Environmental Finance 1

- Environmental Finance 1

Compendium Introduction "Environmental Finance: Value and Risk in an Age of Ecology"

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2 lntroduct~on Mav 1998 Business Strategy and thc Enmrammt, Vol. 5,198-206 (19%) ENVIRONMENTAL FINANCE: VALUE AND RISK IN AN AGE OF ECOLOGY

Mark A. Wte, Mchtire School of Commerce, University of Virginia, Charlottesde, Vir@a, USA

Environmental issues are restructuring markets and reduecting capital flows throughout the world. An outline is pro- ecent years have seen an explosion of concern by individuals, businesses and vided of concerns facing the development Rgovernments regarding the use of the of an environmentally responsible or natural environment. The 'greening' of business is 'environmental finance' perspective. It underway as environmental issues impact and reviews the major ways in which organ- change managerial practices throughout the izations are respondmg to environmental world. Global integration of the world's financial threats and opportunities in the three markets is progressing at a breathless pace and, in some instances, has fostered and/or accelerated the major branches of finance - corporate degradation of natural environments. In others, the finance, investments and financial free flow of capital has faditated a redirection of institutions - hghlighting in particular financial resources towards investment opportun- novel programs and initiatives. In the ities, promising overall increases in both human past, financial concerns have exacerbated and environmental welfare. the degradation of the natural environ- This paper seeks to achieve two objectives. Firstly, it attempts to define the structure of the ment; in the future, they probably hold financial system with respect to the natural envir- the key to their preservation. onment. Secondly, it outlines ways in which environmental concerns are impacting financial Only after the last tree has been cut down, deasion-malung by corporations, investors and only after the last river has been poisoned, financial institutions, briefly describing the current only after the last fish has been caught, only responses to these challenges. The financial system then will you discover that money cannot faditates the exchange of financial resources be eaten. (Cree Indian Prophecy) among economic agents. The exchange of resources is generally not an end in itself; rather, decision- makers engage in such activity to further their own designs. Understanding the relationship between finance and the environment requires an examination of the goals of human activity and the role of hanaal markets in achieving those goals.

THE FIELD OF FINANCE

Traditionally, the role of the hanaal system has CCC W733/%/03019&09 been to fadlitate the transformation of savings into 1996 by John Wiley & Sons, Ltd and ERP Environment. investment. Financial institutions (banks, brokerage

