Assessment of the Costs and Benefits of Environmental Investments

Mohamed E. Hussein and Gim S. Seow (Corresponding Author)

Department of Accounting, University of Connecticut

Kinsun Tam

Department of Accounting and Law, State University of New York at Albany Abstract: This study develops a methodology to analyze environmental investment based on Ansari et als (1997) classification of environmental costs into prevention costs, assessment costs, control costs and failure costs. BP's Deepwater Horizon oil spill demonstrated that the costs of failure significantly exceed the costs of prevention, assessment and control. With better preemption, there is less need for remediation. We argue that BP could have averted the Deepwater Horizon disaster if it had applied our proposed methodology of environmental risk analysis. 1 INTRODUCTION adversely impact short-term profit but, ex post, Economic sustainability is the premise of a compare favorably to costs of internally discovered sustainable society. A sustainable economy requires failures or failures discovered by external monitoring efficient use of finite resources, and reduction in agencies. The example of Allied Signal mentioned waste and emissions (Smith and Ball, 2012), which in above as well as many other cases, including BP's turn require investment in processes and technologies Deepwater Horizon oil spill to be discussed in details that yield long-term benefits but lower short-term later, have shown that the costs of failure in terms of profits. Since these benefits and costs are not entirely remediation, damages and penalties significantly captured in the traditional accounting system, many exceed the costs of prevention, assessment and organizations do not foresee all the environmental control. With better preemption, there is less need for costs until problems occur. For example, a remediation. While environmental investment data is manufacturer might choose cheaper materials that useful on its own, there is a need to assess the enhance short-term profitability but may prove economic impact of such investment. When making costlier to dispose of because of toxicity. The economic decisions, for instance, managers need to additional disposal costs might exceed the cost know the impact of investment in emission remission savings of the cheaper materials over more expensive or waste treatment on the overall profitability of the green materials. A good example was reported by firm. Thus companies must pay attention to all their Ansari et al. (1997) where Allied Signals engineers operations from facilities and processes to design, recommended spending $30,000 to replace disposal production, distribution and disposal of products. pipes in its Bendix plant for fear of PCB leaking. Table 1: Environmental Costs Allied Signal's management overruled the engineers Type of Costs Description and later had to spend $287 million to clean up the Prevention Actions to prevent or reduce environmental contaminated site. accidents. These actions include employee Smith and Ball (2012) argue that the extant training, product and process redesign, use literature on sustainable manufacturing is "generic of nontoxic materials, etc. and high level" (see, for example, Abdul Rashid et al. Assessment Periodic review of potential sources of environmental damages, evaluating policies, 2008, and Seliger et al. 2008), and therefore, procedures and employee awareness. provides little practical guidance on how to attain Control Extra control at points where risks are high, sustainable manufacturing. To correct this deficiency e.g. reinforced concrete where there is high in the literature, this study provides a specific risk of leaks, special valves that relieve methodology for assessing the ex ante risk and pressure and/or sound early warning. comparing expected costs of preemption to expected Failure Costs of repairs and clean up. Medical and compensation costs for employees and costs of remediation and demonstrates with a recent others injured or affected by the failure. case of an environmental disaster in offshore drilling. Damages and Damages awarded to affected parties and The purpose of this study is to develop a process penalties penalties imposed by regulatory agencies. to analyze environmental investment based on the Source: Ansari et al, 1997. classification of environmental costs proposed by Ansari et al (1997) who divide environmental costs into prevention costs, assessment costs, control costs 2 THE ECONOMIC DIMENSION OF and failure costs. Ansari et al's framework is SUSTAINABILITY presented in Table 1. Failure costs can be divided Prior research (e.g., Norman and MacDonald 2004 into remediation costs, and damages and penalties and Carter and Rogers 2008) has viewed costs. Prevention, assessment, and control costs sustainability as comprising of three dimensions:

environmental, economic, and social. This paper focuses on the first two, namely environmental and economic. This path is chosen because there is little in the accounting literature concerning the economic analysis of environmental costs. Thus this paper proposes a methodology that can be used by managers to assess the costs and benefits of environmental investments. The methodology will provide an enterprise with a systematic method for monitoring its environmental costs, generate performance metrics on which decisions can be made by managers to reduce waste and/or pollution and assess environmental risks associated with processes and outputs. An example of such assessment is the decision by the Design for Environment team at Herman Miller, a major office furniture manufacturer, to replace polyvinyl chloride (PVC) with thermoplastic urethane (TPU) for the arm pads of their Mirra chairs (Lee and Bony, 2009). While TPU is more expensive and costlier to fabricate and assemble than PVC, TPU does not generate toxic fumes and therefore is "greener" and cheaper to dispose of at the end of the chairs useful life. This change also reduces the risk to employees health from working with PVC, and thereby helps Herman Miller avoid medical costs and damages payments. Furthermore, Herman Miller avoids any future liabilities if their customers dispose of chairs with TPU arm pads into landfills that do not accept toxic materials.

