Making Business Sense of Environmental Compliance

A major paper manufacturing company built a $500 million plant. Unlike some companies, it had been quite careful about the plant’s environmental requirements. It had painstakingly evaluated its obligations and had installed new environmental controls. The company’s environmental manager had worked with the project manager to get the needed permits in time and to be sure that the pollution control technology satisfied everyone’s requirements. Yet a short time after starting production, the boiler supplying electric power and steam failed the environmental compliance tests, and the facility became the subject of an enforcement action.

At a large steel processing company, the plant manager had received yet another proposal to replace another part of the treatment plant. Over the previous several years, the company had been cited for cyanide, zinc, nickel, and arsenic violations one after another. In each case, the environmental manager had suggested his own solutions and had solicited input from the engineering staff. He had also worked with outside vendors and regulatory authorities to find timely solutions. Still, millions of dollars later, here was another problem, and there was no telling when the next one would occur.

In both of these stories, the companies acted in good faith to comply with regulations. Both had done their jobs, yet they failed to prevent the ensuing problems. What went wrong?

The two environmental managers here are like those in most corporations. They are given responsibility to achieve and maintain environmental compliance, but their hands are tied by the way responsibilities at the plant level are organized (see “Key Players at the Plant Level”). They listen to suggestions offered by the corporate general manager, business staff, and operations manager and must then do their best to find appropriate compliance solutions, which usually means focusing on available technology.

This one-sided approach is uneconomical and frequently fails because it generally ignores the mutual dependency of business and environmental concerns. It also misses opportunities to reduce production levels and cut environmental costs and achieve long-term compliance.

The Truth about Integration

The reality is that business and environmental changes are tightly interwoven. Changes in plant operations affect the quality and quantity of environmental discharges and thus the cost of environmental compliance. In some cases, a plant’s existing controls may have become inadequate. In others, a plant may have too much treatment capacity.

Changes in environmental regulations, in turn, may place limits on production, make it harder to use certain raw materials or particular technologies, or force a plant to change its production processes. Given this interdependency, companies will find the greatest savings in both production and environmental compliance by coordinating the two concerns in a way that reduces the cost of both.

Many have termed this coordination “the integration of business and environment,” but no one seems to know exactly what that means. The literature has not even defined this term, let alone suggested ways to achieve it. Instead, the focus is on pollution prevention, sustainable development, the creation of environment-friendly products, and the like.1 Suitable tools to do the required financial and economic analyses are neither discussed nor offered. Some companies claim to integrate, but their efforts fall far short of the needed scope and depth. This is not because the management teams at these companies do not care about the environment. Most have hired the needed environmental management staff and given them resources to carry out their assigned responsibilities. Many companies also use popular strategies like environmental auditing and pollution-prevention to monitor, promote, or achieve compliance economically.

In short, companies seem to have tried just about everything except a truly integrated approach—and this may very well be the root of most environmental violations. Even a cursory examination of enforcement and compliance data shows that almost all manufacturing plants, including those belonging to Fortune 500 companies, experience periodic environmental compliance problems.2 A truly integrated approach takes an entire-plant perspective. It reviews new regulations, plant operations, emerging technologies, changes in markets, and fluctuations in product demand simultaneously to find solutions that best address both environmental compliance and production concerns. Consequently, the decisions made often reduce the costs in both areas. In this holistic approach, the environment becomes a criterion for making business decisions, and business needs become criteria for making environmental decisions.

Yet the division of responsibilities among different departments at most companies creates a huge gap between production and environmental concerns and makes it difficult to use such an approach. To bridge the gap, companies must force themselves to make decisions differently. They must look at major problems from many perspectives and draw on proven management science techniques to solve them. For example, using the holistic approach, companies would simulate plant operations, run financial models, and use proper cost-allocation methods.

Strategies for Savings

The five case studies below illustrate how and in what situations you can use such methods. Each represents a different strategy that will help you think in a holistic way. The first four strategies are based on enforcement cases I studied to determine if noncom-pliance yielded any financial gain. In each case, the company either lost money or fell far short of realizing the expected gains by delaying compliance. The fifth strategy comes from a study of a company that proactively pursued an integrated solution.

