Financial analysis of a pollution prevention project will assist a company in determining if that particular investment will add economic value to the company. This value can be assessed by calculating cash flows over the life of the project and applying measures of profitability. However, many of the costs and potential savings of pollution prevention projects are not included or are underestimated in conventional financial analysis.
Pollution prevention projects may not effectively compete in the capital budgeting process because the conventional cost accounting systems were not specifically designed to evaluate such projects. Conventional cost accounting systems are used to provide information to management, investors, regulators and other external entities on the financial performance of a business, and also to provide management with information to make decisions.
Traditional cost categories include direct materials, direct labor, and overhead. Many indirect costs may be hidden in the overhead category and traditional financial analysis may underestimate the potential savings from a pollution prevention project. Also, conventional cost accounting might not evaluate the project over a long time period and usually does not consider numerous important qualitative issues, possibly causing the pollution prevention project to be rejected.
What can you do to try to overcome some of these obstacles and to determine the true costs and savings of a pollution prevention project? This fact sheet can help by covering the basic financial evaluation of a pollution prevention project, including the following steps:
Collecting cost information on current process costs and
proposed project costs;
You might read this overview and think, "I don't have time to do all these steps or to design a new accounting system!" Remember, the goal of this analysis is to look at costs and savings associated with a pollution prevention project in a new way, not necessarily to fundamentally change your accounting system. Try this analysis on one small project first to see how it might work, or try portions of the analysis as your time and resources allow.
Collecting cost information on current process costs and proposed project costs
The first phase of the financial analysis of a pollution prevention project entails gathering complete and accurate data for costs that have a material impact on the decision and that are useful to those who evaluate the project proposal. These costs should be expressed as the differences between the costs of the current process and the projected costs of the proposed project. All costs should be converted to total annual amounts in order to perform the financial analysis with common metrics. The following procedures can be used to determine these costs (NEWMOA/OTA,1994).
Draft a process flow diagram of the existing process that will be altered by changes in equipment, materials, process design or other pollution prevention techniques. The diagram should include the primary process and other secondary process flows that are related to or affected by the main process.
Use the process flow diagram to chart all the labor activities, materials equipment and other operating expense items that are involved in the production process and secondary processes. In a pollution prevention project the most important activities to be aware of are those related to the tracking, treatment and disposal of waste, and those related to purchasing, handling and using hazardous chemicals.
A conventional cost accounting system may hide indirect costs in an overhead account. To determine the full cost of a pollution prevention project, you will want to know all the costs, including the hidden costs, that are attributed to a specific process and what drives those costs. Refer to Table 1, Potential Operating Costs, for a checklist of potential operating costs, including hidden costs, that should be considered.
Repeat the first two steps for the new process. Refer to Table 2, "Potential Initial Costs" for a checklist of potential initial costs that should be considered. Look carefully for the "hidden" costs and savings.
Identify all the places where labor activities, materials, equipment and other operating costs are likely to change.
Determine the costs in the current process and in the proposed project for those activities and items that will change because of the proposed project.
Calculate the differences between the current and proposed processes. Be sure to express the costs in after-tax amounts. For example, depreciation of equipment will reduce the taxable income of a company.
Sources of cost information include interviews with operational and environmental personnel; logs of various activities or materials; records from purchasing, payroll, and accounting; receipts and invoices; and vendors.
It is possible that by looking for all of the costs and savings associated with a process or project, you might identify more costs than originally anticipated. The additional costs might cause the proposed pollution prevention project to be rejected. This might be discouraging, but remember that your primary goal is to determine if a particular pollution prevention project will reduce waste and save money when compared to a current process. Keep the rejected project on file and try the financial analysis again at a later time when costs and savings figures may have changed.
Applying measures of profitability
A measure of profitability is a single number that is calculated to characterize project profitability in a concise, understandable form. There are three common methods, or measures of profitability, used to assist the decision makers in a financial analysis to determine if a pollution prevention project will add economic value to a company. These measures include: Payback period, Net Present Value (NPV), and Internal Rate of Return (IRR). Each method is briefly explained here, including appropriate uses, advantages, and limitations (following NEWMOA/OTA, 1994). The reader is encouraged to consult the references at the end of the fact sheet for a more detailed explanation with examples for each of these methods.
