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Does the public sector attempt to incorporate environmental costs within their

capital investment programmes? A Case Study of Water

Mr David Moore –University of Tasmania

Abstract

Capital budgeting is said to be of considerable importance to environmental management in the future. This paper reports the results of a case study which examined the capital budgeting process of a Victorian regional water authority. Specifically, the paper focuses on: (i) the identification of environmental costs (ii) discounting and the identification of environmental risk (iii) mandatory and discretionary capital budgeting projects (iv) the role of capital budgeting techniques (v) the life of capital projects / life cycle costing and (vi) the benefits of identifying and measuring environmental costs within the capital budgeting process. There was no classification of environmental costs within the capital budgeting process, even though the purpose of the process is to satisfy EPA regulations and such decisions are seen as mandatory. There was recognition of the existence of environmental costs as well the less tangible benefits from satisfying environmental regulatory concerns.

David Moore Lecturer B School of Accounting and Corporate Governance Faculty of Business University of Tasmania Locked Bag 1314 Launceston Tasmania 7250 Email: David.Moore@utas.edu.au Phone: (03) 6324 3558

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Does the public sector attempt to incorporate environmental costs within their

capital investment programmes? A Case Study of Water

Mr David Moore

Introduction

Capital budgeting is seen to be of increasing importance with respect to environmental

management (Ditz et al, 1995; Epstein and Roy, 1997; Bartolomeo et. al, 2000; Parker,

2000a). In particular, current and future environmental costs should be included in capital

investment decisions as it will improve the understanding of the likely future costs of

present production and present possible alternative courses of action available to

minimize present and future environmental impacts and their related costs (Epstein and

Roy 1997). In turn, this can facilitate the integration of environmental and other business

objectives (Ditz et al, 1995). With respect to water, better understanding of the nature of

environmental costs can influence waste management decisions. (Ditz et al 1995)

Overall, capital budgeting is important if organizations are to comply with environmental

regulations and government legislation (Parker, 2000a), for example, the Montreal

Protocol (Dunk, 1999). Therefore, costing systems are needed that allow a better

quantification of longer­term environmental management and impact costs (Parker,

2000a).

This study examined the capital budgeting process of a registered Victorian water

authority. The interest was whether or not actual environmental costs of water

management are identified within the capital budgeting process. Specifically, the study

focused on: (1) The identification of environmental costs (2) the assessment and

discounting of environmental risk (3) The role of life cycle costing / analysis (4) the

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capital budgeting techniques employed (5) The identification of relevant costs and (6)

The benefits of identifying and measuring environmental costs within the capital

budgeting process.

Up until now, there has been limited research on the identification of environmental costs

within the capital budgeting process, particularly in the public sector. In particular, it has

been suggested that the task of identifying and quantifying social and environmental

benefits and costs has disappeared from the project appraisal mechanism. (Coleshill and

Sheffield, 2000). This paper contributes to research which has examined the role of

capital budgeting and environmental costs in: (1) local government (Bowerman and

Hutchinson, 1998) (2) the decision processes of refrigerator manufacturers in their

responses to phasing out of CFCs (Dunk, 1999) (3) the Scottish Water Industry (Coleshill

and Sheffield, 2000) (4) projections for future spending for pollution abatement and

control equipment, and whether it corresponds with subsequent environmental action

(actual spending) (Patten, 2005) (5) Australian Electricity Distributors (Deegan, 2005)

and (6) the potential influence of selected Australian environmental social controls

(ESCs) on capital investment decision making (Wood and Ross, 2006). In addition, the

importance of corporate budgeting with respect to the development of and

implementation of corporate eco­efficiency has also been highlighted (Burritt and

Schaltegger, 2001).

This paper is structured as follows. First, a brief overview of the literature relating to

capital budgeting and environmental costs is examined. Second, the case study that

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examined the capital budgeting process within a Victorian public sector water authority is

discussed. Finally, the results of the case study are discussed and analysed.

LITERATURE REVIEW

The following topics are examined in this section: (1) the identification of environmental

costs; (2) discounting and environmental risk; (3) Environmental capital budgeting

projects – Mandatory vs. Discretionary; (4) the role of capital budgeting techniques; (5)

The life of capital projects / Life Cycle Costing and (6) the benefits of incorporating

environmental costs into capital expenditure decisions.

Capital Budgeting: The identification of Environmental Costs

The United States Environment Protection Authority (EPA) has prepared a Pollution

Prevention Benefits Manual which identifies the environmental costs an entity may wish

to consider in its capital budgeting process (Kite, 1995; Grinnell and Hunt III 1999; Gray

and Bebbington, 2001; Deegan, 2005). Theses costs are grouped into four categories or

tiers: 1. Direct Costs. 2. Indirect / Hidden Costs. 3. Contingent Liability Costs and 4. Less

tangible costs. (Kite, 1995; Grinnell and Hunt III 1999; Gray and Bebbington, 2001;

Deegan, 2005).

Direct costs, or Tier 0, of the EPA model contains the “usual” capital, operating, and

maintenance costs, such as those related to process equipment and depreciation, process

materials, utilities direct labour, and energy. (Grinnell and Hunt III 1999; Deegan, 2005).

These costs are typically easily identified by most cost systems, and include the

environmental costs directly identified with the project (Grinnell and Hunt III, 1999).

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Indirect costs, or Tier 1 of the EPA model comprises the indirect environmental costs that

arise from environmental support activities such as handling materials and monitoring,

treating and disposing waste, and hidden environmental costs resulting from compliance

with environmental regulations (e.g. training, inspecting and reporting) (Kite 1995;

Grinnell and Hunt III 1999; Deegan, 2005). Regulatory costs imposed by environmental

protection authorities (EPAs) include licensing costs, emission and disposal charges, and

fines and penalties (Wood and Ross, 2006).These costs can be significant, and pollution

prevention efforts can be instrumental in reducing or eliminating them (Grinnell and Hunt

III, 1999). Regulatory costs are often hidden in overhead accounts. (Gray and

Bebbington, 2001; Joshi, Krishnan and Lave, 2001; Deegan, 2005), along with the

associated environmental impact on the financial performance of the organization

(Parker, 2000b).