Case 1. Review Plant Operations First

During the 1980s, an organic chemicals company that produced copper-based dyes was routinely discharging its wastewater into a creek that fed a nearby river. The U.S. Environmental Protection Agency lowered the discharge limit from about 14 mg per liter to 1.4 mg per liter in 1989 and then to 0.07 mg per liter in 1991. Thus, the concentration of copper in the discharge had to be reduced by a factor of 200 within a short period of time. In 1991, an environmental group brought an enforcement action against the company under the Clean Water Act.

The company could have complied with the new requirements by expanding and modernizing its treatment plant, but it needed quite a bit of capital to do that and it doubted that corporate management would approve the funding. To develop alternative options, the company decided to review its products to determine if it could reduce the offending discharge or if it should just discontinue making some of the products. After the review, the company decided to reduce the production of one product at the plant by shifting production to its overseas plant. This saved about $200,000 annually. The company also decided to drop two products that had become unprofitable and were discharging significant amounts of copper. This eliminated $500,000 in yearly losses.

By taking these two actions, the company significantly decreased the copper discharge. As a result, it reduced the capital costs of upgrading the wastewater treatment plant by more than $2 million. However, after accounting for all the consequences of noncom-pliance, I found that the company had suffered a net loss of $700,000. It also paid a penalty approaching $1 million, not to mention what it spent on its legal defense.

What Companies Do Now.

With no enforcement action, typical companies do not even think of evaluating the profitability of their processes and products or of shifting production to other plants. When faced with major regulations, companies usually let their environmental managers find technical solutions. Companies rarely look at operations unless they face dire circumstances or the technical fixes are very expensive.

Even when facing enforcement actions, most companies react traditionally, letting their environmental managers handle it. Some companies, such as the one in this case, spring into action, finally bringing business, operational, and environmental staff together to find better solutions.

What They Should Do.

When faced with major regulations, a company’s best defense is likely to be to hunt for and eliminate unprofitable products or shift production to other plants. A good strategy is to eliminate marginal products or processes that generate a disproportionate amount of pollution. In this case, the company should have started in the mid-1980s, when it first became aware of the potential regulatory controls. Top management should have formed a committee of business, operations, and environmental staff to evaluate the best way to comply with more-stringent controls.

If a company faces a similar situation today, it should review its processes and products, asking such questions as:

• What products and raw materials are causing most of the pollution?
• Are the offending products in high enough demand to justify spending resources to modify their production?
• Are any polluting products unprofitable enough to eliminate?
• How much will it cost to shift the production of some products to other facilities?

It should then determine the cost of environmental controls under different production scenarios and conduct economic and financial analysis to find the best solution. In other words, it should look at major new regulations in a new light. Instead of viewing them solely as an unnecessary cost burden, it should also see them as an opportunity to eliminate waste and make production more efficient.

This kind of mind set ultimately saves money. True, the company in this case saved considerable funds by postponing the upgrade of the treatment plant, but those savings were more than offset by the losses it could have avoided by eliminating unprofitable products and shifting production to other facilities several years earlier.

Case 2. Find the Best Time To Install Pollution-Control Equipment

In 1989, a plant built a new line to paint plastic parts for its auto industry customers. In justifying the new line to corporate management, the plant manager promised millions of dollars in new business, although neither existing nor potential customers had made any firm commitments. Management, impressed with the potential for additional business, approved the new line.

The company noted that the production levels for the new line were well below a regulatory threshold that would require it to build roughly $2 million worth of pollution-control equipment. Because it saw no reason for production levels to change in the foreseeable future, it decided to postpone installing the pollution-control equipment until the line operated at a higher capacity. The postponement also made it much easier for the plant manager to convince corporate management to approve the new line because the cost of the pollution-control equipment was 25 percent of the total line cost.

To ensure that it got a permit immediately, the company proposed (and the state accepted) a specific emissions limit that was slightly below the regulatory thresholds.

Everything was fine for two years, but at the start of the third year, a long time customer substantially increased the size of its yearly order, and the company realized that it had to exceed the emission limit. It immediately started the process of designing, ordering, and installing emission controls, but the installation ended up taking more than a year to complete. In the meantime, the company was violating the accepted emissions limit and incurring legal liabilities at a rate of $25,000 per day under both federal and state environmental laws. The state filed an enforcement action, but even more important, the violations provided an opportunity for a private citizen to file his own lawsuit.

