1 Does the public sector attempt to incorporate environmental costs within their capital investment programmes? A Case Study of Water Mr David Moore –University of Tasmania Abstract Capital budgeting is said to be of considerable importance to environmental management in the future. This paper reports the results of a case study which examined the capital budgeting process of a Victorian regional water authority. Specifically, the paper focuses on: (i) the identification of environmental costs (ii) discounting and the identification of environmental risk (iii) mandatory and discretionary capital budgeting projects (iv) the role of capital budgeting techniques (v) the life of capital projects / life cycle costing and (vi) the benefits of identifying and measuring environmental costs within the capital budgeting process. There was no classification of environmental costs within the capital budgeting process, even though the purpose of the process is to satisfy EPA regulations and such decisions are seen as mandatory. There was recognition of the existence of environmental costs as well the less tangible benefits from satisfying environmental regulatory concerns. David Moore Lecturer B School of Accounting and Corporate Governance Faculty of Business University of Tasmania Locked Bag 1314 Launceston Tasmania 7250 Email: [email protected]Phone: (03) 6324 3558
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Does the public sector attempt to incorporate environmental costs within their
capital investment programmes? A Case Study of Water
Mr David Moore –University of Tasmania
Abstract
Capital budgeting is said to be of considerable importance to environmental management in the future. This paper reports the results of a case study which examined the capital budgeting process of a Victorian regional water authority. Specifically, the paper focuses on: (i) the identification of environmental costs (ii) discounting and the identification of environmental risk (iii) mandatory and discretionary capital budgeting projects (iv) the role of capital budgeting techniques (v) the life of capital projects / life cycle costing and (vi) the benefits of identifying and measuring environmental costs within the capital budgeting process. There was no classification of environmental costs within the capital budgeting process, even though the purpose of the process is to satisfy EPA regulations and such decisions are seen as mandatory. There was recognition of the existence of environmental costs as well the less tangible benefits from satisfying environmental regulatory concerns.
David Moore Lecturer B School of Accounting and Corporate Governance Faculty of Business University of Tasmania Locked Bag 1314 Launceston Tasmania 7250 Email: [email protected] Phone: (03) 6324 3558
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Does the public sector attempt to incorporate environmental costs within their
capital investment programmes? A Case Study of Water
Mr David Moore
Introduction
Capital budgeting is seen to be of increasing importance with respect to environmental
management (Ditz et al, 1995; Epstein and Roy, 1997; Bartolomeo et. al, 2000; Parker,
2000a). In particular, current and future environmental costs should be included in capital
investment decisions as it will improve the understanding of the likely future costs of
present production and present possible alternative courses of action available to
minimize present and future environmental impacts and their related costs (Epstein and
Roy 1997). In turn, this can facilitate the integration of environmental and other business
objectives (Ditz et al, 1995). With respect to water, better understanding of the nature of
environmental costs can influence waste management decisions. (Ditz et al 1995)
Overall, capital budgeting is important if organizations are to comply with environmental
regulations and government legislation (Parker, 2000a), for example, the Montreal
Protocol (Dunk, 1999). Therefore, costing systems are needed that allow a better
quantification of longerterm environmental management and impact costs (Parker,
2000a).
This study examined the capital budgeting process of a registered Victorian water
authority. The interest was whether or not actual environmental costs of water
management are identified within the capital budgeting process. Specifically, the study
focused on: (1) The identification of environmental costs (2) the assessment and
discounting of environmental risk (3) The role of life cycle costing / analysis (4) the
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capital budgeting techniques employed (5) The identification of relevant costs and (6)
The benefits of identifying and measuring environmental costs within the capital
budgeting process.
Up until now, there has been limited research on the identification of environmental costs
within the capital budgeting process, particularly in the public sector. In particular, it has
been suggested that the task of identifying and quantifying social and environmental
benefits and costs has disappeared from the project appraisal mechanism. (Coleshill and
Sheffield, 2000). This paper contributes to research which has examined the role of
capital budgeting and environmental costs in: (1) local government (Bowerman and
Hutchinson, 1998) (2) the decision processes of refrigerator manufacturers in their
responses to phasing out of CFCs (Dunk, 1999) (3) the Scottish Water Industry (Coleshill
and Sheffield, 2000) (4) projections for future spending for pollution abatement and
control equipment, and whether it corresponds with subsequent environmental action
(actual spending) (Patten, 2005) (5) Australian Electricity Distributors (Deegan, 2005)
and (6) the potential influence of selected Australian environmental social controls
(ESCs) on capital investment decision making (Wood and Ross, 2006). In addition, the
importance of corporate budgeting with respect to the development of and
implementation of corporate ecoefficiency has also been highlighted (Burritt and
Schaltegger, 2001).
This paper is structured as follows. First, a brief overview of the literature relating to
capital budgeting and environmental costs is examined. Second, the case study that
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examined the capital budgeting process within a Victorian public sector water authority is
discussed. Finally, the results of the case study are discussed and analysed.
LITERATURE REVIEW
The following topics are examined in this section: (1) the identification of environmental
costs; (2) discounting and environmental risk; (3) Environmental capital budgeting
projects – Mandatory vs. Discretionary; (4) the role of capital budgeting techniques; (5)
The life of capital projects / Life Cycle Costing and (6) the benefits of incorporating
environmental costs into capital expenditure decisions.
Capital Budgeting: The identification of Environmental Costs
The United States Environment Protection Authority (EPA) has prepared a Pollution
Prevention Benefits Manual which identifies the environmental costs an entity may wish
to consider in its capital budgeting process (Kite, 1995; Grinnell and Hunt III 1999; Gray
and Bebbington, 2001; Deegan, 2005). Theses costs are grouped into four categories or
tiers: 1. Direct Costs. 2. Indirect / Hidden Costs. 3. Contingent Liability Costs and 4. Less
tangible costs. (Kite, 1995; Grinnell and Hunt III 1999; Gray and Bebbington, 2001;
Deegan, 2005).
Direct costs, or Tier 0, of the EPA model contains the “usual” capital, operating, and
maintenance costs, such as those related to process equipment and depreciation, process
materials, utilities direct labour, and energy. (Grinnell and Hunt III 1999; Deegan, 2005).