BUSINESS STRATEGY AND THE ENVIRONMENT M.A. WHIT€

houses, insurance companies) accomplish this by The hnk between finance and the environment creating financial instruments (deposits, mutual ulhmately rests on one's definition of capital, or funds, insurance policies) which are traded on endowments used in the generation of income. finanaal markets. By thts means savings, i.e. income Classical economists recognized two forms of remaining after current-period consumption, are capital: land and labor. Recent scholars in ecological redirected into various forms of productive capital. economics have identified three broad types of The field of finance is often divided into three capital (Costanza and Daly, 1992): (i) natural capital branches: (i) managerial or corporate finance, prirnar- - natural resources used to generate income, i.e. ily concerned with the investment and finandng farmland, forests, and fisheries; (ii) manufactured derisions of corporations and other business organi- capital - factories, buildings, tools and other zations; (ii) investments, whch seek to achieve the artifacts; and (iii) human capital - the stock of greatest return for a gven level of risk and (iii) education, skills, culture and knowledge stored in finanaal institutions and markets, dealing with issues human beings themselves (see also Becker, 1975). specific to the management of finanaal institutions The key in understanding the role of finance in and/or the operation of finanaal markets. As a either exacerbating or alleviating environmental Uphe,hance works towards maximking value damage is to recognize that, for the most part, the wlule managing risk Because risk and value are two above forms of capital are substitutes for one sides of the same coin (decreasingrisk inueases value another and that transforming one to the other and vice versa), it is impossible to entreat one without generally involves a fourth kind: financial capital. invohg the other. Uncertainty in estimating both risk Financial capital, or money, enjoys a spedal place in and value, particularly with regard to environmental this taxonomy, for it alone is truly fungible. It serves amenities, is the source of much fnction between as a unit of account (numeraire), as a store of wealth economists and environmentalists. and as the means to acquire additional welfare. Finance is often dehned as a form of applied Some kinds of capital, e.g. unspoiled wilderness, economics relying heavily on ~nformationcollected factories, education, etc., provide welfare in and in accounting. It comes as no surprise, then, that of themselves. Financial capital is valued for its many of the tools and analyses used in finance are Liquihty, i.e. the ease with which it can be rooted in these fields. The majority of environ- exchanged for the other three kinds of capital. mental amenities are not traded in markets, either More capital, be it natural, manufactured, human because property rights are not well defined (fish- or hnancial, is preferable to less. Moreover, an eries, biodiversity) or because the services in inhvidual's welfare is most likely maximized by question are public goods (clean air and water, the acquisition of some combination of these four beautiful views, etc.). The disapline of economics types. For example, a farmer may choose to offers numerous methods for dealing with both exchange the products of his or her land and labor problems and also provides teduuques for valuing for a new tractor, for education, or simply for non-marketed environmental assets, a first step in money (which is then either consumed or invested). financial decision-rnakmg. lndvidual choices concerning the types of capital to New accounting techniques are expandmg the hold and how much to consume and how much to measurement of environmental costs and benefits save are ultimately responsible for the depletion or to indude regulatory costs, auditing costs, volun- preservation of natural resources. tary costs, contingent costs and irnage/relationship costs. Recognition of the mynad and subtle ways environmental issues impact companies' cost and ENVIRONMENTAL FINANCE revenue streams is often the first step in developing a proadve environmental management program. Environmental finance concerns itself with the Sirmlar efforts are taking place on the mauoeco- impact of environmental issues on financial nomic level. Projects to ascertain the contribution of deasion-making, which is essentially a three-step natural and human or social capital in the national process. The first step is to identify sources of risk income accounts have been undertaken by national and/or opportunities to create value. This requires governments, the United Nations, the World Bank a better understanding of the interconnections and others (6.Ahmad et al., 1989; Peskin, 1991; between ecology and economics, which is a good IBRD, 1995). The results are informative '... identi- thing. 'Knowledge on the whole is an environ- fymg dozens of countries like Kenya, Libya, Nigeria mentally neuhal asset that we can contribute to the and Venezuela that are, in effect, eating their seed future', remarks economist and Nobel laureate corn countries where the accumulation of capital Robert Solow (Solow, 1991). Environmental audit- has been offset by the depletion of raw materials ing, ecobalance analysis and technology forecasting and fertile land'. are useful tools in this process. The second step is to

