The link between enterprise value and EHS
By Richard B. Evans
Former president and CEO, Rio Tinto Alcan, Inc.; current international business advisor and director of companies
Presented at the California Industrial Hygiene Council’s 23rd Annual Conference: Connecting Sound Science and Responsible EHS Solutions – Mark Hopkins Hotel, San Francisco, CA
December 2-4, 2013 (delivered December 2nd)
Provided to ISHN by Chris Laszcz-Davis, MS, CIH, AIHA Fellow
Thank you, Chris (Laszcz-Davis), for that generous introduction - and for this opportunity to address the California Industrial Hygiene Council 2013 annual conference today. I am pleased to discuss this topic - the link between EHS performance and Enterprise Value – because I believe that it is often misunderstood and misinterpreted by EHS professionals and business executives alike.
I know that some people – perhaps many - believe that there is a “trade-off” between EHS and shareholder value. That is, that there is a “cost” to shareholders for achieving superior EHS performance. This is generally not true in my experience. As I will speak to later – I believe that EHS and financial performance more often than not move in the same direction.
In over 45 years in the metals industry, I have led the development and roll-out of two comprehensive company-wide EHS systems in two global companies – Kaiser Aluminum here in the Bay Area and Montreal-based Alcan – a company that operated in 63 countries with approximately 80,000 employees at the time. I believe that Chris was, in fact, the EHS professional at Kaiser, when we developed the extensive Kaiser EHS system.
As a CEO I have also discussed the link between EHS and financial performance with analysts and shareholders – and discovered that more often than not they do “get it”. As a general rule, longer term investors get it much better than hedge funds. But then that should not be a surprise - given the miserable record of shareholder value destruction by most hedge funds. I am sure that some hedge funds must have created investor value at some time, but it would a statistical rarity. Fortunately, the more important investors for company valuations are the longer term mutual funds, pension funds and strategic investors. (If you are especially interested in the record of hedge funds, read “The Hedge Fund Mirage”by Simon Lack).
One reason for misunderstanding the linkage between EHS performance and value creation in my opinion is that the subject often takes on a religious tone in debate – one is either a “true believer” or a “heretic.” This is not conducive to a rational discussion and understanding of the linkage – when it is more a matter of “faith” than “fact.”
A second reason is that - while the data to analyze and compare Financial and EHS performances is readily available - the task of interpreting the result is far more difficult. As professionals in your field, you all know that it is always far easier to demonstrate correlations than it is to prove cause and effect.
It is one thing to observe that DuPont, Dow and Exxon Mobilhave leading EHS and also leading financial performance – it is something very different to prove that their financial performance is due to their EHS performance. Conversely, it is also difficult to prove that their EHS performance is primarily due to their financial success – i.e. by having greater access to human and monetary resources to apply to EHS.
My own conclusion is that these two, in fact, reinforce each other and are both due to strong integrated management systems that drive superior performance in multiple metrics across the organization. My own experience is that superior performing organizations are seldom superior in only one dimension – and that good management process in one dimension usually reinforces good management process in other dimensions. Let me repeat . . . good management process in one dimension usually reinforces good management process in other dimensions.
There are, of course, some clearly identifiable cases where EHS performance does have a direct and measurable impact on Enterprise Value, however, it is unfortunately often in cases related to major single, high-profile negative events or major negative chronic exposures.
I would like to explore this by asking for your help in responding – by a raise of hands – to three short questions:
Are you ready? Here is the first question:
1) How many of you own or invest in stocks? Or direct someone to invest on your behalf –e.g. through a mutual fund? (Comment on response – almost all of you)
2) How many of you can name a stock that you have purchased recently specifically because the company had a superior EHS performance? (Comment on response – no one? I expected at least one or two in this special audience)
3) How many of you can name a stock that you have avoided – or would avoid - due to EHS concerns? For example – a tobacco stock, BP after the Gulf Spill, or closer to home – PG&E after the September, 2010 San Bruno gas explosion. (Comment on response – many of you, which is pretty normal, I think)
If you are like me – and I believe – like the majority of investors, you are more likely to have raised your hand on the last question than on the middle one (as you did).
Interestingly, I think that this is equally true when companies make acquisition and investment decisions – as well as when individuals or fund managers make stock picks.
Of course, if all, (or most) investors act similarly, companies that experience major negative events –or with recognized higher EHS risks will sell at lower multiples of earnings than those with better records – and in fact, they do!
That is why tobacco companies have sold at lower multiples in recent decades - and why BP dropped to a very low multiple immediately following the Gulf spill disaster.
To use an example that is more recent and closer to home here in the Bay Area: Has anybody here followed – or invested in - Tesla, the sleek high-tech electric car produced across the Bay in Fremont?