These costs are typically easily identified by most cost systems, and include the
environmental costs directly identified with the project (Grinnell and Hunt III, 1999).
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Indirect costs, or Tier 1 of the EPA model comprises the indirect environmental costs that
arise from environmental support activities such as handling materials and monitoring,
treating and disposing waste, and hidden environmental costs resulting from compliance
with environmental regulations (e.g. training, inspecting and reporting) (Kite 1995;
Grinnell and Hunt III 1999; Deegan, 2005). Regulatory costs imposed by environmental
protection authorities (EPAs) include licensing costs, emission and disposal charges, and
fines and penalties (Wood and Ross, 2006).These costs can be significant, and pollution
prevention efforts can be instrumental in reducing or eliminating them (Grinnell and Hunt
III, 1999). Regulatory costs are often hidden in overhead accounts. (Gray and
Bebbington, 2001; Joshi, Krishnan and Lave, 2001; Deegan, 2005), along with the
associated environmental impact on the financial performance of the organization
(Parker, 2000b).
Tier 2 includes contingent liability costs (Grinnell and Hunt III, 1999; Gray and
Bebbington, 2001). Consideration of these costs is essential to the evaluation of a
pollution prevention project because, to the extent that a company can eliminate or reduce
pollution, these liability costs are avoidable (Grinnell and Hunt III, 1999). However,
these costs are difficult to estimate due to the requirement to anticipate environmental
risk (Kite, 1995) as well as the uncertainty involved in, and the inherent complexity of,
assessing risks associated with the handling and release of toxic substances (Grinnell and
Hunt III, 1999). Estimation is also difficult as neither future technologies nor future
demands of stakeholder groups (including regulatory requirements) are known. (Burritt
and Schaltegger, 2001). In the United States, firms often cite a lack of estimability as the
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reason why they do not recognize environmental liabilities early in a Superfund site’s
history (Barth and McNichols, 1994;Kennedy, Mitchell and Sefcik, 1998).
Tier 3 includes the less tangible costs and benefits that a company may achieve as a
result of reducing or eliminating pollution (Grinnell and Hunt III, 1999) and therefore
improving environmental management (Gray and Bebbington, 2001). These include
increased revenues and decreased expenses that occur due to improved customer
acceptance, employee relations, and corporate image (Grinnell and Hunt III, 1999). Tier 3
costs may also include avoided costs or liabilities (Kite, 1995). Although these benefits
are difficult to measure, it is reasonable to assume that they may be quite significant.
(Grinnell and Hunt III, 1999). Specifically, they could be expected to have some
influence on the value of intangible assets such as goodwill and brandnames (Deegan,
2005). In the privatized UK water utilities, improvements in the quality of waste water
were used as evidence for claims that companies had become more customer focused,
were responding positively to customer expectations and were conforming to principled
ideals (Ogden and Clarke, 2005), an example of a “less tangible benefit”.
Apart from the U.S. EPA framework, environmental costs, for capital budgeting purposes
within local government, have been defined as expenditure which could be identified by
the local tax payer as helping to improve or to protect the local environment (Bowerman
and Hutchinson, 1998). In the Scottish Water Industry, the main costs identified for
project appraisal purposes are maintenance costs, power costs, chemicals and rates.
(Coleshill and Sheffield, 2000). In particular, the Guidelines for investment appraisal for
Scottish Water and Sewerage Services state that all costs and benefits should be
identified, even if quantifying them will prove challenging. (Coleshill and Sheffield,
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2000). Social costs to be considered, and quantified where possible, include land
reclamation; habitat preservation; energy efficiency; nature reserve construction; tourism;
amenity and housing. (Coleshill and Sheffield, 2000). In Australia, water authorities
allow disposal of some trade waste through the sewerage system, however a ‘userpays’
charge system is not applied to trade waste systems (Wood and Ross, 2006).
In summary, a failure to measure environmental costs within the capital budgeting
process may mean less priority for environmentally sound initiatives, relative to
environmentally destructive ones. (Bowerman and Hutchinson, 1998) The absence of
techniques to demonstrate value for money could have adverse implications for the
success of environmental initiatives. (Bowerman and Hutchinson, 1998).
Discounting and the identification of environmental risk
Environmental risk may be the result of regulatory uncertainty, the sources of which may
include the application and interpretation of existing law, as well as the foreshadowed
introduction of new or more stringent regulation. (Dunk, 1999). In order to effectively
identify points of environmental impact or risk within a project, the decision maker must
eliminate the concept of the organizational “entity” perpetuated by financial accounting
concepts (Kite, 1995). This may then be integrated into the capital budgeting process by
adjusting discount rates in order to measure an environmental risk premium (Birkin and
Woodward 1997). Therefore, the effectiveness of discounted cash flow methods depends
upon the discount rate applied (Bartolomeo et.al.,2000). Kite (1995) suggests that when
environmental risk exists, it may be incorporated into NPV analysis by increasing the
discount rate. The higher the risk the greater the upward adjustment, as increasing the
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discount rate compensates for environmental risk by lowering the net present value of the
project (Kite, 1995). Therefore, the choice of discount rate will have obvious
implications on the evaluation process (Deegan, 2005).
However, using a high discount rate to measure environmental risk is problematic. If
excessively high discount rates are used in investment appraisal techniques, then any
longterm benefits which are identified will be discounted to negligible amounts
(Bartolomeo et al. 2000). As well, projects whose benefits take some time to materialize
are placed at a competitive disadvantage in the selection process because the present
value of benefits that are projected to occur during the later stages of a project’s life are
understated. (Grinnell and Hunt III, 1999). Pollution prevention projects often fall into
this category. (Grinnell and Hunt III, 1999). Specifically, cash flows are not adjusted for
inflation, hence the bias against those projects that generate significant cost savings in the
latter stages of their lives, namely pollution prevention projects. (Grinnell and Hunt III,
1999). An objective approach to deal with this problem is to carefully consider and
quantify the estimated savings associated with contingent liability costs (or use the
“annualized savings” approach), and then use comparable discount rates to evaluate
competing projects. (Grinnell and Hunt III, 1999). However, “discounting discounts the
future” and fails to encourage the present generation to “provide for the future” (Gray and
Bebbington, 2001).
