-------
TABLE 3-7
FACILITY, OWNER COMPANY, AND PARENT COMPANY REVENUES
(Billions of 1990$)
Production Cost Category
1988
Total
Average
1989
Total
Average
1990
Total
Average
Fadlities (n = 212)
Revenues from sales of
pharmaceutical products (domestic
and international)
Nonpharmaceutical sales
Total revenues*
$13.4
$3.4
$16.8
$0.06
$0.02
$0.08
$14.6
$4.0
$18.6
$0.07
$0.02
$0.09
$17.0
$4.2
$21.2
S0.08
$0.02
$0.10
Owner Companies (n = 157)
Revenues from sales of
pharmaceutical products (domestic
and international)
Nonpharmaceutical sales
Total revenues*
$42.6
$42.6
$86.9
$03
$03
$0.6
$44.4
$48.2
$94.4
$03
$03
$0.6
$48.8
$48.9
$99.8
$03
$0.3
$0.6
Parent Companies (n = 68)
Revenues from sales of
pharmaceutical products (domestic
and international)
Nonpharmaceutical sales
Total revenues*
$73.3
$213.7
$2923
$1.1
$3.1
$43
$80.6
$215.1
$295.7
$1.2
$3.2
$43
$80.7
$218.7
$305.2
S1.2
$3.2
S4.5
'Pharmaceutical revenues and nonpharmaceutical revenues might not add to total revenues because of inconsistencies in survey
reporting.
Source: Section 308 Pharmaceutical Survey.
3-24
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TABLE 3-8
DISTRIBUTION OF SURVEYED FACILITIES
BY VALUE OF SHIPMENTS: 1990
($ Millions)
Value of Shipments
0
>0-1
>l-5
>5-25
>25-100
> 100-250
>250
Pharmaceutical
Shipments
Number
3
2
29
64
50
31
15
%
1%
1%
14%
30%
24%
15%
7%
Nonpharmaceutical
Shipments
Number
132
15
9
25
21
8
2
%
62%
7%
4%
12%
10%
4%
1%
Total Shipments
Number
3
11
17
65
62
36
18
%
1%
5%
8%
31%
29%
17%
8%
Source: Section 308 Pharmaceutical Survey.
3-25
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Company-level pharmaceutical revenues in the sample totaled $42.6 billion in 1988, $44.4
billion in 1989, and $48.8 billion in 1990 (see Table 3-7).' Total company-level revenues in the
sample (including nonpharmaceutical revenues) totaled $86.9 billion in 1988, $94.4 billion in
1989, and $99.8 billion in 1990. Average revenues remained essentially flat over the period at
approximately $600 million per owner company. Owner companies in the sample generated close
to 50 percent of total revenues from Pharmaceuticals.10
Parent company pharmaceutical revenues in the sample totaled $73.3 billion in 1988,
$80.6 billion in 1989, and $80.7 billion in 1990. Total revenues reported by parent companies
included in the survey came to $292.3 billion in 1988, $295.7 billion in 1989, and $305,2 billion in
1990. In 1990, parent companies generated 27 percent of their revenues from the sale of
Pharmaceuticals.
Table 3-9 shows the distribution of surveyed owner companies and parent companies by
total revenues. Approximately one-third of the owner companies reported revenues of less than
$25 million, one-third reported between $25 and $200 million, 21 percent between $200 million
and $1 billion, and the remaining 13 percent over $1 billion. Approximately one third of the
parent companies sampled reported revenues of less than $250 million, 16 percent between $250
million and $1 billion, 35 percent between $1 billion and $10 billion, and 16 percent over $10
billion.
3.2.3 Production Costs
The following section presents manufacturing, research and development, and
promotional cost data for the pharmaceutical industry.11 Research and development and
'Approximately 42 percent of the owner companies surveyed derive 100 percent of their revenues
from pharmaceutical sales.
"Company-level revenues from the survey and U.S. Department of Commerce are not directly
compared because foreign revenues are treated differently.
"Unless otherwise noted, all cost data is presented in 1990 dollars.
3-26
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TABLE 3-9
NUMBER OF SURVEYED OWNER COMPANIES AND PARENT
COMPANIES BY TOTAL REVENUES: 1990
($ Millions)
Owner Companies
Total Revenues
$0-$25
>:$25-$200
.>$200-$1,000
^$1,000
Number of
Companies
50
50
33
24
Parent Companies
Total Revenues
$0-$250
^$250-$1,000
.>$1,000-$10,000
>i$10,000
Number of
Companies
23
11
24
10
Source: Section 308 Pharmaceutical Survey.
3-27
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promotional costs are considered separately because of the critical role they play in realizing
long-term gains in the industry.
3.2.3.7 Manufacturing Costs
The most current data on costs of production in the pharmaceutical industry are available
from the Section 308 Pharmaceutical Survey. Table 3-10 presents cost data at the facility, owner
company, and parent company levels for the sampled entities. Costs are broken down into the
cost of pharmaceutical products and nonpharmaceutical products (including the cost of labor,
capital, materials, and overhead), total operating expenditures (e.g., energy, depreciation), and
research and development.
Product and operating costs rose from 1988 to 1990 in real terms at all three levels.
Excluding research and development expenditures, the total cost of production at the facility
level rose from $7.4 billion in 1988 to $9.6 billion in 1990, from $58.7 billion to $63.8 billion at
the owner company level, and from $149.1 billion to $177.3 billion at the parent company level.
The cost of pharmaceutical production as a percentage of the total cost of goods sold was
approximately 67 percent at the facility level, 33 percent at the owner company level, and 17
percent at the parent company level in 1990.
3.2.3.2 Research and Development
The cost of researching, developing, and obtaining market approval for a new drug is a
significant component of total production costs. According to the U.S. Department of
Commerce, the pharmaceutical industry spent approximately $11 billion in 1992 on R&D (U.S.
Department of Commerce, 1993). These expenditures amounted to more than 16 percent of
sales, one of the highest proportions for any U.S. industry. FDA estimates that 9 percent of all
U.S. industrial R&D is in Pharmaceuticals (FDA, 1990).
3-28
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TABLE 3-10
COST OF PHARMACEUTICAL PRODUCTION IN SURVEYED POPULATION
(Billions of 1990 $)
Production Cost Category
1988
Total
Average
1989
Total
Average
1990
Total
Average
Facility Level (n = 204)
Cost of pharmaceutical
products
Cost of nonpharmaceutical
products
Total cost of goods sold
$6.1
$13
$7.4
$0.03
$0.01
$0.04
$63
$3.1
$9.4
$0.03
$0.02
$0.05
$6.4
$32
$9.6
$0.03
$0.02
$0.05
Company Level (n = 98)
Cost of pharmaceutical
products
Cost of nonpharmaceutical
products
Total cost of goods sold
Total operating cost (not
including cost of goods)
Research and
development expenditures
$19.7
$39.0
$58.7
$35.6
$9.8
$02
$0.4
$0.6
$0.4
$0.1
$20.0
$43.0
$63.0
$40.0
$10.3
$02
$0.4
$0.6
$0.4
$0.1
$213
$42.5
$63.8
$40.0
$10.9
$0.2
$0.4
$0.7
$0.4
$0.1
Parent Company Level (n = 63)
Cost of pharmaceutical
products
Cost of nonpharmaceutical
products
Total cost of goods sold
Total operating cost (not
including cost of goods)
Research and
development expenditures
$253
$123.8
$149.1
$67.7
$14.3
$0.4
$2.0
$2.4
$1.1
$02
$27.6
$134.8
$162.4
$77.1
$15.6
$0.4
$2.1
$2.6
$12
$02
$29.7
$145.6
$177.3
$86.0
$17.4
$0.5
$23
$2.8
$1.4
$03
Source: Section 308 Pharmaceutical Survey.
3-29
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Section 308 survey data indicated a similar level of research and development
expenditures by the sampled owner and parent companies. Research and development cost data
were not available at the facility level. In 1990, research and development costs among the
surveyed firms amounted to $10.9 billion at the company level (an average of $100 million per
owner company) and $17.4 billion at the parent company level (an average of $300 million) (see
Table 3-10). R&D costs averaged approximately 20 percent of the cost of goods sold over the 3
years reported in both owner and parent companies. The reported expenditures include
nonpharmaceutical research and development expenditures as well.
The research required to discover and develop NMEs is central to pharmaceutical R&D,
because manufacturers of generics and chemically similar products build on the knowledge
produced in the course of developing NMEs. NMEs are discovered either through screening
existing .compounds or designing new molecules. Once synthesized, NMEs undergo rigorous
preclinical testing in laboratories and in animals and then clinical testing in humans to establish
the compounds' safety and effectiveness. Further clinical studies might be conducted following
market approval.
The primary component of R&D cost is labor. Pharmaceutical R&D draws on the
expertise of a diverse array of biological, chemical, and physical scientists to discover NMEs with
potential therapeutic benefits. Also of importance in pharmaceutical R&D is the opportunity cost
of capital, which can be quite high given the risk and time involved. By some estimates, for every
9,999 compounds on which research is conducted, only one drug product is introduced to the
market. A typical pharmaceutical company will require 9 to 12 years to bring an NME to market
(OTA, 1993).
Tuft's Center for the Study of Drug Research, a research institute specializing in the
pharmaceutical industry, recently estimated that it costs an average of $231 million ($1990) to
bring an NME to market. Approximately half of this total is the cost of capital (DiMasi, 1991).
In a recent study of the costs of pharmaceutical R&D, OTA estimated that the aftertax R&D
cash outlay for each NME that reached the market in the 1980s was about $65 million ($1990).
The full aftertax cost of these outlays, compounded over 12 years to the day of market approval
was approximately $194 million ($1990) (OTA, 1993). Moreover, these costs include R&D
3-30
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expenditures for unsuccessful as well as successful product development efforts. OTA points out
that the cost of pharmaceutical R&D is highly sensitive to changes in science and technology and
in the regulatory environment, both of which are continuously evolving. Consequently, the study
warns that one cannot predict future R&D costs from current estimates, which are based on
R&D costs for drugs that went into development more than 10 years ago. Some evidence exists
that pharmaceutical R&D is becoming more expensive over time as firms devote greater
resources to hiring scientists, investing in new technology, and submitting their products to more
extensive preclinical and clinical testing.
3.2.3.5 Marketing
Promotional expenditures account for approximately 22 percent of the industry's revenues
(Day, 1993). Promotional expenditures tend to decline as a percentage of total sales over the life
of the drug. For example, OTA estimates that in the second year following market approval,
promotional expenditures account for 50 percent of sales. By the product's tenth year, however,
promotional expenditures will have declined to only 6.5 percent of sales (OTA, 1993). Many view
these high promotional expenditures as evidence that the industry does not compete on the basis
of price and instead devotes excessive resources to product differentiation through advertising.
Others contend that these promotional expenditures serve to educate physicians and allow new
competitors to enter specific drug markets (see Section 3.5.1).
3.2.4 International Trade
3.2.4.1 US. Department of Commerce Data
The U.S. pharmaceutical industry has consistently maintained a positive balance of trade
in international markets. In 1991, the industry's trade surplus totaled $961 million, and the U.S.
Department of Commerce estimates that it exceeded $1.3 billion in 1992. Exports totaled $5.7
billion in 1991 compared to $4.8 billion in imports. Nearly 47 percent of the industry's exports
were to the European Community in 1991. With $947 million in U.S. drug purchases, Japan
3-31
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represented the greatest single-country importer of U.S. pharmaceuticals. On the import side, the
United States purchased $831 million in pharmaceuticals from the United Kingdom. Figure 3-7
show U.S. pharmaceutical exports and imports for 1991.
The United States holds a dominant position in many international pharmaceutical
markets. In Europe, for example, U.S. pharmaceutical companies account for 25 percent of total
pharmaceutical sales. The United States also has a strong presence in Japan with 10 percent of
the market. Worldwide (including the United States), U.S. companies account for 33 percent of
total pharmaceutical sales (FDA, 1990). In important markets such as the United States, the
United Kingdom, and France, U.S. companies have introduced the largest percentage of new
drugs. Even in Japan, the United States is second only to Japan in new drug introductions.
As in many U.S. industries, foreign investment in U.S. pharmaceutical companies
subsided in 1992 after peaking in the late 1980s. In 1990, foreign investment in U.S.
pharmaceutical companies totaled $10 billion, while U.S. investment in foreign pharmaceutical
companies totaled $10.6 billion.
The U.S. Department of Commerce expects the United States to maintain its strong
position in international markets over the next decade. Nearly 33 percent of worldwide
pharmaceutical R&D is conducted by U.S. firms, thus providing the United States with a
competitive edge for developing new drug products. The North American Free Trade Agreement
(NAFTA), the advent of an economically unified Europe, and the increasing recognition of U.S.
patent laws in China, Mexico, and Latin America, all suggest continued strength in international
markets for the U.S. pharmaceutical industry. Greater political stability in the former Soviet
Union and other Eastern Block countries also will create new trading opportunities for the U.S.
pharmaceutical industry.
3.2.4.2 Survey Data
According to the Section 308 survey data, international sales account for a significant
proportion of the total revenues of surveyed facilities, owner companies, and parent companies.
3-32
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This finding is not surprising given the multinational character of the pharmaceutical industry
(nearly 50 percent of the parent companies of surveyed facilities are headquartered in foreign
countries). At the company level, international sales accounted for over 25 percent of all
pharmaceutical revenues generated in 1990. Nearly 50 percent of all pharmaceutical sales made
by parent companies in 1990 were to foreign countries. International sales are an important
component of overall pharmaceutical sales at the facility level as well. Table 3-11 presents the
distribution of surveyed facilities by percentage of pharmaceutical shipments accounted for by
international sales. Although a substantial number (44 percent) of the surveyed facilities reported
no international pharmaceutical sales, over 20 percent of the facilities reported receiving more
than 10 percent of their pharmaceutical revenues from international sales in 1990. The mean
pharmaceutical export rate for sample facilities was 8.8 percent in 1990.
3.2.5 Financial Conditions
The Section 308 Pharmaceutical Survey collected data on company costs, revenues,
liabilities, earnings, and other financial statistics. These data allow key financial ratios to be
calculated. The ratios are measures of a company's ability to meet short- and long-term
obligations and to generate a sufficient return on investments. This section presents baseline data
on two financial ratios: (1) rate of return on assets (ROA), and (2) interest coverage or times
interest earned ratio. These ratios will be used in Section Five to assess economic impacts at the
owner company level.
Financial ratios are calculated at the owner company level only, where firm impacts are
most direct and substantial. The ratios are also compared with industry benchmarks obtained
from Dun & Bradstreet Information Services. As explained in greater detail in Section 3.4,
baseline ratio data are used to identify firms whose financial condition, independent of regulatory
action, is sufficiently poor as to jeopardize their ability to make investments in wastewater
treatment systems. These firms are at risk of financial failure even without regulatory impacts.
A variety of financial ratios are available for measuring the financial health of
pharmaceutical companies, including ratios addressing liquidity, asset management, debt
3-34
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TABLE 3-11
NUMBER OF FACILITIES BY PERCENTAGE OF
PHARMACEUTICAL SHIPMENTS EXPORTED
Percentage of
Pharmaceutical
Shipments Exported
0%
>0%-2.5%
>2.5-5%
>5%-10%
>10%
1989
Number
82
33
13
11
36
%
46.9%
18.9%
7.4%
63%
20.6%
1990
Number
77
36
13
10
39
%
44.0%
20.6%
7.4%
5.7%
22.3%
Note: Only 175 facilities reported export data.
Source: Section 308 Pharmaceutical Survey.
3-35
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management, profitability, and market value. The appropriate ratio choice depends on the
purpose of the analysis. This analysis focuses on measuring the possibility of facility closure or
firm financial failure because of regulatory impacts. To attract the financing for a wastewater
treatment system, a firm must demonstrate or project financial strength both before and after the
regulation-induced investment. Financial strength is often assessed on the basis of whether a firm
can incur debt associated with a capital investment while continuing to generate a return on
investment that will attract further investment. Thus measures of debt levels and profitability are
critical to the analysis of financial strength.
The two ratios judged most important to the financial analysis of potential creditors and
investors are the rate of return on assets and the interest coverage ratio. The sections below
define these ratios and discuss their value for this research. Additionally, the discussion reviews
the overall profitability of the industry, which helps to provide background for the remainder of
the financial analysis.
3.2 J.I Return on Assets
A firm's financial performance determines the willingness of creditors and investors to
provide the capital necessary to sustain or expand operations. If performance is poor, investors
will not provide capital or will seek higher returns in the form of higher interest rates on debt or
higher returns on equity to compensate for above-average levels of risks. The higher cost of
capital might in turn limit the ability of a given company to invest in improved wastewater
treatment.
Financial performance will be measured in terms of the pre-tax return on assets (ROA).
ROA is computed as the ratio of net income to assets:
Net Income
Total Assets
3-36
-------
ROA is a measure of profitability of a firm's capital assets, independent of the effects of
taxes and financial structure. It is perhaps the most comprehensive measure of a firm's financial
performance. ROA provides information about the quality of a firm's management, the
competitive position of a firm within its industry, and, on an aggregate level, the economic
condition of an industry overall. In addition, ROA incorporates information about a firm's
operating margin and asset management capability: the ratio of net income to sales (operating
margin), multiplied by the ratio of sales to assets (asset turnover), equals ROA. If a firm cannot
sustain a competitive ROA, it will probably have difficulty financing new investments. This is true
regardless of whether the financing is obtained through debt or equity financing.
Table 3-12 presents baseline ROA data for companies included in the survey sample. The
ratio data are presented by quartile (i.e., with values given that denote the ratios for lowest 25
percent of firms, the median, and the highest 25 percent of firms) for firms grouped by annual
revenues. The mean and standard deviation for each group of firms also is presented.
The return on assets over the years 1988 to 1990 varied from a first quartile of
approximately -3 percent to an upper quartile of 10 percent for the smallest size class of firms
(those with $25 million or less in annual revenues), to between 4 and 9 percent for the largest
firms (those with over $1 billion in revenues). The data indicate that the lower quartile of firms
in the smallest size class, on average, generated negative net income between 1988 and 1990.
These firms appear to be the most vulnerable by the ROA measure. Long-term performance at
this level would threaten these firms' ability to stay in operation. All other ROA values given in
the table were positive.
Table 3-13 presents industry ROA ratios reported by Dun & Bradstreet for each SIC of the
pharmaceutical industry. As can be seen, the results are more or less consistent with those drawn
from the survey sample. Dun & Bradstreet's results reflect data for 266 companies overall. It
should be noted that differences in the organization of data makes the comparison of ratio
results only approximate.
3-37
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TABLE 3-12
BASELINE RETURN ON ASSETS (ROA) AND
INTEREST COVERAGE (ICR) RATIOS, BY ANNUAL REVENUES
Annual
Revenues
(Smillions)
Number
of
Observations
Mean
Lower
Quartile
Median
Upper
Quartile
ROA
0-25
26-200
201-1,000
> 1,000
60
55
33
26
-2%
5%
15%
7%
-3%
1%
2%
4%
5%
5%
7%
6%
10%
12%
26%
9%
ICR
0-25
26-200
201-1,000
> 1,000
60
55
33
26
Infinity
Infinity
Infinity
1,111%
-1%
201%
272%
372%
578%
464%
2,043%
677%
51,267%
8,470%
Infinity
1,130%
Source: Section 308 Pharmaceutical Survey.
3-38
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TABLE 3-13
COMPARISON OF SAMPLE RATIOS WITH PUBLISHED INDUSTRY AVERAGES
Source
Number of
Observations
Quartile
Lower
Median
Upper
ROA
Survey Sample (1988-1990
average)
Dun & Bradstreet Information
Services (1990)
SIC 2833
SIC 2834
SIC 2835
SIC 2836
174*
34
167
29
34
-3% to 4%
-2%
3%
NA
0%
5% to 7%
2%
10%
4%
4%
9% to 26%
11%
21%
7%
10%
ICR
Survey Sample (1988-1990
average)
Robert Morris Associates
(1991-1992)
SIC 2833
174*
113
-1% to
372%
180%
464% to
2,043%
440%
1,130% to
Infinity
1,110%
*Out of 177 firms, only 174 responded with data for computing ROA and ICR.
Sources: Section 308 Pharmaceutical Survey data; Robert Morris Associates (1992); and Dun
& Bradstreet Information Services (1993).
3-39
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3.25.2 Interest Coverage Ratio
The second general area of concern to creditors and investors is the extent to which the
firm can be expected to manage its financial burdens without risk of financial failure. In
particular, if a firm's operating cash flow does not comfortably exceed its contractual payment
obligations (e.g., interest and lease obligations), the firm is vulnerable to a decline in profits or
an increase in costs because in either case its ability to continue meeting interest obligations
would be in jeopardy. Either scenario may (1) sharply reduce or eliminate returns to equity
owners of the firms, and/or (2) prevent the firm from meeting its contractual obligations.
The ability to manage financial commitments is expressed as the ratio of earnings before
interest and taxes (EBIT) to interest obligations, or the interest coverage ratio (ICR):
KR- EBTT
Interest
A low ICR indicates vulnerability of the firm to financial failure and the potential for difficulty in
obtaining financing for wastewater treatment capital investments.
As shown in Table 3-12, the interest coverage ratios vary from approximately -1 percent
to 51,267 percent for the smallest firms to 372 percent to 1,130 percent for the largest firms in
the Section 308 sample of firms. A number of firms reported no or negative interest burdens
over the specified time period. These firms were assigned ICRs of infinity. Only the lowest
quartile of companies in the smallest size class showed negative interest coverage ratios.
