Erci apr2015 webinar counterparty risk

© 2015 Environmental Risk Communications, Inc.
Contact:
John Rosengard
(415) 336-5085
www.erci.com
Calculating and Managing Counterparty Risk
on Environmental Liabilities
April 2015

Outline
 What is “Nonperformance Risk of Counterparty
Default”?
 Why is Counterparty Risk Important?
 Seven Types of Environmental Counterparties
 Five Types of Environmental Liabilities
 How to Value Counterparty Risk on Environmental
Liabilities
 How to Manage and Mitigate the Risks
 Appendix
 Why Did ERCI Build CounterpartyDefender™?
 How Does the Software Work?
 How Do CounterpartyDefender™ Results Help Manage
Counterparty Risk?

What is Non-Performance Risk of
Counterparty Default?
 Short version: accounting term for the financial exposure
from one or more PRPs leaving environmental liabilities to
you
 Non-Performance Risk: risk an obligation will not be
fulfilled and affects the value at which the liability is booked
or transferred
 Environmental Counterparties: any party funding any
portion of an environmental liability; also “potentially
responsible party” (PRP), but not limited to CERCLA situations
 Default: when a PRP fails to meet its obligation
 Loss Given Default: the financial consequence of a liability
shifting (“risk made real”)

What is Non-Performance Risk of
Counterparty Default?
 FASB: 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.
 FASB: 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: applies beyond CERCLA; not new…above is the
exact same language as AICPA SOP 96-1, ¶ 6.20 (1996)
4

 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
5

Seven Types of Environmental Counterparties
1) Successor property owners or tenants, their successors…
2) Predecessor property owners or tenants, their predecessors…
3) Joint venture partners; working interests
4) PRPs on a multiparty site cleanup; their insurers
5) Adjacent property owners sharing common pathway (like
storm sewers) or receptors (like a wetland)
6) Landfills
 Currently used
 Formerly used
7) Insurers backing any of the above
 Future nominees?
 Contractors on fixed-price contracts
 State or Federal agencies funding “orphan share” allocations
 Sureties providing financial assurance bonds
 Banks issuing financial assurance letters of credit
 Insurers backing your contractors with cost cap insurance,
workmen’s comp, commercial/general coverage

Five Types of Environmental Liabilities
Obligations
FASB: ASC 410
GASB: GASB 49
IASB: IAS 37
Commitments
FASB: ASC 440
GASB: Note disclosure
IASB: IAS 16
Contingencies
FASB: ASC 450
GASB: GASB 10
IASB: IAS 37
Guarantees
FASB: ASC 460
GASB: GASB 70
IASB: IAS 39
Liabilities
Five companies sign consent
order to study and clean up a
site; one dissolves and
orphans their share
Your company sells a division
and promises to buy back a
plant if contamination is
found
Fifty companies agree with USEPA
to pay for past response costs; by
the time the settlement is
finalized, only 40 are operating
A State requires a bond for 10
years of OM&M costs on a RCRA
closure site; bond value must be
updated annually
Oil well owner files Chapter
11 bankruptcy, doesn’t plug
and abandon wells; reverts
to you as previous owner