Tier 2 includes contingent liability costs (Grinnell and Hunt III, 1999; Gray and

Bebbington, 2001). Consideration of these costs is essential to the evaluation of a

pollution prevention project because, to the extent that a company can eliminate or reduce

pollution, these liability costs are avoidable (Grinnell and Hunt III, 1999). However,

these costs are difficult to estimate due to the requirement to anticipate environmental

risk (Kite, 1995) as well as the uncertainty involved in, and the inherent complexity of,

assessing risks associated with the handling and release of toxic substances (Grinnell and

Hunt III, 1999). Estimation is also difficult as neither future technologies nor future

demands of stakeholder groups (including regulatory requirements) are known. (Burritt

and Schaltegger, 2001). In the United States, firms often cite a lack of estimability as the

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reason why they do not recognize environmental liabilities early in a Superfund site’s

history (Barth and McNichols, 1994;Kennedy, Mitchell and Sefcik, 1998).

Tier 3 includes the less tangible costs and benefits that a company may achieve as a

result of reducing or eliminating pollution (Grinnell and Hunt III, 1999) and therefore

improving environmental management (Gray and Bebbington, 2001). These include

increased revenues and decreased expenses that occur due to improved customer

acceptance, employee relations, and corporate image (Grinnell and Hunt III, 1999). Tier 3

costs may also include avoided costs or liabilities (Kite, 1995). Although these benefits

are difficult to measure, it is reasonable to assume that they may be quite significant.

(Grinnell and Hunt III, 1999). Specifically, they could be expected to have some

influence on the value of intangible assets such as goodwill and brand­names (Deegan,

2005). In the privatized UK water utilities, improvements in the quality of waste water

were used as evidence for claims that companies had become more customer focused,

were responding positively to customer expectations and were conforming to principled

ideals (Ogden and Clarke, 2005), an example of a “less tangible benefit”.

Apart from the U.S. EPA framework, environmental costs, for capital budgeting purposes

within local government, have been defined as expenditure which could be identified by

the local tax payer as helping to improve or to protect the local environment (Bowerman

and Hutchinson, 1998). In the Scottish Water Industry, the main costs identified for

project appraisal purposes are maintenance costs, power costs, chemicals and rates.

(Coleshill and Sheffield, 2000). In particular, the Guidelines for investment appraisal for

Scottish Water and Sewerage Services state that all costs and benefits should be

identified, even if quantifying them will prove challenging. (Coleshill and Sheffield,

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2000). Social costs to be considered, and quantified where possible, include land

reclamation; habitat preservation; energy efficiency; nature reserve construction; tourism;

amenity and housing. (Coleshill and Sheffield, 2000). In Australia, water authorities

allow disposal of some trade waste through the sewerage system, however a ‘user­pays’

charge system is not applied to trade waste systems (Wood and Ross, 2006).

In summary, a failure to measure environmental costs within the capital budgeting

process may mean less priority for environmentally sound initiatives, relative to

environmentally destructive ones. (Bowerman and Hutchinson, 1998) The absence of

techniques to demonstrate value for money could have adverse implications for the

success of environmental initiatives. (Bowerman and Hutchinson, 1998).

Discounting and the identification of environmental risk

Environmental risk may be the result of regulatory uncertainty, the sources of which may

include the application and interpretation of existing law, as well as the foreshadowed

introduction of new or more stringent regulation. (Dunk, 1999). In order to effectively

identify points of environmental impact or risk within a project, the decision maker must

eliminate the concept of the organizational “entity” perpetuated by financial accounting

concepts (Kite, 1995). This may then be integrated into the capital budgeting process by

adjusting discount rates in order to measure an environmental risk premium (Birkin and

Woodward 1997). Therefore, the effectiveness of discounted cash flow methods depends

upon the discount rate applied (Bartolomeo et.al.,2000). Kite (1995) suggests that when

environmental risk exists, it may be incorporated into NPV analysis by increasing the

discount rate. The higher the risk the greater the upward adjustment, as increasing the

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discount rate compensates for environmental risk by lowering the net present value of the

project (Kite, 1995). Therefore, the choice of discount rate will have obvious

implications on the evaluation process (Deegan, 2005).

However, using a high discount rate to measure environmental risk is problematic. If

excessively high discount rates are used in investment appraisal techniques, then any

long­term benefits which are identified will be discounted to negligible amounts

(Bartolomeo et al. 2000). As well, projects whose benefits take some time to materialize

are placed at a competitive disadvantage in the selection process because the present

value of benefits that are projected to occur during the later stages of a project’s life are

understated. (Grinnell and Hunt III, 1999). Pollution prevention projects often fall into

this category. (Grinnell and Hunt III, 1999). Specifically, cash flows are not adjusted for

inflation, hence the bias against those projects that generate significant cost savings in the

latter stages of their lives, namely pollution prevention projects. (Grinnell and Hunt III,

1999). An objective approach to deal with this problem is to carefully consider and

quantify the estimated savings associated with contingent liability costs (or use the

“annualized savings” approach), and then use comparable discount rates to evaluate

competing projects. (Grinnell and Hunt III, 1999). However, “discounting discounts the

future” and fails to encourage the present generation to “provide for the future” (Gray and

Bebbington, 2001).

In the case of the Scottish Water Industry, one of the problems, and therefore associated

risk, with sewerage projects is the capital profile due to the time lag between the major

capital investment and completion of the project.( Coleshill and Sheffield, 2000). As a

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result, it is only at project completion that revenue can be generated to repay interest on

the debt. .( Coleshill and Sheffield, 2000).

