CHAPTER 6, U.S. EPA Facility Pollution Prevention Guide, EPA/600/R-92/088 ECONOMIC ANALYSIS OF POLLUTION PREVENTION PROJECTS Although businesses may invest in pollution prevention because it is the right thing to do or because it enhances their public image, the viability of many prevention investments rests on sound economic analyses. In essence, companies will not invest in a pollution prevention project unless that project successfully competes with alternative investments. The purpose of this chapter is to explain the basic elements of an adequate cost accounting system and how to conduct a comprehensive economic assessment of investment options. A proposed pollution prevention option must compete with alterna- tive investments. TOTAL COST ASSESSMENT In recent years industry and the EPA have begun to learn a great deal more about full evaluation of prevention-oriented investments. In the first place, we have learned that business accounting systems do not usually track environmental costs so they can be allocated to the particular production units that created those wastes. Without this sort of information, companies tend to lump environmental costs together in a single overhead account or simply add them to other budget line items where they cannot be disaggregated easily. As a result, companies do not have the ability to identify those parts of their operations that cause the greatest environmental expenditures or the products that are most responsible for waste production. This chapter provides some guidance on how accounting systems can be set up to capture this useful information better. Standard accounting systems do not track environmental costs well. It has also become apparent that economic assessments typi- cally used for investment analysis may not be adequate for pollu- tion prevention projects. For example, traditional analysis methods do not adequately address the fact that many pollution prevention measures will benefit a larger number of production areas than do most other kinds of capital investment. Second, they do not usually account for the full range of environmental expenses companies often incur. Third, they usually do not accommodate a sufficiently long time horizon to allow full evaluation of the benefits of many pollution prevention projects. Finally, they provide no mechanism for dealing with the probabilistic nature of pollution prevention benefits, many of which cannot be estimated with a high degree of certainty. This chapter provides guidance on how to overcome these problems as well. Economic analysis of pollution prevention projects is complex because they:  affect multiple areas  have long time horizons  have probabilistic benefits In recognition of opportunities to accelerate pollution pre- vention, the U.S. EPA has funded several studies to demonstrate how economic assessments and accounting systems can be modified to improve the competitiveness of prevention-oriented invest- ments. EPA calls this analysis Total Cost Assessment (TCA). There are four elements of Total Cost Assessment: expanded cost inventory, extended time horizon, use of long-term financial indicators, and direct allocation of costs to processes and products. The first three apply to feasibility assessment, while the fourth applies to cost accounting. Together these four elements will help you to demonstrate the true costs of pollution to your firm as well as the net benefits of prevention. In addition, they help you show how prevention-oriented investments compete with company-defined standards of profitability. In sum, TCA provides substantial benefits for pre-implementation feasibility assessments (see Chapter 2 on preliminary assessments and Chapter 3 on feasibility analysis) and for post- implementation project evaluation (see Chapter 4 on measuring progress.) Elements of Total Cost Assessment:  expanded cost inventory  extended time horizon  use of long-term indicators  allocation of costs by area The remainder of this chapter summarizes the essential char- acteristics of TCA. Much of the information is drawn from a report recently prepared for the U.S. EPA by Tellus Institute. (See Appendix G for the full citation.) The Tellus report addresses TCA methodology in much greater detail than can be provided here and provides examples of specific applications from the pulp and paper industry. The report also includes an extensive bibliography on applying TCA to pollution prevention projects. In a separate but related study for the New Jersey Department of Environmental Protection, Tellus analyzed TCA as it applies to smaller and more varied industrial facilities. A copy of this report can be obtained from the N.J. Department of Environmental Protection. TCA methodology has been the topic of several government studies. EXPANDED COST INVENTORY TCA includes not only the direct cost factors that are part of most project cost analyses but also indirect costs, many of which do not apply to other types of projects. Besides direct and indirect costs, TCA includes cost factors related to liability and to certain "less-tangible" benefits. TCA analyzes  direct costs  indirect costs  liability costs  less tangible benefits TCA is a flexible tool that can be adapted to your specific needs and circumstances. A full-blown TCA will make more sense for some businesses than for others. In either case it is important to remember that TCA can happen incrementally by gradually bringing each of its elements to the investment evalua- tion process. For example, while it may be quite easy to obtain information on direct costs, you may have more trouble estimating some of the future liabilities and less tangible costs. Perhaps your first effort should incorporate all direct costs and as many indirect costs as possible. Then you might add those costs that are more difficult to estimate as increments to the initial analysis, thereby highlighting to management both their uncertainty and their importance. Direct Costs For most capital investments, the direct cost factors are the only ones considered when project costs are being estimated. For pollution prevention projects, this category may be a net cost, even though a number of the components of the calculation will represent savings. Therefore, confining the cost analysis to direct costs may lead to the incorrect conclusion that pollution prevention is not a sound business investment. Direct Costs Capital Expenditures  Buildings  Equipment and Installation  Utility Connections  Project Engineering Operation and Maintenance Expenses or Revenues  Raw Materials  Labor  Waste Disposal  Water and Energy  Value of Recovered Material Indirect Costs For pollution prevention projects, unlike more familiar capital investments, indirect costs are likely to represent a significant net savings. Administrative costs, regulatory