Robert Morris Associates reported data on the interest coverage ratios for 113 firms. As
for ROA, these data are approximately consistent with those reported by the survey sample (see
Table 3-13). The median value in the Robert Morris sample is 440 percent. Median values for
the survey sample by size class ranged from 464 percent to 2,043 percent.
3-40
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3.2.5.3 Overview of Profitability in the Pharmaceutical Industry
This section presents additional evidence on profitability in the pharmaceutical industry.
If the pharmaceutical industry were found to be relatively unprofitable overall, then investment
levels in the industry would be declining and industry benchmarks might underestimate the extent
of vulnerability among industry firms.
Profitability in the pharmaceutical industry has been extensively studied, and a recent
Office of Technology Assessment (OTA) research report, Pharmaceutical R&D: Costs, Risks and
Rewards, summarizes this work (OTA, 1993). OTA compared the pharmaceutical industry's rate
of return with that of other industries. OTA also considered whether the higher rates of return in
the pharmaceutical industry were caused by a higher cost of capital in the industry. Elements of
the OTA research are summarized here.
OTA compiled recent literature on the profitability and internal rates of return (IRR) for
the pharmaceutical industry. The IRR is the interest rate at which the net present value of all
cash flows into and out of the company equals zero. It provides a generally reliable method of
calculating the return on investments. OTA identified a number of studies conducted between
1975 and 1991 that measured the profitability of the industry, including three studies that
compared the pharmaceutical industry to others. These studies were designed to improve on the
measurements possible with publicly available reports of industry profits. Accounting measures of
profitability can be flawed because:
Accounting standards require firms to record R&D, advertising, and promotion
outlays as current expenditures, whereas they are generally investments with a
future return. The value of the "intangible assets" represented by these
expenditures is too uncertain for use in accounting statements but, nevertheless,
represents assets that should be factored in.
Financial statements report income and expenses as they are accrued and not
necessarily as they are realized, which can distort the timing of revenues and
investments and misrepresent the rate of return.
Even if the other distortions are corrected, the accounting rate of return could
still depart from the IRR because accounting profits do not adjust properly for
3-41
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the time profile of cash flows from various investments and are further distorted
by growth or decline in investment over time (OTA, 1993).
The studies identified by OTA used various techniques to develop more accurate
estimates of the rate of return for the companies studied, such as incorporating information
about the timing of investments in R&D, correcting for the effect of inflation, incorporating
depreciation rates for investments in R&D and advertising, and other changes. The various
studies produced estimates of the IRR.
Three studies compared the corrected pharmaceutical industry IRR estimates with
similarly adjusted profit figures for other industries. The study results should be interpreted
cautiously because they covered very small samples of companies. Further, the studies tended to
focus on larger (and presumably more successful) firms. Nevertheless, the studies showed that
the adjusted rate of return for the pharmaceutical industry was found to be consistently higher
than that in the other industries examined.
Table 3-14 summarizes the elements of the most recent of the studies reviewed by OTA,
a study by Megan and Mueller of 10 pharmaceutical firms between 1975 and 1988. Megan and
Mueller compared the IRR for the pharmaceutical industry with that of other industries that
have similarly large investments in R&D and advertising, including the toy, distilled beverages,
and cosmetics industries. These authors used various assumptions about the depreciation of
R&D and advertising to measure the true profitability impact of these investments. This study
found that 10 pharmaceutical firms had an IRR of 12.15 percent. The other industries, with
similarly adjusted depreciation estimates, produced rates of return of 6.6 percent (toys), 11.44
percent (distilled beverages), and 11.5 percent (cosmetics).
OTA also commissioned its own report on the relative level of pharmaceutical industry
profits. This study, authored by Baber and Sok-Hyon, used a recently developed technique for
converting accounting data into an IRR estimate. This study compared rates of return for 54
research-intensive pharmaceutical firms with samples of companies in other industries. The
authors found that the pharmaceutical industry had IRRs that were consistently 2 to 3
3-42
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TABLE 3-14
SUMMARY OF PHARMACEUTICAL INDUSTRY PROFITS STUDY
Study Description
Study Characteristics
Comment
Pharmaceutical industry
sample (Year of Data)
10 major firms, 1975 to 1988.
Other industries sample
Selected firms in advertising or
R&D-intensive industries; 6 firms
in toy industry; 4 in distilled
beverage firms; 9 in cosmetic
firms.
Selected firms with similar
large investments in R&D
and advertising.
R&D capitalization
assumptions
R&D depreciation rates estimated
for each firm by regressing sales
on lagged R&D. Maximum 8-year
life for investment.
Capitalization rate
assumptions are necessary to
improve accuracy of rate of
return estimates over normal
accounting measures.
Advertising
capitalization
assumptions
Same depreciation estimation
technique as for R&D with a
maximum 4-year life for
investment.
Capitalization rate
assumptions are necessary to
improve the accuracy of rate
of return estimates over
normal accounting measures.
Rate-of-return
estimates—
pharmaceutical industry
12.15 percent
None
Rate-of-return
estimates—other firms
Toy industry - 6.66 percent
Distilled beverages -11.44 percent
Cosmetics -1131 percent
Other industries showed
lower rates of return, using
consistent adjustments to the
accounting data.
Source: OTA, 1993.
3-43
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percentage points higher, under various alternative calculation methodologies, than those for
nonpharmaceutical companies.
The question remains whether the observed differences in IRR resulted from differences
in the cost of capital. If pharmaceutical investments are riskier, then investors would require
higher IRR and the cost of capital for the industry would be higher. OTA estimated the average
cost of capital for the industry and for two control groups. OTA found that the pharmaceutical
industry's cost of capital was slightly higher than that for one group of control firms and lower
than that for another group. OTA recognized the potential errors and biases in its measurement
techniques, but nevertheless concluded that the higher rates of return found for the
pharmaceutical industry could not be explained by differences in the relative costs of capital.
Overall, the profitability of the pharmaceutical industry appears to be above average
among U.S. industries. This suggests that the overall baseline viability of the industry is
equivalent to, if not better than, that of other industries.
3.3 INDUSTRY STRUCTURE AND THE PHARMACEUTICAL MARKET
Information concerning market structure, the demand for Pharmaceuticals, and pricing
behavior provides much of the basis for reaching conclusions about the industry's ability to "pass
through" additional regulatory costs via higher drug prices and thereby predicting which entities
bear what portions of regulatory impacts. The first section of the following discussion (Section
3.3.1) examines evidence of market structure as defined by barriers to entry, industry
concentration ratios, and vertical integration patterns. Market structure data must be
complemented by other information on the pharmaceutical industry as well. Subsequent sections
examine the characteristics of pharmaceutical demand (Section 3.3.2) and market conduct and
performance (Section 3.3.3). Section 3.3.4 presents conclusions about the likelihood that
manufacturers can pass through regulatory costs to consumers of pharmaceuticals.
3-44
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3.3.1 Market Structure
The more barriers to entry that exist in a given market, the more likely it is that
monopolistic or oligopolistic conditions will prevail in that market. Such conditions allow firms
greater latitude in setting prices and hence the ability to pass regulatory costs along to
consumers. Barriers to entry and concomitant factors of concentration and vertical integration
are discussed in the following sections.
3.3 J.1 Barriers to Entry
Critics of the pharmaceutical industry often blame barriers to entry (i.e., economic, social,
and regulatory factors that prevent or discourage new firms from entering a given market) for
limiting competition in the pharmaceutical industry and thereby creating inefficiencies in the
supply of a socially desirable product. One major barrier to entry is the high cost of
pharmaceutical R&D. Raising the necessary capital to finance pharmaceutical R&D can be
difficult for new firms that have no capital resources of their own and must attract investors that
can tolerate long-term, high-risk investments. Investors might be more inclined to invest in
established firms that have demonstrated that they can bring a drug to market, recover R&D
expenditures, and produce reasonable returns on investment capital. Investors also might be wary
of new firms that have not demonstrated that they can clear FDA regulatory hurdles. For
example, new firms might be less capable of producing well-documented and organized NDAs,
which can extend the regulatory review process and thus delay returns on investments.
The prevalence of patents also serves to prevent new firms from entering particular drug
markets. By law, patented drugs in the United States enjoy ostensible protection from
bioequivalent drugs for a period of 17 years (OTA, 1993). This protection gives the drug
manufacturer a monopoly over its particular product for the life of the patent. Several factors,
however, act to reduce the effective patent life of drugs. The greatest threat to the effective
patent protection for a drug is the delay between patent issuance and FDA approval, which can
be as much as 10 years. Drug companies obtain patents during the R&D phase, and many years
can elapse before the company can take advantage of its monopoly power. OTA estimates that
3-45
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the effective patent life (i.e., the time between drug approval and patent expiration) on new
drugs averages 11 years (OTA, 1993). Moreover, patents do not provide complete protection
from competition because competitors might be able to offer other drugs with similar therapeutic
benefits.
Once patents expire, manufacturers of bioequivalent, or generic, drugs can enter the
market. Evidence suggests that over the past decade, introduction of generic versions of branded
products is becoming more common. Today, nearly 34 percent of all prescription drug orders are
filled by generics rather than branded, or "pioneer" drugs, an 11 percent increase since 1986. As
noted earlier, the passage of the 1984 Price Act made it easier for generics to gain market
approval from FDA, and both public and private insurers have become more adamant about the
use of less expensive generics.
High promotional expenditures in the pharmaceutical industry also can serve as a barrier
to entry. Traditionally, the economic literature has viewed high promotional expenses as an
indication of an imperfect competitive environment. In a market characterized by oligopoly (i.e.,
the domination of a given market by a small number of firms), firms will use advertising rather
than price competition to differentiate products. New firms might be at a disadvantage with
respect to more established firms if they must compete on the basis of reputation rather than
price. The high promotional expenses required to compete in drug markets also add to the
capital demands on new entrants.
Despite the high cost of promotion, several economists in the late 1970s determined
empirically that industry promotional expenditures were positively related to market entry. Thus,
new entrants use their promotional campaigns to achieve market entry. In a study of 17
therapeutic markets over the period 1969 to 1972, Tessler concluded that promotional
expenditures actually facilitate entry because new products could not compete with existing
products without being able to distinguish themselves through advertising. Hornbrook found
similar results and concluded that promotional expenditures serve more as a market penetration
tool for new pharmaceutical manufacturers than as a barrier to entry (Feldstein, 1988).
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On balance, patent protection and long regulatory lead times for approval of new
Pharmaceuticals represent barriers to entry. Although it is extremely difficult to quantify the
impact of such barriers on market competition, it is likely that established pharmaceutical
companies have a degree of market power because of their regulatory experience, established
R&D operations, and patent protection. Although the number of pharmaceutical establishments,
particularly generics manufacturers, has grown over the past several decades, it is likely that
competition in the industry would have been greater in the absence of high R&D costs, FDA
regulations, and other barriers to entry discussed above.
3.3.1.2 Concentration and Vertical Integration
The degree of concentration and vertical integration in a given industry is often used as
an indicator of barriers to entry. Concentration is generally measured in terms of the percentage
of value of shipments accounted for by a given number of firms in a particular industry. The U.S.
Department of Commerce calculated 4-, 8-, 20-, and 50-firm concentration ratios for all 4-digit
SIC industries through 1987 (see Table 3-15). The higher the concentration ratio in a given
industry, the easier it is for manufacturers to set prices or to collude to set prices. Industrial
economists have proposed that when the leading four firms control 40 percent or more of a given
market, the market may be characterized by oligopolistic conditions that present significant
barriers to entry.
Table 3-15 lists the 4-, 8-, 20-, and 50-firm concentration ratios for SICs 2833, medicinal
and botanicals; 2834, pharmaceutical preparations; and 2836, biological products, as reported by
the U.S. Department of Commerce. As can be seen, the four leading firms in SIC 2833
controlled 72 percent of sales of SIC 2833 products in 1987. This situation contrasts to the four-
firm concentration ratio of 22 percent in SIC 2834 and 45 percent in SIC 2836. There are almost
three times as many companies in SIC 2834 as in SIC 2833. The relatively low four-firm
concentration ratio of 22 percent in SIC 2834 and the relatively large number of companies
suggests that barriers to entry in the pharmaceutical preparations sector of the industry are
relatively insignificant compared with barriers to entry in the medicinals and botanicals sector.
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TABLE 3-15
4-, 8-, 20-, and SO-FIRM CONCENTRATION RATIOS:
SICs 2833, 2834, AND 2836: 1954-1987
SIC Code
2833 Medidnals and
Botanicals
2834 Pharmaceutical
Preparations
2836 Biological
Products, Except
Diagnostics
Year
1987
1982
1977
1972
1970
1967
1966
1963
1958
1954
1987
1982
1977
1972
1970
1967
1966
1963
1958
1954
1987
Percent of Total Value of Shipments
4 Largest
Companies
72
62
65
59
64
74
70
68
64
72
22
26
24
26
26
24
24
22
27
25
45
8 Largest
Companies
80
75
78
75
74
81
81
79
77
84
36
42
43
44
43
40
41
38
45
44
65
20 Largest
Companies
89
85
89
90
NA
91
NA
91
89
93
65
69
73
75
NA
73
NA
72
73
68
80
50 Largest
Companies
95
94
96
98
NA
98
NA
99
98
NA
88
90
91
91
NA
90
NA
89
87
NA
93
NA = Not Available.
Source: U.S. Department of Commerce, 1991a.
3-48
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Nevertheless, concentration ratios calculated for such large industry segments are of
limited value. The overall drug market is fragmented into a number of separate, noncompeting
therapeutic markets. Manufacturers of antibiotics, for example, do not compete with
manufacturers of muscle relaxants. Thus, concentration ratios should be calculated and analyzed
within the specific therapeutic markets in which manufacturers do compete. Only one study was
identified in the economic literature of concentration ratios by therapeutic category. The study,
conducted by Vernon (1971), divided the prescription drug market into 19 therapeutic markets
according to the degree of demand-side substitutability between different drugs (i.e., relatively
close drug substitutes were placed in the same general therapeutic market). The four-firm
concentration ratios calculated by Vernon in the 19 therapeutic markets are presented in Table
3-16. As can be seen, all of the concentration ratios are quite high; the lowest ratio in a
therapeutic market is 46 percent. Several concentration ratios are in the 90 percent range, and
the unweighted average is 68 percent. Vemon's study suggests that a relatively small number of
companies dominate sales in the individual therapeutic markets.
Even therapeutic market-specific concentration ratios might not present an accurate
picture of competitive conditions in the pharmaceutical industry, however. According to Feldstein
(1988), concentration ratios are a static measure of market power. Feldstein notes that although
a particular therapeutic market can be characterized by high concentration at a given point in
time, market shares in that therapeutic market can change radically over time. Instability in
market shares over time indicates intense competition among firms through new product
innovation. One study in the early 1970s noted that of the 20 industries investigated, only the
petroleum industry possessed a higher degree of market instability than the pharmaceutical
industry. Moreover, exit from and entry to the pharmaceutical industry seems to be quite high. In
a study of 17 therapeutic markets between 1963 and 1972,15 markets had five or more new
entrants. Market exit occurred in 16 of the 17 markets (Feldstein, 1988).
A high level of vertical integration might also indicate the presence of barriers to entry in
a given industry. Vertical integration refers to the extent to which production inputs and services
are produced and transferred within a given company, rather than procured from other
companies. In the pharmaceutical industry, a vertically integrated firm might engage in research
and development, several stages of manufacturing (i.e., extraction and formulation), and
3-49
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TABLE 3-16
CONCENTRATION RATIOS IN THE U.S. PRESCRIPTION DRUG INDUSTRY,
BY THERAPEUTIC MARKET: 1968
Therapeutic Market
Anesthetics
Antiarthritics
Antibiotics-penicillin
Antispasmodics
Ataractics
Bronchial dilators
Cardiovascular hypertensives
Coronary-peripheral vasodilators
Diabetic therapy
Diuretics
Enzymes-digestants
Hematinic preparations
Sex hormones
Corticoids
Muscle relaxants
Psychostimulants
Sulfonamides
Thyroid therapy
Unweighted average
Four-Finn
Concentration Ratio
69
95
55
59
79
61
79
70
93
64
46
52
67
55
59
78
79
69
68
Source: Vemon, 1971.
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distribution. In the pharmaceutical industry, the principal advantage of vertical integration is in
achieving economies of scope, which occur when production inputs can be used to produce
several different outputs. For example, cumulative drug R&D and promotional expenditures
might be used jointly in the production of more than one drug product. Economies of scope
might serve as a barrier to entry in the pharmaceutical industry to the extent that the high costs
associated with pharmaceutical R&D and promotion raise start-up costs and reduce the ability of
new firms to raise sufficient capital to profitably enter the industry.12
Evidence from the Section 308 Pharmaceutical Survey provides some indication that
pharmaceutical companies are vertically integrated. Of the 139 parent companies for which
survey data are available, 129 have operations spanning all four of the industry's major
production processes: fermentation (process A), biological and natural extraction (process B),
chemical .synthesis (process C), and formulation (process D). Three of the parent companies own
facilities involved in processes A or C only, and 7 own facilities involved in processes B or D
only. At the facility level, 150 of the 244 facilities surveyed engage in only one production process
(101 of these firms engage only in formulation), 70 perform two production processes, 16
perform three production processes, and 8 engage in all four major production processes. Nearly
85 percent of the owner and parent companies reported R&D expenditures in the 3 years
surveyed.
Thus, many pharmaceutical companies have chosen to integrate vertically. Companies that
engage in research and development, production of active ingredients, and formulation take
advantage of natural economies of scope that reduce the costs associated with developing and
marketing new drugs. The evidence indicates a degree of vertical integration in the industry. The
effect of this factor on market structure and market performance cannot be quantified, but the
data suggest that major pharmaceutical companies have a degree of market power.
"Vertical integration also can lead to economies of scale where the existence of fixed factors
of production such as physical capital can cause unit costs to fall as output rises. It is generally
assumed, however, that unit costs are constant across output levels in the pharmaceutical
industry. Other advantages of vertical integration might include the ability to capture
monopoly/monopsony inefficiency loses and engage in price discrimination (RTI, 1993).
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3.3.2 The Characteristics of Demand for Pharmaceuticals
Demand conditions for pharmaceutical manufacturers will help to determine the impact
of regulation-induced costs on market prices and outputs. This section examines various
characteristics of demand, including the market demographics, the primary market outlets, and
the effect of health insurance on the market.
Demand conditions vary significantly among specific drug markets. Differences in
regulatory requirements and payment mechanisms are particularly important in determining
demand. For example, in the prescription drug market (i.e., new drugs and generics), demand is
complicated by the role of health care providers and the presence of health insurance. Unlike
most consumer markets, consumers of prescription drugs are not directly involved in purchasing
decisions; that is, they do not decide which drugs to take, for how long, and at what dosages.
Health care providers act on the patient's behalf in deciding which medical treatment is most
appropriate given the patient's health status, financial condition, and insurance coverage. These
topics are discussed further below.
The demand for OTC (i.e., nonprescription) drugs, on the other hand, conforms more
readily to standard models of consumer demand. OTC drugs are relatively easy to market,
available without physician consent, and sold in a relatively competitive environment. As for the
demand for other nondurables, the demand for OTC drugs is thought to be positively correlated
with income and negatively correlated with price. Consumers identify a specific health need, such
as relief from minor pain or cold symptoms, and then search for a product to satisfy that need.
Because in most cases a variety of OTC products will meet a given need, demand is heavily
influenced by advertising and price.
332.1 Market Demographics
Like the demand for health care generally, the demand for pharmaceuticals is derived
from the demand for good health. A pharmaceutical is both a consumption commodity, since it
makes the consumer feel better in the present, and an investment commodity, since it may
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extend the life of the consumer. Given this view of pharmaceutical demand, one would expect, all
other things being equal, that the demand for pharmaceuticals will be dependent on factors such
as the incidence of illness and sociodemographic factors like age, education, and income. Other
factors such as perceptions of the seriousness of medical conditions and belief in the efficacy of
medical treatment also influence pharmaceutical demand.
Among individuals, pharmaceutical demand is heavily concentrated in the segment of the
population that includes people of age 65 and older. In fact, today between 30 and 40 percent of
all pharmaceuticals are consumed by persons 65 years old and older (NatWest, 1992). This
finding is not surprising given the strong correlation between age and health. As the U.S.
population ages over the next several decades, the demand for pharmaceuticals will presumably
rise. Since 1980, the number of people age 65 and older has increased at a rate more than twice
that of the general population. By 1996, the U.S. Census Bureau predicts that 13 percent of the
U.S. population will be over 65 years of age. The U.S. Department of Commerce cites the aging
of the U.S. population as one of the main reasons it expects pharmaceutical sales to grow at
more than 5 percent annually over the next 5 years (U.S. Department of Commerce, 1993).
3.32.2 Major Market Outlets
According to a 1991 study of the pharmaceutical market, retail pharmacies and hospital
formularies (i.e., internal pharmacies) dispense over 84 percent of all pharmaceuticals sold in the
United States (see Figure 3-8). Direct mail order establishments and HMOs, however, are
capturing an increasing share of the market. Pharmaceutical purchases by hospitals have fallen by
6 percent since 1983. This drop is credited, in part, to changes in the Medicare system that have
created incentives for hospitals to reduce inpatient services. Drugs once prescribed on an
inpatient basis are now more likely to be prescribed on an outpatient basis and thus dispensed
through retail pharmacies (OTA, 1993).