Examples of Counterparty Liabilities
TypesofCounterparties
Liability Types >
[GAAP Citation >]
Asset Retirement
[ASC410-20, GASB18]
Env Remediation
[410-30, GASB49]
Commitments
[ASC 440]
Contingencies
[ASC 450, GASB 10]
Guarantees
[ASC 460, GASB70]
Successor owners
and tenants
They will fully fund the
assessment and demolition
work, some day, or sell to
someone who will perform.
They will study and
remediate any future spills.
They will not sell to a future
defaulter.
They will indemnify and
defend for any future
spills.
They will indemnify and
defend for any and all
future claims.
They will provide
financial assurance
for LT monitoring.
Predecessor owners
and tenants
They will promptly pay for
their share of future ARO
costs, some day.
They will respond to you or
regulators investigating past
spills, and participate in
good-faith negotiations to
allocate costs.
They will keep
contractual promise to
buy back a
contaminated property.
They will answer a
CERCLA 104(e) info
request and join a PRP
group to fund study
and remediation costs.
They will provide
financial assurance
for LT monitoring.
Joint venture
partners
their share of future ARO
costs, some day.
their share of future study
and remediation costs,
some day.
They will document
their changes in
successors and assigns
perpetually.
They will share the
stranded costs of other
defaulting PRPs, and
redo a failed cleanup .
They will document
their changes in
successors and
assigns perpetually.
PRPs on active
CERCLA sites
NA NA They will honor the
terms of a PRP
agreement perpetually.
They will meet all cash
calls perpetually.
They will share the
cost of EPA financial
assurance, if any
Adjacent property
owners sharing
pathways/receptors
NA Contamination from their
upgradient property will not
reach your property.
NA NA NA
Landfills in use today NA NA They will keep a
contractual
commitment to
indemnify and defend
for any future spills.
They will close current
operations properly,
including the one(s)
which accepted your
waste.
Their guarantees
will continuously be
accepted by State
and Federal
regulators.
Insurers of owners,
tenants, or vendors
They will promptly pay your
eligible claims.
They will promptly pay your
eligible claims.
They will promptly pay
your eligible claims.
They will promptly pay
your eligible claims.
They will promptly
pay your eligible
claims.
Takeaway: polluters are instruments of public policy (“polluter pays”); enforce or forgo your recoveries
…what you have to know for your liability to be zero

Why is Counterparty Risk Important?
 Losses are happening: new sites, growing allocations
 They are quantifiable: credit scoring and time-series forecasting
 Losses are avoidable: daylighting and successors/assigns tracking
 GAAP and duty to measure already exist, specifically for
environmental obligations
 Without measurement, unintentional consequences set in:
 Hiding – as a strategy – works for others without peer enforcement
 Active PRPs decide whether “polluter pays” applies to the next tier
 Capital stewardship based on “unstructured judgment”
 Companies self-insure for perpetual counterparty risk
 Asymmetrical risk management for the same counterparty:
 Environmental risk: $1 million exposure for 15 years
 Commercial credit: $10,000 exposure for <60 days

How to Value Counterparty Risk (Simple)
 Single site, $2 million in unfunded work to achieve closure
 50-50 split with another PRP
 Single payments of $1 million, due in ten years, from each PRP
 Other PRP has the same credit score as your company
 Conclusions:
 Our shares, credit scores match (fair value: “level 1 inputs”)
 Their Expected Value (EV) of default will also match (fair value:
“level 2 output”)
 Next year, credit scores probably won’t match
 Validation of current reserve:
+$1,000,000 cash calls
+$ 152,993 EV of default by the other PRP (range $0 - $1M)
- $ 152,993 EV of our own default (range $0 - $1M)
=$1,000,000 [same as the original cash call value]

How to Value Counterparty Risk (Typical)
 Five PRPs, all have 20% share
 $1 million/year in cash calls, lasting 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 others, in any order (range $0 - $8M)
- $ 152,993 EV of our own default (range $0 - $2M)
=$3,591,280 [80% higher than original $2M]
PRP Credit
Group
(FSS)
2015 credit
percentile
(100 = best)
Prob(failure)
in 2015 (EV)
Prob(failure) by
2025 (EV)
Initial Cash Call
Allocation
“Loss to A”
Given Default of
Others (EV)
Offset for
Default by A
(EV)
A 1 97.50% 3.78% 31.98% $ 2,000,000 $ (152,993)
B 2 81.50% 6.96% 51.39% $ 2,000,000 $ 263,214
C 3 51.00% 10.43% 66.76% $ 2,000,000 $ 367,192
D 4 17.50% 12.44% 73.51% $ 2,000,000 $ 420,660
E 5 1.00% 26.58% 95.45% $ 2,000,000 $ 693,207
$ 1,744,273 $ (152,993)
11