compliance costs (such as permitting, recordkeeping, reporting, sampling, preparedness, closure/post-closure assurance), insurance costs, and on-site waste management and pollution control equipment operation costs can be significant. They are considered hidden in the sense that they are either allocated to overhead rather than their source (production process or product) or are altogether omitted from the project financial analysis. A necessary first step in including these costs in an economic analysis is to estimate and allocate them to their source. See the section below on Direct Cost Allocation for several ways to accomplish this. Indirect Costs Administrative Costs Regulatory Compliance Costs  Permitting  Recordkeeping and Reporting  Monitoring  Manifesting Insurance Workman's Compensation On-Site Waste Management On-Site Pollution Control Equipment Operation Liability Costs Reduced liability associated with pollution prevention investments may also offer significant net savings to your company. Potential reductions in penalties, fines, cleanup costs, and personal injury and damage claims can make prevention investments more profitable, particularly in the long run. In many instances, estimating and allocating future liability costs is subject to a high degree of uncertainty. It may, for example, be difficult to estimate liabilities from actions beyond your control, such as an accidental spill by a waste hauler. It may also be difficult to estimate future penalties and fines that might arise from noncompliance with regulatory standards that do not yet exist. Similarly, personal injury and property damage claims that may result from consumer misuse, from disposal of waste later classified as hazardous, or from claims of accidental release of hazardous waste after disposal are difficult to estimate. Allocation of future liabilities to the products or production processes also presents practical difficulties in a cost assessment. Uncertainty, therefore, is a significant aspect of a cost assessment and one that top management may be unaccustomed to or unwilling to accept. Liability Costs Penalties Fines Personal Injury Property Damage Natural Resources Damage Cleanup Costs  Superfund  Corrective Action Some firms have nevertheless found alternative ways to address liability costs in project analysis. For example, in the narrative accompanying a profitability calculation, you could include a calculated estimate of liability reduction, cite a penalty or settlement that may be avoided (based on a claim against a similar company using a similar process), or qualitatively indicate without attaching dollar value the reduced liability risk associated with the pollution prevention project. Alternatively, some firms have chosen to loosen the financial performance requirements of their projects to account for liability reductions. For example, the required payback period can be lengthened from three to four years, or the required internal rate of return can be lowered from 15 to 10 percent. (See the U.S. EPA's Pollution Prevention Benefits Manual, Phase II, as referenced in Appendix G, for suggestions on formulas that may be useful for incorporating future liabilities into the cost analysis.) Less-Tangible Benefits A pollution prevention project may also deliver substantial benefits from an improved product and company image or from improved employee health. These benefits, listed in the cost allocation section of this chapter, remain largely unexamined in environmental investment decisions. Although they are often difficult to measure, they should be incorporated into the assessment whenever feasible. At the very least, they should be highlighted for managers after presenting the more easily quantifiable and allocatable costs. Consider several examples. When a pollution prevention investment improves product performance to the point that the new product can be differentiated from its competition, market share may increase. Even conservative estimates of this increase can incrementally improve the payback from the pollution prevention investment. Companies similarly recognize that the development and marketing of so-called "green products" appeals to consumers and increasingly appeals to intermediate purchasers who are interested in incorporating "green" inputs into their products. Again, estimates of potential increases in sales can be added to the analysis. At the very least, the improved profitability from adding these less-tangible benefits to the analysis should be presented to management alongside the more easily estimated costs and benefits. Other less tangible benefits may be more difficult to quantify, but should nevertheless be brought to management's attention. For example, reduced health maintenance costs, avoided future regulatory costs, and improved relationships with regulators potentially affect the bottom line of the assessment. Less-Tangible Benefits Increased Sales Due to  improved product quality  enhanced company image  consumer trust in green products Improved Supplier-Customer Relationship Reduced Health Maintenance Costs Increased Productivity Due to Improved Employee Relations Improved Relationships with Regulators "We wanted to make a major effort to show that industry in the U.S. can simultaneously attack and solve environmental problems while improving both products and profitability." - John Dudek, value analysis manager at Zytec, as quoted in Perspectives on Minnesota Waste Issues, January-February, 1992. In time, as the movement toward green products and companies grows, as workers come to expect safer working environments, and as companies move away from simply reacting to regulations and toward anticipating and addressing the environmental impacts of their processes and products, the less tangible aspects of pollution prevention investments will become more apparent. EXPANDED TIME HORIZON Since many of the liability and less-tangible benefits of pollution prevention will occur over a long period of time, it is important that an economic assessment look at a long time frame, not the three to five years typically used for other types of projects. Of course, increasing the time frame increases the uncertainty of the cost factors used in the analysis. Many of the benefits of pollution prevention accrue over long periods of time. LONG-TERM FINANCIAL INDICATORS When making pollution prevention decisions, select long-term financial indicators that account for:  all cash flows during the project  the time value of money. Three commonly used financial indicators meet these criteria: Net Present Value (NPV) of an investment, Internal Rate of Return (IRR), and Profitability Index (PI). Another commonly used indicator, the Payback Period, does not meet the two criteria mentioned above and should not be used. Net Present