[Federal Register Volume 64, Number 117 (Friday, June 18, 1999)]
[Notices]
[Pages 32948-32972]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-15271]
[[Page 32947]]
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Part III
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Environmental Protection Agency
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Calculation of the Economic Benefit of Noncompliance in EPA's Civil
Penalty Enforcement Cases; Notice
Federal Register / Vol. 64, No. 117 / Friday, June 18, 1999 /
Notices
[[Page 32948]]
ENVIRONMENTAL PROTECTION AGENCY
[FRL-6361-7]
Calculation of the Economic Benefit of Noncompliance in EPA's
Civil Penalty Enforcement Cases
AGENCY: Environmental Protection Agency (EPA).
ACTION: Advance notice of proposed action, response to comment, and
request for additional comment.
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SUMMARY: In a Federal Register Notice on October 9, 1996, the
Environmental Protection Agency (``EPA'') requested comment on how it
calculates the economic benefit that regulated entities obtain as a
result of violating environmental requirements; EPA makes this
calculation to establish an appropriate penalty for settlement
purposes. This Notice provides both responses to the public comments
and advance notice of the changes EPA proposes to make to its benefit
recapture approach and to its BEN computer model (which is used by EPA
to calculate economic benefit for purposes of settlement). EPA also
requests comment on these proposed changes. After the comment period
closes, the Agency plans to review all of the comments and revise its
benefit recapture approach as appropriate.
DATES: EPA urges interested parties to comment in writing on its
proposed changes to the BEN model and to the Agency's benefit recapture
approach. Comments must be received by EPA at the address below by July
30, 1999.
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 should 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 20004.
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 User's Manual may be obtained from the National Technical
Information Service by calling (800) 553-6847. Callers should request
order number PB98-500382GEI. Electronic copies of these items are also
downloadable through the Office of Enforcement and Compliance
Assurance's World Wide Web site on the Internet (http://www.epa.gov/
oeca/datasys/dsm2.html). Government users (federal, state, or local)
can also obtain copies of the model and manual through the Agency's
toll-free enforcement economics helpline at (888) ECONSPT. For further
information, contact Jonathan Libber, Office of Regulatory Enforcement,
Multimedia Enforcement Division, at (202) 564-6102, or through
electronic mail at libber.jonathan@epamail.epa.gov.
SUPPLEMENTARY INFORMATION: This Notice is organized as follows:
I. Background
A. Overview
B. EPA Policy and Guidance on Recapturing the Economic Benefit of
Noncompliance
1. Policy Background
2. BEN Calculates the Economic Benefit From Delayed and Avoided
Pollution Control Expenditures
3. Current Model Usage and Applicability
C. How a Firm Obtains an Economic Benefit From Delaying or Avoiding
Compliance Costs
1. The Components of Economic Benefit Measured by the BEN Model
2. Taking Indirect Costs Into Account
II. Proposed Changes
A. Broad Economic Benefit Recapture Issues
1. Alternatives to BEN
2. Illegal Competitive Advantage
B. The BEN Model's Calculation Methodology
1. Investment Tax Credit and Low-Interest Financing
2. Depreciation Method
3. Tax Rates
4. Differences in On-Time and Delay Scenarios
5. Replacement Cycles for Capital Equipment
6. Inflation Treatment
7. Discount Rate
8. Discounting Methodology
C. Improving the BEN Model's User Friendliness
1. Is BEN Too Complex to Operate?
2. Is the Information BEN Needs Difficult or Expensive to Obtain?
III. Response to Comments
A. Broad Economic Benefit Recapture Issues
1. Alternatives to BEN
2. Illegal Competitive Advantage
B. The BEN Model's Calculation Methodology
1. Discount Rate
2. Inflation Rate
3. Other Technical Aspects
C. Improving the BEN Model's User-Friendliness
1. Is BEN Too Complex to Operate?
2. Is the Information BEN Needs Difficult or Expensive to Obtain?
3. Other Issues Affecting Use of BEN
D. General Comments on the Public Comment Process
I. Background
A. Overview
One of EPA's most important responsibilities is to ensure that
regulated entities comply with federal environmental laws. These laws--
and their implementing regulations--set minimum standards for
protecting human health and welfare and for 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 recapturing the
economic benefit that a violator may have gained from illegal activity.
Recapture helps level the economic playing field by preventing
violators from obtaining an unfair financial advantage over their
competitors who made the necessary expenditures for environmental
compliance. Penalties also serve as incentives to protect the
environment and public health by encouraging the prompt compliance with
environmental requirements and the adoption of pollution prevention and
recycling practices. Finally, appropriate penalties help deter future
violations by both the penalized entity and by similarly situated
regulatees.
EPA has promulgated a generic civil penalty policy, as well as
specific penalty policies tailored to suit the needs of particular
regulatory programs. For example, one civil penalty policy specifically
addresses violations of the Clean Water Act. There are usually two
components to the civil penalties sought by EPA: 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, on the other hand, focuses on the
violator's economic gain from noncompliance, which may occur in three
basic ways. The violator 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 competitive advantage may occur, for example, if a
company sells banned products or captures additional market share by
selling its products at a lower cost than its complying competitors.
The Agency designed the BEN computer model to calculate--primarily
[[Page 32949]]
for settlement purposes--the economic benefit from these first two
types of economic gain. BEN may not be appropriate for all cases. The
EPA's regional offices can use an alternative approach that can produce
reasonably accurate benefit calculations; however, the Agency believes
that BEN is by far the best approach available for calculating economic
benefit derived from delayed and avoided costs. The Agency does not
have a computer model for calculating the benefit gained from an
illegal competitive advantage. EPA considers such gains on a case-by-
case basis.
B. EPA Policy and Guidance on Recapturing the Economic Benefit of
Noncompliance
Since the BEN computer model's development in 1984, EPA staff have
used BEN extensively 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 settlement
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. 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--of the economic
benefit derived from noncompliance.
The BEN computer model is a tool that is primarily intended to be
used in calculating economic benefit for purposes of developing a
settlement penalty. In presenting economic benefit testimony at
judicial trial or in an administrative hearing, the Agency 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 own analytical
approach as applied to the particular facts of that case. Use of an
expert in a trial or hearing allows the parties the opportunity to
examine more closely the analysis applied to the facts at issue than
would be possible through reliance solely on a computer model.
1
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\1\ EPA designed the BEN model as a flexible tool for use in
settlement negotiations; it is not used, nor was it ever intended to
function, as a rule. An expert witness testifying for the government
may use the new Windows version of BEN in court, but the
responsibility to determine the economic benefit still resides with
the expert. That expert may choose to use whatever analytical tool
(e.g., customized computer spreadsheets, the BEN model, or even a
calculator) he or she deems appropriate for the particular
calculations necessary in the case.
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2. BEN Calculates the Economic Benefit From Delayed and Avoided
Pollution Control Expenditures
The BEN model is designed to calculate two types of economic
benefit: those gained from delaying and those gained from avoiding
required environmental expenditures. Delayed costs can include capital
investments in pollution control equipment, remediation of
environmental damages (e.g., removal of unpermitted 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 purchasing land). Avoided costs include operation and
maintenance costs and/or other annually recurring costs (e.g., off-site
disposal of fluids from injection wells). BEN does not calculate the
third type of economic benefit: that gained from a violator's
competitive advantage associated with noncompliance.
3. Current Model Usage and Applicability
The BEN model can be used in all cases that have delayed or avoided
compliance costs. (The only exception is Clean Air Act Section 120
enforcement actions, which require the application of a specific
computer model.) EPA designed BEN 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 below lists the inputs to the BEN model. The optional inputs listed
in Table 1 are those for which the model has standard default values.
The BEN 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
User's 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 compliance with environmental regulations usually
entails 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 continuing, annually recurring costs). These expenditures
should result in better protection of public health or environmental
quality, but they are unlikely to yield any direct economic benefit
(i.e., net gain) to the organization. If these financial resources are
not used for compliance, then 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, it is usually in an organization's best economic
interest to delay the commitment of funds for compliance with
environmental regulations and to avoid certain 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 delaying or
avoiding compliance costs. By delaying
[[Page 32950]]
compliance, the violator can earn a return on the delayed capital
investment or one-time expenditures required for pollution control
compliance. 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 costs. Avoided costs typically include the
continuing, annually recurring costs that a violator would have
incurred if it had complied with environmental regulations on time
(e.g., 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
investments and one-time expenditures that 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.
2. Taking Additional Factors Into Account
EPA's BEN model evaluates economic benefit in terms of the effect
that delayed or avoided pollution control costs have on an entity's
cash flows. Cash flow analysis is a standard and widely accepted
technique for evaluating costs and investments. In essence, cash flow
calculations focus on the real, ``out-of-pocket'' cash effects
resulting from an expenditure. Thus, noncash expenditures, such as
depreciation, are considered only to the extent that they affect cash
income or expenses. The three additional factors the model considers
are taxation, inflation, and the time value of money.
a. After-Tax Cash Flows. The BEN model computes economic benefit in
after-tax terms to account for certain financial impacts associated
with environmental expenditures. For example, one important impact of
these expenditures is a reduction in income tax liability.
Depreciation, one-time expenditures, and annual costs all effectively
reduce taxable income and thereby reduce income tax payments. 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 factor for which BEN accounts.
The BEN model initially converts all costs to dollars of the
noncompliance year and then 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 User's Manual (see pages 4-27 to 4-29 and
Appendix A of the manual) contains a more detailed discussion of the
inflation adjustment.
c. Time Value of Money. A third factor relates to the timing of the
cash flows, because 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.
(Alternatively, a dollar last year is worth more than a dollar today
because investment opportunities existed for last year's dollar.)
Therefore, the earlier a cost (or benefit) is incurred, the greater its
economic impact. BEN accounts for this ``time value of money'' effect
by adjusting all estimated cash flows to their ``present value''
equivalents. To accomplish this, BEN first ``discounts'' all cash flows
back to the noncompliance date, then calculates an initial economic
benefit as of this date, and finally ``compounds'' the economic benefit
forward to the penalty payment date. BEN uses a rate that reflects the
time value of money (known as a discount rate or compounding rate) to
adjust the cash flows for both discounting and compounding.2
The selection of the appropriate discounting methodology is a
significant issue in the BEN model. The BEN User's Manual (see pages 4-
30 to 4-35 and Appendix A of the manual) contains a more detailed
discussion of the discounting and compounding that BEN performs for its
present value calculations.
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\2\ For the sake of simplicity, the Agency generally refers to
present value adjustments in either direction as ``discounting,''
although we acknowledge that a more precise term for adjusting the
initial economic benefit forward is ``compounding.''
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II. Proposed Changes
In its October 9, 1996, Federal Register Notice, the Agency sought
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 invited comment on some fundamental questions that the
benefit recapture approach has raised: Can an approach both more simple
and more accurate than BEN measure the economic benefit of delayed and
avoided pollution control expenditures? How should EPA evaluate the
economic benefit that companies receive as a result of any illegal
competitive advantage stemming from noncompliance?
Second, we invited comment on the BEN model's calculation
methodology. While the Agency is confident that the BEN model's overall
approach is theoretically sound, we welcomed 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 with respect to the discount
rate and inflation rate. EPA requested comment on the BEN model's
calculation methodology, or any other aspect of the model's assumptions
or methodology.
Third, we requested comment on the model's user-friendliness. The
Agency had heard concerns that the model is too difficult to use,
particularly regarding BEN's ease of operation and the difficulty of
obtaining the necessary data. Because EPA had never been presented with
any concrete evidence in support of these assertions, the Agency wanted
either to substantiate the problems and address them or to put these
issues to rest.
In the following sections, we address the changes that EPA proposes
to make in each of the areas on which we requested comment.
A. Broad Economic Benefit Recapture Issues
1. Alternatives to BEN
a. Background. EPA requested comment on whether an approach both
more simple and more accurate than BEN could measure the economic
benefit of delayed and avoided pollution control expenditures. EPA
designed the BEN model to calculate the economic benefit of
noncompliance in settlement of the vast majority of its civil penalty
enforcement cases. Although BEN has effectively served this purpose,
the Agency recognizes that it should be improved or even replaced if a
better alternative exists or could be developed easily. This concern is
particularly relevant because an increasing number of state and local
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government enforcement personnel use 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 must also be reasonably
accurate, simple to use, and readily understandable to the vast
majority of the BEN model's users, as these federal, state and local
government enforcement officials usually have limited knowledge of
financial economics or accounting.
b. Proposed Changes. Many commenters expressed various criticisms
on different aspects of the BEN model. These criticisms, however,
focused on suggestions for improving BEN. No commenter proposed an
alternative approach to a stand-alone computer model that performs net
present value calculations. Therefore, the Agency plans to continue its
use of BEN, although it does propose significant revisions (see
following sections).
2. Illegal Competitive Advantage
a. Background. Since 1984, EPA's civil penalty policy has
maintained that any given penalty should be structured, at a minimum,
to recover the economic benefit a violator has enjoyed as a result of
its noncompliance. In addition to this economic benefit component, EPA
assesses a gravity component that reflects the seriousness of the
violation. This gravity component is designed to ensure that the
penalty puts the violator in a worse position than those in the
regulated community who complied with the law. The economic benefit
component of EPA's civil penalty policy focuses specifically on
identifying and recovering the gain to a violator in order to remove
any economic incentive to violate environmental regulations. The policy
does not address incidental and/or indirect losses or gains to society
that might result from a violation. For example, consumers may enjoy an
economic gain if a violator is able to reduce product prices.
The BEN model calculates the savings from the delayed and avoided
costs that the violator realizes through its noncompliance and uses
this measure as a proxy for the total economic gain it accrued. This
approach represents the lower bound of the total economic gain
associated with noncompliance. For example, given a new environmental
standard, if all firms in the market except the violator comply by
investing in pollution abatement technology, the market price for the
product will rise to reflect the higher marginal costs borne by the
producers. The violator has a cost advantage and could (a) charge the
market price and pocket the avoided costs, (b) charge a lower price
than its competitors in order to gain market share, or (c) combine
strategies (a) and (b). BEN is designed to calculate only the delayed
and avoided costs of noncompliance regardless of which strategy the
company pursues. BEN, therefore, implicitly assumes that the violator
follows strategy (a), and does not address the potential market impacts
associated with the violator's lower marginal costs (i.e., strategy (b)
or (c)).
Illegal competitive advantage is an estimate of the total economic
gain that the violator enjoys in the market as a result of the
violation. Illegal competitive advantage focuses on how delaying and
avoiding compliance allows violators to manufacture and sell products
in the marketplace more cost-effectively, and also examines violators'
short-term and long-term economic advantages associated with improved
market position. Note that marginal cost differences are key to illegal
competitive advantage: if a company's violation affects only fixed
costs, then BEN can generally capture the entire economic benefit from
noncompliance. A violator need not demonstrate an intent to improve its
market position in order for it to enjoy an illegal competitive
advantage.
Illegal competitive advantage can occur in a number of different
ways, including:
Violator Sells Products at Below Market Price: A violator might be
able to sell its products at a lower price than its complying
competitors because it does not incur environmental compliance costs.
Depending on market conditions (i.e., elasticity of market demand) the
violator may then secure a bigger share in that particular market, with
the profit from the extra market share constituting the economic
benefit. Some key questions are: how do we assess and prove what share
of the market resulted from underpricing, and how do we determine the
value of that market share?
Example: A metal finishing company fails to install pollution
abatement equipment that would insure compliance with its wastewater
discharge permit in order to keep costs low. A competitor producing
the same product for the same market cannot compete with the price
charged by the metal finisher in noncompliance and, as a result,
exits the market. The violator now gains market share. BEN will
capture the violator's delayed and avoided costs while in
noncompliance, but will not calculate the added profits that the
violator realizes from its increased market share.
Example: An auto shop using illegal disposal methods charges the
same prices as its competitors and spends its avoided costs on
advertising. It builds a larger customer base than it otherwise
would have. BEN does not capture the full dimension of economic
benefit from the auto shop's expanded customer base.
Violator Sells Products that Were Prohibited by Law: Many
EPA regulations prohibit the sale of certain products, either
permanently or until EPA reviews and approves them.3 If the
violator produces and sells the prohibited product, the violator will
achieve an economic benefit by: (1) making money directly from the sale
of the product; and (2) capturing the market for the product,
particularly if the product is new.
\3\ Note that this differs from a company that produces an
approved product through a prohibited process when the final product
possesses all the same characteristics from the consumer's point of
view, regardless of the production process (e.g., oil sold from a
noncompliant underground storage tank, or a metal part finished with
an illegal coating). The economic benefit in such cases would be
based on the pollution control costs that the violator delayed and/
or avoided by producing the approved product through the prohibited
process (e.g., the delayed costs of proper tank inspection or the
avoided incremental costs of a legal--and presumably more
expensive--coating).
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Example: A company mixes overstock of a restricted agricultural
chemical into one of its ``improved'' popular lawn care products.
Sales of the product are strong and customer brand identification
and approval is high. BEN does not calculate the economic benefit
the company has obtained through its illegal sales of the product
nor the benefit that will accrue in the future from customer brand
loyalty.