1 2 3 4 5
How to Value Counterparty Risk (Portfolio)
X
X
Forecasting Engine
Portfolio Forecast
Allocation by
Each Site
Default
Probabilities
[Transition Matrix]
Cash Flows
by Each Site

ERCI’s Computation of Counterparty Risk
“time-homogenous absorbing Markov chain”

Trends ERCI Sees in Counterparty Risk
2005 2015
Lower averages
√ Downward trend is
continuing
No longer stable
√ Larger companies used to
be stable; now all are in flux
Moving across a wider
range
√ Larger swings are normal
Moving more often
√ More frequent swings are
now normal
b
ca
b
ca cb
a
b b bb
b
b b b bb b
b
bb
? ?
Takeaways: expect more issues; continuous monitoring and shorter action cycle.

Site Recognition Benchmark Type Current CP
Score (max
= 1600)
10-year
prob(default)
Risk
opens
Risk
closes
Loss Given
Default
Gross E-CP Risk Less: Self Default Net E-CP Risk
A Counterparty defaults on new ASC 410-20 ARO 1586 20% Now 1/1/2020 $9,020,000 $ 1,804,000 (135,300)$ 1,668,700$
C 35% counterparty fails ASC 410-20 ARO 1319 40% Now Never $11,275,000 $ 4,510,000 (1,014,750)$ 3,495,250$
D Insurer denies coverage ASC 410-20 ARO 1138 15% Now 1/1/2020 $13,530,000 $ 2,029,500 (152,213)$ 1,877,288$
E JV partner fails, four sites revert,
RCRA closures
ASC 410-20 ARO 752 35% Now Never $28,187,500 $ 9,865,625 (2,219,766)$ 7,645,859$
E Insurer for JV denies coverage ASC 410-20 ARO 1186 50% Now 1/1/2020 $28,187,500 $ 14,093,750 (1,057,031)$ 13,036,719$
F Landfill operator CH11, 11 NPL sites ASC 410-20 ARO 920 35% Now Never $45,100,000 $ 15,785,000 (3,551,625)$ 12,233,375$
H 10 AROs for asbestos, enforcement ASC 410-20 ARO 696 60% Now Never $22,550,000 $ 13,530,000 (3,044,250)$ 10,485,750$
A 20% counterparty fails by 2020 ASC 410-30 ERL 713 99% Now 1/1/2021 $225,500 $ 223,245 (16,743)$ 206,502$
B GW P&T add'l 5 years ASC 410-30 ERL 1083 80% Now Never $2,255,000 $ 1,804,000 (405,900)$ 1,398,100$
B 20% counterparty fails by 2020 ASC 410-30 ERL 998 20% Now 1/1/2021 $2,255,000 $ 451,000 (33,825)$ 417,175$
B 10% counterparty fails by 2015 ASC 410-30 ERL 601 40% Now 1/1/2016 $2,818,750 $ 1,127,500 (39,463)$ 1,088,038$
B 25% counterparty fails by 2020 ASC 410-30 ERL 1450 75% Now 1/1/2021 $3,382,500 $ 2,536,875 (190,266)$ 2,346,609$
C Buy back property ASC 440 Commitment 1472 90% Now Never $11,275,000 $ 10,147,500 (2,283,188)$ 7,864,313$
G Low-profile strategy fails ASC 440 Commitment 1207 33% Now Never $5,637,500 $ 1,860,375 (418,584)$ 1,441,791$
A Remedy fails, new remedy ASC 450 Contingency 1270 50% Now Never $9,020,000 $ 4,510,000 (1,014,750)$ 3,495,250$
C Deminimis not pursued ASC 450 Contingency 1595 80% Now Never $2,255,000 $ 1,804,000 (405,900)$ 1,398,100$
D Remedy fails, new remedy ASC 450 Contingency 1460 33% Now 1/1/2020 $4,510,000 $ 1,488,300 (111,623)$ 1,376,678$
F Counterparty pool shrinks ASC 450 Contingency 1242 60% Now Never $22,550,000 $ 13,530,000 (3,044,250)$ 10,485,750$
C Provide financial assurance for
entire group
ASC 460 Guarantees 1180 50% Now Never $33,825,000 $ 16,912,500 (3,805,313)$ 13,107,188$
SUM 122,494,983$ (23,953,146)$ 98,541,837$
p10 85,611,190$ (16,740,745)$ 68,870,445$
Mean 129,592,849$ (25,341,090)$ 104,251,759$
p90 182,466,716$ (35,680,252)$ 146,786,464$

