Business Money – Finance and Banking for Business

Property development

Competitive advantage from environmental risk

May 2005

Let’s be straight about one thing: environmental risk is about cash. Plain and simple, you can make decisions that add value to your business and harm that of your competitors at the same time.

Richard Pawlyn

There are still many lenders and investors who have yet to appreciate this fact and continue to invest funds without full assessment of a development’s opportunities and threats. Eyes are instead ﬁxed squarely on the site’s potential. How long before the eyes become ﬁxed…and dilated? Time’s up, your loan book is contaminated.

Other, more savvy investors and lenders have appreciated the potential ﬁnancial devastation wrought by this underground enemy and buy environmental reports or enlist the services of specialised consultants to minimise their exposure. They are protecting that cash.

Then there are a few, a growing few, who have got their eyes wide open and are a step ahead of the competition. These few have seen the landscape changing, adhered the warnings of the ﬁlm Erin Brokovich, signed up to the principles behind Basel II, and adopted the full science behind the management of ﬁnancial and environmental risk. They are not just protecting their cash, they are making more of it.

At this stage you could either be dismissive, sceptical, curious or perhaps, if in the latter group, wearing a large, satisﬁed smile on your face.

For the sceptics, consider this: one in four commercial properties in the UK’s largest cities face exposure to potential environmental risks and possible loss in land and property values. Most UK cities are at risk to a range of environmental liabilities. For example, nearly 30% of commercial property in Bradford could be at risk from landﬁll and waste contamination. Nearly 40% of commercial property in Bristol could be at risk from pollution, with the city also recording one of the highest risks from ﬂooding (28%). Shefﬁeld demonstrated the greatest potential risk from radon (38%) and subsidence (95%).

Reading these statistics you can understand why investors are quite rightly cautious about committing to sites without fully understanding all the issues. If environmental searches are not completed at the outset, investors risk facing the full remediation costs at a later date if contamination is subsequently identiﬁed.

Surveyors are currently taking a closer look at their processes. When conducting valuations, surveyors are leaving themselves and clients exposed, as many are not covered by professional indemnity insurance to comment on environmental issues. The common practice of using caveats in reports is deemed ‘potentially unsafe and professionally inappropriate’ by the Royal Institution of Chartered Surveyors. These statistics help to demonstrate the extent of environmental issues and should be seen as a stark reminder of the potential risks.

But it is not just potential risks we are dealing with, as the case of commercial housing developer Circular Facilities highlights. The developer was apparently unaware of such environmental risks when it acquired a piece of land for development in the 1980s. Soon after the development was completed emissions of carbon dioxide and methane were found on the properties. Sevenoaks District Council served a remediation notice to Circular Facilities on 5 November 2002 which in a subsequent appeal the judge upheld, stating that the developer should have been aware of the risk posed by the condition of the site and awarded the costs of the remediation legal costs against the developer.

As a lender, this is no trivial matter when millions of pounds are at stake. If an owner defaults on a loan the lender can usually rely on the capital asset to balance the books. But if it turns out to be contaminated land not only will it present an enormous headache of an asset to deal with, the lender may also have to foot the bill to clean it up. A bill which could cost more than the land was worth in the ﬁrst place, and it is also a good deal more rewarding taking an action against a bank than an insolvent developer. So you have three problems, a bad loan, no asset and a liability.

It all paints a picture of a property landscape which is changing fast – squeezed by a number of economic and regulatory pressures on all sides.

Setting the scene, Erin Brokovich ﬁred her warning shot across the bows of environmental risk in 1987 having discovered contaminated land and groundwater at Hinkley in California. It was a class action, which resulted in $333m in compensation and made US banks look closely at their exposure.

Closer to home the latest planning guidance now forces developers to submit detailed environmental assessments with planning applications.

Part IIa of the Environmental Protection Act came into force in April 2000 and local authorities now have a duty to give clean up orders to the ‘appropriate person’ where a site is deemed contaminated. Plus, the introduction of Basel II in 2008 is likely to make the existing framework even more risk sensitive.

It is here we come to the group ‘wearing a large, satisﬁed smile’ on their faces. It is a smile of competitive advantage in a hard fought market where every ‘nth’ percentage of margin carries a signiﬁcant increase in proﬁt. To this group risk management is intrinsic to their business and the loan approval process is no exception.

By incorporating a simple screening tool into the workﬂow process for each loan application these astute lenders instantly minimise their exposure. Screening tool? A £25 environmental report which in less than ﬁve minutes signals the all-clear or ﬂags up a potential risk. It is one simple step among a number of risk management practices, which combine to minimise risk on every property investment.

This committed attitude to minimising risk is rewarded with a positive ﬁnancial side-effect. By minimising risk the lender also minimises the amount needed to be set aside for provisions.

The end result? Increased funds. And in a market where the narrowest of margins can make the widest in proﬁts, this is a crucial advantage to have. As ever, environmental risk increases complexity to the process, but in turn it gives the astute players and early adopters who systematically adopt environmental risk management an important competitive advantage – and the opportunity to land their competitors with expensive problems to solve from a non-optimal loan book.

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