In the case of the Scottish Water Industry, one of the problems, and therefore associated
risk, with sewerage projects is the capital profile due to the time lag between the major
capital investment and completion of the project.( Coleshill and Sheffield, 2000). As a
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result, it is only at project completion that revenue can be generated to repay interest on
the debt. .( Coleshill and Sheffield, 2000).
Environmental capital budgeting projects – Mandatory vs Discretionary
Capital budgeting projects involving environmental costs may be either mandatory or
discretionary. Mandatory projects are those which are necessitated by new
environmental laws or regulations (Grinnell and Hunt III, 1999). For example, at Du
Pont chemicals, if a capital investment is necessitated by a legal requirement, it will be
undertaken without regard to the internal rate of return. (Ditz et. al., 1995). Therefore, in
mandatory projects, managers have little discretion regarding investment in the project,
and will undertake the project without regard to its internal rate of return. (Grinnell and
Hunt III, 1999) In the case of refrigerator manufacturers, compliance with the provisions
of the Montreal Protocol was of paramount concern in the capital budgeting process,
reflecting the view that regulatory compliance is not expected to yield a financial return
(Dunk, 1999,). In the Scottish Water Industry, various government directives such as the
Urban Waste Water Treatment Directive (91/271/EEC), the Bathing Water Directive
(76/160/ EEC) and the Shellfish directive (79/923/EEC) have formed the basis of the
legislative framework that has forced an increase in the sewerage capital programme
within the industry. (Coleshill and Sheffield, 2000). However, whilst regulatory bodies
determined the level of environmental expenditure in the U.K. industry, the main concern
of the regulatory body in the UK, the Office of Water Services, has been to keep prices
down for consumers (Harvey and Schaefer, 2001). In the United States, the Securities
Exchange Commission (SEC) regulation SK, item 1, requires companies to disclose the
material effects compliance with federal, state and local environmental laws may have on
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"capital expenditures, earnings, and competitive position." (Zuber and Berry, 1992).
However, Patten (2005), in a study of environmental disclosures by U.S. firms, observed
that “only a relatively small percentage of companies make environmental spending
disclosures”. In general, Environmental Protection Authorities are aware of the
importance of capital investment to cleaner production (Wood and Ross, 2006).
In the case of discretionary environmental capital budgeting projects, managers are
presented with more planning opportunities. (Grinnell and Hunt III, 1999). However,
there is a general bias against these types of investments (Grinnell and Hunt III, 1999)
due to the difficulty of identifying relevant environmental costs and benefits. (Ditz et.
al.,1995; Grinnell and Hunt III, 1999). In the case of the privatized UK water utilities,
discretionary expenditures undertaken to improve customer service have proven to be
costly in terms of current reported profits, but have been associated with higher
shareholder returns since investors will perceive that future profit levels and risk
exposure will improved (Ogden and Watson 1999) Despite this, water companies have
been accused by The Sewer Renovation Foundation of failing to spend up to 400 million
pounds ($644 million) to improve the water infrastructure. (Letza and Smallman, 2001).
Projections of environmental capital expenditures, as a form of environmental disclosure,
may be a “legitimation device and not an accountability mechanism” (Patten, 2005).
The role of capital budgeting techniques
Bartolomeo et. al (2000) identified that the selection of an investment appraisal method
for environmental investments is important as the benefits of environmental investments
are often of longterm impact. The payback method of project evaluation has been
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criticized as being distorting because it ignores the time dimension of cash flows and
also because, in practice in some companies, it is often based on very short payback
periods. (Bartolomeo et.al.2000). As well, the discounted cash flow model (DCF) model
is considered to be biased against projects with longterm payoffs (which characterizes
many pollution prevention investments) if the discount rate used in the model is
incorrectly established at too high a level. (Grinnell and Hunt III, 1999). In general,
measurement systems are limited with respect to the external aspects of transactions as
externalities such as the depletion of scarce resources or pollution are ignored
(Bowerman and Hutchinson, 1998, p.310)
The arguments identified in the previous paragraph suggest that financial decision tools
fail to address adequately the estimation of the costs of complying with environmental
regulation, and that they also do not satisfactorily assist in assessing benefits in the long
term from adopting strategies that exceed environmental compliance regulations. (Dunk,
1999). As well, although techniques are available to measure externalities, they may be
difficult or expensive to apply, or may be too subjective to satisfy the needs of decision
makers. (Bowerman and Hutchinson, 1998). However, NPV techniques may be of use to
“top management” for large single investments where environmental considerations play
a role (Burritt et al., 2002).
Research has found that techniques such as performance measurement, payback or NPV
are not applied in environmental capital decisions in local government (Bowerman and
Hutchinson, 1998) and, in the case of refrigerator manufacturers, little use was made
formally of financial decision tools other than in budgetary cots containment strategies.
(Dunk, 1999) However, the absence of techniques to demonstrate value for money could
12
have adverse implications for the success of environmental initiatives. (Bowerman and
Hutchinson, 1998, p.315)
Apart from “traditional” techniques such as NPV and IRR, there are also ecological
efficiency measures such as ecological product efficiency and ecological function
efficiency. (Burritt and Schaltegger, 2001). Ecological function efficiency is the ratio
between provision of a function and the associated environmental impact added. (Burritt
and Schaltegger, 2001).
The life of capital projects / Life Cycle Costing
The management of water, in particular effluent disposal, involves hazardous waste
management. The management of hazardous waste extends beyond the useful life of a
product and therefore, the economic life used in the NPV calculation must be expanded
to include waste management. (Kite, 1995). Separate from NPV calculations is Life
Cycle Costing (LCC). LCC requires considerations of the costs that arise throughout the
life of a particular product. (Deegan, 2005). These include operating costs, hidden
regulatory costs, pollution costs and product retrieval, disposal and recycling costs
(Parker, 2000b). These costs are likely to increase in the future, bringing into question the
time horizon employed in the investment appraisal process (Gray and Bebbington,
2001).
LCC adds a costing dimension to Life Cycle Analysis (LCA). LCA is the attempt to
identify all of the internal and external environmental impacts, both good and bad
associated with a process or product, or activity throughout all stages of its life, on the
company, on all of its users, and all of the corporation’s stakeholders (Epstein and Roy
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1997 p.28). The focus of LCC is to consider the inputs and outputs connected with the
production, use and final waste handling of a product. (Deegan, 2005).
