Corporate environmental liabilities in the United States now stand at more than $250 billion. Many remain hidden on balance sheets, only to emerge as surprising and painful charges against earnings. Despite the scale of the problem, most corporations do not manage the environment as an integral part of their everyday activities. Because of legal and technical complexities and the emotional and public relations baggage associated with environmental matters, basic business principles are rarely applied to environmental risks. Instead, the facile mantra of "zero risk, zero violations" echoes in corporate boardrooms across the land. As a result, environmental liabilities are managed piecemeal by lawyers and engineers who lack the training, tools, and incentives to tackle them systematically.

This need not be the case. The solutions to risk management issues are multiplying, permitting unprecedented discretion, flexibility, and effectiveness in the management of risk. The benefits of using the new tools and taking a systematic approach to managing environmental risk are huge. A typical oil or chemical company can avoid creating new liabilities and see its current ones fall by 20 to 40 percent. We believe there are three basic rules for developing integrated environmental risk management:

• Rule 1: Focus on risk, not liability (invest in the right risk)
• Rule 2: Choose your weapons carefully (invest in the right remedy)
• Rule 3: Don’t keep it all to yourself (find the right owner).

Let’s consider how these three rules operate in a hypothetical case: the Goodoil company. Goodoil is active in oil exploration, refining, and distribution. Its pipeline division has a portfolio of over 100 remediation sites, ranging from simple storage tank leaks to potentially disastrous large spills into high-flow aquifers. In response to recent legal action, top management has issued a call for a comprehensive assessment of liabilities and an action plan for wiping out existing liabilities and moving toward a "zero spill" operating environment.

Rule 1: Focus on risk, not liability

Influenced by lawyers and engineers, many companies focus their efforts on those sites with the greatest liabilities. As we will see, this doesn’t make much sense. Such sites are often the poorest candidates for investigation and investment.

A better approach is to target risk, not liability, and to look at two criteria: the possibility that a liability might escalate in scope and cost, and the availability of efficient solutions. Goodoil would do better, for instance, to spend its resources on a $500,000 problem that is rapidly worsening—because physical contamination is spreading, legal standards are becoming stricter, or lawsuits are being filed—than on a $10,000,000 site that is essentially stable. Segmenting Goodoil’s environmental portfolio in line with Exhibit 1 yields the following hierarchy of sites:

Immediate remediation (act while you study). Goodoil’s portfolio includes several sites that qualify for immediate remediation: the potential for cost escalation is high and efficient solutions are available. Consider a site where two pumps are leaking small amounts of refined gasoline close to waterways and community wells. The damage could be considerable, but the solution is straightforward: build berms around the pumps, and excavate as necessary. In a handful of urban sites, the cost of immediate remediation is dwarfed by the benefits, setting the stage for an accelerated remediation approach.

Many companies fail to act on cases like this because no regulatory or shareholder pressure is being brought to bear, and budgets have little room for discretionary expenditure. Yet these are the only sites that must be dealt with immediately; money spent here is earned back many times over. To characterize sites in this way can steer regulators away from mandating endless remediation of sites that pose no change in health risk, and toward the far more productive reduction of genuine risk. The payoff in Goodoil’s case is enormous: up to 80 percent of the ultimate remediation spend can be attributed to the planning and execution of an effective site characterization for the regulators.

Immediate investigation (study hard). Investigation can be a good thing, especially when a company is faced with a number of sites that have high potential for cost escalation and no ready solutions. At Goodoil, leaks from two gas pipeline pump stations have deposited PCBs into nearby lakes over a period of years. No one knows the extent of the toxic deposits; the cost implications could range from zero to disastrous. Further study is essential: What is the true risk to people and the environment? Are the deposits uniform, or in hot spots? Do the benefits of invasive remediation justify the damage it will cause to the lake environment? Can Goodoil eliminate the risk of escalation while stopping short of total remediation? Can regulators be persuaded to proceed with a risk-based approach to remediation, in which the level of clean-up is balanced against the likely future uses of the site? Clearly, neither Goodoil nor the environment will be served by a rush into remediative action when the range of possible outcomes is so broad.