3-53
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3.3.2.3 The Role of Health Insurance and Health Care Providers
The demand for prescription drugs is influenced by the complex structure of health
insurance and health care provision. It is generally believed that the presence of health insurance
makes consumers relatively insensitive to the price of health care. Although not empirically
measured, this relationship is expected to apply to the demand for pharmaceuticals as well. The
full impact of health insurance on prescription demand is somewhat muted by deductibles and
copayments; nonetheless, health insurance almost certainly makes consumers less sensitive to
drug prices. Many privately insured Americans are protected from extraordinary medical costs
and, thus, have little incentive to limit health care expenditures, including the use of prescription
drugs. According to OTA, in 1987, 28 percent of all prescribed drug expenditures were paid for
by private insurance, 10 percent by Medicaid, 6 percent by other insurers such as Medicare and
Worker's. Compensation, and 57 percent by individuals.13
The percentage of Americans with public or private health insurance has risen steadily
over the past decade to 86 percent today (OTA, 1993). Virtually all health insurance plans cover
hospital services, including prescription drugs administered at the hospital. As noted earlier,
however, hospitals account for a declining share of total pharmaceutical sales in the United
States, dropping from 29 percent in 1983 to 23 percent in 1991 (OTA, 1993). This drop can be
attributed to a shift toward a greater reliance on outpatient services, which are often less
expensive than hospital care.
Outpatient prescription drug insurance, although less common than inpatient coverage,
covers an increasing proportion of Americans. The proportion of outpatient prescription drug
purchases paid for by insurers increased from 27 to 43 percent between 1977 and 1987 (OTA,
1993). OTA estimates that in 1987, between 70 and 74 percent of the noninstitutionalized
population had at least some outpatient prescription drug coverage. Very few health insurance
plans cover 100 percent of prescription drug costs, however. Full coverage is most common in
HMOs. Most health insurance plans rely on copayments to limit prescription drug use, although
"Insurance coverage of pharmaceutical expenditures is less than that for health care generally.
Approximately 75 percent of all health care expenditures are paid for by insurance.
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copayments are generally in the range of $5 or less (OTA, 1993). Private insurers generally cover
all drugs approved for market by FDA.14
The lack of price sensitivity among consumers is partly offset by increasing sensitivity
among insurers. To control rising health care costs, many private and public insurers have moved
to limit pharmaceutical expenditures. Many private insurers have created incentives for physicians
and consumers to substitute generic drugs for branded drugs. OTA reports that in 1989,14
percent of all employer-based health insurance plans offered lower copayments for generic drugs
than for branded drugs. HMOs are particularly well suited to encourage generic drug utilization
because they control physicians more directly than fee-for-service plans. Some HMOs require
that their formularies automatically substitute generic drugs for branded drugs unless the
physician explicitly instructs otherwise. HMOs and other insurers also try to reduce drug costs by
negotiating with manufacturers for volume discounts and relying on direct mail-order pharmacies
for drugs that patients need refilled on a regular basis. Medicaid, the nation's major public health
insurer, also creates incentives to keep drug costs low.
3.32.4 SubstitutabiUty among Pharmaceuticals and with Other Medical Services
The availability of close substitutes plays an important role in determining competitive
conditions in various drug markets. Generally, the greater the availability of close substitutes in a
given market, the more difficult it is to raise prices without losing market share. Substitution
occurs within specific drug markets or within the overall health care market (i.e., Pharmaceuticals
can substitute for other forms of health care), and both of these are discussed below.
"Insurance does not always cover uses of prescription drugs not explicitly approved by FDA.
OTA reports that insurers are generally willing to reimburse for "off-label" uses that have been
documented as effective in one of three major medical compendia or in multiple published studies.
The so called off-label use of prescription drugs is common in many branches of medicine, especially
in the treatment of cancer (OTA, 1993).
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Substitutabillty among Pharmaceuticals
The degree of substitutability within or across specific drug markets varies considerably
among the patented drug market, the generic drug market, and the OTC drug market.
Patented Drug Market. Patented drugs in the United States enjoy ostensible protection
from bioequivalent drugs for a number of years. Effective patent life, however, reflects only the
period of time in which a particular compound is formally protected from bioequivalent
competitors. Manufacturers of patented drugs may enjoy market exclusivity for many years after
patent expiration because of the time needed to approve generic competition, or because the
particular market is too small to entice generic competitors.15 In addition, manufacturers of
patented drugs may be able to extend their monopoly power after patent expiration by
developing new dosage forms for the same drug. The 1984 Price Act automatically grants a
3-year period of market exclusivity, regardless of patent status, to any drug for which an
additional full NDA or NDA supplement has been submitted. With a new dosage form that
makes a drug easier to administer or causes fewer side effects, the "pioneer" manufacturer can
retain effective monopoly power because its competitors can only market the earlier, and
presumably inferior, generation of the product.
The availability of close substitutes for many patented drugs, however, erodes the monopoly
power enjoyed by these manufacturers. Drugs of different molecular structure often can compete
in the same therapeutic market. For example, calcium channel blockers, angiotensin-converting
enzyme inhibitors, beta-blockers, and diuretics all compete in the antihypertension drug market.
Between 1987 and 1992, 78 percent of the new drugs approved by FDA were deemed
substantially equivalent to already marketed drugs in terms of medical importance and
therapeutic usage (FDA, 1992). Thus, it would seem that although patents certainly reduce the
availability of identical substitutes during the life of the patent, physicians in many cases can
choose from more than one drug therapy to treat a given ailment.
1SU.S. patent law prohibits companies from conducting commercially valuable research using
patented products.
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Generic Drug Market. The ascendancy of generic competitors in the prescription drug
market has greatly increased the availability of substitutes in the nonpatent drug market. Prior to
the 1984 Price Act, generics accounted for a low percentage of total prescriptions given their
relatively low price and FDA-guaranteed bioequivalence. Brand loyalty, strict FDA regulation,
and state antisubstitution laws that prevented pharmacies from making generic substitutions not
specifically requested by a physician all acted to reduce the ability of generics to compete with
branded prescriptions. Over the past decade, however, generic competition has increased
dramatically, and today generics account for 34 percent of all prescriptions written.
The rise in generic competition is the result of several factors. Perhaps most importantly,
both private and public insurers (i.e., Medicaid/Medicare) encourage, if not require, physicians to
prescribe generic drugs when available (virtually all states have repealed their antisubstitution
laws). Many HMO formularies now automatically prescribe generic drugs unless the physician
makes a handwritten request for a branded drug. As mentioned earlier, the 1984 Price Act made
it easier for generics to obtain FDA approval as well. In a recent study of 18 drugs whose patents
expired in 1983, Grabowski found that nearly all of the manufacturers lost about half of their
market share to generic competition within 2 years after initial entry of generic competitors
(Grabowski, 1992).
OTC Market. As discussed earlier, the OTC market is much like other competitive
commodity markets where there is a high degree of substitutability and demand is relatively
sensitive to changes in price. OTC drugs do not face the same regulatory hurdles as prescription
drugs and generally do not require such large R&D expenditures. Unlike many prescription drug
markets, most OTC drug markets are quite large and thus capable of sustaining many
manufacturers of the same product.
Substitutability with Other Medical Services
Physicians typically can serve the patient in the hospital setting or they.can provide
ambulatory (i.e., outpatient) services, such as prescription medicines. For certain conditions,
Pharmaceuticals might be a very close substitute for inpatient services (e.g., hospitalization,
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surgery). For example, instead of performing surgery, a doctor might prescribe antibiotics to treat
infected tonsils. Also, the use of vaccines reduces the prevalence of certain medical conditions
such as polio, diptheria, and hepatitis. Some argue that pharmaceuticals can provide a relatively
low-cost alternative to other available medical treatments. The Pharmaceutical Manufacturers
Association (PMA) estimates that between 1976 and 1985 a new drug therapy for ulcers reduced
the cost of treating ulcers by $5.8 billion (PMA, 1989).
Nevertheless, pharmaceuticals are not a very close substitute for most other forms of
medical treatments. Certain surgical procedures could be less expensive than drug therapy. For
example, minor outpatient surgery at the onset of disease might be less costly than chronic drug
treatment. Pharmaceuticals might, in fact, act more as complements to other forms of health care
than as substitutes. Many surgical procedures are accompanied with pharmaceutical use both
during and after surgery. Pharmaceuticals are used to diagnose certain diseases, which then might
be treated through surgery or other medical procedure.
Overall, the extent of substitutability is fairly low. Few pharmaceuticals can be replaced
by nonpharmaceutical products and services, although more than one pharmaceutical product is
often available to treat a given ailment. Nevertheless, substitutability is limited in the patented
drug market where pharmaceutical products are protected from direct competition. The degree
of substitution in the prescription drug market increases over time as patents expire and generic
equivalents enter the market. Substitution is highest in the OTC market where market entry is
relatively easy.
3.333 Price Elasticity of Demand
Few econometric studies have attempted to measure empirically the effect of price on the
demand for pharmaceuticals (i.e., the price elasticity of demand). Four such studies (Reekie,
1978; Lavers, 1989; O'Brien, 1989; and Johnston, 1991) have been published, although only one
was conducted in the United States. Their elasticity estimates are presented in Table 3-17, and
the results are discussed below.
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TABLE 3-17
ESTIMATES OF THE PRICE ELASTICITY OF DEMAND FOR PRESCRIPTION DRUGS
Study Author
Reekie (1978)
Lavers (1989)
O'Brien (1989)
Johnston
(1991)
Elasticity
Estimates
-1.03 to -2.83
-0.15 to -0.20
-0.23
-0.64
-0.5
Study Time
Frame
1958-1975
1971-1982
1969-1977
1978-1986
NA
Comments
Study of individual pharmaceutical
products within 25 therapeutically
competitive markets. Price of close
substitutes included in regression
estimate. Calculated separate estimates
for therapeutically significant and
insignificant drugs.
Study of increases in prescription charges
for a wide range of Pharmaceuticals in
the ILK.
Study of increases in prescription charges
for a wide of range of Pharmaceuticals in
the ILK.
Study of increases in prescription charges
for a wide range of Pharmaceuticals in
Australia.
NA = Not Available.
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In separate studies, O'Brien (1989) and Lavers (1989) estimated the effect on demand for
a wide range of prescription drugs given an increase in the copayment demanded by Great
Britain's National Health Service (NHS). Between 1969 and 1986 the charge for prescription
drugs increased substantially in Great Britain from 0.125£ per prescription in 1969 to £2.20 in
1986 (£1986), an increase in real terms by a factor of 17.6. The ratio of patient charges to actual
drug cost also has more than doubled over that same time period from 0.21 in 1969 to 0.43 in
1986. The patient charge is a fixed rate and does not vary by prescription type. Men over the age
of 65, women over the age of 60, children under 16, and low income groups are exempt from the
prescription charges. Approximately 24 percent of the 323 million prescription items dispensed in
1986 included an associated charge.
Both O'Brien and Lavers found a negative relationship between prescription charges and
the volume of nonexempt prescription items dispensed. O'Brien's study estimated a price
elasticity of demand over the entire period of -0.33, indicating that a 1 percent increase in patient
charges leads to a 0.33 percent decrease in prescription drug use. O'Brien also discovered that
there has been a gradual change in time in the elasticity. For the period 1969 to 1977, O'Brien
calculated a price elasticity of -0.23. Elasticity increased in his study, however, to -0.64 between
1978 and 1986. This finding suggests that prescription drug use became more responsive to price
between the study periods. Using similar data, Lavers found an elasticity of demand between
-0.15 and -0.20 for the period 1971 to 1982, remarkably close to O'Brien's 1969-1978 estimate.
Johnston (1991) studied a similar situation in Australia where federal policies led to a
doubling of prescription charges for a large group of Pharmaceuticals in the 1970s. Johnston's
estimate of -0.5 indicates slightly more elastic demand than indicated by studies conducted by
O'Brien and Lavers.
The studies conducted by O'Brien, Lavers, and Johnston do not consider the possibility of
substitution among drug products within specific therapeutic markets, and thus do not provide a
complete measure of demand elasticity for individual drug products. Reekie (1978) accounts for
product substitution by including the price of therapeutically competing drugs in the estimating
equations for individual prescription drugs within therapeutic categories. Using this method,
Reekie found more elastic demand responses than either O'Brien, Lavers, or Johnston. Reekie's
3-61
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estimates ranged from -1.03 to -2.83, depending on the therapeutic significance of the drug and
how many years the drug had been on the market. Predictably, Reekie's estimates were most
elastic for drugs that had been on the market for a number of years and offered only modest
therapeutic gains, and most inelastic for recently introduced drugs that provided important
therapeutic gains.
Although these empirical studies are hardly conclusive regarding price elasticity, they do
indicate that the demand for Pharmaceuticals as a group may be quite inelastic (i.e., between 0
and -1.0), whereas the demand for specific drug product may be relatively elastic (i.e., less than
-1.0). The absence of close substitutes for drug therapies in general and the presence of health
insurance leads one to expect that the overall demand for Pharmaceuticals would be inelastic.
Conversely, given the existence of close substitutes for individual drugs (e.g., generics and other
therapeutically similar drugs) and the pressure to control health care costs, the demand for
specific drugs may be relatively price elastic.
3.3.3 Market Conduct and Performance
To predict regulatory impacts, it is necessary to examine not only how the pharmaceutical
industry is structured, but how it behaves. The pharmaceutical industry has been under attack for
its seemingly uncompetitive pricing tactics, for having excessive market power related to patent
protection advantages, and for other potential barriers to entry discussed above. This section
explores the numerous factors pharmaceutical manufacturers consider when setting drug prices,
examines the evidence on drug price inflation, and discusses some of the recent actions taken by
both industry and government to control drug prices.
A basic element of market performance is the rate of price inflation. The price of drugs
has outpaced the rate of general inflation over the last several decades. Table 3-18 presents
producer price indices (PPI) for selected drug categories including all drugs, single-source drugs,
and multiple-source drugs for selected years between 1981 and 1988. As can be seen in the table,
the rate of increase in the PPI for almost all drug types outpaced inflation (i.e., the change in
PPI for all commodities) in the seven years studied. Price inflation in the drug industry, however,
3-62
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3-63
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has not been as severe as for medical care generally. Table 3-19 lists consumer price indices
(CPI) for medical care generally, prescription drugs, hospital rooms, and physician services
between 1950 and 1985. According to this data, the CPI for drugs rose 187 percent between 1950
and 1985, in contrast to the much larger CPI increases in medical care (651 percent) and hospital
rooms (2,245 percent) over the same time period. Interestingly, between 1950 and 1985, the CPI
for drugs rose less than the rate of inflation (i.e., the change in CPI for all goods and services).
In more recent years (i.e., between 1980 and 1985), however, the CPI for drugs increased twice
as much as the general rate of inflation.
3.3.3.1 Patterns of Price Competition
Manufacturers have considerable latitude to set prices according to factors other than
marginal cost, such as reputation, demand conditions in different markets (e.g., hospital v. retail),
and the company's long-run financial goals.16 Ultimately, the prescription drug manufacturer
must establish a price that can recover the long-run costs associated with pharmaceutical research
and development. Typically, manufacturers of patented drugs will set initial price well above
marginal cost with the understanding that demand for the product will most likely be fairly
inelastic at least until the patent expires and close substitutes become available. The
manufacturer uses the time between market launch and patent expiration to recoup R&D costs
and generate sufficient profits to finance new product development. The prescription drug
manufacturer will devote considerable resources to promoting its product during this period,
convincing physicians and patients of the drug's therapeutic benefits and establishing itself as the
preeminent supplier of the drug in anticipation of generic competition.
Once the patent expires for a given prescription drug, price-competition becomes a
greater consideration. Because patented drugs will have garnered a certain level of brand loyalty
from physicians, generic drug manufacturers must enter the market with a relatively low price to
establish market share. According to NatWest Investment Banking Group, which monitors the
"Evidence suggests that because of the wide availability of close substitutes in the OTC drug
market, OTC drug manufacturers generally act as price takers. It is assumed, therefore, that OTC
prices approximate marginal cost.
3-64
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TABLE 3-19
CHANGE IN CONSUMER PRICE INDEX FOR PHARMACEUTICALS
AND SELECTED HEALTH CARE SERVICES: 1950-1985
Year
1950
1955
1960
1965
1970
1975
1980
1985
1950-1985
Percent Change from Previous Year
All Goods
and Services
(%)
NA
9.4
10.4
6.4
23.2
38.7
53.2
30.6
339.2
Prescription
Drugs
(%)
NA
9.7
13.5
-11.5
-0.8
8.0
41.6
71.5
186.7
Medical Care
(%)
NA
20.7
22.1
13.1
34.7
39.8
57.7
51.6
650.7
Hospital
(Semiprivate
Room)
(%)
NA
39.6
35.5
32.5
91.6
62.4
77.4
69.6
2,244.9
Physician
Services
(%)
NA
18.5
17.7
14.7
37.5
39.5
59.0
48.1
622.5
NA = Not Applicable
Source: Feldstein, 1988.
3-65
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generic industry, the first generic manufacturer to enter a given market generally prices its drug
around 30 percent below the brand-name drug and realizes a gross margin of about 55 percent.
The second generic manufacturer to enter a market usually prices its product at about a 40
percent discount, and the third entrant at about a 50 percent discount. NatWest estimates that by
the time the fourth generic manufacturer enters a market, generic prices are half of brandname
prices and gross margins will have fallen to 30 percent or less (NatWest, 1992). The advantage of
being the first generic entrant in a given market is clear.
Contrary to expectations, manufacturers of branded drugs do not attempt to deter entry
into their markets by competing with generics on the basis of price. Rather, studies show that in
most cases pioneer firms continue to increase prices following entry at the same rate as before
patent expiration. Some industry experts believe that brand-name drug manufacturers do not
have the same force or the breadth of product line to compete with the major generic
manufacturers on the basis of price (NatWest, 1992). Branded manufacturers trust that despite
the relatively high price of their drug, physicians will continue to prescribe their drug over
generic drugs because they are familiar with it and because many question the quality of generic
drugs even though they have been deemed bioequivalent by FDA. Nonetheless, studies show that
branded drugs lose market share rapidly following patent expiration. According to one study,
brand-name drug market share declines to only 40 percent within 5 years following patent
expiration (Grabowski, 1992). Within 6 years, brand name drugs command only 20 percent of the
market. In its study of the industry, OTA made various market analyses using an assumption that
within 10 years brand name drugs will have left the market altogether (OTA, 1993).
3.3.3.2 Government Actions to Limit Pharmaceutical Price Increases
In the last several years, industry as well as state and federal governments have taken
measures to control drug price inflation. For example, in 1990, 10 companies with over 40
percent of the U.S. pharmaceutical market share agreed to keep drug prices in line with inflation
(Solomon, 1993). The PMA, which has spearheaded the effort, continues to enlist new companies
in the price control program. Today, 16 pharmaceutical companies in all have agreed to keep
increases in the price of their products at or below the rate of inflation.
3-66
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Federal and state governments have recently taken steps to control drug prices through
the Medicaid system. Medicaid provides health insurance for U.S. citizens of limited financial
means and is funded jointly by states and the federal government. Medicaid currently covers
outpatient prescriptions in 49 states and the District of Columbia, and accounts for nearly 15
percent of all outpatient prescription drug expenditures in the U.S. today (OTA, 1993). Retail
pharmacies dispense prescriptions at little or no cost to Medicaid recipients. State Medicaid
agencies then reimburse pharmacies according to specified price tables. Some 22 states require
copayments ranging between $0.50 and $3.00 per prescription (OTA, 1993). States must cover all
drugs approved by the FDA.
The 1990 Omnibus Budget Reconciliation Act (PL 101-508) altered state Medicaid
reimbursement policies. Prior to 1990, state Medicaid agencies reimbursed pharmacies according
to the pharmacy's acquisition cost plus a reasonable markup for single-source drugs, at no more
than 150 percent of the lowest published price for multiple-source drugs.17 In 1990, however,
Medicaid instituted a new reimbursement scheme whereby pharmaceutical manufacturers must
give state Medicaid agencies a rebate on their drug purchases. The rebate is designed to keep the
cost of Medicaid drugs at or below the rate of inflation. Beginning in 1994, Medicaid will
institute more stringent reimbursement policies that will create strong disincentives for
manufacturers to introduce drugs at above-average prices. The law will effectively reduce
revenues for manufacturers in the Medicaid segment of the pharmaceutical market. The
mechanics of the new reimbursement policy are still being developed, and its effect on drug
prices is not yet known. National health care reform could alter Medicaid drastically and might
include its new incentives for controlling health care costs generally and drug costs in particular.
The general trend toward cost-containment in the health care field could ultimately
increase the level of price competition in the prescription drug market. Thus, administrative
actions as well as consumer and market behavior combine to determine pricing patterns in the
industry.
"Single-source drugs are those available from only one manufacturer (i.e., a patented name-
brand drug). Multiple-source drugs are available from several manufacturers (i.e., generics).
3-67
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3.3.4 Conclusions about EIA Assumptions on Cost Passthrough Potential
Because regulatory costs associated with effluent guideline limitations for the
pharmaceutical industry can affect a large portion of the industry, the industry as a whole might
be able to pass through regulatory costs to the consumer in the form of higher drug prices.
Individual companies (especially those marketing generic and OTC drugs), however, will have
less latitude to raise prices to the extent that their competitors do not face the same regulatory
costs. Nevertheless, many companies appear to have sufficient market power to pass through
regulatory costs.
