Projecting P2 costs

• May 01, 1999

The Pollution Prevention Act of 1990 authorizes the U.S. Environmental Protection Agency (EPA) to promote technological solutions to reduce pollution. Case studies on EPA and state Web sites document pollution prevention (P2) efforts by industry. Nevertheless, there is a general feeling in the environmental community that viable projects are not being implemented. A better environmental accounting of benefits and costs of technology will ultimately lead to more success, encouraging firms to consider higher risk environmental technology investments. Cost accounting for P2 technology requires special treatment, first because it is not necessarily required for production, and second, because it must satisfy environmental regulatory requirements. Special treatment must address the following:

• Possible adverse effects of the environmental solution on production;
• Delays in receiving regulatory approval of the concept;
• Uncertainty about how vigorously the state will enforce the regulations and push through more stringent amendments;
• Lack of support from corporate management not directly responsible for waste management; and
• Problems valuing the avoidance of environmental risk both quantitatively and qualitatively.

Effect of technology on production The assessment of a proposed P2 technology must be conducted in the context of the firm. A change in production methods could affect inputs, product quality and waste products. Inputs. Reducing the variety of chemicals simplifies warehousing and reduces the disposal of outdated materials as waste. In-house recycling reduces the need for inputs, reducing the potential for warehousing space and waste. It may generate new costs for on-site storage of materials that are to be recycled, including containers, space and handling. Recycling generates revenue and reduces environmental disposal costs. Product quality. Clients usually have to approve product changes from a P2 project, particularly if detailed specifications have to be met. An example is switching from oil-based to solid paints. Performance characteristics could change, changing the product's profitability, such as a reduction in market share, or a reduction in price. The firm might decide to convert only part of their production to the new P2 technology as a lower-cost approach to meeting regulatory requirements. Regulations may be met, for example, by a 50 percent conversion of the production line. The financial analysis would reflect the joint profitability of the two methods. Waste products. Waste management costs are often pooled, much like overhead costs. Wastes also may be combined physically in the wastewater system. A P2 innovation may change part of the wastewater stream, but not enough to eliminate treatment requirements. If there is a marginal reduction in cost, this can be shown as a project benefit. The savings may not be periodic, or they may occur only when the waste load exceeds emission limits. This could result in a violation and penalty or an additional treatment cost. The benefit would be the reduced probability of a fine. Regulatory approval Regulatory review often delays innovative technology that requires permit approval. The environmental agencies are not well-staffed with engineers to evaluate innovation. They operate best when the technology is already specified as "best available" or "best practical technology." They tend to be skeptical of proposals from industry that deviate from standard practice. The burden of proof is on the firm to show that the limits will be met. This may require large investments in research for an uncertain outcome. The P2 proposal will have to include funds for research, as well as capital purchases. Regulatory uncertainty A review of the case study literature shows that the largest single motivation for investigating and adopting P2 technology is to respond to or avoid environmental regulations. Being proactive is not easy, because the political outcome of the environmental legislative debate is difficult to predict. The financial presentation to management can include supplementary information on proposed regulatory changes. The analysis would describe the probability of the legislation being passed and the related compliance cost. Management commitment Environmental managers need the support of line managers who must accept and work with the proposed P2 technology. This is difficult if the production manager will be required to absorb costs from the proposed change. Production managers may not receive credit for waste management improvements. Firms follow different organizational structures depending on their business and history. An oil company, for example, may be organized by business function such as exploration, refining and marketing, with each function being supported by environmental staff. A food manufacturer may be organized by product line with a centralized environmental department at the corporate level. In either case, if the credit for an environmental innovation only accrues to the environmental manager, it may be difficult to gain support from the production department. Ideally, an accounting system traces costs and revenues to the level in the organization with day-to-day responsibility for decision-making. Thus, a paint shop manager should be responsible for the costs of the permit for his emissions. A paint shop manager should know the permit implications when asked to evaluate a change from oil-based to solid paints. He should be able to assess the capital, material, labor and permit costs. Most accounting systems do not credit line managers with environmental savings. These savings accrue to the environmental department. Production managers may have general language in their performance standards on the firm's environmental goals - i.e., performance standards in the paint shop may discuss the firm's air emissions goals. Few costs are under the sole influence of one manager. This generalization is very evident in respect to environmental costs. Environmental emissions are often blended from various sources. This is true of wastewater that funnels into one outlet, or of solid waste that is collected in one trash bin. Some of the ways that this blended waste is allocated to the production point of origin includes:

• Allocation by the degree of difficulty of treating the specific components (an approximation of the treatment cost);
• Allocation by the volume of product from the areas that produce the waste (or the volume of the waste); and
• Allocation by the number of employees, or some other reasonable measure of size of the operation.

