|
23 ELR 10121 | Environmental Law Reporter | copyright © 1993 | All rights reserved
| EPA's Narrow Definition of Economic Benefit Vastly Increases Its Economic Benefit Estimate | | Jasbinder Singh |
| Mr. Singh is President of Policy Planning & Evaluation, Inc., an environmental compliance management firm located in Herndon, Virginia. He frequently estimates economic benefit. Mr. Singh thanks Thomas L. Adams Jr., of the Washington, D.C., office of Dechert, Price & Rhoads and Charles Nestrud of Chisenhall, Nestrud & Julian in Little Rock, Arkansas, for early draft comments and legal references, respectively. |
| [23 ELR 10121]
The policy that a violator should not gain financially from noncompliance with environmental regulations appeals to regulators, the regulated community, and the public. From the government's point of view, the concept provides a basis for treating all companies equally. From the regulated community's point of view, no competitor can gain an economic advantage over another, provided the government applies the concept fairly. From the public's point of view, the application of the concept promotes compliance because no one has a financial incentive to delay compliance. |
| Recognizing its widespread appeal, the U.S. Environmental Protection Agency (EPA) began to encourage the use of the concept in the early 1980s. It named the financial gain the "economic benefit" of noncompliance, and developed a computer model, called BEN, to calculate the economic benefit in noncompliance cases. EPA also established programs to train its employees to use the model. EPA also promoted the BEN model by holding training workshops for employees of state governments. Now all EPA regions and several states regularly use the model to assess penalties in civil and administrative cases. To encourage even greater use of the concept at the state level, EPA suggests that it will not overfile in those instances in which the states recover economic benefit. |
| In short, economic benefit has become the linchpin of EPA's penalty policies. According to EPA policy, it must recover economic benefit and a substantial portion of the gravity component to reach a satisfactory settlement. Thus, economic benefit is the floor from which the Agency must begin negotiating a final penalty. |
| Although the BEN model is a centerpiece of the penalty calculations, it has not been discussed in great detail in the analytical literature. Users generally assume that the BEN model is structured correctly for all cases of noncompliance. This Dialogue examines the basic structure of the model and suggests that it is more important to focus on the statement of the economic benefit problem than on the values of other variables in the BEN model to obtain the lowest estimate of economic benefit. |
| Limitations of the Definition of Economic Benefit |
| The Definition as Embodied in the BEN Model |
| In a typical noncompliance case, a violator has avoided or delayed installation of capital equipment. In other words, the violator has not done something that he or she should have done long ago. EPA's BEN model reflects this thinking in its structure. It constructs the problem mathematically by assuming that (1) a violator has ultimately complied with the regulations by installing a piece of capital equipment in year T, and that (2) the violator should have installed the same piece of equipment in year T-n, n being the number of years of delay. Since the same piece of control equipment is assumed to have been used, the compliance cost (C1) in year T is equal to the compliance cost (C2) in year T-n. Mathematically this means C1 = C2 = C, where C is the compliance cost. The model then estimates the economic benefit by: |
| 1. calculating cash flows associated with the installation of the equipment (costing C) in year T (delayed case); |
| 2. calculating cash flows associated with installation of the same equipment (costing C) in year T-n (on-time case); |
| 3. discounting the cash flows under both cases (discounted to the year T-n); |
| 4. subtracting the two discounted values (the difference is equal to the economic benefit in year T-n); and |
| 5. inflating the value of the economic benefit in year T-n to the penalty payment date. |
| This simple structure, reflecting installation of the same piece of control equipment in both the delayed and on-time compliance cases, and compliance by means of an end of the pipeline control technology, is an inherent part of the BEN model. It results in a positive economic benefit in most noncompliance cases. However, many compliance decisions are far too complex to fit into the structure of the BEN model and compliance delays do not necessarily result [23 ELR 10122] in economic gain for the violator. This Dialogue focuses on such decisions. |
| Limitations of the BEN Approach |
| Several assumptions, that are not apparent in this structure of the model, have a particularly large effect on the estimate of the economic benefit. First, the model does not take into account the circumstances that result in different compliance actions (and costs) in the delayed and on-time compliance cases. For instance, if a violator makes major changes to the plant only under the delayed case but not in the on-time compliance case, the violator probably spent more money than the violator would have spent, had the violator complied on time. Within the structure of the model, this means that the capital cost C1 in the compliance year T is not equal to the capital cost C2 in the noncompliance year T-n. Rather, C1 is greater than C2. Therefore, the model is not valid for calculating the economic benefit in this case. The economic benefit problem must be reformulated to fit the structure of the model or a different model must be used to calculate the economic benefit. |