Environmental capital budgeting projects – Mandatory vs Discretionary

Capital budgeting projects involving environmental costs may be either mandatory or

discretionary. Mandatory projects are those which are necessitated by new

environmental laws or regulations (Grinnell and Hunt III, 1999). For example, at Du

Pont chemicals, if a capital investment is necessitated by a legal requirement, it will be

undertaken without regard to the internal rate of return. (Ditz et. al., 1995). Therefore, in

mandatory projects, managers have little discretion regarding investment in the project,

and will undertake the project without regard to its internal rate of return. (Grinnell and

Hunt III, 1999) In the case of refrigerator manufacturers, compliance with the provisions

of the Montreal Protocol was of paramount concern in the capital budgeting process,

reflecting the view that regulatory compliance is not expected to yield a financial return

(Dunk, 1999,). In the Scottish Water Industry, various government directives such as the

Urban Waste Water Treatment Directive (91/271/EEC), the Bathing Water Directive

(76/160/ EEC) and the Shellfish directive (79/923/EEC) have formed the basis of the

legislative framework that has forced an increase in the sewerage capital programme

within the industry. (Coleshill and Sheffield, 2000). However, whilst regulatory bodies

determined the level of environmental expenditure in the U.K. industry, the main concern

of the regulatory body in the UK, the Office of Water Services, has been to keep prices

down for consumers (Harvey and Schaefer, 2001). In the United States, the Securities

Exchange Commission (SEC) regulation S­K, item 1, requires companies to disclose the

material effects compliance with federal, state and local environmental laws may have on

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"capital expenditures, earnings, and competitive position." (Zuber and Berry, 1992).

However, Patten (2005), in a study of environmental disclosures by U.S. firms, observed

that “only a relatively small percentage of companies make environmental spending

disclosures”. In general, Environmental Protection Authorities are aware of the

importance of capital investment to cleaner production (Wood and Ross, 2006).

In the case of discretionary environmental capital budgeting projects, managers are

presented with more planning opportunities. (Grinnell and Hunt III, 1999). However,

there is a general bias against these types of investments (Grinnell and Hunt III, 1999)

due to the difficulty of identifying relevant environmental costs and benefits. (Ditz et.

al.,1995; Grinnell and Hunt III, 1999). In the case of the privatized UK water utilities,

discretionary expenditures undertaken to improve customer service have proven to be

costly in terms of current reported profits, but have been associated with higher

shareholder returns since investors will perceive that future profit levels and risk

exposure will improved (Ogden and Watson 1999) Despite this, water companies have

been accused by The Sewer Renovation Foundation of failing to spend up to 400 million

pounds ($644 million) to improve the water infrastructure. (Letza and Smallman, 2001).

Projections of environmental capital expenditures, as a form of environmental disclosure,

may be a “legitimation device and not an accountability mechanism” (Patten, 2005).

The role of capital budgeting techniques

Bartolomeo et. al (2000) identified that the selection of an investment appraisal method

for environmental investments is important as the benefits of environmental investments

are often of long­term impact. The payback method of project evaluation has been

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criticized as being distorting because it ignores the time dimension of cash flows and

also because, in practice in some companies, it is often based on very short payback

periods. (Bartolomeo et.al.2000). As well, the discounted cash flow model (DCF) model

is considered to be biased against projects with long­term payoffs (which characterizes

many pollution prevention investments) if the discount rate used in the model is

incorrectly established at too high a level. (Grinnell and Hunt III, 1999). In general,

measurement systems are limited with respect to the external aspects of transactions as

externalities such as the depletion of scarce resources or pollution are ignored

(Bowerman and Hutchinson, 1998, p.310)

The arguments identified in the previous paragraph suggest that financial decision tools

fail to address adequately the estimation of the costs of complying with environmental

regulation, and that they also do not satisfactorily assist in assessing benefits in the long

term from adopting strategies that exceed environmental compliance regulations. (Dunk,

1999). As well, although techniques are available to measure externalities, they may be

difficult or expensive to apply, or may be too subjective to satisfy the needs of decision­

makers. (Bowerman and Hutchinson, 1998). However, NPV techniques may be of use to

“top management” for large single investments where environmental considerations play

a role (Burritt et al., 2002).

Research has found that techniques such as performance measurement, payback or NPV

are not applied in environmental capital decisions in local government (Bowerman and

Hutchinson, 1998) and, in the case of refrigerator manufacturers, little use was made

formally of financial decision tools other than in budgetary cots containment strategies.

(Dunk, 1999) However, the absence of techniques to demonstrate value for money could

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have adverse implications for the success of environmental initiatives. (Bowerman and

Hutchinson, 1998, p.315)

Apart from “traditional” techniques such as NPV and IRR, there are also ecological

efficiency measures such as ecological product efficiency and ecological function

efficiency. (Burritt and Schaltegger, 2001). Ecological function efficiency is the ratio

between provision of a function and the associated environmental impact added. (Burritt

and Schaltegger, 2001).

The life of capital projects / Life Cycle Costing

The management of water, in particular effluent disposal, involves hazardous waste

management. The management of hazardous waste extends beyond the useful life of a

product and therefore, the economic life used in the NPV calculation must be expanded

to include waste management. (Kite, 1995). Separate from NPV calculations is Life

Cycle Costing (LCC). LCC requires considerations of the costs that arise throughout the

life of a particular product. (Deegan, 2005). These include operating costs, hidden

regulatory costs, pollution costs and product retrieval, disposal and recycling costs

(Parker, 2000b). These costs are likely to increase in the future, bringing into question the

time horizon employed in the investment appraisal process (Gray and Bebbington,

2001).

LCC adds a costing dimension to Life Cycle Analysis (LCA). LCA is the attempt to

identify all of the internal and external environmental impacts, both good and bad

associated with a process or product, or activity throughout all stages of its life, on the

company, on all of its users, and all of the corporation’s stakeholders (Epstein and Roy

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1997 p.28). The focus of LCC is to consider the inputs and outputs connected with the

production, use and final waste handling of a product. (Deegan, 2005).

Life cycle assessment and life cycle costing process provides information on cost drivers

that enables improved environmental management and the reduction of environmental

costs (Epstein and Roy 1997). It may improve decision making by revealing that a

product with low acquisition costs but high operations, maintenance, environmental, or

disposal costs is a less desirable alternative as compared to a competing product with a

higher initial cost (Kreuze and Newell 1994 p.38). In addition, LCC refocuses

accountants’ and managers’ thinking from the short­run assessment of operating costs to

the longer­term cycle of costs occasioned by a product’s existence and final demise

(Parker, 2000b).