Life cycle assessment and life cycle costing process provides information on cost drivers
that enables improved environmental management and the reduction of environmental
costs (Epstein and Roy 1997). It may improve decision making by revealing that a
product with low acquisition costs but high operations, maintenance, environmental, or
disposal costs is a less desirable alternative as compared to a competing product with a
higher initial cost (Kreuze and Newell 1994 p.38). In addition, LCC refocuses
accountants’ and managers’ thinking from the shortrun assessment of operating costs to
the longerterm cycle of costs occasioned by a product’s existence and final demise
(Parker, 2000b).
The benefits of identifying and measuring environmental costs within the capital
budgeting process.
Identifying environmental costs within the capital budgeting process may improve the
understanding of the likely future costs of present production and present possible
alternative courses of action available to minimize present and future environmental
impacts and their related costs (Epstein and Roy 1997), which can also facilitate short
term planning and control (Burritt et al., 2002). It can also facilitate the integration of
environmental and other business objectives (Ditz et al., 1995) and therefore place “green
capital investments” such as waste management or pollution control plant on a “level
playing field” with other capital expenditure proposals (Parker, 2000b). The importance
of managing fixed environmental costs through capital expenditure decisions will gain
14
momentum as environmental standards will probably rise in the future (Kreuze and
Newell 1994; Parker 2000a). The absence of such management could have adverse
implications for the success of environmental initiatives. (Bowerman and Hutchinson,
1998, p.315).
The literature review suggests that the following issues be examined via a case study: (1)
the identification of environmental costs; (2) discounting and the identification of
environmental risk; (3) mandatory vs discretionary investment (4) the role of capital
budgeting techniques; (5) the life of capital projects / life cycle costing and (6) the
benefits of identifying and measuring environmental costs.
Method
A case study of a Victorian regional water authority was undertaken, examining the
capital budgeting process of a Victorian regional water authority. Specifically, the case
study focused on: (1) the identification of environmental costs; (2) discounting and the
identification of environmental risk; (3) mandatory vs discretionary investment (4) the
role of capital budgeting techniques; (5) the life of capital projects / life cycle costing
and (6) the benefits of identifying and measuring environmental costs.
A case study was chosen as it provides considerable scope for further examination of the
capital budgeting procedures adopted within specific entities by providing in depth case
study evidence (Frost and Toh, 1998). The water authority chosen for this case study
undertakes an extensive capital works investment programme, as evident by their capital
works investment plan. The major sources of evidence were available documents,
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interviews and direct observation. The specific documentary evidence were: (1) the
annual report and (2) the capital works investment plan manual. The capital works
investment plan manual provided detailed evidence of: (a) economic evaluation
principles; (b) the costs and benefits to be included and (c) the costs and benefits to be
excluded in capital works investment decisions.
In addition to documentary evidence, a semistructured interview was undertaken with
personnel from the Strategic Planning Department, which is responsible for the capital
budgeting / investment program. A list of the interview questions is contained in the
Appendix. The documentary evidence outlined in the previous section was used to
corroborate and augment information gained from interviews.
An open ended / unstructured interview was undertaken with the Manager – Strategic
Planning and the Economist – Strategic Planning. The questions, contained in the
appendix, addressed the following topics: (1). The objectives of capital expenditure
decisions at the sewerage treatment plants. (2). Identification and incorporation of
environmental costs into project evaluation decisions. (3). Discounting and its
implications for environmental costs and benefits. (4). Discretionary Investment in
Treatment Plants. (5). Incorporation of Environmental Risk into Capital Expenditure
Decisions. (6). The Role of contingent Liabilities in Decision Making and (7). Relevant
Costs and Decision Making at the Treatment Plants.
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Once the interviews were completed, data analysis was undertaken using pattern
matching (Yin, 1994). Scapens (1990) identifies that as the case study progresses, various
themes and patterns should emerge and sometimes it is helpful to prepare models, which
attempt to link the various themes and issues. In order to analyse the evidence, the
interview transcripts and observation notes were examined to find the major relevant
theories. This analysis was undertaken manually. Documents such as management
accounting reports were examined to verify the issues raised in the interviews, as well as
answer specific questions pertaining to the research.
In the next section, the responses to the questions posed to the participants in this case
study are discussed.
Results
This section will be discussed as follows: First, how does the water authority identify
(environmental) costs within its capital budgeting process. Second, what policy does the
water authority adopt with regard to the discounting of costs and how is environmental
risk assessed. Third, to what extent are the capital budgeting decisions mandatory
decisions as opposed to discretionary decisions. Fourth, what is the role of capital
budgeting techniques within the capital budgeting process. Fifth, what is the life of the
capital projects undertaken and what is the role of life cycle costing. Finally, what the
water authority identifies as the benefits of identifying and measuring environmental
costs will be examined.
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Capital Budgeting: The identification of Environmental Costs
The Capital Works Investment Plan (CWIP) Manual identifies the following costs and
benefits that may be used in a cash flow analysis, provided that they can be quantified,
for capital works projects: 1. Capital costs. 2. Opportunity Costs. 3. Operating /
maintenance /modification/replacement costs 4. Significant costs and benefits affecting
other parts of the organisation. 5. Significant direct costs and benefits external to the
organisation. 6. Cost savings. 7. Additional revenue and 8. Residual benefits of assets.
The manual identifies that all costs and benefits should be incremental to the “do
nothing” or sustaining alternative (Barwon Water CWIP Manual, 2000).
The CWIP manual defines an opportunity cost as the next best option benefit foregone as
a result of proceeding with the project (Barwon Water CWIP Manual, 2000). In the case
of environmental projects that may involve the disposal of waste, the opportunity costs of
alternative methods of disposal would need to be taken into consideration.
Operating and maintenance costs refer to those recurring costs that are required to keep
the assets functioning at their required level and will usually be ongoing for the life of the
project. These costs are estimated from past experience, comparative experience, field
trials and test work (Barwon Water CWIP Manual 2000 p.1). With reference to sewerage
treatment plants and therefore environmental costs, these costs would include direct costs
associated with the project such as labour and labour overheads, fuel, spare parts,
management and administration costs. These costs are similar to the costs that are
18
classified within Tier 0 and Tier 1 of the U.S. EPA model (Kite 1995; Grinnell and Hunt
III 1999; Gray and Bebbington, 2001; Deegan, 2005).
