integrated reporting, stakeholder engagement, and balanced investing at american electric power

VOLUME 24 | NUMBER 2 | spRiNg 2012

APPLIED CORPORATE FINANCEJournal of

A M O R G A N S T A N L E Y P U B L I C A T I O N

In This Issue: sustainable Financial Management

Toward a 21st Century social Contract 8 Carl Ferenbach, Berkshire Partners LLC and the

High Meadows Foundation, and Chris Pinney,

Aspen Institute

sustainability as Adaptability 14 Martin Reeves, Knut Haanaes, and Claire Love,

Boston Consulting Group; and Simon Levin,

Princeton University

public pensions and U.s. infrastructure investment: The perfect partnership?

23 J. Perry Offutt, James Runde and Stacie D. Selinger,

Morgan Stanley

integrated Reporting, stakeholder Engagement, and Balanced investing at American Electric power

27 Katherine W. Parrot, MIT Sloan School of Management,

and Brian X. Tierney, American Electric Power

sustainability at Dow Chemical 38 Kathleen M. Perkins, Miller Consultants,

Robert G. Eccles, Harvard Business School, and

Mark Weick, Dow Chemical

How Does sustainability Disclosure Drive Behavior Change? 45 Nigel Topping, Carbon Disclosure Project

New Corporate Forms: One Viable solution to Advancing Environmental sustainability

49 Susan Mac Cormac and Heather Haney,

Morrison and Foerster

sEC Esg Noncompliance: Where the Rubber Meets the Road 57 Linda M. Lowson, CSR Insight™ LLC

The Need for Sector-Specific Materiality and sustainability Reporting standards

65 Robert G. Eccles, Harvard Business School, Michael P. Krzus,

Mike Krzus Consulting; Jean Rogers, Sustainability

Accounting Standards Board, and George Serafeim,

Harvard Business School

Performance Measurement for Nonprofits 72 David M. Glassman and Kathy Spahn,

Helen Keller International

private Landowners Cooperate to sustain Wildlife Habitat: The Case of the sabi sand game Reserve

78 David Schmidtz and Elizabeth Willott,

University of Arizona

Journal of Applied Corporate Finance • Volume 24 Number 2 A Morgan Stanley Publication • Spring 2012 27

Integrated Reporting, Stakeholder Engagement, and Balanced Investing at American Electric Power

* Acknowledgements: We acknowledge AEP’s staff for their help in providing raw material and editorial help for this paper: Joe Buonaiuto, Bruce Braine, Lonni Dieck, Dale Heydlauff, Mark McCullough, Rich Munczinski, Sandra Nessing, Melissa Tominack, Den-nis Welch, and Chuck Zebula.

1. Federal Energy Regulatory Commission, EIA-923 data, (2009)2. Global Reporting Initiative data, (2011)3. Award given by Ceres and the Association of Chartered Certified Accountants

(ACCA).

T

by Katherine W. Parrot, MIT Sloan School of Management, and Brian X. Tierney, Executive Vice President and Chief Financial Officer, American Electric Power*

he policies and actions of American Electric Power (AEP) present a number of seeming para-doxes in the domain of sustainability. AEP relies predominantly on coal for electricity generation,

which puts the company squarely in the center of national debates on how to address global climate change and national air quality while supporting economic growth. At 65% of the company’s generation portfolio, AEP’s coal generation assets represent the legacy of investment during the 1960s and ’70s in a physical geography that favored coal. Burn-ing coal produces emissions of carbon dioxide (a greenhouse gas), mercury, nitrogen oxide, and sulfur dioxide, which are all regulated under the Clean Air Act. Burning coal to gener-ate electricity also creates combustion residuals, which under current regulations can either be disposed at an approved site or used for beneficial purposes like cement, structural fill, and roads.

Between coal and natural gas, AEP is one of the largest fossil-fueled electricity generators in the nation. In 2009, AEP was the largest user of coal in the western hemisphere1 and, to the company’s knowledge, the largest emitter of carbon dioxide among U.S. electric utilities. As context, the U.S. electric power sector overall accounts for 40% of U.S. carbon dioxide emissions; transportation contributes 34%; and the remainder are emissions from residential, commercial, and industrial activities.

AEP’s carbon profile is one of many factors that investors weigh when they consider buying the company’s stock. Inves-tors want to know if AEP’s fleet of coal plants will survive new environmental regulations and, if so, at what cost. They also want assurance that the investments the company must make to comply with these regulations will be recovered and earn a return for investors. AEP is an attractive target for other stakeholders—primarily environmental groups—who are agitating to shift the nation’s electricity generation away from coal, and to end the use of coal obtained from mountaintop removal mining in Appalachia.

Although it might seem paradoxical that a large coal-burning utility could be a sustainability leader, AEP is also

recognized for taking action on issues beyond what the company is required to do by regulations.

In the area of energy efficiency, stakeholders give AEP high marks for its leadership and proactive, collaborative approach. On policy, the company was one of the first large coal-burning electric utilities to support the 2009 Waxman-Markey bill, which addressed clean energy, energy efficiency, and the goals of reducing greenhouse gas (GHG) emissions and transitioning to a clean-energy economy. AEP was also a founding member of, and the first major utility company to join, the Chicago Climate Exchange (CCX). The CCX, which as of 2011 was no longer operating in the U.S., was the only voluntary, legally binding GHG reduction and trading system in North America.

On the technology front, one of AEP’s recent large investments was in carbon capture and storage (CCS) at a 20 megawatt (MW) validation scale facility that was built at the company’s Mountaineer Plant in West Virginia. The project, which was the world’s first integrated CCS, successfully captured more than 51,000 metric tons of carbon dioxide and stored more than 37,000 metric tons underground between September 2009 and May 2011. A second 235 MW commer-cial scale project was planned, but was shelved when funding could not be secured. However, extensive engineering and geologic work was completed that the company believes will one day provide substantial benefits for this and other CCS projects.

