The calculus of compliance
Environmental decisions embody financial risk, whether those decisions are to change manufacturing processes or exceed compliance with environmental regulations. Business decisions with environmental implications include:
- Maximizing output, while inadvertently increasing chances of an environmental upset;
- Employing less expensive chemical processes while increasing the likelihood of a spill;
- Operating in violation due to low risk of discovery; or
- Operating out of compliance because the potential fine is low compared to cost of corrective action.
The U.S. Environmental Protection Agency (EPA) considers a company's decisions when calculating the severity of a penalty. While fines for many administrative actions are set by statute, EPA adjusts the amount based on the firm's behavior and damage done to human health and the environment.
EPA and the states adjust penalties based on past record, investment in compliance technology and willingness to cooperate with regulators. Knowledge of the relevant penalty guidance documents can help firms minimize their exposure to excessive penalties.
Why have fines?
Fines are levied to encourage firms to change destructive business practices. A violation may result from poor recordkeeping, an accident or a pattern of excess emissions. The purpose of the penalty is to compensate society for damages, and to eliminate the financial advantage gained from breaking the law. It should be more cost effective for a business to correct a problem rather than suffer the negative publicity a notice of violation entails.
Computing the penalty - EPA guidance
Civil penalties have three components: economic benefit from noncompliance with the statute, gravity of harm to persons and the environment, and adjustments based on the firm's track record (See Figure 1
Economic benefits of noncompliance
Compliance delay and avoidance releases funds for other investments. EPA uses the BEN - short for benefit - computer model to calculate the economic benefits of noncompliance for settling penalties. The text can be downloaded from es.epa.gov/oeca/models
, or the software can be ordered from NTIS (Order# PB98-102308). Additional adjustments are required to account for income tax liability, tax credits for purchasing environmental control equipment and discounting of purchases over time.
The presumption is that firms with lower compliance costs have a competitive advantage in their flexibility to reduce prices. Alternatively, the same benefit may be realized by profits from reduced costs, rather than from competitive advantage. The BEN model correctly focuses on savings to the firm, leaving the opportunity for economists to study the impacts on competition in the industry.
EPA and the states rely on the firm to supply input data for the BEN model. Estimates are based on the actual expense of installing equipment to correct a problem. There may be a dispute over which costs to use. The firm might argue that part of the expenditure was for its own convenience, and is unrelated to compliance. This could include structures for housing equipment, special features that improve production efficiency or landscaping. In most cases, EPA assumes that expenses were for good business reasons related to compliance and should be included in calculating penalties. The BEN model manual includes examples and case studies to illustrate the data selection process.
Another concern is the time period for calculating the cost of capital. Records should show when the compliance problem started. The regulatory agency must certify when corrections were made to stop the clock on the fine.
Gravity of noncompliance
Gravity has three considerations. First, a violation that causes harm to humans or the environment will be considered more severe. Second, EPA assesses the extent to which a violation is simply a paperwork error or due to a lack of attention to regulations (e.g., a required permit was not requested). Third, EPA determines if the firm a major or minor entity as defined by federal statutes. (For example, a major air source emits 100+ tons of regulated pollutants.)
Penalty adjustments are based on a firm's behavior. First, EPA must determine if the firm was neglectful or willful in its lack of response to previous notifications of violation (NOVs). Were NOVs ignored or was corrective action taken? Second, a firm's cooperation, with full disclosure of data and access for regulatory staff, is considered. Has the firm taken strong action to comply since it was notified, working with the regulatory agency to achieve compliance? Third, EPA officials review the firm's history of non-compliance for a pattern of abuse. Fourth, EPA officials determine if the fine would cause the firm to become insolvent. Penalty adjustments might be required to allow the firm to continue as a viable entity.
The language in EPA's guidance has its roots in the myriad of enforcement policy regulations. EPA does not publish a single document that parallels the BEN model on how to make qualitative decisions. States, however, have developed guidance on how to adjust the economic analysis. Florida and Texas guidelines are used to illustrate the decision process.