BUSINESS STRATEGY AND THE ENVIRONMENT 199 ENVIRONMENTAL FINANCE analyze various alternatives for increasing value or permits allowing them the right to emit sulfur laying off risk Various valuation techruques (indud- dioxide, a pollutant responsible for the formation of ing contingent valuation), cost-benefit analysis and acid rain. Because these permits are tradable (and, full-cost accounting are used to monetize trade-offs in fact, are also available as pollution futures), the between ddferent resource allocations. Finally, a utilities can choose how best to achieve predefined decision must be made, based on a thorough policy goals by decreasing emissions or purchasing analysis of all costs, benefits and uncertainties. sutiiaent permits forward to meet their expected needs, i.e. hedging. Certain agents may demonstrate preferences for The Financial System: Earth's Friend or Foe? particular kinds of capital, or inaeased current There is nothmg inherent in the structure of the consumption, which may come at the expense of financial system which necessarily leads to environ- natural capital, but, again, this is a problem with mental destruction. If economic agents desire preferences, not the system as a whole. 'How much greater amounts of current consumption (for what- is enough?' asks Duming (1992). Individuals have ever reason), a well-functioning financial system different satiation levels for different kinds of facilitates the aduevement of these goals in an capital. With regard to natural capital, the majority effiaent manner. In some cases the avdability of of humanity lies somewhere between Ronald financial capital may lead to the degradation of Reagan ('A tree is a tree: how many more do you environmental amenities which would not other- need to look at?') and John Muir ('In God's wildness wise have taken place. For instance, a fisherman lies the hope of the world'). Other business might borrow money from a bank to buy a boat, disaplines face similar dilemmas with regard to which he then employs to harvest fish at rates well environmental issues. A central goal of marketing, above maximum sustainable yield, ultimately lead- for instance, is to increase the consumption of a ing to the demise of the fishery. The problem lies firm's goods and services. But consumption seems not with the financial system, but with the hsparity to be the problem, not the solution! between private and social objectives. Environ- The remainder of this paper provides examples mental economics publications are replete with concerning the impact of environmental issues on examples on how best to reahgn these interests (cf. finanaal decision-making by corporations, inves- Cropper and Oates, 1992). tors and financial institutions. For corporations, The financial system can also work to preserve failure to manage environmental risks is likely to natural capital. The Nature Conservancy (TNC), an inaease financing costs and/or decrease invest- international conservation organization, provides ment returns. For investors, a major task is in an excellent example of this approach. Its tactics are forecasting the effects of increased environmental deceptively simple: to protect rare plants and concern on investment returns (value) to determine animals, TNC buys the places they need to survive. which companies are kely to profit from increased Funded by individuals, businesses and government attention to environmental issues (e.g, recychg, subsihes, ths organization directly transforms waste management firms) and which will be financial and other hds of capital into natural impacted in a negative fasluon (e.g. older manu- capital, increasing the welfare of its donors. facturing hsfaced with expensive remodeling or Schmidheiny et al. (1996) provide numerous other compliance expenses, firms with significant liability examples of how financial institutions and financial for the remediation of toxic wastes). Banks and markets are working to advance the cause of other financial institutions are addressing increased sustainable development and sustainability. credit risks arising from a borrower's environmental exposure (induding the possibility of lender liability in the event of loan default) and weighg Value and Risk the advantages of 'eco-banking'. In each of these Financial markets exist to transfer value and to areas, the prinaples of value maximization and risk transfer risk Transfening value is akin to the management provide guidance in determining the transformation of different hds of capital into Uely outcome of financial decision-making with one another. Transfening risk essentially refers to regard to environmental issues. the laying off of risk from hedgers to speculators. Individuals and businesses have different appetites for risk, just as they have preferences for different CORPORATE FINANCE AND THE kinds of capital. Well-functioning financial markets ENVIRONMENT provide opportunities to insure against adverse scenarios. For example, under the 1990 Clean Air Attempts to integrate environmental concerns into Act, certain electric utilities in the USA must hold the corporate finance function immediately come

200 BUSINESS STRATEGY AND THE ENVIRONMENT M.A. WHITE # up against a central doctrine of finance: the deged dropped precipitously (White, 1995~).Consumer goal of the financial manager is to maximize boycotts against Exxon (Exxon Val& oil spill), shareholder wealth. Ln a capitalistic system, those Bumblebee tuna (dolphtuna controversy), Gen- who contribute capital to an economic enterprise eral Electric (nuclear power), Royal Dutch Shell are entitled to special treatment by virtue of their @rent Spar) and other companies have engendered ownerslup position (Friedman, 1970; Malkiel and sigmhcant losses in public goodwill and company Quandt, 1971). A corporation, though a legal entity value. in its own right, is nonetheless owned by its shareholders, who work their collective will Functionality through the h'sboard of directors and manage- Process modifications to achieve better environment team. Firms engagvlg in behaviors not mental performance aeate new risks. For instance, providing direct pecuniary benefits to shareholders, Esprit's new dothing he made with naturally e.g, employmg more environmentally sound but colored cotton required the development of new higher cost production processes or donating a ginning and weaving techniques due to the cotton's porhon of profits to environmental organizations, shorter fibers. Recycled materials contain impuri- should earn investment returns inferior to busin- ties and contaminants not present in virgin feed- esses pursuing less lofty goals. Although some st&, the removal of wh~hoften outweighs their shareholders prefer these sorts of firms (the so- lower initial costs. called 'ethical investors'), the majority of the investment community does not appear to, and Liability share prices are likely to fall, decreasing share- Liability for environrnental incidents is a growing holder wealth. concern for businesses in the developed nations of Today, very few hsare apt to adrmt that they the world. The 'Superfund' law in the USA is pursue the hard-line maximization of shareholder perhaps the most draconian example of legislation wealth. Managers are much more Wcely to espouse designed to prevent environmental mishaps. some variant of the stakeholder paradigm, in which Designed to facilitate the identification and deanup business is considered as a system of agreements or of hazardous substance disposal sites, this law contracts between many parties (Freeman, 1984; imposes strict, joint and several liability for deanup Comell and Shapiro, 1987). Management's response costs on owners and operators of contaminated to the firm's stakeholders - an amorphous group sites, and transporters and generators of hazardous comprising customers, employees, suppliers, share- substances. Moreover, it is retroactive, requiring holders, competitors and others - depends on the companies to remehate dsposal sites whch at one relative importance of a particular stakeholder time were in full compliance with the law. The fear group to the company's overall strategy. If the of environmental liability, and a general inabihty to natural environment is granted stakeholder status, insure against it, is driving more and more as some scholars argue (Hart, 1995; Shnvastava, businesses to practice pollution prevention. In 1995a, 1995b), corporate decision-making becomes essence, fmns which do not aeate waste or much more difficult and a rather large ethical can of pollution in the first place need not be concerned worms is opened. with deaning it up.