Violator Initiates Construction or Operation Prior to
Government Approval: Some regulatory requirements prohibit construction
or operation until EPA or another government agency grants a permit.
When a violator initiates construction or operation prior to this
approval, it can begin operating earlier than it would have been able
to had it complied with the law (e.g., if operation begins nine months
earlier than it should have, the violator can generate sales it should
not have made and thereby gain a head start in developing its market).
The violator may be partly motivated by the desire to gain an ``early
mover'' advantage in a new market. (Note that in many of these cases,
the violator will obtain governmental approval anyway. In such cases,
no environmental damage has occurred. A penalty is nevertheless
necessary, as EPA's policy is designed to maintain incentives to comply
promptly with regulations.)
If the violator is operating in a new or rapidly evolving market,
it may benefit
[[Page 32952]]
from an ``early mover advantage.'' For example, by signing long-term
supply contracts with buyers at prices lower than from other potential
entrants (who plan to comply with environmental regulations), the
violator may forestall competition in the market. An ``early mover''
may also benefit by building a customer base before other entrants. If
decreasing costs are associated with the size or scale of production,
the ``early mover'' could also enjoy a long-term cost advantage over
its competitors. Presumably an ``early mover'' could then parlay
relatively thin profits (or even losses) in the early periods with
higher profits in later periods.
One key issue in determining economic benefit is that new
businesses often expect to lose money in the first few years of
operation. Thus, if a firm starts operating one year earlier than it
should have, and EPA examines gross income minus expenses only for that
first year, then the violator might argue that its economic benefit is
zero even though this was part of the violator's plan. A more
appropriate measure of the violator's economic benefit may be the
difference in the present value of expected cash flow over the life
cycle of the facility from operating under compliance (i.e., delayed
opening) and in violation (i.e., actual opening date).
Example: A telephone cable company needed to obtain a dredging
permit to lay cable between the mainland and an island. Because of
competitive pressures to be the first to offer fiber optics cable
services on the island, the company proceeded on an accelerated
schedule. Had the company gone through the permitting process, it
would have been delayed by eight months. A competitor in the same
market is within eight months of being permitted. One of two
scenarios is possible here:
The violating company lays the cable and gains the first mover
advantage, preventing the other company from being able to enter the
market profitably. In this case, illegal competitive advantage
includes both the profits the company receives during its eight
months of operation that were the result of noncompliance, and also
any monopoly profits the company enjoys after this time.
The violating company lays the cable and enters the market with
other competitors selling the same service. In this case, illegal
competitive advantage includes the profits the company receives
during its eight months of operation that were the result of
noncompliance. In the absence of this company's entrance, the
remaining companies would have expanded to meet demand and would
have earned the profits.
In both of these cases, BEN will not estimate the current and
future benefits that the company realized from being the first to
market.
Violator Operates at Higher Capacity: A firm may be able
to comply with applicable environmental regulations by maintaining its
output or throughput below a given threshold level. A violator might
produce above this threshold level in order to take advantage of high
product prices. Alternatively, a violator might realize its lowest unit
production costs at an output level that exceeds the level at which it
can maintain environmental compliance.
Example: A paper mill can comply with the terms of its
wastewater permit as long as its daily output does not exceed 200
tons per day. In order to reap the benefits of a market surge in
paper prices, the mill produces an average of 240 tons per day over
a six-month period. BEN does not capture the profits realized by the
violator from the additional 40 tons per day produced on average
over the period of noncompliance.
Example: A cheese manufacturer is committed to purchase the
total output of 55 dairy farms through long-term ``take or pay''
contracts. Milk production from the farms exceeds the level that the
manufacturer can process while staying within the regulatory limits
of its wastewater permit for a three month period. Rather than pay
for milk that it does not process, the manufacturer chooses to
operate at a level that causes it to exceed its permit levels. The
manufacturer enjoyed economies of scale due to noncompliance. That
is, the manufacturer's production costs of the additional units are
lower while it is in noncompliance because there is no additional
cost associated with pollution control.
In summary, EPA is examining the recovery of illegal competitive
advantage in cases where the BEN model fails to assess adequately the
total economic benefit that the violator enjoys as a result of the
violation. The proper evaluation of illegal competitive advantage in
EPA policy will involve either identifying the incremental benefit
enjoyed by the violator and not addressed by the BEN model, or applying
a different analytic tool than BEN for the entire economic benefit
calculation.
b. Proposed Changes. The Agency does not believe that a stand-alone
computer model analogous to BEN (or an add-on module to BEN) could
easily and reliably determine the economic benefit from the widely
varying examples of illegal competitive advantage described above. To
examine the potential market repercussions of noncompliance clearly
involves a significantly greater effort than calculating the benefit
from delayed and avoided costs. Tracing the probable use of the avoided
cost savings by the violator, investigating the specific conditions of
the market or markets in which the violator operates, and determining
the resulting impacts of noncompliance on the market dynamics are all
usually time-intensive tasks. The Agency proposes to assist enforcement
staff in measuring economic benefit in such cases by developing a
module for the BEN model that alerts the user to situations in which
illegal competitive advantage may be significant and to develop
guidance to assist enforcement staff in their calculation of illegal
competitive advantage.
EPA proposes to have the BEN model query users regarding a series
of conditions that might characterize situations where significant
economic benefit from illegal competitive advantage could exist.
Whenever the user creates a case, the model would prompt the user to
provide answers to a series of questions. Depending on the user's
answers to these questions, the model would advise the user to seek
assistance in assessing the possible existence and magnitude of the
economic benefit gained from illegal competitive advantage. The
following questions target certain types of violations that may result
in illegal competitive advantage. They are designed to require only a
basic knowledge of the company's products and markets. An example of
the types of questions to be included in this module (with
interpretations of positive responses in parentheses) are as follows:
1. Violator Initiates Construction or Operation Prior to Government
Approval
a. Did violator's failure to obtain the appropriate review/permits
allow it to begin production or sales sooner than it should have? (If
``yes,'' then the violator may have received early mover advantage.)
2. Violator Sells Products Prohibited by Law
a. Did violator sell prohibited products? (If ``yes,'' then go to
next question. If ``no,'' then this is not an issue.)
b. Does the violator plan to continue selling similar products in
same market after coming into compliance? (If ``yes,'' then possible
lasting market share effects may result from the illegal action.)
3. Violator Sells Products Below Market Price
a. Are the required compliance costs significant enough for the
violator to have been able to undercut its competitors during the
noncompliance period? (If ``yes,'' then the violator may have
benefitted from market share gains, as it may have been able to
undercut its competitors through its price advantage from
noncompliance.)
[[Page 32953]]
b. Does violator market products that can develop ``brand loyalty''
or high switching costs? (e.g., computer software, service such as auto
maintenance.) (If ``yes,'' then price advantage could have long-term
market distribution effects that benefit the violator.)
c. Has violator developed or marketed new products while in
noncompliance? (If ``yes,'' than violator may gain ``early mover''
market share and discourage competitors by keeping prices low.)
4. Violator Operated at Higher Output
a. Could the violator have operated within the law cost-effectively
by reducing its output/throughput to a certain level? (If it could have
done so, but did not, the violator's gain from the incremental output
above the level at which it would have been in compliance should be
examined.)
EPA seeks comment on these questions and suggestions for other
questions that would be necessary to assess sufficiently whether the
economic benefit beyond avoided or delayed costs a violator gains from
noncompliance are likely to be significant.
For situations where the model advises the user to assess the
possible existence and magnitude of the economic benefit gained from
illegal competitive advantage, EPA proposes to develop a guidance
document to assist enforcement staff in evaluating illegal competitive
advantage. The goal of this document is not to provide a fixed approach
to calculating the economic benefit from illegal competitive advantage.
Rather, the goal is to educate enforcement staff on the types of
illegal competitive advantage that may arise in enforcement actions, as
well as to provide a framework for EPA analysts and outside experts who
perform the actual calculations. This guidance will eventually be
incorporated into a revision of the 1984 ``Guidance for Calculating the
Economic Benefit of Noncompliance for a Civil Penalty Assessment.'' EPA
proposes the following general outline for the content of the illegal
competitive advantage guidance document:
1. Definition of Illegal Competitive Advantage
2. Situations in Which Competitive Advantage May Be Significant
a. The violator has an early mover potential in a changing industry
(i.e., has opened facility early).
b. The violator is one of a few members in an industry that
dominate that particular industry.
c. The violator has been the low-price producer and gained market
share during non-compliance.
d. The violator could have operated within the law cost-effectively
by reducing its output/throughput to a certain level, but instead
operated above that level and that conduct made the violator more
profitable.
3. Situations Where It Is Reasonable To Assess
What is the appropriate threshold value for use by EPA? (E.g., how
large does the potential economic benefit beyond avoided or delayed
cost need to be to warrant EPA's closer scrutiny?)
4. Guidance Principles
EPA needs to keep information collection and analysis as simple and
quick as possible.
5. Avoiding Potential Double Counting
a. Use of an integrated approach that constructs compliance on time
and delay compliance scenarios, incorporating the relevant cash flows
from delayed/avoided compliance costs and illegal competitive
advantage.
b. Potential for recapture of both the benefits from savings and
illegal competitive advantage in cases where the economic benefit from
illegal competitive advantage is additive to the traditional BEN
analysis.
c. Cases in which either the traditional BEN analysis or the
illegal competitive advantage analysis drops out of the economic
benefit calculation.
EPA seeks comment on the suggested approach and outline for this
guidance document.
B. The BEN Model's Calculation Methodology
Over the years, the BEN model has received criticism for alleged
flaws in its calculation methodology. The two issues with the greatest
potential impact on economic benefit estimates involve the model's
discount rate and its inflation rate. The Agency requested substantive
and constructive comments on how the BEN model handles these two
issues. In addition, EPA invited comment on all aspects of BEN's
calculation methodology. The Agency asked commenters to address whether
their proposed changes would add any complexity to the computer model,
and if so, why the benefit of the change justified the added
complexity.
1. Investment Tax Credit and Low-Interest Financing
a. Background. Economic benefit calculations for cases with
noncompliance dates prior to the mid-1980s must account for two
important tax-code effects: the investment tax credit (ITC) and low-
interest financing (LIF).
Prior to 1986, the Federal government allowed companies an ITC on
capital investments. 4 The ITC effectively reduced the
after-tax cost of a capital investment. Complicated--and changing--
rules governed the depreciation basis for a capital investment with an
associated ITC.
---------------------------------------------------------------------------
\4\ Note that this and other tax-related adjustments are
irrelevant for municipalities and other not-for-profit entities
because their marginal tax rate is equal to zero.
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BEN accounts for the ITC that was available on projects completed
before January 1, 1986, but does not do so for the transition years of
1986 and 1987. The transitional rules allowed companies to obtain an
ITC for projects completed after December 31, 1985, if the project met
one of three criteria regarding the level of planning and construction
that had occurred by that date. 5 Because the allowance of
the ITC in these years was far from automatic (although still
possible), BEN warns the user about this issue if the noncompliance
date is between January 1, 1986, and June 30, 1987. If further research
and analysis shows that the granting of an ITC was likely in a
particular case, then a financial analyst can adjust the BEN result
through an ``off-line'' calculation.
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\5\ The criteria are: ``1. It is constructed, reconstructed, or
acquired under a written contract binding on December 31, 1985; 2.
it is constructed or reconstructed by the taxpayer, construction was
begun by December 31, 1985, and the lesser of $1 million or five
percent of the cost was incurred or committed by December 31, 1985;
or 3. it is an equipped building or plant facility, construction was
begun by December 31, 1985, under a written specific plan, and more
than one-half of its cost was incurred or committed by December 31,
1985.'' (Commerce Clearing House, Inc., Explanation of Tax Reform
Act of 1986, page 328.)
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Prior to 1987, LIF was available for a business's investment in
pollution control. An earlier version of the BEN model included a
variable that accounted for LIF. The 1993 version removed this variable
because it was relevant only for cases with noncompliance dates before
1987. BEN issues a warning to the user about LIF if the noncompliance
date is before January 1, 1987. If further research and analysis show
that LIF was probably available in a particular case, then a financial
analyst can adjust the BEN result through an off-line calculation.
b. Proposed Changes. As a few commenters suggested, EPA could
revise the BEN model to allow an option for ITCs during the 1986-87
transition years, as well as to account for LIF in years prior to 1987.
These revisions
[[Page 32954]]
would, however, add considerable complexity to the model. Furthermore,
the Agency did not receive any comments documenting recent instances in
which an off-line calculation was necessary to account for ITCs or LIF.
This is not surprising--EPA Headquarters has received only one call in
the last two years in response to the BEN model's current warning about
LIF. Furthermore, the already low likelihood of the need to account for
ITCs or LIF continues to decline with the passage of time, as EPA is
not likely to see many enforcement actions now in the late-1990s for
violations that began in the early to mid-1980s.
EPA instead proposes that the revised BEN model not accept
noncompliance dates before July 1, 1987. This will ensure that BEN's
omission of ITCs and LIF is not leading to incorrect economic benefit
estimates in instances where users do not heed the current model's
current warning. EPA will provide assistance in performing the
necessary calculations for cases that actually involve noncompliance
dates before July 1, 1987.
The Agency welcomes comment on this proposed change. We are
particularly interested in how often BEN users have recently analyzed
cases with noncompliance dates before July 1, 1987, and how often they
anticipate doing so after June of 1999, the expected introduction of
the revised BEN model.
2. Depreciation Method
a. Background. The BEN model calculates depreciation for capital
investments, as the tax deduction for accounting depreciation charges
provides a real after-tax positive cash flow to businesses.6
BEN calculates depreciation using a five-year straight-line methodology
for capital investments made before January 1, 1987, and a seven-year
Modified Accelerated Cost Recovery System for capital investments made
after January 1, 1987. These assumptions represent the most rapid
depreciation periods available for typical pollution control
investments, thereby producing the positive depreciation cash flow
effects as early as possible. These particular depreciation methods
generally result in a conservative economic benefit calculation (i.e.,
lower than would otherwise be calculated) because they minimize out-of-
pocket costs to the violator. Therefore, BEN is often producing
economic benefit figures that are very conservative.7
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\6\ The IRS does not allow companies to write off completely a
capital investment in the year of purchase. Companies must spread
the expense of the investment over several years using the
appropriate depreciation schedule.
\7\ The IRS requires that many types of pollution control
equipment be depreciated over a longer period than assumed in the
BEN model. Were EPA to tailor the depreciation to account for that
longer period, the result would be a higher economic benefit
calculation.
---------------------------------------------------------------------------
For capital equipment that has a very short useful life, the
selection of alternative depreciation schedules might be available and
also more beneficial to a business. In unusual cases where the violator
can demonstrate that an alternative depreciation schedule would be both
available and beneficial, then more detailed calculations by a
financial analyst in lieu of the BEN model are necessary.
b. Proposed Changes. A revised BEN model could conceivably allow
users the option of assuming an alternative depreciation schedule, but
we believe the drawbacks of the added complexity and potential user
confusion outweigh the gains from addressing a rare circumstance. The
Agency welcomes feedback from BEN users on how often violators have
asserted that a different depreciation schedule would be both available
and beneficial, and how often off-line calculations have been
necessary.
3. Tax Rates
a. Background. BEN uses three marginal tax rates: a rate for 1986
and before, one for 1987 through 1992, and one for 1993 and beyond.
Users can accept the standard values--which incorporate national
averages of state tax rates--or modify the inputs to reflect specific
state values.8
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\8\ Users might also wish to modify the tax rates to reflect a
business whose low net income entails a tax bracket other than the
highest one assumed in the standard values. Note though that BEN's
assumption of the highest marginal tax rate produces a lower
economic benefit estimate (because a higher tax rate decreases the
after-tax value of the compliance costs).
---------------------------------------------------------------------------
b. Proposed Changes. EPA proposes that the revised BEN model
require the user to enter the state in which the violator is located.
The model will then automatically reference an internal database of
state tax rates and perform the necessary calculations for the
violator's combined federal and state tax rate.9 EPA also
proposes that BEN calculate the tax rate for each separate year of
noncompliance, to allow for annual changes in the relevant state tax
rate (even when the federal rate remains constant). Users will have the
additional option of entering year-by-year combined federal and state
rates in a spreadsheet-like format.10
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\9\ The model will also offer the option of the national average
of all the state tax rates for cases in which it is unclear to what
state the violator pays taxes.
\10\ This option would allow users to account for--among other
situations--a company whose profitability (and hence tax bracket)
was highly variable over different years. (As noted before, BEN's
assumption of the highest marginal tax rate throughout the
noncompliance period results in a lower economic benefit estimate.)
This option could allow users to account for the 1987 transition
year in the federal tax rate change, but this is a moot point if the
BEN model is changed (as proposed in a previous section) to require
noncompliance dates after June 30, 1987.
---------------------------------------------------------------------------
Although these options may sound complex, the only data required of
the user would be the violator's state. The other screens for
additional data entry and modification would appear only to those users
who selected such advanced options. The Agency welcomes comments on the
added flexibility and applicability that would result from these
proposed changes.
