BA 850
Sustainability-Driven Innovation

 

Regulatory Risk and the Hidden Cost of Compliance

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Some Liabilities are Not Recorded on any Balance Sheet

As we continue to discuss the third of the 3Ps, Profit, we may tend to think of those affirmative actions an organization takes which help it turn a profit, therefore helping it remain solvent and sustainable in the long term. This is certainly true. But it is also important to consider how a byproduct of sustainability efforts can invisibly affect an organization's bottom line by reducing or eliminating the costs of regulatory compliance.

Not many organizations have a clear picture of what exactly having to comply with a given regulation costs the organization every year, in terms of productivity, additional capital and equipment, handling areas and disposal contractors, additional training for employees, recordkeeping requirements, or any other factors. It may be a fun exercise for an otherwise bored actuary to take on, but it is a bit pointless for most operations: why go through the significant complexity of the calculation when the end result remains that the facility still has to comply with the regulation?

In an increasingly competitive international marketplace, operating a business exempt from regulations which may hinder the speed or profitability of peers could be a strategic strength. Unfortunately, the way for some organizations to operate without regulatory oversight is not to reduce the substances or practices being regulated, but to simply conduct those operations overseas in a region with little or no meaningful regulation to start with.

The Hidden Costs of Compliance

So while very few organizations would have a reason to calculate the incremental cost of every environmental or labor regulation they are subject to, in some cases, isolated regulations may be accounted for if they affect operations in a significant way. Despite a concerted effort to understand the cost of complying with a given regulation, evidence shows that organizations may still significantly under-account for the costs of regulations.

In one examination of plant-level financial data of 55 steel mills, Joshi, Krishnan, and Lave (2001) found each was significantly lacking in capturing the total cost of complying with a specific set of new regulations. Emphasis is mine:

The results indicate that visible costs, as reported by these firms’ accounting systems, identify only a minor portion of the overall costs associated with regulatory compliance. For firms in the integrated mill sector, a $1 increase in visible environmental operating expenditure is associated with an increase of $9.23 in total cost (at the margin), of which $8.23 is hidden, and embedded in accounts other than "regulatory costs." Similarly, for firms in the mini-mill sector, an increase of $1 in the visible environmental operating expenditure is associated with an increase in total cost of $10.68 (at the margin), of which $9.68 is hidden. Thus, considering only the visible costs of environmental regulation will seriously underestimate the effect of regulation on cost and profit.

We also conducted structured interviews with corporate-level executives and plant-level accountants from seven steel firms to validate our econometric estimations and to gain insight into such questions as: are the managers aware of the large hidden costs of environmental regulation? What are the reasons for the large hidden costs? What types of decisions are large hidden costs likely to affect? We found that the managers are aware of these hidden costs but seriously underestimate their magnitude. The managers cited several reasons why the accounting system does not identify all environmental costs: difficulty in separating the environmental portion of the incremental costs of materials, utilities, and overheads; problems of aggregation across plants and functional departments; and complexity in separating environmental component of costs of process changes that have multiple objectives.

Our finding that the steel industry suffers from large hidden costs has implications for the design of costing systems in industries facing significant environmental regulations. Gross under-estimation of hidden costs is likely to lead to sub-optimal decisions in managing these costs. Hidden costs may distort variance analysis, contribute to product mis-pricing, and lead to inappropriate product mix, plant closure, and investment decisions. Our interviews reveal examples of these effects. We conclude that managers have under-estimated the magnitude of hidden costs, and our results suggest that they should reconsider the costs and benefits of updating standard costing systems to better track environmental costs.

In addition to the costs of compliance at the Federal level, we can not forget about the highly variable state regulations. Levinson(2001) created a model to index state environmental compliance costs, and found that the variation in compliance costs between states was significant:

Expenditures on pollution abatement in 1994 ranged from 0.5 percent of GSP in Nevada, to 6 percent in Louisiana. While much of this difference is accounted for by differences in the two states’ industrial compositions, the industry-adjusted index for the most expensive state (Maine) remains 1.7 times the national average, and 4.13 times as large as for the least expensive state (Nevada).

A more personal story of the hidden cost of environmental regulation is provided by Drew Greenblatt, President of Martin Steel in a piece he wrote for Inc.(2013):

When I testified before Congress last winter about the impact of regulatory excess on business, a Congressman posed this question: Don’t the total benefits of environmental regulation offset their cost? After all, the Office of Management and Budget has estimated the regulatory benefits exceed the costs by as much as 16 to 1. Other estimates have found even higher benefit-to-cost ratios, he said.

But the analysis omits one major question: How do you calculate the opportunity cost of thousands of small businesses like mine whose employees are focusing on regulatory paperwork and agency communications instead of serving and finding customers? I’m not sure how those costs are being measured. Is it by the amount of federal employee time and resources put into the effort? Or by the amount of time my employees are filling out forms? (By the way, according to that study that the congressman referenced, the benefits of EVERY agency’s rules outweighed the costs. And the more rules an agency had, the greater the benefits over the costs. Who knew?)