The benefits of identifying and measuring environmental costs within the capital

budgeting process.

Identifying environmental costs within the capital budgeting process may improve the

understanding of the likely future costs of present production and present possible

alternative courses of action available to minimize present and future environmental

impacts and their related costs (Epstein and Roy 1997), which can also facilitate short­

term planning and control (Burritt et al., 2002). It can also facilitate the integration of

environmental and other business objectives (Ditz et al., 1995) and therefore place “green

capital investments” such as waste management or pollution control plant on a “level

playing field” with other capital expenditure proposals (Parker, 2000b). The importance

of managing fixed environmental costs through capital expenditure decisions will gain

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momentum as environmental standards will probably rise in the future (Kreuze and

Newell 1994; Parker 2000a). The absence of such management could have adverse

implications for the success of environmental initiatives. (Bowerman and Hutchinson,

1998, p.315).

The literature review suggests that the following issues be examined via a case study: (1)

the identification of environmental costs; (2) discounting and the identification of

environmental risk; (3) mandatory vs discretionary investment (4) the role of capital

budgeting techniques; (5) the life of capital projects / life cycle costing and (6) the

benefits of identifying and measuring environmental costs.

Method

A case study of a Victorian regional water authority was undertaken, examining the

capital budgeting process of a Victorian regional water authority. Specifically, the case

study focused on: (1) the identification of environmental costs; (2) discounting and the

identification of environmental risk; (3) mandatory vs discretionary investment (4) the

role of capital budgeting techniques; (5) the life of capital projects / life cycle costing

and (6) the benefits of identifying and measuring environmental costs.

A case study was chosen as it provides considerable scope for further examination of the

capital budgeting procedures adopted within specific entities by providing in depth case

study evidence (Frost and Toh, 1998). The water authority chosen for this case study

undertakes an extensive capital works investment programme, as evident by their capital

works investment plan. The major sources of evidence were available documents,

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interviews and direct observation. The specific documentary evidence were: (1) the

annual report and (2) the capital works investment plan manual. The capital works

investment plan manual provided detailed evidence of: (a) economic evaluation

principles; (b) the costs and benefits to be included and (c) the costs and benefits to be

excluded in capital works investment decisions.

In addition to documentary evidence, a semi­structured interview was undertaken with

personnel from the Strategic Planning Department, which is responsible for the capital

budgeting / investment program. A list of the interview questions is contained in the

Appendix. The documentary evidence outlined in the previous section was used to

corroborate and augment information gained from interviews.

An open ended / unstructured interview was undertaken with the Manager – Strategic

Planning and the Economist – Strategic Planning. The questions, contained in the

appendix, addressed the following topics: (1). The objectives of capital expenditure

decisions at the sewerage treatment plants. (2). Identification and incorporation of

environmental costs into project evaluation decisions. (3). Discounting and its

implications for environmental costs and benefits. (4). Discretionary Investment in

Treatment Plants. (5). Incorporation of Environmental Risk into Capital Expenditure

Decisions. (6). The Role of contingent Liabilities in Decision Making and (7). Relevant

Costs and Decision Making at the Treatment Plants.

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Once the interviews were completed, data analysis was undertaken using pattern

matching (Yin, 1994). Scapens (1990) identifies that as the case study progresses, various

themes and patterns should emerge and sometimes it is helpful to prepare models, which

attempt to link the various themes and issues. In order to analyse the evidence, the

interview transcripts and observation notes were examined to find the major relevant

theories. This analysis was undertaken manually. Documents such as management

accounting reports were examined to verify the issues raised in the interviews, as well as

answer specific questions pertaining to the research.

In the next section, the responses to the questions posed to the participants in this case

study are discussed.

Results

This section will be discussed as follows: First, how does the water authority identify

(environmental) costs within its capital budgeting process. Second, what policy does the

water authority adopt with regard to the discounting of costs and how is environmental

risk assessed. Third, to what extent are the capital budgeting decisions mandatory

decisions as opposed to discretionary decisions. Fourth, what is the role of capital

budgeting techniques within the capital budgeting process. Fifth, what is the life of the

capital projects undertaken and what is the role of life cycle costing. Finally, what the

water authority identifies as the benefits of identifying and measuring environmental

costs will be examined.

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Capital Budgeting: The identification of Environmental Costs

The Capital Works Investment Plan (CWIP) Manual identifies the following costs and

benefits that may be used in a cash flow analysis, provided that they can be quantified,

for capital works projects: 1. Capital costs. 2. Opportunity Costs. 3. Operating /

maintenance /modification/replacement costs 4. Significant costs and benefits affecting

other parts of the organisation. 5. Significant direct costs and benefits external to the

organisation. 6. Cost savings. 7. Additional revenue and 8. Residual benefits of assets.

The manual identifies that all costs and benefits should be incremental to the “do

nothing” or sustaining alternative (Barwon Water CWIP Manual, 2000).

The CWIP manual defines an opportunity cost as the next best option benefit foregone as

a result of proceeding with the project (Barwon Water CWIP Manual, 2000). In the case

of environmental projects that may involve the disposal of waste, the opportunity costs of

alternative methods of disposal would need to be taken into consideration.

Operating and maintenance costs refer to those recurring costs that are required to keep

the assets functioning at their required level and will usually be ongoing for the life of the

project. These costs are estimated from past experience, comparative experience, field

trials and test work (Barwon Water CWIP Manual 2000 p.1). With reference to sewerage

treatment plants and therefore environmental costs, these costs would include direct costs

associated with the project such as labour and labour overheads, fuel, spare parts,

management and administration costs. These costs are similar to the costs that are

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classified within Tier 0 and Tier 1 of the U.S. EPA model (Kite 1995; Grinnell and Hunt

III 1999; Gray and Bebbington, 2001; Deegan, 2005).

Significant direct costs and benefits external to the organisation refer to changes to the

conditions external to the Water Authority which are directly attributable to the capital

project. These include changes to the environment, service quality, public health or the

image of the Water Authority. Where such costs and benefits can be quantified they

should be included in the cash flow statement. Non­quantifiable costs and benefits should

be described and taken into account in the overall project evaluation (Barwon Water

CWIP Manual 2000 p.2). These costs are similar to the costs that are classified within

Tier 3 of the U.S. EPA model (Kite 1995; Grinnell and Hunt III 1999; Gray and

Bebbington, 2001; Deegan, 2005).