In addition to staggering penalties, the company wasted managerial and staff time and suffered a loss of goodwill among clients and regulatory agencies: The federal government began watching the plant and continued to do so for almost eight years.

What Companies Do Now.

When corporate management decides to expand a plant, the environmental staff has to act fast. They must determine regulatory requirements, select the control technology, and get the necessary permits, typically within a few months. The construction start date is set, and the staff has no choice but to do almost anything to make that deadline. In this case, corporate management wanted the new line up and running quickly at a minimal cost. Environmental engineers had to accept this, and so did the plant managers—even though it meant they could not increase production.

Another current practice is for top management to postpone any compliance expenditure that is not immediately necessary. This discourages all but the heroic from suggesting a more forward-looking approach. Most plant managers dismiss long-term needs because they believe the costs they avoid will more than pay for any extra cost of future retrofitting. Others focus on only short-term needs, reject the possibility that product demand could increase, and hope they never have to install pollution controls.

In this case, the company saved $625,000 by postponing the $2 million to install the pollution-control equipment for four years. But the postponement cost far more than that in the long run. First, retrofitting the plant in 1992 cost $500,000 more than it would have in 1989, when it would have been part of a new building. To retrofit, the company had to cut the roof open to install ducts, change three-year-old wiring, alter relatively new computer controls, and modify the process-control equipment. Thus, the net savings, before any penalties and legal costs, was only $125,000. The state-imposed penalty of $225,000 easily ate up that savings. And the private citizen’s lawsuit lasted five years and cost well over $2 million.

What They Should Do.

Some of these trade-offs would have become apparent had corporate management taken the time to calculate the costs and benefits of delaying the installation of pollution controls. A proper economic and financial analysis is essential when there is even the potential for a large fluctuation in product demand. For example, an auto manufacturer’s orders for supplying specific parts will depend on the popularity of specific car models and on the company’s decision to offer the parts as standard or optional. From the painting plant’s perspective, production could very well have increased quickly.

Despite this uncertainty, companies usually do not evaluate potential variations in demand and their consequences on environmental compliance when they first build a facility such as a plant or a paint line. One reason may be that they lack the tools or expertise to do the required analysis. Calculating the financial gain from postponing expenditures requires a model similar to the BEN (Economic Benefit of Noncompliance) model the EPA uses in enforcement cases. The BEN model, available to the public on the World Wide Web (http://es.epa.gov/oeca/models/ben.html), has many weaknesses, and its formulation of the financial gain calculation (gain from postponing capital expenditures) may not be valid for many manufacturing situations.

However, companies can develop more appropriate models rather quickly. Such models can help managers (1) calculate the financial gain from postponing capital expenditures under different operating scenarios, (2) assess potential liabilities accurately, and (3) make informed decisions. Neither environmental engineers nor operational personnel generally have the requisite background in economics and finance to develop such models. If suitable models are not available in-house, companies must call on outside experts or specially-trained personnel to do the analysis. The cost of outside help is likely to be well below the cost of future retrofits and lawsuits.

Case 3. Find the Best Time To Upgrade Production Technology

In the early 1980s, a foundry’s production processes were old and inefficient, and its productivity was relatively low. The foundry was also facing the need to comply with forthcoming occupational safety and environmental regulations that could impose major costs, so it appeared that it might have to invest in either pollution-control equipment or production technology, or both. However, because the new regulations were still on the horizon and because productivity was still acceptable, the facility took no action.

In 1983, a deep, long-lasting economic recession hit the United States, and the foundry was unable to attempt any modernization of the production equipment. In 1987, as economic conditions improved, management decided to revamp its manufacturing equipment to improve productivity as well as solve most of the health and safety problems. Once it installed the new production technology at a cost of $4 million, the foundry was able to reduce its work force by almost 50 people. This saved $200,000 annually through reduced use of natural gas and another $100,000 per year through reduced use of other utilities and raw materials. Overall, annual costs went down by a minimum of $2 million per year, and production capacity increased substantially. The company could have saved this much money every year for about eight years if it had installed the new technology in the early 1980s.

