Dec2016 - Calculating and Managing Environmental Counterparty Risk

© 2017 Environmental Risk Communications, Inc.

Contact:

John Rosengard(510) 548-5570

www.erci.com

Calculating and Managing Environmental Counterparty Risk

December 2016


Webinar Outline for Counterparty Risk

What is counterparty risk?

Why does counterparty risk matter?

Who are my environmental counterparties?

Which types are problematic?

How can you manage and mitigate?


Speaker Background: John RosengardWrote 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

ERCI supports Corporate remediation teams PRP groups Port authorities The engineering/consulting and legal partners Their internal and external auditors

Member of ASTM E2137 workgroup, tech contact E2173

MBA, Northwestern; BS, Georgetown

John RosengardFounder/CEO, [email protected], CA


What is it?

Counterparty risk:

- “non-performance risk of default”

- the incremental expense of another’s unfulfilled obligation to you, which affects the value at which the liability is booked or transferred

- It is an obligation, usually self-insured, to proportionally assume a defaulter’s liabilities


Examples of Counterparty RiskExample Book Now Next Steps Worst

CaseYour company sold a plant to operating management in 2007, with a $2 M in ARO and $4 M for a RCRA closure. Their credit rating equates to a 65% probability of bankruptcy in 18 months.

65% x $2 M +65% x $4 M =$3.9 M, adjust for inflation and new regs

Be ready to assert a claim in bankruptcy.

Discovering other releases since 2007.

Your outside laboratory fails a regulatory audit, and data from the last two years is reclassified as uncertified.

Cost to redo samples

Reevaluate the data; make claim to lab

Correcting a material financial error

Your plant kept insurance from 1950 to 1980. Offsite sediment contamination was found in 2009. Your insurance carrier paid claims @50% until 2017, when it dissolved.

Book the remaining 50% of future costs.

File final claim for future costs

All future claims denied

Your company agrees to jointly fund a CERCLA sediment study and cleanup. Two years ago, your allocation was 8%; now it is 10% due to defaults.

Counterparty risk increases your share by 1-2% every 18 months

Monitor health of counterparties; cash them out before they go.

Counterparties liquidate before you act.


Why does this risk matter?

1. “Joint and several” liability, which means

- larger/healthier PRPs provide counterparty risk insurance (probably for free)

- Defaulters transfer their costs to other PRPs, not to a government

2. US Federal law created the liability

3. GAAP (accounting principles) make this calculation mandatory (ASC 410, ASC 820; GASB 72; IFRS 13)

4. Counterparty risk is accelerating


Who are your counterparties?Indemnitors (who promised to protect you)

- Successor owners/tenants, their successors…

- Predecessor owners/tenants, their predecessors…

- Joint venture partners; working interests

- Bank, insurer or surety providing financial assurance or guarantees to any of the above

PRPs on a multiparty site cleanup (who promised a government to do work and/or promised you future cash calls)

Adjacent property owners sharing common pathway (like storm sewers) or receptors (like a wetland)

Landfills or TSDFs (current & former)


Which types are problematic?

Short answer: all counterparties are problematic

Watch for certain behaviors or characteristics Won’t disclose their creditworthiness

Won’t sign PRP agreement

Won’t execute parent guarantee or letter of credit

High turnover, low institutional memory, compartmentalization

“Claims adjuster” approach, not a “project manager”

No in-kind work contribution, just funding contribution

Slow to pay

Checks from all over (entities without revenues or employees?)

This site is their only site


What Level of Detail Works Best?

9


Trends ERCI Sees in Counterparty Risk2005 2015

Lower average scores√ Downward trend is continuing

Unstable scores√ Larger companies used to be stable; now all are in flux

Scores move across a wider range√ Larger swings are normal

Scores change more frequently than ever√ Scores now change quarterly or monthly

b ca b ca cba

b b bb

b

b b b bb b

bbb

? ?

Takeaways: expect more issues; continuous monitoring and shorter action cycle.


0 10 20 30 40 50 60 70 80 90 100

0 10 20 30 40 50 60 70 80 90 1001 FSS Class 2FSS Class 3FSS Class 45

2 0 1 4

2 0 1 6

How dynamic are credit scores?