| Second, the model does not explicitly take the consequences of the compliance actions into account. It assumes that compliance activities do not have any effect on plant, property, products, or operations of the facility. What if a violator could have prevented damage to its property by complying on time? The violator could have saved the capital spent on replacing the damaged equipment. The BEN model cannot take these savings into account; therefore, this problem also does not conform to the structure of the BEN model. The economic benefit problem consists of two parts: the benfit due to the delayed installation of the control equipment less the "disbenefit" (cost) due to the replacement of the capital equipment at an earlier date than anticipated. |
| Third, the model assumes that compliance can be achieved only by installing end-of-the-pipeline control equipment. This assumption is not necessarily true because many companies achieve compliance by modernizing production technology, by shifting production to other facilities, or simply by eliminating unprofitable lines. Such major operational decisions are aimed at achieving greater productivity and reduction in future capital and operating costs. In the context of the compliance problem, the violator does not realize these financial gains until after the requisite changes have been made. As a result, the delay is not beneficial to the violator. Once again, the economic benefit problem consists of two parts: the benefit due to delayed compliance and the disbenefit due to any foregone financial gains from increased productivity. The net benefit would depend on the magnitudes of the benefit and disbenefit in each case. The BEN model probably cannot be used because of the limitations of its structure. It is most likely that the economic benefit problem would have to be restated and an appropriate model would have to be used to estimate the net benefit. |
| Application to Case Scenarios |
| The discussion above suggests that whenever (1) the compliance costs would have been different under the delayed and on-time scenarios; (2) compliance affects the violator's costs for plant, property, products, or operations; or (3) alternative means to comply with the regulations are used, the BEN model is not likely to be suitable for calculating the economic benefit. Under such conditions, an accurate estimate of economic benefit can require an understanding of the reasons for compliance actions and their consequences. We must also examine whether a violator would have taken the same actions under both the on-time and delay cases. Based on the results of this examination, we must reformulate the economic benefit problem, which in many instances will not fit into the framework of the BEN model. If the structure of the problem is different from that of the BEN model, an appropriate model must be developed to estimate the economic benefit. The following examples, based on real-world cases, show that the effect of the restatement of the problem on the estimate of economic benefit is often dramatic. |
| Incorrect Equipment Design/Retrofitting a Facility |
| Often companies design pollution control facilities incorrectly, and have to retrofit them later with additional devices. Retrofits are usually very unpleasant and money-wasting experiences; therefore, it should be surprising to find that a company has gained an economic benefit in such situations. Consider a manufacturing facility that has to be retrofitted because the initial design of the air pollution control equipment was inadequate. Assume that in 1990, the company installed a piece of control equipment at a cost of $5 million. Although the equipment was designed carefully, it did not work properly right from the start. After the initial start-up phase, it became clear that the equipment was seriously undersized. The subsequent evaluation showed that the company could achieve compliance by retrofitting the facility with an additional incinerator. However, in order to retrofit, the company had to change existing pipes, replace some of the existing equipment, and make changes to the plant layout. It took the company two years to design, order, and install the new equipment at a cost of $2 million (C1). But if the company had designed the equipment correctly in the first place, it would have paid only $500,000 (C2) more than it spent on the original installation. Therefore, the company spent an extra $1.5 million to correct its mistake. (To simplify the illustration, assume that the equipment's useful life is 15 years, the company's discount rate is 17.5 percent, the penalty payment date is the same as the compliance date, and all dollars mentioned above are in 1992 dollars.) |
| * EPA's BEN Estimate: In all likelihood, EPA will assume that the company delayed the $2 million expenditure for two years and thus the delay results in a significant economic benefit. EPA would not pay attention to the complexities resulting from the retrofit situation, especially the fact that the company could have complied on time by designing the equipment correctly, and spending only an additional $500,000. Based on the capital expenditure of $2 million and a delay of two years, the economic benefit, using the BEN model, would be equal to $515,000. The EPA would demand that the company pay $515,000 in economic benefit, not counting the additional amount for the "gravity" of the offense, which is not part of economic benefit. |
| * The Actual Benefit: The economic benefit problem actually consists of two parts in this case. The benefit it gained by delaying an expenditure of $500,000 for a period of two years and the disbenefit it suffered because it spent [23 ELR 10123] $1.5 million more than it would have spent had it complied on time. The economic benefit of the delay in spending $500,000 is equal to approximately $129,000. In this simplified example, the disbenefit is equal to the extra $1.5 million the company spent in order to correct the original mistake. The net benefit to the company, therefore, is $129,000 - $1,500,000 = - $1,371,000. |
