Random mix of credit ratings, ours is FSS Class 1 (best)

Recalculation of reserve:+$2,000,000 cash calls+$1,744,273 EV of default by the other four parties (range $0 - $8M)- $ 152,993 EV of our own default (range $0 - $2M)=$3,591,280 [80% higher than original $2M]

$1,744,273 ($152,993)

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What Mitigation Steps Can You Take?

Identify Your CounterpartiesKnow when insurance, purchase/sale terms & conditions expireRevisit full list every three years, add new transactionsDon’t assume everyone knows

Track the CounterpartiesPerform a credit check every 90 days, supplement with a review of

stock prices, GoogleAlerts, your company’s credit limit with this counterparty, anything and everything

80% of business exits are non-bankruptcy “dissolution”Know which entity is your counterparty; don’t assume your Fortune 500

counterparty has retained liabilities in-house and/or perpetually

Act on What You LearnDocument successors/assigns changesNegotiate cash-out or cash-in to unwind the relationshipReward and recognize liability prevention internally


Takeaways on Nonperformance Risk

The rich get richer…while the poor get poorer PRPs in top quartile of creditworthiness tend to remain there PRPs in other credit classes tend to last 10 years or less

Time is money Delays create nonperformance risk (“musical chairs”) Delays come from negotiation of allocation, lack of regulatory

enforcement, rescoping of remedial investigations Consequence is material: 50% of a typical PRP group is gone in

7.5 years Risk is concentrated in smaller PRP groups (2-5 parties) Any group can lose a any PRP any year

You can’t have it both ways If your reserve is zero because of a counterparty, your reserve

value of $0 depends on them not defaulting

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Coming Soon to Environmental Liabilities?

Language from recent FASB and IASB drafts on credit losses

Estimates of lifetime losses must consider: all relevant, reasonable, and supportable information, a range of possible outcomes, and the time value of money.

Source: FASB Proposed Accounting Standards Update: Financial Instruments (Topic 825-15) – Credit Losses, released for comment May 2013


Reminders: Questions Auditors Can Ask

About the forecasts… Independent of stakeholders (P&L unit, vendors)?

Peer reviewed?

Bracketed w/consistent confidence intervals (p10 to p90)?

About the weighting of scenarios… Pro/con documented; based on similar liabilities?

Confidence of success and backup plan

Do users understand the procedures and tools?

About the sites… Are any estimates more than 12 months old?

Would a buyer’s due diligence would show unreserved investigation or remediation costs >$1 million?

Does “lack of enforcement” alone bring reserve to $0?


PCAOB Audit Standard 15: Audit Evidence

15.4 to 15.6 – is there sufficient audit evidence

15.8 – is audit evidence reliable

15.10 – is company’s data sufficient and appropriate

15.11 to 15.12 – five categories of assertions; are there misstatements: Existence or occurrence Completeness Valuation or allocation Rights and obligations Presentation and disclosure

Effective for fiscal years after 12/15/2010


PCAOB AU 336: Using the Work of a Specialist

336.08 – auditor should evaluate specialist’s qualifications

336.11 – auditor should determine if the specialist’s objectivity is impaired, act accordingly

336.13 – auditor should determine if the financial statements and specialists’ statements line up, act accordingly

Originally stated in SAS 73, effective 12/15/1994

AU 336 applicable after 12/15/2010


Reminders on Enforcement/Compliance

Overstating assets or understating liabilities is a crime Negligence, malfeasance Securities fraud Sarbanes-Oxley (2002)

SEC prosecuted Waste Management (2002)

Complaint 02C 2180 alleged $1.7B in inflated earnings 1992-97

The company “established inflated environmental reserves (liabilities) in connection with acquisitions so that the excess reserves could be used to avoid recording unrelated environmental and other expenses.”