Adjusting for Environmental Risks Discounting the Future Even without wholly embracing the stakeholder In general, risks and uncertainties about future concept, certain modifications to 'business as usual' costs or benefits are best handled by adjusting the make sense within the traditional paradigm of stream of expected future cash flows, not the shareholder wealth maximization. Most of these hscount rate. However, the practice of discounting relate to a !inn's investment policies. The financing has itself come under criticism on the grounds that function is impacted inctrectly to the extent that a it negatively dsaiminates against future genera- failure to manage environmental risks increases the tions. Moreover, the higher the discount rate, the company's cost of capital. Some of the risks faced by faster resources are likely to be depleted, i.e. companies with regard to environmental issues are dscounting appears to be inconsistent with sustain- described in the following sections. ability. Several rationales are offered for discounting, including the observations that humans exhibit Consumer Backinsh positive time preference and that the productivity Immediately following the Eua Val& oil spill, of capital implies current resources diverted to returns to Exxon shareholders and shareholders in production yield higher levels of future consump- unrelated 'environmentally irresponsible' companies tion. Critics, however, respond that individual

BUSINESS STRATEGY AND THE ENVIRONMENT 201 ENVIRONMENTAL FINANCE

impatience is not necessarily consistent with maxi- focusing on investments in hswith exemplay mizing lifetime welfare, and that what individuals records in employee relations, equal opportunity want should not necessarily influence public policy. practices, community development, the advance- The number of publications on discounting the ment of women and minorities, product saiet?. and future is vast and generally slanted according to the environmental responsibility. During the late 1980s, authors' personal beliefs (Markandya and Pearce, interest in 'environmentally friendly' investing 1991; Partridge, 1981; Norgaard, 1992; Summers, grew untd at one time more than three dozen 1992; Brennan, 1995). Although there may be vahd funds worldwide were dedcated exclusively to arguments against &counting from society's point environmental concerns. Although there is no of view, these do not appear to extend to the case of consensus on what, exactly, constitutes an 'environ- individual or corporate decision-makers. It may be mental' fund, the term is generally taken to mean more appropriate, for instance, to incorporate a funds investing in companies involved in the sustainabhty constraint, i.e. irrespective of the environmental services and hazardous waste dis- benefits and costs, the stock of natural capital posal industries, e.g. Waste Management and must remain constant (Costama, 1994; Daly, Browning-Fenis Industries and/or firms screened 1994). This is essentially the point of mitigation for superior environmental performance in recyd- banking, discussed in a later section of this paper. ing, pollution control, alternative energy and production processes and voluntarily ~nformation disclosure. GREEN INVESTING Investor interest in these funds has waxed and waned with their performance (or lack thereof). The En\lronmental protection spending in the USA has majority of funds are offered to investors in the grown three times faster than the GDP since the late USA, Great Britain and Germany. Numerous 1960s. In 1992, the total expenditure for environ- adblsory services exist to assist investors in evalu- mental goods and services was approximately $170 ating potential investment candidates. Reports billion, or 2.8% of the GDP. By the year 2000, ths of environmental mutual fund performance are figure is estimated to increase to 8250 billion (3.1% mixed, varying by performance appraisal method of the GDP), an amount approximately equal to the and the time period under investigation. White's anticipated defense budget at that time (Bezdek, (1995a) analysis of environmental mutual funds in 1993). The worldwide market for environmental the USA and Germany appears to be the most goods and services is expected to grow rapidly from comprehensive treatment of this issue to date; see 5300 bihon to $600 bdlion by 2000, with annual Hamilton et 01. (1993) for a review of socially growth rates ranging from 5 to 25% PRD, 1991). responsible mutual funds. Excepting one fund in Areas for investment growth in industrial nations Germany, Wlute (1995a) reports that funds in both include waste management and pollution control, counlries significantly underperformed market energy efficient technolog~es, alternative energy indces on a risk-adjusted basis during 1991-1993. sources and environmental consulting (Wlute, Several reasons are offered for their poor showing, 1992). In developing nations, game ranchmg. including investment set restrictions and/or inept plantation forestry, specialty products, genetic management. The former argument, however, is material and ecotourism are expected to increase weakened by the contemporaneously strong per- in importance. Smaller firms may distinguish formance of the Domini Social Index, a benchmark themselves by providmg environmentally desirable portfolio of companies screened using socially alternatives to current consumer products, eg, The responsible investment criteria. Body Shop, Cultural Survival, Shaman Enterprises, dkk Scharfenstein. Corporate Codes of Environmental Conduct Many firms have adopted corporate codes of Green Mutual Funds environmental conduct, partly to disseminate Environmentally oriented mutual funds are a environmental commitments throughout the firm subset of the general phenomenon of socially and partly to achieve better relations with investors responsible investment or etlucal investing. In and the public (Nash and Ehrenfeld, 1996). The the USA, ethical investment funds date back to chemical industry's Responsible Care initiative, the the late 1920s, when many religious institutions International Chamber of Commerce's Business eschewed investments in 'sin stocks,' i.e. firms Charter for Sustainable Development and the connected with alcohol, tobacco or gambling CERES, previously the Valdez, Principles are activities. The Pax World and Dreyfus Third some of the better known codes to which a Century funds were established in the late 1970s corporation might pledge itself. To the extent that