Costs and benefits that are to be excluded from capital works investment decisions

include indirect costs and benefits and unquantifiable costs and benefits. Indirect costs

and benefits refer to indirect or secondary costs which occur further down the operational

chain for a project e.g. the economy at large. (Barwon Water CWIP, 2000). They are

generally not included in the analysis as they often add an unnecessary complication to

the initial study­ only direct benefits are included, unless the indirect benefits are

considered to be substantial and directly identifiable (Barwon Water CWIP, 2000).

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Unquantifiable costs and benefits refer to costs and benefits that cannot be directly

measured or valued. They include service performance, public image, broad managerial

or political factors, aesthetics or odour. Such costs and benefits are required by the Water

Authority to be listed and quantified as far as practical, making it clear to the decision

maker that they are additional factors to be taken into account (Barwon Water CWIP

2000 p.1). These costs are similar to the costs that are classified within Tier 3 of the U.S.

EPA model (Kite 1995; Grinnell and Hunt III 1999; Gray and Bebbington, 2001; Deegan,

2005). With reference to treatment plants, environmental issues such as odour occurring

as a result of effluent discharge and the possible impact that this has on the corporate

image of the Water authority could be identified within this category. It needs to be

emphasized that there is no formal environmental cost classification structure developed

by regulatory bodies, similar to the U.S. EPA model (Kite 1995; Grinnell and Hunt III

1999; Gray and Bebbington, 2001; Deegan, 2005) that identifies environmental costs.

During the interview, personnel from the strategic planning department were asked if and

how the organization identifies and classifies environmental costs within the capital

budgeting process:

Not necessarily….. If we were able to quantify those environmental costs, we do include them as part of the analysis…..it’s part of the capital works manual there. It’s pretty difficult to actually quantify both environmental and social costs and I think that’s pretty much a major issue for all government trading enterprises really. It doesn’t matter if you’re a government or non­ government for that matter. Trying to identify and allocate… OK…we’re going to improve the environmental flows of this particular river or this creek, which is going to have a positive benefit downstream. Now, how do you actually quantify that in terms of, you know, the improved benefits downstream of that particular outcome?. I mean..to a certain extent….we definitely look at those environmental and social impacts, but we don’t actually quantify them and say the value of this is a million dollars or the benefit of this is half a million dollars, we say, Ok, there are going to be improved environmental outcomes or we’re going to deliver better water quality for the township of x and y and stuff like that but we don’t actually put a figure to them and say this is going to result in $50000 or $100000 in that respect.

the improved outcomes are identified but not quantified.

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In the decision making process, we consider the operational costs of various types of treatment plants through the options evaluation process. Once an option is decided to proceed with, the ongoing costs become part of our normal recurrent budget and the capital investment, so they’re separated once you basically decide this is the type of treatment plant we’re going to build, that’s the way to go. When you’re evaluating what type of plant, or all the options, you consider the cap x or op x range, which include all those bits about monitoring and the costs to run the plant.

Research undertaken by Parker (2000a) found that seven of the eleven companies

interviewed reported that they separately identified environmental capital costs of any

project or other activity. Subsequent to this, it was asked how does the water authority

incorporate contingent liabilities, tier 2 of the U.S. EPA model (Kite 1995; Grinnell and

Hunt III 1999; Gray and Bebbington, 2001; Deegan, 2005), into the capital investment

decision making process:

I think contingent liabilities, they’re almost in the same basket as your environmental and social benefits, to be honest. I mean, how do you actually, in this type of business, how do you actually allocate a contingent liability and say, Ok, we might need to allow for a $100,000 in year 5 because of this or this particular process might happen or something like that. I mean, it just depends on how you actually equate contingent liabilities in this particular industry itself. Are you able to actually say, there is a risk of this treatment plant breaking down in year 5, therefore, we need to allocate $100,000 to upgrade this particular section of it, and if that is a quantifiable risk, then obviously that becomes part of the project evaluation process.

The difficulty in estimating contingent liabilities in the capital budgeting process appears

to be due to the difficulty in identifying the risk of a treatment plant breaking down and

then subsequently quantifying that risk. This is consistent with previous observations

(Kite, 1995; Grinnell and Hunt III, 1999; Burritt and Schaltegger, 2001). In the United

States, recognition of a contingent environmental liability is dependent upon estimability

(Barth and McNichols, 1994). Estimability depends upon the complexity of the site,

remediation alternatives, changes in remediation technology, uncertainty over cleanup

standards and the financial responsibility of Potentially Responsible Parties (Barth and

McNichols, 1994). Six of the eleven companies interviewed by Parker (2000a) identified

contingent liabilities within their accounting systems.

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Discounting and the identification of environmental risk

All capital investment programmes undertaken by the Water Authority should be

evaluated using real discount rates of 6%, 8% and 10% and the recommended risk

premium to apply depends on the type of project (Barwon Water CWIP Manual, 2000).

Department of Treasury and Finance guidelines stipulate a risk premium of 2% for non­

revenue generating investments, increasing to 6% for higher risk revenue­generating

projects (Barwon Water CWIP Manual, 2000). Where selection of a particular project

option is sensitive to the discount rate used in the calculation of Net Present Values,

further consideration should be given to selection of a discount rate which is appropriate

given the actual risk associated with the project (Barwon Water CWIP Manual, 2000).

The CWIP Manual does not specifically identify environmental risk or environmental

risk premium, however, the policy appears to be where the risk is higher, the greater the

upward adjustment to the discount rate (Kite, 1995).