3 THE METHODOLOGY The methodology entails a systematic analysis of the risks and costs of environmental situations (see 4 THE CASE OF BP DEEPWATER OIL SPILL Exhibit 1). The analysis starts with identifying the On April 20th 2010, the Deepwater Horizon oil rig environmental risks in facilities, processes, designs, exploded and sank. The explosion caused the death production, distribution and disposal at end of of 11 workers and spilled 4.9 million barrels of oil product life-cycle. Each environmental risk is before it was capped on July 15, 2010 (Wikipedia, evaluated for the worst-case scenario, expected case 2013). The spill caused damage to marine life and the scenario and best case scenario. The probability eco-system of the Gulf of Mexico. It seriously assessment of environmental risk is based on prior impacted the livelihood of fishermen and people who environmental failure incidents. depended on tourism. It affected the health of the people of the Gulf and of the cleanup workers. According to Relocate Magazine (February 5th, 2013), BP's estimate of the costs of the disaster reached 42 billion by the end of 2012. There are still cases going through the courts that would add to the 42 billion. Many experts have argued that BP's emphasis on cutting costs was a major cause to the disaster. BPs own investigation concluded that the accident was caused by "a complex and interlinked series of mechanical failures, human judgments, engineering design, operational implementation and team interfaces." BP's report found that the cement and Figure 1: Environment Risks and Costs shoe track barriers failed to contain the hydrocarbons within the reservoir as they were designed. Over a 40-minute period the Transocean (subcontractor of

The second step is to estimate the different types of environmental costs of remediation, damages & penalties. The third step is to identify actions to avert environmental failures. These will include prevention in terms of waste treatment, designs, equipment, use of green materials, training of employees, and assessment and control activities that help detect problems before they turn into disasters. The fourth step is to calculate the net benefit of the environmental investment which is the difference between the investment on prevention, assessment & control and the estimated costs of remediation, damages and penalties. The next section uses the environmental disaster of BP Deepwater Horizon oil spill in the Gulf of Mexico as an example. We show that this disaster could have been avoided if BP had done the right analysis of prevention, assessment and control costs in comparison to the expected costs of failure. We argue that BP had experienced two disasters (i.e. the Texas City Refinery in 2005 and the Prudhoe Bay oil spill in 2006) that took place not too long before the Deepwater Horizon disaster. Such events should have made BP and the rest of the industry sensitive to risks of environment disasters. We chose the Deepwater Horizon disaster rather than a manufacturing example because it provides a vivid illustration of what could happen when a company ignores environmental risks. In addition, this case had attracted worldwide attention. Hence, there is enough publicly available data to demonstrate the methodology.

the rig) rig crew failed to recognize and act on the influx of hydrocarbons into the well until the hydrocarbons were in the riser and rapidly flowing to the surface. After the well-flow reached the rig it was routed to a mud-gas separator, causing gas to be vented directly on to the rig and into the engine rooms through the ventilation system. The rigs safety system did not prevent the subsequent ignition. Even after the explosion and the fire had disabled its crew-operated controls, the rigs blow-out preventer on the sea-bed should have been activated automatically to seal the well. It also failed to operate probably because critical components were not functioning. BP could have better handled the incident if it had followed a methodology of environmental investment assessment similar to what we propose. Considering that BP had two environmental disasters not long before the Deepwater Horizon oil spill, BP would be more aware that the cost of failures far exceeded the costs of prevention, assessment and control. In Table 2, we apply our methodology to the Deepwater Horizon oil spill. Our analysis is based upon the findings detailed in a letter from the Energy & Commerce Committee of the United States House of Representatives to BP CEO Hayward.
Table 2: Analysis of Environmental Risks and Costs of the Deepwater Horizon Oil Spill Risks BP's Actions The influx of oil or gas BP underestimated the risks and is the primary risk. The opted for the lower common rig design and choice of denominator when deciding design materials used should options: 1. Using a well design with eliminate or reduce the few barriers to gas flow, 2. Using risk of the influx. A insufficient number of related risk is that the centralizers to prevent the workers on the rig do formation of mud channels in not have the training to cement columns during the cement be aware of the risk of process, 3. Failure to run a cement the oil or gas influx nor blog, 4. Failure to circulate the skills to respond potentially gas-bearing drilling mud when an influx takes out of the well, 5. Failure to secure place. the wellhead with a lockdown sleeve. BP also did not ensure that subcontractor employees on the rig were adequately trained. They took 40 minutes to react to the problem. Prevention BP's Actions Because of the high If BP has accepted the better design, safety risk in oil the liner option of cement casing drilling, especially which is easier to cement into place offshore, the design and properly but costs an additional choice of materials used amount of $7 to $10 million and should emphasize add more days, the disaster might safety. Additionally, have been averted. A better construction and training of the crew on the rig operating crews should would have resulted in a quicker be highly trained. reaction to the problem. The crew