Opportunistic remediation (pick and choose). Goodoil owns several sites that are both stable and relatively straightforward to clean up. Though they are certainly candidates for remediation, their stability suggests that Goodoil might do better to concentrate on more efficient risk reduction investments in the short term unless legal or stakeholder pressures come into play.

Monitoring (watch and wait). Goodoil has little to gain by investigating or remediating stable, nonthreatening sites for which there are no efficient short-term solutions. To do so might divert capital and other resources away from more effective remediative measures. In such situations, a company should confine itself to monitoring for unforeseen escalation. For many companies, this segment of their portfolio is surprisingly large and contains sites previously considered highly problematic and costly. The trick is to shift investment away from the "worst" (most costly) sites to those that are actually deteriorating.

Goodoil can carry out this sort of basic segmentation by using existing site data. Developing an algorithm to predict a given site’s cost and potential for risk escalation is a straightforward exercise. It will involve such variables as the site’s previous history of spills; soil permeability; proximity to wells or aquifers; potential for dermal contact, inhalation, or ingestion; proximity to communities; community concerns; and regulatory sensitivity to the contaminants involved. Models like these that include only information that could affect the outcome of the analysis are highly efficient. In most cases, the data is already available and no further sampling or testing is necessary.

Companies that use this type of systematic portfolio management approach quickly learn a great deal about their environmental liabilities. It can help them optimize investments in problem prevention or maintenance, identify practices that create new liabilities (and adjust operations accordingly), assess liabilities prior to acquisitions, and incorporate environmental liabilities into business decision making.

Goodoil put the insights garnered during the segmentation of its sites to good use. It identified the most important drivers of risk and then screened each of its facilities (pump stations, buried valves, transfer stations, river crossings) against these drivers and ranked them in terms of their potential to hurt the company. No intrusive measurements or site characterizations were required. For the top-ranking sites, Goodoil devised and costed solutions, producing a final ranking by cost/benefit. It transpired that a few very small investments had huge impact, and the ranking provided a guide to a comprehensive, highly efficient risk reduction program.

Rule 2: Choose your weapons carefully

Goodoil’s focus now shifts to the sites identified as requiring immediate remediation. The trick is to determine which of many possible solutions is appropriate to a given site—and to get regulators and stakeholders to agree. In environmental remediation, benefit/cost ratios can be astronomical: a $10,000 slurry wall can prevent a $1 million aquifer contamination. However, the cost/benefit curve tends to flatten out very quickly (Exhibit 2). Goodoil found the steep rise in its remediation costs could largely be ascribed to the host of projects with dubious cost/benefit profiles that were mandated by regulators and managers alike.

The best technical, regulatory, and financial risk management strategy varies from one remediation project to the next. Some sites require only the simple sampling and hauling of soil. Others demand radically new approaches. We have found that the choice of a strategy for a particular site is driven principally by cost and by the degree of uncertainty regarding the type, level, or extent of contamination. By classifying a site in these terms, companies can determine the best remediation solution for it (Exhibit 3).

The fact that a site is potentially dangerous does not mean that the solution must be complex or expensive. In fact, Goodoil’s "remediate now" portfolio contains some sites that are best handled by straightforward "mucking and trucking." Sites like these offer few silver bullets. Goodoil should focus on basic efficiency measures such as capturing volume discounts by bidding out commodity services and using standard work plans with regulators.

For more complex and expensive sites, conventional project management may not work. The amount of time required for actual remediative measures is dwarfed by the time spent waiting for regulatory decisions (which can frequently seem arbitrary and remote from the operating realities of the site by the time they arrive). The best approach is to include regulators as part of the project team if they are willing, and focus on effectiveness. This speeds up decisions and cuts transaction costs. Integrated teams can achieve spectacular performance in terms of both technical excellence and cost efficiency, reducing overall remediation costs by more than 50 percent.

