Uncertainty persists on chemical equations

The EU’s REACH directive is mired in controversy – and presents the chemicals sector with uncertain risks. But Steve Waygood argues that chemical manufacturers should be doing more to prepare for its possible financial impact

The EU’s proposal to introduce a new chemical testing regime have generated a storm of controversy – with chemicals companies warning of crippling costs, NGOs arguing that the proposals are already too watered down, and even the US government recently weighing in.

Such is the pitch of the debate that, despite the European Commission first issuing proposals last summer, agreement on the ‘REACH’ (Registration, Evaluation and Authorisation of Chemicals) directive is unlikely to come before the second half of next year.

REACH under the microscope – but few chemicals companies have done their research

Nonetheless, three things are already clear: this is one of the most far-reaching pieces of legislation under consideration in Europe, and probably the most important public policy chemicals initiative for three decades; it is likely to have substantial financial implications for the industry; and many companies appear unprepared for its introduction.

The REACH directive is designed to address growing concerns that the widespread use of certain chemicals can have serious impacts on human health and the environment. For example, research by the EU has shown that it is probable that everyone now has traces of persistent organic pollutants (POPs) in their body tissue.

Since 1988, the EU has been evaluating the impacts of all chemicals in use. It has determined that sufficient environmental and human health impact data does not exist for more than 90% of the approximately 80,000 chemicals that have been synthesised to date.

At present, public authorities carry the burden of proving that a chemical is hazardous. REACH is essentially a proposal to reverse the ‘burden of proof’, such that the chemicals industry would be responsible for generating and providing the necessary human and environmental health information to demonstrate that its products are safe.

However, industry is concerned that the costs of the proposal will be prohibitive – with the more realistic direct costs to industry from the proposed testing regime alone estimated to be between €1.45 billion ($1.78 billion) and €7.2 billion over a decade. Some industry associations suggest that up to 20% of chemicals on the market would have to be discontinued. In addition, other sectors such as pharmaceuticals, retailing and automotives all use chemical companies’ products and will all be affected to some degree.

There have been strong representations regarding the need to reduce bureaucracy and testing costs from, among others, the US, UK, French and German governments. While some amendments have been made, the current draft remains highly contentious, with companies, trade associations and NGOs all expressing significant disquiet.

Despite a lengthy assessment and consultation phase, a number of significant problems remain to be resolved. First, the current proposal for the prioritisation of chemicals for evaluation is contentious. Some would prefer to prioritise on a risk basis instead of the current proposal of focusing on high-volume chemicals. Second, there are questions regarding how to apply REACH to chemical substances in imported products.

Third, due to the potential for significant regulatory efficiency gains associated with ‘one substance, one registration’ proposal, it has been proposed that companies collaborate in consortia when testing chemicals. However, there are commercial tensions surrounding the sharing of data in such consortia.

Given the continuing uncertainties, it is unclear how the regulation will play out in different sectors and which companies will be winners and which losers. There is little reliable data available on the potential financial impacts of different REACH scenarios. As a consequence, Insight surveyed 17 chemical companies in the UK and continental Europe, including BASF, Bayer, BOC Group, ICI, Victrex and Yule Catto, requesting information that will help us to assess how REACH may impact them financially.

Specifically, we asked them to tell us how well they were addressing the following four REACH-related issues, which we believe to be potential earnings drivers:

- Market loss – REACH proposes that, without acceptable data, chemicals cannot be marketed. Therefore, it is possible that certain key chemicals may have to be discontinued.

- Raw material loss – Companies that depend on the output of primary chemical manufacturers may find that essential raw ingredients are no longer available.

- Potential for innovation – A major aim of the EU policy is to stimulate the development of ‘safer substitutes’ to existing chemicals. When approving chemicals for specific use, strong preference will be given to less hazardous alternatives. As a result, REACH could benefit companies with research and development programmes that attempt specifically to identify such safer substitutes.

- Litigation risk – REACH represents an increase in litigation risk as it proposes a greater level of public access to testing data.

Our initial assessment is that, while there were a few outstanding exceptions, many companies appeared unprepared for the introduction of REACH. Most were not in a position to give estimates of the financial impact but, nonetheless, many expressed confidence that the impact would not be material.

Those few companies that did offer cost estimates varied significantly in their assessment of the likely impact (even when taking into account differing product types). Regrettably, many appeared not to recognise the opportunity to establish new market share based on the innovation of substitutes for chemicals of high concern. However, there were notable exceptions – exceptions that help us to add depth to our long-term investment view on specific company performance.

While recognising that there are a number of unknowns regarding the draft REACH proposal, given the scale of its potential impact, it is reasonable for investors to expect implicated companies to have established some idea of the scale of costs based on different scenarios. It is surprising, therefore, that our research did not identify more companies that appeared to have done so.

We would expect more nimble companies to be adopting a management approach that accepts that REACH is a reality. We would also expect them to be moving to reduce the potential costs of market loss, and innovating to realise the potential of new markets arising from the principle of substitution. Experience with previous regulations has shown that first movers generally have the advantage.

Steve Waygood is London-based director of investor responsibility at Insight Investment, the asset management arm of the UK’s HBOS banking group.

E-mail: steve.waygood@insightinvestment.com