Another advantage to allocating costs to the source of the waste is that it highlights problem areas that management can address. Waste, for example, may be a result of spoilage of product. This could be corrected by improved warehousing. Waste could result from mistakes in cutting. The cutting machine may need adjustment or replacement. The manager of the cutting operation is likely to replace the machine sooner if he has to cover waste handling costs. Risk analysis Environmental decisions are risky because they are based on environmental data that is considered somewhat speculative. Why is environmental data treated differently from other financial data? First, environmental factors in the firm are often quantified in volume, or units of material, rather than cost. The data on the quantity of waste product generated may be correlated to volume, or units of product. However, the cost of processing waste may be included in a general waste management budget or even a facilities management budget. In some cases, it may not make sense for management to split out the costs where several wastes are treated together. Nevertheless, a cost benefit analysis would miss an important benefit, particularly if the material being reduced is hazardous, or is a large part of the volume being treated. Second, projecting costs is difficult because changes in legislation or regulations disrupt the historical record. For example, amendments were proposed for the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as Superfund, when the Clinton administration took office in 1992. CERCLA compliance is expensive because of conflict over allocating costs under the law's joint and several responsibility provisions. The act was not amended, so EPA started a new program focused on cleaning up brownfields - abandoned industrial sites stigmatized by real or perceived environmental contamination. The standards for cleaning up brownfields are less stringent than those under CERCLA. It is unlikely management anticipated brownfields as an outcome of failure to amend CERCLA. Third, environmental costs are usually considered overhead. This raises uncertainty over which budget will absorb the cost of a proposed environmental technology. Technology located in the waste treatment area of the facility might logically be funded from the environmental budget. The cost accounting philosophy is to pass the cost to the department or production area where the problem is being solved. This is more likely if the P2 equipment is located in the production area, or if it is replacing equipment that is less environmentally safe. Often there will be additional costs, either because the new equipment is more expensive or because the equipment being replaced is not fully amortized (or is amortized but still has useful life). These uncertainties may discourage some accounting departments from trying to quantify benefits and costs as part of project justification. This is a mistake. Speculative benefits should be included as a probabilistic function, just as if it were future sales being projected. This applies to such costs and benefits as the following:

• Reduced worker exposure;
• Probability of reduced fines;
• Improved community relations; and
• Improved employee morale.

Evaluative terms such as "optimistic," "most likely" and "speculative" may be used to describe the probability of financial change. These evaluative rankings of benefits and costs can be assigned probabilities by experts and quantified. They can be presented to management separately so as not to diminish the perceived reliability of the more conventional cost/benefit estimates. The alternative of omitting environmental benefits from the financial analysis will understate the rate of return and lead to misallocation of resources. Conclusions Pollution prevention projects present unique problems in developing useful and accurate estimates of costs and benefits.

• These projects are often funded because of environmental regulations and compliance requirements. The passage of environmental laws can be as fickle as the political wishes of our legislators and regulators who approve environmental standards. This increases uncertainty about dollar value of compliance costs to be avoided.
• P2 projects may require longer payback periods because of delays in implementation and lower rates of return.
• They may be difficult to justify because environmental management costs are generally considered overhead. Managers are less likely to support P2 technology when they do not benefit from the savings.

Managers find it relatively easy to obtain funds for projects that are mandated by law and projects where the benefits are obvious. However, there are other reasonable projects and technology that are proposed but not implemented because they do not satisfy the above two criteria. It is these projects that would benefit from a more complete financial analysis, an analysis that conforms to the same accounting standards as all other capital investments of the firm. This would allow a fair evaluation of technology that could add to a firm's profitability as well as improve their environmental performance.

This article originally appeared in the 05/01/1999 issue of Environmental Protection.