The price elasticity data also suggests that at least some of the regulatory costs can be
passed on to consumers. The price elasticity studies indicate that demand is highly inelastic in the
case of patented drugs with no substitutes (in the range of -0.2 to -0.4), mildly inelastic for
generic drugs (-0.6 to -0.8), and elastic for OTC drugs (less than -1.0). Thus, if the EIA
distinguished among these three market segments, regulation-induced price increases in each
component of the industry could be examined. Unfortunately, product-specific cost and price
data were not available from the Section 308 Pharmaceutical Survey, and so the EIA can
examine impacts only on the drug market as a whole.
Despite the evidence relating to market power and price elasticities, the EIA primarily
will use the conservative assumption that manufacturers cannot pass through compliance costs
except when impacts on consumers are investigated. In this latter case a 100 percent cost
passthrough assumption is used. The assumption of no cost passthrough maximizes the potential
regulatory impacts on manufacturers, whereas an assumption of 100 percent cost passthrough
maximizes the potential regulatory impacts on consumers.
3.4 REFERENCES
Day, Kathleen. 1993. Putting a Price on a Pill: Drug Firms Weigh New Intangibles in Setting
Costs. The Washington Post. March 21,1993.
3-68
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DiMasi, J.A., Hansen, R.W., Grabowski, H.G., et al. 1991. The Cost of Innovation in the
Pharmaceutical Industry. Journal ofHeakh Economics 10:107-142.
Dun & Bradstreet Information Services. 1993. Industry Norms and Key Business Ratios:
Desk-Top Edition. New York: Dun & Bradstreet.
Feldstein, Paul J. 1988. Health Care Economics. New York, NY: John Wiley & Sons.
Grabowski. 1992. Brand Loyalty, Entry, and Price Competition in Pharmaceuticals After the 1984
Drug Act. Journal of Law and Economics 35(2):331-35Q. October 1992.
HCFA. 1992. Health Care Financing Administration. Pharmaceutical Price Changes: 1981-1988.
Health Care Financing Review 14(1):90-105. Fall 1992.
Johnston, 1991. As cited in RTI, 1993.
Lavers, R J. 1989. Prescription Charges, the Demand for Prescriptions and Morbidity. Applied
Economics 21:1043-1052.
NatWest. 1992. The NatWest Investment Banking Group. The U.S. Generic Drug Industry. New
York NatWest.
O'Brien, Bernie. 1989. The Effect of Patient Charges on the Utilization of Prescription
Medicines. Journal of Health Economics 8:109-132.
Reekie, Duncan W. 1978. Price and Quality Competition in the United States Drug Industry. The
Journal of Industrial Economics 26(3):223-237.
Robert Morris Associates. 1992. Annual Statement Studies. Philadelphia, PA: Robert Morris
Associates.
RTI. 1993. Research Triangle Institute. Economic Analysis of Effluent Guidelines Regulations
for the Pharmaceutical Industry. Draft Report. Contract No. 68-C8-0084. Research Triangle
Park, NC: RTI.
Sherwood, Ted. 1993. U.S. Food and Drug Administration, Center for Drug Evaluation, Office
of Generic Drugs. Telephone conversation. May 19,1993.
Solomon, Jolie. 1993. Drugs: Is the Price Right? Newsweek. March 8,1993, pp. 38.
U.S. Congress, OTA. 1993. Office of Technology Assessment. Pharmaceutical R&D: Costs,
Risks, and Rewards. Washington, DC: U.S. Government Printing Office.
U.S. Department of Commerce. 1993. U.S. Industrial Outlook: 1993. Washington, DC: U.S.
Government Printing Office.
U.S. Department of Commerce. 1991a. U.S. Census of Manufactures: 1987. MC87I1A (CD-
ROM). Washington, DC: U.S. Government Printing Office.
3-69
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U.S. Department of Commerce. 1991b. Current Industrial Reports: Pharmaceutical Preparations,
Except Biologicals. MA28G(91)-1. Washington, DC: U.S. Government Printing Office.
U.S. Department of Commerce. 1990. County Business Patterns: 1990. Washington, DC: U.S.
Government Printing Office. Published in 1993.
U.S. EPA. 1992. U.S. Environmental Protection Agency. Pharmaceutical Manufacturing Industry:
Revision of Effluent Guidelines. Unpublished Status Briefing. Washington, DC: U.S. EPA.
U.S. EPA. 1991. U.S. Environmental Protection Agency. Guides to Pollution Prevention: The
Pharmaceutical Industry. EPA/625/7-91/017. Washington, DC: Office of Research and
Development, U.S. EPA.
U.S. EPA. 1983. U.S. Environmental Protection Agency. Development Document for Effluent
Guidelines, New Source Performance Standards, and Pretreatment Standards for the
Pharmaceutical Manufacturing Point Source Category. Washington, DC: U.S. EPA.
U.S. EPA. 1982. U.S. Environmental Protection Agency. Proposed Development Document for
Effluent-Limitations Guidelines and Standards for the Pharmaceutical Point Source Category.
Washington, DC: U.S. EPA.
U.S. FDA. 1992. U.S. Food and Drug Administration. Office of Drug Evaluation: Statistical
Report. Rockville, MD: U.S. FDA.
U.S. FDA. 1990. U.S. Food and Drug Administration, Office of Drug Evaluation. Overview of
the Competitiveness of the U.S. Pharmaceutical Industry. Presentation to the Council on
Competitiveness. Rockville, MD: U.S. FDA.
Vemon, John M. 1971. Concentration, Promotion, and Market Share Stability in the
Pharmaceutical Industry. Journal of Industrial Economics 19:246-266. July 1971.
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SECTION FOUR
ECONOMIC IMPACT ANALYSIS METHODOLOGY
OVERVIEW AND COMPLIANCE COST ANALYSIS
The economic impact analysis (EIA) of effluent guidelines and standards for the
pharmaceutical industry covers several components necessary for identifying and characterizing
the potential impact of regulatory compliance costs at the facility and owner company levels, as
well as other secondary impacts. The fundamental component of the methodology is the
facility-level analysis, which identifies facilities likely to close because of incremental compliance
costs. This analysis is performed in Section Five. Results of the facility analysis, combined with
additional firm-level and other data, provide the basis for determining the extent of secondary
impacts on owner companies (Section Six), employment (Section Seven), foreign trade (Section
Eight), small businesses (Section Nine), and specific demographic groups (Section Ten).
Together, the impact analyses offer a comprehensive assessment of economic impacts at
all relevant levels of economic activity. Figure 4-1 shows how the three principle individual
models (the cost annualization model, the facility closure model, and the owner company model)
relate to one another, the inputs required for these models, and the outputs they generate. At
the heart of the EIA is the cost annualization model, which uses facility-specific cost data and
other inputs to determine the annualized capital and operating and maintenance (O&M) costs of
improved wastewater treatment. Annualized cost data feed into the facility analysis, which
investigates the economic impacts on individual manufacturing facilities irrespective of ownership.
The company-level analysis examines the possible effects of increased regulatory costs and facility
closures on companies that own one or more affected pharmaceutical establishments. The EIA
then explores the impact of facility and owner company closures on employment and other
measures of community welfare. Additional analyses explore how increased compliance costs
will affect the balance of trade and whether small businesses and certain demographic groups will
experience disproportionate impacts.
Ideally, the EIA methodology would include an analysis at the product-line level of detail.
Higher compliance costs could be expected to cause product-line closures at some facilities that
4-1
-------
MODELS
Discount Rate
Tax Rate
Depreciation Factor
Years of Equipment Life
Cost
Annualization
Model
(SECTION 4.2)
Annual Cost of Compliance Per Facility
Cost of Production
Value of Shipments
-Salvage Value
Earnings Forecast
Owner
Company
Analysis
Facility Closure
Analysis
••*•—Assets
MODEL
OUTPUTS
Likely Owner-
Company Failures
and Other
Significant Impacts
Number of Facility
Closures (Baseline
and Post-
Compliance)
Employment Impacts
(SECTION 7)
Total Annual Cost of
Compliance
Trade Impacts
(SECTION 8)
Regulatory Flexibility
(SECTION 9)
(SECTION 4.3)
Distributional Impacts
(SECTION 10)
Figure 4-1. Interrelationship of HA methodology components.
4-2
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remain in operation. An analysis of product-line closures, however, is not possible because the
Section 308 Pharmaceutical Survey did not collect financial information on individual product
lines. The facility closure and owner company-level analyses, however, are expected to be
adequate for evaluating impacts on this industry.
The remainder of this section describes the cost annualization model (Section 4.1) and
employs the model to calculate the total annualized cost of compliance for the pharmaceutical
industry as a whole (Section 4.2).
4.1 COST ANNUALIZATION MODEL
4.1.1 Purpose of Cost Annualization
The cost annualization model estimates the annual compliance cost to the facility of new
pollution control equipment and operation. Cost annualization calculations consider the annual
cash outflow for the facility given the tax-reducing effects of expenditures (i.e., depreciation
allowances allowed on corporate income tax). The cost of additional pollution control
equipment can be divided between two components: the initial capital investment to purchase
and install the equipment, and the annual cost of operating and maintaining such equipment
(O&M costs). Capital costs are a one-time expense incurred only at the beginning of the
equipment's life, and O&M costs are incurred every year of the equipment's operation. The
engineering cost model used to estimate facility compliance cost defines both capital and O&M
costs.1
To determine the economic feasibility of upgrading a facility, the costs must be compared
against the facility's income statement and its capital structure. The initial capital outlay should
not be compared against the facility's income in the first year because this capital cost is incurred
only once. Additionally, it reflects the common practice of financing capital expenditures. This
aCost data from Radian Corp.'s engineering cost model are reported for capital costs, O&M
costs, and energy costs. For simplicity, the cost annualization model treats energy costs as part
of O&M costs.
4-3
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initial investment, therefore, should be spread out over the equipment's life. Annualizing costs is
a technique that allocates the capital investment over the lifetime of the equipment, incorporates
a cost-of-capital factor to address the costs associated with raising or borrowing money for the
investment, and includes annual O&M costs. The resulting annualized cost represents the
average annual payment that a given company will need to make to upgrade its facility. The
annualized cost is analogous to a mortgage payment, which spreads the one-time investment in a
home into a series of constant monthly payments.
4.1.2 Inputs and Assumptions
4.12.1 The Regulatory Options
The engineering cost estimates that feed into the cost annualization model are based on a
set of regulatory options developed by EPA. The following section summarizes these options.
The derivation of the initial engineering cost estimates under each option is discussed in the
Development Document (EPA, 1995).
The pollution control options are divided into those for direct dischargers and those for
indirect dischargers. Within each discharger category, additional distinctions are made. First, all
technology options are divided between industry subcategories, with A and C industry
subcategories (representing facilities that use fermentation or biological and chemical synthesis
processes) being distinguished from B and D industry subcategories (representing facilities that
use biological and natural extractive processes or that are formulators of pharmaceutical
products). For direct dischargers, the technologies are then further broken down into Best
Practicable Control Technology Currently Available (BPT), Best Conventional Pollutant Control
Technology (BCT), Best Available Technology Economically Achievable (BAT), and New Source
Performance Standards (NSPS) options; for indirect dischargers, Pretreatment Standards for
Existing Sources (PSES) and Pretreatment Standards for New Sources (PSNS) technology
options are examined.
4-4
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Table 4-1 presents the regulatory options addressed in this analysis and defines the
technologies associated with each option. The abbreviations used to briefly identify the options
(e.g., BAT-A/C#1, which represents the BAT control technology option 1 for the industry
subgroup consisting of facilities using the A and/or C production processes) are introduced in
this table. In all, there are 37 separate options, 21 for A/C facilities and 16 for B/D facilities.
None of these options is a zero-discharge option. Zero discharge options were eliminated
because EPA determined that they were not technologically feasible.
As Table 4-1 shows, five BPT options were evaluated for A/C facilities that are direct
effluent dischargers. BPT-A/C#1 consists of current biological treatment, while BPT-A/C#2 is
based on advanced biological treatment along with cyanide destruction. BPT-A/C#3 includes the
same processes as BPT-A/C#2, plus effluent filtration. BPT-A/C#4 also includes the same
processes as BPT-A/C#2, but adds a polishing pond. Finally, BPT-A/C#5 also includes BPT-
A/C#2 processes, along with both effluent filtration and a polishing pond. Only three BPT
options are proposed for the direct discharging B/D facilities. BPT-B/D#1 consists of current
biological treatment, while BPT-B/D#2 entails advanced biological treatment. BPT-B/D#3 adds
effluent filtration to the processes required for BPT-B/D#2.
Three BCT options for A/C facilities and two BCT options for B/D facilities were
evaluated for direct dischargers.2 All of these options require advanced biological treatment. In
addition to the advanced biological treatment, BCT-A/C#1 adds effluent filtration and
BCT-A/C#2 adds a polishing pond. BCT-A/C#3 adds both effluent filtration and a polishing
pond to the use of advanced biological treatment. BCT-B/D#1 requires only advanced biological
treatment, while BCT-A/C#2 adds effluent filtration to the advanced biological treatment.
Four BAT options, which include advanced biological treatment as a minimum, were
evaluated for direct discharging A/C facilities. BAT-A/C#1 requires the use of advanced
Development Document (U.S. EPA 1995) refers to these options as BCT-A/C #3, #4,
and #5 and BCT-B/D #2 and #3 because several less stringent BCT options (equivalent to BPT-
A/C #1 and #2 and BPT-B/D #1) here were considered before the preferred BPT option was
selected. These options are not considered here because they were equal to or less stringent
than the selected BPT options, thus are associated with no incremental costs. This document
does not address options that are not incremental to BPT.
4-5
-------
TABLE 4-1
REGULATORY OPTIONS CONSIDERED IN THE ECONOMIC IMPACT ANALYSIS
Type of
Option
Name
Description
• Direct Dischargers
Best
Practicable
Technology
Best
Conventional
Technology*
Best Available
Technology
BPT-A/C#1
BPT-A/C#2
BPT-A/C#3
BPT-AO4
BPT-A/C35
BPT-B/D#1
BPT-B/D#2
BPT-B/D#3
BCT-A/C#1
BCT-A/C#2
BCT-A/C#3
BCT-B/D&1
BCT-B/D#2
BAT-A/C#1
BAT-A/C#2
BAT-A/C#3
BAT-AO4
BAT-B/D#1
BAT-B/D#2
Current biological treatment
Advanced biological treatment + cyanide destruction
Advanced biological treatment + cyanide destruction
filtration
Advanced biological treatment + cyanide destruction
pond
Advanced biological treatment + cyanide destruction
filtration + polishing pond
+ effluent
+ polishing
+ effluent
Current biological treatment
Advanced biological treatment
Advanced biological treatment + effluent filtration
Advanced biological treatment + effluent filtration
Advanced biological treatment + polishing pond
Advanced biological treatment + effluent filtration +
polishing pond
Advanced biological treatment
Advanced biological treatment + effluent filtration
Advanced biological treatment + cyanide destruction
nitrification where necessary
Advanced biological treatment + cyanide destruction
stripping
Advanced biological treatment + cyanide destruction
stripping/distillation
Advanced biological treatment + cyanide destruction
stripping/distillation + activated carbon
with
+ in-plant steam
+ in-plant steam
+ in-plant steam
Advanced biological treatment
Advanced biological treatment + in-plant steam stripping
4-6
-------
TABLE 4-1 (cont)
Type of
Option
Best Available
Technology
(Cont.)
New Source
Performance
Standard
Name
BAT-B/D#3
BAT-B/DM
NSPS-A/C#1
NSPS-A/C32
NSPS-B/D#1
NSPS-B/D#2
Pretreatment
Standards for
Existing
Sources
Pretreatment
Standard for
New Sources
PSES-A/C#1
PSES-A/C#2
PSES-A/C#3
PSES-A/C#4
PSES-B/D#1
PSES-B/DS2
PSES-B/D#3
PSNS-A/C#1
PSNS-A/C#2
PSNS-A/C#3
PSNS-B/D#1
PSNS-B/DS2
Description
Advanced biological treatment + in-plant steam stripping/distillation
Advanced biological treatment + in-plant steam stripping/distillation
+ activated carbon
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation
Advanced biological treatment + cyanide destruction + in-plant steam
stripping/distillation + activated carbon
Advanced biological treatment + in-plant steam stripping/distillation
Advanced biological treatment + in-plant steam stripping/distillation
+ activated carbon
: ? ;r-'':-:':'-:Iaii^eeit IJEsctoaBceieisf'- ••>< ';:••' ''ft--- 4K:;-K&j;4y.' "*•-'. i,::^..:'.; "•'. . ' ;";
• ::. . -....;.. -. •;& -:.:.-- •-•••-•••••:-.-.;:••••:...- : • ••-..•• : • • . .
In-plant steam stripping + cyanide destruction
In-plant steam stripping/distillation + cyanide destruction
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment + activated carbon
In-plant steam stripping
In-plant steam stripping/distillation
In-plant steam stripping/distillation + activated carbon
In-plant steam stripping/distillation + cyanide destruction
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment
In-plant steam stripping/distillation + cyanide destruction + end-of-
pipe advanced biological treatment + activated carbon
In-plant steam stripping/distillation
In-plant steam stripping/distillation + activated carbon
*In the Development Document (EPA, 1995), BCT-A/C#1, 2, and 3 in this table actually correspond to
Options 3, 4, and 5, and BCT-B/D#1 and 2 in this table correspond to #2 and #3. The options not listed in
this table were never considered in this report because they are equal to or less stringent than the requirements
of the selected BPT option, and thus no incremental costs are incurred over BPT.
4-7
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biological treatment, as well as cyanide destruction and nitrification where necessary. BAT-
A/C#2 includes the same processes at BAT-A/C#1, along with in-plant steam stripping (both
steam stripping and distillation control ammonia, however, so nitrification is not necessary).
BAT-A/C#3 replaces steam stripping with in-plant steam stripping/distillation. BAT-A/C#4 adds
activated carbon treatment to the processes required in BAT-A/C#3. Four BAT options based
on the use of advanced biological treatment also were evaluated for direct discharging B/D
facilities. BAT-B/D#1 involves the use of advanced biological treatment alone. BAT-B/D#2
adds in-plant steam stripping to advanced biological treatment, BAT-B/D#3 replaces steam
stripping with in-plant steam stripping/distillation. Finally, BAT-B/D#4 adds activated carbon
treatment to BAT-B/D#3.
Also for direct dischargers, two NSPS options that use advanced biological treatment at a
minimum were evaluated for A/C facilities. NSPS-A/C#1 involves the use of cyanide destruction
and in-plant steam stripping/distillation, along with advanced biological treatment. NSPS-A/C#2
adds to this option activated carbon treatment. Two NSPS options also were evaluated for B/D
facilities. NSPS-B/D#1 involves the use of advanced biological treatment plus in-plant steam
stripping/distillation. NSPS-B/D#2 adds activated carbon treatment to this option. The selected
NSPS options are discussed in Section Eleven, Impacts on New Sources.
Four PSES options were evaluated for A/C facilities. PSES-A/C#1 consists of the use of
in-plant steam stripping and cyanide destruction. PSES-A/C#2 consists of the use of in-plant
steam stripping/distillation. PSES-A/C#3 adds end-of-pipe advanced biological treatment to
PSES-A/C#2. PSES-A/C#4 adds activated carbon to the processes required for PSES-A/C#3.
For B/D facilities, three PSES options were evaluated. PSES-B/D#1 requires the use of in-plant
steam stripping. PSES-B/D#2 requires the use of in-plant steam stripping/distillation, while
PSES-B/D#3 consists of the use of activated carbon along with in-plant steam
stripping/distillation.
Three PSNS options were evaluated for A/C facilities that are indirect dischargers.
PSNS-A/C#1 involves the use of in-plant steam stripping/distillation and cyanide destruction,
while PSNS-A/C#2 adds end-of-pipe advanced biological treatment to the processes required for
PSNS-A/C#1. PSNS-A/C#3 adds activated carbon treatment to PSNS-A/C#2. Two PSNS
4-8
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of in-plant steam stripping/distillation, while PSNS-B/D#2 consists of the use of both in-plant
steam stripping/distillation and activated carbon. The selected PSNS options are evaluated in
Section Eleven, Impacts on New Sources.
Although all of these options are evaluated in the EIA, EPA has selected the following
options for inclusion in the regulation:
• For direct discharging A/C facilities, BPT-A/C#2 is selected for conventional
pollutants and BAT-A/C#2 is required for nonconventional pollutants.
• For direct discharging B/D facilities, BPT-B/D#2 is selected for conventional
pollutants and BAT-B/D#1 is required for nonconventional pollutants.
• NSPS-A/C#1 is selected for new A/C facilities that are direct dischargers (this
option is identical to BAT-A/C#3).
• NSPS-B/D#1 is selected for new B/D facilities that are direct dischargers (this
option is identical to BAT-B/D#3).
• PSES-A/C#1 is selected for A/C facilities that are indirect dischargers.
• PSES-B/D#1 is selected for B/D facilities that are indirect dischargers.
• PSNS-A/C#1 is selected for new A/C facilities that are indirect dischargers (this
option is identical to PSES-A/C#2).
• PSNS-B/D#1 is selected for new B/D facilities that are indirect dischargers (this
option is identical to PSES-B/D#2).
As can be seen in Table 4-1, the selected BAT options include all of the processes mandated in
the selected BPT options.
EPA also investigated an alternative regulatory scenario for existing sources and is
soliciting comments on this alternative. The alternative regulatory scenario for existing sources
consist of BAT-A/C#3, BAT-B/D#1, PSES-A/C#2, and PSES-A/C#2. Thus, in this alternative
scenario (with the exception of BAT-B/D#1), in-plant steam stripping is replaced by in-plant
steam stripping/distillation. The impacts of this alternative regulatory scenario (referred to as the
in-plant steam stripping/distillation scenario) are discussed briefly in comparison with the selected
regulatory scenario for existing sources.
