Calculation of the Economic Benefit of Noncompliance in EPA's Civil Penalty Enforcement Cases

SUMMARY: The Environmental Protection Agency (``EPA'') requests comment

on how it calculates the economic benefit obtained by regulated

entities as a result of violating environmental requirements. In

particular, the Agency is seeking comment on three categories of

issues: The most effective mechanism for recapturing economic benefit;

the methodology and assumptions incorporated in the economic benefit

(``BEN'') computer model used by the Agency to calculate that benefit;

and the model's precision and user-friendliness. After the comment

period closes, the Agency plans to review all the comments and revise

its benefit recapture approach as appropriate.

DATES: EPA urges interested parties to comment in writing on the BEN

model and the EPA's benefit recapture approach. Comments must be

received by EPA at the address below by January 1, 1997. Comments may

also be communicated verbally at two public meetings EPA will hold

during the comment period. The first one is scheduled for Washington,

DC in the auditorium at EPA's Education Center at 401 M Street, SW., on

November 6, 1996. The second one is scheduled for San Francisco at the

Holiday Inn Golden Gateway at 1500 Van Ness Ave on November 13. Both

meetings will begin at 9:30 a.m. and end at 4:00 p.m.

ADDRESSES: Written comments should be submitted in triplicate to: U.S.

Environmental Protection Agency, Office of Enforcement and Compliance

Assurance, Economic Benefit Docket Clerk, Mail Code 2248-A, 401 M

Street, SW., Washington, DC 20460, and reference this docket.

EPA will maintain a record of all written comments submitted

pursuant to this notice. Copies of the comments may be reviewed at the

Ariel Rios Federal Building, 1200 Pennsylvania Avenue, Washington, DC

20044. Persons interested in reviewing the comments must make advance

arrangements to do so by calling (202) 564-2235.

FOR FURTHER INFORMATION CONTACT: Copies of the BEN computer model and

the BEN Users Manual may be obtained from the National Technological

Information Service by calling (703) 487-4650. Callers should request

order number PB95-502514INC. Electronic copies of these items are also

downloadable through the Office of Enforcement and Compliance

Assurance's communications network called ``Enviro$en$e.'' Enviro$en$e

is a free public network accessible via the World Wide Web on the

Internet (http://es.inel.gov), and via an electronic Bulletin Board

System ([703] 908-2092). For further information, contact Jonathan

Libber, Office of Regulatory Enforcement, Multimedia Enforcement

Division, at (202) 564-6011.

SUPPLEMENTARY INFORMATION:

I. Introduction

A. Overview

One of the Environmental Protection Agency's most important

responsibilities is ensuring compliance with the federal environmental

laws. These laws, and their implementing regulations, set minimum

standards for protecting human health and welfare and achieving

environmental protection goals, such as clean air and clean water. EPA

upholds these laws through vigorous enforcement actions that correct

the violations and appropriately penalize violators.

A cornerstone of the EPA's civil penalty program is recapture of

the economic benefit that a violator may have gained from illegal

activity, whenever EPA can effectively measure that gain. Recapture

helps level the economic playing field, preventing violators from

obtaining an unfair financial advantage over their competitors who

timely made the necessary investment in environmental compliance.

Generically, penalties serve as incentives to protection of the

environment and public health by encouraging the adoption of pollution

prevention and recycling practices that limit exposure to liability for

pollutant discharges. Finally, appropriate penalties help deter future

violations by the violator and by others similarly situated.

EPA has promulgated a generic civil penalty policy, as well as

specific penalty policies tailored to suit the needs of particular

programs. For example, there is a civil penalty policy specifically

designed to address violations of the Clean Water Act. Civil penalties

imposed by EPA usually have two components: gravity and economic

benefit. The gravity component reflects the seriousness of the

violation and is generally determined through the application of the

appropriate EPA civil penalty policy.

The economic benefit component focusses on the violator's economic

gain from noncompliance, which may occur in three basic ways. It can:

(1) Delay necessary pollution control expenditures; (2) avoid necessary

pollution control expenditures; or (3) gain an illegal competitive

advantage during the period of noncompliance. This advantage may occur,

for example, if a company sells banned products, or captures an extra

market share through selling its products at a lower cost than its

complying competitors.

The Agency designed the BEN computer model, for settlement purposes

only, to calculate the economic benefit from these first two types of

economic gain. The Agency does not have a standard methodology for

calculating the benefit gained from an illegal competitive advantage,

which is considered on a case-by-case basis.