4. Differences in On-Time and Delay Scenarios
a. Background. The BEN model assumes that the violator would have
used the same technology and approach in the hypothetical on-time
compliance as it did in the actual delayed compliance scenario. The
only allowed differences are in the two scenarios' exact costs of
compliance, which BEN's inflation rate adjusts automatically. But
technological, legal, or other relevant changes between the on-time and
delay scenarios can conceivably alter the components of the compliance
scenarios, increasing or decreasing the compliance costs by a rate
other than general price inflation. Where the delay case costs are
substantially less than the on-time case costs (e.g., a technological
breakthrough in control equipment), BEN will understate the benefit.
Where the delay costs are substantially higher (e.g., regulations
become more strict, but with ``grandfather'' clauses for already-
compliant firms), BEN will overstate the benefit.
Where the on-time and delay compliance scenarios are significantly
different, BEN's normal assumption of two identical scenarios is
inappropriate. More sophisticated calculations are
necessary.11
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\11\ A similar problem arises when no technologically feasible
method of compliance is available. In that case, the only possible
compliance method is to cease all production, with the economic
benefit calculation requiring a lost-profits approach, which is
beyond the scope of the BEN model.
---------------------------------------------------------------------------
b. Proposed Changes. Modifying BEN to accommodate such
circumstances is possible, and we believe the gains from the model's
consequently enhanced applicability outweigh the drawbacks of the added
complexity and potential user
[[Page 32955]]
confusion. EPA, therefore, proposes to change the BEN model to allow
users to enter separate on-time and delayed compliance costs.
It should be noted that the standard operation of the model would
still entail only a single compliance scenario, and the other screens
for additional data entry and modification would appear only to those
users who select such advanced options. The availability of more
advanced options would also enhance the model's ability to account for
such atypical situations such as valid pre-compliance expenditures and
credits for salvaged capital equipment, thus decreasing the need for
off-line calculations. The Agency welcomes comments on this proposed
change and how significantly it will enhance the model's flexibility
and applicability.
5. Replacement Cycles for Capital Equipment
a. Background. One of the three types of compliance costs BEN
analyzes is the capital investment, which represents depreciable
pollution control equipment. As the name implies, depreciable equipment
wears out with usage and the passage of time. BEN, therefore, asks the
user if the violator will need to replace the equipment at some point
in the future. If the user specifies that the investment in capital
equipment is recurring, then the user can accept the standard value of
15 years for the useful life of the capital equipment, or enter another
value.
If the cost of capital equipment is recurring, then a violator
receives more than one benefit from delaying the purchase of capital
equipment. The violator first receives a benefit from delaying the
purchase of the initial capital equipment, and then receives further
benefits from delaying the purchase of the replacement capital
equipment for each future recurring cycle.
b. Proposed Changes. Some commenters stated that BEN's option of
recurring capital equipment replacement cycles is ``speculative,'' as
these cycles have yet to occur in the typical case. Although BEN makes
an assumption about the future, this assumption is essentially a
baseline one: BEN assumes that future pollution control requirements
will be neither more stringent nor more lax than current requirements,
and that the cost of the replacement equipment will increase by no more
and no less than the projected rate of inflation. Therefore, the Agency
proposes to keep the option of replacement cycles.
Some commenters argued that BEN should not offer infinitely
recurring replacement cycles. The modeling of infinite cycles might at
first seem excessive, but all future costs are ``discounted'' back to
their present values (see following sections for an explanation of
discounting). The result is that any cycle after the first one
typically has a negligible impact upon the economic benefit estimate.
Therefore, the Agency proposes that the revised BEN model use a default
value of one replacement cycle, and offer users a choice of anywhere
from zero to five replacement cycles. This approach is in contrast to
the current choice of zero or infinite replacement cycles, with no
intermediate option.
6. Inflation Treatment
a. Background. The first step in the economic benefit calculation
is to determine the compliance costs--for both the on-time and delay
scenarios--as of the year in which they were actually incurred (or
should have been incurred). Therefore, BEN adjusts the compliance costs
from the date they were estimated to the date the costs will be
incurred to account for the effects of inflation.
To adjust for inflation, BEN currently uses a standard-value rate
calculated from the appropriate ten years of monthly inflation data
from the Plant Cost Index (PCI) in the magazine Chemical Engineering.
This simple inflation rate adjusts the initial compliance cost
estimates, both back in time into noncompliance- and compliance-year
dollars, and then forward in time into future-year dollars (typically
for capital equipment replacement cycles). The PCI is particularly
appropriate for adjusting the costs for inflation that are typically
associated with pollution control technology.
b. Proposed Changes. Despite the Agency's specific request for
comment on BEN's inflation adjustment, we received almost none. The
issues that the few commenters did raise were:
(1) The use of a single inflation rate for both actual and
projected inflation,
(2) The basis for the actual inflation rate, and
(3) The basis for the projected inflation rate.
The Agency proposes to change the BEN model to allow two separate
inflation adjustments. One adjustment would be for cash flows incurred
during the period of historical noncompliance, and then a separate rate
for projected inflation which would adjust for future replacement
cycles (and other future compliance costs in cases where the violator
has not yet come into compliance).
For actual historical inflation, the Agency proposes that BEN
adjust each cash flow from the date of the cost estimate to the date on
which it is incurred by referencing a look-up table of cost index
values.12 The default cost index would be the PCI. This
particular index may not be appropriate for every single case, but we
have yet to encounter any other cost index that would form a better
basis for a standard value. EPA also proposes that the revised BEN
model allow the user to select from multiple look-up tables
representing different cost indices--including the Building Cost Index,
Construction Cost Index, Consumer Price Index, and the Employment Cost
Index--and the option of selecting different indices for different
compliance components.13 The user would also be able to
override BEN's inflation adjustments for the capital investment and
one-time nondepreciable expenditure, and instead enter separate
estimates for these compliance costs as of the noncompliance date,
compliance date, and the initial recurring cycle start dates. This
customized data entry could represent another alternative cost index,
case-specific inflation assumptions, or entirely different actions for
on-time and delayed compliance.
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\12\ The model would not apply an explicit inflation rate,
although an annualized rate could be imputed from the model's data.
For example, suppose a $200 cost estimate from 1991 must be adjusted
for inflation to the same day in 1992. The 1991 cost index value is
100, whereas the 1992 index value is 103. The calculation the model
performs is $200 x 103/100 = $206 (i.e., multiplying the original
cost estimate by the ratio of the cost index values from the date on
which the cost is actually incurred, and the date on which the
estimate is made). The index change from 1991 to 1992 does represent
an annual inflation rate of three percent (i.e., 103/100 = 1.03-1 =
0.03), although the model would not directly apply this rate. The
calculation that uses the ratio of the index values is both more
precise and more simple than calculating multiple annual inflation
rates over different periods for historical costs.
\13\ See the following table, Different Cost Indicies.
[[Page 32956]]
Different Cost Indicies
------------------------------------------------------------------------
Abbreviation and full name Description Typical applications
------------------------------------------------------------------------
BCI--Building Cost Index.... Building costs; General construction
based on 1.128 tons costs, especially
Portland cement, structures.
1,088 bd. ft. 2x4
lumber, 68.38 hrs.
skilled labor.
BEN--Current BEN model's Average of PCI's Replication of
constant inflation rate. last 10 years; results from
i.e., a constant current BEN model.
1.8% increase each
year.
CCI--Construction Cost Index Construction costs; General construction
same as BCI, except projects,
200 hrs. common especially where
labor. labor costs are a
high proportion of
total costs.
CPI--Consumer Price Index... Representative Compliance involves
consumer goods. use of consumer
goods.
ECIM--Employment Cost Index: Employment costs for One-time
Manufacturing. the manufacturing nondepreciable
industry. expenditures or
annual costs;
mainly labor costs.
ECI--Employment Cost........ Employment costs for Same as ECIM, except
W--Index: White Collar...... white collar labor. pro-fessional labor
(e.g., permits).
PCI--Plant Cost Index....... Plant equipment Standard value.
costs.
------------------------------------------------------------------------
The Agency welcomes suggestions for other cost indices that the BEN
model should offer. Commenters' suggestions should not merely list
various indices, but also provide a sufficient rationale for the
inclusion of each index, including its components, relevance to
pollution control costs, and both historical and future availability.
For projected future inflation, the Agency proposes that the model
use a simple, uniform rate. The model will provide a separate standard
value for each cost index. (As explained above, users will be able to
override the entire inflation adjustments for the capital investment
and one-time nondepreciable expenditures as of the initial recurring
cycle start date, as well as any compliance dates that are expected to
occur in the near future.) The model will also use a separate projected
inflation rate for additional recurring cycles, and allow the user to
specify an alternative value for this rate.
The Agency proposes using a projected value for each index. (This
is a more sophisticated approach than the DOS version of BEN.) However,
because published forecasts are generally not available for specialized
cost indices, we propose to start with an average of published
forecasts for the Consumer Price Index (CPI) because such forecasts are
widely available. We would then multiply the average CPI projection by
the ratio of the CPIs to the relevant cost index's respective ten-year
historical averages. Each of the alternative indices would have its own
default future inflation rate, calculated in a similar manner. (Note
that the user would not perform this calculation, nor would the model;
instead, the Agency would perform the calculations each year to update
the standard value, and the model would contain a single, simple
projected inflation rate.) We welcome suggestions for other methods of
calculating a projected future inflation rate.
The standard operation of the model would still entail absolutely
no input whatsoever from the user who is satisfied with BEN's default
values. The other screens for additional data entry and modification
would appear only to those users who selected more advanced options.
EPA welcomes comment from BEN users on whether the proposed changes
will enhance the model's accuracy, flexibility, and adaptability.
7. Discount Rate
a. Background. Once the compliance cost estimates are adjusted for
inflation, and then for taxation, the BEN model must adjust these
after-tax cash flows to a common present value as of the date of
noncompliance. The difference between the two present values (of the
on-time and delay scenarios) is the initial economic benefit as of the
noncompliance date. BEN then compounds this initial economic benefit
forward from the noncompliance date to the penalty payment date to
determine the final economic benefit. A single rate to adjust all
present values both backward and forward in time.14 This
section addresses only the calculation of BEN's standard value for this
single discount rate, which is currently based upon a ten-year after-
tax weighted average cost of capital (WACC), with the inputs
representing averages across all industries.15
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\14\ The Agency received many comments on the use of a single
rate as opposed to two different rates. The Notice addresses this
issue in section B(8), Discounting Methodology.
\15\ The discount rate standard value for not-for-profits is
based upon municipal bond yields, averaged across the four
investment-quality ratings of Aaa, Aa, A, and Baa. The only comment
EPA received on the not-for-profit discount rate was a suggestion
that municipal economic benefit be calculated using a discount rate
for private entities that perform similar functions (e.g., on a
municipal Clean Water Act case, the discount rate would be the
average WACC for privately owned wastewater treatment plants).
However, because the Agency is trying to calculate the economic
benefit that the municipality and its residents or rate payers have
actually gained, the Agency prefers to use an estimation of the
municipal government's opportunity cost of financing projects, which
is equal to the interest rate on the municipality's bonds. This debt
rate--which forms the basis for the BEN model's not-for-profit
standard value discount rate--will almost always be substantially
lower than the private-sector-equivalent cost of capital.
---------------------------------------------------------------------------
The WACC is the average of the cost of debt and the cost of equity,
weighted by the portions of debt and equity out of total financing. The
WACC is first calculated for each year, and then these annual values
are averaged over the most recent ten-year period. The (after-tax) cost
of debt is the average return on corporate bonds averaged across all
industries, and then multiplied by one minus the average corporate tax
rate (state and federal combined). The cost of equity is based upon the
widely used Capital Asset Pricing Model (CAPM), and is equal to a risk-
free rate component plus the expected equity risk premium (i.e., the
difference of the arithmetic means of stock market returns and risk-
free rates since 1926).
b. Proposed Changes. We propose that the BEN model automatically
tailor the standard value discount rate to the period from the
noncompliance date to the penalty payment date.16 The
standard value will reference a look-up table, averaging the annual
values over the relevant years. Each individual annual calculation will
be similar to the standard value's current methodology, as displayed in
Exhibit 4-7 of the BEN User's Manual.17
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\16\ Although the following discussion focuses on the for-profit
discount rate, the tailoring of the discount rate to the relevant
time period would also apply to not-for-profit cases.
\17\ We propose two minor changes to the annual calculation of
the WACC. First, we propose replacing the standard value that
currently applies the most recent figure for the expected equity
risk premium to all prior years' calculations. Instead, each year's
calculation will employ the figure that was actually available in
that year.
Second, we propose altering the horizon for the equity risk
premium. The standard value currently combines the long-term
Treasury security rate with the long-horizon equity risk premium,
the latter being equal to the difference of the arithmetic means of
stock market returns and the corresponding-maturity risk-free rate.
Because the WACC calculation combines the equity risk premium with
the risk-free rate of the same maturity that is used initially to
calculate the premium, the issue of which horizon premium to use is
largely moot. (The expected deviations of the resulting WACC will
thereby be both small and nonsystematic.) We propose to switch to
the intermediate-horizon risk premium (and the corresponding risk-
free rate) as a simple compromise between the long-horizon and
short-horizon.
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[[Page 32957]]
The model will also perform additional customizing automatically,
or with minimal input from the user. Because we have already proposed
that BEN have an input for the violator's state (thereby customizing
the tax rate for compliance costs), we propose using that same
customized tax rate for the after-tax debt cost component of the WACC.
The model will even select the individual tax rate if the company is
not organized as a C-corporation (as profits and losses from S-
corporations, partnerships, and sole proprietorships flow through the
owners' individual tax returns).
The standard operation of the model would still entail absolutely
no input whatsoever from the user who is satisfied with BEN's default
values. The other screens for additional data entry and modification
would appear only to those users who selected such advanced options.
EPA welcomes comment from BEN users on how the proposed changes will
enhance the model's accuracy, flexibility, and adaptability.
8. Discounting Methodology
a. Background. As stated in the previous section, once the
compliance cost estimates are adjusted for inflation, and then for
taxation, the BEN model must adjust these after-tax cash flows to a
common present value as of the noncompliance date. The difference
between the two present values (of the on-time and delay scenarios) is
the initial economic benefit as of the noncompliance date. BEN then
compounds this initial economic benefit forward from the noncompliance
date to the penalty payment date in order to determine the final
economic benefit. BEN uses a single interest rate to adjust all present
values both backward and forward in time. Because BEN uses the same
rate for going both backward and forward, this calculation is
computationally equivalent to bringing all cash flows--both past and
future--directly to the penalty payment date at the WACC rate.
The comments fell into three categories. Some thought the WACC rate
was too high and especially that the compounding part of the
calculation should be based on a risk-free rate. Some agreed with EPA's
approach. Others commented that EPA's discount rate was too low and
should instead be based on financing pollution control investments with
100% equity.
Several commenters claimed that BEN's use of a WACC-based rate in
all parts of the benefit calculation yielded inappropriately high
economic benefit calculations. They claimed that future cash flows
represent uncertainty and risk, while past cash flows are known,
certain and riskless. Thus, they generally agreed that discounting
future cash flows should be done with a WACC-based rate or some other
risk-free rate, but felt that compounding past cash flows forward
should be done with a riskless rate. They cited selected academic
literature from economic and financial analysis of commercial damages
in torts cases, proposing two alternative methodologies:
(A) Use BEN's intermediate figure for the economic
benefit as of the noncompliance date (i.e., bring all cash flows,
irrespective of when they occur, back to the noncompliance date at a
rate reflecting risk), but then bring this intermediate economic
benefit figure forward to the penalty payment date at a risk-free
rate.
(B) From the perspective of the penalty payment date,
bring all future cash flows back in time at a rate reflecting risk
(e.g., the WACC) and bring all past cash flows forward in time at a
risk-free rate (e.g., the after-tax return on short-term U.S.
Treasury securities).
Both of these methodologies produce significantly lower economic
benefit estimates than the BEN model. A range for the magnitude of the
typical differences is difficult to provide because of the many
different types of cases, but alternative B will often produce negative
economic benefit estimates for the capital investment portion of the
compliance scenario.
The second group of commenters agreed that the WACC was appropriate
for discounting all future costs back to the noncompliance date, and
then compounding the initial economic benefit forward to the penalty
payment date.18 The third group commented that BEN's use of
the WACC is incorrect and leads to economic benefit estimates that are
too low. These commenters instead favored a company's higher cost of
equity capital, rather than the weighted average of the relatively
higher-cost equity capital and the relatively lower-cost debt capital.
Their rationale was that excess returns flow to a company's equity
holders, not to a mixture of its debt and equity owners.
---------------------------------------------------------------------------
\18\ One commenter agreed with compounding the initial benefit
forward at the WACC rate, but only to the compliance date, after
which a lower compounding rate would be appropriate. His rationale
was that a company then must set aside specific funds to pay a
penalty; therefore, the economic benefit estimate should be
compounded either at the actual interest rate on an escrow account
or at the company's debt rate (which reflects its risk of going out
of business, resulting in an inability to pay a penalty).
