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August 25, 2006
Trucost Joins Yale Professor to Devise Tool to Gauge Financial Cost of Environmental Impacts
    by Bill Baue

Professor Robert Repetto and Trucost Researcher Dan Dias apply the TRUEVA methodology for measuring externalities in financial terms to the US electric sector, which scores terribly.


In theory, business functions in society's best interest because it is a self-contained system that amalgamates human and natural resources (work + raw materials) into products or services that benefit customers while at the same time creating financial wealth that is dispersed to workers and shareowners. Unfortunately, this is an alchemical myth that ignores the fact that companies do not bear (or "internalize" in the business vernacular) all of the costs necessary do business--in other words, the system has a leak in it. Specifically, many production processes necessarily degrade the environment, yet companies typically shirk (or "externalize") this financial burden, leaving society at large to foot the bill--for example through higher healthcare costs due to environmental pollutants.

Companies have been able to avoid internalizing these externalities not only because governments allow it, but also due to the lack of methods for calculating the financial cost of externalities. This may no longer be the case. Bob Repetto, professor of economics and sustainable development at Yale University, and Dan Dias, director of research at UK-based environmental research firm Trucost, have devised an empirical methodology for calculating the financial cost of externalities. Called True Economic Value Added, or TRUEVA, the protocol measures companies' environmental externalities against their ability to bear these costs through surplus revenues as expressed through economic value added, or EVA.

TRUEVA follows in the footsteps of other recently-introduced environmental performance metrics such as sdEffect and ADVANCE through a marketplace orientation, using an accepted financial yardstick (EVA) to measure environmental impacts in monetary terms.

"This approach lends itself to a bottom line assessment, which we believe is more useful to investors and financial analysts focused on financial risk and return," Prof. Repetto told SocialFunds.com. "TRUEVA is also useful as a management tool with which to assess the overall performance of a business or business segment."

To illustrate this, Prof. Repetto and Mr. Dias apply TRUEVA to the US electric utility sector. They estimate environmental damage costs conservatively by looking only at air emissions of three greenhouse gases (GHGs)--carbon dioxide (CO2), sulfur oxides (SO2), and nitrogen oxides (NOx)--while acknowledging that many other externalities exist. Measured by EVA, most companies appear to be contributing to the economy. However, when taking their environmental impacts into account by subtracting the cost of their externalities, the picture changes dramatically.

"Remarkably, by this measure few electric power companies were adding value to the economy," said Prof. Repetto. "The damages they imposed exceeded their surpluses, often by a large margin."

The biggest externalizers were American Electric Power (ticker: AEP) and Southern Company (SO), which imposed net costs on society of $4.85 billion and $3.35 billion respectively in 2004, the year examined. Interestingly, in April when the Senate Committee on Energy & Natural Resources held a Climate Change Conference calling on energy companies to testify in response to a white paper suggesting new legislation to regulate emissions, the only two companies to oppose mandatory limits on GHG emissions in favor of the Bush Administration's voluntary reductions approach were AEP and Southern.

Value
added--US electric power companies, 2004


Exelon (EXC--one of the companies to support mandatory limits) and PG&E (PCG) were among the handful of companies generating positive TRUEVA scores ($225 million and $497 million, respectively)--meaning their surplus revenues (or EVA) outweighed their externalizations.

Southern spokesperson Mike Tyndall conveyed to SocialFunds.com that the company is not familiar with TRUEVA and did not have enough time to assess the methodology and results to provide informed commentary. AEP spokesperson Melissa McHenry echoed this lack of familiarity with TRUEVA, but called into question some of the methodology's assumptions, such as the "arbitrary dollar value for the externalities."

"For example, it would be interesting to see how the author developed a $14 impact for a ton of CO2 emissions since there is no current consensus on the cost or impact of a ton of CO2 emissions," Ms. McHenry told SocialFunds.com.

Prof. Repetto used the median value of estimates for marginal damages from a meta-analysis (or examination of multiple published studies) by Richard Tol, jointly appointed at Hamburg (Germany), Vriej (Netherlands), and Carnegie Mellon (US) Universities. Trucost uses marginal damage estimates because they represent externalization costs, whereas carbon trading prices represent marginal abatement costs, according to Prof. Repetto.

"Also, since SO2 and NOx are already significantly regulated, it seems that society has addressed the externality of those emissions, so we are confused about their inclusion in an evaluation of the future economic risk of emissions," Ms. McHenry said.

"The fact that SO2 and NOx are regulated doesn't mean that these substances aren't being emitted and creating externalities," Prof. Repetto said. "All it means is that the company is not breaking the law."

Ms. McHenry pointed to the multiple different initiatives AEP is undertaking to address emissions. AEP started with an August 2004 report to shareowners. It was the first US utility to join the Chicago Climate Exchange (CCX) committing it to reduce GHG emissions. It is investing $4.1 billion through 2010 in environmental retrofits at its coal-fueled plants to significantly reduce our emissions of NOx, SO2, and mercury. AEP also ranked highest of electric utilities in a recent Ceres report
report on climate change governance strategies.

Finally, Ms. McHenry pointed out that the companies with the highest TRUEVA scores have significant nuclear operations, which do not emit the substances under examination (Exelon is the largest nuclear producer in the country.)

"What are the externalization costs of managing nuclear waste, or of addressing the issue of nuclear weapons proliferation?" she asked.

Gil Friend, founding president and CEO of environmental performance and sustainability metrics consultancy Natural Logic, similarly questions the decision to limit the externalities covered. He notes the distinction between minimizing environmental impact while maximizing profit on the one hand, and achieving true sustainability on the other.

"I'm not sure that TRUEVA promotes progress toward true sustainability, as it only includes those "externalities" whose impacts can be readily monetized--though enough to make a compelling case," Mr. Friend told SocialFunds.com. "It's worth remembering Albert Einstein's admonition that 'not everything that matters can be measured, and not everything that can be measured matters.'"

"But whether or not TRUEVA promotes progress toward 'true sustainability,' it certainly seems to promote progress toward financial markets taking 'true sustainability' into account," he added. "And that's clearly a step in the right direction."

Others seem to agree.

"We are just in the process of introducing this measure but there has been a good deal of initial interest, not only from the socially responsible investing world but also from mainstream financial analysts and portfolio managers," Prof. Repetto said.

 

 
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