AEP is also noted for its advanced sustainability reporting, putting it with a minority of companies that publish a single report that integrates the annual report and the sustainability report. In 2010, of all companies globally that published a sustainability report adhering to the guidelines of the Global Reporting Initiative (the most widely used standard), only 12% published an integrated report.2 And in 2011, AEP won the first runner-up award for the best sustainability report from a panel of independent judges,3 who commended AEP for its integrated report and transparency in reporting.

Integrated reporting is considered a leading-edge practice. A recent white paper from Generation Investment Manage-

28 Journal of Applied Corporate Finance • Volume 24 Number 2 A Morgan Stanley Publication • Spring 2012

4. Generation Investment Management, “Sustainable Capitalism” (2012)5. Robert Eccles and Michael Krzus, One Report: Integrated Reporting for a Sustain-

able Strategy (Hoboken, NJ: Wiley & Sons, 2012).

tant to AEP. Most electric utilities in the U.S. operate in a highly regulated environment. Because of the capital-intensive nature of infrastructure investments, the industry’s long-term investment horizons, and the need to locate electricity gener-ation in geographical proximity to end users, governments historically granted monopoly franchises to investor-owned utilities. Today, AEP’s operating companies are primarily regulated utilities.

To counterbalance the monopolistic pricing power conferred on utilities by these exclusive rights to operate, state and federal authorities developed a regulatory frame-work that gives regulators the power to set electric rates. As part of this contract, utilities are required to provide electric service at the lowest reasonable cost to the ratepayer over the life of the investment, usually on a present value basis. Utilities can legally change their base rates by filing rate cases with regulatory bodies. State Public Utility Commissions or Public Service Commissions, which are made up of elected or appointed officials, are the primary retail rate-making authorities.

In practice, rate setting is a complex, time-consuming, and often contentious process in which utilities and a variety of stakeholders present arguments to regulators about what factors should influence rates. Rate-case hearings open portals for stakeholders to weigh in on decisions that directly influ-ence a company’s earnings and operations. Interveners in rate cases encompass a wide variety of stakeholders, including residential, commercial and industrial customers, environ-mental groups, industry experts, and other special interests. Each of these groups represents a different set of interests, ranging from rate minimization, environmental regulation, market competition, energy efficiency, and renewable energy development.

Regulators hear testimony from these different stake-holder groups and then issue a decision that sets “base” level rates that are supposed to cover the anticipated cost of provid-ing service to customers plus a “fair” or “reasonable” return on that cost base. Utilities are entitled to earn an equity return on their investments, which have recently been set at a risk-adjusted return in the range of 10 to 10.5%. The entire rate-setting process typically takes 12 to 18 months, and hence creates an earnings lag that utility companies try to minimize.

In addition to deciding what costs can be recovered through base rates, and defining revenue by determining rates and other cost-recovery mechanisms, regulators control other important aspects of the utility industry landscape. From a financial perspective, chief among these is the power to regulate the debt-to-equity ratios that are used to calculate

ment listed mandatory integrated reporting as one of five key actions to accelerate the move towards sustainable capital-ism.4 As defined by researchers, integrated reporting is a way of “communicating to all stakeholders that the company is taking a holistic view of their interests, both as they comple-ment one another and compete against each other.”5 It is also a way of demonstrating the link between financial and non-financial information, including concern about risks that may arise from environmental and social issues.

Finally, AEP is a leader and innovator in the domain of stakeholder engagement. The company has developed a variety of forums, both in person and through social media, for interacting with stakeholders on issues such as the cost of electricity, the future of coal, energy efficiency, environmental regulations, climate change, supply chain management, and the company’s business model. In 2011, AEP held twelve stakeholder meetings, several of which were attended by the company’s most senior leaders.

As AEP says in its 2011 integrated report, “Our ability to succeed as an organization and to deliver financial and social value is tied directly to the strength of our relationships with our shareholders and with other stakeholders. We provide an essential service to society and to local communities that requires us to be accountable, transparent, and trustworthy. We have found that if we work with our stakeholders in good faith to find common ground, and if we are honest and candid about our decisions and the basis for them, they will respond in kind—even when our views differ sharply.”

A recent policy disagreement between AEP and its environmental stakeholders notwithstanding, stakeholders acknowledge that AEP is acting with integrity with these values. They have described AEP as having a constructive, responsive, and proactive stance in the engagement process.As one said recently, “There aren’t many companies that make time in their day for you to go to them and give them honest advice, and they did a very good job of listening and interact-ing [during the engagement].”

In this article, we discuss why integrated reporting and stakeholder engagement are central to the AEP’s success, and how AEP seeks to integrate financial, environmental, and social factors in its investment decisions. We then comment on the theory of “enlightened value maximization,” origi-nally proposed by Michael Jensen in this journal in 2001, which views stakeholder engagement as an integral part of how companies generate long-term market value.

The Utility Industry Regulatory LandscapeUnderstanding the utility business environment is critical for appreciating why stakeholder engagement is so impor-

29Journal of Applied Corporate Finance • Volume 24 Number 2 A Morgan Stanley Publication • Spring 2012

6. Moody’s Investors Service, “Global Infrastructure Finance: Regulated Electric and Gas Utilities,” (2009).

Stakeholder Engagement at AEPIn the past ten years, stakeholder engagement has come into fashion in corporate social responsibility and sustainable finance circles. The argument for engagement is that companies that do a better job engaging its stakeholders will be better positioned, for a variety of reasons, to make good business decisions.