Significant direct costs and benefits external to the organisation refer to changes to the
conditions external to the Water Authority which are directly attributable to the capital
project. These include changes to the environment, service quality, public health or the
image of the Water Authority. Where such costs and benefits can be quantified they
should be included in the cash flow statement. Nonquantifiable costs and benefits should
be described and taken into account in the overall project evaluation (Barwon Water
CWIP Manual 2000 p.2). These costs are similar to the costs that are classified within
Tier 3 of the U.S. EPA model (Kite 1995; Grinnell and Hunt III 1999; Gray and
Bebbington, 2001; Deegan, 2005).
Costs and benefits that are to be excluded from capital works investment decisions
include indirect costs and benefits and unquantifiable costs and benefits. Indirect costs
and benefits refer to indirect or secondary costs which occur further down the operational
chain for a project e.g. the economy at large. (Barwon Water CWIP, 2000). They are
generally not included in the analysis as they often add an unnecessary complication to
the initial study only direct benefits are included, unless the indirect benefits are
considered to be substantial and directly identifiable (Barwon Water CWIP, 2000).
19
Unquantifiable costs and benefits refer to costs and benefits that cannot be directly
measured or valued. They include service performance, public image, broad managerial
or political factors, aesthetics or odour. Such costs and benefits are required by the Water
Authority to be listed and quantified as far as practical, making it clear to the decision
maker that they are additional factors to be taken into account (Barwon Water CWIP
2000 p.1). These costs are similar to the costs that are classified within Tier 3 of the U.S.
EPA model (Kite 1995; Grinnell and Hunt III 1999; Gray and Bebbington, 2001; Deegan,
2005). With reference to treatment plants, environmental issues such as odour occurring
as a result of effluent discharge and the possible impact that this has on the corporate
image of the Water authority could be identified within this category. It needs to be
emphasized that there is no formal environmental cost classification structure developed
by regulatory bodies, similar to the U.S. EPA model (Kite 1995; Grinnell and Hunt III
1999; Gray and Bebbington, 2001; Deegan, 2005) that identifies environmental costs.
During the interview, personnel from the strategic planning department were asked if and
how the organization identifies and classifies environmental costs within the capital
budgeting process:
Not necessarily….. If we were able to quantify those environmental costs, we do include them as part of the analysis…..it’s part of the capital works manual there. It’s pretty difficult to actually quantify both environmental and social costs and I think that’s pretty much a major issue for all government trading enterprises really. It doesn’t matter if you’re a government or non government for that matter. Trying to identify and allocate… OK…we’re going to improve the environmental flows of this particular river or this creek, which is going to have a positive benefit downstream. Now, how do you actually quantify that in terms of, you know, the improved benefits downstream of that particular outcome?. I mean..to a certain extent….we definitely look at those environmental and social impacts, but we don’t actually quantify them and say the value of this is a million dollars or the benefit of this is half a million dollars, we say, Ok, there are going to be improved environmental outcomes or we’re going to deliver better water quality for the township of x and y and stuff like that but we don’t actually put a figure to them and say this is going to result in $50000 or $100000 in that respect.
the improved outcomes are identified but not quantified.
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In the decision making process, we consider the operational costs of various types of treatment plants through the options evaluation process. Once an option is decided to proceed with, the ongoing costs become part of our normal recurrent budget and the capital investment, so they’re separated once you basically decide this is the type of treatment plant we’re going to build, that’s the way to go. When you’re evaluating what type of plant, or all the options, you consider the cap x or op x range, which include all those bits about monitoring and the costs to run the plant.
Research undertaken by Parker (2000a) found that seven of the eleven companies
interviewed reported that they separately identified environmental capital costs of any
project or other activity. Subsequent to this, it was asked how does the water authority
incorporate contingent liabilities, tier 2 of the U.S. EPA model (Kite 1995; Grinnell and
Hunt III 1999; Gray and Bebbington, 2001; Deegan, 2005), into the capital investment
decision making process:
I think contingent liabilities, they’re almost in the same basket as your environmental and social benefits, to be honest. I mean, how do you actually, in this type of business, how do you actually allocate a contingent liability and say, Ok, we might need to allow for a $100,000 in year 5 because of this or this particular process might happen or something like that. I mean, it just depends on how you actually equate contingent liabilities in this particular industry itself. Are you able to actually say, there is a risk of this treatment plant breaking down in year 5, therefore, we need to allocate $100,000 to upgrade this particular section of it, and if that is a quantifiable risk, then obviously that becomes part of the project evaluation process.
The difficulty in estimating contingent liabilities in the capital budgeting process appears
to be due to the difficulty in identifying the risk of a treatment plant breaking down and
then subsequently quantifying that risk. This is consistent with previous observations
(Kite, 1995; Grinnell and Hunt III, 1999; Burritt and Schaltegger, 2001). In the United
States, recognition of a contingent environmental liability is dependent upon estimability
(Barth and McNichols, 1994). Estimability depends upon the complexity of the site,
remediation alternatives, changes in remediation technology, uncertainty over cleanup
standards and the financial responsibility of Potentially Responsible Parties (Barth and
McNichols, 1994). Six of the eleven companies interviewed by Parker (2000a) identified
contingent liabilities within their accounting systems.
21
Discounting and the identification of environmental risk
All capital investment programmes undertaken by the Water Authority should be
evaluated using real discount rates of 6%, 8% and 10% and the recommended risk
premium to apply depends on the type of project (Barwon Water CWIP Manual, 2000).
Department of Treasury and Finance guidelines stipulate a risk premium of 2% for non
revenue generating investments, increasing to 6% for higher risk revenuegenerating
projects (Barwon Water CWIP Manual, 2000). Where selection of a particular project
option is sensitive to the discount rate used in the calculation of Net Present Values,
further consideration should be given to selection of a discount rate which is appropriate
given the actual risk associated with the project (Barwon Water CWIP Manual, 2000).
The CWIP Manual does not specifically identify environmental risk or environmental
risk premium, however, the policy appears to be where the risk is higher, the greater the
upward adjustment to the discount rate (Kite, 1995).
