Erci mar2015 webinar fair value measurement

© 2015 Environmental Risk Communications, Inc.
Contact:
John Rosengard
(415) 336-5085
www.erci.com
Fair Value Measurement of
Environmental Liabilities
March 2015

Outline for Today’s Webinar
Speaker’s Bio and Elevator Speech
Fair Value Measurement in GAAP
Why Transition to Fair Value Measurement
ERCI Observations
How to Document Fair Value Measurement
Q&A

Speaker Background: John Rosengard
Wrote 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
We support
 Corporate remediation groups
 PRP groups
 Port authorities
 The engineering/consulting and legal partners
 Their internal and external auditors
MBA, Northwestern; BS, Georgetown
John
Rosengard
President & CEO,
ERCI
john@erci.com
Oakland, CA

Elevator Speech: How/Why on FVM
What
“Market price”, since 2006, preferred basis for pricing liabilities, per
GAAP.
Why
Common sense. Potentially validated by a counterparty, not a regulator.
And it might be free. Factor in deferred tax assets, full spectrum of cost
recoveries, and avoidable escalation (lifecycle oversight,
counterparty default, remedy failure)
How
Stop equating cleanup projects/budgets with environmental liabilities.
“Think like a counterparty” when we value an environmental liability.
Understand why they would take on a liability; after all, this is how
your company bought into the liabilities in the first place.

Fair Value Volatility
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)

Conceptual Framework
Source: FASB Statement of Financial Accounting Concepts No. 8, September 2010
Enhancing
Qualitative
Characteristics
Fundamental 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

GAAP Alignment Among Standard Owners
Standard owner FASB GASB IASB
For… US Corporations Govt Agencies Non-US Corp.
Environmental
Obligations
ASC 410-30
Oct1996
GASB 49
Nov2006
GASB 18
Aug 1993
IAS 37
Sep1998
ARO ASC 410-30
Oct1996
Project
Oct2016 (est)
IFRIC 1
Jul2004
Fair Value ASC 820 -
Sep2006
GASB 72 –
Feb 2015
IFRS 13 –
May2011
Commitments ASC 440 Note in
disclosures
IAS 16
Contingencies ASC 450 GASB 10 IAS 37
Guarantees ASC 460 GASB 70 IAS 39
Nonperformance
risk of counterparty
default
ASC 820-10-
35-17 and ASC
410-30-30-7
GASB 72,
¶62
IFRS 13:42

What Are Environmental Liabilities (FASB)?
Obligations
ASC 410
Commitments
ASC 440
Contingencies
ASC 450
Guarantees
ASC 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

Fair Value Measurement
Defined in FAS 157, now ASC 820 (Sep 2006)
For public agencies, GASB 72 (Feb 2015)
Presume an arm’s length, third party transfer in an
orderly market
Three approaches
 Market
 Cost – best for environmental liabilities
 Income
Counterparty risk included (a PRP fails and their liability
defaults back to you)
Hierarchy of Inputs (next page)

Fair Value Hierarchy (ASC 820, GASB 72)
Level 1 (preferred): quoted price, active market, identical
liabilities
Example: Excavated soil will be “Class C” waste and trucked to
landfill for a drive-off cost of $84.50/ton
Level 2: some observable inputs, less-active market,
similar liabilities
Example: 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

Speaker’s Bio and High-Level View
ERCI Observations
Q&A
√

Useful to decisions and decision makers
Eliminates surprises
GAAP Compliant: “relevant”, “faithful representation”
GAAP Compliant: comparable, verifiable, timely,
understandable
Focuses spending on liability reduction (not deferral or
remedy)
Helps manage knowledge loss
Improves execution on acquisitions and divestitures
Identifies portions of portfolio with long-term recoveries
at risk
- cost recovery mechanisms in customer contracts, which may
be time limited
- counterparties in danger of defaulting

Where Do Liability Disclosures Fit In?
Source: FASB Statement of Financial Accounting Concepts No. 8, September 2010
Enhancing
Qualitative
Characteristics
Fundamental 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
GAAP Conceptual Framework

Legacy Behaviors: Liabilities not at Fair Value
Date Event
12-31-2008 GM environmental reserve: $297 million
6-01-2009 GM files Chapter 11
6-30-2009 GM updates their reserve to $536 million
10-20-2010 $773 million for first six settlements
12-14-2010 +$25.0 million settlement = $798.0 million
11 settlements = 3.2x reserve, three years
$297 million >>> $940 million
Source: USEPA press releases

Source: 10-K Reports
ERL: Dow and DuPont
Takeaways on Environmental Remediation Liabilities
From 1995-2014, Dow spent $2.4B, DuPont $1.5B
At yearend 2014, Dow assets $69B; DuPont $50B
Major Dow mergers: Union Carbide in 2001, Rohm and Haas in 2009.
Major DuPont divestiture: Conoco 1998.