However, the insight that a company’s success is inter-twined with its stakeholder relationships is hardly new. The enterprise of business has always unfolded in the context of relationships with customers, investors, employees, and regulators. What has changed is the degree of power and sophistication that stakeholders now bring to the table, and the degree of influence they can have on how companies do business. What has also changed is the complexity and speed of the business environment, and the demands on companies for increased transparency and improved social and environ-mental performance.

In its 2011 integrated report, AEP says that it invests heavily in relationships with its non-investor stakeholders because they:

• “Informusofkeyissuesthataffectpeoplewhoareimportant to us.

• Challengeus continually to improveourperfor-mance.

• Giveusinsightsintopointsofviewthatwemaynothave considered.

• Helpusunderstandhowweareperceivedontheoutside.

• Workwithustofindcommongroundandcollaborateon common objectives.

• Holdusaccountableforouractionsandimpacts.• Arewillingtoengage inmeaningfuldialogueto

achieve reasonable solutions.”What this list does not mention is that AEP also engages

with stakeholders for the simple reason that they have signif-icant power to inf luence how the company conducts its business. Stakeholders both influence and make use of legisla-tive, regulatory, and legal channels to address their concerns. Whether it is through their influence on environmental or market regulations, lawsuits on specific infrastructure projects, shareholder resolutions, or public activism campaigns, stake-holders find ways to translate their interests into tangible impacts on AEP and the utility industry more broadly.

In particular, the state Public Utility Commission rate cases are a unique forum through which regulators and other stakeholders influence AEP’s profitability and operations by

• Establishingwhatcostscanberecoveredandhowmuch return is allowed on investment;

• Influencingearningslagthroughthetimelinessofratedecisions;

rates. Regulators can also define service territories, mandate the level and reliability of electricity and gas service that must be provided, and set or revise safety standards.

Financial ImplicationsAs mentioned earlier, electric utilities are capital-intensive companies that depend on ready access to both debt and equity to finance large-scale infrastructure projects. Because utilities are entitled to the opportunity to earn a fair rate of return and because regulators set a maximum limit on equity ratios to drive down the cost of capital (and ultimately elec-tricity rates), companies in the industry are typically highly leveraged, with debt-to-capital ratios of from 50 to 60%.

Since regulated utilities are legally obligated to provide reliable service to customers at the lowest reasonable cost, they need to maintain an investment-grade credit posture to ensure access to capital at a reasonable cost. They aim to achieve a debt-equity capital structure that supports a position in the credit ratings “sweet spot”—that is, a rating that is low enough to access capital markets at the lowest possible weighted average cost of capital, but not so low that access to capital is jeopardized. At this writing, AEP is rated Moody’s: Baa2 (stable), S&P: BBB (stable) and Fitch: BBB (stable). At these rating levels, AEP finds adequate access to capital at reasonable rates.

In addition to financial strength and liquidity, a major factor in utility credit ratings is the stability of the regula-tory framework in which a company operates. Moody’s rating methodology for electric and gas utilities states, “From a credit standpoint, the regulators’ ability to set and control rates and returns is perhaps the most important regulatory consideration in determining a rating.”6 Moody’s gives the predictability and supportiveness of a company’s regulatory framework a 25% weighting.

Closely related to this is the ability of a company to quickly recover costs and earn a return in a timely manner. This, according to Moody’s, is “perhaps the single most important credit consideration for regulated utilities, as the lack of timely recovery of such costs has caused financial stress for utilities on several occasions.” Moody’s also gives this factor a 25% weighting, bringing the total regulatory-related impact on a company’s credit rating to a substantial 50%. The other factors are financial strength (40%), and business diversification (10%).

Because the regulatory environment plays such an impor-tant role in determining the amount and timing of revenues granted to utilities, AEP places enormous attention and resources on managing relationships with these regulatory bodies and stakeholders that intervene in the rate-setting process.


AEP sees these connections more clearly because the company is heavily regulated, and there are mechanisms like rate-case hearings through which stakeholders can exert influence. Moreover, the nature of the business and the business context undoubtedly forces utility companies to think more than other kinds of companies about the relationship of environmental and social issues to material risk and financial health. Although integrated reports represented only 12% of the reports filed with the Global Reporting Initiative (GRI) in 2010, they represented 20% of those filed by utility companies.

But industry characteristics cannot fully explain the differences in companies’ reporting approaches. Many utility companies still do not issue a sustainability report, much less one that conforms to GRI standards. Those that prepare a single integrated report remain in a small minority. Why AEP chose to start issuing integrated reports is in large part a function of the company’s culture of openness and transpar-ency. AEP’s commitment to joint financial and sustainability reporting is shown by its investment in professional and staff time dedicated to its reporting activities and to stakeholder engagement.

Stakeholder Engagement and Integrated Decision-MakingWe now present several examples that show how AEP thinks about stakeholder engagement and balancing financial, environmental, and social considerations in its decision-making.

Climate Change and AEP’s Generation StrategyClimate change may be one of the most significant sustain-ability issues for AEP. As its 2010 integrated report says, “The link between our environmental and financial performance as a company has begun to be seen, at least in part, in terms of our ability to address global climate change.” Investors and other financial stakeholders are paying more attention to companies’ carbon profiles. For instance, Moody’s and S&P both point to the likelihood that the electric utility industry will face increasing expenditures from new and uncertain future carbon requirements. In 2008 a group of large banks formed the Carbon Principles to help financial institutions and their power generation clients better understand and

• Requiringandapprovingspecificcapitalstructureratios;

• Influencingtheoverallpredictabilityandconsistencyofthe regulatory environment, which impacts credit ratings; or

• Delayingand/orincreasingthecostsofnewinfrastruc-ture, especially new power plants.

AEP sees the value of stakeholder engagement as stemming in large part from its obligation to balance many different stakeholder interests in the rate-setting process. As one person at AEP said of rate case hearings, “If you’re going to run into stakeholders at your cash register, you should try to find common ground with them.”