If so, you may know that the market cap recently dropped about 40% following a second and third reported battery fire.
In another well known instance of battery fires, Boeing stock improved significantly once its “fix” for the Lithium battery fires on the 787 Dreamliner was approved and went into place earlier this year.
These are examples of where companies’ market capitalizations reacted instantaneously and markedly to perceived changes in major risks – and future cash flow - e.g. environmental events, major health issues or product liability concerns.
Incidentally, while I am referring the Market capitalization and Enterprise value as if they are the same, technically, they are significantly different. For definitional purposes - Market cap equals Enterprise value reduced by debt and long term liabilities. These can be very different numbers – it is akin to the total value of your house vs. the equity in your house net of the mortgage. For most of us these are quite different numbers.
However, both are affected and move in the same direction and absolute magnitude by changes Enterprise value, although the percentage impact is obviously greater on Market caps than Enterprise value.
Market caps are set, of course, by the interaction of buyers and sellers. But it is helpful to understand how professional buyers and sellers determine their view of values and the mechanism behind these valuations.
In making buy/sell decisions both individual and institutional investors rely heavily on analysts’ studies and reports. Individual investors generally rely on “sell-side” analysts employed by brokerages and investment banks – e.g. Merrill Lynch, Goldman Sachs to inform their decisions. Institutional investors rely on their own in-house or hired “buy-side” analysts.
By the way, virtually all of what you read in the WSJ or hear from your broker comes from sell-side analysts. The buy side keeps their information close to their vest for their private use.
However, both use essentially the same analytical approach to value companies – standard models that calculate the discounted NPV of future cash flows. Therefore, the bulk of their analysis is focused on determining future years’ cash flows.
Therefore, if there is meaningful – and measurable - data available on EHS risks, that goes into the model. As mentioned earlier, this is unfortunately more likely to go into the model with the recognition of a major identified risk - or occurrence of a major negative event - or knowledge of a chronic long term exposure - rather than with the evidence of no such events or risks.
However, companies with sustained positive performance over multiple years that communicate effectively to analysts and investors will often see a “reputational” premium. Alcan was fortunate to benefit from this when it was acquired by Rio Tinto in 2007 for an all-time record value for the metals industry of $40 billion.
Alcan benefitted from its excellent EHS performance, being named Fortune’s most admired metals company worldwide, and from its substantial ownership of sustainable hydro-electric power. Many analysts commented on these attributes in forecasting a substantial premium for Alcan when it was put into play by Alcoa’s hostile takeover attempt. I cannot tell you today whether it was $ 1 billion, 2 billion, 5 billion or 10 billion – but it was definitely a factor – and not untypical of acquisitions of a highly reputed company.
I have to stress that this is not a short term or easy path to higher multiples and values – it takes multiple years to establish the credibility and to effectively communicate the benefit and value to investors.
The reason that this is difficult, of course, is the problem of accurately assessing – and reducing – the true likelihood of major EHS events. As all of you as Industrial Hygiene professionals know, it is extremely difficult to assess these risks from inside a company – let alone from the outside. Invariably, major high-severity events are simply not on the radar screen – of the company or the investors.
For this reason analysts often fall back on entire industry track records – or that of similar companies in assessing these risks. It is just very difficult, by definition, to predict low-frequency, high-severity events.
I would like to use a recent example from Quebec, Canada, where I spent the last 10 years before moving back to the Bay Area – and where I still have many close personal friends and business colleagues – to illustrate this point.
Again, I am going to ask you to help me by raising your hands to a simple question.
Let me set the stage for you – and then I will ask the question.
Here are the facts:
1) At 10:30 PM on July 5th, 2013 a freight train with 5 locomotives and 72 tanker cars filled with crude oil pulls to a stop for the night on a private rail line in rural Quebec in the small town of Nantes.
2) Because the train and line are privately owned, there is no other traffic on the track– and the siding where the train might otherwise park was being used for storage of empty cars. The parking location is relatively flat with a grade of slightly over 1 %.
3) The single engineer leaves the lead engine idling to maintain air pressure on the air brakes, but also sets the manual hand brakes on all 5 locomotives and 10 of the 72 tanker cars - per the standard company practice.
4) The engineer leaves the site to retire for the night at a nearby motel.
So here is the question: What was the most likely result over the next 3 hours?
a) A runaway train, or
How many think “a runaway train”? Comments on response - A few of you think this.
How many think “nothing”? (Comment on the result of the raised hands- most of you believe this –nothing.
The correct answer, as the majority of you guessed, is NOTHING. Absolutely NOTHING.
“NOTHING” was not only the “most likely” outcome – it was probably 99.9 % plus most likely.
The same or similar set of circumstances had no doubt occurred hundreds, if not thousands, of times before with exactly the same outcome – “NOTHING”!