B. EPA Policy and Guidance on Recapturing the Economic Benefit of

Noncompliance

Since its development in 1984, the BEN computer model has been

extensively used by EPA staff in generating penalty figures for

settlement purposes that reflect the economic benefit a violator

derived from delaying or avoiding compliance with environmental

statutes.

1. Policy Background

Calculating a violator's economic benefit using the BEN computer

model is usually the first step in developing a civil penalty figure

under the Agency's Policy on Civil Penalties (PT.1-1) February 16,

1984, and A Framework for Statute-Specific Approaches to Penalty

Assessments (PT.1-2) February 16, 1984 (hereinafter the ``Framework'').

The Agency developed the BEN computer model to assist in fulfilling one

of the main goals of the Policy on Civil Penalties: recovery, at a

minimum, the economic benefit from noncompliance.

The BEN computer model is intended to be used in calculating

economic benefit for purposes of developing a settlement penalty, not

for use at trial or in an administrative hearing. In presenting

economic benefit testimony at trial or in an administrative hearing,

the Agency typically relies on an expert to provide an independent

financial analysis of the economic benefit the violator obtained as a

result of its violations. This independent financial assessment

reflects the expert's analytical approach as applied to the particular

facts of that case. Although such an analysis is usually consistent

[[Page 53027]]

with the principles of the BEN model, it may not be identical to that

set forth in the BEN User's Manual.

2. BEN Calculates the Economic Benefit From Delayed and Avoided

Pollution Control Expenditures

The BEN model is designed to calculate two types of economic

benefits: those gained from delaying and from avoiding required

environmental expenditures. Delayed costs can include capital

investments in pollution control equipment, delayed costs to remediate

environmental damages caused (e.g., remove unpermitted dredged or fill

material and restore wetlands), or one-time expenditures required to

comply with environmental regulations (e.g., the cost of setting up a

reporting system, or land purchases). Avoided costs include operation

and maintenance costs and/or other recurring costs (e.g., off-site

disposal of fluids from injection wells). BEN does not calculate a

third type of benefits: those derived from a competitive advantage

gained by a violator.

3. Current Model Usage and Applicability

The BEN model can be used in all cases where there is a measurable

benefit from delaying or avoiding compliance, except for Clean Air Act

Section 120 enforcement actions. (Section 120 requires the application

of a specific computer model.) BEN was designed to be easy to use for

people with little or no background in economics, financial analysis,

or computers. Because the program contains standard values for many of

the variables needed to calculate the economic benefit, BEN can be run

with only a small number of inputs from the user. The program also

allows the user to replace those standard values with user-specific

information. Table 1 lists the inputs to the BEN model. The optional

inputs listed in Table 1 are those for which the model has standard

values.

The model can estimate economic benefit for many types of

organizations: corporations, partnerships, sole proprietorships, not-

for-profit organizations and municipalities. The BEN model has two sets

of standard values: one applies to for-profit business violators and

the other applies to not-for-profit organizations. The BEN inputs

listed in Table 1 are discussed in detail in Chapter 4 of the BEN Users

Manual for both for-profit and not-for-profit organizations.

Table 1.--Inputs for BEN

------------------------------------------------------------------------

-------------------------------------------------------------------------

Required Inputs:

(1) Case Name, Profit Status, and Filing Status.

(2) Capital Investment.

(3) One-Time Nondepreciable Expenditure.

(4) Annual Expenses.

(5) Date of Noncompliance.

(6) Date of Compliance.

(7) Date of Penalty Payment.

Optional Inputs (Standard Values that May be Modified):

(8) Useful Life of Pollution Control Equipment.

(9) Marginal Income Tax Rate for 1986 and Before.

(10) Marginal Income Tax Rate for 1987 to 1992.

(11) Marginal Income Tax Rate for 1993 and Beyond.

(12) Inflation Rate.

(13) Discount Rate.

------------------------------------------------------------------------

C. How a Firm Obtains an Economic Benefit From Delaying or Avoiding

Compliance Costs

An organization's decision to comply with environmental regulations

usually implies a commitment of financial resources, both initially (in

the form of a capital investment or one-time expenditure) and over time

(in the form of annual, continuing expenses). These expenditures should

result in better protection of public health or environmental quality;

however, they are unlikely to yield any direct economic benefit (i.e.,

net gain) to the organization. If these financial resources were not

used for compliance, they presumably are invested in projects with an

expected direct economic benefit to the organization. This concept of

alternative investment--that is, the amount the violator would normally

expect to make by not investing in pollution control--is the basis for

calculating the economic benefit of noncompliance.