AEP’s leaders have learned that proactive engagement of stakeholders can both generate creative business solutions and limit potentially costly opposition later on. Good engage-ment means getting stakeholders’ input on the front end to develop solutions that take their interests into account (Phase I), communicating with and educating stakeholders to build support for decisions before they are implemented (Phase II), and working with stakeholders through the implemen-tation phase to ensure transparency, accountability, and fair monitoring of outcomes (Phase III).

Integrated ReportingAEP’s 2011 integrated report states, “The connections between our environmental, financial, and social perfor-mance are central to our strategy and to our thinking about who we are and what we do. The more we align and integrate our activities in these three areas, the more successful we will be.” And as the first integrated report in 2010 says:

During the past decade, many businesses have seen how financial, environmental and social performance are connected, and AEP is no exception. Our success is increasingly related to our ability to meet environmental responsibilities, maintain financial strength, deliver safe, reliable electricity to our custom-ers, safeguard our work force, and deepen relationships with communities and key stakeholders. This report demonstrates our efforts to be more transparent and to integrate environmental and social risks and opportunities into everything we do. We believe that global environmental and social forces will increas-ingly move corporations toward considering these issues as part of their routine business decisions.

Figure 1 Opportunities for Stakeholder Engagement in Decision Making

PHASE II

Building Decision Support

PHASE III

Decision Implementation

PHASE I

Decision Formation


AEP is also monitoring, and in many cases is actively involved in, research on disruptive technologies like distrib-uted electricity generation, which would reduce reliance on electricity generated by large, centralized power plants, and energy storage technologies, which would make intermittent renewable energy sources like wind and solar more attrac-tive and provide uninterrupted power to customers when an outage occurs.

All these activities are part of AEP’s approach to strength-ening its generation portfolio, and keeping the company on the path to continued CO2 reductions. The risk of future carbon regulations is one factor that the company considers in formulating generation strategy, but is only one among many. And AEP is limited in what it can do in the absence of mandated regulations.

AEP’s approach to managing climate risk also involves making voluntary reductions in CO2 emissions. In 2000, the company made a decision to join the Chicago Climate Exchange (CCX), North America’s only voluntary, legally binding greenhouse gas (GHG) reduction and trading system for emission sources and offset projects in North America and Brazil. As a founding member, AEP committed to cumulatively reduce or offset 48 million metric tons of CO2 from 2003 to 2010. This represents a 15% reduction in CO2 emissions from 2003 levels. AEP exceeded its goal, reducing or offsetting a cumulative 95 million metric tons, almost double the original commitment.

AEP made several calculated business decisions in joining CCX. First, participating in the CCX was a strategy to facili-tate compliance with future carbon mandates, which looked likely to happen at some point. Verified carbon credits that were generated in a voluntary system with wide recognition and support would presumably carry over if and when carbon regulations took effect. Furthermore, AEP believed that the CCX would set desirable public policy precedents around flexibility of offsets and other provisions for meeting climate goals.Duringitsmembershipperiod,AEPalsoworkedwithlegislators, regulators, policymakers and other stakeholders to gain support for regulatory cost recovery of carbon credits in the rate-setting process.

In 2010, the CCX trading platform ceased operating in the United States. The fact that today there is no national carbon regulation or trading system in place raises the question of what will happen to the carbon credits that AEP generated with CCX. AEP had hoped that the credits—or at least those that the company “banked” but never had to use in the program due to over-compliance—would be usable in a federal carbon legislative system. Now that federal cap

respond to the risks of carbon exposure and climate change. In 2010 the Securities and Exchange Commission ruled that companies should disclose climate-related risks. These and other developments mean that AEP must pay attention to the climate implications of its current and future investments.

Investors want to understand how AEP plans to grow the company, and to avoid or mitigate risks associated with current and future business operations. To date, investors have been more concerned about risks that are better under-stood (and whose expected effects are more short term) than climate change, and that have a more direct link to AEP’s earnings. While there is broad acknowledgement that climate change poses some level of business risk, quantifying it is nearly impossible because of the enormous uncertainty about the severity of the issue, the scope and timing of future regula-tions, and cost of compliance. At this point, the best that AEP can do is to disclose the risks, take proactive steps to address them, and communicate its actions to investors. Thus far, investor reaction to AEP’s handling of climate change risk, the risk of which we outline below, ranges from indifferent to positive.

Climate considerations are inextricably linked with the company’s current and future electricity generation portfolio. AEP’s approach centers on the company’s current generation mix and developing a future fuel portfolio that is balanced in terms of the following considerations: costs; a sustainable and diverse resource mix; the stability and reliability of genera-tion; and risks, especially those that arise from environmental regulations on air quality and climate change.

AEP believes that coal will continue to play an impor-tant role in the nation’s energy supply. Coal is a relatively affordable, abundant, secure, and indigenous fuel. However, company leaders recognize that costs for coal-fired genera-tion are likely to increase due to environmental compliance requirements.

The transition of AEP’s electricity generation business, which is now underway, is expected to reduce the company’s reliance on coal from 67% in 2011 to an estimated 50% in 2020. Natural gas is expected to increase from 24% in 2011 to 27% by 2020, and the remainder will be achieved through renewable energy, nuclear, hydro, energy efficiency, and demand response programs. AEP’s goal was to add 2,000 megawatts of renewable energy capacity by the end of 2011 with investments in wind, solar, and biomass energy. The economic recession and regulatory pushback have slowed that progress, and AEP did not meet the goal. However, the company will continue to expand its renewable mix, provided the company gains support from regulatory commissions.7

7. Here and in the remainder of this section of the article on integrated decision-making, we incorporate some language about AEP’s policies and investment decisions that was originally published in the company’s 2010 and 2011 integrated reports. We acknowledge the primary authors of these reports: Sandra Nessing, Jerra Thomas-Schlagheck, Chris Amatos, and David Hagelin.


deal of criticism from some state regulatory commissions, legislators, and the U.S. Chamber of Commerce. Yet, AEP believed that supporting the bill made good business sense given that some form of carbon regulation seemed likely. Had it passed, the bill would have created a cap-and-trade regula-tory regime for carbon that AEP believed would have been preferable to the 2011 proposals to regulate greenhouse gas emissions through the Clean Air Act.

