A Quantitative Approach to Strategic Environmental Risk Management
Repetto, Robert, Austin, Duncan, Journal of Business Administration and Policy Analysis
The financial performance of modern business is increasingly affected by the costs and opportunities presented by environmental issues. Regulations, materials and energy prices, consumer demands, and the development of new markets may all be influenced by environmental concerns that thereby materially affect company earnings and balance sheets. Moreover, because the outcome of many environmental issues is unclear, environmental pressures create risks that companies must manage strategically. Yet, firms and analysts find it difficult to translate the potential impacts and risks of environmental issues into the financial terms required for business planning and valuation (e.g. UNEP, 1999). This paper presents a new methodology that enables managers and analysts to evaluate impending environmental pressures in terms of their impact on shareholder value and financial risk. These capabilities are important because in many industries environmental issues can significantly affect companies' financial results (Cairnc ross, 1995). Unless environmental issues are handled in ways similar to those used to manage other business risks and opportunities in those companies, then environmental control will remain an internal regulatory function superimposed on the company's core business concerns rather than become part of the process of maximizing shareholder value (Smart, 1992). The need for strategic environmental management will only intensify as affluent consumers demand better environmental quality while economic growth presses increasingly on ecological constraints.
Business managers and analysts could use this approach to:
- uncover hidden liabilities or risks in potential acquisitions;
- estimate the value of investments that would reduce environmental exposures;
- measure the self-insurance value of environmental control programs;
- benchmark a company against its competitors; and
- communicate its environmental strategy to financial analysts.
To demonstrate the methodology, we have used it to evaluate the environmental risks facing leading U.S. pulp and paper companies. 
THE APPROACH BRIEFLY EXPLAINED
Like financial markets, the approach is forward-looking. It is based on developing scenarios for significant future environmental issues and seeing how companies are likely to be exposed and financially affected under each scenario. It uses probabilities derived from past experience and expert judgement to weight the possible scenarios and uses these weights to forecast a likely financial impact and to construct measures of financial risk.
The successive steps in the methodology are a) identifying salient future environmental issues, b) building scenarios around each, c) assigning probabilities to scenarios, d) assessing company exposures to each issue, e) estimating financial impacts contingent on scenarios, f) constructing overall measures of expected impact and risk. The methodology can be seen as iterative, since probabilities, exposures and estimated financial impacts change over time. The underlying analysis can readily be updated as new information emerges.
A. Building Environmental Scenarios for the U.S. Pulp and Paper Industry
The pulp and paper industry is an appropriate one with which to demonstrate this approach because environmental developments will significantly affect future materials and energy costs, earnings, and balance sheets. This sector depends on forest harvests and recycled paper for its raw materials; it is one of the most energy-intensive of all industries; it emits a wide range of toxic and conventional pollutants to air, water, and land; it is one of the largest contributors to the solid waste stream; it is identified in the public mind with pollution and resource degradation; it is subject to an enormous range of environmental and natural resource regulation and litigation and it must allocate significant fractions of investment and operating outlays to environmental control programs. …