| This example illustrates that in retrofit situations, EPA's calculations are likely to result in an estimate of economic benefit that is far removed from the actual benefit gained by a company. |
| Negative Effects of Not Complying on Time |
| The BEN model also does not allow one to take the consequences of noncompliance actions into account in estimating economic benefit. Often, the consequences are negative, implying that the violator could have saved resources by complying on time. Consider a case in which a company installed a new production line containing an acid bath. A required scrubber would treat the acidic fumes, but the company did not install one. Since the company did not install the scrubber on time, the fumes escaped into the plant's inside environment and corroded steel columns, ductwork, and machinery. By the time the company noticed the damage and installed the scrubber, the useful life of the corroded equipment had been reduced to one-fourth its normal life. Assume that the replacement cost of the damaged equipment, whose original life was 20 years, is $500,000, and that the cost of the scrubber is also $500,000. Also assume that the period of the delay is two years. All other assumptions are the same as before. |
| * EPA's Estimate: In all likelihood, EPA will focus on the delay in installing the scrubber and ignore the negative consequences of not complying on time. EPA will calculate the economic benefit of a two-year delay in installing the scrubber as $129,000. |
| * TheActual Benefit: A realistic estimate of economic benefit should include the disbenefit due to the damage caused by acid fumes. Calculating the economic disbenefit is rather tricky, but is certainly a large positive number.1 |
| Alternative Means of Complying With the Regulations |
| In addition to installing end-of-the-pipeline treatment, companies use a variety of means to comply with environmental regulations. These include stopping production of specific products, shifting production from one facility to another, using different production raw materials, and changing production technology. Different sets of economic issues must be analyzed to make an accurate estimate of economic benefit in each case. |
| Consider an example involving shifting of production from one facility to another. Assume that a company with multiple facilities was operating an old plant that emitted excessive amounts of volatile organic chemicals. The company needed to install an incinerator costing $2 million to comply with air pollution emissions' requirements. However, the business had been declining for some time and the company had been exploring the possibility of shifting production to other facilities. The need to install the air pollution control equipment precipitated the decision to move the production to another facility. However, the uncertainty about the potential move and the move itself resulted in noncompliance for two years. |
| The company saved considerable sums of money by shifting to the new facility. It saved $1.5 million dollars by incurring a one-time expenditure of only $500,000 at the new facility, rather than the $2 million needed for installing the incinerator at the old facility. Furthermore, since the new plant was more efficient, the company could produce the same product at a savings of $50,000 per year. This benefit, however, would be offset by an increase in the new plant's incinerator's annual operating costs of $50,000. Thus, the move did not increase the operating costs of the new plant, yet the company was able to produce more from it. The background investigation showed that the spare production capacity had been available for a long time and that the company could have easily shifted the production two years earlier. How can EPA be expected to calculate the economic benefit? How should it be calculated? |
| * EPA's Estimate: EPA, in all likelihood, will focus on the violating facility and assume that the shift of production never took place. It will assume that the company delayed a capital expenditure of $2 million for two years by not installing the incinerator at the older facility. Under the earlier assumptions, EPA's calculations would show an economic benefit of $515,000. |
| * The Actual Benefit: In reality, the company delayed only the expenditures associated with the move. The company delayed a one-time expenditure of $500,000 for a period of two years. The economic benefit of a delay in making a one-time expenditure of $500,000, based on the same assumptions as before, is $89,600, or approximately $425,400 less than what EPA would calculate it to be. One thing is certain: the correct answer would usually be different from the BEN model's answer. |
| EPA has not discussed the existence of situations in which the economic benefit is either negative or very low. Even if EPA wanted to address them, EPA's engineers and attorneys cannot administratively afford to do customized analysis of each case. However, in many real world situations, the net economic benefit consists of two components: the traditional benefit component that fits into the structure of the BEN model and the thinking behind it, and a disbenefit component that represents either foregone opportunities or consequences of not taking timely actions. |
| The disbenefit component often has a dramatic effect on the estimate of economic benefit. If it appears that there is low or negative economic benefit, for example, one should not expend valuable resources on the discount rate controversy. The magnitude of the changes involved by correctly accounting for disbenefit can easily dwarf comparatively small changes in fine-tuning the discount rate. |
| 1. In calculations that are beyond the size limitations of this Dialogue, the author calculates the disbenefit to be $306,513, yielding a net benefit of $129,000 - $306,513 = - $177,513. |
23 ELR 10121 | Environmental Law Reporter | copyright © 1993 | All rights reserved
|