As part of the Civil Penalty Policy, the Agency uses its penalty

authority to remove or neutralize the economic incentive to violate

environmental regulations. In the absence of enforcement and

appropriate penalties, an organization's best economic interest will

usually be to delay the commitment of funds for compliance with

environmental regulations and to avoid certain other associated costs,

such as operation and maintenance expenses.

1. The Components of Economic Benefit Measured by the BEN Model

A violator may gain economic benefit from either delayed or avoided

compliance costs. By delaying compliance, the violator can earn a

return on the delayed capital or one-time costs of pollution control

equipment. In other words, violators have the opportunity to invest

their funds in projects other than those required to comply with

environmental regulations. These other investments are ordinarily

expected to yield a monetary return at the violator's marginal rate of

return on capital. But environmental expenditures typically yield no

direct economic benefit. Thus, by delaying compliance, the violator

benefits by the amount of earnings that could be expected from

alternative investments.

A violator can also gain an economic benefit from avoiding

pollution control expenditures. Avoided expenditures typically include

the annual continuing expenses that a violator would have incurred if

the facility had complied with environmental regulations on time, such

as the costs of labor, raw materials, energy, lease payments and any

other expenditures directly associated with the operation and

maintenance of the pollution control equipment. Unlike capital and one-

time expenditures which are only postponed, annual expenditures are

avoided altogether. The resulting benefits to the violator are the

total avoided annual costs as well as the return that could be expected

on these avoided costs.

[[Page 53028]]

2. Taking Indirect Costs Into Account

EPA's BEN model evaluates economic benefit in terms of the effect

that delayed or avoided pollution control expenditures have on an

entity's cash flows. Cash flow analysis is a standard and accepted

technique for evaluating costs and investments. In essence, the result

of cash flow calculations is to determine the actual dollar costs and

revenue resulting from an expenditure. Thus, noncash expenditures, such

as depreciation, are only considered to the extent that they affect

cash income or expenses. The three factors the model accounts for here

are tax, inflation and discounting.

a. After-Tax Cash Flows

The BEN model computes economic benefit in after-tax terms to take

into account certain financial impacts associated with environmental

expenditures. For example, one important impact of these expenditures

is a reduction in income tax liability. Depreciation and annual

expenditures serve to reduce taxable income, thereby reducing income

taxes. Also, depending upon the tax year, the original purchase of

equipment might have resulted in an investment tax credit. To account

for these tax effects, BEN calculates the economic benefit using after-

tax cash flows.

b. Inflation

Inflation is another indirect factor that the BEN model accounts

for. The BEN model initially converts all costs to dollars of the

noncompliance year before it compares the cost of complying on time

with the cost of complying late. The model uses the inflation rate to

adjust the current or future cost of compliance into dollars from the

year noncompliance began. The BEN Users Manual (see pages 4-27 to 4-29

and Appendix A of the manual) contains a more detailed discussion of

the inflation factor.

c. Discounting

A third impact relates to the timing of the cash flows since cash

flows occurring in different years are not directly comparable. A basic

concept of financial theory is ``present value.'' This concept is based

on the principle that: ``A dollar today is worth more than a dollar a

year from now,'' because today's dollar can be invested immediately to

earn a return over the coming year. Therefore, the earlier a cost (or

benefit) is incurred, the greater its economic impact. BEN accounts for

this ``time value of money'' effect by reducing all estimated future

cash flows to their ``present value'' equivalents. This widely-used

technique is known as ``discounting'' and ``net present value''

analysis. The BEN Users Manual (see pages 4-30 to 4-35 and Appendix A

of the manual) contains a more detailed discussion of discounting and

the concept of present value.

II. Issues

The Agency is seeking comment on three categories of issues: (1)

Broad economic benefit recapture questions, (2) the BEN model's

calculation methodology and assumptions, and (3) the model's user-

friendliness.

First, we invite comment on some fundamental questions the benefit

recapture approach has raised. Is there a better way to measure benefit

for settlement purposes than using the BEN model? In addition, what is

the best approach to calculate the economic benefit derived from

illegal profits?