The new technology also improved environmental performance considerably, but the environmental problems did not receive sufficient management attention until the state issued major citations and demanded millions of dollars in penalties. Some of the citations reflected violations of regulations that were put in place more than five years earlier. To address the violations, the factory spent well over $2.5 million to install air pollution control systems for the new production system.

The air pollution system might have cost several million more had the company retained the old production technology. The pollution controls alone could have cost more than the new production system and new air pollution system combined. In addition, the company’s cumulative labor and operating costs would have increased from $10 million to $15 million.

What Companies Do Now.

Although this case dates back almost two decades, the same management mind-set persists in most companies. When facing major regulations, business and operations managers do not consider changing production technology first, even if it is causing pollution problems. They will not spend money to change that technology unless they are facing urgent production problems—and even then, they are likely to overlook environmental and safety concerns. Their focus would remain on the production problems, and they would leave the environmental concerns to the environmental managers.

In this case, the foundry’s management had reasoned that productivity was not low enough to change the outdated processes, and the state did not appear to be enforcing compliance with new environmental and health and safety requirements. Therefore, the managers must have thought, why change anything?

Increasingly, however, noncompliance under such circumstances is no longer an option. If a company is facing compliance deadlines, it must to do something. It may get away with the incursions by obtaining compliance extensions for a short period, but if the regulatory agency is unsympathetic, the company will have to install pollution controls immediately. The company’s business and operations managers will resist installing more efficient production technology by citing unnecessary financial and business risks. And the company will almost certainly delay revamping its production technology if its industry is in economic recession. As this example shows, this means the company will almost certainly spend more money than if it had been more proactive and forward-looking.

What They Should Do.

As radical as this suggestion may seem, to maximize their savings, companies should not always wait until low productivity is a major concern to install new production technologies. An economic analysis of this case suggests that 1980–1981 was the best time to introduce the new technology.

The foundry would have saved as much as $2 million per year and would have easily complied with forthcoming regulations. Further, it might have recovered its investment by the time the recession hit the industry. And, had it changed the technology in 1980 or 1981, it might not have attracted so much enforcement attention. When it finally did install the new technology, it saved almost as much through improved environmental performance as it spent on the new technology.

This case illustrates a simple rule of thumb: The best time to install new technology is when many factors have the potential to converge, such as low productivity, availability of more efficient technologies, and forthcoming environmental regulations. The plant manager and staff must actively search for information about emerging technologies, assess existing productivity, determine costs imposed by new regulations, and conduct economic analyses of available options.

Case 4. Allocate Environmental Costs Properly

Changing market conditions can cause a manufacturing plant’s product mix to change rapidly, and a new product mix can alter the type and quantity of wastes. It may also introduce wastes that increase pollution when mixed with others. If the costs associated with waste treatment are not correctly distributed across the offending products, managers are not likely to know the true costs of producing those products. In a case such as this one, the managers may not even realize that a product costs too much to make in the first place.

In 1991, a small chemical commodities plant was producing inorganic and organic chemicals as part of contracts with larger chemical companies. On the inorganics side of the business, neither the production processes nor the discharges of hazardous waste changed much over time. However, the processes involved in the production of organic products and the composition of the resulting discharges of hazardous waste fluctuated substantially.

The company’s normal practice was to accept whatever business came in without first examining the consequences of generating different wastes, including the effect on the cost of treating wastes from all of its products. Between 1991 and 1996, it introduced at least 20 new chemicals into production. The company had to stop production of several chemicals because their wastes consisted of complex chemical compounds or when mixed with those of other products, formed compounds that the plant’s treatment system could not treat.

The company also tended to lump all of its treatment costs together as overhead and estimate the waste-treatment cost of products by allocating a figure to each product from the lump sum in proportion to the product’s share of the plant’s overall production level. The organic products constituted only one-third of the plant’s total production volume, so the company allocated them only one-third of the total treatment cost. It also used that allocation figure when pricing the products.