If you do not have a background in financial analysis or feel you do not have time to perform numerous calculations, don't despair! There are numerous spreadsheets and relatively straightforward computer programs that can do most of the work for you. If you have identified and collected cost and savings information, you have already done much of the work.
Payback period analysis (simple payback) measures how long a project will take to return its original investment and ranks projects according to the length of the period: the shorter the period, the more attractive the project. The payback period is the amount of time required for an investment to generate enough cash flow to just cover the initial capital outlay for that investment (Tellus, 1995). Cash flow from an investment is the dollars coming to the company (cash inflow) or paid out by the company (cash outflow) resulting from a given investment (Tellus, 1995).
Depending on the nature of the cash flows, payback period can be calculated as follows:
If annual cash flows are equal, the initial investment amount is divided by the annual cash flow. For example, if the initial investment is $12,000 and the first year annual cash flow is $15,000, then the payback period is 12,000/15,000 = 0.8 years.
If the first year cash flow is greater than the initial investment, the initial investment amount is divided by the first year cash flow.
If cash flows vary, and the initial investment is greater than the first year cash flow, succeeding years' cash flows are added incrementally until they equal the initial investment amount.
Payback period analysis has two drawbacks: it ignores the time value of money, and it ignores cash flows that occur after the initial investment has been recouped and does not show costs and savings past the point where the project has paid for itself. A chart that tracks the percentage payback of all cash flows over the life of the project may increase the payback method's usefulness.
Payback analysis provides a useful preliminary assessment of a project's attractiveness. If the payback is very short and the project is relatively simple, payback period analysis may be sufficient. However, this initial assessment should be verified by a Net Present Value analysis.
Net Present Value (NPV) analysis relies heavily on the concept of the time value of money and is the most powerful tool for assessing profitability over the life of a project. The time value of money recognizes that receiving $100 today is not equivalent to receiving $100 at some point in the future, because the $100 today can be invested to earn a return. Net Present Value is the present value of the future cash flows of an investment, minus the investment s current cost (Tellus, 1995).
The time value of money measures the value of money at different points in time as determined by a discount rate. The discount rate is the interest rate that is used to relate the future value of the money to the present value of the money. The discount rate is the rate of interest or return that a business or person can earn on the best alternative use of the money at the same level of risk. The discount rate is a function of what that company must pay to acquire capital (money) and what rate of return for a given level of risk it must earn on the investment to satisfy management and shareholders. Note that discount rates are not inflation rates, although they usually incorporate the projected rate of inflation. An example of how Net Present Value can be calculated is shown in Table 3.
Net Present Value analysis should be used when initially evaluating major pollution prevention projects and for the final analysis of most projects. Advantages of Net Present Value analysis are it considers the time value of money and it measures the risk-adjusted value added to the company. Disadvantages include that it is more information and calculation intensive, requires the estimation of cash flows over the life of the project and requires the calculation of a discount rate.
Internal Rate of Return (IRR) is a profitability measure, expressed in percentage terms, that is analogous to an average rate of return from an investment. IRR is the discount rate that will yield a net present value of zero for a given stream of cash flows. This method allows a comparison between the IRR of a project and a company's self-determined discount rate. A financial calculator or computer spreadsheet should be used to determine IRR. In general, if the IRR is greater than the discount rate, the project will be accepted. If the IRR is less than the discount rate, the project will be rejected.
The IRR can provide a convenient way of examining the return that a project will generate. Using the NPV and the IRR approaches result in the same alternative being chosen because these approaches are essentially the same. IRR shows the rate of return that a project generates, while NPV shows the present day dollar value of the return that a project generates. However, IRR analysis ignores the impact of the scale of a project. For example, a project that requires an investment of $100 and returns $125 in one year will have the same IRR as a project that requires a $200,000 investment and returns $250,000 in one year. IRR should only be used to judge if a project is profitable, not for prioritizing projects. Use NPV for prioritizing and comparing projects because it yields consistently valid results.