Assessment Considering the high risk, the monitoring and assessment of the construction are just as important as the design. An acoustic cement bond test should have been conducted. Control High quality cement and liners should have been used to protect against the influx of oil and gas. Circulation of gas-bearing mud out of the well must be controlled. Failure Lost 11 lives. Impact on the environment would continue for many years.

training cost could not be comparable to the cost of failure. BP's Actions The cement bond test would have cost over $128,000 and took an additional 9 to 12 hours. We do not have an estimate of what the other assessment and monitor actions would cost but we can assume that they will not be in the hundreds of millions of dollars. BP's Actions BPs five crucial decisions outlined in the congressmen letter are strong evidence that BP did not establish the necessary controls.

BP's Actions The costs so far of remediation, damages and penalties are 42 billion and counting!

The following three statements from the Energy & Commerce Committee's letter provide clear evidence that BP did not have appropriate prevention, assessment and control procedures in the Deepwater Horizon project: (i) "At the time of the blowout, the Macondo well was significantly behind schedule. This appears to have created pressure to take shortcuts to speed finishing the well. In particular, the Committee is focusing on five crucial decisions made by BP: (1) the decision to use a well design with few barriers to gas flow; (2) the failure to use a sufficient number of "centralizers" to prevent channeling during the cement process; (3) the failure to run a cement bond log to evaluate the effectiveness of the cement job; (4) the failure to circulate potentially gas-bearing drilling mud out of the well; and (5) the failure to secure the wellhead with a lockdown sleeve before allowing pressure on the seal from below. The common feature of these five decisions is that they posed a trade-off between cost and well safety." (ii) On April 19, one day before the blowout, BP installed the final section of steel tubing in the well. BP had a choice of two primary options: it could lower a full string of "casing" from the top of the wellhead to the bottom of the well, or it could hang a "liner" from the lower end of the casing already in the well and install a "tieback" on top of the liner. The liner-tieback option would have taken extra time and was more expensive, but it would have been safer because it provided more barriers to the flow of gas up the annular space surrounding these steel tubes. A BP plan review prepared in mid-April recommended

against the full string of casing because it would create "an open annulus to the wellhead" and make the seal assembly at the wellhead the "only barrier" to gas flow if the cement job failed. Despite this and other warnings, BP chose the more risky casing option, apparently because the liner option would have cost $7 to $10 million more and taken longer." (iii) "BP's decision not to conduct the cement bond log test may have been driven by concerns about expense and time. The cement bond log would have cost the company over $128,000 to complete. In comparison, the cost of canceling the service was just $10,000.45. Moreover, Mr. Roth of Halliburton estimated that conducting the test would have taken an additional 9 to 12 hours. Remediating any problems found with the cementing job would have taken still more time." It is evident that BP had overlooked or underestimated the importance of prevention, assessment and control. BP ignored the technical information that the design of the well had weaknesses. The training of employees working on the rig was inadequate as it took 40 minutes for them to recognize and act on the influx of the hydrocarbons. If BP had done an analysis similar to that outlined in Table 2, it might have made different decisions and avoided the disaster. Although this is an ex post analysis, even with significantly lower estimates of the cost of failure would have justified spending money on the risk items identified by the Energy & Commerce Committee and by BP's own investigations. 5 CONCLUSION Commitment to environmentally sound policies is a sound business strategy that reaps benefits and safeguard assets, save lives, and uphold corporate reputations in the long run. The world is replete with cases of environmental disasters that have led to bankruptcies of major companies. Emphasis on short-term profits and analysis that understate the risks and costs of environmental disasters can lead companies such as BP and its subcontractors to catastrophic results. Better classifications and measures of environmental risks and costs can lead to more efficient decision making and balancing between the short-term and the long-term. The proposed methodology is a small contribution towards better classifications and measures. 6 REFERENCES
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