Second, we invite comment on the BEN model's calculation

methodology. While the Agency is confident that the BEN model's overall

approach is theoretically sound, it welcomes constructive and

documented comment on alternative approaches. In addition, EPA is aware

of substantial differences of opinion with respect to the basis of some

of the model's assumptions, particularly the discount rate and

inflation rate. EPA requests comment on the BEN model's calculation

methodology, or any other aspect of the model's assumptions or

methodology.

Third, we request comment on the model's user-friendliness. The

Agency has heard comments that the model is too difficult to use,

particularly regarding BEN's ease of operation or how difficult it may

be to obtain the data needed to run BEN. EPA has never been presented

with any concrete evidence in support of these assertions. Thus, the

Agency would like to either substantiate the problems and address them,

or put these issues to rest.

A. Broad Economic Benefit Recapture Issues

1. Alternatives to BEN

EPA requests comment on whether there is a more accurate, simpler

approach to measuring the economic benefit of delayed and avoided

pollution control expenditures than the BEN model. The BEN model was

designed to calculate the economic benefit of noncompliance for the

vast majority of EPA's cases. While BEN has effectively served this

purpose, the Agency recognizes that it should be improved or even

replaced if a better alternative exits or could be easily be developed.

This is particularly relevant as an increasing number of State and

local government enforcement personnel are using the BEN model

regularly. Any alternative approach must meet EPA's policy objective of

ensuring that violators are put on an even financial footing with those

regulated entities that comply on time. Alternatives should also be

reasonably accurate, simple to use and readily understandable to the

vast majority of the BEN model's users. These Federal, State and local

government enforcement officials usually have limited knowledge of

corporate or municipal finance or accounting.

2. Illegal Competitive Advantage

The Agency would like routinely to evaluate the economic benefit a

violator derives from a competitive advantage gained as a result of the

violation. While the Agency has maintained since 1984 that this was one

aspect of economic benefit we would seek to recapture, EPA is seeking

advice on what should be employed as a standard methodology to measure

what that benefit is. This benefit can accrue to a violator in a number

of different ways:

a. Violator Sells Products at Below Market Price

Depending upon the particular market situation, a violator could

sell its products at a lower price than its complying competitors

because it does not have to pay for environmental compliance costs. It

could then secure a bigger share in that particular market. For

example, instead of controlling 25% of the market for a particular

product, it controls 35% of the market. In theory, the extra 10% of the

market is the economic benefit. Some of the key questions are: how do

we assess and prove what share of the market came from underpricing,

and how do we determine the value of that market share?

b. Violator Sells Products That Were Prohibited by Law

Many of EPA's regulations prohibit the sale of certain products

either permanently or until EPA reviews and approves them. If the

violator produces and sells the prohibited product, the violator will

achieve an economic benefit in two ways. First, it will make money

directly from the sale of the product. Second, it will capture the

market for the product, particularly if it is a new product. Some of

the key questions here are: should the measure of economic benefit be

gross sales, gross sales minus expenses, or some other measure? If it

is the net, what expenses should be considered in determining the

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net (e.g., how should EPA allocate advertising expenses for a violator

producing more than one product)?

c. Violator Initiates Construction or Operation Prior to Government

Approval

Some regulatory requirements prohibit an entity from initiating

construction or operation until it obtains a permit from EPA or another

government agency. When a violator initiates construction or operation

prior to this approval, it can begin operating earlier than it would

have been able to do had it complied with the law. For example, if the

violator's operation begins nine months earlier than it should have,

the violator has an opportunity to generate sales it should not have

made and gain a head start in developing its market. Some of the

motivation to violate could be to take advantage of a business cycle

(e.g., the violator illegally completes construction of a golf course

without the required permits so that it can open at the start of the

golfing season). Another incentive might be to initiate construction as

soon as the financing is available and not wait until approval is

given. (In either of these situations, we assume that the government

will eventually issue the permit, if it does not, then every dollar

produced by the new facility is an illegal economic benefit.)

One of the key issues here is: how should EPA determine the amount

of benefit when a violator initiates construction or operation prior to

government approval? Firms often expect to lose money on a new facility

in the first few years of operation. Similarly, new businesses expect

to lose money in the first few years of operation. For example, if a

firm starts operating one year earlier than it should have, and if EPA

only looks at the gross income minus the expenses, then the violator

may be able to argue that it actually lost money the year it was in

violation. Although that violator will ultimately be able to start

showing a profit one year earlier than it should have, it will show a

loss for that first year.