Reminders on Enforcement/Compliance

SEC prosecuted Ashland Chemical (2006) Three employees filled out “code of conduct” questionnaire Admin Proceeding 3-12487 found $26M+ in improper

environmental reserve reductions in 1999-2001 SEC decided company and the remediation manager

personally violated Securities Exchange Act of 1934 Section 13(a) Reporting Violations Section 12(b)(2)(A) Recordkeeping and Internal Control

Violations

IRS prosecutes based on false statements If your organization issues financial

statements to investors, bondholders and/or the IRS, you must comply with GAAP


Best Practices

A. Recognition

Recognition Benchmarks

B. Measurement

Fair Value Measurement

Nonperformance Risk of Counterparty Default

C. PresentationReserve Display

Watch List

D. Disclosure

Elements of Financial

Statements

Recognition

Measurement

Presentation

Disclosure


Recognition Benchmark Review

ASC 410-30-25-15Identification and verification of an entity as a potentially responsible party.

Receipt of unilateral administrative order.

Participation, as a potentially responsible party, in the RI/FS.

Completion of feasibility study.

Issuance of record of decision

Remedial design through O&M, including postremediation monitoring.

FAS

B

(six

item

s)G

AS

B

(fiv

e it

ems)


Fair Value Term Sheet (Reserve = A through F)

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. Income for brownfield Ground lease $500K/yr to 2025 2 +$5.0 million

H. Recovery of current & future spending

•Asserted claims•Unasserted claims

50% recoverable under Federal contract20% recoverable from legacy owner

2+$7.4 million+$3.0 million

I. Income for sunk cost recovery•Asserted claims•Unasserted claims

50% recoverable under Federal contract20% recoverable from legacy owner

1+$0.5 million+$3.0 million

J. 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


Best Practices in Lifecycle Cost Measurement

Point estimates

Expected values from modeling

sheet

User selects subtasks from

drop-down menus

Common WBS

Takeaway: WBS separates costs for study, remediation, O&M, overhead and legal costs; recovery rates (%) apply to one or more PRPs and insurers

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Best Practices in Measurement, Display

Common work breakdown structure for all sites in the portfolio Study, design, implementation, OM&M, legal, project mgmt

For costs >$100K, pinpoint Level 1 and 2 inputs “Four years OM&M after excavation concludes” “Groundwater P&T system based on two pore volumes; five-

year term, single flood event to reach 50gpm design requirement”

“25,000 cubic yards of soil, bulking factor of 1.25 due to high sand ratio, 83 miles to approved disposal facility”

Justification for revising the scenario weighting “Completed decision analysis exercise in June 2016” “Reweighted the three scenarios after the community advisory

board meeting in August and email exchange with regulator in September 2016”

“Operating plant asked that closure construction be synchronized with turnaround project X, now scheduled for Q4-2017”


Capitalizing Liability Spending

If spending has no current operations or assets, skip this analysis

Capitalize where spending: Increases the asset base Extends the useful life of an asset Decreases the OPEX of an asset

Test: is there a “return” on the incremental spending on the company-owned asset?

Preparing an asset for sale requires professional judgment


Why Capitalize Environmental Spending?

Investment tax credit eligibility Loan/grants eligibility Offset to regulated/mandated spending Complies with GAAP

Matching principle Matches spending to benefits of the

mitigation work


Best Practices: Reserve DisplayEnvironmental Reserve 2014 2013 2012

Opening Reserve Balance [Liability] 700 800 800+ Reserve Increases [New Sites] 0 50 100+/- Updated Estimates [Existing Sites] 0 50 100- Spending (200) (200) (200)= End of Year Reserve 500 700 800

Loss Contingencies [see next page] 1250 1400 1500

Opening Recoveries Balance [Contra Liability] 200 200 200+ Recoveries Recognized 100 100 100- Recoveries Received (100) (100) (100)= End of Year Recoveries 200 200 200

Recoveries Contingencies 100 200 300

Clear Trend

Correlation is clear

Correlation is clear

Good downward trend

Good downward trend

ASC 820-10-50-2 makes disclosure of this data mandatory.37


Best Practices: Watch List Display

Reserves are the visible portion of environmental liabilities

The “watch list” is the portion below the waterline

The waterline is set through consultation with auditors, board members and senior management

Reserve + watch list = full liability

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Site Recognition Trigger Prob Low Value