In reality, organic waste accounted for two-thirds of the total treatment cost because the company was finding it impossible to treat these wastes. It had been so difficult to treat one product that the company lost more than $200,000 on it alone between 1991 and 1994. The company eventually had to stop selling the product. Further, even though the facility changed its wastewater treatment system every year, it perennially violated its permit limits and became the object of a federal enforcement action that cost several hundred thousand dollars.

What Companies Do Now.

Even though the company was relatively small and did not have sophisticated managerial cost controls, this case holds important cost-allocation lessons for many firms—especially those with centralized treatment facilities. Most companies are likely to include the direct environmental costs associated with a production line or a product in the total cost to operate the production line or make the product. For example, if a line generates hazardous waste that is sent to a disposal site, the disposal costs are easy to track, so management is likely to allocate them to the cost of operating the line.

In contrast, when a centralized treatment plant serves several product lines and many products, the company generally allocates the cost of running the treatment plant to factory overhead, which is often allocated to all products according to production volume. If one or two production lines or products cause most of the pollution, their production costs will not reflect this disproportionate share of the total environmental cost. Thus, a product may be allocated $5 per unit for environmental costs under a commonly used formula, but its actual treatment may be closer to $15 per unit. The difference of $10 per unit may make the product unprofitable, yet most companies do not consider allocating greater shares of their environmental costs to products or processes that cause more pollution than others.

What They Should Do.

Companies must attribute a product’s real share of the environmental cost to the total cost of manufacturing that particular product. This is particularly important when the product mix changes rapidly or when wastes generated at one line create special treatment problems when mixed with other wastes. Working closely with production and environmental managers, a plant manager should determine equitable cost allocations, thereby providing proper input into product pricing and production decisions. Without knowing the true costs of production, a company misses many opportunities for negotiating higher prices with its customers, reducing costs, or ceasing unprofitable production.

Case 5. Integrate Business and Environmental Decisions

In the previous four cases, the companies lost millions of dollars because plant managers and environmental engineers did not work together. In this case, the company decided to take a proactive, holistic approach to integration, and it reaped considerable benefits.

In 1996, a steel plating facility was producing about 20 types of products for a variety of customers. At the same time, it was considering several pollution-prevention projects that would inevitably change the quality of discharges to the treatment plant. The factory was also planning to install a new nickel steel product line that, under certain circumstances, could discharge wastewater into the facility’s centralized wastewater-treatment plant. The wastewater quantity and quality depended, among other things, on the following:

• annual demand for different product types,
• treatment plant process equipment,
• processes used to produce the products,
• customers’ specifications and requirements,
• raw materials being used for a particular product type (for example, incoming steel coils used to produce nickel steel were covered with much less oil than other coils),
• extent to which pollution-prevention equipment was used to save chemicals, and
• amount of wastewater being disposed off-site.

Consequently, amount and type of wastewater varied from day to day. When the company decided to upgrade the centralized treatment plant, the plant manager, who was weary of approving modifications to the treatment plant every year, wanted to make sure that the redesign was integrated with operations. The company had solicited bids from traditional engineering companies to redesign the plant. The average bid was $800,000, and each company recommended completely rebuilding the plant.

The company agreed to let me analyze various redesign options using an integrated approach.

During the four-month study business, operational, and environmental staffs worked closely together. We projected demand for each major product over 2, 5, and 10 years; examined the technical and operating characteristics of processes; and determined the quality and quantity of the discharges under different operating scenarios. We also considered alternative ways of reducing, treating and disposing of different wastes. These included initiating pollution-prevention projects, segregating wastewater flows, and treating some wastes within the plant rather than off site. We developed capital and operating costs of the treatment system under each scenario and conducted net present value analyses to find the least-costly solution.

The resulting integrated design had an estimated capital cost of only about $200,000, and it eliminated the need for one of the pollution-prevention projects. Further, it saved so much money in operating costs that the payback period for the recommended investments was only one year. The solution recommended by the engineering companies, in contrast, would have cost about $800,000 and increased operating costs substantially.

What Companies Do Now.