202 BUSINESS STRATEGY AND THE ENVIRONMENT M.A. WHIT€

the adoption of these codes reflects an organiza- the financial services sector, 70% of the respondents tion's genuine intent to head more lightly on the believed environmental issues have a material earth, they serve a useful purpose by signaling the impact on their business (UNEP, 1995). Liability possibihty of reduced future liability, cost savings for past environmental transgressions or unantid- and better scanning for environmental oppoMties. pated future inadents was the primary environmental concern facing most fmanaal inter- medaries. The vast majority (80%) of institutions Financial Environmental Performance and Firm perform some kind of environmental risk manage- Performance ment, generally before committing funds to a More recent research on the investment perform- transaction. ance of ind~vidualfinns has been more encourag- ing. Johnson (1995) has conducted the most Lender Liability thorough investigation of the relationslup between corporate environmental performance and several Under the Comprehensive Environmental Response, measures of economic performance to date. He Compensation and hbility Act (CERCLA or 'Super- reports mixed results, though '... for most cases in fund'), lenders can become liable for environmental wluch a statistically sigmhcant relationship was cleanup costs as owners if they hold title to observed, poorer environmental performance contaminated property seized as collateral in loan translates to poorer economic performance ...' foreclosures. Because liability is joint and several, if (Johnson, 1995: 201). one party is unable to pay its share of the deanup White (199%) used environmental reputation costs, the EPA looks to other parties with deeper data from the Cound on Economic Priorities and pockets. Cleanup costs can easily exceed the value an event study analysis of hs'signing the CERES of the property, such that lenders stand to lose more Prinaples to show that a positive reputation for than just the value of the loan. The cost of environmental responsibhty is associated with investigating and deaning up a site on the National superior risk-adjusted investment returns. Hart Priorities ht(NPL) averages $50 milLon (Plewa, and Ahuja (1996) examined the relationslup pers. comm., 1994). between pollution prevention and firm perform- The Superfund Amendment and Reauthorization ance using data from the EPA's Toxic Release Act (SARA) of 1986 provided two defenses under inventory. They report evidence of a positive link which lending institutions might be exempted from between emissions reductions (pollution preven- liability under the Superfund statutes. The innocent tion) and financial performance. Cohen et al. (1995) landowner defense provides an exemption for also find sigruFjcantly lower risk-adjusted returns potentially responsible parties unaware of existing for 'high emissions' portfolios versus 'low emis- contamination before becoming owners of the sions' portfolios using TRI data. property and who exercised due diligence in Although these findings are encouragmg. it is determining whether such contamination in fact important to bear in mind that in efficient financial exjsted. A lender must show it dd not know and markets, investors will earn returns commensurate had no reason to know about the presence of any with the Ievel of expected risk taken on. Evidence hazardous substances disposed at the site. Due that 'green' companies earn superior risk-adjusted diligence presumes all appropriate inquiries were returns prompts investors to purchase shares in made concerning the previous and current owner- these firms, dnving up stock prices and deaeasing ship and uses of the site were made and that returns. If markets are efficient, 'green' firms are there was no reason to know the property was unlikely to emrisk-adjusted returns either greater contaminated. or lower than is appropriate for their level of risk The security interest exemption addresses the once equilibrium is reached. problem of lender liability more directly. Spe- dfically, it clarifies the meaning of an 'owner or operator', explaining that it does not indude '... a FINANCIAL INSTITUTIONS AND THE person who without participating in the manage- ENVIRONMENT ment of the fadlity, holds indicia [a form] of ownership primarily to protect his security interest The Chinese word for 'crisis' consists of two in the vessel or fadity'. The exemption was characters: 'danger' and 'opportunity'. Banks, designed to protect lenders who held title solely insurance companies and other financial insti- for the purpose of securing a loan. Unfortunately, tutions are responding to our present environmen- sigxuficant confusion exists concerning the inter- tal crisis on both fronts. Jn a recent international pretation of this passage. A 1992 rule issued by the survey on environmental policies and practices of EPA was supposed to have clarified the agency's

