TCA – Capturing environmental costs and savings in investment appraisal

17th March 2008

As our general awareness of the importance and potentially lethal outcomes of environmental impacts has grown, the task of investment appraisal has become complicated by the need to recognise and account for environmentally induced future costs. Total Cost Assessment or TCA is one technique that provides long term and comprehensive financial analysis of the full range of internal or private costs and savings of an investment. This includes less tangible costs, into the financial evaluation of projects and programmes so that environmental considerations are fully accounted for. Niki Leahy, FSN senior writer explains the technique.

Total cost assessment expands traditional financial analysis by including a consideration of:-

  • An expanded cost inventory, that includes less direct, less tangible costs.
  • A comprehensive allocation of costs that may usually be assigned to overhead and are allocated on the basis of an inappropriate cost driver or not allocated at all.
  • An extension of the time horizon, in order to better capture the full benefit of the investment, a significant portion of which may be realised after the first 2 -3 years and use of longer term profitability indicators such as NPV and option value which account for the time value of money, making the results more realistic and reflective of an investment's true cost or benefit.

Developments in TCA have been led by the chemicals industry, with other sectors including utilities and pharmaceuticals also active in applying the technique. Other industries where uncertainty in the potential and / or future costs of environmental remediation and clean up is increasing are also using the assessment process.

As an investment appraisal technique, total cost assessment comes into its own when it is used to assess with greater accuracy, which environmental investment is the most economically favourable. As a methodology, it can also evaluate the potential health impacts and costs that may result from exposure to environmental pollutants. However, its primary role lies in including the costs and benefits derived from the environmental initiatives and policies on the balance sheet and in decision making. It does this by identifying, analysing and improving cost estimates in key areas such as energy, waste and pollution prevention, both internally and externally, as the case studies below illustrate.

Evaluating environmental projects using TCA means that projects that may appear to be financial weaker using conventional analysis look stronger and more competitive once their true return has been identified. For example, an investment in a process change that considers only direct labour and material costs over a three year period will appear a poor investment option until the full environmental costs of the existing process – including disposal costs, regulatory permits, worker health, liabilities for spills or leaks are included in the analysis which is considered over a longer period. This may well yield an impressive rate of return and a shorter than expected discounted payback.

The table below illustrates a conventional & TCA approach to financial analysis for a pollution prevention alternative. This process modification would require a capital investment of approximately £1.7m, and changes to operating costs.

Capital investment of £1.7m, operating costs and savings analysed include:-

In addition to the cost analysis outlined in Column 1, the TCA included the following assessment of savings:-

increase in raw material costs - £180,000

energy & chemical use for new equip. £200,000 per annum

reduction in waste water treatment fees of £500,000 per annum

increase in labour costs of £2,000 per annum

Management expects to reduce future liabilities by reducing waste sent off site

reduction in use of fresh water, reduction in use of freshwater treatment & pumping

= savings of £100,000 per annum

reduction in energy use for freshwater heating = savings of approx. £300,000 per annum

reduction in waste water generation & savings of approx £50,000 in waste water pumping & £70,000 per annum in pre-treatment maintenance costs

enhanced company image, & reduction in future permit costs of £50,000 per annum

reduction in future liabilities from current off site treatment range up to £3m, with the probability of incurring future liability very low due to extensive monitoring & control procedures in place

The American Institute of Chemical Engineers' (Centre for Waste Reduction Technologies) TCA programme identifies five types of costs; type 1 are direct costs; type2, potentially hidden costs; type 3, future & contingent liability costs; type 4, internal intangible costs; type 5, external costs. Potential costs are identified first using company specific information. The analysis is stream lined by considering only those costs deemed potentially high. Probability is also assessed. Type 3 future and contingent liability costs considered include data drawn from past data and future estimates for spending on pollution control equipment, remedial costs of plant contamination, natural resource damage costs, potential liabilities for offsite contamination, industrial process risk, including cost data for past industrial accidents.

A similar TCA model to the CWRT one has been developed by the US Tellus Institute. This stratifies costs into four tiers, omitting the external costs which are accounted for under a full cost assessment process.

The Tellus Institute have also developed a spreadsheet software application, P2/FINANCE, which is designed to capture a broad range of potential environmental costs and savings, including internal indirect and less tangible environmental costs, using profitability indicators and time horizons that capture long term characteristics of environmental investments, over appropriate timeframes. As well as the additional costs and savings that a TCA can reveal, anticipated changes in annual revenues can also be calculated. A TCA analysis can help identify where improved customer service can be made, or where additional services or product types can be developed, as well as quantifying improved overall process controls, increased capabilities, and faster turnaround.

In summary TCA can be used as a model for making procedural changes and operational changes, as well as for decisions related to capital equipment purchases. Traditional business financial decision tools focus on the financial impact of a purchase or operational change without considering the environmental aspects. Main considerations were capital cost, operational cost, interest cost, and return on investment. This approach ignores key changes that every business must be concerned with, including the impact of investment decisions on employees, on energy requirements, on permits, on plant layout and so on. By considering environmental impacts upfront, a company can anticipate future environmental impact – making sure that there are no costly surprises later.