Florida penalty policy
Florida guidance applies to civil actions, but excludes damages to natural resources. The Florida Department of Environmental Protection (DEP) has statutory authority to assess daily penalties from $5,000 for drinking water violations to $50,000 for hazardous waste violations. The amount depends on the potential for environmental harm and extent of deviation from statutes and regulations. DEP classifies harm, or duration, into major, moderate and minor, depending on potential, or extent, of harm (e.g., substantial threat vs. minimal pollution) and the degree of deviation (e.g., substantial noncompliance vs. most requirements met).
- Good faith effort to comply prior to discovery;
- History of non-compliance;
- Economic benefit of non-compliance, including use of BEN model where necessary; and
- Ability to pay.
Violators may reduce the fine by contributing to restoration and education and by donating property. They may also implement in-house pollution prevention projects.
The Texas Natural Resource Conservation Commission (TNRCC) Penalty Policy has two matrices, one for potential releases and one for documentation. The analysis distinguishes between potential and actual degree of harm. TNRCC uses EPA's designation of major and minor facilities to correlate firm size with the fine. Adjustments are made for the following:
- Frequency of violations (daily, monthly, quarterly or a single event);
- Not anticipating and avoiding violations or not responding to previous notifications;
- Good-faith efforts to comply with appropriate strategies;
- Examination of compliance history over five years under all environmental statutes;
- Economic benefit received by not complying because of reduced investment in equipment, by postponing a one-time corrective cost and by avoiding periodic costs; and
- Other behavioral factors, such as self reporting through internal audits or reporting where not required.
Both Florida and Texas penalty policies are available on the Web at www.state.fl.us/ogc/documents/enforcement/appendix/dep923
The Crown Petroleum penalty
TNRCC announced a record $1.06 million fine against Crown Central Petroleum for an air violation. The TNRCC action set aside a suit filed July 1997 by Trial lawyers for Public Justice, a non-profit citizens action group. Trial Lawyers issued a press release Aug. 27, 1998, stating that, "Crown's fine should have been at $8.1 million. TNRCC only assessed a fine for slightly more than a quarter of the violations and also failed to assess the economic benefit - estimated at $14 million - that Crown gained through years of violations." The group has asked the court to reinstate their case.
The $14 million maximum fine suggested by Trial Lawyers is equivalent to $25,000 daily, the maximum allowed under Texas Health and Safety Code for the 590 violation days reported. EPA is considering separate action because of the low fine.
What mitigating factors could TNRCC staff have legitimately used to justify a smaller penalty?
First, Crown is one of a few large firms joining the Texas governor's emissions reduction program. Crown may have received consideration for corrective actions taken in advance of receiving a notice of violation. TNRCC guidance also allows staff to recommend up to a 50 percent reduction for voluntary improvements in environmental management that are part of the governor's program.
Second, the order does not mention specific harm to persons or the environment. Staff guidance allows for a 25 percent reduction where harm is minimal.
Third, a small number of violations were administrative reporting errors. These are considered programmatic violations, that allow a 10 to 25 percent reduction for a major firm.
Fourth, Crown installed control technology in 1997, prior to the order, and instituted monitoring procedures. Staff have authority to reduce a fine by 50 percent for action that goes beyond what is required under the rules and is taken before issuance of an order. Twenty-five percent is allowed for required corrections.
How much did a firm benefit from not investing in control technology and from not managing operations to conform with environmental law? This question is at the root of determining the appropriate penalty. The potential dispute in the Crown Petroleum case is between the TNRCC proposed penalty of $1.06 million and the maximum $14 million suggested by the citizens group.
Knowing the rules for penalty calculus may help a company's management justify the implementation of programs that reduce their exposure to fines. It may also improve management's negotiation strategy if they are subject to an enforcement action.
Figure 1: Components of civil penalty calculation
Economic benefit component:
- Benefit from delayed costs
- Benefit from avoided costs
- Benefit from competitive advantage
- Actual or possible environmental harm
- Importance to regulatory scheme
- Size of violator
- Severity of violations
- Degree of willfulness or negligence
- Degree of cooperation/non-cooperation
- History of non-compliance
- Ability to pay
- Other unique factors
This article originally appeared in the 03/01/1999 issue of Environmental Protection.