The normally burdensome method of exchanging full remediation plans with agencies at the 30, 60, and 90 percent design levels can be simplified if regulators are heavily involved, with project teams jumping directly to approval at 90 percent design. It may also be possible to make investigation part of the remediation process, short-circuiting the endless cycle whereby investigation begets still more investigation. To eliminate uncertainty completely is always expensive and almost never necessary in making the right managerial decision.

Large, complex sites where uncertainty is high give Goodoil’s portfolio managers a great opportunity to replace traditional investigation and remediation with a variety of risk-based approaches. Quantum leap approaches are possible when regulators, vendors of remediation technology, potential users of the site, and other stakeholders get involved early on. Rigid clean-up standards can often be replaced with risk-based standards specific to the intended end use of the site.

By virtue of their sheer size, complexity, and level of uncertainty, a small number of sites have the potential for truly catastrophic cost exposure. In our experience, corporations incur dramatic losses when they apply traditional operational strategies to sites in this category. Ideally, Goodoil should either gather information about these damage control sites and use advanced techniques to shift them into a more manageable category, or else find a solution that contains the risk without entailing premature capital commitments.

Rule 3: Don’t keep it all to yourself

Ten years ago, it was impossible to transfer any but the simplest environmental liabilities to insurers, contractors, or investors. The reason was simple: not enough empirical data existed to allow the structuring of risk transfers. Since then, secondary markets have emerged for a great variety of environmental risks. Liabilities can now be moved off the balance sheet through the use of AAA-rated insurance products. Risks can be distributed between Goodoil, its remediation contractors, and its insurers to ensure an equitable alignment of economic interest. In addition, insurance coverage has made the outright sale of environmentally tainted properties a far more attractive option.

At each of its remediation sites, Goodoil is faced with five basic categories of financial risk (Exhibit 4). To improve our understanding of the nature of these risks, we collaborated with the ERIC group, a firm specializing in environmental risk quantification and insurance, to profile a real $4.4 million site. Together, we conducted a risk analysis using a database containing details of some 10,000 environmental risk audits and their outcomes, environmental com-mon law actions and their results, defence and other legal costs associated with environmental liabilities, and a number of clean-ups with estimated and actual costs.

The results appear in Exhibit 5. In the exhibit, "cumulative probability" is the likelihood that the cost will be no higher than the estimated level. For the post-remediation clean-up liability, for example, there is a 95 percent likelihood that the cost will be $6.8 million or lower. Put another way, if we took 100 similar sites, 95 would have post-remediation costs of $6.8 million or less.

By their very nature, environmental liabilities are of the "low probability, high outcome" variety: the chances are good that costs will remain within reason, but spectacular overruns can occur. The type of insurance coverage a company chooses thus depends on its balance sheet and appetite for risk. The lion’s share of the risk can be covered at a relatively attractive premium: the risks detailed in Exhibit 5, for example, can be covered at the 90 percent probability level for about $1 million, with an aggregate limit of $15 million ($5 million each for basic liability, remediation cost overrun, and post-remediation coverage). Alternatively, insurance can be designed to cover only the most extreme overruns, an especially attractive option for a company structuring complex risk-sharing agreements with contractors. If the risk is underwritten by AAA-rated insurers, all or part of these liabilities can be moved off the balance sheet, with obvious impact on the bottom line.

Although contracts vary from situation to situation, they generally follow one of three fundamental financial models, each suited to a particular type of site remediation (Exhibit 6).

Though owner and contractor will find advantages in sharing risks in most cases, there will always be some situations where uncertainty is so high that contractors are unwilling to share risk, and insist on a time and materials (T&M) contract structure.

Consider one of Goodoil’s most complex and expensive sites, projected to cost $40 million over ten years. On a T&M basis, contractor profits—driven down by the razor-thin margins typical in commodity environmental services and by the large volume of work outsourced to subcontractors—are projected at a paltry $300,000. (We are assuming that the $700,000 subcontractor management fee, a standard mark-up in the remediation and construction industries, was dropped in the intense competition for the job). The real value creation opportunity for contractor and owner alike lies in the contractor’s cost performance: a 10 percent deviation from the variable project cost projections could create or destroy $1.3 million at net present value.

