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Putting Corporations on the Carbon Scale

Mike Wallace helps climate-savvy investors determine whether companies will prosper or shrivel as carbon dioxide regulation becomes reality.
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Mike Wallace and I are talking in a café in San Francisco's Financial District when a giant mobile shredding truck pulls up to the curb outside. Its driver starts feeding blue wheelie bins of paper into the truck's maw, and hundreds of pounds of financial documents begin disappearing in a blizzard of confetti. But, Wallace explains over the roar, most of that paperwork probably never reflected the companies' true cost of doing business, anyway.

Traditional accounting methods have often made corporations look more financially sound than they really are. Now, though, Wallace is helping investors who are worried that the companies whose stocks they own don't include all their environmental liabilities on their balance sheets — especially their greenhouse-gas emissions.

For decades, some economists have warned that under traditional accounting methods, companies "externalize" the costs of the environmental damage they cause. Today, a company can spew greenhouse gases into the air at no cost. If, however, the government begins regulating carbon dioxide emissions, the company could suddenly see a multimillion-dollar chunk torn out of its bottom line.

Companies routinely exclude not just greenhouse gases but a long list of environmental liabilities from their balance sheets. But global warming has brought the environmental-accounting movement to a full boil — especially now that carbon regulations in the U.S. seem to be less a matter of if than of when.

"Because carbon's become such a sexy issue," Wallace says, "that's what most people want to talk about."

And so Wallace, the president of Wallace Partners, a corporate-sustainability consulting firm, and the U.S. representative for Trucost Plc, a London-based environmental research company, has stepped in to help develop a sort of product labeling for corporations. Working with large, institutional investors, including several state pension funds, Wallace is persuading companies to assess their carbon footprints — or, as he puts it, to "get on the scale and measure yourself" — and disclose those numbers to investors. The results are, in some cases, astonishing, showing that highly profitable firms may become money-losers if they don't decrease their carbon emissions.

Wallace got his start doing due diligence for corporate mergers and acquisitions, when the business world was grappling with the first round of expanded environmental accountability. In 1980, Congress passed the Comprehensive Environmental Response, Compensation, and Liability Act, also called Superfund, which made polluters liable for the costs of cleaning up contamination. Banks found themselves especially vulnerable. If, for instance, a bank loaned money to a company to buy an oil refinery and the company went bankrupt, the bank would be stuck holding the contaminated property — and the liability for cleanup.

"Once you own it," Wallace says, "you're going to have to pay to clean it up."

Suddenly, banks and businesses began realizing that they were carrying heavier liabilities than they had ever imagined. "A weird example is telephone poles," Wallace says. "Those telephone poles have creosote on them, and you can't just throw them into a landfill. How much does it cost to dispose of one utility pole? Multiply it by tens of thousands of them, and you have a potential liability there that you need to figure out."

It is now routine for corporations to endure intense scrutiny of their environmental liabilities every time they're bought and sold, and no CEO would argue that polychlorinated biphenyls, cyanide and hexavalent chromium are meaningless to a profit-and-loss statement. But only recently have companies begun acknowledging that greenhouse gases like carbon dioxide are a form of pollution that could eventually cost the companies money.

Although no federal law exists that makes companies responsible for the greenhouse gases they emit, it's looking more and more likely that there soon will be one. In 2006, California passed a law mandating that the state's greenhouse-gas emissions be cut 25 percent by 2020. This year, the full U.S. Senate took up the Climate Security Act, sponsored by Joe Lieberman, I-Conn., and John Warner, R-Va. The act would create a trading market in the rights to emit carbon dioxide, effectively putting a price on each ton sent into the atmosphere.

The bill died in June, but Congress will revisit the issue next year, when a new administration is in place. And investors are beginning to wonder how the inevitable climate regulations will affect the stocks they hold.

"Today, we're suddenly seeing shareholders start to ask some of these same questions (about carbon)," Wallace says. "You want to make sure your shares are safe."

Much of the initial agitation for companies to disclose their carbon liabilities came through socially responsible investment funds like Domini Social Investments. The effort now is driven by large state-employee retirement programs, such as California's CalPERS and CalSTRS. Large investors have also been working together under initiatives like the Investor Network on Climate Risk and the Carbon Disclosure Project, whose members manage $57 trillion of assets, to lobby corporations to make their climate-change risks more transparent.

"It's kind of like smoking: You can keep smoking cigarettes, but your premium's going to go up," Wallace says. "You can keep emitting carbon, but we know there's a risk there, and you're not preparing for it."

Climate-savvy investors need to understand a business's carbon footprint the same way that one corporation needs another's environmental-liability information during a merger or an acquisition. "In essence, this same environmental due diligence is occurring," Wallace says. "But it's a different audience that's interested in it, and they don't have the ability to go walk through the company like someone who's going to buy that company."