Integrating Environmental, Social, and Financial Factors in Capital InvestmentsAEP must weigh many factors in making capital investments, including the obligation to provide low-cost, reliable electric-ity; environmental and other rule requirements; impacts on customer electric rates; and the need to maintain financing requirements set forth by regulators.

AEP’s major categories for investing capital in infra-structure are generation, transmission and distribution, and mandatory environmental controls like scrubbers on coal plants. From a strict ROI standpoint, investing in transmis-sion and distribution is generally the most attractive of the three choices because it is expected to involve less time for cost recovery, and is relatively low risk compared to other options such as building a new power plant.

In 2012, AEP plans to spend $201 million (or 6%) of its $3.1 billion capital investment plan on new generation, $375 million (12%) on base fossil, hydro and nuclear generation, $922 million (30%) on electricity transmission, $845 million (27%) on electricity distribution, and $503 million (16%) on environmental controls for regulated pollutants and plant effluent. The following examples illustrate some of the ways that AEP thinks about integrating social and environmental considerations in investment decisions, and the role of stake-holder engagement in the process.

and trade legislation will almost certainly not pass for several years, if at all, this prospect is unlikely. AEP had also hoped that its participation in CCX would prepare the company and other industry participants for a market-based approach to GHG regulations.

Through its membership in the CCX, AEP endeavored to be pro-active and environmentally responsible. The company is pleased with what it was able to learn from its participation and the accomplishments it made in reducing CO2 emissions. However, in this case, regulatory uncertainty forestalled an immediate profit result. This is an example of the kind of challenge that AEP confronts when trying to make investment decisions in the face of uncertain public policy. However, given the company’s significant carbon footprint and the likelihood of future carbon legislation, AEP believes that investment in initiatives that reduce carbon in the company’s generation portfolio is a long-term, profit-maximizing move.

By this reasoning, AEP continues to set emissions reduc-tion goals. The goal by 2020 is to reduce CO2 emissions by 10% from 2010 levels, much of which will occur as older, inefficient coal units are retired. In the absence of federal carbon regulations, and because of its obligation to provide low cost service, AEP can address climate change only through measures that make strict economic sense.

As the debate about climate change and carbon legislation continues, AEP continues to play an active role in the regula-tory and legislative landscape, believing that it has insight and experience that will both help address climate issues in a meaningful way and in a manner that is economically benefi-cial to its shareholders and society as a whole. For the sake of transparency, these activities are disclosed in the company’s integrated report.

In 2009, AEP came out publicly in support the Waxman-Markey climate change bill. This decision attracted a great

Figure 2 Opportunities for Stakeholder Engagement in Decision Making

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states where AEP’s has operations. Regulators typically do not approve cost recovery for environmental investments without a state or federal mandate. If history is any guide, investing in environmental controls in the absence of regulations would have resulted in AEP’s investors, not its customers, footing the bill.

This issue ref lects disagreement, and perhaps some misunderstandings, about the specifics of AEP’s situation in a regulated context. But there is a broader challenge, in that stakeholders tend to advocate for issues from their point of view. While this is understandable, they do not always appreciate the full range of other stakeholder interests that companies must consider in making decisions.

AEP needs to balance its compliance with existing and future environmental regulations with its commitment to managing the company’s overall financial health and access to capital markets; meeting its obligation to provide reliable service; and limiting rate increases, especially in an economic downturn. Sometimes these interests conflict with one another directly; a good example are proposed environ-mental controls that would raise the rates of customers who live in economically depressed areas. As the 2011 integrated report states:

Even though our rates remain below the national average, our customers generally live in lower-income regions and are particularly sensitive to rate increases. A comparison of state median incomes shows that virtually all of our states are below the national median income. This is particularly true in our Appalachian Power and Kentucky Power service areas. Both companies have seen rising customer complaints due to recent rate increases. Customers of both operating companies have voiced protest in person, in petitions, on social media outlets and through legislators who are taking a more active role in opposing rate increases for their constituents. As the economy remains weak in both areas, we can expect continued resistance and opposition to future rate increases – and vocal criticism from customers who are finding it increasingly difficult to pay their electric bills, particularly during the coldest and hottest times of the year.

It is up to AEP to integrate all its stakeholders’ consid-erations into its decision-making process to best address the interests of all involved. The question, which we will take up at the end of this article, is how company leaders can navigate this balancing act.

Investing in Advanced Coal Technologies. As part of its generation strategy, AEP has for a number of years been involved in developing and building advanced coal technolo-gies. These investments are consistent with the history of the company as a technology innovator. They are also a strate-gic move to protect AEP’s coal-based generation portfolio in anticipation of future carbon regulations. And, they are

Investing in Environmental Controls. Federal and state environmental regulations have required AEP to spend more than $7 billion on environmental upgrades since 2000, which are ultimately reflected in higher electricity rates. As the nation addresses issues such as climate change and the need to further reduce sulfur dioxide, nitrogen oxide, mercury, and other emissions, AEP anticipates that the cost to produce its electricity will increase significantly, although it will still be competitive compared to other alternatives.