Counterparty Risk Example

12

Fifteen PRPs, all have 6.7% share

$75 million lifecycle project, cash calls deferred until 2027

Only difference: credit ratingsPRP 2017

credit score (100

= best)

P(failure) in 2018

(EV)

P(failure) by 2027

(EV)

Initial Cash Call Allocation

of $75 M

Offset for Self-Default (EV)

Premium for the Loss Given Default of

Others (EV)

Liability, weighted for Counterparty

Risk

A 100.0% 0.1% 1.0% $5,000,000 ($49,776) $7,500,000 $12,450,224 B 96.7% 3.8% 32.0% $5,000,000 C 93.3% 7.0% 51.4% $5,000,000 D 90.0% 6.6% 49.5% $5,000,000 E 86.7% 7.6% 54.7% $5,000,000 F 83.3% 8.5% 58.9% $5,000,000 G 80.0% 9.3% 62.4% $5,000,000 H 76.7% 10.1% 65.4% $5,000,000 I 73.3% 10.7% 67.9% $5,000,000 J 70.0% 11.4% 70.2% $5,000,000 K 66.7% 12.0% 72.2% $5,000,000 L 12.5% 19.4% 88.4% $5,000,000 M 9.2% 19.7% 88.9% $5,000,000 N 5.8% 20.1% 89.4% $5,000,000 O 2.5% 26.6% 95.4% $5,000,000 ($3,976,500) $ 1,351,534 $2,375,034


Counterparty Risk Example What Did That Mean? Perfect rating? Counterparty risk doubles cash calls For average credit, premium and discount cancels out Rock bottom rating? Your net liability is half of the cash calls

because…healthier counterparties will cover you

What Else? Healthy PRPs now give away joint-and-several insurance But…no one said to give it away …to the other counterparties and regulators …probably without authorization


GAAP on Counterparty Risk

FASB: ASC 410-30-30-1(b) [Environmental Obligations Subtopic] 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 [Environmental Obligations Subtopic] 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.

14


FASB: ASC 820-10-35-17 [Fair Value Measurement Subtopic] 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)

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)

15

GAAP on Counterparty Risk


1 FSS C

lass 2FSS C

lass 3FSS C

lass 45

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 16 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.


1 2 3 4 5

How to Value Counterparty Risk (Portfolio)

X

X

Forecasting Engine

Portfolio Forecast

Allocation by Each Site

DefaultProbabilities

[Transition Matrix]

Cash Flows by Each Site


How Does Counterparty Risk Act?

Normal Default: 1.4%/year Randomized for Credit Rating1

98

8

19

93

19

98

20

03

20

08

20

13

20

18

19

88

19

93

19

98

20

03

20

08

20

13

20

18

Randomized for Allocation

19

88

19

93

19

98

20

03

20

08

20

13

20

18

Same dynamics as the rest of your enterpriseAverage 1.4%/yr default, 6.0%/yr dissolution

But over time, there is a range of outcomes for each individual counterparty

…and the allocation varies from risk to risk

Net impact: one project can lose all counterparties next year, and details are in plain sight today.


How Does Counterparty Risk Act?


How To Manage Counterparty RisksKnow Your Counterparties

Listen to how they describe themselvesInsurance policies in play? (cost cap, scope, time limit, other constraints)Review public data (company histories, 10-Ks, purchase/sale documents) Build a full list, consider publishing itDon’t count on consistency

ActDo an “ability to pay” analysisFocus where the risk is: bottom 10%Get parent guarantees or letter of creditRedocument every year

Keep a ScorecardShare the stories and cautionary talesApply the “intelligence cycle” because >>>counterparty risk is a process, not a project


Peer-to-Peer Financial Assurance Process

Continuous Monitoring

Primary Testing (quarterly)

Secondary Testing(as needed)

Tertiary Testing(as needed)

PRP Maintenance

WorkoutKeep valid LOC

Primary Tests- D&B Rating: 4 or 5- Fin Stress: 1, 2 or 3

Secondary Tests- Liquidity: most recent “cash & equivalents” are ≥ 25 x site liability- Profitability: Most recent annual “cash flow from continuing operations” are≥ 25 x site liability

Tertiary Tests- Provide D&B with current data- Review tax returns (privileged)- USEPA ABEL model- Altman Z-Score- CFO/Treasurer/Auditor interviews


Speeds up payments for riskier parties

Defers/eliminated the need for healthy PRPs to recognize long-term credit risk of many other parties

If a counterparty does file bankruptcy, financial assurance instrument settles liability quickly and the guarantor avoids filing a claim or handling a preferential payment claw-back

Compliance with GAAP as ASC 410-30-25-12 “Uncertainties Related to the Allocation of Estimate”

Business Case for Counterparty Tracking

22


What Do We Know About Counterparties Already? Identity; successors/assigns Terms of contracts (leases, Purchase & Sales Agreements, etc) Current credit rating and capacity If publicly-traded, financials and possibly their reserve policy

What Don’t We Know About Counterparties?

If they have transferred a liability onward If they have a reasonable reserve for the counterparty liability If they have bought any insurance coverage, including self-

insurance


Why do Your Environmental Counterparties Matter?

#1 source of new environmental liabilities #1 cause of increased allocations at multiparty sites Clear benefits from thoughtful preemptive action Buy back a formerly-owned site before an enforcement action Join a PRP group before a formerly-utilized landfill enters

CERCLA Cash out a PRP before they enter Chapter 7 (liquidation) or 11

(reorganization)

Tracking is mandatory per GAAP Stakeholders need to know Cost is significant and growing


How Do You Report the Risks? (1 of 2)

Measure the financial exposure (single site) Who are our counterparties? How stable are the allocations? (actual % may be privileged) When does risk start, peak, end?