 If the ERLs were $439M annuities paying $79.6M/yr, they
would be yielding 18% (!).
 Use a lower discount rate instead, the liability shifts up:
 Takeaway: “probably and reasonably estimable” liability
balances are not consistent with PV of historical spend
 Takeaway: adjust for inflation, distortion worsens
Are Reserve Balances Too Low?
Discount rate justification Discount rate Liability Value
“probable and reasonably
estimable”
$79.6M/$439M
= 18.13%
$439M
NYSE – Price/Earnings
Multiplier of 19 (March 2015)
5.27% $1,511M
DuPont pension plan (2014) 4.55% $1,749M
DuPont’s cost of LT debt (2015) 2.43% $3,276M
DuPont 2010-2014 1995-2014
ERL Spending/year $79.6M $75.4M
ERL Balance (avg) $439M $422M
Shelf life (years) =439/79.6 = 5.5 =422/75.4 = 5.6

ERCI’s FAQ on Fair Value Measurement
Quote ERCI’s Reply
FVM applies to valuing assets, like
our pension plan investments
FVM applies to liabilities, too.
And not just financial
instruments.
Our reserve policy generally treats
Environmental Liabilities (ASC 410-
30) as Contingencies (ASC 450)
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 now
that 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.

 Employee compliance with reserve policy is paramount
 From divestitures: FVM discounts are last-minute surprises
 From acquisitions: FVM discounts sometimes go unreserved;
field observations never get resolved
 Purchase accounting window closes after an acquisition
 Multiyear budget ≈ reserve, which defaults to ≈ liability
 Incumbent vendors pricing “their” reserves @ “their” sites
 Reserve is not current market value of liability
 “Don’t know what accounting does with our numbers”
 “Heave it over the transom”
 “I can’t explain the number in our SEC 10-K (20-F) report”
 “Our auditor is not asking us for this; no one is….”
 Acceptance of the above
ERCI Observations on FVM

Fair Value Reserve Calculation Example
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
$3.5
$4.0
Vendor
Quote
Remedy
Failure
Project
Management
Counterparty
Default
Fair Value
Vendor Quote
Groundwater P&T System
$2M install, $3 M O&M
Less 50% in cost sharing
= $2.5M
Remedy Failure
80% status quo OK
20% expand remedy (+$4M, less 50%)
= [(80% x 0) +(20% x $2M)]
= $0.4M
Project Mgmt
10% add-on
= $0.3M
Counterparty
60% no defaults
25% one PRP default, +$1M
15% 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

How to transition to FVM @ lowest cost
 Term Sheet for Each Liability
 Lifecycle cost projection
 Contingencies for changes to scope, schedule and vendor
 Premium for full/partial strategy failure
 Premium for project management
 Premium/discount for counterparty risk
 Premium/discount for your company’s own ability to pay
 Insurance covering cost escalation, reopener, NRDA risk
 Income for brownfield redevelopment
 Recovery of current and future spending
 Asserted and unasserted claims
 Income for sunk cost recovery
 Asserted and unasserted claims
 Consequences of deferred tax assets

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. 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 costs
Asserted and unasserted claims
50% recoverable under Federal contract
20% recoverable from legacy owner
2 +$7.4 million
+$3.0 million
J. Recovery – sunk costs
Asserted and unasserted claims
50% recoverable under Federal contract
20% 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 Outflows
Inflows
Net
-$14.8 million
+$23.7 million
+$8.9 million

How to Efficiently Transition to FVM
 Objective: comply with the duty to display the obligation to
management, and possibly to disclose
 Build consensus for a Pilot Project
 Environmental project team
 Legal department
 Audit (internal and external)
 Treasury/Risk Management
 Board of Directors

 Conduct a Pilot FVM Evaluation Project
 Opportunity Question: what can an acquirer find out/pay out by
2025?
 Select a division, plant, asset type; <15% of company
 90-day effort; use an FVM term sheet template; document what
contingencies do/don’t cover; learn if the remedy can fail and if
so…what is the backup plan and probability
 Produce a term sheet for each liability, listing key assumptions
 Numerical: soil and groundwater volume, cleanup goal(s), unit costs
 Regulatory: contaminants of concern, driving regulations, future land use
 Counterparties: identity, tentative allocation, current credit rating
 Timeline: deadlines, constraints
 Scorecard: Level 3 answers moved to Level 2; Level 2 to Level 1
 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

 Conduct Post-Pilot Evaluation
 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
 Make final decision
 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 FVM
 Project managers
 Key external consultants
 Corporate leadership, asset managers, property managers
 Auditors
 Counsel
 Use your spending data to justify -30%/+50%
accuracy; reassure cost engineers (“never shoot the
messenger”) that uncertainty is expected
 Document 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)

Best Practices: Site Estimates
 Common work breakdown structure for all sites in the
portfolio
 Study, remedial design, remediation, OM&M, legal, project management
 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”

Speaker’s Bio and High-Level View
Why to Document Fair Value Measurement
ERCI Observations
Q&A√

Resources to Read
 ASC 410 – current FASB GAAP on environmental obligations
 ASC 820 – current FASB on fair value measurement
 GASB 49 – Pollution Remediation Obligations
 GASB 72 – Fair Value Measurement and Application
28

Next Steps
 Website: www.erci.com
 LinkedIn Group – webinar announcements
 YouTube page – select webinar recordings
 Email john@erci.com or call me at (415) 336-5085
 PDF of this presentation (original PPTX format on request)
 March 2015 webinars on
 Managing Nonperformance Risk of Environmental Counterparties
 Obstacles to Recognizing and Measuring Environmental Liabilities
 April 2015 webinars on
 Estimating and Disclosing Environmental Liabilities
 Auditor’s Tough Questions on Environmental Liabilities
 Calculating Counterparty Risk on Environmental Liabilities
29

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