Value, Internal Rate of Return, and Profitability Index are useful financial indicators. Discussions on using these and other indicators will be found in economic analysis texts. DIRECT ALLOCATION OF COSTS Few companies allocate environmental costs to the products and processes that produce these costs. Without direct allocation, businesses tend to lump these expenses into a single overhead account or simply add them to other budget line items where they cannot be disaggregated easily. The result is an accounting system that is incapable of (1) identifying the products or processes most responsible for environmental costs, (2) targeting prevention opportunity assessments and prevention investments to the high environmental cost products and processes, and (3) tracking the financial savings of a chosen prevention investment. TCA will help you remedy each of these deficiencies. Developing a pollution prevention program may well provide the first real understanding of the costs of polluting. Like much of the TCA method, implementation of direct cost allocation should be flexible and tailored to the specific needs of your company. To help you evaluate the options available to you, the discussion below introduces three ways of thinking about allocating your costs: single pooling, multiple pooling, and service centers. The discussion is meant as general guidance and explains some of the advantages and disadvantages of each approach. Please see other EPA publications (such as those listed in Appendix G), general accounting texts, and financial specialists for more detail. Three methods of direct cost allocation:  single pooling  multiple pooling  service centers Single Pool Concept With the single pool method, the company distributes the benefits and costs of pollution prevention across all of its products or services. A general overhead or administrative cost is included in all transactions. Single pool accounting is the easiest method, but it does not point up the effects of action within a given area. Advantages. This is the easiest accounting method to put into use. All pollution costs are included in the general or administrative overhead costs that most companies already have, even though they may not be itemized as pollution costs. It may therefore not be a change in accounting methods but rather an adjustment in the overhead rate. No detailed accounting or tracking of goods is needed. Little additional administrative burden is incurred to report the benefits of pollution pre- vention. Disadvantages. If the company has a diverse product or service line, pollution costs may be recovered from products or services that do not contribute to the pollution. This has the effect of inflating the costs of those products or services unnecessarily. It also obscures the benefits of pollution prevention to the people who have the opportunity to make it successful Ä the line manager will not see the effect of preventing or failing to prevent pollution in his area of responsibility. Multiple Pool Concept The next level of detail in the accounting process is the multiple pool concept, wherein pollution prevention benefits or costs are recovered at the department or other operating unit level. Multiple pool accounting comes closer to tracking responsibility. Advantages. This approach ties the cost of pollution more closely to the responsible activity and to the people responsible for daily implementation. It is also easy to apply within an accounting system that is already set up for departmentalized accounting. Disadvantages. A disparity may still exist between respon- sible activities and the cost of pollution. For example, consider a department that produces parts for many outside companies. Some customers need standard parts, while others require some special preparation of the parts. This special preparation produces pollution. Is it reasonable to allocate the benefit or cost for this pollution prevention project across all of the parts produced? Service Center Concept A much more detailed level of accounting is the service center concept. Here, the benefits or costs of pollution prevention are allocated to only those activities that are directly responsible. Advantages. Pollution costs are accurately tied to the generator. Theoretically, this is the most equitable to all products or services produced. Pollution costs can be identified as direct costs on the appropriate contracts and not buried in the indirect costs, affecting competitiveness on other contracts. Pollution costs are more accurately identified, monitored and managed. The direct benefits of pollution prevention are more easily identified and emphasized at the operational level. Service center accounting applies costs or benefits to the activities that are directly responsible. Disadvantages. Considerable effort may be required to track each product, service, job, or contract and to recover the applicable pollution surcharges. Added administrative costs may be incurred to implement and maintain the system. It may be difficult to identify the costs of pollution when pricing an order or bidding on a new contract. It may be difficult to identify responsible activities under certain circumstances such as laboratory services where many small volumes of waste are generated on a seemingly continual basis. SUMMARY Environmental costs have been rising steadily for many years now. Initially, these costs did not seem to have a major impact on production. For this reason, most companies simply added these costs to an aggregate overhead account, if they tracked them at all. The tendency of companies to treat environmental costs as overhead and to ignore many of the direct, indirect, and less-tangible environmental costs (including future liability) in their investment decisions has driven the development of TCA. TCA is an increasingly valuable tool as the business costs of pollution continue to rise. Expanding your cost inventory pulls into your assessments a much wider array of environmental costs and benefits. Extending the time horizon, even slightly, can improve the profitability of prevention investments substantially, since these investments tend to have somewhat longer payback schedules. Choosing long- term financial indicators, which consistently provide managers with accurate and comparable project financial assessments, allows prevention oriented investments to compete successfully with other investment options. Finally, directly allocating costs to processes and products enhances your ability to target prevention investments to high environmental cost areas, routinely provides the information needed to do TCA analysis, and allows managers to track the success of prevention investments. Overall, the TCA method is a flexible tool, to be applied incrementally, as your company's needs dictate.