The simple answer is a promise to pay, or an IOU. It is a liability on a balance sheet.

It is not a dedicated account with liquid assets. It is not cash waiting to be spent. Environmental liabilities are not matched with sequestered capital – unless a regulator or counterparty agrees that funds should be in a letter of credit or insurance policy. Otherwise, future environmental cleanup costs are offset by the working capital, goodwill, and other co-mingled assets in the business.

The reserves are today’s recognition of future spending on environmental clean ups. Judgment calls occur when an asset – especially one which can be used as collateral – is created or improved.

For example, a plant has a wastewater treatment plant, primarily to handle process and stormwater from the facility. This plant has a discharge permit and an on-site laboratory to check water quality. The costs to build and maintain this plant are capital expenditures and the routine period costs, like electricity, are operating expenses. As a capital expenditure, the asset cost is deducted from taxable income gradually, over the life of the plant. If this wastewater treatment plant is modified to handle the water from a groundwater remediation system, that incremental cost is usually a reserve expense, meaning the costs are estimated in advance and deducted (from taxes) as spent.

Where does judgment come in? A spill or discontinued waste handling practices are basis for reserving associated future costs. In other words, if a wastewater treatment plant has a diesel fuel spill, the costs to cleanup that spill are reservable, while the routine operating costs are expensed without a reserve.

The rule of thumb is if the cost would stop when production stops, it is an operating cost. If a cost would continue after production stops, it is likely either an asset retirement cost (like asbestos removal or demolition) or an environmental remediation cost.

While operating, the same plant can be discharging a mix of stormwater, process water and remediated groundwater, but the costs probably need to be split out.

When a company increases their environmental reserves, quarterly earnings (and then shareholder equity) usually decrease by the same amount. If this happens once and if this amount is immaterial, that is where the impact usually ends.

However, for most companies with environmental liabilities, new data or issues (or acquisitions) crop up within a year or two and reserves need updating. Here is where the shareholders come in:

• Did the shareholders get the benefit of a dollar-for-dollar reduction in liability for capital spent on environmental clean ups?
• Did new information or issues lead to a timely reassessment of future environmental spending?
• Did the results of that quantification promptly get to the reserve?

Environmental reserves matter to a range of stakeholders, from the shareholders to employees and regulators. Accuracy, reliability, and consistency with measurement of similar contingent liabilities are all important.

If a company understates environmental liabilities by $50 million, then it is overstating shareholder book value by the same amount. If an investor trusts the pension cost forecast as accurate, prepared with rigor, do they expect environmental reserve estimates to be managed to a different standard?