The proposition / question was posed during the interview that the costs at the end of a
plants life such as site cleanup and remediation can be significantly high, and that if a
high discount rate is used, then these costs can appear to be immaterial or inconsequential
in decision making. The response of the economist was as follows:
Yeah, that’s right. I suppose that’s an issue with the NPV process in itself, especially if you’re using a high discount factor, that anything beyond really years 10 sort of don’t really have the same influence when you’re using a significant discount factor, and particularly if you get from years twenty to thirty then it’s almost seems inconsequential as to what actual amount you put in there. I mean, if you’re using a discount factor of %12 or something like that, then, it doesn’t matter if you’ve got $50 million in year 25, that’s going to be discounted so far that its overall impact on the NPV process is going to be fairly minimal. But that’s the issue of trying to get that $50 million estimate in year 25 or whatever it’s going to be reasonably accurate. I think that’s just one of the pitfalls of the NPV process that, the benefits very much outweigh what the disadvantages of the process are.
22
This appears to be a recognition that the use of high discount rates by the water authority
may place pollution prevention projects at a disadvantage (Grinnell and Hunt III, 1999)
as the benefits of such projects are long term (Grinnell and Hunt III, 1999; Bartolomeo et
al., 2000). Accurate estimation of costs is one means of attempting to address this
problem, but accurate estimation of environmental costs, in particular contingent
liabilities (Barth and McNichols, 1994; Kennedy, Mitchell and Sefcik, 1998) is difficult.
Environmental risk is identified and managed through compliance with EPA regulations,
as explained by the manager, strategic planning:
Risks are primarily dealt with in compliance. When we look at the treatment plants, we’re looking to see have we got a margin for safety, and those elements, and we also look at the byproducts, where they may be, sludge, the water quality criteria, they’re the major risks associated with, the reliability of the plant, and so, to the degree, compliance is the driver. So there’s redundancy built into the plants, to make sure that if something breaks down, we can bring something else on. So there’s backup. That’s how it’s managed.
Compliance with EPA regulations is seen as managing Environmental Risk. However,
there was no indication that the manager believed that environmental risk extended
beyond the boundaries of the organizational “entity” (Kite, 1995).
Environmental capital budgeting projects – Mandatory vs Discretionary
A significant portion of the water authority’s capital investment is mandatory due to
regulatory requirements, as explained below:
From our perspective, a lot of that investment is not discretionary because we have to put in the treatment plants to meet the regulators …
EPA guidelines...
standards, so in a sense, the decision as to whether we’re going to build a treatment plant or not is not discretionary. So the discretionary powers come from what sort of plant would we build and whether we got or do we invest in spare capacity for the future. And our processes now require
23
valuing the varying processes to be undertaken with those sorts of projects and that’s …the purpose of that is to try and eradicate the gold plating and come up with some sort of reasonable compromise between future and present demand and ……
Subsequent to this, the question was asked how important is the role of the NPV or IRR
calculation when there is a regulatory requirement to undertake a capital investment:
I mean, basically, as Ian mentioned earlier, in terms of discretionary expenditure, it’s not all that discretionary in terms of, OK, we might have three or four different options, and we’ll do an NPV analysis on that to see which one comes up best, but a lot of the times when you do the NPV analysis, it’s not necessarily going to be a net present value, it’s more likely to be a net present cost, in terms of, OK, if we upgrade a water treatment plant somewhere in a certain town and say OK, this treatment plant is going to provide better quality water to all these customers, say 5000 customers in this area, I mean, what are the benefits associated with that, I mean it’s going to cost us $5 million ,what are we getting in additional revenue, we’re not getting additional revenue besides those new customers coming on line in the next 10 or twenty years which is fairly insignificant, I suppose you would say.
Those existing customers, we would still get the revenue from them regardless of whether we upgraded that treatment plant or not. I mean, to a certain extent, the NPV sorts out which are the best options in financial terms, but, in terms of only going ahead with this particular capital works program because it’s got a NPV of greater than five million or ten million or whatever your threshold might be, it’s not really relevant to this industry, really.
We do all that, I mean, the capital works program, the NPV calculations are done, we’ve got a process where we look fairly crudely at the risks, there are some issues there, but a lot of it is driven by meeting obligations. The component of asset management is in there, that’s a recognition that we’ve got this huge asset base that needs to be maintained, and there’s a component of growth. And it relies heavily on the internal knowledge of people about when we need to do this.
The Department of Natural Resources and the Environment (DNRE), which is
responsible for price reviews of water and sewerage services (DNRE, 2000), recognizes
that capital investment is the key determinant of operating costs and therefore future price
and revenue needs (DNRE, 2000). In particular, it suggests that the prices set for water
businesses should discourage ‘gold plating’ by providing only for that level of investment
necessary to satisfy agreed service standards. (DNRE, 2000).
24
There is also recognition by a key stakeholder, the Government, that capital expenditure
may be deferred by increasing operating expenditure on asset maintenance or demand
management (DNRE, 2000). As well there may be tradeoffs between operating
expenditure, capital expenditure and service levels (DNRE, 2000). This can be compared
to the case of the privatized UK water utilities where discretionary expenditure has been
associated with higher shareholder returns due to the perception by shareholders of
improvements in profit levels and risk exposure (Ogden and Watson, 1999).
The recognition that investment may be undertaken where there is net present “cost” is
not unusual given that in mandatory projects, such as a capital investment at Du Pont
chemicals (Ditz et. al., 1995) and compliance with the provisions of the Montreal
Protocol in the case of refrigerator manufacturers (Dunk, 1999), managers have little
discretion regarding investment in the project, and will undertake the project without
regard to its internal rate of return. (Grinnell and Hunt III, 1999). The lack of
discretionary, or voluntary, environmental capital expenditure by the water authority,
may indicate that management does not perceive a need to use disclosures of
environmental capital expenditures “as a tool for gaining or maintaining social
legitimacy” (Patten, 2005).