Expected Value

HighValue

Timing

Site 1 CAMU size and installation year 100% 28 40 60 3/31/2014

Site 2 Remedy selection: SVE for 10 years 100% 7 10 15 2014-2015

Site 3 √ Insurer denies coverage 50% 49 70 105 1/1/2015

Site 3 30% design of soil removal 20,000 MT (lead) 50% 35 50 75 2016-2018

Site 4 Scope of investigation 100% 3.5 5 7.5 1/1/2014

Site 5 NRDA claim/damages 80% 7 10 15 2015-2018

Site 5 √ 25% PRP defaults 33% 21 30 45 7/1/2016

Site 5 Remedy selection for 195,000 MT (solvents) 100% 28 40 60 7/1/2016

Site 6 Spill excavation, pipeline areas A-1 to C-10 100% 14 20 30 2015-2016

… Others… … 975 … …

Sum of Loss Contingencies 1250

Best Practices: Watch List v1

Takeaways It displays “reasonably possible” reserve changes Site-specific Clear “recognition benchmark” or “obligating event” for tracking Range of costs, range of timing This table is described in ASC 410-30-50-9 as “disclosures that are encouraged but not required”

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Best Practices: Watch List Display

Watch List v2Recognition Trigger Amount prob% Date

Change order for excavation $ 100,000 99% 10/1/2014Remedy fails, new remedy $ 4,000,000 50% 10/1/2015Counterparty defaults on new remedy

$ 4,000,000 20% 10/1/2015

GW P&T add'l 5 years $ 1,000,000 80% 7/1/2015GW P&T add'l 5 years $ 1,250,000 75% 7/1/2020GW P&T add'l 5 years $ 1,500,000 70% 7/1/202520% counterparty fails by 2020 $ 1,000,000 20% 7/1/202010% counterparty fails by 2015 $ 1,250,000 40% 7/1/201510% counterparty fails by 2020 $ 1,500,000 75% 7/1/2020

OU-2 final remedy $ 5,000,000 90% 12/31/2016OU-2 remedy @5 ppb PCBs $ 15,000,000 50% 12/31/201635% counterparty fails $ 5,000,000 40% 1/1/2016Deminimis not pursued $ 1,000,000 80% 4/30/2015

Remedy fails, new remedy $ 2,000,000 33% 10/1/2015Insurer denies coverage $ 6,000,000 15% 10/1/2015

JV partner fails, four sites revert, RCRA closures

$ 12,500,000 35% 10/1/2020

Insurer for JV denies coverage $ 12,500,000 50% 12/1/2020

Landfill operator CH11, 11 NPL sites $ 20,000,000 35% 9/1/2018Counterparty pool shrinks $ 10,000,000 60% 9/1/2018

Low-profile strategy fails $ 2,500,000 33% 9/1/2017

Non-performance on 10 AROs for asbestos, enforcement action

$ 10,000,000 60% 1/1/2020

Apply ASC 820 – Fair Value Measurement: “would your biggest competitor agree?”

Go beyond time constraints of reserve horizon

Factor in counterparty risk of default ( )

Show everything a peer would include as a premium

Success metric: everyfuture reserve increase will come from this list


Summing Up

GAAP GAAP is comprehensive, evolving Your reserve policy, tools and training might not apply “fair value” or

“counterparty risk” yetRecognition and Measurement Use Fair Value Measurement Avoid “probable” & ”reasonably estimable”: works against “relevant”

and “faithful representation” Know your counterparties; treat nonperformance risk like any other

environmental riskPresentation and Disclosure Rethink reserve policies and procedures, tools, training Develop and display a Watch ListRemember GM, Honeywell case studies is your reserve at fair value today?


Next Steps

Website: www.erci.com

LinkedIn Group, Facebook page, YouTube page

Email [email protected] Link to on-demand webinars @ YouTube (audio + video) PDF of this presentation (original PPTX format on request) Where to find ASC 410, GASB49, ASTM, IAS37

February 2015 webinars on Fair Value Measurement Estimating and Disclosing Environmental Liabilities Auditors Tough Questions on Environmental Liabilities

March 2015 webinars on Managing Nonperformance Risk of Environmental Counterparties Obstacles to Recognizing and Measuring Environmental Liabilities

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