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b. Proposed Changes. Although both the conceptual bases and results
of the two risk-free rate methodologies contradict each other, they
share a similar rationale: cash flows that have yet to occur in the
future are uncertain and risky, whereas cash flows that have occurred
in the past are certain and riskless. These methodologies, therefore,
apply to future cash flows a rate that includes a risk premium (e.g., a
company's WACC or some other risk-adjusted rate) and apply to past cash
flows a risk-free rate (e.g., the return on short-term Treasury
securities). As discussed below, the Agency believes that even if this
approach were justified in the context of calculating damages owed to
plaintiffs in certain types of tort cases, it is entirely inappropriate
in economic benefit calculations for enforcement actions. The goal in
the tort damages approach is to make the plaintiff whole by
compensating him for his losses. The fundamentally different goal in
enforcement actions is to deter future violations by both the defendant
we are suing and by other similar situated defendants.
By contrast, the third approach to calculating interest rates
advocates the use of an equity-based discount rate. This approach is
more reasonable than the risk-free rate alternatives. Not only is it
more persuasive, but there have been several court decisions that
adopted an equity-based discount rate and rejected a risk free rate
approach. Nevertheless, the Agency still believes that using the WACC
throughout all aspects of the calculation is the most reasonable and
preferable approach.
(i) Risk-Free Rate Forward: Theoretical Issues. The goal in a tort
action is to make the plaintiff ``whole.'' The settlement or court
determination ultimately should place the plaintiff in the same
financial position as if the wrong had not occurred. The first step in
such a case is to calculate the necessary compensation at the time of
the actual wrong. The next step is to adjust the compensation
calculated at the time of the actual wrong to the time
[[Page 32958]]
at which such compensation is to be made. Certain authors writing about
tort damages have advocated bringing such compensation forward at a
risk-free rate.19 Otherwise, the plaintiff would be
``having-its-cake-and-eating-it-too'': the initial compensation has
essentially been invested at the time of the actual wrong at a rate
reflecting risk taking, yet the plaintiff is now granted the
compensation which grew at that rate, without ever bearing the
accompanying risk. (In contrast, the regular investor would have made
the investment and then had to stand by nervously as the investment's
value either grew or fell). Some commenters thought BEN should employ
such a risk-free rate approach.
---------------------------------------------------------------------------
\19\ No consensus exists, however, and many other authors have
advocated other approaches. Judges in tort cases have arrived at
rulings that mandate many different rates, with many different
values and rationales.
---------------------------------------------------------------------------
While the appropriate focus in a tort damage action is on
compensating the victim (i.e., plaintiff), this is not appropriate in
an enforcement action. The enforcement agency is not suing for damages
it has suffered. The goal is not to make the plaintiff whole (i.e., to
restore to it the amount by which it was damaged). The goal of the
economic portion of a civil penalty is to return the defendant to the
position it would have been in had it complied, and thus disgorge from
it the amount it wrongfully gained. If civil penalties, composed of the
economic benefit and gravity components, effectively allow the violator
to gain an economic advantage from its violations, other companies will
see an advantage in similar noncompliance. This is a fundamentally
different perspective from a tort case, and demands a fundamentally
different view of discounting.
The appropriate discount rate for economic benefit calculations is
a company's opportunity cost of capital, reflecting the financing costs
for pollution control investments or the value of investment
opportunities foregone because of pollution control purchases. The
opportunity cost of capital is the incremental expected rate of return
a company must earn to pay back its lenders (i.e., bond holders) and
owners (i.e., stockholders), which is the weighted-average cost of
capital (WACC).
The risk-free rate methodologies use short-term U.S. Treasury bill
rates that are unrelated to a company's opportunity cost of capital.
Only the Treasury of the United States of America is able to borrow at
the U.S. Treasury bill rate.20 Companies lack the advantage
of such low financing rates. To finance additional projects, they must
either issue debt at higher interest rates, and/or issue equity, which
requires returns of even higher rates.
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\20\ This is a very favorable rate, because of the U.S.
Treasury's over two-century default-free record, its ability to
create money, and also the state tax-free status of its debt
instruments.
---------------------------------------------------------------------------
Applying the risk-free rate to a company's cash flows presumes an
unattainably low borrowing rate and an insufficient return on
investments. (With the exception of mutual funds, a company whose main
business was investing in T-bills would not be in business for very
long.) The true opportunity cost of capital for a company far exceeds
the T-bill rate. The risk-free rate will therefore systematically
understate the economic benefit of pollution control noncompliance.
Penalties based solely on economic benefit calculated with a T-bill
rate would allow a defendant to retain a potentially substantial gain.
Because of the precedent of this retained gain, other regulated
companies might see an economic advantage in similar noncompliance, and
the penalties based on a risk-free rate approach will fail to deter
potential violators.
(ii) Risk-Free Rate Forward: Practical Implications. Not only are
the theoretical underpinnings of the risk-free rate forward
methodologies flawed, but their practical implications are also
troubling. Specifically, the use of the risk-free rate fails to achieve
the overriding goal of economic benefit recapture: to make the violator
financially indifferent between compliance and noncompliance, which in
turn constitutes a critically important element of
deterrence.21 An example helps to illustrate this point.
---------------------------------------------------------------------------
\21\ Because benefit recapture by itself merely makes the
violator indifferent between compliance and noncompliance, only a
total penalty amount that exceeds the economic benefit (by
incorporating a gravity component) can achieve actual deterrence.
Therefore, a civil penalty should always be at least equal to the
economic benefit calculation plus some non-trivial gravity
component.
---------------------------------------------------------------------------
Suppose a company is deciding whether to purchase pollution control
equipment this year (i.e., 1999), or to wait until the same month in
the next year (i.e., 2000). The company is not necessarily
contemplating a willful violation of the law--perhaps the law's
interpretation is unclear, and the company would like to know the
financial consequences of not purchasing the equipment, and then later
being found to be in noncompliance. The company, therefore, wants to
know how much better or worse off it will be by delaying the purchase
one year.
The company performs three sets of economic benefit calculations.
First, it calculates the economic benefit as of the present time (e.g.,
June 1999). This lets the company know how much better off it will be
by delaying the purchase (i.e., until June 2000), in the absence of any
penalty. Second, it calculates the economic benefit as of one year
later (i.e., June 2000, when it would otherwise purchase the equipment,
and also pay any penalty), and then discounts the calculated economic
benefit back to the present (i.e., June 1999). This lets the company
know the present value of any economic benefit based penalty that is
calculated and paid the following year in 2000. Third, it subtracts the
second result from the first result to determine the net amount by
which it is better or worse off (i.e., the economic benefit of its
noncompliance, minus the present discounted value of the economic-
benefit-based penalty it can expect to pay in 2000).
The first economic benefit calculation yields the same result
regardless of which economic benefit methodology is used, because all
the cash flows occur in the future.22 In this example, the
only compliance measure is a one-time capital investment of $10
million.23 The company calculates that it is financially
better off now in 1999 by $494,314 from a projected one-year compliance
delay.
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\22\ The results might be slightly different depending on what
``risk-adjusted rate'' the risk-free rate forward methodologies use
for the future cash flows in their calculations. Different
practitioners have used different ``risk-adjusted rates'' in
different cases, including the same WACC-based discount rate that
the BEN model uses. Therefore, for the purposes of the examples that
follow, we assume that the alternative methodologies also use the
WACC for future cash flows. If, instead, they were to use a
different rate, the exact figures for the results would be slightly
different, but the overall implications would remain the same.
\23\ Other inputs include a 40-percent tax rate, 2.2-percent
inflation rate, and 10-percent discount rate.
---------------------------------------------------------------------------
The company also needs to know how much better off it will be on
net should the enforcement agency assess a penalty in 2000 equal to the
calculated economic benefit from its delayed compliance. Assuming that
the agency uses BEN, the economic benefit is brought forward one year
by an estimate of the company's WACC (in this case 10 percent), so the
economic-benefit-based portion of the penalty the company will pay is
$543,745.24 But because the company will pay the penalty a
year in
[[Page 32959]]
the future, it must discount that amount back to the present. If it
discounts the penalty at the same rate that BEN used to compound the
penalty forward to the penalty payment date, the present discounted
value of the future penalty will always be equal to the economic
benefit the company calculates for itself (in this case, $494,314). The
company can therefore expect to have any economic benefit disgorged
from itself, which makes the company financially indifferent between
compliance and noncompliance. The column in the exhibit below labeled
``BEN''summarizes these calculations.
---------------------------------------------------------------------------
\24\ Because the time between the noncompliance date and the
penalty payment is only one year, the compounding takes the form of
simply multiplying the initial economic benefit by the sum of one
plus the discount/compound rate (i.e., $494,314 x (1 + 0.10) =
$543,745).
----------------------------------------------------------------------------------------------------------------
Economic benefit BEN Alternative A Alternative B
----------------------------------------------------------------------------------------------------------------
1. Penalty Payment Date of 6/1/1999............................. $494,314 $494,314 $494,314
2a. Penalty Payment Date of 6/1/2000............................ 543,745 507,166 (175,797)
2b. Result 2a discounted back to 6/1/1999....................... 494,314 461,060 0
3. Net Result (i.e., 1-2b)...................................... 0 33,254 494,314
----------------------------------------------------------------------------------------------------------------
Perhaps, however, the enforcement agency uses one of the
alternative methodologies. Under alternative A, as described in Section
II B(8)(a), above, the initial economic benefit as of the noncompliance
date is calculated with BEN, but is then compounded forward at the
after-tax risk-free rate. In this case, compounding the initial
economic benefit forward from 1999 to 2000 at an illustrative risk-free
rate of 2.6 percent yields $507,166. The company discounts this future
penalty back to the present (i.e., 1999) at its WACC, and arrives at
$461,060.25 Because this is less than the current economic
benefit of $494,314, the company realizes a net gain of $33,254. This
approach fails to make the company indifferent between compliance and
noncompliance and, in the absence of any additional gravity-based
penalty components, the company will have an incentive to delay
compliance.
---------------------------------------------------------------------------
\25\ Even if the company were to discount the future penalty
back at a rate lower than its WACC, this rate would still exceed the
risk-free rate that alternative A uses to compound the economic
benefit forward, and therefore the discounted future penalty would
still exceed the currently calculated economic benefit.
---------------------------------------------------------------------------
If the enforcement agency instead uses alternative B, as described
in Section II B(8)(a), the economic benefit as expected to be
calculated a year from now in 2000 is a negative $175,797.26
The company realizes that an enforcement agency using this approach
will conclude a year from now in 2000 that no economic benefit has been
gained, and therefore the economic benefit-based portion of the penalty
will be zero. But the company currently calculates its economic benefit
in 1999 to be a positive $494,314. At the time of initial noncompliance
in 1999, the company concludes that delaying the equipment purchase
will result in an economic gain, but that it will never have to pay any
economic-benefit-based portion of the penalty. Once again, a risk-free
approach fails to make the company indifferent between compliance and
noncompliance and, therefore, in the absence of any additional gravity-
based penalty components, the company will have a significant incentive
to delay compliance.
---------------------------------------------------------------------------
\26\ A negative economic benefit result for the capital
investment portion of compliance is typical for alternative B. In
many recent cases, practitioners implementing this approach have
arrived at negative economic benefit results for delayed capital
investments, despite no changes in technological or legal
requirements over time between the dates of noncompliance and
compliance. Applying the combination of an extremely low risk-free
rate for past cash flows and a higher risk-adjusted rate for future
cash flows to delayed capital investments (with their past cash
outflows for the actual investment and their future cash inflows for
depreciation tax shields) can produce aberrant results that defy
common sense. These perverse negative economic benefit estimates do
not reflect any real economic losses because of the expenditure
delay. Furthermore, even if the parameters in this example were
different, the economic benefit--although perhaps positive--would
still be much smaller than even under alternative A, and would
similarly fail to make the company indifferent between compliance
and noncompliance.
---------------------------------------------------------------------------
(iii) Equity Rate Approach. By contrast, an approach that employs a
company's equity rate focuses solely on the company's equity owners, as
opposed to its other stakeholders (who hold the company's debt).
Because the company's cost of equity capital will always exceed or at
least be equal to a company's WACC, the economic benefit estimate--with
all other assumptions held constant--will be higher or at least the
same.27 While the Agency believes that a reasonable argument
supports the use of equity, we nevertheless prefer the WACC, because it
better represents firms' total capital structures and their own typical
business decision-making practices.
---------------------------------------------------------------------------
\27\ The WACC will equal the equity cost of capital if the
company has no long-term debt. Note also that an economic benefit
calculation using the equity rate should first net out any cash
flows attributable to debt financing, as the focus in such a
calculation is on the returns to the company's equity holders only.
---------------------------------------------------------------------------
(iv) Proposed Change: Use WACC, Except for a Possible Early Penalty
Payment. For the above reasons, the Agency believes that the current
basic discounting methodology is appropriate and should not be changed,
with one exception: If a company pays to the United States the benefit
portion of the penalty while the case is still in litigation, EPA will
cut off the compounding rate at the date of payment. Thus, there will
no longer be any dispute in that case over the appropriate compounding
rate from the date of payment into the future. In appropriate cases,
the United States may consider allowing the violator to escrow funds
for the economic benefit portion of the penalty demand (whether at the
compliance date or at any other time). Then, when EPA runs the BEN
model, it will use the date the funds were escrowed as the penalty
payment date. The violator would have to furnish proof that it
established the escrow account, as well as placed on the account
appropriate restrictions (e.g., all accrued interest would go to the
Agency).28 In cases where the period from the initial
noncompliance date to the escrow date is short, this will eliminate
much of the deviation in results between the competing economic benefit
methodologies. We propose that BEN incorporate this guidance into its
on-line help system and user's manual.
---------------------------------------------------------------------------
\28\ Should the escrowed amount exceed the benefit component,
then the interest on the amount that exceeded the economic benefit
component would accrue to the violator.
---------------------------------------------------------------------------
C. Improving the BEN Model's User Friendliness
EPA understands that some users find the BEN model difficult to
use. While that has not been EPA's experience, the Agency expressed its
interest in learning of any difficulties users encountered when running
the model. The Agency particularly requested suggestions for realistic
alternatives that would preserve the model's degree of precision.
[[Page 32960]]
1. Is BEN Too Complex To Operate?
a. Background. EPA invited comments on whether any aspect of BEN's
operation or the BEN User's Manual is too complex. Although the Agency
designed BEN to be straightforward and easy to use, we welcomed any
suggestions to make the model and manual easier to use without
compromising BEN's degree of precision.
b. Proposed Changes. Many commenters thought that although the BEN
model is generally easy to use, certain aspects of its operation are
cumbersome. These concerns largely stem from the model's original
programming for a mainframe computer environment and its current
existence in the DOS operating environment. Because nearly all computer
users are now accustomed to the WindowsTM operating
environment, the Agency proposes to reprogram the model for
WindowsTM. The switch to the WindowsTM operating
environment should make basic data entry and runs much easier to
perform, as well as allow the addition of various advanced features
without burdening the user with additional complexity.
Furthermore, EPA has now established a toll-free helpline for
federal, state, and local government enforcement staff who need
additional assistance in using the BEN model. The helpline provides
federal, state, and local environmental enforcement agencies with
advice regarding financial issues that impact enforcement cases. The
main types of inquiries EPA is addressing with this helpline are:
The calculation of a violator's economic benefit from
noncompliance;
The evaluation of a violator's claim that it cannot
afford to comply, clean up, or pay a civil penalty, and the
application of the three computer models--ABEL, INDIPAY, and MUNIPAY
29--that address these issues; and
---------------------------------------------------------------------------
\29\ ABEL, INDIPAY and MUNIPAY evaluate inability to pay claims
from for-profit entities, individuals and municipalities,
respectively.
---------------------------------------------------------------------------
The calculation of the after-tax net present value of a
supplemental environmental project, and the application of the
computer model--PROJECT 30--that addresses this issue.
\30\ As most supplemental environmental projects (SEP's) are tax
deductible and completed long after the cases are settled, any
stated SEP cost is usually far above the actual cost to the
violator. PROJECT determines a violator's actual out-of-pocket costs
for a SEP.
---------------------------------------------------------------------------
Callers can obtain copies of the BEN model and BEN User's Manual,
copies of the previously mentioned other key models, as well as
relevant policies and guidance documents. In addition, callers can
obtain advice on how to access training courses on the models and
related subjects. Inquiries regarding the interpretation of federal
statutes and EPA policies will be referred to the EPA, as will
inquiries from non-governmental employees.
The toll-free helpline phone number is 888-ECONSPT (326-6778), and
is staffed by a contractor, Industrial Economics, Incorporated, located
in Cambridge, Massachusetts. The helpline is in operation from 8:00 AM
to 6:00 PM Eastern time and will accept voice mail messages when it is
not in operation. In addition, the contractor is providing a companion
e-mail address: benabel@indecon.com. When requesting help, enforcement
staff should identify the government entity for which they are working.
2. Is the Information BEN Needs Difficult or Expensive To Obtain?
a. Background. 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 apparently feel the data is
difficult to obtain. This has not been EPA's experience, as most (if
not all) of the required data inputs are based on facts that are
already or should be known to the litigation team as the data are
important to other parts of the settlement. Nevertheless, the Agency
welcomed any suggestions on how to make this data easier to obtain as
long as we can still preserve the model's degree of precision.
b. Proposed Changes.--The Agency received a wide range of responses
on this issue. Most users thought the necessary data was easy to
obtain; others thought it was prohibitively difficult to obtain. EPA
did not receive any specific suggestions on how to streamline the
model's data requirements even further. The Agency did receive
suggestions that the BEN model incorporate some basic, generic
compliance data.