4-9
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4.12.2 The Cost Annualization Model
Table 4-2 presents the cost annualization model using assumed data for illustrative
purposes. The inputs and assumptions for the analysis are listed above the spreadsheet. The
first input is the facility code for the facility analyzed. The second line is the type of facility (e.g.,
A/C direct or B/D indirect). The third line presents the regulatory option or alternative for
which the annualized costs are calculated.3 The fourth and fifth lines are the option's capital and
O&M costs, developed by Radian Corp. (Development Document, EPA, 1995). These costs are
provided in terms of 1990 dollars for comparison with 1990 survey data.
The life of the asset is determined according to the Internal Revenue Code's classes of
depreciable property. Fifteen-year property is assumed to have a class life of 20 to 25 years—a
typical life span for the equipment considered in the costing analysis. According to the U.S.
Master Tax Guide, 15-year property includes such assets as municipal wastewater treatment
plants (page 311, Commerce Clearinghouse, Inc., 1991). Thus, for the purposes of calculating
depreciation, most components of the capital cost for a pollution control option would be
considered 15-year property.
The discount rate is used in calculating the present values of the cash flows. The discount
rate reflects pharmaceutical facilities' average cost of capital. The discount rate used in the EIA
is based on the discount rates reported by pharmaceutical facilities in the Section 308 Survey.
Reported discount rates of less than 4 percent and more than 19 percent, however, were not
included in the discount rate calculation. Discount rates of less than 4 percent were thought to
be too low for inclusion in the calculation because banks were charging a prime rate of nearly 11
percent and the Federal Reserve Bank of New York had instituted a discount rate of nearly 7
percent during that time. Similarly, discount rates of more than 19 percent were considered to
represent a hurdle rate (the rate of return desired for a project before it will be undertaken),
rather than a true discount rate. Once these discount rates were excluded, the mean and median
of the remaining discount rates reported in the survey were calculated. The mean was 11.4 and
3The terms "option" and "alternative" are used interchangeably in this section.
4-10
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the median was 11.2. This EIA uses the discount rate of 11.4 percent, which generates a slightly
more conservatively high estimate of annual costs.
The final inputs to the model are the federal and average state tax: rates, which are used
in determining the facility's tax benefit or tax shield. A facility is allowed to offset taxable
income both with incremental O&M costs and with the depreciation of the equipment itself
(page 310, Commerce Clearinghouse, Inc., 1991). These tax rates represent the marginal federal
tax rate (the rate applied to corporate income above $335,000)4 and the average state corporate
income tax rate (see Appendix A). A facility could be located in one state, while its corporate
headquarters is located in a second state and the corporation's holding company is located in a
third state. Given the uncertainty over which state tax rates apply to a given facility's revenues,
the average state tax rate is used in the cost annualization model.
4.12.3 Annualizing Costs
Two assumptions were made in annualizing compliance costs. The first assumption is
that the facility owners will be using the Modified Accelerated Cost Recovery System (MACRS)
to depreciate capital investments, which reduces the effective cost to the facility of purchasing
and operating the pollution control equipment. The second is that a 1-year delay occurs between
the purchase of pollution control equipment and its operation. The details of these assumptions
and their impact on the results of the MACRS cost annualization model are presented in
Appendix A.
In Table 4-2, the spreadsheet contains numbered columns that calculate the cost of the
investment to the facility. The first column lists each year of the equipment's life span, from its
The cost annualization model uses the 34-percent marginal federal income tax rate.
Adjustments to this rate could not be made to account for S corporations because the survey did
not identify corporate type.
4-12
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installation through its 15-year depreciable lifetime.5 Column 2 represents the portion of capital
costs that can be written off or depreciated each year. These rates are based on MACRS as
derived in Appendix A. Multiplying these rates times the capital cost gives the annual amount
the facility can depreciate (Column 3). These amounts will be used to offset annual income.
Column 4 shows the tax benefit provided from the depreciation expense—the overall tax rate
times the depreciation amount for the year.
Column 5 of Table 4-2 is the annual O&M expense. These costs are constant, except in
Year 1 when no O&M costs are incurred because the equipment is not yet in service. Column 6
is the tax shield or benefit provided from expensing the O&M costs. Column 7 lists the facility's
total expenses associated with the additional pollution control equipment. It is assumed that
capital costs are incurred during the first year when the equipment is installed, and continue for
the life of the equipment. Added to this for all years except Year 1 is each year's O&M
expense. Column 8 lists the annual cash outflow minus the tax shields from the O&M expenses
and depreciation, because the facility will recoup these costs as a result of reduced income taxes.
Once the yearly cost to the facility has been determined, it is transformed into a constant
cost stream. The bottom line in Column 8 represents the present value of the costs over the
equipment's life span. The annualized cost is calculated as the 15-year annuity that has the same
present value as the bottom line in Column 8 of Table 4-2. The annualized cost represents the
annual payment required to finance the cash flows after tax shields. In essence, paying the
annualized cost every year and paying the amounts listed in Column 8 for each year are
equivalent. In this example, the capital investment of $614 thousand and annual O&M cost of
5An asset's depreciable life can differ from its actual life. The pollution control equipment
considered in this analysis is in the 15-year property class; however, the actual life could extend
to 25 years. Under these circumstances, up to 10 years of O&M expenses would be excluded
from the present value calculations. The effect of excluding such costs, however, would not be
large, since in Year 16, a dollar is worth only $0.20 (assuming a 11.4 percent discount rate).
Furthermore, by adding more years to the calculation, the annualized cost is lowered, because,
even though O&M costs are incurred during the extra years, payments for the capital investment
will be spread over a longer time period.
4-13
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$59 thousand (1990 $) result in an annualized cost of $101 thousand.6 Table 4-3 presents the
equations used to calculate present value and annual cost.
The present value of the cost for incremental pollution control is used in the closure
analysis (Section Five). The social cost of the regulation differs from the compliance cost. The
social cost is the full value of resources used, ignoring tax shields, which affect only the
distribution of burdens between industry and government7. The cost to society, therefore, is
always higher than the cost to industry. Results of the calculation of aggregate compliance costs
are presented below in Section 4.2.
4.2 TOTAL ANNUALIZED COMPLIANCE COSTS
Total annualized compliance costs are calculated by aggregating the annualized
compliance costs for all affected facilities, based on the output of the cost annualization model.
Table 4-4 presents the results of this aggregation for A/C direct dischargers by category and by
option. BPT-A/C#1 represents the baseline regulatory scenario. BPT-A/C#1 also is a proposed
option for this regulation and, consequently, has been evaluated as such in this EIA. Because
BPT-A/C#1 has already been implemented, however, it generates no economic impacts. As the
table shows, the total posttax annualized costs for the 24 A/C direct discharge facilities, excluding
the zero costs associated with BPT-A/C#1, range from $3.5 million for BCT-A/C#1 to $76.1
million for BAT-A/C#4. Average costs per facility range from $0.1 million to $3.2 million per
year, depending on the option, not including BPT-A/C#1.
6Note that the annualized cost can be determined in two ways. The first way is to calculate
the annualized cost as the difference between the annuity value of the cash flows (Column 7) and
the tax shields (Columns 4 and 6). The second way is to calculate the annuity value of the cash
flows after tax shields (Column 8). Both methods yield the same value.
7When social costs are derived, the appropriate discount rate is the social discount rate,
currently held to be 7 percent by OMB.
4-14
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TABLE 4-3
PRESENT VALUE EQUATIONS USED IN THE
COST ACTUALIZATION MODEL
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4-15
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TABLE 4-4
COMPLIANCE COSTS FOR A/C DIRECT DISCHARGERS (1990 $)
Option
Number
Total
Capital Costs
Total
O&M Costs
Total Posttax
Annualized Costs
Average
Annual Cost
per Facility*
BPT Option Costs
BPT-A/C#1
BPT-A/C#2
BPT-A/C#3
BPT-A/C#4
BPT-AO5
$0
$14,742,689
$21,891,929
$37,455,760
$44,204,216
$0
$7,046,870
$7,488,423
$21,764,186
$23,420,779
$0
$5,681,474
$6,717,116
$16,665,409
$18,359,400
$0
$236,728
$279,880
$694,392
$764,975
BCT Option Costs
BCT-A/C#1
BCT-A/C#2
BCT-A/C#3
$16,875,845
$32,439,676
$39,188,132
$2,957,486
$16,545,942
$19,054,074
$3,551,327
$13,102,463
$15,288,512
$147,972
$545,936
$637,021
BAT Option Costs
BAT-A/C#1
BAT-A/C#2
BAT-AO3
BAT-AO4
$15,050,112
$56,392,127
$68,035,029
$92,851.663
$8,544,621
$35,689,088
$57,980,678
$114.229,651
$6,580,502
$26,779,144
$40,931,284
$76,143.696
$274,188
$1,115,798
$1,705,470
$3.172,654
*Total Posttax Annualized Costs divided by the total number of A/C direct discharge facilities.
Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.
Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment
4-16
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Table 4-5 presents the same information for the 14 B/D direct dischargers. Again, BPT-
B/D#1 is the baseline, as well as a proposed option for this regulation. Total posttax annualized
costs, excluding the zero costs associated with BFT-B/D#1, range from $0.3 million to $2.9
million, or about $23 thousand to $207 thousand per facility per year, depending on the option
chosen.
As discussed earlier in this section, all direct discharging facilities discharge both
conventional and nonconventional pollutants and therefore must implement both BAT and BPT
selected options. The selected BAT options include all of the processes required in the selected
BPT options. Consequently, the results of the cost analysis for the selected BAT options
(BAT-A/C#2 and BAT-B/D#1) represent the full costs (i.e., include BPT-A/C#2 and BPT-
B/D#2) for all existing direct discharging facilities.
Table 4-6 presents compliance costs for indirect dischargers, both A/C (88 facilities) and
B/D (153 facilities). The total posttax annualized costs to all A/C facilities range from $34.6
million to $123.0 million per year, or $0.4 to $1.4 million per year per facility on average. For
the B/D facilities, the aggregate costs range from $7.9 to $63.5 million annually, at an average
cost per facility per year of approximately $52 thousand to $415 thousand.
Table 4-7 outlines the costs for the selected regulatory options. Total aggregate costs are
approximately $70.0 million per year, at an average annual cost per facility of approximately
$0.25 million. In comparison, under the alternative regulatory scenario (the in-plant steam
stripping/distillation scenario), aggregate costs are $111.9 million per year at an average annual
cost per facility of approximately $0.4 million.
4.3 REFERENCES
U.S. EPA. 1995. U.S. Environmental Protection Agency. Development Document. Washington,
DC. February.
Commerce Clearinghouse, Inc. 1991. U.S. Master Tax Guide. Chicago, 1990.
4-17
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TABLE 4-5
COMPLIANCE COSTS FOR B/D DIRECT DISCHARGERS (1990 S)
Option
Number
Total
Capital Costs
Total
O&M Costs
Total Posttax
Annualized Costs
Average
Annual Cost
per Facility*
BIT Option Costs
BPT-B/D#1
BPT-B/D#2
BPT-B/D#3
$0
$605,700
$2,976,515
$0
$519,349
$754^33
$0
$366,228
$760,837
$0
$26,159
$54,346|
BCT Option Costs
BCT-B/D#1
BCT-B/D#2
L_ $559,015
$2,929,830
$448,905
$683,889
$320,426
$715,035
$22,888
$51,074
BAT Option Costs
BAT-B/D#1
BAT-B/D#2
BAT-B/D#3
BAT-B/D#4
$644,446
$1,741,330
$3,002,607
$10,310,180
$1,104,801
$937,108
$1,950,161
$3,058,423
$708,758
$731,606
$1,454,688
$2,892,869
$50,626
$52,258
$103,906
$206,634
Total Posttax Annualized Costs divided by the total number of B/D direct discharge facilities.
Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report
Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment.
4-18
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TABLE 4-6
COMPLIANCE COSTS FOR INDIRECT DISCHARGERS (1990 $)
(PSES)
Option
Number
Total
Capital Costs
Total
O&M Costs
Total Posttax
Annualized Costs
Average
Annual Cost
per Facility*
A/C Facilities
PSES-A/C#1
PSES-A/C#2
PSES-A/C#3
PSES-A/C#4
$70,795,915
$90,082,486
$143,989,655
$186,990,945
$46,441,499
$81,860,584
$105,781,635
$177,615,256
$34,564,845
$57,137,102
$76,844,867
$123,048,025
$392,782
$649,285
$873,237
$1,398,273
B/D Facilities
PSES-B/D#1
PSES-B/D#2
PSES-B/D#3
$25,160,649
$30,429,899
$61.970,107
$8,956,179
$16,986,223
$98,119,347
$7,922,101
$13,137,467
$63,463,066
$51,778
$85,866
$414,791
*Total Posttax Annualized Costs divided by the total number of indirect discharge facilities.
Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.
Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment.
4-19
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TABLE 4-7
COMPLIANCE COSTS FOR SELECTED REGULATORY OPTIONS (1990 $)
Option
Number
BAT-A/C#2
BAT-B/D#1
PSES-A/C#1
PSES-B/D#1
Total
Capital Costs
$56,392,127
$644,446
$70,795,915
$25,160.649
Total
O&M Costs
$35,689,088
$1,104,801
$46,441,499
$8,956,179
Total Posttaz
Annualized Costs
$26,779,144
$708,758
$34,564,845
$7,922,101
Average
Annual Cost
per Facility*
$1,115,798
$50,626
$392,782
$51,778
Total**
$152,993,137
$92,191,568
$69.974,8481 $250,806
* Total Posttax Ammalized Costs divided by the total number of facilities for each subcategory.
** Total number of facilities includes seven nondischargbg facilities.
Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report
Source: ERG estimates based on Radian Corp. capital and operating costs estimates for pollution control
equipment
4-20
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SECTION FIVE
ANALYSIS OF FACILITY-LEVEL IMPACTS
This section outlines the facility-level economic impact methodology and reports the
results of the analysis. An overview of the methodology and how it relates to subsequent
analyses is discussed in Section Four. The facility closure analysis takes output from the cost
annualization model to predict facility failures (see Section 5.1). Section 5.2 summarizes the
number of baseline closures and additional closures resulting from compliance with various BPT,
BCT, BAT and PSES control options.1 Conclusions of the facility-level analysis are presented in
Section 5.3.
This section discusses the impacts on 282 facilities in the survey universe.2 Of these 282
facilities, 148 facilities are not directly considered by the facility closure model. These 148
facilities comprise two groups: certifying facilities and single-facility firms. These groups and the
reasons they are not directly considered by the model are described below.
EPA exempted facilities from providing facility-level data if the company owners certified
that the regulation would have no impact on the facility. Sixty-five facilities (which represent 72
facilities in the survey universe) certified no economic impact on the facility (i.e., the rulemaking
will be economically achievable for the company and its certified facilities). Another 76 facilities
in the survey universe indicated that their owner firm and the facility are the same entity (i.e.,
the firm owns only one facility). In these cases, the firm-level analysis in Section Six was
determined to be the appropriate level at which to evaluate impacts on these facilities. These 76
"firm/facilities," as well as the 72 certifying facilities, are placed automatically in the "no-closure"
category by the facility closure model. This approach avoids double counting of impacts at both
Options for new sources are evaluated in Section Eleven. See Section Four for a description
of all regulatory options.
2A total of 286 facilities are represented by 244 facilities in the Section 308 survey. Four
survey facilities provided insufficient data in the Section 308 survey and are not included in this
analysis.
5-1
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the firm and facility level. Results of the analysis show impacts relative to all 282 facilities in the
analysis.
5.1 FACILITY CLOSURE MODEL
Facility closures typically are estimated by comparing the facility's "salvage value" to the
present value of its future earnings. The salvage value represents the expected amount of cash
the owner would receive if the facility were closed and liquidated. The present value of earnings
represents the value in current dollars of the expected stream of earnings that the facility can
generate over a specified period of time. If the salvage value is greater than what the facility is
expected to generate in earnings, then it is assumed that the owner would liquidate the facility
and invest those resources in an investment with a higher expected return.3 This methodology,
however, is considered less realistic for facilities where firm and facility are the same entity. It is
assumed that the firm-level analysis better reflects the decisionmaking at these establishments.
Thus, although all facilities are analyzed here, the firm/facilities pass through the facility level
analysis unaffected and are analyzed in Section Six. Note that any firm failures among these
firm/facilities are distinguished from other types of firm failures in Section Six, and employment
losses are counted in Section Seven.
Sections 5.1.1 and 5.12 describe the calculation of both sides of the closure equation (i.e.,
salvage value and the present value of future earnings). Section 5.13 discusses how closures are
evaluated using the closure equation and Section 5.1.4 presents a closure calculation for a
hypothetical facility. Figure 5-1 provides a schematic diagram of the methodology and
components used in the closure analysis.
3When a facility is liquidated for its salvage value, EPA assumes that the facility is no longer
operated; thus, closure-related impacts could result. In contrast, facilities that are sold because a
new owner presumably can generate a greater return are considered transfers. Transfers cause no
closure-related impacts, even if the transfer was prompted by increased regulatory costs.
5-2
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Incremental Capital
and O&M Costs
(from Engineering
Cost Model)
1
Net Income
I
Analysis of Recent
Industry Trends
Equipment Lifetime
Discount Rate
Depreciation Rates
Tax Rates
i
Discount Rate
Earnings
Forecast
rte
PRESENT VALUE OF
FACILITY CASH
FLOWS
I
Assessed Value
of Land,
Buildings, and
Equipment
t
Factor for
Inventories and
Other Current
Assets
t
Recovery Factor
i
SALVAGE VALUE
A-B = (-)
CLOSURE
A-B =
NONCLOSURE
Figure 5-1. Basic facility closure analysis methodology.
5-3
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5.1.1 Salvage Value
Salvage value is calculated assuming the pharmaceutical facility will be closed
permanently. Thus, assets are evaluated based not on their potential for contributing to
operations, but only on their market value in a liquidation sale of land, buildings, equipment, and
inventories. Salvage value is discussed assuming that all cash transactions are realized in the
current year and that discounting is not required. In fact, many facilities could face multiyear
obligations that are not dismissed upon closure. The salvage value is the net cash realized by the
plant owner after all assets are sold and obligations met.
In theory, salvage value includes the value of current (i.e., short-term) assets and fixed
(i.e., long-term) assets. Current assets, defined as those assets not expected to be held beyond
one year,, include cash, short-term Certificates of Deposit (CDs), inventory, and other assets.
Fixed assets include financial instruments expected to be held beyond a year and assets such as
of buildings, equipment, and land.
Short-term assets held on balance sheets generally will be considered part of the facility's
working capital and therefore are part of the facility's asset base. Long-term financial assets,
such as deferred bond expense, stocks, bonds, and intangibles, might be held on the balance
sheet of either the facility or the owner company.
The Section 308 Pharmaceutical Survey did not consistently collect data on current and
fixed assets at the facility level. Typically, these data are held at the owner-company and parent-
company levels. Out of the 163 noncertified facilities surveyed, only 36 independently owned,
single-establishment companies reported facility-level data on fixed and current assets. For
these 36 facilities, salvage value was calculated4 as the sum of total reported current assets and a
'These data ultimately were not used directly in the facility closure analysis because of the
decision to evaluate firm/facilities in the firm-level analysis.
5-4
-------
portion of fixed assets.5 For the remaining 127 facilities, other measures of fixed and current
assets were used to calculate salvage value as described below.
5.1.1.1 Valuing Fixed Assets
The model uses data on the assessed value of land, buildings, and equipment reported in
the Section 308 Survey to approximate the value of fixed assets for the 127 facilities not
reporting fixed assets.6 Assessed value of the facility is determined by local tax assessors.
Most facilities pay local property taxes based on the assessed value of the facility's fixed assets.
Nonetheless, a number of facilities (33) failed to report assessed value in the survey. These
facilities might not have been assessed for tax purposes in recent years.
A regression equation capable of modeling assessed value with a reasonable degree of
confidence could not be developed. Although one might think that assessed value would be
somewhat related to the size of the plant as measured by the number of employees and other
variables, in fact, assessed value may have more to do with local real estate conditions, politics,
and the competence of the local tax assessor. Rarely does assessed value correspond neatly to
actual market value, and market value itself is not easily predicted from size and other available
data.
Given the inadequacy of regression analysis, a simpler approach was developed for
imputing assessed value. In this approach, facilities with assessed value data (134 facilities) were
5As explained below, a recovery factor of 20 percent is applied to reported fixed assets.
Current assets are valued at 100 percent.
6Although assessed value is not a perfect approximation of fixed assets, it should be noted
that potential difficulties also arise when the book value of assets is used to estimate the salvage
value of a facility. The book value understates the true value of some assets while overstating
the value of others. For instance, a facility's land could have been purchased as long ago as the
19th century and would have since appreciated in value tremendously. Other assets, however,
might have no market value, but could continue to carry a book value because they have not yet
been completely depreciated.
5-5
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divided into eight groups corresponding to manufacturing process (i.e., AC or BD) and
employment size (i.e., 1-18, 19-168,169-748, and >748) and then the median assessed value from
each of those groups was used to estimate assessed value for the 33 facilities not reporting these
data. Table 5-1 shows the mean and median assessed values for each of the eight groups. EPA
selected the median value. It is the more robust estimator (i.e., it is less sensitive to outliers than
the mean).
This approach assumes that there is some relationship between assessed value and
employment size and production process. However, this relationship is assumed to be
nonparametric. Regression analysis requires parametric assumptions that are unsupported by the
data. The median value approach is simple, robust, and avoids parametric assumptions.