BUSINESS STRATEGY AND THE ENVIRONMENT ENVIRONMEMAL FINANCE

position; however, it was vacated by a 1994 court (at a discount) by conservation organizations and decision and lenders are once more faced with its subsequent redemption in local currency with uncertainties at the Federal and state level (Prager the proceeds used for conservation purposes. White and Witte, 1994). (1994) discusses several reasons why a bank or finandal institution might choose to partidpate in this process, including tax breaks, the removal of Eco-Banking non-performing loans and the chance to improve its Mutual funds are not the only financial inter- public image. Since 1987, approximately $500 medmry seeking to satisfy the needs of more million worth of Latin American debt has been environmentally conscious consumers. Brokerage retired in these agreements (Anonymous, 1991). firms, commeraal banks, insurance companies and Unique environmental habitats in Costa Rica, credit card companies have increased their offer- Brazil, Madagascar and more than two dozen ings of environmental products and services other countries have been preserved as a result of (Schierenbeck and Seidel, 1992; White and Moli- these novel financing schemes. Although not a naro, 1992). In May 1988, the world's first 'ecobank' panacea for the developing world's debt and opened in Germany, dedicated to the provision of environmental crises, debt for nature swaps do environmentally sound banlung services. Loan exemphfy one method of harnessing the market- requests are screened for social benefits and place to serve environmental ends. depositors are encouraged to direct their funds Conservation or mitigation banking is another towards investments in the areas of environment, means by which financial institutions are taking an social justice, education and equal opportunity active role in balancing environmental and econ- (GeMUT, 1989; Stiidemann, 1993). In the USA, omic concerns. A conservation bank is a parcel or South Shore Bank established a svnilar subsidiary series of parcels of habitat owned by a private party in the Pacific Northwest. Its goal is to fadtate or public agency and managed for its natural conservation-based development and improve the resource values. In exchange for permanent guaran- economy while preserving the last stands of tees to restore and/or enhance natural habitats and temperate rain forest in existence. By allowing wetlands within the 'bank', developers receive depositors to 'invest their p~apalwith p~aples', credts whch can be used to offset unavoidable both institutions are differentiating themselves in a habitat or wetland losses at more desirable loca- hghly competitive market. On a related note, tions. Spurred by President Clmton's wetlands financial services firm Working Assets offers a reform package in 1993, conservation banks are credit card promising donations to various environ- rapidly becoming a favored means for moving the mental causes each time the card is used. development process forward while protecting Though few commeraal banks are going as far as environmentally sensitive habitats in a more Germany's Okobank or South Shore Bank many rational and coordinated manner (Marsh et al., in others have pledged themselves to pursue prin- press). ciples of sustainable development. The United In April 1995, Bank of America created the Nations Environment Program first presented 'A nation's first multi-species conservation bank Statement by Banks on the Environment and (Lawrence, 1996). Two years earlier, the bank Sustainable Development' at the 1992 UN Confer- foreclosed on Carlsbad Highlands, a 263 aae ence on Environment and Development (the Earth property in northern San Diego County. The Summit). It acknowledges that 'environmental risks parcel appraised at a very low value, in part should be part of the normal checklist of risk because it was home to the Cahfornia gnatcatcher, assessment and management' and pledge the banks a songbird classified as 'threatened' under the Us's to proactive poliaes to minimize environmental Endangered Species Act. After Bank of America impacts. As of January 1995,65 finanaal institutions sold a portion of this land to the California (includmg many large European and Canadian transportation authority as mitigation land for a banks, but few from the USA or Japan) were highway project running through gnatcatcher habi- signatories to this statement (Vaughn, UNEP, tat, it set up a full-fledged conservation bank to sell pers. comm., 1995). the remaining 180 acres to others in need of similar offsets. Developers are expected to benefit from an Debt for Nature Swaps and Conservation Banking increased opportunity set, environmentalists are pleased with a more integrated approach to habitat Debt for nature swaps were first proposed in 1984 planning (versus the former piecemeal practices), as a means of protecting the earth's biodiversity and financial institutions/investors are able to while realiz~nga return on hitherto unproductive realize higher prices for environmentally sensitive banking assets. They entail the acquisition of debt land assets.