To help investors, Trucost has spent the past eight years assembling a database of more than 4,200 companies listed on major indices like the S&P 500. The database can be used to compare and rank the environmental footprints of various companies in the same industry, such as electricity generation, manufacturing or oil and gas.

To create the database, Trucost's analysts mine publicly available information — annual reports, government databases, filings with the Securities and Exchange Commission — to create profiles of individual companies and entire industries. Then they combine that information into an input-output economic model, the same sort that the government (and, more specifically, the IRS) uses to track and verify the flow of goods and services. That helps cross-check companies' individually reported data against numbers reported for each industry as a whole.

"If you see the automotive industry saying, 'We sell this many cars per year,' and you see the tire industry saying, 'Oh, but we only sell this many tires per year,'" Wallace says, "those numbers don't compute. You know how many tires go on a car, and it doesn't add up."

Through its research, Trucost can make at least a rough determination of, say, how much carbon dioxide a company emits for every car that rolls off one of its assembly lines. Trucost fine-tunes its estimates and sends them to each company for comment and verification.

Early on, Wallace says, "We would get a lot of responses from the corporate lawyers, saying, ‘Who are you guys? Where did you get this information? You can't publish this. We'll sue you!'"

Because Trucost extrapolates its numbers from information in the public domain, its reports are perfectly legitimate (if at times irritating to subject firms). And because the attempt to quantify the cost of carbon dioxide emissions is all so new, many corporations are just beginning to get their heads around the real size of their own carbon footprints. Ultimately, though, it's in a company's interest to help Trucost refine the published numbers on its environmental impact rather than have potential investors looking at overestimates.

Still, three out of four companies that receive a footprint estimate from Trucost don't respond. But Wallace says that resistance to carbon transparency is beginning to change, in part because Trucost has repeatedly shown its prowess at accurately estimating companies' environmental impacts. "I'm having more conversations with companies who are saying, 'I'm interested,'" he says, "'because your numbers are close to what we're seeing ourselves.'"

And the numbers that Trucost produces can be eye-opening. In a 2006 report for CalPERS and CalSTRS, the California public employees' and teachers' retirement systems, respectively, Trucost analyzed the carbon footprints of the 265 largest electric utilities on the planet. Examining how each utility's bottom line would be affected by a 25 percent emissions reduction (the same as mandated by California's law) at a cost of $22 per metric ton of carbon dioxide, Trucost found that American Electric Power — which emits more greenhouse gases than any other U.S. utility — would face costs equal to about 7 percent of its annual revenue under an emissions-control framework. In contrast, Pacific Gas and Electric, which has a high percentage of hydropower and other renewables in its portfolio, would see only 0.03 percent of its revenue at risk. The Trucost report found that once the environmental impacts from all of American Electric Power's emissions are factored in, the company doesn't add value to the economy but actually has a negative impact of about $3.6 billion per year.

Even if you're the kind of person who doesn't give a hoot about climate change, Wallace says, you should care about a company's exposure to new greenhouse-gas regulations that could put your investments at risk.

"The corporation's going to pass on that cost to you. Don't you want to know a little bit about whether they're ready?" Wallace says. "Which one of those companies is more prepared for some kind of carbon regulation in this country?"

Wallace remembers meeting with several department heads from a state pension fund and encountering a skeptical chief economist. "The guy even said to me, 'Quite frankly, I don't believe any of this. I think it's just a big hoax.' And then I showed him that utilities study," Wallace says. "And these guys ended up getting in an argument over this. 'Let's say that there is a carbon tax; the utility companies will pay for a little bit of it, but they're going to push it down to everybody, including us.'
"They're sitting there, and the chief economist is suddenly going, 'This really will affect the entire market.'"

The move toward climate accountability is converging with the push for more rigorous corporate accountability that grew out of the Enron scandal. Some analysts have raised the possibility that companies that don't work to address their climate impacts will be vulnerable to lawsuits from shareholders for abdication of fiduciary responsibility.

The SEC, of course, requires companies to make public all "material" information about their financial health — material essentially meaning significant enough that it might cause "a reasonable person" to think twice about where to put his money. As some companies begin disclosing information that shows climate liabilities large enough to be considered material by almost any definition, it will be hard for others to continue withholding it.

"If these things are so important that all these other companies are putting it out there in their financial statements," Wallace says, "and I as a shareholder, or maybe a regulator, see that this one company seems to be dragging its feet — is it because they're hiding something? Or they don't really know what they're doing? It then becomes a corporate governance discussion: How are you really running this company?"

The European Union has had a carbon-emissions trading market since 2005. When a national climate law finally passes in the U.S., it will spur a rush on several fronts: to create third-party verifiers of carbon emissions, like the companies that certify organic food now. Countries will also have to agree on a standard unit for emissions and "harmonize" different emissions-accounting systems that are developing worldwide.

"That's where the rubber really meets the road: There's a requirement to do it. There'll be a need to audit it, and there'll be a need to enforce it.

"Suddenly," Wallace says, "it gets much more serious."

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