5.1,1.2 Valuing Current Assets
Current assets include cash and near-cash financial assets, accounts receivable, and
inventories. The valuation of these assets is based on their probable value during an
auction/liquidation process. Because cash and near-cash financial instruments would not decline
in value in the event of liquidation, they command their face value even in a distress sale.
Accounts receivables and inventories (including both inventories of raw materials and finished
products) are likely to decline in value to some degree depending on factors such as company
and industry experience with bad debt problems, economic conditions, and the geographic
proximity of potential purchasers of raw materials or finished products.
Current assets are carried in accounting statements based on their original purchase cost
or, in the case of finished goods, on their manufacturing cost. They are made up of two
components: intangibles (e.g., cash, receivables, and short-term investments) and inventories
(e.g., raw materials, supplies, fuels, work-in-progress, and finished goods).
Because most intangible current assets are quite liquid and do not decline in value when
liquidated, it is assumed they would be recovered at their face value. Some items, such as CDs
and other short-term investments, could even appreciate in value compared to their cost as
5-6
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TABLE 5-1
ASSESSED VALUE BY EMPLOYMENT SIZE AND
PROCESS CATEGORIES
Category
Sample
Size
Assessed Value
Mean
Median
Number of
Imputed
Values
A/C
1-18
19-168
169-748
>748
3
30
21
10
$644
$21,309
$50,915
$268,622
$811
$12,274
$28,228
$187,792
1
5
4
4
B/D
1-18
19-168
169-748
>748
5
24
30
11
$1,441
$7,355
$44,223
$90,645
$1,485
$4,215
$25,948
$72,843
3
4
8
4
Source: Section 308 Pharmaceutical Survey.
5-7
-------
recorded on the books because of accumulated interest. Accounts receivable, however, could be
worth less than their book value, depending on each facility's accounting practices for recognizing
bad accounts. Overall, the combined book value of these intangible current assets is likely to
approximate their actual market value (i.e., they are valued at 100 percent in the salvage value
calculations).
Inventories are not as marketable as the rest of current assets because of their unique or
specialized purposes. In the event of liquidation, a facility would have to sell its inventories at a
fraction of their recorded book value. In anticipation of this, the survey asked facilities to
report the value of inventories at cost or fair market value, whichever was lower. Thus, this EIA
will use the value of inventories as reported.
As noted above, current assets data were available for only 36 of the 163 noncertified
facilities. Table 5-2 shows data on current assets and assessed value of land, buildings, and
equipment for 18 of these 36 facilities (assessed value data was unavailable for the other 18
facilities). As can be seen, inventories and other current assets tend to be as large as the
assessed value of land, buildings, and equipment for most of these facilities—the median ratio of
current assets to assessed value is approximately 100 percent. The EIA uses this median current
assets to assessed value ratio for the 18 companies listed in Table 5-2 as a proxy for current
assets in the other 127 facilities. Further refinement of the model is not possible given the small
sample.
5.1.1.3 Salvage Value Calculation
Once fixed assets were defined, either using direct survey data on assessed value, or by
extrapolation, a 20-percent recovery factor was applied to the facilities' fixed assets. The
recovery factor is intended as an approximation of the percentage of fixed asset value recovered
in a liquidation. This figure has been used in previous Office of Water EIAs (see U.S. EPA,
1993) and is considered a conservative estimate allowing for very rapid liquidation of assets. One
hundred percent of the current assets estimate, as discussed in Section 5.1.1.2, was then added to
the recoverable portion of fixed assets to compute an estimate of salvage value.
5-8
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TABLE 5-2
CURRENT ASSETS AND
ASSESSED VALUE
(Thousands of 1990 $)
Number
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Current Assets/
Assessed Value
of Land, Buildings,
and Equipment
4.0%
12.9%
31.2%
48.2%
84.1%
90.6%
93.0%
96.3%
10^3% *
118.6%
122.1%
124.5%
154.4%
179.8%
179.9%
196.5%
262.3%
266.8%
' Median value.
Source: Section 308 Pharmaceutical Survey.
5-9
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Facility closure costs are not included in the salvage value estimates. These costs reduce
the overall salvage value of the facility and are difficult to estimate even by facility executives.
These costs can include pension administration, payout costs, and site cleanup before sale. As a
result of their omission, the calculated salvage value could be high, which would overstate the
likelihood of closure. This approach provides a more conservative estimate (by biasing economic
impacts upward) of the potential facility closures.
5.1.2 Present Value of Forecasted Earnings
The present value of each facility is equal to its future stream of earnings in current
dollars. The valuation assumes that the facility continues to be used for the manufacture of
Pharmaceuticals. The methodology uses recent earnings and other data to estimate future
earnings, and then applies discount rates to derive their present value. The components of this
analysis include measuring earnings, establishing a time frame for the analysis, projecting
earnings, discounting earnings, and incorporating the incremental costs of regulation.
Because of the number of assumptions that must be made in calculating salvage value
and because it is not always clear that a parent company would liquidate a "captive" facility,"
a salvage value approach might not be appropriate. A captive facility does not operate as a
profit center but transfers its products to the firm or another facility and values these shipments
at the cost of production. This arrangement might be common in a vertically integrated firm
structure. Appendix B presents a sensitivity analysis of facility closures based on salvage value
set equal to zero. Assuming a salvage value of zero is equivalent to assuming that a facility will
not close unless its present value of net income equals zero. The sensitivity analysis (Appendix
B) shows that the closure analysis is not very sensitive to no or lower salvage value assumptions.
Thus, the salvage value approach is considered an appropriate measure of facility-level impacts.
5-10
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5.12.1 Definition of Economic Earnings
Two approaches typically are used to estimate the present value of future plant
operations:
Net income, calculated as revenues less manufacturing cost of goods sold; selling,
general, and administrative expenses; depreciation; interest; and taxes.
Cash flow, which equals net income plus depreciation.
Estimates of the present value generated from future plant operations generally are based on
cash flow projections. Depreciation is added to net income because it reflects previous, rather
than current, spending and does not actually absorb any portion of incoming revenues.
Net income figures also can be used to project the value of continued plant operations.
This approach assumes that ongoing reinvestment in plant and equipment will be necessary and
that in the long run, depreciation costs should be reflected as a charge against earnings (i.e.,
annual maintenance is not sufficient to ensure a facility's efficiency and capacity in the long run).
This approach, however, might overestimate potential closures in some newer facilities, which
would report higher depreciation figures and thus lower earnings. Another factor that could
affect either net income or cash flow is inter-facility transfers of product among facilities owned
by the same firm. The Section 308 Pharmaceutical Survey asked respondents for their value of
shipments including transfers to other facilities owned by the same firm, but these transfers often
are valued at the cost of production, rather than at market value. Net income or cash flow,
therefore, could be understated at these facilities which could lead the closure model to overstate
total facility closures.
In the closure model, future earnings are based (to the extent possible) on net income
because it is a somewhat more conservative estimate of earnings than cash flow. Reported net
income data is available for only the 36 independently owned facilities. For the remaining 127
facilities, the model approximates net income as the reported value of shipments minus the total
costs of production. The survey asked respondents to include depreciation of land and buildings
in the costs of production; depreciation of equipment is not specifically requested. If
5-11
-------
depreciation is included by the respondent, value of shipments minus total costs of production
should approximate net income. If depreciation of equipment is omitted from the costs of
production, the estimate will lie somewhere between net income and cash flow.
5.12.2 Earnings Forecast
The EIA uses a flat earnings forecast over the defined 16-year period (15 years plus 1
years of installation—see Section 4.1.2.2). In Table 5-3 one can see that, overall, net income
grew in real terms between 1988 and 1990 in the surveyed facilities. In general, the surveyed
facilities experienced strong growth in net income in nearly all employment size categories
between 1988 and 1990. This growth rate is consistent with Commerce data that shows real
growth in shipments for the industry as a whole of 5 percent between 1988 and 1990. Between
1988 and 1989, however, the surveyed facilities showed a small, real decline in net income. The
median growth rate between 1988 and 1989 was -0.2 percent, and a number of facilities showed
actual losses. Growth surged between 1989 and 1990, however, to more than make up for the
previous declines.
Despite the earnings dip in 1988-1989 among some facilities, the flat earnings growth
projection is expected to be a reasonable, and possibly conservative, approach to estimating the
present value of future earnings for several reasons. First, the pharmaceutical industry as a
whole is expected to grow in real terms at a modest rate over the next few years, barring the
institution of major price controls (see Section Three).7 In the longer term, as the "baby boom"
generation ages, demand for Pharmaceuticals is likely to increase.
Second, a large portion of the survey respondents showed appreciable real growth in net
income over the 3-year period captured by the survey. Among respondents for whom net income
7It is beyond the scope of the EIA to predict major price shocks such as those possible with
the institution of comprehensive health system changes. It should be noted, however, that many
pharmaceutical firms have limited or are considering limiting price increases to the rate of
inflation (see Section Three). If this type of limit on price increases is proposed, the incremental
impact on earnings growth in the industry might not be as severe as would be expected without
the voluntary controls.
5-12
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TABLE 5-3
CHANGE IN NET INCOME BY EMPLOYMENT
SIZE CATEGORY: 1988-1990
Employment
Size
0-19
20-99
100-499
500 - 750
>750
Number of
Facilities**
13
41
59
15
17
Change in Real Net Income*
Median
8.0%
-9.1%
4.4%
3.3%
6.4%
Range
Minimnm
-87.6%
-403.5%
-9589.0%
-60.4%
-7.1%
Maximum
1250.6%
374.4%
591.7%
120.0%
97.7%
All
145
5.3%
-9589.0%
1250.6%
* Six facilities had a change of infinity (i.e., net income in the base year was zero).
** Includes only those facilities with net income data for all three years.
Source: Section 308 Pharmaceutical Survey.
5-13
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could be calculated for all three years, real net income growth ranged up to 1,251 percent
between 1988 and 1990, with a median real growth rate of approximately 5.2 percent.8
Finally, using an assumption of declining earnings at some facilities could lead to more
facilities closing under the baseline scenario, potentially understating the impacts of the
regulation. This would occur if, in fact, the declines seen in 1988-1990 are not transitory.
Although an assumption of flat earnings over the time period of the analysis might understate
baseline closures for some facilities, it is unlikely that all facilities showing a decline in the 1988-
1990 period would continue to decline over the analysis timeframe. Thus the general trends
predicted for the industry as a whole are considered a more accurate predictor of earnings
growth over the next 16 years than the 3-year history at any one facility.
Several reasons lead to the rejection of a rising earnings projection. First, the facilities
might be running at or near full capacity and significant growth would not be possible without
making major capital investments in buildings and production equipment. Second, for many
facilities, a flat earnings projection is quite conservative, leading to a conservative assessment of
postcompliance closures.
In addition to flat earnings growth, The model employs several other assumptions and
procedures as well:
Zero cost passthrough. The facility is assumed to be unable to raise prices to
recoup incremental pollution control costs. It is as if there is a supply of foreign-
made Pharmaceuticals waiting at the U.S. border; if domestic facilities raise their
prices, imports will flood into the domestic market. As discussed in Section
Three, this assumption might not be realistic given that many firms act as price
setters in certain drug markets. This assumption, therefore, is extremely
conservative.9
8Nineteen of the 163 respondents did not report sufficient data to calculate the change in net
income between 1988 and 1990. These 19 respondents were removed from the sample prior to
calculating the median net income growth rate.
"Because impacts were found to be so small, alternative assumptions on cost passthrough
were not investigated (see Section 5.2).
5-14
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Constant 1990 dollars. Data from 1988 and 1989 are inflated using the change in
the Consumer Price Index for SIC 283.
Discounting. Net income is discounted over a 16-year period, since, as explained
in Section 5.1.1, the capital expenditures associated with additional pollution
control for the pharmaceutical industry are depreciated over a 15-year lifetime
plus a 1-year construction period. The same cost of capital factor used in the cost
annualization model is also used to discount earnings. This factor takes into
account the rate of inflation.
5.1.3 Evaluating Closures
The model evaluates closure on a facility-specific basis. As discussed above, salvage value
and net income are estimated for each facility. In the baseline analysis, the basic model
calculates the present value of the earnings stream (using the 3-year average net income from the
survey) over the 16-year time frame and subtracts that present value from the calculated salvage
value. If salvage value exceeds the present value of net income, the model classifies the facility
as a "closure" in the baseline. These "closure" facilities are eliminated from the subsequent
postcompliance closure analysis, as a real-life closure under this scenario could not be attributed
to the regulation. Note that all facilities whose 3-year average net income is negative are
assumed to close in the baseline.
For postcompliance closure analysis, the model uses the facility-specific annualized costs
for each BPT, BCT, BAT, and PSES option to calculate declines in net income. Annualized
compliance costs are subtracted from the present value of net income to arrive at the present
value of postcompliance net income. Salvage value minus the present value of postcompliance
net income is then calculated, and, again, where the salvage value exceeds the present value of
net income, the model classifies the facility as a closure. The number of estimated closures
under each regulatory scenario is recorded by employment size and option.
5-15
-------
5.1.4 Sample Closure Analysis
Figure 5-2 presents an example of the calculations undertaken to determine closure. The
salvage value net income and compliance costs of a hypothetical facility are used to calculate
whether closure is likely to occur. As can be seen in this case, this facility is projected to remain
open in the baseline and postcompliance analyses.
5.2 RESULTS
5.2.1 Baseline Closures
The analysis indicates that 38 facilities, or 13 percent of the total, will close in the
baseline. The highest number of closures occurs in the B/D indirect discharge facilities
employing 19-167 employees. In this group, 12 facilities, or 23 percent of the total number of
facilities in this group, are estimated to close in the baseline (see Table 5-4). Nearly all the
closures occur among indirect dischargers (36 of the 38 facilities estimated to close are indirect
discharging facilities), and the highest number of these closures occur among the facilities
employing 19 to 167 employees. (As noted earlier, total facilities include firm/facilities, but these
establishments are analyzed in Section Six.)
5.2.2 Postcompliance Closures
Tables 5-5 through 5-7 present estimates of postcompliance facility closures by type of
discharger (A/C direct dischargers, B/D direct dischargers, and indirect dischargers) by each
option under consideration for each group. As shown in Table 5-5, one A/C direct discharging
facility closes (in the 1-18 employees size category) under the most stringent option,
BAT-A/C#4. No other regulatory options considered for A/C direct dischargers are expected to
result in closures of A/C direct discharging facilities. Table 5-6 presents the analysis for B/D
direct dischargers. No B/D direct facilities are predicted to close as a result of any of the
proposed regulatory options. Table 5-7 presents results for indirect dischargers. A B/D indirect
5-16
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FACILITY NO. 0001
Key parameters (Smillions)
Estimated salvage value (ESV):
Present value of net income (PVNI):
Annualized cost of compliance (ACC): -
Present value of annualized compliance cost (PVAC):
$ 1.33
$ 14.23
$ 0.45
$ 4.29
Sample Calculation
Baseline Calculation
Postcompliance Calculatiori
14.23 (PVNI) > 1.33 (ESV)
No Closure
[14.23 (PVNI) - 4.29 (PVAC)] > 1.33 (ESV)
No Closure
Figure 5-2. Sample Facility Closure Calculation.
5-17
-------
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facility (employing 19-167 employees) is expected to close under PSES-B/D#3. No other
closures are expected under any other options for indirect dischargers. Thus closures occur only
under the most stringent options considered, and only A/C direct and B/D indirect dischargers
will experience significant impacts under these options.
As discussed in Section Four, the following options have been selected by EPA:
BPT-A/C#2, BPT-B/D#2, BAT-A/C#2, BAT-B/D#1, NSPS-A/C#1, NSPS-B/D#2,
PSES-A/C#1, PSES-B/D#1, PSNS-A/C#1, and PSNS-B/D#1. (NSPS and PSNS options are
discussed in Section Eleven.) As discussed in Section 4.2, the cost impacts of the selected BAT
options (BAT-A/C#2 and BAT-B/D/#1) also cover the cost impacts of the other BPT and BCT
selected options for direct dischargers. Thus the impacts of BAT-A/C#2, BAT-B/D#1, PSES-
A/C#1, and PSES-B/D#1 are evaluated as the selected regulatory options. As Table 5-8 shows,
no facility closures are expected to occur as a result of the selected regulatory options (see
Section Six for a discussion of any impacts on firm/facilities). Additionally, no facility closures
are expected to occur as a result of the alternative regulatory scenario (the in-plant steam
stripping distillation scenario; see Appendix C).
5.3 REFERENCES
U.S. EPA. 1993. Economic Impact and Regulatory Flexibility Analysis of Proposed Effluent
Guidelines and NESHAP for the Pulp, Paper, and Paperboard Industry. Office of Water,
November.
5-22
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SECTION SIX
ANALYSIS OF FIRM-LEVEL IMPACTS
The firm-level analysis evaluates the effects of regulatory compliance on firms owning one
or more affected pharmaceutical facilities. It also serves to identify impacts not captured in the
facility analysis. For example, some companies might be too weak financially to undertake the
investment in the required effluent treatment, even though the investment might seem financially
feasible at the facility level. Such circumstances can exist at companies owning more than one
facility subject to regulation. Given the range of possible firm-level responses, the firm-level
analysis is an important component of the EIA.
Parent company (i.e., the owner of the owner company) impacts are not analyzed. As
one progresses up the corporate hierarchy and assets increase, the impacts of a given facility
closure or major facility-level capital investment become more dilute. For the 63 single
establishment firms in the survey universe (the firm/facilities), however, analysis at the facility
level, firm level, and corporate parent level coincide. As noted in Section Five, analysis of these
firm/facilities was deferred to the firm-level analysis.1
The firm-level analysis summarized in Section 6.1 assesses the impacts of facility closures
on each firm and the impact of compliance costs at all facilities owned by the firm that do not
close. These impacts are assessed using ratio analysis, which employs two indicators of financial
viability: the rate of return on assets (ROA) and the interest coverage ratio (ICR). Results and
conclusions of the firm-level analysis are presented in Sections 6.2 and 6.3.
'The total number of firms discussed in this section is 187. Three firms provided insufficient data
and thus were not analyzed and are not included in this count. Included hi the 187 firms are 38 firms
that certified all their facilities as not incurring impacts from the regulation. However, since two of
these certified provided financial data, they were analyzed in the firm failure model. Thus, a total of
36 certifiers are excluded from some of the analyses.
6-1
-------
6.1 RATIO ANALYSIS METHODOLOGY
The ratio analysis is conducted from the perspective of creditors and equity investors who
would be the source of capital to finance a company's treatment system investment. To attract
financing for a treatment system, a company must demonstrate financial strength both before
and, on a projected basis, after the treatment system has been purchased and installed. The ratio
analysis simulates the analysis an investor and or creditor would employ in deciding whether to
finance a treatment system, or make any other investment in the firm.
A baseline ratio analysis evaluates the company's financial viability before the investment,
and a postcompliance analysis predicts the company's financial condition subsequent to the
investment. The baseline analysis identifies companies whose financial condition, independent of
pending regulatory actions, is extremely weak. Such companies are at risk of financial failure
even without the additional cost of the regulation. Before the baseline firm-level analysis is
undertaken, baseline facility closures are accounted for, since these closures affect baseline net
income, earnings, and assets. Firms that are projected to fail in the baseline analysis are
excluded from the postcompliance analysis. The postcompliance analysis identifies those
companies, otherwise financially sound, whose financial viability is threatened by regulatory
compliance. Such companies would be weakened by the burden of financing wastewater
treatment equipment purchases and operating and maintaining the system. These companies are
characterized as significantly affected by the revised effluent standards.
The postcompliance analysis has two components. The first component uses the results
of the facility closure analysis to identify losses in net income and earnings before interest and
taxes (EBIT), and assets stemming from a facility closure (baseline impacts from closures are
accounted for in the baseline analysis and are carried forward into the postcompliance analysis).
The next component uses the annualized compliance costs from all facilities that are projected to
remain open to identify their losses of net income and EBIT. The postcompliance net income
6-2
-------
and EBIT reflecting facility closures and higher production costs is then used to calculate
postcompliance financial ratios.2
The ratio analysis relies on two financial measures: ROA and ICR.3 ROA is a
comprehensive measure of company financial performance, whereas ICR is an indicator of a
company's ability to manage financial commitments. Both measures are of great importance to
creditors and investors in deciding whether to provide investment capital. The methods for
calculating both baseline and postcompliance ROAs and ICRs are described in more detail
below.
6.1.1 Explanation of Ratios
6.1.1.1 Return on Assets (ROA)
ROA is a measure of the profitability of a company's capital assets, independent of
financial structure. It is computed as the ratio of net income to assets:
„_.. _ Net Income
KUA
Total Assets
If a company's ROA is lower than that of its competitors, the company might not be able
to provide the expected investment return to its creditors and investors. Unless significant
improvement in performance is likely, investors and creditors generally will avoid providing
financing to such companies. Alternatively, investors and creditors might seek higher returns (in
the form of higher interest rates or higher required returns on equity) to compensate for the
additional risk associated with the capital they provide. The higher cost of capital might in turn
that where one facility has a statistical weight of 2, the model assumes that both
facilities are owned by the same firm, conservatively assigning impacts of two facilities to one
firm, except in the case of the firm/facilities, in which case, two firm/facilities are assumed.
3The reason for choosing these two financial ratios over other available ratios is explained
more fully in Section 3.2.4.
6-3
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decrease the likelihood that such companies will be able to invest in the treatment options
required for compliance with an effluent guideline.