The Agency is in the process of developing a computerized data base
for RCRA compliance costs, based on the current RCRA compliance cost
handbook. This data base should enable the user to look up the
appropriate RCRA compliance costs easily, and then use them in the BEN
model to calculate an economic benefit figure. Although this database
will not be a substitute for case-specific data, it will at least
provide a starting point and a reasonably accurate estimate when a
violator refuses to provide any detailed cost information. The Agency
welcomes comment on which statutes would benefit the most from similar
databases, and what specific compliance components most often need cost
estimates.
Also, as noted at end of Section II C (1) (b), above, EPA has
established a toll-free helpline to provide assistance to government
enforcement personnel regarding financial economics issues in
environmental enforcement cases. Helpline staff can provide suggestions
on how to obtain the necessary data to run the BEN model.
III. Response to Comments
A. Broad Economic Benefit Recapture Issues
1. Alternatives to BEN
Comment: One commenter stated that the BEN result should be
adjusted for the violator's probability of detection and prosecution.
Response: The commenter's suggestion that the penalty should be
multiplied by the inverse of the chance of detection and prosecution
finds solid support in the literature on deterrence and economics. In
brief, the theory underlying the comment is that a reasonable economic
actor will weigh its willingness to violate against the size of the
penalty that will be assessed, multiplied by the inverse chance of
getting caught. For instance, if preventing a violation would cost a
person $100, and the penalty that would be assessed if the person is
prosecuted is $200, then the person will elect to violate, all other
things being equal, unless the chance of getting caught is at least
50%. Nonetheless, despite the validity of the commenter's premise, the
comment is beyond the scope of the current public notice. The Agency
has asked for comments only on the method for calculating economic
benefit, not on the broader deterrent effect of penalties generally.
Comment: One commenter thought BEN understates the economic benefit
of noncompliance because the model defines benefit as the income earned
from investing the funds that otherwise would have been used to pay
compliance costs. The real economic benefit, according to the
commenter, is the producer's surplus obtained during the noncompliance
period. The commenter proposed that EPA obtain estimates of how people
value pollution reductions to estimate a demand curve from which to
determine the supply-demand framework facing the violator.
Response: This comment misunderstands the Agency's task, which is
to calculate the economic benefit that an individual firm has
[[Page 32961]]
gained (whether from mere delay of compliance costs or larger issues of
market share gains), not the benefit the society gains from pollution
level changes. The commenter might also be confusing the economic
benefit to the violator (which the Agency is trying to measure) with
the monetized value of environmental damages that result from
noncompliance (which in this context the Agency is not trying to
measure).
2. Illegal Competitive Advantage
Comment: One commenter maintained that if EPA decides to pursue
illegal competitive advantage (that is, focusing on issues such as
illegal profits or market share), then it must establish the
appropriate analytic tools that conform to both mainstream financial
and economic theory (considering items such as price effects,
elasticities, and economies of scale), while keeping BEN relatively
user-friendly.
Response: The Agency generally agrees with these sentiments.
Nevertheless, keeping BEN relatively user friendly is a nonissue as the
model cannot be modified to calculate a benefit based upon illegal
competitive advantage.
Comment: Several commenters thought that revenues from the sale of
prohibited products were too complicated to include in the BEN model.
Response: The Agency believes that the concept of capturing the
revenues or profits from the sale of prohibited products is relatively
uncomplicated. Nevertheless, the Agency agrees that it could not modify
the BEN model to perform this calculation and remain sufficiently user-
friendly for its intended audience. Therefore, the Agency is proposing
guidance to address this question as well as the other illegal
competitive advantage questions. In addition, the Agency is proposing
adding some questions to the BEN model to alert users to these issues.
Comment: One commenter stated that if the prohibited product is the
only product produced by a company, then the after-tax net profit is
the best measure of the economic benefit of noncompliance. If the
prohibited product is one of several produced, then one should allocate
the costs and revenues among the products to determine the profit per
product. In this case, the commenter concluded, the after-tax profit on
only those products that are prohibited should be included in the
economic benefit of noncompliance.
Response: The Agency agrees that one factor which it should
consider is whether the company is a single-product company or a multi-
product company in recapturing any benefit from producing a prohibited
product. However, a clear distinction does not always exist between
products, product lines, or even companies and divisions within
corporations. Where possible in such cases, the analyst may have to
evaluate several similar products and make a reasonable judgment
regarding the per-unit or per-division after-tax profits that were
unlawfully gained.
Comment: One commenter thought that to calculate the benefit a
violator gains from selling illegal products, one should calculate the
net profit gained by sales of that product, augmented by interest and
discounted over time. According to this commenter, net profit equals
gross profit less the proportion of gross expenses and overhead
attributed to sales of that product, which BEN can already calculate.
Response: The Agency is in agreement that this is a conceptually
valid method for calculating the economic benefit from the sale of an
illegal product. But the correct allocation of incremental overhead to
a specific product is a difficult task, and one for which the BEN model
is irrelevant.
Comment: Several commenters thought that the benefit of
noncompliance in cases in which losses are reported in the first year
of the business's operation is too complicated for the BEN model to
address. Another commenter thought that the benefit in such cases
equals the future tax benefit received from these net operating losses.
However, because the business may choose not to apply these losses for
some time, it is difficult to calculate.
Response: The Agency agrees that the BEN model is unable to address
the situation in which start-up costs lead to initial losses, even
though future profits may be significant.
Comment: One commenter thought another kind of benefit that EPA
does not recognize is ``advantage of risk,'' which is the benefit a
company gains by putting off expenses in the hopes that future events
will render the expenses unnecessary.
Response: EPA already addresses this advantage: the economic
benefit calculation can reflect whether events after the noncompliance
date (NCD) have rendered the expenses unnecessary. In such a situation,
it is necessary to analyze the expenses the company has not merely
delayed, but instead has avoided entirely (which increases the
resulting benefit). The current BEN model requires an off-line
calculation to arrive at the correct result, although the revised BEN
model may be able to add flexibility to perform such a calculation
internally.
Comment: Several commenters thought that the issue of competitive
advantage cannot be adequately calculated in terms of an economic
benefit penalty. For example, one person noted that a given market edge
may grow over the years, or may be the deciding factor determining
whether the violator could stay in business, making it difficult to
calculate a benefit figure. Others noted that BEN is inapplicable to
cases involving illegal market share gains from violating concentration
limits or cap limits in permits. Another suggested that EPA should
develop a protocol or give more guidance for illegal competitive
advantage cases, including source-specific factors agencies could use
to calculate illegal profits or market share gained.
Response: The Agency agrees that there are a number of complex
factors to consider in many analyses of illegal competitive advantage.
The Agency plans to issue guidance that will aid analysts in such
situations.
Comment: One commenter noted that EPA should develop a punitive
penalty to discourage violators from achieving a competitive advantage,
instead of trying to determine the economic benefit from competitive
advantage. Similarly, one person thought that the profit associated
with illegal competitive advantage should be a non-negotiable portion
of the gravity component of a penalty. Another person thought that when
illegal competitive advantage has been proven, companies should be
financially punished to a point at which they are worse off (not equal
to) their industrial counterparts.
Response: The total penalty comprises two components: economic
benefit and the gravity (of the violation). The recapture of economic
benefit is designed to place all firms on a ``level playing field'' so
that no firm can benefit by avoiding or delaying the necessary
compliance expenditures. It is not punitive in nature, but rather is
``no-fault.'' Competitive advantage is a component of economic benefit,
and, therefore, should be analyzed in a ``no-fault'' framework. But the
presence of competitive advantage could indicate the existence of
certain other factors (e.g., recalcitrance) that can enter into the
gravity calculation. Once the full economic benefit is recaptured, the
Agency then imposes a significant gravity component to ensure that the
violator will be worse off than its competitors.
Comment: A few commenters asserted that the competitive advantage
gained by delaying or avoiding compliance
[[Page 32962]]
costs does not exist after collecting a penalty equal to the BEN-
calculated economic benefit. For example, the disadvantages of
``predatory'' underpricing by a company of its products may outweigh
the temporarily enhanced market share. Therefore, pursuing illegal
competitive advantage would be a form of double recovery. Another
commenter stated that ``lost profits'' and ``illegal competitive
advantage'' measure the same thing (i.e., the economic benefit from
noncompliance), and that EPA is not authorized to collect both.
Response: The apparent disagreement would again appear to stem from
wording issues. EPA does not intend to ``double count'' economic
benefit, but instead seeks different conceptual terms to approach
economic benefit calculations in different situations. As stated
previously, EPA's intention is to determine fairly what economic
benefit is, and then recapture it as part of an overall penalty,
including a significant gravity component reflecting the seriousness of
the violation. Alternative approaches such as calculating illegal
competitive advantage are meant to add flexibility and are not
necessarily additive. Nevertheless, should EPA determine that it needs
to consider both types of economic benefit in a particular case, it
will do so. Predatory pricing may sometimes be counterproductive, but
in certain situations the enhanced market share may constitute an
addition to the economic benefit.
Comment: One commenter stated that any marginally increased
deterrent effect from trying to capture any illegal competitive
advantage would be more than offset by the complications and
controversy involved in performing such a calculation. Similarly, some
commenters asserted that because evidence suggests that the BEN model
is meeting its goal of deterring noncompliance, adding new
complications to the model is not justified. Others warned that adding
another dimension of economic benefit to measure would make BEN less
attractive for states to use, decreasing the usage of BEN in even
simpler cases.
Response: Measuring illegal competitive advantage may add
complexity to the economic benefit calculation. In some cases it may be
worth dealing with the additional complexity if there is only a small
increase in economic benefit. In other cases, however, the presence of
significant illegal competitive advantage will cause the BEN model to
miss most of the economic benefit, and therefore the additional efforts
are necessary.
Comment: One commenter contended that EPA's ``illegal competitive
advantage'' proposal is driven at least in part by a desire to avoid
any possible reductions in fines resulting from proposed changes to the
BEN model.
Response: EPA's goal since the establishment of the benefit
recapture requirement has been to determine accurately--within reason--
the violator's economic benefit of noncompliance from all sources,
including illegal competitive advantage. In pursuing that goal, EPA has
never reached its various decisions on modifying the BEN model based on
keeping annual penalty assessments at a certain level. If that were the
case, EPA would never have changed its discount rate assumptions from
the equity cost of capital to the weighted average cost of capital
(WACC), which--all else being equal--would lower penalty assessments.
With regard to illegal competitive advantage, EPA is concerned that its
penalty assessments are missing a major component of economic benefit
by ignoring illegal competitive advantage. Therefore, EPA is committed
to calculating the benefit from illegal competitive advantage in
appropriate cases regardless of what other modifications are made to
the BEN model.
Comment: One commenter expressed the view that all illegal
competitive advantage situations cannot be grouped under the heading of
``illegal competitive advantage,'' and noted that removing such an
advantage is only one reason for the economic benefit component of the
penalty. The commenter further noted that a violator can receive an
economic benefit even without competitive advantage; i.e., when all the
firms in an industry are simultaneously out of compliance.
Response: The Agency believes that any apparent disagreement on
this issue stems mainly from wording issues. The Agency agrees that
many different types of economic benefit exist outside of avoided and
delayed pollution control expenditures, but uses the term ``illegal
competitive advantage'' as a convenient catch-all. The Agency also
agrees that economic benefit can exist even if all firms in an industry
are not in compliance.
B. The BEN Model's Calculation Methodology
1. Discount Rate
Comment: Several commenters stated that the discount rate for
future cash flows and the compounding rate for past cash flows (i.e.,
the rate at which the initial economic benefit as of the noncompliance
date (NCD) is brought forward to the penalty payment date (PPD)) should
continue to be the same. One person noted that using a discount rate
that is larger than the compounding rate would underestimate economic
benefit. One commenter stated that the reason the weighted average cost
of capital (WACC) is the appropriate rate to use as the for-profit
entity discount rate is that it represents the fairest and most
realistic rate available. Several commenters similarly stated that the
WACC should be used for both compounding and discounting, if the EPA
wants to ensure that companies do not profit from the additional funds
available through noncompliance, as the WACC accurately reflects the
opportunity return of alternative investments.
Response: EPA agrees with these positions, as the WACC is the
minimum rate that one would expect companies to return to their
investors in order for those companies to continue to operate in their
current lines of business.
Comment: Some of the commenters expressed concern that the BEN
model is essentially flawed by using only one rate--the WACC--for both
discounting future cash flows (back to the NCD) and compounding the
initial economic benefit (from the NCD to the PPD). These commenters
contended that a proper calculation should use two different rates.
Response: The Agency believes that using one rate for compounding
and discounting cash flows is soundly based in financial and economic
theory. (See Section II.B(8) above.) The use of one rate also maintains
an internal consistency within each cash flow that using two different
rates could not achieve. For example, assume that a $100 after-tax cash
flow was incurred a year after NCD. These commenters would advocate
discounting the $100 back to the NCD at a rate of, for example, 10
percent, which would give the cash flow a present value of
approximately $91 as of the NCD. But the commenters would then compound
the $91 forward to the PPD at a lower rate of, for example, 4 percent.
The resulting cash flow would have a present value of approximately $95
as of one year after the NCD (as it is brought forward to the PPD),
even though the actual cash flow as of that time was really $100. This
result is clearly inconsistent with reality and common sense. (This is
an entirely different situation than one in which the violator is
already in compliance and has either paid the benefit portion to the
United States or escrowed (at the discretion of the government) funds
for the economic
[[Page 32963]]
benefit portion of the penalty demand. If the benefit portion is paid,
then the benefit portion will immediately cease accruing any interest.
In the escrow situation, the economic benefit portion will accrue
interest at the escrow fund's interest rate, but all the interest will
accrue to the United States. In either situation, when EPA runs the BEN
model it should use the date the funds were paid or escrowed as the
penalty payment date.)
Comment: Several commenters stated that the compounding rate should
account only for the ``time value of money,'' and that the after-tax
risk-free rate is the correct rate to use. They further contended that
since no risk is borne by shifting the net economic benefit forward in
time, BEN's use of the company's WACC is wrong because it reflects a
risk premium. Another commenter similarly stated that noncompliance,
while representing a benefit to the firm, is essentially a new project
deserving its own project-specific cost of capital, which is equal to
the risk-free rate or the company's debt rate (which reflects its risk
of going out of business and hence its inability to pay a penalty).
Response: The process of recapturing the economic benefit of
noncompliance is not merely an exercise in moving disembodied cash
flows through time to account for the time value of money. Bringing
cash flows forward in time (compounding) at a risk-free rate fails to
capture the reasonable benefit the company could earn from alternative
internal or external investments. The Agency believes that using a
risk-free rate would fail to make the violator indifferent to
noncompliance.
Comment: One commenter stated that using the equity cost of capital
to determine the correct compounding rate lacks support within the
mainstream of modern financial theory. Several commenters alternatively
argued that the cost of equity was the best rate for bringing the
economic benefit forward in time, because excess funds available from
noncompliance have a very wide investment opportunity horizon that is
best reflected in the equity market rates. Another commenter stated
that using equity was preferable because it is simple, fair, easily
calculated, and not as prone to a ``battle of the experts'' as is the
WACC.
Response: The Agency believes that the use of WACC best captures a
violator's benefit. Nevertheless, the Agency also believes that a
reasonable argument supports the use of equity, as the equity rate
reflects the economic benefit earned by the company's equity owners.
The Agency disagrees that using equity would significantly diminish the
contentiousness surrounding expert witness analysis in negotiation. If
anything, it would probably make it even greater.
Comment: Several commenters asserted that future cash flows should
be discounted at an after-tax risk-adjusted rate that is less than a
company's WACC, because capital investment in pollution control
equipment usually involves a lower degree of risk than in other capital
investment projects.
Response: Because investments in pollution control equipment allow
a company to remain in business, they are essentially investments in
the company as a whole. Therefore, these types of investments have the
same degree of risk as other capital investment projects and are
financed at the company's overall cost of capital (i.e., the WACC).
Comment: One commenter thought the default discount rate is too
general and results in incorrect economic benefit results. The
commenter thought that EPA should instead require a case-specific input
for the discount rate. Another commenter thought that while default
values are sufficiently accurate for most cases, BEN could be improved
by adding an option that allows the user inputting current and
historical data to calculate a discount rate specific to the time
period during which noncompliance occurred.
Response: The model's default rates (for the discount rate and
certain other inputs) allow enforcement staff with little knowledge of
financial economics to perform reasonably accurate analyses. This is
one of BEN's significant improvements upon its predecessor (CIVPEN),
whose many required inputs limited its applicability and utility. In
the vast majority of cases, the default rates do not differ
significantly from case-specific inputs, and EPA is always open to
good-faith efforts by a violator to supply case-specific inputs.
Furthermore, the revised BEN model for the Windows operating
environment will incorporate look-up data tables that will be able to
provide more tailored default rates without any input from users.