In this case, the traditional T&M model is untenable. The contractor’s profits are small, and the real value driver—the difference between actual and estimated costs—gives the contractor and the owner directly conflicting incentives, since the contractor does better as costs rise, while the owner benefits when costs are better controlled (Exhibit 7, scenario 1). Goodoil would be much better served by an arrangement that creates a powerful incentive for the contractor to minimize costs. This can be accomplished via a lump-sum contract that transfers all the risk and reward to the contractor (Exhibit 7, scenario 2).

In complex projects, however, high contingency premiums make this approach impractical. The best option here is a target price/performance-based contract (Exhibit 7, scenario 3), in which the contractor receives a share of any cost savings in return for risking a share of its profits to pay for overruns. Such a contract aligns the interests of both parties. Contractors are usually willing to enter this kind of arrangement without charging an upfront premium.

Risk-sharing contracts like this one can involve an insurer as a third party. Consider the shared-risk contract Goodoil structures for a $10 million site, using stop-loss insurance to cap the cost of remediation (Exhibit 8). Cost overruns of up to $20 million are covered by a $1 million stop-loss premium. The $1.5 million deductible is covered in full by the contractor, which is putting all its profits at risk. Goodoil is left to bear only the improbable risk of costs exceeding coverage, while sharing with the contractor any cost savings according to a predetermined formula.

Risk sharing can be extended by introducing performance criteria that make a contractor’s profits contingent on its meeting explicit cost, time, and qualitative goals

The concept of risk sharing can be extended by introducing performance criteria that make a contractor’s profits contingent on its meeting explicit cost, time, and qualitative goals. Some of these goals are easy to quantify; qualitative goals (such as a commitment to "minimize operational disruption" or "ensure owner and other stakeholder satisfaction") can play an equally important part in determining a program’s success, but are harder to measure. Here, success or failure can be judged by measurable behavioral indicators and contractors held financially accountable for the results.

Companies are beginning to use a number of organizational vehicles to formalize these risk-sharing agreements. Rather like the "bad bank" model used to isolate and manage problem portfolios in the financial sector, separate "legacy corporations" are being established with the sole purpose of administering portfolios of non-operating environmental liabilities. Environmental consulting firms are increasingly being asked to act as equity partners in these corporations.

More and more outside investors are assembling portfolios of urban sites with potential for real estate development. In 1996, three of the largest US environmental consulting and engineering firms raised a total of almost $700 million in debt and equity financing to invest in contaminated properties. Financed largely by institutional sources, these investors typically syndicate the services of remediation contractors, lawyers, financial institutions, and real estate developers. They take advantage of federal brownfield legislation by using innovative technologies to remediate sites at a cost far lower than expected.

While it is impossible to divest 100 percent of the liability for a given site or portfolio, companies can protect themselves sufficiently to make transfer possible. Property transfer remediation insurance (also called remediation insurance), typically taken out by the buyer, protects previous and subsequent owners from remediation cost overruns, thus shifting most of the exposure to the deep pockets of the insurer. While not cheap (premiums seem to be converging at 10 percent of expected costs), this coverage has been instrumental in enabling massive portfolio transfers in the past five years.

Those selling property of this kind need to be cautious in dealing with investors. Too many are offering "black box" deals rather than a clear economic argument for divestiture. At the minimum, prospective sellers should ask themselves the following questions:

• Do the portfolios to be divested include a fair and representative risk profile, or are we being "cherry-picked"?
• What value (in terms of real estate value minus remediation cost) is the buyer giving up?
• What benefits (cost avoidance, balance-sheet relief, certainty, and so on) is the buyer realizing?
• Is the buyer putting capital at risk, or functioning solely as a broker?