Present preventive options (single site) Results of counterparty monitoring Status of requested parental guarantees (successors/assigns

paperwork) Status of credit enhancements: letter of credit, insurance

policy, prepayment(s) issued, expiration dates

Periodically remeasure Export to the portfolio


How Do You Report the Risks? (2 of 2) Display reserve recommendation (portfolio report)

Liability Type: AROs, ERLs, Commitments, Contingencies, Guarantees By counterparty: confirm any concentrations of risk >5%

Share tracking insights with corporate finance team “What is the value of others’ commitments and guarantees to us” “How does this compare to our commitments and guarantees 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?”

Review “watch list” of future reserve increases

Help due diligence team price in credit rating differentials Buying embedded commitments and guarantees is worth a discount of x%

off of the purchase price (“because we’re more likely to pay in full”) Explain difference between retaining and selling embedded commitments

and guarantees, which is y% or z% of total value (“because we permanently guarantee buyers won’t default”)


How to Measure Counterparty Risks (1 of 3)Site Recognition Benchmark Type Current CP

Score (max = 1600)

10-year prob(default)

A Counterparty defaults on new ASC 410-20 ARO 1586 20% C 35% counterparty fails ASC 410-20 ARO 1319 40% D Insurer denies coverage ASC 410-20 ARO 1138 15% E JV partner fails, four sites revert,

RCRA closuresASC 410-20 ARO 752 35%

E Insurer for JV denies coverage ASC 410-20 ARO 1186 50% F Landfill operator CH11, 11 NPL sites ASC 410-20 ARO 920 35% H 10 AROs for asbestos, enforcement ASC 410-20 ARO 696 60% A 20% counterparty fails by 2020 ASC 410-30 ERL 713 99% B GW P&T add'l 5 years ASC 410-30 ERL 1083 80% B GW P&T add'l 5 years ASC 410-30 ERL 1063 75% B GW P&T add'l 5 years ASC 410-30 ERL 1465 70% B 20% counterparty fails by 2020 ASC 410-30 ERL 998 20% B 10% counterparty fails by 2015 ASC 410-30 ERL 601 40% B 25% counterparty fails by 2020 ASC 410-30 ERL 1450 75% C Buy back property ASC 440 Commitment 1472 90% G Low-profile strategy fails ASC 440 Commitment 1207 33% A Remedy fails, new remedy ASC 450 Contingency 1270 50% C Deminimis not pursued ASC 450 Contingency 1595 80% D Remedy fails, new remedy ASC 450 Contingency 1460 33% F Counterparty pool shrinks ASC 450 Contingency 1242 60% C Provide financial assurance for

entire groupASC 460 Guarantees 1180 50%

Takeaway: losses are present, quantifiable, and auditable.

Counterparty risk exists in all types of liabilities

Many unrelated triggers for risk


How to Measure Counterparty Risks (2 of 3)

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 closuresASC 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 GW P&T add'l 5 years ASC 410-30 ERL 1063 75% Now Never $2,818,750 $ 2,114,063 (475,664)$ 1,638,398$ B GW P&T add'l 5 years ASC 410-30 ERL 1465 70% Now Never $3,382,500 $ 2,367,750 (532,744)$ 1,835,006$ 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 groupASC 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$

Takeaway: losses are present, quantifiable, and auditable.


How to Value Counterparty Risks (3 of 3)

Self

defa

ult:

-$25

.3 M

Gro

ss C

P Ri

sk: $

129.

6 M

Net

CP

Risk

: $10

4.3

M


Takeaways on Counterparty Risk

30

Opportunity cost…and a tax on inexperience GAAP said “track it”…from 1996 onward Known issue; benefits of the solution are >>> costs

Counterparty risk growsexponentially and feeds on time Project delays are common: allocation negotiations, litigation, extended

studies, regulatory input on remedy, lack of regulatory enforcement For owned properties, there might be operational issues, standstill

agreements for a time, “no look” agreements

Larger economy, more dynamic and leveraged than ever Regulatory mindset is obvious: “just need one PRP” Companies change: who will go out in the next recession?

Value of counterparty risks keeps growing 10-K reserves/AROs are at record highs in 2016 Increasing regulation worldwide adds to costs


Next Steps

Website: www.erci.com

LinkedIn Group – webinar announcements

YouTube page – select webinar recordings

Email [email protected] or call (510) 548-5570 PDF of this presentation (original PPTX format on request)

December 2016 webinars on Calculating Environmental Liabilities Calculating and Managing Environmental Counterparty Risk Presenting and Disclosing Environmental Liabilities Fair Value Measurement for Environmental Liabilities

Dec2016 - Calculating and Managing Environmental Counterparty Risk

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