The proposition / question was posed during the interview that the costs at the end of a

plants life such as site cleanup and remediation can be significantly high, and that if a

high discount rate is used, then these costs can appear to be immaterial or inconsequential

in decision making. The response of the economist was as follows:

Yeah, that’s right. I suppose that’s an issue with the NPV process in itself, especially if you’re using a high discount factor, that anything beyond really years 10 sort of don’t really have the same influence when you’re using a significant discount factor, and particularly if you get from years twenty to thirty then it’s almost seems inconsequential as to what actual amount you put in there. I mean, if you’re using a discount factor of %12 or something like that, then, it doesn’t matter if you’ve got $50 million in year 25, that’s going to be discounted so far that its overall impact on the NPV process is going to be fairly minimal. But that’s the issue of trying to get that $50 million estimate in year 25 or whatever it’s going to be reasonably accurate. I think that’s just one of the pitfalls of the NPV process that, the benefits very much outweigh what the disadvantages of the process are.

22

This appears to be a recognition that the use of high discount rates by the water authority

may place pollution prevention projects at a disadvantage (Grinnell and Hunt III, 1999)

as the benefits of such projects are long term (Grinnell and Hunt III, 1999; Bartolomeo et

al., 2000). Accurate estimation of costs is one means of attempting to address this

problem, but accurate estimation of environmental costs, in particular contingent

liabilities (Barth and McNichols, 1994; Kennedy, Mitchell and Sefcik, 1998) is difficult.

Environmental risk is identified and managed through compliance with EPA regulations,

as explained by the manager, strategic planning:

Risks are primarily dealt with in compliance. When we look at the treatment plants, we’re looking to see have we got a margin for safety, and those elements, and we also look at the by­products, where they may be, sludge, the water quality criteria, they’re the major risks associated with, the reliability of the plant, and so, to the degree, compliance is the driver. So there’s redundancy built into the plants, to make sure that if something breaks down, we can bring something else on. So there’s backup. That’s how it’s managed.

Compliance with EPA regulations is seen as managing Environmental Risk. However,

there was no indication that the manager believed that environmental risk extended

beyond the boundaries of the organizational “entity” (Kite, 1995).

Environmental capital budgeting projects – Mandatory vs Discretionary

A significant portion of the water authority’s capital investment is mandatory due to

regulatory requirements, as explained below:

From our perspective, a lot of that investment is not discretionary because we have to put in the treatment plants to meet the regulators …

EPA guidelines...

standards, so in a sense, the decision as to whether we’re going to build a treatment plant or not is not discretionary. So the discretionary powers come from what sort of plant would we build and whether we got or do we invest in spare capacity for the future. And our processes now require

23

valuing the varying processes to be undertaken with those sorts of projects and that’s …the purpose of that is to try and eradicate the gold plating and come up with some sort of reasonable compromise between future and present demand and ……

Subsequent to this, the question was asked how important is the role of the NPV or IRR

calculation when there is a regulatory requirement to undertake a capital investment:

I mean, basically, as Ian mentioned earlier, in terms of discretionary expenditure, it’s not all that discretionary in terms of, OK, we might have three or four different options, and we’ll do an NPV analysis on that to see which one comes up best, but a lot of the times when you do the NPV analysis, it’s not necessarily going to be a net present value, it’s more likely to be a net present cost, in terms of, OK, if we upgrade a water treatment plant somewhere in a certain town and say OK, this treatment plant is going to provide better quality water to all these customers, say 5000 customers in this area, I mean, what are the benefits associated with that, I mean it’s going to cost us $5 million ,what are we getting in additional revenue, we’re not getting additional revenue besides those new customers coming on line in the next 10 or twenty years which is fairly insignificant, I suppose you would say.

Those existing customers, we would still get the revenue from them regardless of whether we upgraded that treatment plant or not. I mean, to a certain extent, the NPV sorts out which are the best options in financial terms, but, in terms of only going ahead with this particular capital works program because it’s got a NPV of greater than five million or ten million or whatever your threshold might be, it’s not really relevant to this industry, really.

We do all that, I mean, the capital works program, the NPV calculations are done, we’ve got a process where we look fairly crudely at the risks, there are some issues there, but a lot of it is driven by meeting obligations. The component of asset management is in there, that’s a recognition that we’ve got this huge asset base that needs to be maintained, and there’s a component of growth. And it relies heavily on the internal knowledge of people about when we need to do this.

The Department of Natural Resources and the Environment (DNRE), which is

responsible for price reviews of water and sewerage services (DNRE, 2000), recognizes

that capital investment is the key determinant of operating costs and therefore future price

and revenue needs (DNRE, 2000). In particular, it suggests that the prices set for water

businesses should discourage ‘gold plating’ by providing only for that level of investment

necessary to satisfy agreed service standards. (DNRE, 2000).

24

There is also recognition by a key stakeholder, the Government, that capital expenditure

may be deferred by increasing operating expenditure on asset maintenance or demand

management (DNRE, 2000). As well there may be trade­offs between operating

expenditure, capital expenditure and service levels (DNRE, 2000). This can be compared

to the case of the privatized UK water utilities where discretionary expenditure has been

associated with higher shareholder returns due to the perception by shareholders of

improvements in profit levels and risk exposure (Ogden and Watson, 1999).

The recognition that investment may be undertaken where there is net present “cost” is

not unusual given that in mandatory projects, such as a capital investment at Du Pont

chemicals (Ditz et. al., 1995) and compliance with the provisions of the Montreal

Protocol in the case of refrigerator manufacturers (Dunk, 1999), managers have little

discretion regarding investment in the project, and will undertake the project without

regard to its internal rate of return. (Grinnell and Hunt III, 1999). The lack of

discretionary, or voluntary, environmental capital expenditure by the water authority,

may indicate that management does not perceive a need to use disclosures of

environmental capital expenditures “as a tool for gaining or maintaining social

legitimacy” (Patten, 2005).

The role of capital budgeting techniques

The major capital budgeting technique employed by the water authority is NPV, as

explained during the interview:

25

I mean, basically, as Ian mentioned earlier, in terms of discretionary expenditure, it’s not all that discretionary in terms of, OK, we might have three or four different options, and we’ll do an NPV analysis on that to see which one comes up best, but a lot of the times when you do the NPV analysis, it’s not necessarily going to be a net present value, it’s more likely to be a net present cost, in terms of, OK, if we upgrade a water treatment plant somewhere in a certain town and say OK, this treatment plant is going to provide better quality water to all these customers, say 5000 customers in this area, I mean, what are the benefits associated with that, I mean it’s going to cost us $5 million ,what are we getting in additional revenue, we’re not getting additional revenue besides those new customers coming on line in the next 10 or twenty years which is fairly insignificant, I suppose you would say.