Organizing to capture benefits

Research and experience indicate that managers at many companies favor the approaches presented here, but are unable to implement them because of organizational barriers. Consider Goodoil. The company has separate environmental groups for upstream and downstream issues, each with its own budget, staff, and management. Both groups are responsible for tackling contamination once it occurs. This duplication of effort makes it much harder for Goodoil to capture any advantages of scale in its environmental management.

It will be unable, for example, to optimize its use of clean-up resources across businesses, or to pool its purchasing power in negotiating big product and service contracts. Short of total centralization, the best solution will be to coordinate capital expenditure decisions by means of a combined budgeting process that makes it possible to compare the types of spending that the two groups are planning.

The lack of integration also means that Goodoil is unable to present a single face to regulators. It can never paint a comprehensive picture of its clean-up work, or show how it is trading off priorities between projects. Neither can it take full advantage of the good working relationships that one group has developed with local regulators. To address this issue, some companies have designated one manager to participate in all negotiations with a given regulator, while others have taken to distributing internal contact memoranda to keep all interested parties up to date.

Nor can Goodoil easily share knowledge across its organization under the present structure. Some companies rotate people between groups to create cross-pollination, while others have instituted peer review processes that span the various groups.

Much of the value of clean-up groups can come from getting involved in decision making early on

These organizational problems flow from the historical role clean-up groups have played in managing costs only after damage has been done. In fact, much of the value of these groups can come from getting involved in decision making early on.

Suppose that Goodoil’s downstream unit wants to close one of two service stations. The operators will base their choice on historical site performance, traffic flows, and on-site management, and on the assumption that the environmental costs attached to closing the two sites are roughly equal or unknowable. They will be wrong. Two properties in the same area may have wholly different environmental risk/cost profiles for a number of reasons involving site history, soil and water-table conditions, or neighborhood. Neglecting these factors will impair the company’s ability to secure the least expensive solution.

Given the chance, risk management professionals can also play an invaluable role in mitigating third-party liability, a job often assumed exclusively by legal departments. Much of a site clean-up is done at the instigation of aggrieved private parties rather than at the behest of regulators. Assessing both the factual basis for a claim and the postures of the various stakeholders before committing to a course of action can be invaluable.

Environmental liability to private parties is often triggered by changes in the status quo, such as the closure of an operating facility. Yet operators of environmentally sensitive properties seldom try to negotiate with nearby stakeholders before committing themselves to a course of action. The reason may be that the costs of a lawsuit accrue two to five years after the decision is made so that the operating unit never sees them on its profit statement, or simply that such costs are regarded as an unavoidable part of doing business. Whatever the case, legal and environmental specialists are not usually recognized as valuable participants in the planning of a site closure; instead, companies are forced to spend time and resources on post-closure damage control.

In large-scale operations such as a chemical plant, a mine, or a refinery, the benefits of thinking carefully through the environmental ramifications before making a decision can be enormous. How many companies have closed a plant because it loses a few million dollars a year, only to discover that the closure triggers regulatory scrutiny that results in a clean-up costing tens or hundreds of millions? Once a plant has closed and jobs are lost, there is little reason for regulatory forbearance.

More than a few US plants have been reopened in order to manage down their environmental costs

Managers should seek out their own environmental staff, regulators, and third parties to determine the likely scope and time frame of a clean-up before a site is closed or the company is committed to a course of action. Such a process invariably allows management to make a better-informed decision. More than a few US plants have been reopened in order to manage down their environmental costs. If we calculate the present value of avoiding the costs of decommissioning a plant and its workforce, starting regulatory compliance, and later recommissioning the plant, we get a glimpse of the benefits of carrying out thorough analysis prior to making a decision.

Twenty years from now, most major industrial companies will have reorganized to integrate environmental liability management into their standard business decision-making processes. They will also be using the tools and approaches we have described to minimize the costs of new and existing environmental liabilities. The most successful companies have already started to use these new tools within their current organizational structures. Those now experiencing the economic payoff are building momentum to transform themselves to fully integrated environmental management.