Comment: One commenter stated that the initial economic benefit
should be brought forward from NCD to the compliance date (CD) at the
WACC, and then from the CD to the PPD at the debt cost of capital.
Another commenter proposed a lower compounding rate based on the
violator's actual after-tax rate of return on funds in a dedicated
escrow account--if the violator has actually set aside such funds for a
penalty payment.
Response: The Agency fully agrees with using the lower rate, but
only if the violator has actually escrowed such funds. Because such
instances seem to be extremely rare, the Agency does not believe the
economic benefit should automatically be brought forward from the
compliance date at the lower rate. Instead, if a company escrows funds
for the economic benefit portion of the penalty demand (whether at the
compliance date or at any other time), then when EPA runs the BEN
model, it will use the date the funds were escrowed as the penalty
payment date. Once the government approved of the arrangement, the
violator would have to furnish proof that it established the escrow
account, as well as placed on the account appropriate restrictions
(e.g., all accrued interest would go to the Agency, except for any
interest that is attributable to escrowed amounts in excess of the
benefit component). In cases where the period from the initial
noncompliance date to the escrow date is short, this approach will
eliminate much of the deviation in results between the competing
economic benefit methodologies. We propose that BEN incorporate this
guidance into its on-line help system and user's manual.
Comment: One commenter made the point that choosing an appropriate
``interest rate'' was very important, and it was not clear from the
Federal Register notice that EPA was soliciting comments specifically
on this issue.
Response: This seems to be a misunderstanding caused by word
choice, as the Agency's request for comment on the ``discount rate''
issue is intended to encompass both the rate used to bring future cash
flows back in time, and the ``compounding'' or ``interest'' rate used
to go forward from the NCD to the PPD.
Comment: A few commenters stated that the tort law literature
suggests rates for bringing the initial economic benefit forward in
time from the NCD to the PPD.
Response: The goal in a tort action is to make the plaintiff
``whole.'' In a tort action, the settlement or court determination
should place the plaintiff in the same position as if the ``wrong'' had
not occurred. The first step in such a case is to calculate the
necessary compensation at the time of the actual wrong. The next step
is to adjust the compensation calculated at the time of the actual
wrong to the time at which such compensation is to be made. This
requires compounding and the issue then becomes: what is the
appropriate compounding rate to use to make the plaintiff ``whole''?
This is sometimes a risk-free rate or a corporate debt rate. On
[[Page 32964]]
the other hand, in an environmental enforcement action the Agency is
not suing for damages it has suffered. The goal is not to make the
plaintiff whole, restoring to it the amount by which it was damaged.
Rather, the goal is to return the defendant to the position it would
have been in had it complied, and thus disgorge from it the amount it
wrongfully gained. This is a fundamentally different perspective from a
tort case and demands a fundamentally different view of compounding the
initial economic benefit forward to the penalty payment date. The
literature from tort law is not relevant.
Comment: Another commenter stated that moving all cash flows
directly to the PPD--as opposed to first moving them back to the NCD
and then forward to the PPD--was a way of avoiding moving the same
funds through time at two different rates.
Response: This approach would eliminate the advantage of being able
to see the initial economic benefit as of the NCD, which can provide
insight into the violator's decision making. In any event, the BEN
model itself uses the same rate to move cash flows back to the NCD and
to move the initial economic benefit forward to the PPD. Adopting this
approach would not change the end result.
Comment: A commenter stated that the theoretically correct
discounting method would be first to discount back to the NCD the
expected cash flows for the on-time compliance case (including the
depreciation tax shields that occur after the NCD, as well as the
annual costs that are avoided under the delayed-compliance scenario),
and then to compound these cash flows forward to the PPD. The commenter
further stated that cash flows for the delayed compliance case should
be discounted back to the compliance date (i.e., the beginning date of
that delayed-case set of cash flows), before similarly compounding them
forward to the PPD. The difference between the two present values as of
the PPD would be the economic benefit.
Response: The Agency believes the BEN model's current approach is
theoretically correct; i.e., the cash flows for both the on-time and
delay scenarios should be discounted back to the NCD to calculate the
initial benefit as of the NCD, and then brought forward to the PPD. The
calculation for the initial economic benefit as of the NCD can be
thought of from the violator's viewpoint at the time of the NCD,
weighing the options of on-time compliance and delayed compliance.
Therefore, the violator is looking forward at the two sets of cash
flows, implicitly discounting both sets back to the ``present'' (i.e.,
the NCD). Nevertheless, with identical discounting and compounding
rates, this approach yields exactly the same result as the BEN model.
Comment: One commenter advocated calculating the economic benefit
for municipalities by using a discount rate for private entities that
perform similar functions (e.g., on a municipal Clean Water Act case,
the discount rate would be the average WACC for privately owned
wastewater treatment plants).
Response: In municipal cases, the Agency is trying to calculate the
economic benefit that the municipality and its residents or rate payers
have actually gained. Therefore, the Agency prefers to use an
estimation of the municipal government's opportunity cost of financing
projects, which is equal to the interest rate on the municipality's
bonds. This debt rate--which forms the basis for the BEN model's not-
for-profit standard value discount rate--will almost always be
substantially lower than the private-sector-equivalent cost of capital.
Comment: One commenter argued that smaller firms have higher
capital costs and as a result should reflect a higher economic benefit.
Response: The BEN standard value discount rate is based upon the
typical large firm's WACC. Although this rate is reasonable for most
cases, BEN allows the user to enter a different value for cases in
which the specific values may differ significantly, whether because a
small firm has a higher cost of capital or for some other reason.
Significant evidence exists that small companies on average have higher
returns than larger ones, but EPA has conservatively decided to base
its standard value discount rate on large companies, instead of on
small firms' higher (by about two percentage points) discount rate. For
small firms, application of this generic WACC rate yields a benefit
number that is smaller than it would otherwise be and thus is
particularly conservative in regard to small firms. (For a detailed
discussion of this issue, see the Ibbotson Associates Stocks, Bonds,
Bills, and Inflation annual yearbooks, in particular Chapter 7, ``Firm
Size and Return.'')
2. Inflation Rate
Comment: One commenter thought BEN suffers from three inflation
rate defects: (1) it uses the same rate for past and future time
periods; (2) it uses a 10-year average rather than the actual rate
during noncompliance; and (3) it relies on the McGraw-Hill Chemical
Engineering Plant Cost Index (PCI) to the exclusion of all other
relevant inflation indices. A few commenters similarly thought that BEN
could be improved by establishing subroutines or look-up tables that
allow inputting current and historical inflation rate data to calculate
a rate specific to the time period during which noncompliance occurred.
Response: The Agency proposes to address these three concerns in
the revised BEN model. First, the model will use a separate projected
inflation rate for compliance costs occurring in the future. Second,
BEN will use look-up tables (without requiring any input from the user)
of cost indices for actual historical inflation. Third, users will have
the option to reference cost indices other than the default PCI for
cases in which compliance costs merit a different index.
3. Other Technical Aspects
Comment: One commenter thought BEN incorrectly changes the tax
rates on July 1 instead of on January 1. This individual felt that if
this is not changed, the BEN manual should explain why this convention
is used.
Response: This is not in fact what BEN does. The Agency believes
that the commenter's attempt to replicate BEN's calculations may have
been thrown off by BEN's use of the mid-point of each year to calculate
the present value of annual costs and depreciation tax shields (with
each year starting at month of the NCD).
Comment: One person commented that BEN does not account for
investment tax credits (ITCs) for capital investments after 1985, even
though ITCs were still available for certain types of projects in 1986
and 1987.
Response: Given how rare these circumstances are, the Agency
believes that the BEN model's current warning about this issue (and the
consequent need to consult a financial analyst for the necessary off-
line calculations) is sufficient. Nevertheless, the Agency proposes
that the revised BEN model not accept noncompliance dates before July
1, 1987. This will ensure that BEN's omission of ITCs--and also low-
interest financing (LIF)--is not leading to incorrect economic benefit
estimates in instances where users do not heed the current model's
current warning. EPA will provide assistance in performing the
necessary calculations for cases that involve noncompliance dates
before July 1, 1987.
Comment: One person thought that EPA had not adjusted the standard
values in BEN for more than two years,
[[Page 32965]]
even though they should be updated regularly.
Response: The Agency updates the standard values every year and
encourages users to download the most current model version from its
Internet site, at http://es.epa.gov/oeca.
Comment: One commenter stated that using BEN is inappropriate in
instances in which the violator achieves compliance by using a
different production method or by simply submitting the proper
paperwork. Similarly, another commenter noted that BEN should have the
flexibility to incorporate changes in technology between the on-time
and delayed compliance scenarios, taking into account the lowest total
cost of compliance as of the compliance date, rather than the actual
cost incurred. One commenter stated that changing pollution
technologies are inconsistent with the recapture of economic benefit
based solely on the BEN model (regardless of the discount or inflation
rate used). Another commenter stressed that more of the structure of
the model and circumstances of the noncompliance scenario need to be
taken into account, which cannot be addressed by just changing input
values.
Response: If the violator eventually came into compliance using
significantly different methods than would have been required had it
complied on-time (i.e., if the compliance components and costs for the
on-time scenario differ from those for the delay scenario by more than
just the inflation rate), then the current BEN model lacks the
flexibility to analyze such a situation without assistance from a
financial analyst, who would perform the necessary off-line
calculations. The Agency hopes that the revised BEN model for the
WindowsTM operating environment will be able to offer such
flexibility without additional complexity.
Comment: One commenter thought that BEN is not applicable to not-
for-profit entities.
Response: This commenter appears to be misinformed, as BEN offers
the user the option of selecting not-for-profit status, which then sets
the tax rate to zero and the discount rate to the cost of municipal
debt.
Comment: One commenter argued that minor infractions should not be
considered when determining the dates of noncompliance and compliance--
only significant violations should signal the noncompliance date.
Similarly, as soon as the facility has remedied the vast majority of
its violations, the period of noncompliance should be considered over.
Response: The Agency disagrees. The appropriate noncompliance and
compliance dates for an economic benefit analysis are usually the same
as their legal counterparts. The noncompliance date is when the
violator should have incurred the costs necessary for compliance, and
the compliance date is when the violator actually incurred such costs
(typically, when compliance is achieved). The significance of the
violations is irrelevant: what matters is when the company should have
spent the money necessary for compliance, and when--by contrast--it
actually did spend such money. There are some situations in which the
noncompliance date may have different legal and economic meanings, such
as when the first instance of noncompliance occurred prior to the
statute of limitations cutoff. For purposes of settlement, the
enforcement team may choose to use the statute of limitations date as
the noncompliance date even though this means the actual economic
benefit that has accrued to the violator may substantially exceed the
economic benefit that the enforcement team calculates. Nevertheless,
EPA believes that a very strong argument can be and should be made for
using the actual noncompliance date and not the statute of limitations
date. Economic benefit is a factor for consideration in imposing a
civil penalty, and a trier of fact should not be precluded from
considering the violator's entire economic gain from its violations. In
these situations, the statute of limitations would serve to limit the
maximum size of the civil penalty.
Comment: One person stated that unless the penalty is paid over a
long period of time through several installments, no additional charges
should accrue if the penalty is paid within 90 days of the date when
the parties agree to the payment. The commenter also noted that the
regulator should act quickly to propose an amount and immediately make
the violator aware of the possibility of further compounding the
penalty if the payment date is pushed back.
Response: Once final settlement is reached, the payment date and
the rate at which the penalty should be compounded if not paid on time
are debt collection issues and not relevant to the economic benefit
analysis. In contrast, the payment date selected for a benefit analysis
is a relevant consideration. Here, the Agency agrees and encourages
enforcement staff to make violators aware early in negotiations that
the later the penalty payment date, the higher the benefit number.
Nevertheless, there is no legal obligation on the enforcement staff to
do so.
Comment: One person felt that because BEN, by design, can only
calculate an ``estimate,'' it cannot create values that should be used
as hard and fast penalties.
Response: Any calculation of economic benefit is by necessity an
estimate, as one can never determine economic benefit as precisely as,
say, determining the money a bank robber stole (i.e., a violator's
financial statements have no line item for ``economic benefit from
pollution control noncompliance.'') The Agency believes that BEN is
sufficiently accurate for its intended purpose. Furthermore, the
economic benefit is only one component of the penalty, to which is
added the gravity component.
Comment: One person suggested that a list of common environmental
expenditures that are known to be tax-deductible (e.g., engineering
costs for permits) would be helpful to those with little or no
knowledge of this area.
Response: While the EPA does not give tax advice, the Agency
understands that virtually all environmental compliance expenditures
are tax-deductible, except for land.31 Enforcement staff
using BEN can always check with the IRS for confirmation of case-
specific items.
---------------------------------------------------------------------------
\31\ Penalties are almost never deductible. (The only area where
they are deductible is where the ``penalty'' is compensating the
government entity harmed by the violation, but this is rarely an
issue in the benefit context.)
---------------------------------------------------------------------------
Comment: One state agency thought it could not use BEN to evaluate
a company that failed to install a piece of control equipment that was
required for only a three-year period. (The equipment in this
particular case was a condenser.) Thus, the company avoided the
equipment cost entirely, but if the company had incurred the cost, then
the equipment would have commanded a resale value after three years.
Response: In the vast majority of cases, the equipment is installed
and operated by the firm for its entire useful life. BEN assumes there
is no resale value since the equipment has no useful life left and/or
is not worth moving to a new site. In a temporary use situation, off-
line calculations are necessary. A user in this situation should
consult Appendix B in the BEN User's Manual to determine the economic
benefit from an avoided capital investment, and then subtract from that
the resale value (or salvage value) of the condenser once it no longer
would have been needed. Alternatively, the equipment's lease cost (if
such a lease is feasible, and the data
[[Page 32966]]
is available) could be entered as an annual cost.
Comment: One commenter stated that BEN should stress
``incremental'' operating and maintenance (O & M) costs (i.e., the
additional costs necessary for compliance, over and above the costs the
company would otherwise incur in the absence of compliance).
Response: BEN already stresses this; for example, the ``help''
statement option that is available when entering annual costs states,
``The annual expense is an estimate of average annual incremental costs
of operating or maintaining required environmental control measures.''
Comment: One group of commenters stated that the analysis of the
on-time case must be based on the compliance alternative that would
have been chosen from a rational business decision perspective, meaning
the compliance option with the lowest ex ante net present value of
total cost to the company. They further stated that no rational
business would spend more than this amount to achieve compliance.
Another group argued that the economic benefit calculation should be
adjusted for compliance costs that go beyond the regulatory effort, and
that companies should not be penalized for implementing ``Cadillac''
remedies when trying to be good environmental stewards. They commented
that companies will have no incentive to move ``beyond compliance'' if
the BEN model continues to calculate economic benefit based on the more
expensive control option chosen by the company.
Response: The Agency agrees that regulatees will generally select
the compliance option that has the lowest cost. However, this
assumption is only a starting point and does not always hold true;
therefore, case-specific information must be examined. Regulatees may
choose more expensive compliance options because they will ultimately
work better with existing equipment and, consequently, a seemingly more
expensive outlay will ultimately entail lower total costs.
Alternatively, a lower quote from one vendor may not be as reliable or
realistic as a higher quote from another vendor. The Agency generally
agrees, nevertheless, that the compliance costs for the BEN inputs
should not include additional costs expended in an effort to go beyond
minimum compliance. The Agency also cautions enforcement staff to
scrutinize such claims closely as the more expensive approach is often
undertaken because that was the minimum that a rational business would
take for the regulatory requirements at issue.
Comment: A few individuals thought that in cases where a violator
ineffectively spends significant resources trying to achieve
compliance, or where funds are spent on other unprofitable ventures,
the company's economic benefit of noncompliance is smaller than that
estimated by BEN. This result occurs because BEN assumes that all
resources not spent on achieving compliance are spent on alternative
profitable ventures. One commenter noted that not allowing credits for
unsuccessful compliance implementation is not an economic decision, but
simply a bad policy decision by EPA. Similarly, one group stated that
denial of credit for failed precompliance expenditures ``sends a clear
message'' that mitigation of pollution problems has no value. Some
commenters stated that a way should exist to account for ``good faith''
yet unsuccessful attempts at compliance. In contrast, other commenters
argued that no adjustment or credit for costs of compliance efforts
that eventually fail should be given. One reason given was that the
entire regulated community faced a similar set of challenges in
achieving compliance by the required date; another reason given was
that ineffective compliance methods should be treated as delaying
tactics.
Response: The current BEN User's Manual (1993 edition) provides an
explanation of the Agency viewpoint, which is that credit may be given
for unsuccessful yet good-faith efforts to comply, as opposed to
purported compliance actions that in fact had other motives.
Nevertheless, the decision as to what constitutes such a good-faith
efforts can be made only on a case-specific basis.
Comment: One commenter stated that the EPA could provide more
guidance on the subject of compliance credits. The commenter suggested
that to provide the correct incentives, EPA should not grant credit
unless ``compelling evidence'' was present that the noncompliant firm
had reason to believe that its effort and costs would actually bring it
into compliance. Another commenter echoed the sentiment that a case-by-
case determination is required.
Response: The Agency will try to elaborate more on its guidance in
future versions of the BEN User's Manual, but the determination in each
case still requires the judgment of the enforcement staff.
