TRIRIGA Insights

A year of natural disasters

So far, 2010 headline stories have been marked by a series of natural disasters of almost unprecedented scale. Whether we examine the earthquakes of Haiti and Chile or the winter storms that have battered the Northeastern United States, structural damage to facilities, electrical grid failures and transportation disruptions limit the continuity of business operations and disaster recovery efforts within these affected areas. (see figure 1.)

Figure 1: Storm causes havoc in the Northeast – 2/27/2010

Suspension of operations at mission critical facilities such as headquarters, data centers, call centers, manufacturing sites and laboratories can rapidly translate into millions of dollars of lost productivity and customer disaffection.

Lack of an integrated facilities database can hamper disaster recovery

To minimize the impact of natural disasters on mission critical facilities, real estate and facilities departments must deliver vital insights required to formulate an overall business continuity plan and specific disaster recovery scenarios. From these plans, real estate and facilities departments must be prepared to execute these plans immediately with other members of the recovery team including IT, human resources, risk management, operations management and communications.

Unfortunately, many organizations lack the unified and integrated facilities database and process support that are crucial in the planning and execution of a comprehensive facilities disaster recovery plan.

Make sure your company is prepared

While the February 27th 8.8 magnitude earthquake in Chile was measured to be 500 times stronger than that of Haiti’s, Chile’s preparedness and rapid response translated into less loss of life and critical infrastructure.

Use of an Integrated Workplace Management System (IWMS) within your business continuity planning can similarly prepare your organization to respond immediately and minimize disastrous consequences. At a high-level, IWMS identifies mission critical facilities and serves as the centralized repository of essential facility information, processes and procedures for an effective emergency response.

To discover how IWMS delivers the capabilities to support your organization’s disaster recovery plans, read Integrated Workplace Management System – A critical tool in business continuity and disaster recovery management, a whitepaper authored by leading industry analyst Michael Bell.

On Monday (February 22) the Environmental Protection Agency (EPA) announced that planned regulation of greenhouse gas (GHG) emissions under the authority of the Clean Air Act would be phased in over the next several years. As reported previously, the EPA’s proposed regulation of GHG emissions from large emitters was expected to take effect in 2010.

Since the EPA’s announcement in September, a number of legislators and business leaders have expressed concerns about the cost of complying with new regulations in a struggling economy. In response to these concerns, the EPA has decided to postpone the start of the regulation and take a phased approach to implementation. Starting in the first half of 2011, the largest GHG emitters who are already required to comply with other provisions of the Clean Air Act will be required to obtain a GHG permit by demonstrating that best practices and technologies are being used to minimize GHG emissions. Depending on the amount of GHG emitted, other large emitting organizations will be phased into the program between 2013 and 2016.

In addition to the delay in implementation, the EPA may also increase the GHG emission threshold used to determine whether an organization is required to obtain a GHG permit. This could significantly decrease the number of organizations that are required to obtain permits.

Impact to Your Organization:

Although the changes to the EPA’s proposed regulation will reduce the compliance burden for most large emitters of GHG, it is important to note that this announcement has no effect on the EPA Mandatory GHG Reporting rule or any other federal, state, or local GHG legislation. And, given the fact that the material risks from climate change are not limited to the direct impact from legislation and regulation, the EPA’s announcement should have little influence on an organization’s carbon management strategy.

The bottom line is that organizations should not interpret the EPA’s announcement as a devaluation of GHG reduction efforts. More than ever, organizations that manage energy use and GHG emissions today will have a competitive advantage over those that wait for regulation to compel action.

Facilities and real estate assets represent a top-four cost of business for more than 67% of organizations. As organizations seek to contain their facilities operating costs, the real estate and facility management function has become strategic to the enterprise with the majority of C-suite executives having moderate (55.6%) to high (27.8%) awareness and priority for this function - see Figure 1.

Figure 1. CRE Function

While many organizations will struggle to contain escalating energy, occupancy and maintenance costs, Aberdeen Group reports that best-in-class organizations achieved annual savings rates of more than twice the annual TCO savings per square foot when compared to others – see figure 2.

Figure 2. Annual Savings Rates Achieved

A real solution to cut facility costs

When asked, 65% of these high-performers are more likely than their peers to rationalize their facilities portfolio to reduce costs and 55% develop a strategic real estate and facilities plan. According to the Aberdeen report, they understand the need for enterprise-class software to increase their utilization of space and achieve 20% higher space utilization than those that don’t.

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.