TRIRIGA Insights

March 2009, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a joint discussion paper highlighting proposed changes to financial accounting standards for leases (FAS 13) which governs the accounting treatment of operating leases. The FAS 13 changes outlined could have an enormous impact on the balance sheets and income statements of companies with significant operating lease obligations.

Today, FAS 13 requires that operating leases are classified as an off-balance sheet transaction and only the current year operating lease expense is accounted for in the income statement. Corporations must also include a note in their Security and Exchange Commission 10-Q and 10-K filings detailing the anticipated rent expense for the next five years. Proponents for changing the FAS 13 rule argue that the current standards fail to give an accurate view of a company’s liabilities. This argument seems valid given the fact that operating leases represent the single largest source of off-balance sheet financing for most organizations. Furthermore, for many organizations, operating lease obligations represent a larger liability than all other liabilities on the balance sheet combined. For this reason, the FASB has spent decades debating the proper accounting treatment of operating leases.

Highlight of proposed changes to FAS 13
The FAS 13 changes proposed in the March discussion paper would require that all operating leases be reclassified as capital leases. Capital leases differ from operating leases in that they must be recorded on the balance sheet and are treated as a financing transaction on the income statement. The right to use the leased property would be capitalized as an asset and the present value of future lease payments would be accounted for as a liability. Rent payments would no longer be included in EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Instead, a before tax depreciation and interest amount would be calculated to account for the annualized use of the property. For a more in depth summary of the proposed changes read “FAS-Talking: Unpacking Real Estate’s Impact on Financial Statements” in the September 2009 issue of the CoreNet Leader magazine.

The proposed changes are currently being reviewed by FASB, IASB, and others. The next draft of the new lease accounting standards should be available later this year and the final rule could be put in place as early as 2011.

Impact of FAS 13 change to financial statements
There is little doubt that the proposed FAS 13 lease accounting changes would have an enormous impact on financial statements. Simply moving operating leases onto the balance sheet would add over one trillion dollars to the balance sheet of U.S. companies. The income statement changes would have a positive effect on EBITDA due to removal of rent expense from operating expenses. However, the additional depreciation and interest expense required by the proposed FAS 13 changes would result in an overall decrease to net income during the first half of the lease term.

For companies that control most of their real estate through operating leases, the proposed lease accounting change will have a significant effect on financial statements. Balance sheet and income statement changes have the potential to adversely affect debt covenants and performance ratios. All else being equal, financial metrics such as the debt-to-equity ratio and interest coverage ratio could increase significantly. There is much debate about the effect this will actually have on a company’s valuation and cost of capital since many investors and financial institutions already factor in operating leases into financial analysis. Regardless, companies who are affected by the proposed FAS 13 accounting change will need to thoroughly predict and explain upcoming changes to financial statements.

Impact of FAS 13 change on strategic real estate decisions
It is important to keep in mind that the proposed FAS 13 lease accounting changes do not have a direct effect on cash flow; arguably the most important indicator of financial performance. However, companies will need to invest time and money to evaluate lease structures, determine the impact to financial statements, and communicate the impact to investors well in advance. Although this exercise is critical, real estate executives and professionals must not lose focus on the primary goal to align real estate assets with the business strategy. Although the proposed FAS 13 rule change may alter the buy versus lease decision or add a new variable to lease negotiations, accounting rules are seldom a primary driver of real estate decisions. The proposed FAS 13 changes illustrate the fact that, more than ever, real estate executives and professionals require a decision support system that provides the ability to prioritize objectives and make tactical decisions that align with the business strategy.

January 23, 2010, the U.S. Securities and Exchange Commission (SEC) agreed for the first time that corporations are required to disclose climate change risks to investors. According to a joint press release from CERES and EDF, the SEC’s guidance is “the first economy-wide climate risk disclosure requirement in the world”.

The SEC’s decision was influenced by repeated requests over the past three years by investor groups who urged the SEC to require full corporate disclosure of climate-related business risks and strategies for addressing those risks. The announcement highlights a number of areas where disclosure of climate change risks would be required. These include: direct impact from legislation and regulation, indirect consequences of regulation or business trends, and the physical impact of climate change.

Direct impact from legislation and regulation
Increasingly organizations will face material impacts from climate change legislation and regulation. This is especially true for organizations that directly emit large amounts of carbon emissions. Many of these organizations are already experiencing the risks and challenges of complying with the EPA’s Mandatory Greenhouse Gas (GHG) Reporting rule and potential regulation. Under the SEC’s guidance, the potential material impact of this regulation should be addressed in financial reports to investors. As proposed legislation sits in the U.S. Senate, a price on carbon becomes more probable, organizations will certainly need to disclose the potential financial impact of direct carbon emissions.

Indirect consequences of regulation or business trends
Large direct emitters of carbon emissions will not be the only organizations affected by the SEC’s guidance. Many organizations with modest direct GHG emissions will still be affected by regulations and business trends related to carbon management. As discussed previously, regulation that puts a price on carbon will have the indirect affect of increasing energy costs for all organizations. And, increasingly, organizations that have direct or indirect carbon emissions in excess of the industry average will face a material risk of increased costs and decreased customer demand.