Those existing customers, we would still get the revenue from them regardless of whether we upgraded that treatment plant or not. I mean, to a certain extent, the NPV sorts out which are the best options in financial terms, but, in terms of only going ahead with this particular capital works program because it’s got a NPV of greater than five million or ten million or whatever your threshold might be, it’s not really relevant to this industry, really.

We do all that, I mean, the capital works program, the NPV calculations are done, we’ve got a process where we look fairly crudely at the risks, there are some issues there, but a lot of it is driven by meeting obligations. The component of asset management is in there, that’s a recognition that we’ve got this huge asset base that needs to be maintained, and there’s a component of growth. And it relies heavily on the internal knowledge of people about when we need to do this.

The water authority relies upon the NPV calculation to identify the best programme in

financial terms, however, relying upon an NPV calculation to make a capital investment

decision is not the only criteria the water authority adopts in its decision making process.

There also appears to be recognition by the manager of the limitation of the NPV in

addressing the long term impact of capital budgeting projects, supporting the view that

discounted cash flow models are biased against programs with long term payoffs, in

particular pollution prevention programs (Dunk, 1999; Grinnell and Hunt III, 1999;

Bartolomeo et al., 2000).

The comment that, “only going ahead with this particular capital works program because

it’s got a NPV of greater than five million or ten million or whatever your threshold

might be, it’s not really relevant to this industry” may imply that NPV may lack

26

subjectivity (Bowerman and Hutchinson, 1998), as a capital budgeting technique. The

interviews also highlight that limitation of the NPV as it ignores externalities such as the

depletion of scarce resources or pollution (Bowerman and Hutchinson, 1998). This

limitation is also highlighted in the capital works investment plan manual of the water

authority. It specifically identifies that unquantifiable costs and benefits are to be

excluded from capital investment calculations. However, where costs and benefits cannot

be directly measured or valued, such as aesthetics, odour and public image, they should

be listed and quantified where practical within the decision making process, making it

clear to the decision maker that they are additional factors to be taken into account

(Barwon Water CWIP Manual, 2000).

The life of capital projects / Life Cycle Costing

When the water authority undertakes its capital works plan, it does not adopt a life cycle

analysis approach:

From a very crude perspective when the options are developed, in picking an option, evaluating the options, but it’s not done, when we do the capital works plan every year, we’re not looking at a life cycle……a project comes on ….

Unless that particular project is a water resources augmentation that we’ve allocated x million dollars for and we’re looking at that say in comparison to something else…is that building a new dam or is that using more reclaimed water option or something like that…it’s basically when we’re looking at certain projects that might have a number of options in terms of the longer term here in the organisation but I would say in general probably not.

As distinct from life cycle costing and analysis, sewerage treatment plants for example,

have a useful life of forty years, but the associated project evaluation programme may be

for twenty years:

You look at the various components. All the treatment plants have, generally, a replacement equipment allocation every year, so they’re ongoing, if a pump breaks down, some electrical or

27

mechanical stuff needs to be replaced, that’s replaced. In terms of the total, civil asset, they will have a much greater life cycle than fifty years and they are rehabilitated on an as needs basis in terms of…that’s the general thrust of things. You get to a place like Colac, where the treatment plant has been there since 1925, and been upgraded by add on components to improve its performance over a period of time. We’re now at a stage where we have to produce an even better quality effluent, so we’re going to have a greenfields site. Abandon all the existing treatment processes and build something on the same site. A completely new process. But that’s not always the case. It depends what standards you’re trying to meet, what we think the future’s going to be.

A lot of those things are picked up as part of your ongoing costs. You might have a forty­year useful life for your treatment plant but your project evaluation might be twenty years. Having said that, you might have mechanical, electrical equipment which needs to be replaced every five years, which is $10000 say, so you allocate that as part of your project evaluation process so you’ve got $10000 in year 5, $10000 in year 10 etc. etc. and the same thing for civil, and the same thing for any other ongoing costs that you might have as part of the treatment plant itself. Just because you’ve got that initial $10 million capital contribution, doesn’t mean that everything else is going to be a benefit from there on.

The life of the project evaluation programme therefore includes waste management (Kite,

1995; Deegan, 2005). Whilst the water authority does not specifically adopt life cycle

costing, it does attempt to identify internal and external environmental impacts over the

life of its capital budgeting programme, which is similar to the principles of life cycle

costing (Epstein and Roy, 1997).

The benefits of identifying and measuring environmental costs within the capital

budgeting process.

Whilst the water authority does not adopt a formal environmental cost classification

model within its capital budgeting process, it does recognize benefits from undertaking

capital expenditure for the purpose of satisfying environmental regulations:

I mean, well, obviously, there’s the improved quality of the receiving waters, environmentally, that’s a major benefit, it does produce a quality of effluent, a resource that can be used……….

I think that there are obviously improved social outcomes in terms of the treatment plant investment and stuff like that as well. I mean if we look at Black Rock and the effluent that was going out in the late 80’s before the treatment plant was actually upgraded, and now the feedback that we get from a lot of our customers in terms of what’s actually going out there and people are surfing out there and all that sort of stuff then I think the overall…. its not only the perception from our customers, it’s the perception of Barwon Water that we’re doing the right thing by their

28

customers and by the environment. It’s been much improved since that treatment plant was upgraded.

It’s pretty hard to quantify something like that in terms of improved corporate image or something like that, I mean it’s just one of the factors that’s attributed to….

Those environmental benefits are not, don’t flow back to our business, having a better quality of receiving waters, having more fish in the vicinity of black Rock or whatever it may be, they don’t actually come back to our business in any financial way. We’re not able to determine that. It would be drawing a long bow to say that because we cleaned up the environment, those waters, it’s made the whole area more attractive and therefore, there’s more people coming to the area and we’re getting more customers. I think that that would be very long bow to draw in terms of our financial considerations. We don’t include those.