Comment: One commenter provided reports from actual cases in which
he had calculated a negative economic benefit, typically because the
violator's avoidance and/or delay of pollution control expenditures had
ramifications that resulted in economic losses.
Response: The Agency recognizes that economic benefit can be
negative--in both theory and practice. Enforcement staff must
scrutinize such claims very carefully because violators generally do
not avoid or delay pollution control expenditures when making such
expenditures are in the violators' best financial interests. Critical
factors in such a case may be the various assumptions for hypothetical
transactions, the postulated sequence of events, and the relevance of
claimed environmental expenditures to the statute at issue.
Furthermore, there are limits as to what the Agency will consider in
this regard.
Comment: A few commenters made the point that BEN does not take
into account different types of compliance credits, such as those for
increased production, reduced operating costs, or recycling in the
production process.
Response: The Agency's position is that the economic benefit
component of the penalty should not be adjusted for any supplemental
environmental projects that the violator elects to undertake, which can
instead mitigate the gravity portion of a proposed penalty. If the
commenter is referring to the cost savings from compliance
expenditures, then BEN will accept negative entries for annual costs.
For example, suppose a $1 million capital investment will require
annual operation and maintenance costs of $100,000, but at the same
time will entail annual savings of $200,000. In that case, the BEN user
can enter $1 million for the capital cost estimate, but a negative
$100,000 for the annual cost estimate. The BEN User's Manual provides
further guidance and examples for this issue.
Comment: One commenter expressed the idea that BEN could be
adjusted to take into account market-based pollution control
strategies, such as a permit system or pollution taxes.
Response: For atypical cases that involve noncompliance under an
incentive-based pollution control system, a relatively simple computer
model such as BEN is generally not sufficient, and the assistance of a
financial analyst is necessary.
Comment: Several commenters noted that the BEN model uses inputs
that are a mixture of both ex ante (i.e., known only at the time of
initial noncompliance) and ex post (i.e., known only now that the
calculation is being performed). Several of the commenters stated that
BEN should use an ex ante view for the cost inputs, although others
felt an ex post view was
[[Page 32967]]
appropriate. Still another commenter saw little value in the ex ante/ex
post distinction, and felt that virtually all models use a combination
of ex ante and ex post data.
Response: A pure ex ante approach is generally impractical because
it would require ignoring all information (e.g., tax rate changes,
inflation data) that has become known since the date of initial
noncompliance. Therefore, BEN uses ex post data as an approximation of
ex ante expectations. The Agency also agrees that the entire ex ante/ex
post distinction is not very important.
Comment: One commenter stated that the EPA should ``affirmatively
indicate'' that specific input values are preferred over the BEN
default values. He also stated that BEN needs to reflect the plant-
specific financial information within the context of complex
corporations. This idea was echoed by another commenter who stated that
if a firm has two specific lines of business, then each line will have
its own cost of capital and, therefore, the discount rate should be
division-specific. However, another commenter stated that the use of
the WACC to discount future cash flows was in most cases appropriate
and constituted a harmless approximation.
Response: Specific input values are generally preferred, although
the basis for their calculation must be in accordance with the general
principles of the BEN standard values (e.g., WACC for discount rate
with for-profit entities, marginal tax rates, etc.). However, the
effort required for their calculation may not always be worth the
additional accuracy gained. The Agency agrees that, where practical,
discount rates should ideally be tailored to specific lines of
businesses, although often these separate lines are sufficiently
similar so that a company-wide rate can be used, especially if
calculating a line-specific discount rate will entail further
complications and inaccuracies.
Comment: One commenter stated that the BEN model should use a 20-
year pollution control capital replacement cycle with a finite facility
or process lifetime, instead of infinitely recurring future replacement
cycles. One commenter thought the use of an infinite number of cycles
was speculative.
Response: BEN uses a 15-year capital replacement cycle default
value, but the user has the option to enter another value, such as 20.
The user must also specify whether the capital investment is one-time,
or whether future replacement cycles will occur. Even if the user
chooses an infinite number of replacement cycles, the discounting of
future cycles means that only the first several replacement cycles
typically have any noticeable effect upon the economic benefit result.
Furthermore, although BEN is making an assumption about the future,
this assumption is essentially a baseline one and hardly speculative:
BEN assumes that future pollution control requirements will be neither
more stringent nor more lax than current requirements, and that the
cost of the replacement equipment will increase by no more and no less
than the projected rate of inflation. But because the additional cycles
after the first several have almost no impact upon the economic benefit
result, the Agency plans to modify the BEN model to incorporate a
default value of two replacement cycles, with the option for the user
to specify anywhere from zero to five replacement cycles.
Comment: One commenter expressed the opinion that BEN should use an
average marginal corporate tax rate in lieu of the highest marginal
corporate tax rate. By contrast, a few commenters asserted that EPA
appears to have picked the rates for the BEN model that will produce
the highest economic benefit. Another commenter felt the inputs and
structure of BEN do not capture the ``real world.''
Response: The BEN model, like any other financial economics model,
is designed to capture the essence of the ``real world'' by use of
simplifying assumptions that produce a reasonable approximation of the
violator's economic benefit. The Agency believes that its default rates
are reasonable approximations and are appropriate to use in most cases.
The BEN standard values are nevertheless only a default, and the user
is free to enter any value. Regarding the tax rate, in most cases the
highest marginal rate applies, which is why such a rate is the basis
for the default value. Note that the use of the highest marginal rate
is highly conservative in that it lowers the after-tax cost of
compliance to the greatest extent possible, and as a result produces a
lower economic benefit estimate than would a lower marginal tax rate.
Comment: One commenter stated that BEN's replacement cycle
assumptions should be consistent with those of the PROJECT model (which
calculates the after-tax net present value of a supplemental
environmental project).
Response: The replacement cycle assumptions used in BEN and PROJECT
are based on different conditions. BEN assumes that the violator will
have to replace the capital equipment in the future, because the
equipment's operation is mandated by law. PROJECT, by contrast, gives
no credit for future replacement cycles because the capital equipment
purchased as part of the supplemental project is by definition not
required by law; it has been put in place for penalty mitigation, with
no law or agreement mandating future replacement. Investment in SEP
equipment carries no guarantee that the violator will be replace it
after its useful life.
Comment: One commenter noted that EPA should recognize that in some
situations no technologically feasible means of compliance may exist.
Response: One means of compliance always exists: shutdown. The
economic benefit in this situation is the illegal profits the violator
gained during the period of noncompliance (i.e., when operations should
not have occurred).
Comment: One commenter maintained that the EPA should recognize
that when it changes the interpretation of a rule, newly noncompliant
companies have gained no past economic benefit. Similarly, another
commenter stated that there should be no recovery of economic benefit
when an entire industry misinterprets EPA's rule.
Response: Economic benefit is ``no fault'' in nature: a company
need not have deliberately violated the law, or even have been aware of
its violation, to gain economic benefit. If a company should have been
in compliance, but was not, then it is better off economically for not
having complied--whether determined prospectively or retroactively.
Furthermore, if any entire industry has been in noncompliance, then all
of the firms in that industry have gained an economic benefit.
Comment: One commenter claimed that BEN should not be applied to
regulated utilities.
Response: The Agency disagrees with this comment and believes that
the BEN model applies to regulated utilities without regard to
arguments that they would have received higher rates from their
ratepayers had they complied on time. Whether and how a business
recoups its pollution control expenditures is not part of the benefit
calculation for for-profit entities and generally should not be
considered in benefit calculations for regulated utilities.
Comment: One commenter noted that alternative depreciation
schedules should be allowed when pollution control costs can be
verified.
Response: If a company has in fact used a depreciation schedule
other than the depreciation schedule that BEN uses, then a financial
analyst can perform the necessary off-line calculations to supplement
or substitute for the BEN model's results.
[[Page 32968]]
C. Improving the BEN Model's User-Friendliness
1. Is BEN Too Complex To Operate?
Comment: Several commenters thought that the BEN model is easy to
use and understand, and that it should be kept that way.
Response: The Agency believes that BEN represents a proper balance
between ease of operation and accuracy in calculation, and will try to
ensure that any future enhancements preserve this balance.
Comment: One commenter suggested that to improve user friendliness,
EPA should make the model and manual readily available to the public.
Another commenter expressed the difficulty he had in downloading the
BEN model and user's manual from the electronic bulletin board system.
He also had a difficult time obtaining these materials from the EPA
regional library. Another commenter noted that both the model and
manual were available from the National Technical Information Service
(NTIS).
Response: The Agency is aware of the difficulty of downloading
large documents such as the BEN User's Manual and will try to rectify
this in the future, as well as to improve the printed quality of the
downloaded document. The easiest way to obtain the model is through the
Office of Enforcement and Compliance Assurance's World Wide Web site on
the Internet (http://www.epa.gov/oeca/datasys/dsm2.html).
Government users can also obtain the model and manual (for BEN and
other applications) via the newly created enforcement economics
helpline: 888-ECON-SPT (326-6778), which is staffed by a contractor,
Industrial Economics, Incorporated, located in Cambridge,
Massachusetts. The helpline is in operation from 8:00 AM to 6:00 PM
Eastern time and will accept voice-mail messages when it is not in
operation. In addition, the contractor is providing a companion e-mail
address for this helpline: benabel@indecon.com. The helpline is
strictly limited to providing advice to federal, state, and local
environmental enforcement agencies regarding financial issues that
impact enforcement cases. Callers will also be able to obtain advice on
how to access training courses on the models and related subjects. EPA
feels that many of the public comments it received from state and local
government enforcement agencies could have been addressed easily and
quickly with a call to the helpline. Inquiries regarding the
interpretation of federal statutes and EPA polices, will be referred to
EPA, as will inquiries from non-governmental employees. Non-government
users can obtain the models and user's manuals from NTIS at 800-553-
6847. (NTIS packages each model and its user's manual together;
requesters will also need the following publication numbers--BEN: PB
98-500382GEI; ABEL: PB 99-500357GEI; CASHOUT: PB 98-500390GEI; PROJECT:
PB 98-500408GEI; INDIPAY: PB 99-500407GEI; and MUNIPAY: PB 99-
500415GEI.)
Comment: One commenter stated that BEN could be used without the
manual, although this made the application more difficult.
Response: The Agency agrees, and also reminds users that the model
provides significant on-line help, both in the introductory statement
and by allowing the user to enter ``HELP'' at each prompt.
Comment: One commenter thought that increasing the flexibility of
BEN could result in a less accurate measure of the economic benefit
(i.e., too wide a dispersion of many economic benefit values). Another
commenter expressed the view that increasing the flexibility of BEN
would also increase the complexity of using BEN, which in turn would
preclude some states from calculating economic benefit.
Response: The Agency does not feel that the added flexibility will
make BEN any less accurate, although it does agree that the potential
for added complexity must be considered when adding flexibility to the
BEN model.
Comment: Many commenters suggested that in order to improve user-
friendliness, EPA should use a Windows-type format. One commenter
suggested that an interactive format for BEN could be based on some
commercially published financial or tax programs, which have a
``Wizard''-type guidance feature; another suggested that BEN should use
a format for common spreadsheet software. Although, one commenter
stated that although point-and-click Windows-type features and the
ability to move between data entry fields freely would improve the
model, it might not be worthwhile to scrap all the original code.
Various commenters also suggested that the model should:
Allow users to add headings and explanatory text to the
BEN output;
Calculate avoided costs without the need for a hand-held
calculator;
Allow printing of individual BEN runs, make printing more
straightforward, and print each result on its own sheet of paper;
Accept data in a table format for cases in which each
month must be entered in a separate run;
Prompt the user about whether to use the standard
[default] or state-specific values;
Accept other than the capital letters ``Y'' and ``N'' for
yes and no answers;
Save model inputs electronically for future use;
Modify instructions for printing the output--
``positioning the paper'' seems irrelevant; and
Allow the user to exit the model in the middle of a run.
Response: The Agency plans to reprogram the model for the Windows
operating environment, which should address most of these concerns.
(The Agency will still maintain the current DOS-based version for a
time.) An actual spreadsheet may confuse many users, although the
Windows-based model will incorporate many spreadsheet-type features.
2. Is the Information BEN Needs Difficult or Expensive To Obtain?
Comment: One commenter thought that although BEN is a very
effective tool for cases in which the violator must install pollution
control equipment or perform similar actions to achieve compliance, it
is less effective when compliance comprises administrative activities.
The commenter explained that this is primarily because of the
difficulty of obtaining cost figures for such activities, and suggested
that BEN have a subroutine for such cases that provides default cost
values.
Response: The Agency understands that cost data can be difficult to
obtain for certain cases. But if the violator has already come into
compliance, then an estimate of its actual costs should be available.
The Agency has begun developing a computerized RCRA compliance cost
database which will complement the revised version of the BEN model.
Comment: While some users felt that inputs for BEN are readily
available, others found that inputs are difficult to obtain when
violators are uncooperative.
Response: In such situations, enforcement staff should use the
discovery process to obtain the necessary information, whether through
interrogatories, depositions, requests for production, or other legal
processes. Another approach is to contact state or federal experts
familiar with the regulatory requirement at issue for advice on cost
estimates. Finally, retaining an outside consulting expert may
occasionally be necessary to develop the compliance cost estimates.
Comment: One commenter wanted the Agency to develop a set of
standardized rules or a protocol to be
[[Page 32969]]
followed when applying case-specific information to an economic benefit
calculation.
Response: The Agency strives to provide sufficient guidance to
enforcement staff, but does not feel that a strict protocol is
feasible. Therefore, enforcement staff will always have to exercise
case-specific judgment.
Comment: One commenter suggested that users should perform a cost-
benefit analysis when contemplating the use of case-specific inputs in
lieu of BEN default values. The commenter further stated that the
Agency should consider allowing enforcement staff more flexibility with
respect to the use of investment tax credits, depreciation schedules,
tax rate choices, different inflation options, and low-interest
financing. Another commenter stressed the increased workload and
questionable reliability associated with case-specific data. Similarly,
another commenter noted that BEN is intended to serve as only a gross
indicator of the economic benefit, rather than as a precise
calculation, and that more specific information should be used only if
such information will improve the result significantly. This commenter
further asserted that the occasional use of more specific data than
BEN's default values will lead to skewed results in the aggregate,
because only firms that will benefit from the precise information will
make it available.
Response: The Agency agrees that the pursuit of case-specific
inputs takes place within a resource-constrained environment and should
be measured against the expected gains in accuracy. The Agency adopts
the same approach to adding flexibility to the model, where such
flexibility may make the model more difficult to use for less advanced
users. The Agency also agrees that, theoretically, a firm will dispute
standard values such as the discount rate only when a more accurate
value is in its best interests. But it is the Agency's policy that if
it the violator urges the use of a particular company-specific value in
place of standard value, the Agency will insist on using company-
specific values in place of all the standard values. The Agency
believes this approach will limit the aggregate impact of adopting
regulatee-specific values instead of standard values.
3. Other Issues Affecting Use of BEN
Comment: One person stated that Appendix A of the BEN User's Manual
should be expanded to include the model's entire mathematical
algorithm, and should be written with more focus on economic theory,
like a textbook. Another stated that Appendix A should include a
thorough development of equations 15a and 15b.
Response: The Agency is pleased that at least some members have
taken the time and effort to familiarize themselves with the details of
the BEN User's Manual. A user's manual for any computer model, however,
can not take the place of a textbook on mathematics or financial
economics. To answer some of the specific concerns, Equation 15a is the
sum of an infinite geometric series, which can be found in most
calculus texts. Equation 15b is a simple discount formula similar to
the one given on page A-4 in Appendix A. Equation 15c is the sum of the
present value of the first replacement cycle plus all the additional
replacement cycles to infinity. The Agency encourages enforcement staff
who have further questions along these lines to contact its enforcement
economics helpline at 888-ECONSPT. As mentioned above, this helpline is
strictly limited to employees of federal, state and local government
enforcement agencies.
Comment: One person thought the model departs from the formulae in
Appendix A for depreciation, and instead appears to use a simplified
formula that calculates each year's depreciation as a percentage of the
previous year's. This commenter felt that any simplifications or
departures from theory made for the sake of simplifying the model's
programming should be detailed in the manual.
Response: BEN uses no such simplifying formula, and instead uses a
seven-year depreciation life (for capital investments after 1987). The
first four years use a double-declining balance with a half-year
convention switching to a straight-line depreciation for the rest,
corresponding to the revised tax law's Modified Accelerated Cost
Recovery System (MACRS). The model adjusts the depreciation deduction
to occur once a year at midyear.
Comment: One person stated that the manual should answer questions
such as: What is the difference between a C Corporation and an S
Corporation? What, other than land, constitutes a one-time
nondepreciable expense? What happens when you choose a useful life that
is shorter than the depreciation schedule?
Response: Between the BEN User's Manual and the ``Help'' prompts
within the model, BEN attempts to provide as much guidance as is
feasible in answering these frequently asked questions. For example,
the difference between a C Corporation and an S Corporation can be
found by selecting ``3'' of input number 1C--BEN will show information
about both types of corporations. On page 4-10 of the user's manual,
``nondepreciable expenditures'' are defined as items that ``do not wear
out;'' the manual proceeds to list several examples, such as a record-
keeping system, employee training, waste removal, etc. For questions
such as how to account for a useful life shorter than BEN's
depreciation schedule (which requires off-line calculations by a
financial analyst), the Agency encourages enforcement staff to contact
its enforcement economics helpline at 888-ECONSPT. As mentioned above,
this helpline is strictly limited to employees of federal, state and
local government enforcement agencies.