Physical impact of climate change
Certain industries such as insurance and finance will be directly affected by the climatic changes predicted by many scientists. Increased natural disasters such as storms and droughts will result in increased insurance payments and investment write-offs. As the evidence for climate change grows, organizations located in areas most affected will be required to disclose the risks of business disruption due to climatic changes and the risk of increased insurance premiums and capital costs.

With the SEC’s announcement, organizations that fail to disclose material risks from climate change face the real threat of lawsuits from investor groups or punitive action from the SEC. Mindy Luber, president of CERES and directory of the Investor Network on Climate Risk called the SEC’s announcement, “a clarion call about the vast risks and opportunities climate change poses for US companies and the urgency for integrating them into investment decision making”.

There is little doubt that the trend towards increased scrutiny of climate change risks by investors, regulators, and customers will continue. The longer an organization ignores the risks from climate change, the greater the negative effect on company valuation and profitability. As TRIRIGA CEO, George Ahn, stated in an article in the Environmental Leader last August, “All else being equal, companies that adequately disclose and address risks from climate change will be rewarded with higher valuations and a lower cost of capital.”

The first step toward accurately addressing risks from climate change is to baseline your organization’s energy use and environmental impact. To gain a sense of where and how to start reporting, consider real estate. Buildings represent 48 percent of energy consumption and present the most significant opportunities to reduce environmental impact, improve operating costs, and demonstrate carbon reduction accountability.

Although the economy has been the number one priority of business and political leaders over the last twelve months, climate change has remained a top issue across the globe. State and local governments continue to lead the way on legislation to reduce energy use and greenhouse gas emissions. As President Obama finishes his first year in office, federal legislation designed to reduce carbon emissions and address climate change gained momentum and will likely become law in 2010. Below is a recap of climate change legislation as 2009 comes to an end. The clear trend is for more stringent climate change legislation in the near future.

International
The much anticipated Copenhagen climate summit failed to deliver the legally binding climate treaty that many hoped for. However, the non-binding Copenhagen Accord that came out of the summit does demonstrate a commitment on the part of industrialized and developing countries to reduce global greenhouse gas emissions. Most importantly, China and other large developing countries made a commitment to reduce the carbon intensity of their economies. This step will help remove a key barrier to the passage of climate legislation in the United States.

Federal
The EPA Mandatory Greenhouse Gas Reporting rule is the first nationwide GHG regulation. Although this rule is focused on heavy emitters and requires only emission reporting and not actual abatement, it will most likely be used as a foundation on which to build federal legislation designed to reduce GHG emissions. Both of the climate change bills currently in Congress call for a cap and trade program that will likely use the EPA benchmark data to determine carbon emission allocations. The Waxman-Markey bill passed the House earlier this year and the Kerry-Boxer bill is still making its way through various committees. Although it is likely to take several months before a consolidated climate bill is passed by the House and Senate, the process is likely to move forward at a steady pace as long as EPA regulation of greenhouse gas under the Clean Air Act remains a possibility.

States
As is often the case with environmental legislation, California is leading the way with energy and greenhouse gas legislation. California's version of mandatory GHG reporting started in 2008. This year was the first year that organizations were required to report greenhouse gas emissions to the California Air Resources Board. In addition to California, at least 16 other states have passed some sort of mandatory GHG reporting legislation. A number of states, including California, have also enacted laws requiring large private buildings to provide an annual benchmark of energy use.

Cities
Many cities are also aggressively addressing carbon and greenhouse gas emissions within their jurisdictions. Since 2005, more than 1,000 mayors across the country have signed the U.S. Conference of Mayors Climate Protection Agreement. Participating cities commit to implement policies that will reduce GHG emissions in line with the targets set in the Kyoto Protocol. Although much of the effort to date has been focused on city owned buildings and operations, there is an increasing push to require private buildings to track and manage energy use and GHG emissions. Washington D.C. recently announced legislation that will require large privately owned buildings to provide an annual benchmark of energy use. New York City recently introduced a series of bills that require large privately owned buildings to benchmark energy use, make lighting improvements and sub-meter multi-tenant buildings. Several other cities will soon follow suit and, undoubtedly, legislation will include tougher measures to require privately owned buildings to make energy improvements to meet a minimum performance level.

Climate change legislation is a part of doing business
Increasingly organizations realize that the risks from climate change are real and have a material impact on the bottom line. Legislation to address this threat will only become more stringent and most organizations will likely be required to measure and manage energy use and greenhouse gas emissions. Organizations that begin managing energy use and GHG emissions today will have a competitive advantage over those that wait for regulation to compel action.

Last Friday, President Obama addressed the United Nations Climate Change Conference in Copenhagen. During his short speech to the plenary session, the President reiterated the commitment of the United States to reduce greenhouse gas (GHG) emissions. As expected, the President specifically stated his GHG emission reduction goals of 17% by 2020 and over 80% by 2050 from 2005 levels. President Obama also expressed his disappointment with the lack of progress at the conference toward forming a legally binding climate change treaty while also reaffirming his conviction that, "America is going to continue on this course of action to mitigate our emissions and to move towards a clean energy economy, no matter what happens here in Copenhagen."