204 BUSINESS STRATEGY AND THE ENVIRONMENT M.A. WHITE

Insurance Companies this terrain, posing threats and rewards to man- Insurance companies are perhaps the most con- agers in all branches of finance. This paper has attempted to review the structure of the financial cerned group of financial institutions. Environ- system and its relationshp with the natural enviton- mental risks can be exbemely expensive and difficult to predict Chanpng scien~creports ment. Additional information was provided high- lighting the ways in which the financial markets and, worse, changing liability rules, have created - currently worhg to address environmental pp an unusually hostile dvnate for insurers. During blems, always centered on the twin objectives of the latter part of the 1980s, commercial property value maximization and risk management. insurers virtually abandoned the pollution Liability Numerous questions, however, remain unan- market, fearing catastrophic losses as potentially swered. For instance, what additional environmen- responsible persons under the Superfund laws. A tal costs are appropriate for the 6rm to indude in its few have since returned, though with very expens- investment decision-making? How does a firm's ive coverage. environmental reputation affect its cost of capital? Changing dimate patterns are another problem What is driving recent findings of a positive for property and casualty companies. A recent relationship between corporate environmental per- report by the UN-sponsored intergovernmental formance and firm financial performance? Are eco- Panel on CLuIlate Change (FCC) confirms a global banking services costcompetitive with ordinary temperature rise. This could have seriously unfor- offerings? 'Avoiding environmental incidents tunate effects, submergmg entire coastal population remains the single greatest imperative facing centers, altering agricultural growth patterns across industry today', notes Edgar Woolard, chief execu- the world and increasing the severity of droughts, tive officer of the DuPont Corporation. Further floods and storms (ZPCC, 1995). In the USA, natural research into the vitally important field of environ- dsasters already appear to have inaeased in mental finance would seem to be in order. number and intensi?:

From 1966 to 1987, no single natural catastrophe generated claim payments of ACKNOWLEDGEMENTS over $1 billion (in 1992 dollars), whereas between 1987 and April 1993, no less than The author gratefully acknowledges hanaal support provided by the Virginia Environmental Endowment and 11 catastrophes topped the $1 billion mark. the University of Virgirua's Mdntire School of Commerce. From 1989 to 1992, US insurers paid out 1 thank David Angle, Larry Pettit, George Overstreet, 939.5 bfion in catastrophe losses, exceed- David Smith and two anonymous reviewers for helpful ing all catastrophe payments for the prior suggestions. 26 years (Sabar, 1994).

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