When faced with decisions to upgrade, replace, or expand centralized pollution-control facilities, a typical company usually turns to an outside engineering firm. Someone from the firm spends one or two days at the plant to learn about its problems. On the basis of rather cursory knowledge gained from this short visit, the firm develops a suitable design. However, because it lacks an in-depth knowledge of plant operations, the firm ends up focusing on what it can do: sample discharges, examine discharge data, and develop a conservative design. It does not have the expertise (or the inclination) to understand the plant fully and perform deep economic and financial analyses.

It is also not easy to educate an outside firm. Because of the way plants operate (see “Key Players at the Plant Level”), companies rarely have anyone with a detailed knowledge of all processes. Some people know how a few processes are supposed to work and how one process affects another, but they know the operations only qualitatively. They basically know how things work, but lack the quantitative data needed to fully understand interdependent problems. Thus, decision-making becomes parochial by default. Production managers focus on a specific production line, its production goals, product quality, and productivity. Project engineers focus on solving the problem at hand. Line supervisors make sure that their lines are operating efficiently. Environmental managers concentrate on treating incoming wastes and obtaining permits. Nobody is left to develop a detailed global perspective and solve problems from a plantwide, or systems, view.

This makes it hard to remove inefficiencies that develop as a plant changes Process A first, then Process B a few years later, and finally Process C a few months or years after that.

Parochial and sequential decision-making is particularly harmful when dealing with environmental issues, which are usually viewed as a very small part of each business or operating decision.

Operations managers recognize that the cost of not meeting production goals or quality is very high because it immediately affects the bottom line. In contrast, they do not consider environmental impacts to be very critical, believing that “the environment can be taken care of somehow.” What they fail to consider is that sequential decisions add up and their impact on the environment can be quite significant. Over time, the character of discharges and emissions can change substantially.

Operations managers also tend to ignore even the major changes production can cause in environmental discharges. Changes in demand may change the quality and quantity of the discharges and make existing treatment schemes uneconomical. As the production equipment grows older, it generates more waste. As products and production machinery change, new types of wastes may be generated, requiring new treatment schemes, or discharges may dramatically decrease (when some products are dropped), resulting in excess treatment capacity. Unless new wastes and new inefficiencies cause unmanageable treatment problems, they are not even noticed, much less evaluated. Yet they do increase costs and may require a company to take actions year after year—as the plant manager in this case knew only too well.

What They Should Do.

First, in designing centralized facilities, a company must take a systems approach: Evaluate the entire plant and incorporate the planned changes at the plant level. Among other things, a systems view helps identify and eliminate inefficiencies that are bound to creep into operations. Although it was more difficult and took more time (four months versus two days), my study ended up saving the plating facility a substantial amount of money. The primary lesson here is: Do not hire an engineering company to do the detailed design until you have evaluated plant operations and developed appropriate design scenarios.

Second, because sequential decision-making is unavoidable, those making important operating decisions must do so with the rest of the plant’s operations in mind. Companies make many equipment replacement or upgrade decisions using parochial information. Such decisions are also based on circumstances that are fixed in time. But a plant is a living entity; its business, economic, and technical issues are constantly changing. One way to ensure that decisions account for this is to document plant operations, perhaps in the form of computer models. In this case, it would not have taken as long to study design scenarios if I had had a suitable model of the plant’s operations. To develop a systems view and keep it current may be a bit difficult and time-consuming, but it might be the only feasible way to cost-effectively develop alternatives and conduct the required economic analyses.

Conclusion

I believe almost any company will benefit by adopting this kind of integrated approach, and it makes business sense to try something new when the old methods are not economical. Companies have continued to cling to traditional methods, in part because managers are typically unaware of potential losses; they just cannot foresee them. In the more than 30 enforcement cases I reviewed, the companies were actually surprised to find that they had suffered losses by delaying compliance. There is also a general lack of awareness and appreciation of the expertise and tools needed to do a true integration. Finally, the prevailing managerial mind-set does not promote integration, perhaps in large part because business and environmental management are organizationally disconnected.

As the case studies have shown, these obstacles are not insurmountable. However, to get these kinds of savings in both compliance and production costs, companies must take two important first steps: They must depart from traditional modes of thinking, and they must begin to use techniques and tools that help them work in a truly integrated manner. It will not be easy, but the potential benefits are well worth the effort it takes to put an integrated approach into practice.