Net Present Value is generally the most valuable, problem-free measure of profitability. Other indicators that consider the time value of money, such as Internal Rate of Return, are also useful. Payback should be used only for small projects, for a first-cut rough screening analysis, or to complement NPV and IRR information. (Tellus, 1995)
If you have accurately estimated cash flows and selected the appropriate discount rate, all projects with a positive NPV are profitable and may be worth implementing. If you have several projects competing for funding, or more than one pollution prevention option, choose the alternative with the highest NPV, not the highest IRR. (U.S. EPA, 1994)
Considering less tangible costs
Pollution prevention projects may have other factors that affect a business that are difficult to quantify, but may still have strategic significance. Issues such as product quality, productivity, market share, stakeholder relations, employee health and safety, public image, a proactive environmental strategy, and criminal and financial liability can be very important criteria in the analysis of a pollution prevention project. Potential liability categories include disposal, storage, transportation, real property damage, civil actions, toxic tort suits, fines, penalties, and criminal liability.
Table 1. Potential Operating Costs
This list is from NEWMOA/OTA, 1994, as adapted from material published by the Tellus Institute. The items led by hyphens are those most likely not to be included in the financial analysis of a pollution prevention project either because they are hidden in overhead or because their allocation is insufficiently specific.
Table 2. Potential Initial Costs
This list is from NEWMOA/OTA, 1994, as adapted from material published by the Tellus Institute. Many of these costs may or may not be capitalized depending upon the judgment of a company s financial staff.
Table 3. Net Present Value calculation
Try to keep in mind that businesses deal with probabilities of success and failure of many aspects of their work all the time. Now you will be trying to apply this probabilistic/qualitative approach to the analysis of a pollution prevention project. Decide which issues have a strategic significance to the company and which issues are related to a particular pollution prevention project. Assess the possible impacts of those issues and include the issues and the assessment in your presentation of the pollution prevention project to decision makers. More detailed discussion of how to evaluate qualitative issues and how to communicate their importance in a pollution prevention project is presented in "Improving your competitive position: Strategic and financial assessment of pollution prevention projects" (NEWMOA/OTA, 1994).
Presenting the pollution prevention project to decision makers
After completing your financial analysis, whether or not the pollution prevention project is approved and funded may partially depend on how you present the project to the decision makers. Because you have accumulated good cost information and performed many supporting calculations, you may be tempted to present numerous pages of technical financial data. A better approach is to begin the proposal with a short executive summary, including a concise project description, a graph illustrating the project's profitability using the measure that best suits your project, and a very brief discussion of the most important qualitative benefits of the project. These areas can then be supplemented with more detailed information in following pages.
If you are not successful in your first attempt at obtaining funding for the pollution prevention project, try to determine the reasons for rejection and critically review and revise the proposal. Remember that changes in cost accounting methods to include all the costs and savings of a pollution prevention project and careful consideration of the qualitative aspects of the project may be new ways of thinking about capital budgeting for the decision makers. You might want to try this approach on one small project to demonstrate the benefits of a different approach to thinking about costs of a pollution prevention project.
Some pollution prevention projects are not approved during their first review. Revise your proposal and submit it again. You might also want to consider assistance available from Ohio EPA and the State of Ohio to strengthen your proposal, such as low interest loans (see below) and pollution prevention technical assistance from the Ohio EPA's Office of Pollution Prevention.
State of Ohio Pollution Prevention Loan Program
The Ohio Environmental Protection Agency and the Ohio Department of Development are offering low-interest capital-improvement loans to small and medium sized businesses in the State of Ohio for Pollution Prevention. The program is a revolving loan fund and has ten million dollars total set aside for 1995 and 1996. Loans are available from $25,000 to $350,000, at a fixed interest rate currently set at two-thirds of the prime rate. The loans can be used for part of the costs of acquisition or renovation of machinery and equipment for pollution prevention and/or energy conservation. Preferential interest rates are available on a case-by-case basis in distressed areas of the state.
Ohio EPA performs a technical review of the application and then forwards it to the Ohio DOD to determine loan eligibility. Applicants are asked to describe the amount of pollution currently generated and how much will be prevented. Companies must be able to demonstrate measurable environmental improvements through pollution prevention for the program.
ContactWilliam Narotskiat OPP at the address or telephone numbers listed at the bottom of this page for more information.
Office of Pollution Prevention Technical Assistance Activities
Technical assistance is a major portion of the Office of Pollution Prevention's services, and the Office has several staff assigned to providing pollution prevention information. On-site visits, mail, telephone and other communications and services are provided. In addition to conducting on-site pollution prevention assessments at Ohio business, the Office of Pollution Prevention (OPP) provides information on pollution prevention facility planning to many Ohio companies by conducting meetings and facility visits. Both efforts help facilities help themselves in initiating or improving their own programs.