Comment: Several commenters agreed that BEN is a useful tool for
calculating the economic benefit of noncompliance, and encouraged EPA
to retain the model. But other commenters asserted that the regulator's
discretion should be used in lieu of BEN's calculation to determine
economic benefit; these commenters felt that EPA should not mandate the
use of BEN. From the defense bar's viewpoint, one commenter thought
that the plaintiff's failure to accept anything other than a BEN
calculation can lead to ``unprincipled negotiations.''
Response: Although computer spreadsheets or even programmable
calculators can calculate economic benefit accurately, the Agency
suspects that leaving economic benefit determination up to the
regulator's discretion will result in either no calculations at all or
fundamentally flawed calculations. (For example, the Agency examined
one state's ``alternative'' to BEN and found it unreliable and even
more difficult to use than BEN.) The Agency is convinced that BEN is a
reasonably accurate, relatively simple way to calculate the economic
benefit from noncompliance, and it continues to promote the use of BEN.
The Agency does not require state enforcement agencies to use BEN, but
the Agency strongly encourages them to employ it. State enforcement
personnel who want to employ a valid alternative to BEN are welcome to
do. For example, one state enforcement staff member's spreadsheet
version of BEN was perfectly adequate. Nevertheless, EPA strongly
believes that the ``risk-free rate'' approaches are seriously flawed
and discourages their use as alternatives.
Comment: Some commenters noted that BEN is reasonable and provides
results that are fair to the violator. Others thought that estimates of
economic benefit obtained from BEN are at times so high that they are
useful only
[[Page 32970]]
for their shock value. Some commenters noted that BEN gives penalty
amounts that are so high that many Agency resources are spent
negotiating or pursuing legal judgments with violators who are not
confident of the accuracy of BEN's assumptions and methodology. One
commenter felt that BEN was designed to produce the maximum possible
penalty.
Response: The Agency strives to provide enforcement staff with a
model that makes reasonable estimates of economic benefit. If the model
produces numbers so high that they are shocking to either the
enforcement staff or the violator, then that is generally because the
violator has gained a high economic benefit and not because the model
is designed to produce the maximum possible penalty. The compliance
cost inputs to the BEN model are always open to discussion, but the
methodology, by contrast, is not open to compromise. The Agency is
comfortable defending its benefit calculations based on the BEN
approach.
Comment: One commenter noted that BEN is an inexpensive method of
determining economic benefit, making it an economical option for case
work, although others thought that BEN is resource-intensive and not
cost-effective. Several others felt that attempting to use BEN in
``small'' enforcement activities was a waste of resources, with one
commenter noting that in many small cases, the cost associated with
using BEN would exceed that of the penalty itself.
Response: The Agency disagrees that BEN is ``resource-intensive and
not cost-effective.'' A typical analysis takes about five minutes. The
only potential issue is the user's need to determine the compliance
costs, which normally should not take much time, particularly for small
enforcement actions. In addition, the Agency is not confident that
enforcement staff are always able to determine beforehand that a case
is too small to merit the use of BEN. Often, it is only after running
BEN that the magnitude of the economic benefit becomes apparent.
Comment: Some commenters thought BEN was difficult to understand
and explain for enforcement staff, who are often engineers untrained in
and unfamiliar with financial economics. While BEN may be designed for
people with little background in financial economics, many commenters
felt that determining actual numerical inputs, and whether to use BEN's
standard values, requires the judgment of a financial expert. Another
commenter similarly noted that the EPA needs sufficiently trained staff
to handle a variety of ``real world'' circumstances which presumably
may require calculations in addition the BEN model.
Response: The Agency strives to make BEN as easy to understand for
non-experts as is possible. Interestingly, BEN's compliance cost inputs
typically require engineering expertise, not knowledge of financial
economics. Once such cost inputs have been obtained--either based on
the violator's actual purchases or through the discovery process--then
the BEN model can be run with no knowledge of financial economics. The
Agency also encourages enforcement staff who have questions to contact
its enforcement economics helpline at 888-ECONSPT, from which staff can
receive copies of training videos, training materials, and user's
manuals. The helpline can also assist users in performing off-line
calculations for circumstances that the BEN model cannot accurately
calculate by itself. As mentioned above, this helpline is strictly
limited to employees of federal, state and local government enforcement
agencies. Finally, in the coming years training courses for the new,
revised BEN model will be conducted in each EPA Region and at the
national headquarters, to which state and local government enforcement
staff will be invited.
Comment: One commenter felt that EPA should not ``oversell'' the
idea that BEN can be used by people with no knowledge of economics, as
that may invite misuse. According to this commenter, users of BEN must
at least be willing to learn what the model is doing.
Response: Our experience with the model over the last thirteen
years is that users can be very effective in the settlement context
without thoroughly understanding the theory behind the model. We do
include an extensive presentation of the theory in the BEN training
course, although the model is sufficiently simple that users need not
possess an intricate knowledge of economic theory to calculate accurate
and reliable results.
Comment: One commenter noted that it is not feasible to expect
states to hire financial experts and, therefore, that the BEN model
should be made easier to understand for non-expert users. Several other
commenters thought that EPA should provide the expert assistance to
states.
Response: EPA believes that the model is easy to understand and
operate as is. Most of our users have taken the four-hour BEN training
course, which we have found covers almost every situation our
enforcement professionals will encounter. While we are working on ways
to improve BEN's simplicity and yet make it more flexible, the current
model was designed for use by enforcement professionals with little or
no background in finance. The model is used effectively across the
country by such personnel. With respect to providing expert assistance
to the states, EPA has established the helpline, mentioned above, to
address this need.
Comment: One commenter suggested that EPA develop a program to
provide investigative and analytical assistance to state and local
agencies.
Response: The provision of analytical assistance is being addressed
by the helpline mentioned above. The provision of investigative
assistance is clearly beyond the scope of this effort to review and
revise the Agency's benefit recapture approach.
Comment: In addition, many commenters felt that EPA should provide
more training for users of the BEN model.
Response: The EPA has presented over forty BEN courses since 1988.
The Agency has conducted over thirty ``live'' BEN training courses at
EPA facilities, and EPA invited state enforcement staff to nearly all
of them. In addition, EPA has conducted fourteen BEN training courses
primarily for state and local government personnel in Hartford,
Connecticut (twice); Indianapolis, Indiana (twice); Little Rock,
Arkansas; Baton Rouge, Louisiana; Trenton, New Jersey; Boise, Idaho;
Ft. Lauderdale, Florida; El Monte, California; Baltimore, Maryland;
Richmond, Virginia, Phoenix, Arizona; and Anchorage, Alaska. (Other
state and local governments that are interesting in at least sharing
the delivery costs with the EPA can also arrange for such a course.)
EPA also presented a BEN course via satellite in 1994, and has made
videotapes of that broadcast available to government enforcement staff
on request.
Comment: One commenter argued that EPA should put pressure on
individual states to account for the economic benefit component of
noncompliance in their enforcement programs; another stated that EPA
should help states incorporate the concept of economic benefit in
penalties or assessments.
Response: The issues the Agency is addressing in this Notice are
related to the determination of the economic benefit of noncompliance.
Whether states are adequately accounting for the economic benefit
component is beyond the scope of this effort. The EPA is ready and
willing to provide support to states in using the model. Not only has
the Agency provided such support to states in the past, but it has even
[[Page 32971]]
provided it to the governments of Indonesia, China, Taiwan, Brazil,
United Kingdom and Mexico.
Comment: Several commenters noted that short, in-depth, case-
specific reviews by experts should replace BEN analyses, as they yield
more credible, defensible results than BEN.
Response: The Agency is convinced that the BEN model produces
reasonably accurate calculations of economic benefit. It has proven to
be an effective enforcement tool over the past 14 years. Furthermore,
the new BEN model may often be a sufficiently accurate analytical tool
for experts to use in such case-specific reviews. By contrast, to adopt
an in-depth review of every case would require costs--either in
contractor support and/or full-time in-house staff--that would be
prohibitive, as well as add little value.
Comment: Several commenters noted that defending the BEN model's
results in court is difficult, for a variety of reasons. While EPA's
earlier guidance explains that BEN should be used only in settlement
discussions, and that the regulator should never be put in the position
of having to defend BEN in court, one commenter felt that most state
users cannot follow EPA's advice. According to this commenter, a
state's negotiations or settlements occur after a document has already
been mailed to the violator with a penalty amount on it; therefore, if
the case goes to court, the state must defend the amount.
Response: The suggested protocol is to hire an expert witness to
perform an economic benefit calculation for presentation in court, as
an expert is necessary to explain the methodology (either that of BEN
or of some other analytical tool). If the result of this more
customized analysis differs significantly from the initial BEN result,
then the penalty demand can be changed.
Comment: One commenter noted that although BEN is not appropriate
for all cases, if BEN is not used in every case, then the regulator is
subject to criticism for inconsistency.
Response: BEN is appropriate in every case in which compliance
costs were avoided or significantly delayed. BEN is not appropriate
when the benefit comes from an illegal competitive advantage. As long
as the regulator applies the BEN model to all the cases for which it
was designed, then the regulator will be consistent.
Comment: Several commenters thought that small businesses and
sources which are genuinely ignorant of their violations should be
treated differently than large companies which have many resources and
who commit egregious violations. One commenter suggested that small
communities and businesses should be helped by small business
assistance programs to achieve compliance, rather than be penalized for
what may well be a genuine mistake. This commenter also suggested that
if EPA continues to support the use of the BEN model in these cases,
BEN should at least allow the regulator to account for the size of the
community or business in question. A few commenters noted that
sometimes, even when BEN calculates a positive economic benefit, it may
be inappropriate to ask the violator to pay that amount; similarly,
some commenters suggested that the regulator should run the ABEL model
in conjunction with the BEN model to determine the effects of payment
on the entity.
Response: Economic benefit is no-fault in nature and as a result
accrues regardless of genuine mistakes. If a small business delays a
required pollution control expenditure--for whatever reason--then it
obtains an economic benefit. The regulatory agency must recover this
benefit, otherwise the business will have an unfair advantage over
those businesses that complied. If violations are especially egregious,
then this should be reflected in the gravity component of the penalty
or in criminal sanctions. The size of the violator is relevant only to
the ability to pay a civil penalty. The Agency maintains the ABEL,
INDIPAY, and MUNIPAY models (for corporations, individuals, and
municipalities, respectively) to guide its enforcement personnel in
determining ability to pay. BEN already favors small businesses in that
the standard value discount rate is based upon the typical large
company's WACC. Significant evidence exists that small companies on
average have higher costs of financing than larger ones, but EPA has
conservatively decided to base its standard value discount rate on
large companies, instead of small firms' higher (by about two
percentage points) discount rate. (For a detailed discussion of this
issue, see the Ibbotson Associates Stocks, Bonds, Bills, and Inflation
annual yearbooks, in particular Chapter 7, ``Firm Size and Return.'')
Similarly, many small communities have higher debt costs on average
than large communities, but the not-for-profit standard value discount
rate is nevertheless based upon the average interest rate for
communities that have access to the municipal bond market and are able
to obtain ratings for the debt issues. If the discount rate were
tailored to such small businesses and communities, then the discount
rate, economic benefit result, and hence the penalty demand, would be
higher. In order to maintain simplicity, BEN actually favors small
businesses and communities in this regard.
Comment: One commenter stated that the BEN model should be used
more as a tool for promoting environmental compliance than merely for
recapturing the economic benefit of noncompliance. Another commenter
noted that the EPA should de-emphasize penalty assessment and instead
encourage self-compliance. One commenter noted that EPA's goal should
be to prevent future noncompliance, which could in some circumstances
be accomplished with a fine smaller than the economic benefit.
Response: The Agency is always in favor of promoting compliance and
encouraging self-compliance. One means of promotion and encouragement
is penalty assessment based upon full economic benefit recapture, which
ensures that any gain potential violators reap from noncompliance will
be fully taken away from them in the form of a civil penalty. Any
penalty assessment short of this creates an incentive among regulatees
to wait until they are caught before complying.
Comment: One commenter suggested that the EPA has been secretive
regarding the BEN methodology.
Response: The BEN model and its user's manual are freely available,
and the calculations are easily replicable.
Comment: One commenter noted that a supplemental environmental
project (SEP) would in some cases be better than a ``disgorge'' of
economic benefit.
Response: The Agency's policy is that a SEP can be performed for
mitigation of only the gravity component of the civil penalty, not for
the economic benefit component. Otherwise, given the additional
motivations a violator may have for performing a SEP, the Agency could
never ensure that the violator was really financially indifferent with
respect to noncompliance. Therefore, the civil penalty must always, at
a minimum, recapture economic benefit.
Comment: One commenter noted that the EPA should address the issue
that competing regulatory requirements may force firms into
noncompliance under one set of regulations when these firms comply with
another.
Response: This is outside the scope of the issue of economic
benefit recapture.
Comment: One commenter noted that it would be helpful if some type
of ``gravity'' component could be incorporated into BEN for
noncompliance prevention and/or a compliance incentive.
Response: The Agency feels that gravity component calculations in
the various penalty policies are sufficiently
[[Page 32972]]
simple and straightforward so that a module in BEN is not necessary.
Comment: One commenter stated that BEN has historically been
available only through a mainframe, making it useless to staff without
such access.
Response: BEN now runs on the EPA LAN or on a personal computer.
Copies for the latter are available through the Internet (http://
es.epa.gov/oeca) or, for enforcement staff, through EPA's enforcement
economics helpline at 888-ECONSPT or, for non-government employees,
through National Technical Information Service (NTIS) at 800-553-6847.
D. General Comments on the Public Comment Process
Comment: Several commenters made the point that EPA does not need
to go through a formal rulemaking process with the BEN model.
Response: The Agency recognizes the distinct advantages of public
input on its benefit recapture approach which is why it is seeking
comment at this time.
Comment: Some of the commenters expressed the need for the
formation of one or more ``blue ribbon'' panels of outside experts in
financial economics (similar to the National Oceanic and Atomospheric
Administration panel on the use of contingent valuation in natural
resource damage assessment). Along these lines, one commenter thought
EPA's goal should be to find a solution with the broadest possible
support in the financial field. By contrast, one commenter strongly
opposed the ``weight of opinion'' process for adopting changes in BEN.
Another commenter felt that although such expert panels might be
beneficial, the financial and economic principles BEN uses are simple
enough that any finance professor could discover whether the model held
to the mainstream of modern finance and economics.
Response: Given that both academicians and practitioners in the
field of financial economics disagree significantly (both on economic
benefit analysis and a myriad of other issues), the Agency does not
feel that the formation of an expert panel would be a productive
exercise. For instance, tenured professors from business schools have
reached diametrically opposed conclusions in the written comments they
have submitted on the BEN model.
Comment: Some commenters expressed doubts about the nature of and
manner for this public comment process and recommended a more open
policy. To do otherwise, they state, would only continue the
controversy and would not be in either EPA's or the regulated
community's best interest. Similarly, one commenter stated that the
adoption of the procedures for the public comment session should be
subject to administrative due process.
Response: The Agency has made every effort to make the public
comment process as open as possible.
Comment: A few commenters criticized the limited time for
interested parties to respond to the request for comment as listed in
the Federal Register notice of October 9, 1996.
Response: In response to such concerns, the Agency extended the
deadline for public comments from the originally stated January 1,
1997, to a significantly later March 3, 1997, (see Federal Register
notice on December 12, 1996, at page 65391).
Comment: Some commenters expressed concern that EPA has yet to
release earlier statements made by several prominent professors in the
field of finance that allegedly criticized the BEN model. These
commenters asserted that the professors' prior remarks, if relevant,
should also become part of the public record and be incorporated into
any forthcoming decision.
Response: The Agency released these statements in April of 1997.
The Agency recognized the merit of those comments long before they were
released, but some of the statements were the subject of a three-year
Freedom of Information Act case. That case was eventually resolved, and
the Agency has since released the analyses sought in that case. In
addition, the Agency released three other similar analyses which were
not sought. Some of the statements were critical of the BEN model as it
then existed, and the Agency adopted many of the changes they
suggested. In any event, all of the analyses were of the prior BEN
model version, not the current version. Copies of these statements are
available by calling 202-564-2235.
Comment: Several commenters felt that the EPA should follow up on
the public comment period by first drafting the findings, then
requesting and evaluating further public comment, and finally
publishing a formal draft on the final decision.
Response: The Agency agrees, and is taking that approach.
IV. Request for Comments
The Agency is interested in comments relating to its proposed
changes to its benefit recapture approach as discussed in Section II of
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.
Dated: June 8, 1999.
Sylvia K. Lowrance,
Deputy Assistant Administrator, Office of Enforcement and Compliance
Assurance.
[FR Doc. 99-15271 Filed 6-17-99; 8:45 am]
BILLING CODE 6560-50-U