How Do You Manage the Inputs to CP Risk?
Know Your Counterparties
Know if insurance, purchase/sale terms & conditions expire
Revisit full list every three years, add new transactions
Reminder: 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
Price and Prioritize
Confirm cost forecasts and allocations
Collect and rescore credit data
Keep the Scorecard
Recognize loss prevention; share the stories
Apply the “intelligence cycle” >>>

How Do You Manage the Outputs?
 Single site
 Quantify the exposures (PRPs at risk, timeline to prevention)
 Display preventive options
 Document the baseline for auditing and benchmarking
 Portfolio
 Confirm reserve values and budgets
 Confirm “watch list” of future reserves
 GAAP compliance: recognition, measurement, display
 Answers to key questions
 “What is the value of indemnifications to us from others? How are they
booked?”
 “How does this compare to the indemnifications we made to others?
 “What is the sum of all counterparty risks we have with company XYZ
over the next ten years?”
 “How does that sum compare with the credit limit in place at our
operating business units for XYZ?”
 “Are any indemnifications with XYZ worth cross-cancellation?”

Takeaways on Counterparty Risk
 Riskier economy, more dynamic than ever
 PRPs in top quartile of creditworthiness tend to remain there
 PRPs in other credit classes tend to last 10 years or less
 Larger promises from and to counterparties
 Increasing regulation worldwide adds to costs
 Time creates counterparty risk
 Extended allocation negotiations
 “No look” agreements in M&A
 Temporary lack of regulatory enforcement
 PRPs maintaining low profile, or dissolving
 Nonperformance is an option – if you let it happen
 Consequence is material: 50% of a typical PRP group is gone in
less than ten years
 Any PRP group can lose any PRP…at any time
 If a counterparty prevents a liability coming to you, your
strategy depends on their health
19

Steps Forward
 Website: www.erci.com
 LinkedIn Group: Environmental Risk Communications, Inc.
 Email john@erci.com or phone (415) 336-5085
 Demo and needs analysis for CounterpartyDefender™
 PDF of this presentation (original PPTX format on request)
 Link to ERCI YouTube Channel for on-demand webinars
20

Appendix
 Why Did ERCI Build CounterpartyDefender™?
 Document risks
 Standardize tracking
 Prevent losses
 How Does the Software Work?
 How Do CounterpartyDefender™ Results Help Manage
Counterparty Risk?

Why ERCI Built Counterparty Defender™
Document risks
Standardize tracking
Prevent losses

How Does CounterpartyDefender™ Work?
We start with the fact that every company has a starting point, today.
0 10 20 30 40 50 60 70 80 90 100
1FSS Class 2FSS Class 3FSS Class 45

1FSSClass2FSSClass3FSSClass45
2014 2015 2016 2017 2018 2019 2020 2021 2022
Takeaway: uncertainty sets in quickly
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Over 14 years, ERCI has built a data set and process that forecasts
where each PRP will be in one year, in five years, in 30 years.

Calculation Engine: Transition Matrix
ERCI built the most complex part, its Transition Matrix, to automate
and speed up the calculations for a full portfolio of counterparty risks.
❷ ❸ ❹
❺
default
❶
51%
15%
1%
10%
21%
2%

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