ROA is perhaps the single most comprehensive measure of a company's financial
performance. ROA provides information about the quality of management, the competitive
position of a company within its industry, and the economic condition of the industry in which
the company competes. In addition, ROA incorporates information about a company's operating
margin and asset management capability: the ratio of income to sales (operating margin),
multiplied by the ratio of sales to assets (asset turnover), equals ROA If a company cannot
sustain a competitive ROA, on both a baseline and postcompliance basis, it probably will have
difficulty financing the pollution control investment. This is true regardless of whether financing
is to be obtained as debt or equity.
6.1 J3 Interest Coverage Ratio (ICR)
ICR is the ratio of EBIT to interest obligations:
KR_ EBJT
Interest
ICR is equally as important to creditors and investors as ROA because it indicates the
extent to which the company can be expected to manage its financial burdens without risk of
financial failure. If a company's operating cash flow does not comfortably exceed its contractual
payment obligations (e.g., interest and lease obligations), the company is seen as vulnerable to
any significant decline hi sales or increase in costs.4 Should sales decline or costs rise, there are
two possible results: (1) returns to the equity owners of the company either will be eliminated or
sharply reduced, and (2) the company will be prevented from meeting its contractual payment
obligations. In the first case, earnings might fall or become negative, with a consequent
reduction or elimination of dividends and/or reinvested earnings. The market value of the
4For this analysis, a company's operating cash flow is considered to be value of shipments
minus production costs, with the exception of interest, lease expense, and depreciation, where
distinguishable.
6-4
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company's equity also is likely to fall, causing a capital loss to investors. In the second case,
failure to make contractual credit payments will expose the company and its equity owners to the
risk of bankruptcy, forced liquidation of assets, and probable loss of the entire equity value of the
company.
6.1.2 Recalculating Ratios Incorporating Compliance Costs
The data necessary to calculate baseline and postcompliance ROAs and ICRs are
available from the survey and engineering costs analyses. For the baseline analysis, ROA and
ICR are computed with the survey data after baseline facility closures are considered. Baseline
closures can reduce net income at the firm level (if net income at the facility was positive).
Additionally liquidation of assets leads to some reduction in the firm's total assets because when
assets are liquidated, their total market value might not be realized. For the postcompliance
analysis, the relevant survey data (net income, EBIT, total assets, and interest expenses) are
adjusted to reflect annual compliance costs estimated at the facility level as well as any changes
in net income and assets caused by facility closures, if any.
In the facility analysis, compliance costs are estimated in two categories: capital costs
(facility and equipment), and annual operating and maintenance costs.5 The sum of these
annualized costs over the nonclosing facilities owned by each company is used to adjust the
survey data as follows:
5The operating and maintenance (O&M) cost category includes discharge costs (e.g., the cost
of sludge disposal) and monitoring costs.
6-5
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(1) Postcompliance Net Income or EBTT = Net Income or EBIT - S of Nonclosing Facilities'
Annual Compliance Costs - [(£ of closing facilities' net income or EBIT) x tax factor6]
(2) Postcompliance Total Assets = Total Assets + S Nonclosing Facility Capital Compliance
Costs - E of Closing Facilities'Nonrecoverable Fixed Assets
(3) Postcompliance Interest Expense = Interest Expense + E Annual Nonclosing Facility Interest
Expense for Pollution Control Technologies
6.1.3 Evaluating Baseline and Postcompliance Ratios
.1 Baseline Analysis
To evaluate the baseline viability of the companies analyzed, the baseline ROA and ICR
values are compared against the lowest quartile (25th percentile) values for the pharmaceutical
sector (SIC 283) in 1992 as reported by Robert Morris Associates (RMA, 1992) for ICR and
Dun & Bradstreet (D&B, 1993) for ROA.7 The benchmark values for ROA and ICR are 0.027
and 1.8, respectively. Those companies for which the value of either the ROA or the ICR is less
than the first quartile value from RMA and D&B are judged to be vulnerable to financial failure,
independent of the application of a pharmaceutical effluent guideline. Because both measures
are judged to be critically important to financial success and the ability to attract capital, failure
with regard to either measure alone is reason for finding the company to be financially
vulnerable.
Where sufficient data were available, three-year average (1988-1990) ROAs and ICRs
were calculated and used as the baseline ratios. In some cases, however, companies did not
provide sufficient net income, EBIT, assets, and interest payments data to calculate three-year
ROA and ICR averages. In these cases, two-year ratio averages were used where possible. For
factor used for net income only. This factor accounts for the fact that any loss or gain
of income will be net of taxes. Note that baseline closures are accounted for during the baseline
analysis, so the net income, earnings, and asset adjustments for baseline closures are already
incorporated into the net income, EBIT, and assets at the beginning of the postcompliance
analysis. Thus, the closing facilities to be addressed in this equation are only those facilities that
close in the postcompliance analysis.
'The affected firms make up only a portion of these larger pharmaceutical industry categories.
EPA determined that a substantial portion of the pharmaceutical industry does not discharge or does
not discharge pollutants of concern (see Section Two).
6-6
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several companies, only a single year of data was available. In three cases, the owner companies
failed to provide sufficient data to calculate either ROA or ICR ratios. These firms were
removed from the analysis.
6.133, Postcompliance Analysis
Standard Methodology
The postcompliance analysis is undertaken primarily for those companies that are not
found to be vulnerable in the baseline analysis. For these healthier companies, if either of the
postcompliance ROA and ICR values fall below their respective benchmarks, then the company
is judged to be vulnerable to financial failure as a consequence of regulatory compliance; these
companies are said to sustain a "significant impact" as a result of the regulation. This standard
analysis is identified as Baseline and Postcompliance Analysis 1, and the results of this analysis
are presented in Section 6.2.1.
Alternative Methodologies
The 25th percentile value for ROA and ICR is only one possible means of defining poor
financial performance and condition. Use of these benchmarks implies that the weakest one-
fourth of companies in an industry are automatically in poor financial condition and at risk of
financial failure. By definition, such companies are in poorer condition than 75 percent of their
competitors. In spite of this, some (and possibly all) companies in the lowest quartile might still
be in good financial condition, particularly during periods of strong industry economic
performance. Alternatively, during a period of weak economic performance, more than 25
percent of the companies in an industry might be in poor condition and at risk of failure.
Additionally, some firms in vertically integrated conglomerates might not be showing
profits (i.e., although manufacturing and R&D are undertaken at the owner company level, sales
are accounted for primarily at the parent company level). The firm thus acts as "captive" to the
6-7
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parent company. Furthermore, because of the research-intensive nature of the pharmaceutical
industry, a startup firm might show many more years of loss before turning a profit. This
characteristic is associated with the very long lead times from the creation of a new drug product
to its introduction to market. Investors are aware of these long lead times and are likely to be
more tolerant of early losses because of the chances of high profit in the long term. For these
reasons, the firms that, under the standard methodology, are considered likely to fail in the
baseline (and thus are not analyzed in postcompliance scenarios using the standard methodology)
are looked at more closely.
This analysis of marginal firm is undertaken as a sensitivity analysis because there is no
way of knowing whether these firms really can be credited with significant impacts from
compliance costs. This analysis provides an upper bound of potential impacts from compliance
costs.
The worst-performing firms are divided between those with negative ROA and/or ICR
(which are the result of negative net income or EBIT) and those with positive ROA and ICR.
For firms that have positive net income and/or EBIT, but whose ROA or ICR fall below
benchmarks, Postcompliance Analysis 2 looks at the relative percentage change in ROA or ICR
as a result of compliance costs or facility closures. This analysis is undertaken to determine the
severity of impact (under a worst-case options scenario), assuming these firms do not, in fact,
close in the baseline. A percentage change in ROA or ICR of 5 percent or less is considered
minimal impact. A change of more than 5 percent is considered a major impact. The results of
this analysis are presented in Section 6.22.
Changes in ROA or ICR ratios that are already negative are difficult to present
meaningfully. However, the proportion of the postcompliance net income or EBIT loss
attributable to compliance costs provides a qualitative sense of impact. This analysis is presented
as Postcompliance Analysis 3, and results are summarized in Section 6.23. Those firms that have
a substantial net loss of income or earnings before even relatively large compliance costs are
incurred are most likely to fail whether or not compliance costs are incurred. Firms with
minimal losses, on the other hand, might be able to survive, but only if compliance costs are not
substantial. In this analysis, if worst-case compliance costs (i.e., the highest cost options are
6-8
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chosen for all facilities) are 5 percent or less of the postcompliance net income or EBIT loss, we
determine that if the firm were to remain open, compliance costs would not be a major factor in
its continued viability. A change of more than 5 percent is considered a major impact.
All firms identified as potentially experiencing a major impact in Postcompliance
Analyses 2 and 3 are investigated further to determine the likelihood of baseline failure. Several
measures pointing to likely firm failure in the baseline are investigated. Unless two or more of
the following are true, the firm is considered highly likely to fail, even given the reservations
noted above:
• Research and development expenditures are much higher than average
• The firm has facilities with startup dates of 1987 or later
• Rising net income (more than 10 percent per year) is noted
• Rising working capital (more than 10 percent per year) is noted
Any facilities not identified as highly likely to fail in this analysis were then further assessed on a
case-by-case basis to determine if they constitute a potential upper bound on overall impacts
from the proposed effluent guidelines.
Profitability Analysis Methodology
One final analysis (Profitability Analysis) is undertaken to determine impacts on
profitability among firms estimated to have no significant impact from compliance costs in
Postcompliance Analysis 1 (significant impact here means likely to fail). Compliance costs,
although not necessarily leading to the likelihood of firm failure, might have other major impacts
on a firm's financial outlook. Using the selected regulatory options, this analysis investigates the
percentage change in ROA among the healthy firms to assess impacts on profitability. Again, a
5 percent change is used as a benchmark. A change of 5 percent or less is considered a minimal
impact. A change of more than 5 percent is considered a major impact (although potentially less
significant than firm failure).
6-9
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Also note that even if a company is considered likely to fail, this does not necessarily
mean that its nonclosing facilities also will close. In the cases where a firm is considered likely to
fail, we assume that the company's viable facilities could be sold as part of the company
liquidation process and operated successfully under different ownership. Alternatively, some
facilities might be sold (and continue to operate) to raise the necessary capital to finance the
installation of pollution control equipment at the remaining facilities. Thus firm closures are not
considered an indicator of additional facility-level impacts. The one exception to this approach is
the analysis involving firm/facilities. To be conservative, failing firm/facilities are assumed to be
liquidated (similar to a facility closure). In fact, firm/facilities might offer themselves for sale,
thus extending the life of the facility (although possibly not the firm). Thus it is possible that
impacts on firm/facilities might be overstated.
6.2 RESULTS
The results of the firm-level analysis are presented in three sections. Section 6.2.1
presents the basic firm-level analysis (Baseline and Postcompliance Analysis 1). This analysis
uses the standard methodology, outlined previously, in which baseline failures are estimated using
the lowest quartile ROA and ICR values for the industry as benchmarks. The postcompliance
portion of Analysis 1 is then developed using only the firms that are determined to have ROAs
and ICRs above benchmarks in the baseline (i.e., the financially healthy firms). Section 6.22
presents Postcompliance Analysis 2, which investigates potential impacts on firms with positive
net income or earnings that appear likely to fail in the baseline under Analysis 1. Section 623
presents the results of Postcompliance Analysis 3. Firms with negative net income or earnings
are analyzed in this third analysis to determine how much more negative their income or
earnings might become if they incur the estimated compliance costs. Finally, Section 6.2.4
presents the results of the profitability impacts analysis. Firms that continue to appear financially
healthy following the installation and operation of pollution control equipment (i.e., those that
are not expected to fail as a result of the proposed regulation) are investigated to determine the
impact of compliance costs on their profitability as measured by declines in ROA. This analysis
is a measure of additional impact short of firm failure.
6-10
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6.2.1 Baseline and Postcompliance Analysis 1—Standard Methodology
The baseline analysis for Analysis 1, which separates financially healthy firms from those
likely to fail regardless of whether the regulation is promulgated, is presented in Table 6-1. As
the table shows, out of 187 firms in the survey universe, 54 (29 percent) are considered likely to
fail even before the impact of the effluent guideline requirements is considered8. These firms
are projected to fail in the baseline and are not considered in the postcompliance portion of
Analysis 1.
Tables 6-2 through 6-4 show the impacts associated with each proposed option, assuming
that only one option is in effect at any one time (i.e., if a firm owns an A/C direct and a B/D
direct facility, the impact of the BAT option for the A/C facility is tallied separately at the firm
level from the impact of the BAT option for the B/D facility. These tables reflect results of
analyses for firms owning A/C direct facilities (Table 6-2), B/D direct facilities (Table 6-3), and
indirect discharging facilities (Table 6-4).
As the tables show, only one firm owning an A/C direct discharger is expected to fail and
only as a result of the most stringent option considered (see Table 6-2); no B/D direct
dischargers are expected to fail under any option (see Table 6-3). A maximum of only four firms
with A/C indirect facilities and six firms with B/D indirect facilities are expected to experience
significant impacts (i.e., to be likely to fail) under the most stringent regulatory options for these
industry subcategories (PSES-A/C#4 and PSES-B/D#3—see Table 6-4). These 10 firms
represent 7.5 percent of all firms with A/C indirect facilities, 7.6 percent of all firms with B/D
indirect facilities, and 7.5 percent of all postcompliance firms.
Table 6-5 examines the impacts generated by EPA's selected options. As can be seen in
the table, when all selected options are applied to the firms concurrently, two A/C indirect firms
8Although this percentage seems high, it is an artifact of the benchmark. On average 25
percent of pharmaceutical firms could be expected to fail if a 25th percentile benchmark is
chosen. The choice of this benchmark is thought to be realistic, however, given the high rates of
entry and exit seen in this industry (see Section Three). These failure rates do not imply that
over one-quarter of the industry will fail in any one year; rather over a reasonable period, these
weaker firms are considered likely to fail, even if the regulation is not imposed.
6-11
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TABLE 6-1
BASELINE ANALYSIS
Firms with A/C Direct Facilities
Firms with B/D Direct Facilities
Finns with A/C Indirect Facilities
Firms with B/D Indirect Facilities
Firms with A/C Nondischarging Facilities
Firms with B/D Nondischarging Facilities
Total
Number
of Firms
19
11
70
107
4
3
Financially
Healthy Firms
#of
Firms
15
7
53
72
2
3
%of
Group
78.9%
63.6%
75.7%
67.3%
50.0%
100.0%
Firms Likely
to Fail
#of
Firms
4
4
17
35
2
0
%of
Group
21.1%
36.4%
24.3%
32.7%
50.0%
0.0%
% of All
Firms*
2.1%
2.1%
9.1%
18.7%
1.1%
0.0%
All Firms**
187
133! 71.1%
54
28.9% | 28.9%
* Out of all firms in the analysis (187 firms).
** Number of firms for All Firms might be less than the total firms by subcategory because some
firms have more than one type of facility. Total number of All Firms includes firms that have
nondischarging facilities
Note: Analysis excludes three firms because of lack of financial data.
Source: ERG estimates.
6-12
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TABLE 6-2
POSTCOMPLIANCE ANALYSIS 1
A/C DIRECT DISCHARGE REGULATORY OPTIONS (15 AFFECTED FIRMS)*
Regulatory
Option
Total
Number
of Firms*
No Significant
Impact
#of
Firms*
%of
Group
Significant
Impact
#of
Firms*
%of
Group
% of All
Firms**
BPT Options
BPT-A/C#1
BPT-A/C#2
BPT-A/C#3
BPT-A/C#4
BPT-A/C#5
15
15
15
15
15
15
15
15
15
15
100.0%
100.0%
100.0%
100.0%
100.0%
0
0
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
BCT Options
BCT-A/C#1
BCT-A/C#2
BCT-A/C#3
15
15
15
15
15
15
100.0%
100.0%
100.0%
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
BAT Options
BAT-A/C#1
BAT-A/C#2
BAT-A/C#3
BAT-A/C#4
15
15
15
15
15
15
15
14
100.0%
100.0%
100.0%
93.3%
0
0
0
1
0.0%
0.0%
0.0%
6.7%
0.0%
0.0%
0.0%
0.7%
* Number of firms remaining after baseline analysis that have A/C direct discharge facilities.
** Out of all firms in the postcompliance analysis (133 firms). Note that the numbers of
facilities in Tables 6-2 through 6-4 total more than 133, because several firms have more
than one type of facility.
Source: ERG estimates.
6-13
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TABLE 6-3
POSTCOMPLIANCE ANALYSIS 1
B/D DIRECT DISCHARGE REGULATORY OPTIONS (7 AFFECTED FIRMS)*
Regulatory
Option
Total
Number
of Firms*
No Significant
Impact
#of
Firms*
%of
Group
Significant
Impact
#of
Firms*
%of
Group
% of All
Firms**
BPT Options
BPT-B/D#1
BPT-B/D32
BPT-B/D#3
7
7
7
7
7
7
100.0%
100.0%
100.0%
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
BCT Options
BCT-B/D#1
BCT-B/D#2
7
7
7
7
100.0%
100.0%
0
0
0.0%
0.0%
0.0%
0.0%
BAT Options
BAT-B/D#1
BAT-B/D#2
BAT-B/D#3
BAT-B/D#4
7
7
7
7
7
7
7
| 7
100.0%
100.0%
100.0%
100.0%
0
0
0
0
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
* Number of firms remaining after baseline analysis that have B/D direct discharge facilities
** Out of all firms in the postcompliance analysis (133 firms). Note that the numbers of
facilities in Tables 6-2 through 6-4 total more than 133, because several firms have more
than one type of facility.
Source: ERG estimates.
6-14
-------
TABLE 6-4
POSTCOMPLIANCE ANALYSIS 1
PSES INDIRECT DISCHARGE REGULATORY OPTIONS
Regulatory
Option
Total
Number
of Firms*
No Significant
Impact
#of
Firms*
%of
Group
Significant
Impact
#of
Firms*
%of
Group
% of All
Firms**
PSES-A/C Options
PSES-B/D#1
PSES-B/D#2
PSES-B/D#3
PSES-B/D#4
53
53
53
53
51
51
50
49
96.2%
96.2%
94.3%
92.5%
2
2
3
4
3.8%
3.8%
5.7%
7.5%
L 1.5%
1.5%
2.2%
3.0%
PSES-B/D Options
PSES-B/D#1
PSES-B/D#2
PSES-B/D#3
79
79
79
78
78
73
98.7%
98.7%
92.4%
1
1
6
1.3%
1.3%
7.6%
0.7%
0.7%
4.5%
* Number of firms remaining after baseline analysis that have indirect discharge facilities.
** Out of all firms in the postcompliance analysis (133 firms). Note that the numbers of
facilities in Tables 6-2 through 6-4 total more than 133, because several firms have more
than one type of facility.
Source: ERG estimates.
6-15
-------
TABLE 6-5
POSTCOMPLIANCE ANALYSIS 1 *
SELECTED REGULATORY OPTIONS
Firms with A/C Direct Facilities
Firms with B/D Direct Facilities
Finns with A/C Indirect Facilities
Finns with B/D Indirect Facilities
Total
Number
of Firms
15
7
53
72
No Significant
Impact
#of
Firms
15
7
51
71
%of
Group
100.0%
100.0%
96.2%
98.6%
Significant
Impact
#of
Firms
0
0
2
1
%of
Group
0.0%
0.0%
3.8%
1.4%
% of All
Firms**
0.0%
0.0%
1.5%
0.7%
AllFirms-)-
133
130
97.7%
3
2.3%
2.3%
* This scenario analyzes impacts from regulating A/C Direct facilities under options BAT-A/C#2
and BPT-A/C#2, B/D Direct faculties under options BAT-B/D#1 and BPT-B/D#2, A/C Indirect
facilities under option PSES-AOl, and B/D Indirect facilities under option PSES-B/D#1.
** Out of all firms in the postcompliance analysis (133 firms).
+ Number of firms for All Finns might be less than the total firms by subcategory because some
firms have more than one type of facility. Total number of All Firms includes firms that have
nondischarging facilities
Note: Analysis excludes three firms because of lack of financial data.
Source: ERG estimates.
6-16
-------
and one B/D indirect firm are expected to be likely to fail as a result of the proposed effluent
guidelines. Additionally, the one B/D indirect firm is a firm/facility, which is therefore assumed
to be liquidated (i.e., closed). Note, however, that this is an upper-bound estimate of significant
impacts, since zero-cost passthrough is assumed. A market-based model might show fewer or
even no firm failures. The same results are obtained under the alternative regulatory scenario
(the in-plant steam stripping/distillation scenario; see Appendix C).
6.2.2 Postcompliance Analysis 2
Tables 6-6 and 6-7 present the results of the analysis of firms that are estimated to fail in
the baseline analysis but that have positive EBIT or net income. This analysis investigates
whether compliance cost impacts on these marginal firms would be onerous, if they did not fail
for other reasons. As Table 6-6 shows, changes in ICR (shown in absolute value) in these
marginal firms are insignificant in many cases. Nearly a third of the firms (9 firms) in this group
show no change in ICR. More than two-thirds are estimated to incur changes in ICR of
5 percent or less (20 firms). A total of nine firms, or about 31 percent of marginal firms with
positive EBIT, would be expected to incur substantial impacts (i.e., greater than 5 percent
change) if they do not fail for other reasons (see Section 6.2.4 for a more in-depth analysis of
how likely these firms are to fail in the baseline).