The role of capital budgeting techniques
The major capital budgeting technique employed by the water authority is NPV, as
explained during the interview:
25
I mean, basically, as Ian mentioned earlier, in terms of discretionary expenditure, it’s not all that discretionary in terms of, OK, we might have three or four different options, and we’ll do an NPV analysis on that to see which one comes up best, but a lot of the times when you do the NPV analysis, it’s not necessarily going to be a net present value, it’s more likely to be a net present cost, in terms of, OK, if we upgrade a water treatment plant somewhere in a certain town and say OK, this treatment plant is going to provide better quality water to all these customers, say 5000 customers in this area, I mean, what are the benefits associated with that, I mean it’s going to cost us $5 million ,what are we getting in additional revenue, we’re not getting additional revenue besides those new customers coming on line in the next 10 or twenty years which is fairly insignificant, I suppose you would say.
Those existing customers, we would still get the revenue from them regardless of whether we upgraded that treatment plant or not. I mean, to a certain extent, the NPV sorts out which are the best options in financial terms, but, in terms of only going ahead with this particular capital works program because it’s got a NPV of greater than five million or ten million or whatever your threshold might be, it’s not really relevant to this industry, really.
We do all that, I mean, the capital works program, the NPV calculations are done, we’ve got a process where we look fairly crudely at the risks, there are some issues there, but a lot of it is driven by meeting obligations. The component of asset management is in there, that’s a recognition that we’ve got this huge asset base that needs to be maintained, and there’s a component of growth. And it relies heavily on the internal knowledge of people about when we need to do this.
The water authority relies upon the NPV calculation to identify the best programme in
financial terms, however, relying upon an NPV calculation to make a capital investment
decision is not the only criteria the water authority adopts in its decision making process.
There also appears to be recognition by the manager of the limitation of the NPV in
addressing the long term impact of capital budgeting projects, supporting the view that
discounted cash flow models are biased against programs with long term payoffs, in
particular pollution prevention programs (Dunk, 1999; Grinnell and Hunt III, 1999;
Bartolomeo et al., 2000).
The comment that, “only going ahead with this particular capital works program because
it’s got a NPV of greater than five million or ten million or whatever your threshold
might be, it’s not really relevant to this industry” may imply that NPV may lack
26
subjectivity (Bowerman and Hutchinson, 1998), as a capital budgeting technique. The
interviews also highlight that limitation of the NPV as it ignores externalities such as the
depletion of scarce resources or pollution (Bowerman and Hutchinson, 1998). This
limitation is also highlighted in the capital works investment plan manual of the water
authority. It specifically identifies that unquantifiable costs and benefits are to be
excluded from capital investment calculations. However, where costs and benefits cannot
be directly measured or valued, such as aesthetics, odour and public image, they should
be listed and quantified where practical within the decision making process, making it
clear to the decision maker that they are additional factors to be taken into account
(Barwon Water CWIP Manual, 2000).
The life of capital projects / Life Cycle Costing
When the water authority undertakes its capital works plan, it does not adopt a life cycle
analysis approach:
From a very crude perspective when the options are developed, in picking an option, evaluating the options, but it’s not done, when we do the capital works plan every year, we’re not looking at a life cycle……a project comes on ….
Unless that particular project is a water resources augmentation that we’ve allocated x million dollars for and we’re looking at that say in comparison to something else…is that building a new dam or is that using more reclaimed water option or something like that…it’s basically when we’re looking at certain projects that might have a number of options in terms of the longer term here in the organisation but I would say in general probably not.
As distinct from life cycle costing and analysis, sewerage treatment plants for example,
have a useful life of forty years, but the associated project evaluation programme may be
for twenty years:
You look at the various components. All the treatment plants have, generally, a replacement equipment allocation every year, so they’re ongoing, if a pump breaks down, some electrical or
27
mechanical stuff needs to be replaced, that’s replaced. In terms of the total, civil asset, they will have a much greater life cycle than fifty years and they are rehabilitated on an as needs basis in terms of…that’s the general thrust of things. You get to a place like Colac, where the treatment plant has been there since 1925, and been upgraded by add on components to improve its performance over a period of time. We’re now at a stage where we have to produce an even better quality effluent, so we’re going to have a greenfields site. Abandon all the existing treatment processes and build something on the same site. A completely new process. But that’s not always the case. It depends what standards you’re trying to meet, what we think the future’s going to be.
A lot of those things are picked up as part of your ongoing costs. You might have a fortyyear useful life for your treatment plant but your project evaluation might be twenty years. Having said that, you might have mechanical, electrical equipment which needs to be replaced every five years, which is $10000 say, so you allocate that as part of your project evaluation process so you’ve got $10000 in year 5, $10000 in year 10 etc. etc. and the same thing for civil, and the same thing for any other ongoing costs that you might have as part of the treatment plant itself. Just because you’ve got that initial $10 million capital contribution, doesn’t mean that everything else is going to be a benefit from there on.
The life of the project evaluation programme therefore includes waste management (Kite,
1995; Deegan, 2005). Whilst the water authority does not specifically adopt life cycle
costing, it does attempt to identify internal and external environmental impacts over the
life of its capital budgeting programme, which is similar to the principles of life cycle
costing (Epstein and Roy, 1997).
The benefits of identifying and measuring environmental costs within the capital
budgeting process.
Whilst the water authority does not adopt a formal environmental cost classification
model within its capital budgeting process, it does recognize benefits from undertaking
capital expenditure for the purpose of satisfying environmental regulations:
I mean, well, obviously, there’s the improved quality of the receiving waters, environmentally, that’s a major benefit, it does produce a quality of effluent, a resource that can be used……….
I think that there are obviously improved social outcomes in terms of the treatment plant investment and stuff like that as well. I mean if we look at Black Rock and the effluent that was going out in the late 80’s before the treatment plant was actually upgraded, and now the feedback that we get from a lot of our customers in terms of what’s actually going out there and people are surfing out there and all that sort of stuff then I think the overall…. its not only the perception from our customers, it’s the perception of Barwon Water that we’re doing the right thing by their
28
customers and by the environment. It’s been much improved since that treatment plant was upgraded.
It’s pretty hard to quantify something like that in terms of improved corporate image or something like that, I mean it’s just one of the factors that’s attributed to….
Those environmental benefits are not, don’t flow back to our business, having a better quality of receiving waters, having more fish in the vicinity of black Rock or whatever it may be, they don’t actually come back to our business in any financial way. We’re not able to determine that. It would be drawing a long bow to say that because we cleaned up the environment, those waters, it’s made the whole area more attractive and therefore, there’s more people coming to the area and we’re getting more customers. I think that that would be very long bow to draw in terms of our financial considerations. We don’t include those.