Prior to 2008, AEP’s total capital spending on environ-mental controls was much higher than it is today due to investments needed to comply with the Clean Air Act (see Figure 2). Although the percentage of environmental spending is currently lower today, the company is about to embark on a new environmental compliance program that is estimated to cost between $6 and $7 billion through 2020. These costs are the result of new environmental rules, including the Cross-State Air Pollution Rule (CSAPR) and the Mercury and Toxics Standard Rule (MATS).

AEP’s investments in environmental controls to comply with these rules became the subject of sharp disagreements with the company’s environmental stakeholders in 2011. At the heart of the debate was the design and timing of new air quality regulations, which would have required significant new investments in environmental controls on coal plants. AEP objected to the short timing, stringency, and the cost impact on customers. A full explanation of the issues from each side’s perspective is beyond the scope of this article, but there is one in particular that highlights the kinds of challenges inherent in stakeholder engagement.

A key area of disagreement was stakeholders’ contention that AEP knew for years that regulations were coming, and should not now ask to have its timelines extended when it could have acted sooner and more proactively. Stakehold-ers pointed to the example of other utilities that say they can comply within a shorter timeframe than AEP believes is feasible.

AEP maintains that the company could not have known about the stringency and requirements of the regulations until they were finalized, and therefore should not have been expected to make specific technical judgments about how to comply most efficiently. Had AEP overestimated that strin-gency of the regulations and “overcomplied” with the final regulations, it would not likely have been able to recover its full investment. On the other hand, had AEP underestimated the stringency of the final regulations and installed technology that was insufficient to comply with regulations, it may have had to scrap those plans and begin again, thus wasting capital and imposing unnecessary costs on consumers. In either case, making large investments in environmental controls before regulations are finalized would be a risky proposition.

Other companies were required to reduce emissions because of state-imposed mandates, which did not exist in the


plants, thereby achieving higher efficiencies and greater CO2 reductions. Construction is nearing completion at the 600 megawatt, $1.8 billion ultra-supercritical John W. Turk Jr., Plant in Arkansas, which includes advanced emissions controls that will allow the plant to meet stringent new environmental regulations. The plant will be the first of its kind in the U.S.

Ultra-supercritical technology was selected for the Turk Plant because of its excellent lower-emissions performance and its suitability for the Western coal that is used in AEP’s South-western Electric Power Company (SWEPCO) territory. The coal-fueled baseload Turk Plant is part of AEP SWEPCO’s balanced approach to new generation, which also included 800 MW of natural gas-fueled capacity—the Mattison Plant completed in Tontitown, Arkansas in 2007 and the J. Lamar Stall Unit completed in Shreveport, Louisiana in 2010.

Although the Turk project encountered many legal challenges over a four-year period, these were ultimately settled with stakeholders, including the Hempstead County Hunting Club and other local landowners in July 2011 and the Sierra Club, the National Audubon Society, and Audubon ArkansasinDecember2011.EventhoughAEPconsiderstheTurk project an overall success, the many legal challenges and delays that encumbered the project indicate that there is even more opportunity to engage stakeholders during Phase 2 of building support for a decision, and Phase 3 decision imple-mentation (see Figure 1). Although it may not be possible to avoid the courtroom entirely, stakeholder engagement could open the door to earlier, faster, non-litigated solutions that better satisfy all parties’ interests. Ultimately AEP’s share-holders and other stakeholders could both benefit.

On “Enlightened Value Maximization”Throughout this article, we have presented examples of how AEP has wrestled with the challenges of balancing finan-cial, social, and environmental considerations in its decisions. When determining its capital investment strategy, AEP must balance the company’s overall financial health and access to capital markets; compliance with existing and future environ-mental regulations; meeting its obligation to provide reliable service; and keeping rate increases under control, especially in economically depressed areas. In practice, trying to incorpo-rate all these factors is a complex undertaking. The question is, how should managers make decisions in light of many different stakeholder interests and demands?

This is precisely the question that Michael Jensen is seeking to answer with his theory of enlightened value

an expression of AEP’s belief that technology plays a critical role in addressing climate change as well as having balanced, effective public policy. We highlight two examples here.

In 2009, AEP completed construction on a carbon capture and storage (CCS) validation project on its Mountaineer plant in West Virginia. The system operated successfully as the first demonstration project of its kind in the world. AEP requested cost recovery and a return on investment on an equal share basis from the state utility commissions in Virginia and West Virginia. However, the rate-case decisions in both states were unfavorable because the two states were unwilling to shoulder the entire financial burden and risk of a project that they believed should be shared among all of AEP’s customers.8 This resulted in a $76 million write-off for the company. At the time of this writing, AEP has discontinued plans to move forward with a second commercial-scale phase of CCS due to the absence of a working market for carbon credits, and the reluctance of regulators to allow cost recovery for CCS operating costs.

This experience exemplifies the kind of challenge that AEP constantly faces—calculating which actions are likely to create long-term value without the safety net of legal or regulatory mandates that would ensure a return on invest-ment. In this case, AEP’s decision resulted in the successful demonstration of CCS technology that may one day be useful in addressing GHG emissions on fossil-fueled power plants. On the other hand, the write-off of millions of dollars in investments irritated some of the company’s stakeholders—namely, shareholders—who did not receive the value they expected from the investment.

From this and other experiences, AEP has learned to be cautious about getting too far ahead of regulatory require-ments. With CCS, AEP attempted to lead the way, proactively searching for solutions to issues that had not yet seen manda-tory actions. Because regulators declined to grant recovery of costs that were not required by law, AEP was unable to recover and earn a return on its investment.

AEP has also learned to invest more time and energy engaging stakeholders proactively at the front end of a decision (Phase 1 in Figure 1). Especially when a new, innovative idea is being proposed, early involvement of stakeholders to gauge their reactions and concerns can help diffuse potentially costly problems, and open up the space for creative solution genera-tion at the front end of the decision process.