OPP's technical assistance activities are provided in a non-regulatory manner. However, in addition to this voluntary program, OPP is able to provide information directly related to regulatory issues. The Office often assists in addressing regulatory issues of Ohio businesses and others through pollution prevention.
OPP creates, collects and distributes current pollution prevention information. OPP provides presentations to about 100 groups per year, mostly business organizations. The Office also assists in the planning of several pollution prevention seminars and conferences per year in cooperation with local and state business organizations and others.
Much of the information for this fact sheet was modified and directly quoted from the Northeast Waste Management Officials Association and the Massachusetts Office of Technical Assistance publications, "Improving your competitive position: Strategic and financial assessment of pollution prevention projects," Training manual and Instructor's guide (two separate publications). We are grateful for their assistance with this fact sheet.
References and Resources
(For more information on how to obtain these publications, please contact Ohio EPA's Office of Pollution Prevention at 614-644-3469)
American Institute for Pollution Prevention. 1992. A primer for financial analysis of pollution prevention projects. AIPP, Cincinnati, Ohio.
Northeast Waste Management Officials Association and the Massachusetts Office of Technical Assistance. 1994. Improving your competitive position: Strategic and financial assessment of pollution prevention projects. Training manual and Instructor's guide (two separate publications). NEWMOA and MA OTA, Boston, Massachusetts.
Pacific Northwest Pollution Prevention Research Center. 1993. Environmental economics: What's the bottom line? Pollution Prevention Northwest, Spring/Summer, 1993.
Rooney, Charles. 1993. Economics of pollution prevention: How waste reduction pays. Pollution Prevention Review, Summer, 1993.
U.S. EPA. 1994. Environmental accounting resource listing: Design for the Environment (DfE) accounting and capital budgeting for environmental costs. EPA 742-F-94-004. U.S. EPA, Office of Pollution Prevention and Toxics, Washington, D.C.
U.S. EPA. 1994. Green Lights Program Lighting Upgrade Manual, Financial Considerations chapter. U.S.EPA, Office of Air and Radiation, Global Change Division, Washington, D.C.
White, Allen, Monica Becker, and Deborah Savage. 1993. Environmentally- smart accounting: Using total cost assessment to accelerate industrial pollution prevention. Pollution Prevention Review, Summer, 1993.
White, Allen and Deborah Savage. 1995. Environmental cost accounting and capital budgeting. Tellus Institute, Boston, Massachusetts. July 12, 1995 Videoconference, Modern Manufacturing series, National Technological University, Fort Collins, Colorado.
World Resource Institute. 1995. Green ledgers: Case studies in corporate environmental accounting. World Resource Institute.
This is the thirty-third in a series of fact sheets that Ohio EPA has prepared on pollution prevention. For more information, call the Office of Pollution Prevention at (614) 644-3469.
The Office of Pollution Prevention was created to encourage multi-media pollution prevention activities within the state of Ohio, including source reduction and environmentally sound recycling practices. The office analyzes, develops, and publicizes information and data related to pollution prevention. Additionally, the office increases awareness of pollution prevention opportunities through education, outreach, and technical assistance programs directed toward business, government, and the public.
Pollution prevention means the use of source reduction techniques in order to reduce risk to public health, safety, welfare and the environment and, as second preference, the use of environmentally sound recycling to achieve these same goals. Pollution prevention avoids cross-media transfers of waste and/or pollutants and is multi-media in scope. It addresses all types of waste and environmental releases to the air, water and land.
The Office of Pollution Prevention was created to encourage multi-media pollution prevention activities within the state of Ohio, including source reduction and environmentally sound recycling practices. The office analyzes, develops and publicizes information and data related to pollution prevention. Additionally, the office increases awareness of pollution prevention opportunities through education, outreach and technical assistance programs directed toward business, government and the public.
For printed copies of this or other pollution prevention publications distributed by the Ohio Environmental Protection Agency, Office of Pollution Prevention, please call the Office of Pollution Prevention at (614) 644-3469.
A printed copy of the Office of Pollution Prevention publications distribution list, "Pollution Prevention Information Available from Ohio EPA", may also be ordered by calling (614) 644-3469.
Office of Pollution Prevention
Ohio Environmental Protection Agency
P.O. Box 1049
Columbus, Ohio 43216-1049
Phone (614) 644-3469
Fax (614) 728-1245