But as many of you also probably already know, this time was different:
1) Shortly after the engineer left, a small fire broke out from an oil leak in lead locomotive
2) A passerby reported the fire to the local fire department, which put out the fire and shut down the lead locomotive as a precaution at 11:45 PM
3) Within an hour of shutting down the lead locomotive the air pressure had dropped below minimum levels to maintain the air brakes due to leaks.
4) The hand brakes were either inadequate or not properly set – and the train began to slowly roll east on the tracks.
5) The train gradually accelerated down the 1 % + grade for over 11 kilometers of relatively straight main line.
6) At 1:15 AM at the end of 11 kilometers it had reached a speed of over 100 kph as it entered the small town of Lac Megantic, where the track makes a sharp turn.
7) The 5 locomotives made the turn and continued on out of town. The 72 tanker cars did not - and derailed
8) The resulting explosion and fire flattened and incinerated the core section of the entire town, killing 47 people (with 5 more still missing) and inflicting massive property damage.
Now, 5 months later, the rail company has gone bankrupt, owners and others are being sued for hundreds of millions of dollars and the investigations are still ongoing.
No one would deny that there is a link between EHS and enterprise value in this case. But this is, of course, after the fact – and demonstrates just how difficult it is to forecast low-frequency high-severity events into future cash flows. This is also why it takes multiple years of superior EHS performance to get a read-through to a higher enterprise value – whereas it takes one major negative event to destroy it.
As for this particular case, some would say – and have said – that it was a “perfect storm” that could never have been predicted. I am not convinced.
Admittedly, in this case the occurrence and the ultimate impact was influenced many special circumstances:
1) The single engineer as an operator (allowed, but not “approved” – a gray area of regulation)
2) Parking on the main line, rather than the siding – which had a safety derailment feature which would have derailed the train at low speed with minimal damage
3) The random occurrence of the locomotive fire – and turning off the engine by the fire department (they tried unsuccessfully to locate the engineer to tell him)
4) Possible leaks in the air system that allowed it to bleed quickly
5) Questions of whether the manual brakes were set properly – or at all
6) Whether the specified number of manual brakes were adequate – or if a prescribed positive safety check took place or not
7) The fact that the mainline was a straight shot with continuous downgrade for 11 KM (note that derailments often take place in remote sections of track)
8) The surprise combustibility of the crude oil – was it contaminated?
9) The possibility that the train cars struck a bank of propane tanks in Lac Megantic?
10) The fact that so many people were having a birthday party near the tracks on that night
If any of these circumstances had been different – the actual result would likely have been - NOTHING.
In my 45 years as an engineer, plant manager, CEO and Board Director of multiple companies, I have had the regretful experience of being involved or overseeing the investigation of approximately 100 accidents resulting in fatalities – and many, many more resulting in serious injuries, near misses, or potential major environmental impacts.
The initial conclusion – in virtually every case – is that the particular circumstances involved in virtually every case were a “perfect storm” that could not have been predicted. However, upon further investigation it is almost always found that the accident was a culmination of multiple unsafe acts and unsafe conditions that had been repeated individually numerous times without consequences. It was only when all conditions line up simultaneously that the high-severity event occurred.
This is why it is always necessary to look at “near misses” - over extended time periods - and actual events - over many years and many companies - to truly assess risks.
In the aluminum industry, the vast majority of fatalities came from five exposures: Lock-out Tag-out, Confined Spaces, Working at Heights, Mobile Equipment and Crush-Points. Metal explosions and health exposures to Carbon anode paste used to be common causes – but have now been dramatically reduced through process and practice changes.
For Railroads I am not an expert – but would venture that runaway cars and derailments must be at the very top of the list. In fact, today’s Wall Street Journal has a photo on the front cover of a fatal derailment in New York City. Even in the aluminum industry – which makes limited use of rail – I know of two fatalities and several serious near misses from these causes on our plant sites.
The Lac Megantic case is only exceptional in its tragic impact. The risks were well known by the company and the industry. In retrospect it was a tragedy waiting to happen – and likely brought to light simply by the statistical probability increased by the major increase in crude oil being transported by rail – as domestic U.S. and Canadian oil production has boomed.
In conclusion I would like to turn to what this means to each of you – presuming that you would like to both enhance your company’s EHS performance and add Enterprise value at the same time.
Here are my thoughts for your consideration – after which I would love to take a few questions and hear your comments:
1) Research your own organization’s history over at least 10 years, if possible, to identify any recurring major EHS events or exposures. Do the same for your industry data – or with a group of similar organizations – if no industry data is available.
2) Review your organization’s insurance coverage for clues as to how they assess the major risks. Insurance companies make a living out of assessing risks – and what they charge for different coverages can provide helpful leads.