A second example involves AEP’s investments in ultra-supercritical coal technology, which uses less fuel and produces fewer emissions than conventional pulverized coal

8. Virginia was the first to issue its decision in 2009, stating that “although AEP as-serts that this demonstration project will benefit customers of all AEP’s operating com-panies and of all utilities in the United States, ratepayers (and not shareholders) are being asked to pay for all of the costs incurred by AEP for this project…to shoulder the entire financial burden and risk associated with AEP’s [CCS] research and development.” West Virginia was more sympathetic, arguing that Virginia might have allowed some of

the expenses below 50%, and that CCS technology held enormous potential for West Virginia. However, West Virginia ultimately allowed only portion of the operating ex-penses of the plant, and denied cost recovery for the plant itself, using arguments similar to those of the Virginia Commission.


But as already noted, Jensen is not in fact opposed to what might be called the core insight of stakeholder theory. As he writes, “[I]t is a basic principle of enlightened value maximization that we cannot maximize the long-term market value of an organization if we ignore or mistreat any important constituency.” Moreover, what Jensen’s refers to as “enlightened” stakeholder theory” is consistent with his concept of enlightened value maximization in the sense that managers must pay attention to and invest in all constituencies that can affect the value of the company. The theory of enlightened value maximization simply adds the specification that the long-term firm market value should be the single objective function—the overriding goal—of the firm. Accepting this objective function, Jensen claims, should help to limit problems arising from the multiple objectives of traditional stakeholder theory by giving managers a clear way to think about and make tradeoffs among corporate stakeholders.

We agree with Jensen that long-term value maximiza-tion is a useful and appropriate measure of performance for a company. Managers have both a fiduciary duty and a competitive imperative to maximize market value. If they make decisions that repeatedly fail to maximize value, or do so only in the short-term at the expense of the long-term, they violate their fiduciary duties and run the risk of being sanctioned or fired. In the worst case, their actions can threaten the very survival of the company. Maximizing firm value over the long-term is therefore an obvious and respect-able way to measure an organization’s performance.

We also agree with Jensen’s premise that stakeholder engagement both supports and enhances value maximization. Companies have a choice about how they behave. They can deny that other points of view exist and refuse to acknowl-edge societal views or expectations. Or, they can choose to be inclusive and take stakeholder interactions into account in their intelligence gathering and decision-making processes. At AEP, stakeholder engagement provides critical input to the company’s strategy and investment decisions. We believe that, in general, companies are in a better position to maximize long-term value if they engage meaningfully with stakehold-ers. In this, we are in full agreement with Jensen.

However, we believe there are two key problems with Jensen’s theory of enlightened value maximization, namely:

1. The theory does not, in practice, provide a useful crite-rion for evaluating tradeoffs among stakeholder interests. In the end, balancing stakeholder interests is left to the judgment of individual managers.

2. Elevating long-term value maximization to the position of an organization’s single overriding objective creates risks that managers may sacrifice ethical and relational concerns in

maximization.9 The theory proposes that corporate managers should aim to increase the long-run efficiency and value of their companies, and that the scorecard by which a compa-ny’s (or its management’s) success should be measured is the increase in the value of the firm’s long-term market value. This “objective function” is offered as an answer to the dilemma of trying to weigh the interests of many different stakeholders in decision-making, a problem that Jensen says is not addressed by current stakeholder-based theories of the firm.

Stakeholder theory, in essence, holds that managers should weigh the concerns of all of a company’s significant stakeholders in their decision-making. The theory does not automatically privilege investor interests over those of other stakeholders, as shareholder theory does. Rather, managers are charged with the responsibility to consider a range of stake-holder interests with the objective of creating as much value as possible for all of a firm’s stakeholders, without resorting to trade-offs. That is, “Where stakeholder interests conflict, the executive should find a way to rethink the problems so that these interests can go together, so that even more value can be created for each. If trade-offs have to be made, as often happens in the real world then the executive must figure out how to make the trade-offs, and immediately begin improv-ing the trade-offs for all sides.”10

Jensen argues that although the goal of value maximiza-tion effectively requires that companies take account of the interests of all its important stakeholders, managers should be guided by one single objective: the (long-run) maximiza-tion of a company’s efficiency and value. Trying to achieve multiple objectives, according to Jensen, is a prescription for corporate failure. In his words, whereas value maximization provides corporate managers with a single objective, stakeholder theory directs corporate managers to serve many masters. And, to paraphrase the old adage, when there are many masters, all end up being shortchanged. Without the clarity of mission provided by a single-valued objective function, companies embracing stakeholder theory will experience managerial confusion, conflict, inefficiency, and perhaps even competitive failure.

A stakeholder orientation also creates problems by giving managers free rein to pursue their own special interests at the expense of the company’s investors. A firm that “adopts stakeholder theory will be handicapped in the competition for survival because, as a basis for action, stakeholder theory politicizes the corporation and leaves its managers empow-ered to exercise their own preferences in spending the firms’ resources.” A stakeholder orientation “allows managers and directors to devote the firm’s resources to their own favorite causes—the environment, art, cities, medical research—without being held accountable for the effect of such expenditures on firm value.”

9. Michael Jensen, “Value Maximization, Stakeholder Theory, and the Corporate Ob-jective Function,” Journal of Applied Corporate Finance, Vol. 14, No. 3 (2001).

10. R. Edward Freeman et al., Stakeholder Theory: The State of the Art, Cambridge: Cambridge University Press (2010)


action. Considered, realistic judgment applied to a corpora-tion’s present situation and alternative courses of action in pursuit of profit are what managers should strive for. This is hard work, involving fact-based, informed decision-making based on sound and experienced managerial judgment. There is no shortcut to it.