As was widely expected, the Copenhagen conference ultimately fell short of delivering a binding international climate change treaty. However, due in large part to President Obama's direct negotiations with China, India and several other key developing and industrialized countries, the conference did produce an interim climate change accord that received nearly unanimous approval by the attending nations and kept the possibility of a future legally binding treaty alive.

Although certainly not as strong as a legally binding international treaty, the Copenhagen Accord will likely influence climate change legislation in the US simply because China, India and many other developing countries have made a commitment to reduce their own GHG emissions. China's previous reluctance to commit to reducing the carbon intensity of its economy was an especially large barrier to US climate change legislation. By accepting the Copenhagen Accord, China has certainly made it easier for sponsors of US climate change legislation to gather the sixty votes necessary to break a filibuster and pass climate legislation in the Senate. As long as developing countries continue to show a commitment to reduce their own emissions and as long as the Environmental Protection Agency's (EPA) regulation of GHG emissions through the Clean Air Act remains a real possibility, climate change legislation will likely become law within the next two years.

In contrast to the uncertainty surrounding the timeframe and structure of federal climate change legislation, large organizations will likely be affected immediately by the EPA's Mandatory GHG Reporting rule or by one of the increasing number of state and local energy and environmental laws. The EPA's Mandatory GHG Reporting rule and other proposed regulations will directly affect organizations with carbon intensive facilities. At the state level, California continues to lead the way with legislation to track and reduce GHG emissions and energy use in facilities. At the local government level, cities are competing for the title of "Greenest City" by enacting tough energy standards in building codes and requiring large public and private buildings to monitor and report on energy use. The City of New York recently enacted a series of bills to reduce energy use in public and commercial buildings. These measures include more stringent building codes and periodic energy audits and retrocommissioning for large buildings. This trend towards legislation that addresses GHG emissions and energy use in existing buildings is certain to spread to more cities in the near future.

Each new energy and GHG law that is enacted will make it more expensive for organizations to ignore their own energy use and carbon emissions. In order to effectively comply with the multitude of current and planned energy and GHG laws and make cost effective improvements to reduce environmental impact, large organizations require environmental sustainability software to track and manage carbon emissions, energy use and environmental impact.

Beginning January 1, 2010, organizations will be required to track and report on greenhouse gas (GHG) emissions from those facilities that fall within the EPA Mandatory GHG Reporting guidelines. The EPA Mandatory GHG Reporting rule is just the first step to actually regulating GHG emissions. The EPA has taken the next step with the signing of the Endangerment Finding that officially places GHG emissions under the regulatory authority of the Clean Air Act. The EPA has also recently proposed a rule that would require carbon intensive facilities to implement "best practices and technologies" to minimize GHG emissions. In addition, both houses of Congress have proposed GHG regulation to significantly reduce emissions over the next several decades. Finally, President Obama is expected to address the United Nations Climate Conference in Copenhagen on December 18th and formally announce a non-binding GHG reduction commitment for the United States that aligns with the reduction levels proposed by Congress.

As with the EPA Mandatory GHG Reporting rule, the GHG regulations being proposed would directly affect large emitters of GHG. Facilities that fall under the EPA Mandatory GHG Reporting rule would most likely also have to comply with any GHG regulation. In total, somewhere between 10,000 and 14,000 facilities would fall under the proposed GHG regulations. For these facilities, there will be a direct cost to emit GHG. A recent study by Trucost and the IRRC Institute found that carbon intensive industries could experience a reduction in EBITDA (earnings before interest, tax, depreciation, and amortization) of between 1 and 117 percent as a result of proposed GHG legislation. These carbon intensive organizations need to look beyond mandatory reporting of GHG emissions and begin to implement programs to reduce the carbon intensity of facilities and processes. In order to accomplish GHG reduction in a cost effective manner, organizations need tools to identify carbon intensive facilities and pinpoint opportunities to reduce emissions. With the right decision support system in place, industrial facilities have an enormous opportunity to reduce energy use and carbon emissions.

All of the proposed GHG reduction regulation is designed to place a cost on carbon for those organizations that directly emit large amounts of GHG. This means that most organizations will not have facilities that fall under the GHG regulations. However, all organizations will be affected through increased energy prices and increased prices for carbon intensive inputs. GHG regulation with reduction targets in line with what Congress and President Obama propose could increase electricity prices by 30 percent over the next five years. Given the increased probability of GHG regulation, organizations must prepare for significantly increased energy costs in the near term. The good news is that there are many cost effective strategies that organizations can implement to reduce energy costs and environmental impact. The bad news is that few organizations have the tools to gather the energy and environmental information necessary to optimize capital and resource allocation to the projects with the highest financial and environmental return.

Whether your organization is directly or indirectly affected by GHG regulation, the time to prepare is now. Organizations that proactively prepare for GHG regulation will be positioned to capitalize on opportunities to reduce energy use and improve environmental performance.