B. The BEN Model's Calculation Methodology

Over the years, the BEN model has been criticized for alleged flaws

in its calculation methodology. The two issues with the greatest

potential impact involve the model's discount rate and its inflation

rate. The Agency requests substantive and constructive comments on how

the BEN model handles these two issues. In addition, comments are

invited on all aspects of the calculation methodology. Comments that

address issues involving the calculation methodology should clearly

state the rationale for the proposed changes. In addition, the

commenters should address whether the proposed changes would add any

complexity to the computer model. If any of them do add complexity, the

commenter should state why the benefit of the change justifies the

added complexity.

1. Discount Rate Assumptions

The discount rate is an interest rate that reflects the violator's

cost of capital. In essence, this is the cost of financing pollution

control investments. The BEN model bases its discount rate for for-

profit entities on the weighted average cost of capital (WACC) for a

typical firm. This means that the cost of financing a project is based

on a weighted average of a typical firm's cost of debt capital (e.g.,

bonds and bank loans) and equity capital (e.g., stocks). For

municipalities, the discount rate is based on an average municipal bond

yield for the top four grades as reported in Moody's Municipal and

Government Manual.

The discount rate is a key assumption employed in the computer

model. Any changes to the discount rate have a substantial effect on

the BEN results. For a more detailed discussion of the discount rate,

see the BEN Users Manual (at pages 4-30 to 4-35 and Appendix A).

2. Inflation Rate Assumptions

The inflation rate variable is the annual rate at which the costs

of environmental control measures have grown and are expected to grow

over time. These cost increases are the result of various factors

affecting supply and demand for particular products and services, as

well as general inflationary pressures in the economy. BEN applies the

inflation rate to adjust the cost of compliance measures as

appropriate. The standard value of the inflation rate is based on a

ten-year running average of the ``Plant Cost Index'' that appears in

Chemical Engineering. For a more detailed discussion of the inflation

rate, see the BEN Users Manual (pages 4-27 to 4-29).

C. Improving the BEN Model's User Friendliness

EPA understands that some users find the program difficult to use.

While that has not been EPA's experience, the Agency is interested in

learning of any difficulties associated with running the model.

Comments on these issues will be particularly helpful if they suggest

realistic alternatives that would also preserve the model's degree of

precision.

1. Is BEN Too Complex to Operate?

EPA invites comments on whether an aspect of the model's operation

or its user's manual is overly complex. Although designed to be

straight-forward and easy to use, the Agency would welcome any

suggestions to make the model and manual easier to use as long as we

can preserve its degree of precision.

2. Is the Information BEN Needs Difficult or Expensive to Obtain?

One of the main breakthroughs BEN achieved over its predecessor

model was its streamlining of the data needed to operate the model.

While the model requires a minimum of seven and a maximum of only

eighteen pieces of data, some users find that the data is hard to

obtain. This has not been EPA's experience as most, if not all the

required data inputs, are based on facts that are already known to the

litigation team as they are important to other parts of the settlement.

Nevertheless, the Agency would welcome any suggestions as to how to

make this data easier to obtain as long as we can preserve the model's

degree of precision.

III. Public Process

As part of EPA's effort to obtain comments on the BEN model, the

Agency is planning to hold two public comment sessions. At those two

meetings, interested parties may attend and provide verbal comments on

the issues. The first one is scheduled for Washington, D.C. in the

auditorium at EPA's Education Center at 401 M Street, SW, on November

6, 1996. The second one is scheduled for San Francisco at the Holiday

Inn Golden Gateway at 1500 Van Ness Ave on November 13. Both meetings

will begin at 9:30 a.m. and end at 4:00 p.m.

The Agency is especially interested in comments relating to the

issues specified in this Notice. After the comment period closes, the

Agency plans to review all the comments and revise its benefit

recapture approach and the BEN computer model as appropriate. EPA

encourages parties of all interests, including State and local

government, industry, not-for-profit organizations, municipalities,

public interest groups and private citizens to comment so that we can

have as broad a spectrum as possible.

[[Page 53030]]

Dated: September 24, 1996.

Steven A. Herman,

Assistant Administrator, Office of Enforcement and Compliance

Assurance.

[FR Doc. 96-25893 Filed 10-8-96; 8:45 am]

BILLING CODE 6560-50-P