In this process, managers are not the only parties responsible for exercising sound judgment. Boards of direc-tors also carry enormous responsibility. All of AEP’s major strategic decisions—for instance, the company’s position on climate legislation and its decisions to develop advanced coal technologies like carbon capture and storage—were subjected to in-depth discussion and approval by the board. The only way that boards and managers can make sound decisions is if their exchanges are candid and transparent. In this, managers bear the responsibility to present the risks and downsides of recommended actions.

Sound Judgment Involves More than Maximizing a Single Objective Function We agree with Jensen that long-term value maximization is a worthwhile and appropriate way to measure a company’s performance outcomes. We also agree that value maximiza-tion is a useful and important objective that managers should seek to achieve. We disagree, however, that it should stand in as the firm’s sole objective function.

The paradox is the kind of business judgment that does stimulate long-term value creation involves much more than maximizing a single (economic) objective function. For instance, AEP’s rate cases require someone at the company to exercise judgment about which competing interests are most compelling and how can they be addressed in such a way that not only maximizes the long term value of the company but also preserves the foundations of future working relationships and results in an outcome that is ethically acceptable.

If any one of these three objectives—economic, ethical, and relational—is compromised, long-term value creation can be put at risk. We think that Jensen would probably agree, and argue that a firm cannot maximize long-term value if it is making ethical missteps or destroying relation-ships along the way. Our point is that it is a question of where managers train their attention. If, as Jensen suggests, managers seek to maximize economic value as their sole objective—even if it is long-term value—they run the risk of diverting attention away from relational and ethical concerns. Striving for economic value as the single overrid-ing goal for a firm threatens to create an overly utilitarian mindset in which an economic goal may be used to justify, or at least to weaken vigilance against, the use of ethically or relationally dubious means. In the wake of recent corpo-rate scandals, it is not difficult to imagine how managers might convince themselves that a decision is right for maximizing firm value, and ignore or minimize the firm’s

order to achieve financial returns. The kind of judgment that does create long-term value involves more than maximizing a single financial objective function.

The Role of Judgment in Balancing Stakeholder InterestsBalancing and integrating stakeholder interests in corpo-rate decision-making is a challenging task. Jensen does not offer workable criteria for navigating this challenge. Simply saying that managers should always act to maximize long-term market value is not an answer in itself, because people need to exercise judgment in arriving at an outcome calcu-lus. Companies need people to exercise not just any kind of judgment, but sound judgment about how to reconcile differ-ent stakeholder interests in making decisions.

Jensen says, “The world may be complex and difficult to understand. It may leave us in deep uncertainty about the effects of any decisions we may make. It may be governed by dynamic systems that are difficult to optimize in the usual sense. But that does not remove the necessity of making choices on a day-to-day basis. And to do this in a purposeful way we must have a scorecard.” He goes on to evaluate and then reject the Balanced Scorecard as a decision tool because it fails to yield a single score about an organization’s perfor-mance. This, Jensen claims, prevents people from making purposeful decisions. In place of multiple objectives, Jensen proposes a single one: the maximization of long-term firm market value.

While it is certainly true that the world is complex and managers must make decisions with only imperfect infor-mation, enlightened stakeholder theory offers little practical guidance on how managers should balance and weigh many factors in pursuit of long-term value maximization. As already noted, Jensen advises managers to “spend an additional dollar on any constituency to the extent that the long term value added to the firm from such expenditure is a dollar or more.” We agree with this in principle as one input into decision-making, but we do not find it useful in practice. This principle would offer little useful guidance to AEP’s managers in a rate case hearing to navigate the competing goals of maximizing earnings and keeping rate increases under control. Nor would it help AEP in developing an investment strategy that simul-taneously optimizes AEP’s overall financial health and access to capital markets; manages risk; complies with existing and future environmental regulations; and meets its obligation to provide reliable service.

What AEP has found to be helpful in weighing and balancing conflicting interests are carefully tested and stressed pro forma financial metrics, combined with information about strategic, regulatory, and market expectations about various alternative courses of action. This is why stakeholder engagement is so important—in providing critical inputs, engagement helps companies determine a wise course of


gle and willingness to tolerate uncertainty that progress can be made.

In closing, at AEP, management must daily balance the myriad interests of the stakeholders it serves: customers, share-holders, regulators, legislators, environmental interests, and business interests. In this, AEP’s management is focused on maximizing the long-term value of the company. Enlightened value maximization theory does not offer a practicable guide to decision-making because it does not tell management how to weigh or balance sometimes conflicting interests when seeking long-term value maximization. Furthermore, sound judgment involves more than a sole focus on economic objec-tives. Instead of reducing the objective function of a firm to a single economic goal, managers should embrace the hard work of balancing often competing interests. This, in the end, will contribute to long-term value maximization, as the natural outcome of sound business judgment.

katherine parrot is a doctoral candidate at the MIT Sloan School

of Management.

brian tierney is Executive Vice President and Chief Financial Officer

at American Electric Power.

or society’s cultural, ethical, and moral values. In the end, these decisions can mean disaster for a company’s long-term value creation, even if managers do not realize it at the time.

In summary, sound decision-making requires manag-ers to consider many objectives, including but not limited to long-term value creation. Jensen’s theory treats non-value maximizing objectives as being subsumed under, and support-ive of, the overarching goal of long-term value creation. We suggest, however, that conflicting interests cannot be resolved by focusing solely on economic value creation as the single overriding goal. Wise managers make decisions that optimize long-term market value and relational value creation while maintaining the highest ethical standards.

This creates precisely the dilemma that Jensen is hoping to avoid with the single objective function theory. But it is not avoidable. Company leaders bear the responsibility for wrestling with the challenges inherent in balancing multiple competing objectives and stakeholder interests simultaneously. Managers should engage stakeholders to hear their perspectives, ideas, and feedback. With this information, managers should struggle, and they may well be confused. There may not be a known, single answer to the challenges that they face, but it is in that honest strug-

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