My company’s success relies partly on our ability to reach the 95 percent of consumers who live outside the U.S. But unnecessary paperwork impedes that mission. While we need only three minutes to fill out the requisite form when we ship to Canada or Mexico, it takes us 20 minutes per form when shipping to a non-NAFTA country. If that happened on rare occasion, no big deal, but multiply that step hundreds of times a year and it becomes a mountain. A few years ago, we took a photograph of two Martin Steel employees standing beside the cartons that held our files to respond to government regulations. The stack was three feet taller than they were--and would be even higher today.

Every Risk is an Opportunity for Innovation

As we begin to merge from understanding the pure frameworks and philosophies of sustainability and into the process of layering understandings of how to find opportunities in sustainability, we will continue to revisit and reinforce those earlier frameworks and philosophies. In this case, I'd like us to do a little bit of that now, in consideration of our discussion of regulatory risk and the hidden costs of compliance.

In each of the three examples above–the poor accounting of the cost of compliance by steel mills, the tremendous variance of the cost to comply with state environmental regulations, and the Martin Steel example of compliance paperwork–we need to realize one important point before moving on:

Without exception, each case represents a unique opportunity for innovation and the creation of a service, software, or product offering.

This is why impartiality will be so important in our work together this semester. Do you have a personally-held belief on the situation in each of the examples above as being unjust or overstated, oppressive, regressive, or progressive, believing that regulations go too far or not far enough? Save it for the kitchen table.

When we are talking about finding opportunity for innovation, we have to be able to turn off that biasing part of our brains to be able to recognize the underlying needs of the situation at hand. Those needs may not necessarily fit our organization's competencies, or perhaps they do, but we first need to be able to see without bias:

  • Steel mills could use a good accountant and consulting firm to help them capture regulatory costs more appropriately, or a software package to help in creating uniform assumptions of environmental costs. According to the findings of the paper, it's fairly safe to say there are at least 55 steel mills who could potentially need the product.
  • The huge variation in state compliance costs offers similar opportunities, from consulting to software to clearinghouses of data to assist in financial projection. I would be curious how organizations with nexus in many states would account for the differences in state compliance costs, if they do.
  • Mr. Greenblatt's example of NAFTA v. Non-NAFTA paperwork sounds like a problem many companies could have, and one which occurs with high volume. Are there automation steps, software packages, or regulatory fast-tracks to be benefited from?

Also note that being able to evaluate a situation impartially first does not mean that you suppress your beliefs, ethics, or otherwise... exactly the opposite. It simply means that the first operation is to see, and the second is to layer in our personal perspectives and experiences. Interesting developments and discussions can happen at that confluence of the impartial and the reapplication of our personally-held philosophies. It sounds esoteric, but we will begin to see it in our case discussions as the semester progresses.

Regardless of the needs and potential opportunities created from the need to comply, Porter and van der Linde offer an interesting perspective, and one which relies on data as opposed to a blindly-held belief:

We are currently in a transitional phase of industrial history where companies are still inexperienced in dealing creatively with environmental issues. The environment has not been a principal area of corporate or technological emphasis, and knowledge about environmental impacts is still rudimentary in many firms and industries, elevating uncertainty about innovation benefits. Customers are also unaware of the costs of resource inefficiency in the packaging they discard, the scrap value they forego and the disposal costs they bear. Rather than attempting to innovate in every direction at once, firms in fact make choices based on how they perceive their competitive situation and the world around them. In such a world, regulation can be an important influence on the direction of innovation, either for better or for worse.

[...]

A few studies of innovation offsets do go beyond individual cases and offer some broader-based data. One of the most extensive studies is by INFORM, an environmental research organization. INFORM investigated activities to prevent waste generation-so-called source reduction activities-at 29 chemical plants in California, Ohio and New Jersey (Dorfman, Muir and Miller, 1992). Of the 181 source-reduction activities identified in this study, only one was found to have resulted in a net cost increase. Of the 70 activities for which the study was able to document changes in product yield, 68 reported yield increases; the average yield increase for the 20 initiatives with specific available data was 7 percent. These innovation offsets were achieved with surprisingly low investments and very short payback periods. One-quarter of the 48 initiatives with detailed capital cost information required no capital investment at all; of the 38 initiatives with payback period data, nearly two-thirds were shown to have recouped their initial investments in six months or less. The annual savings per dollar spent on source reduction averaged $3.49 for the 27 activities for which this information could be calculated. The study also investigated the motivating factors behind the plant's source reduction activities. Significantly, it found that waste disposal costs were the most often cited, followed by environmental regulation.

Please read "Toward a New Conception of the Environment-Competitiveness Relationship" by Michael E. Porter and Claas van der Linde, from which I cited above. It's an excellent piece, and recounts specific examples of regulatory compliance as fertile ground for innovation.

Five word summary - Every risk is an opportunity