The (intangible) benefits of undertaking environmental regulatory capital expenditure,
whilst recognized in the interview, are not quantified within the capital expenditure
process. In particular, improved social outcomes, improved customer acceptance and the
perception that the water authority is doing the “right thing” is evidence of less tangible
benefits (Grinnell and Hunt III, 1999) that may affect the goodwill (Deegan, 2005) of the
water authority. This is also similar to an observation by Ogden and Clarke (2005), who
observed that, in the case of the privatized UK water utilities, improvements in the
quality of waste water were used as evidence for claims that companies had become more
customer focused, were responding positively to customer expectations and were
conforming to principled ideals.
Conclusion and limitations
The water authority identifies costs for capital investment decisions in its Capital Works
Investment Plan. These costs include capital costs, opportunity costs and operating and
maintenance costs. There is no classification of environmental costs within the capital
budgeting process, as there is no regulatory requirement. The existence of environmental
29
costs was recognized, however, it was explained that they are difficult to measure, in
particular, contingent liabilities.
There was recognition and agreement that the discounting of long term costs within the
NPV process may be to the disadvantage of pollution prevention projects, which was
highlighted as a limitation of the NPV technique itself. With respect to environmental
risk, this was addressed through compliance with EPA regulations, however, there did
not appear to be a recognition of that risk extending beyond the boundary of the entity
(Kite, 1995). In addition, environmental capital budgeting projects were seen as
mandatory, as they are determined by EPA regulations, which meant that investment was
undertaken, in some instances, irrespective of the NPV calculation.
The NPV appears to be the primary capital budgeting technique employed, but the water
authority attempts to take into consideration unquantifiable costs and benefits by
considering them as additional factors to be taken into consideration in the capital
budgeting process. In particular, there appears to be recognition of the less tangible
benefits of undertaking environmental regulatory capital expenditure, such as improved
social outcomes, improved customer acceptance.
The study was limited due to the fact a single case study was undertaken. The results and
findings therefore cannot be generalized beyond the existing case study. A multiple case
study would have enabled similar results to be predicted (literal replication) or
contrasting results produced but for predictable reasons (theoretical replication) (Yin,
1994). Multiple case study evidence is considered to be more compelling and robust
30
(Yin, 1994). This case study therefore may provide the basis for future case studies that
may develop further observations (Williamson, 2000) of the identification and
measurement of environmental costs within the capital budgeting process.
31
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34
Appendix 1
INTERVIEW WITH MANAGER – STRATEGIC PLANNING AND
ECONOMIST –STRATEGIC PLANNING
KEY QUESTIONS
Qu. 1 What are the goals and objectives of capital expenditure decisions at sewerage
treatment plants?
Qu. 2 Are there any constraints on longterm capital expenditure decisions?
Qu. 3 The profit of the water authority is governed by the prices that the government
sets. Does this shift the emphasis from longterm decision making to shortterm
decisionmaking?
Qu. 4 What would you classify as environmental costs in your capital expenditure
decisions?
Qu. 5 How do you identify and classify these costs in your capital expenditure
decisions: a) Compliance with environmental regulations b) Monitoring costs c)
Materials costs and d) Treating and disposing of waste?
Qu.6 What do you identify as the economic / useful life of a sewerage treatment plant?
Qu.7 It is argued that the costs at the end of the life of a chemical plant, for example,
such as cleanup costs, can be very high, and if you discount those costs too
heavily, they can be immaterial or inconsequential in decision making, whereas at
the time of cleanup, they can be quite high. What is your opinion of this argument
with respect to sewerage treatment plants?
Qu.8 What do you identify as the benefits of incorporating environmental issues into
capital expenditure decisions?
35
Qu. 9 With respect to the privatization of water authorities in the United Kingdom, there
is a recognition that “discretionary expenditure undertaken to improve the quality
of service, in this case, the quality of treatment, may be detrimental to short term
profit, but over the longer term, it may be associated with higher long term returns
because there may be a perception that future profit levels and risk exposure may
be improved”. How does this argument apply to expenditure undertaken by the
water authority to improve the quality of treatment at sewerage treatment plants?
Qu. 10 When capital expenditure is undertaken in order to comply with EPA regulations,
how important is the role of the NPV and / or IRR calculations?
Qu. 11 How do you identify and assess environmental risk in capital budgeting decisions
at sewerage treatment plants?
Qu. 12 What is the role of life cycle costing / analysis in the capital budgeting process at
sewerage treatment plants?
Qu. 13 How do you estimate / measure / contingent liabilities into the capital budgeting
process with respect to sewerage treatment plants?
Qu. 14 In your role as manager of the sewer segment, how did you incorporate
environmental considerations into your budgeting for direct costs at the start of
each year? Did your expense category of corporate expenses include any items
that could be classified as environmental expenditure?
Qu. 15 Could you explain why overheads are traced to one account in the sewer segment,
organizational overheads, and not to the individual treatment plant account
department, as there are arguments that this would improve decisionmaking?
36
Qu. 16 Has the requirement for cost recovery (to recover costs from other segments /
departments that provide services to the sewer segment) had any impact on the
direct costs of treating effluent? Was the requirement for cost recovery driven by
the Council of Australian Governments (COAG) water reform package? Has this
had any impact upon environmental standards?
Qu. 17 How do you identify the relevant / incremental costs associated with the
evaluation of different methods of effluent treatment (e.g. reuse as opposed to
disposal)?
Qu. 18 What are the objectives of the water authority with respect to effluent treatment
and discharge and how are they measured at a strategic level?
Qu. 19 What are the financial objectives with respect to effluent treatment and discharge
at a strategic level and how are they measured?
Qu. 20 What is the objective / function of the Environmental Management System
(EMS)?
Qu. 21 Does the EMS examine how the meeting of environmental objectives impacts
upon financial objectives / goals or the relationship as to how environmental
activities impact upon financial activities?
Qu. 22 How do you measure the objectives of the EMS? Does the EMS contain any
financial performance indicators?
Qu. 23 How do you identify /define environmental information with respect to effluent
treatment and discharge?
Qu. 24 How does your risk management strategy operate with respect to sewerage