3) Re-evaluate your “Safety Pyramid”. We all have seen numerous “Safety Pyramids”. The bottom of the pyramid should not exclusively be first-aid or recordable injuries. These are far too narrow as indicators and can distract a disproportionate share of your time and resources. The bottom of the pyramid needs to include unsafe behaviors and unsafe conditions, with a focus on those that can lead to low-frequency high-severity events.
4) Review you time allocation and that of top management regarding EHS activities. Insure that you have a balanced approach between targeting frequency and severity. In my experience many EHS organizations get trapped in spending the bulk of their time and resources on high frequency, but low impact consequences.
5) Start an active dialogue with senior line management about priorities in EHS and their views on the link between enterprise value and EHS.
6) And finally, take a refresher course in statistics. In my view an understanding of statistics has been one of the very top three or four abilities that have helped me in every role in my career.
Especially in your field – it is absolutely essential. I realize that statistics can be difficult and inhibiting – one good way to tweak your interest is to read Nate Silver’s recent bestselling book: “The Signal and the Noise.” Silver’s book is mainly about Poker (he was educated as a statistician but started as a professional poker player), major league baseball averages (think “Moneyball”), and forecasting political elections. But the principals of understanding statistics are the real message – that applies to EHS as well.
Incidentally, another excellent book on statistics and probability – this time focused on financial markets is “Fooled by Randomness” by Nassim Nicholas Taleb.
With that, as mentioned earlier, I would love to hear your reactions and respond to your questions.
Once again, thank you for the opportunity to join you and share my ideas.
And make the best of this excellent conference.
Richard B. Evans is a senior international business advisor and director of companies. He is currently Non-Executive Chairman of Constellium, a Paris, France based world leader in advanced aluminum Engineered Products, an independent director of CGI, one of North America’s leading IT consulting and outsourcing companies based in Montreal, Canada, an independent director of Noranda Aluminum Holdings based in New York City and an independent director of Tyhee Gold based in Vancouver BC, Canada. He retired in May 2013 as Chairman of Resolute Forest Products and in April 2009 as an Executive Director of London-based Rio Tinto plc and Melbourne-based Rio Tinto Ltd., and as Chief Executive of Rio Tinto Alcan, a wholly-owned subsidiary of Rio Tinto, one of the world’s leading producers of aluminum. Previously, Mr. Evans was President and CEO of Montreal-based Alcan Inc. and led the negotiation of the friendly $ 40 billion acquisition of Alcan by Rio Tinto in October 2007. Under Mr. Evans’ leadership in 2006 Alcan won the coveted National Safety Council Campbell Award for large enterprises and was named the world’s most respected metals company in Fortune Magazine’s annual survey.
Prior to being CEO at Alcan, Mr. Evans was its Executive Vice President and Chief Operating Officer, during which he oversaw Alcan’s four business groups: Bauxite and Alumina, Primary Metal, Engineered Products and Global Packaging. Before taking on this role, he led the successful integrations of Pechiney and algroup into Alcan following their acquisitions in 2004 and 2001 respectively. He joined Montreal-based Alcan Aluminium Limited in January 1997 as Senior Advisor, Corporate Development, following 27 years of US and international management experience with Kaiser Aluminum & Chemical Corporation. He has lived in and led businesses in five countries and conducted business extensively in North America, Europe, Africa, the Middle East, Asia and Australia.
Mr. Evans is currently a member of the Advisory Board of the Global Economic Symposium based in Kiel, Germany and is a past Executive in Residence and Advisory Board member at the McGill University Faculty of Business. He is a twice past Chairman of the London based International Aluminium Institute (IAI) and is a past Chairman of the Washington, DC based U.S. Aluminum Association. He is also past Co-Chairman of the Environmental and Climate Change Committee of the Canadian Council of Chief Executives and a past member of the Board of USCAP, a Washington, DC, based coalition concerned with climate change. He served as Co-Chairman of the Montreal Museum of Fine Art’s “2007 Bal du Musée” fundraising campaign and was Co-Chairman of the 2008 Greater Montreal Centraide Campaign. In 2009 he co-founded a photography web gallery, In Transit Images and has published several photographic books, including most recently in 2012 “San Francisco and the Bay Area – The Haight Ashbury Edition.”
A native of Oregon, USA, he is a 1969 graduate of Oregon State University with a bachelor’s degree in engineering and earned a Master’s in management in 1978 from the Stanford University Graduate School of Business. He and his wife, Gretchen, have two married daughters who reside in California, USA and recently welcomed their second grandson. He and Gretchen, an artist and interior designer, have lived primarily in San Francisco since 2009 and currently split their residency between Montreal and San Francisco, California. His personal interests include outdoor photography, fly fishing, bicycling and international travel.