The (intangible) benefits of undertaking environmental regulatory capital expenditure,

whilst recognized in the interview, are not quantified within the capital expenditure

process. In particular, improved social outcomes, improved customer acceptance and the

perception that the water authority is doing the “right thing” is evidence of less tangible

benefits (Grinnell and Hunt III, 1999) that may affect the goodwill (Deegan, 2005) of the

water authority. This is also similar to an observation by Ogden and Clarke (2005), who

observed that, in the case of the privatized UK water utilities, improvements in the

quality of waste water were used as evidence for claims that companies had become more

customer focused, were responding positively to customer expectations and were

conforming to principled ideals.

Conclusion and limitations

The water authority identifies costs for capital investment decisions in its Capital Works

Investment Plan. These costs include capital costs, opportunity costs and operating and

maintenance costs. There is no classification of environmental costs within the capital

budgeting process, as there is no regulatory requirement. The existence of environmental

29

costs was recognized, however, it was explained that they are difficult to measure, in

particular, contingent liabilities.

There was recognition and agreement that the discounting of long term costs within the

NPV process may be to the disadvantage of pollution prevention projects, which was

highlighted as a limitation of the NPV technique itself. With respect to environmental

risk, this was addressed through compliance with EPA regulations, however, there did

not appear to be a recognition of that risk extending beyond the boundary of the entity

(Kite, 1995). In addition, environmental capital budgeting projects were seen as

mandatory, as they are determined by EPA regulations, which meant that investment was

undertaken, in some instances, irrespective of the NPV calculation.

The NPV appears to be the primary capital budgeting technique employed, but the water

authority attempts to take into consideration unquantifiable costs and benefits by

considering them as additional factors to be taken into consideration in the capital

budgeting process. In particular, there appears to be recognition of the less tangible

benefits of undertaking environmental regulatory capital expenditure, such as improved

social outcomes, improved customer acceptance.

The study was limited due to the fact a single case study was undertaken. The results and

findings therefore cannot be generalized beyond the existing case study. A multiple case

study would have enabled similar results to be predicted (literal replication) or

contrasting results produced but for predictable reasons (theoretical replication) (Yin,

1994). Multiple case study evidence is considered to be more compelling and robust

30

(Yin, 1994). This case study therefore may provide the basis for future case studies that

may develop further observations (Williamson, 2000) of the identification and

measurement of environmental costs within the capital budgeting process.

31

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Appendix 1

INTERVIEW WITH MANAGER – STRATEGIC PLANNING AND

ECONOMIST –STRATEGIC PLANNING

KEY QUESTIONS

Qu. 1 What are the goals and objectives of capital expenditure decisions at sewerage

treatment plants?

Qu. 2 Are there any constraints on long­term capital expenditure decisions?

Qu. 3 The profit of the water authority is governed by the prices that the government

sets. Does this shift the emphasis from long­term decision making to short­term

decision­making?

Qu. 4 What would you classify as environmental costs in your capital expenditure

decisions?

Qu. 5 How do you identify and classify these costs in your capital expenditure

decisions: a) Compliance with environmental regulations b) Monitoring costs c)

Materials costs and d) Treating and disposing of waste?

Qu.6 What do you identify as the economic / useful life of a sewerage treatment plant?

Qu.7 It is argued that the costs at the end of the life of a chemical plant, for example,

such as cleanup costs, can be very high, and if you discount those costs too

heavily, they can be immaterial or inconsequential in decision making, whereas at

the time of cleanup, they can be quite high. What is your opinion of this argument

with respect to sewerage treatment plants?

Qu.8 What do you identify as the benefits of incorporating environmental issues into

capital expenditure decisions?

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Qu. 9 With respect to the privatization of water authorities in the United Kingdom, there

is a recognition that “discretionary expenditure undertaken to improve the quality

of service, in this case, the quality of treatment, may be detrimental to short term

profit, but over the longer term, it may be associated with higher long term returns

because there may be a perception that future profit levels and risk exposure may

be improved”. How does this argument apply to expenditure undertaken by the

water authority to improve the quality of treatment at sewerage treatment plants?

Qu. 10 When capital expenditure is undertaken in order to comply with EPA regulations,

how important is the role of the NPV and / or IRR calculations?

Qu. 11 How do you identify and assess environmental risk in capital budgeting decisions

at sewerage treatment plants?

Qu. 12 What is the role of life cycle costing / analysis in the capital budgeting process at

sewerage treatment plants?

Qu. 13 How do you estimate / measure / contingent liabilities into the capital budgeting

process with respect to sewerage treatment plants?

Qu. 14 In your role as manager of the sewer segment, how did you incorporate

environmental considerations into your budgeting for direct costs at the start of

each year? Did your expense category of corporate expenses include any items

that could be classified as environmental expenditure?

Qu. 15 Could you explain why overheads are traced to one account in the sewer segment,

organizational overheads, and not to the individual treatment plant account

department, as there are arguments that this would improve decision­making?

36

Qu. 16 Has the requirement for cost recovery (to recover costs from other segments /

departments that provide services to the sewer segment) had any impact on the

direct costs of treating effluent? Was the requirement for cost recovery driven by

the Council of Australian Governments (COAG) water reform package? Has this

had any impact upon environmental standards?

Qu. 17 How do you identify the relevant / incremental costs associated with the

evaluation of different methods of effluent treatment (e.g. reuse as opposed to

disposal)?

Qu. 18 What are the objectives of the water authority with respect to effluent treatment

and discharge and how are they measured at a strategic level?

Qu. 19 What are the financial objectives with respect to effluent treatment and discharge

at a strategic level and how are they measured?

Qu. 20 What is the objective / function of the Environmental Management System

(EMS)?

Qu. 21 Does the EMS examine how the meeting of environmental objectives impacts

upon financial objectives / goals or the relationship as to how environmental

activities impact upon financial activities?

Qu. 22 How do you measure the objectives of the EMS? Does the EMS contain any

financial performance indicators?

Qu. 23 How do you identify /define environmental information with respect to effluent

treatment and discharge?

Qu. 24 How does your risk management strategy operate with respect to sewerage

treatment plants?

37