11.5 Identify and understand environmental costs in organisations
Leanne Gaul and Rina Dhillon
Environmental costs arise because of an interaction between economic and environmental activities. A positive relationship exists between the degree of impact and the extent of environmental damage. This underscores the importance of sustainability reporting, or even more specifically environmental accounting in this case, which seeks to identify environmental risks and consequently improve organisational efficiencies to reduce their impact. Environmental costs can present as traditional accounting expenses such as employee expenses, general expenses, service charges (taxes, fees, and levies), depreciation and amortisation expenses, maintenance expenses, education and training expenses and research and development expenses. All of these items appear in the income statement and as noted in Cbus income statement in the previous section of this chapter, can be undetectable without more specific information. Therefore, the <IR> reduces information asymmetry for stakeholders and provides for greater accountability to external stakeholders over environmental and social impacts. Let’s look at an example to get a deeper understanding of how environmental costs can be accounted for in the income statement.
There are four categories of environmental costs that can be used to better understand how environmental resource consumption is managed. These are:
Prevention costs
Prevention costs are costs incurred by a business to ensure that environmental problems do not arise, or the likelihood of environmental problems arising is minimised. For example, an organisation that implements a filtration system to eliminate chemical spillage into river streams is undertaking a preventative measure that eliminates the possibility of future environmental pollution impacting the eco-system around which it conducts its operations. Prevention costs avoid future problems from arising, and is seen as being a longer term, increasingly sustainable and more engaging method of environmental investment.
Appraisal costs
Appraisal costs are costs incurred by a business to monitor an organisation’s environmental exposures. Essentially, these are costs of monitoring the effects of business operations in relation to environmental performance. For example, an airline might invest a few hundred thousand dollars to implement electronic monitoring systems that measure fuel emissions of its aircraft as they age. When older airplanes start to show higher fuel emission, they may be retired from service. Monitoring systems don’t prevent problems from arising. If an environmental problem eventuates, monitoring systems allow for their prompt detection and subsequent management.
Internal failure costs
Internal failure costs are costs incurred by a business to address problems that arise within the company, resulting from negative sustainability related events affecting any company resource (people, materials, processes, etc.). These costs include the cost to fix technologies or care for employees owing to environmental incidents that may have occurred. For example, PT Industri Kereta Api (Persero) an East Javanese government company producing trains and carts, has numerous waste by-products including solid waste, liquid waste and noise/air pollution. It clearly has issues over noise, vibration, smell and emissions, as it pays a cost of nuisance permit, but how are the employees impacted by these issues? Some may not be mitigated and any costs that the company incurs for respiratory and health impacts to inhalation of emissions, physical impacts of vibration and noise which may lead to deafness and other side-effects to its employees would be categorised as internal failure costs.
External failure costs
External failure costs are costs incurred by a business to cover the costs or incur fines relating to environmental breaches that have impacted stakeholders outside of the business. Because organisations and broader communities share the environment collectively, the environmental problems caused by an organisation often have broader societal impacts. External failure costs are expenditures incurred to alleviate these broader societal and environmental impacts. For example, PT INKA pays a cost of nuisance permit each year for the purpose of protecting residents from noise, vibration, smell and emissions, however it is not clear how this mitigates these issues. Additionally, the company produces a large range of waste by-products which may cause highly impactful environmental damage if handled inappropriately. Thus any costs related to cleaning and maintain protected forest nearby, due to the emissions it produces or physical and consequently financial damage to local community residents would be categorised as external failure costs.
Keeping It Real: PT Industri Kereta Api (Persero) (PT INKA)
Basuki et al. (2018) conducted an investigation into PT Industri Kereta Api (Persero) (PT INKA) an East Javanese government company that produces trains and carts. This company produces three forms of waste; solid waste, liquid waste, and noise/air pollution. Within the PT INKA income statement, general and administrative expenses included numerous environmental costs and as it is not a requirement to clearly label these under environmental expenses the user of the report is not aware without further investigation. To get a deeper understanding of the environmental costs we are going to divide these into four main types:
(1) Prevention costs – activities that when put in place seek to avoid prospective environmental damage. Examples from PT INKA include:
- Facility maintenance fees: these are used to maintain facilities and equipment in the management of hazardous and toxic waste.
- Safety signage and barriers to prevent accidents
- Employee education and training costs related to environmental monitoring and other activities.
(2) Appraisal – monitor environmental risks with the intention to avoid exposure to damage through the occurrence of a risk event. Examples include:
- Coordination fee with environmental division team: this is to coordinate internal environmental team with local government officials.
- Cost of wastewater test for quality control
- Cost of air analysis and stack emissions
- Audit fees related to health and safety checks
- Installation of equipment to detect emissions
(3) Internal failure costs – environmental issues that arise within the company.
Whilst the company did not have any listed internal failure costs an example of this might be ineffective training in safety protocols over storing hazardous waste causing a breach of containment.
(4) External failure costs – are those adverse environmental impacts that affect the broader society. Examples include:
- Cleaning and maintaining protected forest due to emissions released by mills and dust particles from grid blasting and pigmentation processes. As this impacts the community surrounding the business premises it is an external failure cost.
- Additionally the cost of nuisance permit could also be viewed as an external failure cost, as there is a failure to mitigate the effects on the surrounding community of increased noise, vibration, smell, and pollutants.
This exploration of external costs generated by an organisation’s daily operations indicates a need for greater transparency and accountability to concerned stakeholders. By reporting this information, stakeholders are able to make more informed decisions, which does not only include those adversely impacted such as the local community, but customers of PT INKA, who place importance of operating sustainably. If this were the case, to maintain trade relationships broad transformative consequences would occur at PT INKA, including changes to operating processes and practices and the scope of reporting extended to greater environmental and social disclosures.
PT INKA focuses more on prevention and detection activities as indicated by the prevention and appraisal costs, rather than the internal and external failure costs. This indicates that this company is successful in avoiding internal and external environmental damage, which may be attributable to their prevention and detection activities, or they may not be reporting breaches, which may not be required under law in their jurisdiction. Ideally, organisations should focus on prevention and appraisal costs as opposed to internal and external failure costs. However, failure costs are not always clear. For example, would you invest $100 million into a prevention system to avoid an accident that happens once in a thousand years? These are difficult questions to answer and require careful analysis. Good cost–benefit analysis using accounting can better help to identify the failure costs to be weighed up against the costs of investment into problem prevention or appraisal.
Conclusion
For an organisation to become sustainable it requires substantive change commencing with an engaged, supportive, and communicative culture. In the exploration of sustainability reporting throughout this chapter it is clear that reporting is not merely an additional organisational practice, it is a whole new way of thinking, acting, and communicating. It is not limited to managers and employees, but across the supply chain. Whilst this type of reporting is relatively new when compared with traditional financial reporting, there are numerous sustainability tools, frameworks, standards, and advisory professionals entering the industry and providing greater choice for organisations.