Table 6-7 presents a similar analysis for ROA among marginal firms with positive net
income. Nine firms in this category incur changes in ROA (again in absolute values) of 5
percent or less (45 percent). Eleven firms (55 percent of the marginal firms with positive ROA),
however, would be expected to incur substantial impacts (i.e., decline in ROA greater than 5
percent) if these firms do not fail for other reasons (see Section 6.2.4 for a more in-depth
analysis of how likely these firms are to fail in the baseline).
6-17
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6.2.3 Postcompliance Analysis 3
Tables 6-8 and 6-9 present the results of an analysis of declines in EBIT and net income
for firms where EBIT or net income is already negative in the baseline. The analysis measures
absolute changes in EBIT and net income. As Table 6-8 shows, 19 firms (76 percent) with
negative EBIT would incur changes in EBIT of 5 percent or less (i.e., EBIT becomes more
negative, but only by 5 percent or less of the firm's existing loss). Only six firms (24 percent of
firms with negative EBIT) are thus estimated to incur substantial impacts if they do not fail for
other reasons (see Section 6.2.4 for a more in-depth analysis of how likely these firms are to fail
in the baseline).
Table 6-9 presents the change in net income among firms with negative net income in the
baseline. Twenty-nine firms (85 percent) are associated with a change in net income of 5 percent
or less. Only five firms (or 15 percent) would be expected to incur substantial impacts if they do
not fail for other reasons (see Section 6.2.4 for a more in-depth analysis of how likely these firms
are to fail in the baseline).
6.2.4 Further Investigation into Likelihood of Firms Failing in the Baseline
As Sections 6.2.2 and 6.23 indicate, 9 firms with positive EBIT projected to fail in the
baseline analysis are expected to incur a change in ICR of greater than 5 percent; 11 firms with
positive net income will incur a change in ROA of greater than 5 percent; 6 firms with negative
EBIT will incur changes in EBIT of more than 5 percent, and 5 firms with negative net income
will incur changes in net income of more than 5 percent.
Many of these firms overlap in these counts, thus only 16 firms identified as likely to fail
in the baseline are considered likely to incur major impacts if they do not actually fail. These 16
firms are analyzed in more detail in Table 6-10. In this table various measures of potential
financial viability are assessed. Where two or more items are noted as "yes," it is assumed that
baseline failure might not occur and that some unusual factors, such as facility startup costs or
unusually high R&D expenditures, are causing a superficial appearance of poor financial health.
6-20
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6-23
-------
As the table shows, three firms (Numbers 5,12, and 14) showed substantial increases in net
income and working capital over the 3-year period of data collection (one firm had insufficient
data to confirm or deny the baseline failure assessment). Net income at two of the three firms,
although showing improvements, remained quite negative in all 3 years and no other mitigating
factors (such as a new facility or high R&D expenditures that might explain the negative income)
were present. Thus there is no evidence that their financial health is other than what was
determined in the baseline analysis. The third firm, however, showed outstanding growth in net
income, going from negative to strongly positive in 1990. The firm's 1990 financial picture,
therefore, was considered more likely to represent its future trend than the average of the three
years of financial data. If this assumption is used, the firm would pass the baseline analysis with
an ROA of 22 percent and no debt payments (i.e., ICR = infinity). When compliance costs are
considered, its ROA drops only to 21 percent and its ICR is excellent. Thus even if this firm
were not to fail in the baseline, if its financial health continues strong in future years, this firm
should have no difficulty affording to comply with the regulation.
In summary, the results of this last analysis indicate that the baseline analysis was
reasonably accurate in identifying firms in poor health. Thus the results of Postcompliance
Analysis 1 can be reasonably assumed to represent an upper bound on firm-level impacts from
the selected regulatory options.
6.2.5 Profitability Analysis
Table 6-11 presents the results of an analysis to determine the effects of the selected
regulatory options on profitability, measured as ROA, among firms that are considered healthy in
the baseline and in Postcompliance Analysis 1. As the table shows, 82 firms (nearly 85 percent
of all healthy, noncertifying firms) are associated with declines in ROA of 5 percent or less.
Fifteen firms are anticipated to have more substantial impacts; only one firm is expected to
experience impacts of greater than 50 percent. Only one direct discharging firm (an A/C direct)
will have a change in ROA of greater than 5 percent. Firms with indirect discharging facilities
bear more impacts. Six A/C indirect dischargers are expected to experience changes in ROA
exceeding 5 percent. Eight firms with B/D indirect discharges are expected to experience a
6-24
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-------
change in ROA of more than 5 percent. When certifying firms are included in the analysis, the
15 firms estimated to incur major impacts on ROA are only 11 percent of all firms in the
postcompliance analysis. Furthermore, if some passthrough of compliance costs are possible,
these impacts could be much lower.
Although these firms have large declines in ROA, it is useful to note that the average
baseline ROA among these firms is 27 percent, which is well above industry average. Thus even
with large declines, postcompliance ROA is probably substantial.
These results are broken down by firm size in Section Nine in the discussion of the
regulatory flexibility analysis.
63 REFERENCES
Dun & Bradstreet Information Services. 1993. Industry Norms and Key Business Ratios:
Desk-Top Edition. New York: Dun & Bradstreet.
Robert Morris Associates. 1992. Annual Statement Studies. Philadelphia, PA: Robert Morris
Associates.
6-26
-------
SECTION SEVEN
EMPLOYMENT AND COMMUNITY-LEVEL IMPACTS
This section of the EIA investigates employment and community-level impacts resulting
from compliance with the proposed effluent limitations guidelines for the pharmaceutical
industry. Compliance with the proposed effluent guidelines imposes a cost at both the facility
and the firm level. The expenditures to meet the regulatory standards might result in facility
closures and firm failures and thereby a loss in employment. This primary loss in employment
can lead to reduced production in the industries that supply inputs to the pharmaceutical
industry, thus leading to secondary employment losses. These secondary losses are calculated by
using product input-output tables that take into account geographic and industrial patterns and
the associated employment changes. When total primary and secondary losses are compared to
employment levels in the communities in which the firms and facilities are located, community-
level impacts can be determined. These losses are, however, offset to some extent by the need to
hire workers to manufacture, install, and maintain the pollution control equipment. This
increase in economic activity results in employment gains in the related industries and is factored
into this analysis.
The analysis in this section is divided into three parts. Section 7.1 examines primary and
secondary employment losses, presenting the methodology and results of the employment losses
and community-level impacts resulting from baseline and postcompliance facility closures and
firm failures. Section 7.2 analyzes labor requirements and potential employment benefits from
the manufacture, installation, and maintenance of the necessary pollution control equipment.
Finally, Section 7.3 presents the net employment impacts of the proposed regulation.
7-1
-------
7.1 PRIMARY AND SECONDARY EMPLOYMENT LOSSES
7.1.1 Introduction
Primary employment losses occur only within the targeted pharmaceutical manufacturing
industry. Secondary impacts include employment losses in other industries providing inputs to
the pharmaceutical manufacturing process and other supporting industries such as community-
based services that lose income when layoffs occur; these losses would result from any significant
decline in demand for inputs as well as from regional reductions in personal income.
Primary and secondary employment losses are summed to obtain the total impact on
community employment levels resulting from implementation of the effluent guidelines.
Although secondary employment losses do not necessarily occur at the community level (since
national multipliers cannot differentiate between input sources within and outside the
community), they are included in this analysis to present a conservative estimate of all potential
employment losses.
7.1.2 Methodology
7.13.1 Primary Employment Losses
Primary employment losses consist of employee layoffs associated with the facility
closures estimated in the facility-level analysis and firm failures in the firm-level analyses. These
job losses are estimated from survey data on annual employment hours.
Three types of employment losses (measured in hours) are estimated and summed to
estimate total employment losses. Losses are calculated for facilities, for facilities that are also
firms (known here as firm/facilities—see Section Five), and firms where the firm and the facility
are not the same entity (multifacility firms). Facility closures are considered a liquidation (not a
7-2
-------
sale), thus all employees of the facility are assumed to lose their jobs. Total direct job losses are
equal to the total employment at the closed facility.1
Firm/facilities (where the firm and the facility are the same entity) are not analyzed in the
facility closure analysis, but in the firm failure analysis. Thus, these firm/facilities are not
assumed to be liquidated based on the facility-level analysis. Instead they are analyzed to
determine whether they can absorb the costs of compliance and still be considered financially
healthy, i.e., not likely to fail (based on an analysis of standard financial ratios). If firm/facilities
are shown to be likely to fail under a regulatory option, the total employment of the firm/facility
is counted as an employment loss and added to those losses accounted for under the facility
closure analysis. Note that this assumption is conservative. If the present value of net income at
the firm/facility is not too low after accounting for compliance costs, the facility might be
purchased by another firm.
Multifacility firms also are analyzed to determine whether they are likely to fail under the
various regulatory options. Employment losses at the firm level are more difficult to quantify,
since the Section 308 Survey did not obtain information on firm-level employment. Therefore 10
percent of the total employment at all the facilities owned by the firm was used as a proxy for
employment strictly related to the administrative functioning of the firm:
Total employment of all facilities * 0.1 = Total nonfacility employment at the firm level.
If a firm is shown to be likely to fail, we assume that this nonfacility employment is lost,
representing administrative and executive staffing at the firm level only. Note that facilities that
closures are estimated based on an analysis of the salvage value of the facility vs. the
present value of net income at the facility. If the salvage value of the facility exceeds the present
value of net income of the facility (estimated based on data from the Section 308 Survey), the
firm is projected to liquidate the facility. Thus closures are considered the loss of a facility in
contrast to a sale, which is considered the transfer of a facility to new ownership. All facilities
that are projected to remain in operation in the baseline case (i.e., without the regulation) are
assigned annual costs of compliance with the effluent guideline option under consideration.
These costs in turn reduce facility net income. If the salvage value is greater than the new
present value of net income, these facilities are considered to close and the closures are assigned
to the regulatory option under consideration (see Section Five).
7-3
-------
do not close as a result of the proposed guidelines are assumed to be sold intact with no loss of
employment when their owner company fails. Thus no additional employment losses are
associated with firm failure beyond the 10 percent factor discussed above. This estimate of firm-
level employment losses also is added to the number of employee losses projected under the
other two analyses.
Total employee hours lost because of a facility closure or firm failure (i.e., the sum of
pharmaceutical production and nonproduction hours) are converted to fulltime equivalents
(FTEs), assuming that 2,080 hours (52 weeks/year x 40 hours/week) equals one FTE. The
analysis is divided into two stages. The first stage analyzes the employment losses associated with
baseline closures and failures (i.e., those closures and failures that are expected to occur even
without the proposed effluent guidelines). The second stage calculates the closures associated
with compliance with the selected options. These postcompliance employment losses in
employment are then converted into FTEs.
7.12.2 Secondary Employment Losses
Secondary losses in employment occur in other industries providing inputs to the
pharmaceutical manufacturing industry and are caused by reduced demand for these inputs.
Secondary impacts are assessed through multiplier analysis, which measures the extent of impacts
in other industries as a function of impacts in the primary industry. Multiplier analysis provides
a straightforward framework as long as the direct effects are small and certain limiting
assumptions about technology are valid (e.g., constant returns to scale, fixed input ratios).
The multiplier used in this analysis is based on input/output tables developed by the
Department of Commerce, Bureau of Economic Analysis (BEA, 1992). The BEA multipliers are
estimated using the Regional Industrial Multiplier System (RIMS II) developed by the Regional
Economic Analysis Division of the BEA. The multipliers reflect the total national change in the
7-4
-------
number of jobs given a change in the number of jobs for a particular industry.2 In this analysis,
the industry directly affected is the Drugs Industry (SIC 283).3 The multiplier reported by BEA
for this industry is 5.95.4 The total number of job losses, both primary and secondary, is
computed as the primary losses in pharmaceutical industry jobs (measured in FTEs) multiplied
by 5.95:
Total job losses = 5.95 * Primary losses in the Pharmaceutical Industry
These secondary losses are calculated both for the baseline analysis and for each option,
postcompliance.
7.12.3 Measuring Impacts at the Community Level
The significance of employment losses on the community is measured by their impact on
the community's overall level of employment. Data necessary to determine the community
impact include the community's total labor force and employment rate. The community
employment information used in this analysis is from the end-of-year 1990, as estimated by the
Bureau of Labor Statistics. For purposes of this analysis, the community is defined as the
Metropolitan Statistical Area (MSA) in which the facility is located and is assumed to represent
the labor market area within which residents could reasonably commute to work.5 If the facility
is located in a Primary Metropolitan Statistical Area (PMSA) within the MSA, then the PMSA
2 Employment multipliers for a given industry show the number of full- and part-time jobs
that the industry provides, both directly and indirectly, given a $1 million change in final demand.
'Multipliers based on direct employment changes are available at an aggregated industry level
only.
The use of this national multiplier might overstate the number of jobs affected within the
community because some of the inputs might be from sources outside the community or even
outside the country. No multipliers that differentiate among the locations of input sources are
known to exist.
5MSAs are defined by the U.S. Office of Management and Budget.
7-5
-------
total labor force is used. If a facility is not located within an MSA, then the community's total
labor force is defined as the total labor force of a county (or township, for eastern states).
This analysis too, is divided into a baseline and postcompliance analysis. For simplicity,
baseline losses are analyzed only if there is a postcompliance closure or failure in the same
community. In that case baseline losses are subtracted from current employment numbers to
reduce the base employment and possibly the base employment rate in the community of
concern. An increase in the community employment rate equal to or greater than one percent is
considered significant. This impact would correspond to a considerable change in the community
employment rate.
-7.1.3 Results
7.13.1 Employment Impacts
Baseline Losses: Primary and Secondary Employment Losses
As discussed above, employment losses are counted when a facility closes (100 percent of
facility employment), when a firm/facility fails (100 percent of facility employment) and when a
firm fails (10 percent of facility employment for all facilities owned).
Table 7-1 presents the results of primary employment losses in the baseline. As the table
shows, before any compliance costs are incurred, 14,381 jobs are estimated to be lost, out of a
total employment of 147,804 workers6 (9.7 percent of total employment in the affected portion
of the industry). These losses are associated with 38 facility closures, 21 firm/facility failures, and
33 firm failures. The baseline analysis predicts that secondary job losses will total 85,567, using
the multiplier of 5.95 (as discussed in Section 7.12). These baseline losses constitute an
6In the affected portion of the pharmaceutical industry. Employment at other pharmaceutical
firms not covered by the proposed effluent guidelines is not counted here.
7-6
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insignificant portion (0.07 percent) of national employment (which totaled 117.9 million in 1990),
thus these losses have a negligible impact on national-level employment rates.
Table 7-2 presents baseline employment losses categorized by facility employment size
(thus it excludes firm-level losses and includes only facility and firm/facility losses). The largest
percentage of baseline job losses as a proportion of total employment within an employment size
group is in the two smallest employment categories (1 to 18 and 19 to 167 employees). A total
of 72 out of 237 jobs, or 30 percent, are expected to be lost in the baseline among the smallest
employment size group (1-18 employees), and 3,402 out of 8,523 jobs, or 40 percent, among the
next smallest employment size group (19-167 employees).
Postcompliance Losses: Primary and Secondary Employment Losses
Tables 7-3 and 7-4 cover employment losses among the A/C and B/D direct dischargers,
respectively. Among the A/C direct dischargers, only BAT-B/D#4 results in any impacts. One
facility is expected to close and one firm/facility is expected to fail, leading to total employment
losses of 62 FTEs. No facility closures or firm failures are expected to occur as a result of any of
the regulatory options for B/D direct dischargers, thus no employment losses are predicted for
this group.
Table 7-5 presents employment losses associated with PSES options for indirect
dischargers. Losses range from those for PSES-A/C#1, which is expected to result in two firm
failures and an estimated loss of 78 FTEs (based on the 10 percent employment loss factor used
for firm failures) to those for the most stringent option, PSES-A/C#4. This latter option results
in four firm/facility or firm failures. These establishments are associated with job losses totaling
224 FTEs.
Employment losses for B/D indirect dischargers range from 13 FTEs under PSES-B/D#1,
which is expected to result in one firm/facility failure, to 392 FTEs associated with PSES/B/D#3.
This most stringent option results in a total of six firm or firm/facility failures.
7-8
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Table 7-6 summarizes the facility- and firm-level primary employment losses for the
selected regulatory option (BAT-A/C#2, BAT-B/D#1, PSES-A/C#1 and PSES-B/D#1). As the
table shows, all the employment losses occur in the indirect discharge category. Two firms
(owning A/C indirect discharging facilities) are predicted to fail as a result of complying with
PSES-A/C#1, leading to an estimated loss of 78 FTEs. One B/D indirect firm/facility also is
predicted fail as a result of PSES-B/D#1, leading to a loss of 13 FTEs. Total estimated primary
employment losses thus total 91 out of 133,423 jobs in the affected industry (accounting for
baseline employment losses), or 0.07 percent of total employment for the affected portion of the
industry. Secondary losses are estimated at 541 FTEs, using the multiplier of 5.95. These losses
are negligible when compared to total U.S. employment and will have no impact on national-
level employment rates. The same results are obtained when the alternative regulatory scenario
(in-plant steam stripping/distillation) is considered (see Appendix C).
Note that two out of three firms and firm/facilities projected to fail under the selected
regulatory scenario employ fewer than 750 employees. The affected firms range in size from 13
to 755 total employees (measured as FTEs).
7.132 Community-Level Impacts
The three firms estimated likely to fail as a result of the selected regulatory options are
located in two areas, a small county with an employed population of about 45,000 and an
unemployed population of about 4,400 and the CMSA of New York and Northern New Jersey
with nearly 8 million employed persons. In the first case, the employment rate drops by 0.01
percent due to a loss of 69 FTEs. In the other case, employment rate changes are negligible
(FTEs lost total 22). Thus no community-level impacts are expected.
7-13
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7.2 LABOR REQUIREMENTS AND POTENTIAL EMPLOYMENT BENEFITS
7.2.1 Introduction
Firms will need to install and operate pollution control systems to comply with an
effluent limitations guideline for the pharmaceutical industry. The manufacture, installation, and
operation of these systems will require use of labor resources. To the extent that these labor
needs translate into employment increases in affected firms, an effluent guideline for the
pharmaceutical industry has the potential to generate employment benefits. If realized, these
employment benefits might at a minimum partially offset the employment losses that are
expected to occur in facilities affected by the rule. The employment effects that would occur in
the manufacture, installation, and operation of treatment systems are termed the "direct"
employment benefits of the rule. Because these employment effects are directly attributable to
the pharmaceutical industry rule, they are conceptually parallel to the primary employment losses
estimated as a result of the rule. This section looks at the employment gains (benefits)
associated with the selected regulatory options only.
In addition to direct employment benefits, the proposed guidelines might generate other
employment benefits through two mechanisms. First, employment effects might occur in the
industries that are linked to the industries that manufacture and install compliance equipment;
these effects are termed "indirect" employment benefits. For example, a firm that manufactures
the pumps, piping, and other hardware that make up a treatment system will purchase
intermediate goods and services from other firms and sectors of the economy. Thus, increased
economic activity in the firm that manufactures the treatment system components has the
potential to increase activity and employment in these linked firms and sectors. Second, the
increased payments to labor in the directly and indirectly affected industries will lead to
increased purchases from consumer-oriented service and retail businesses, which in turn lead to
additional labor demand and employment benefits in those businesses. These effects are termed
"induced" employment benefits.
In view of these possible employment benefits, EPA estimated the labor requirements
associated with compliance with the proposed regulatory options as outlined in Section Four.
7-15
-------
The following discussion summarizes the findings from this effort. Labor requirements—and
thus the possible employment benefits—were estimated in two steps. First, the direct
employment effects associated with the manufacture, installation, and operation of the
pharmaceutical industry compliance equipment were estimated. These effects are discussed in
Section 122. Second, EPA considered the additional employment effects that might occur
through the indirect and induced effect mechanisms outlined above; these effects are discussed in
Section 7.23.
7.2.2 Estimating Direct Labor Requirements
As discussed above, an effluent guideline for the pharmaceutical industry will create
demand for labor services for manufacturing, installing, and operating compliance equipment.
EPA analyzed each of these components of direct labor requirements separately. The sum of the
estimated requirements for the three labor categories represents the estimated total direct labor
requirement, and thus the potential direct employment benefit, from compliance with the
effluent guideline.
722.1 Direct Labor Requirements for Manufacturing Compliance Equipment
The direct labor requirements for manufacturing compliance equipment are estimated
based on the cost of the equipment and labor's expected contribution to the equipment's value in
its manufacture. Labor's contribution was estimated in dollars and was converted to an FTE
equivalent based on a yearly labor cost. Each component of the calculation is discussed below.
Cost of Compliance Equipment
The cost of compliance equipment was presented in Section Four for each of the
regulatory options. Compliance equipment requirements and their associated costs for each
facility included in the Section 308 Survey were used where applicable. For the labor
7-16
-------
requirements analysis, compliance costs and their associated labor requirements were considered
only for those facilities that were not assessed either as a baseline closure or as a postcompUance
closure. That is, the analysis considers the labor requirement effects associated only with those
facilities that were assessed as likely to comply with the rule and continue pharmaceutical
production activities. These costs were weighted, where appropriate, according to the number of
facilities each sampled facility represents in the underlying pharmaceutical industry population
and summed to give an aggregate compliance equipment cost for the industry. The total
estimated one-time capital equipment cost in 1990 dollars for complying with the selected
regulatory options for A/C and B/D direct dischargers and A/C and B/D indirect dischargers is
$153.0 million (see Table 4-7).7
Labor's Expected Contribution to the Equipment's Value
Input-output tables assembled by BEA provide information on the composition of inputs
used to produce the outputs of industries in the U.S. economy (BEA, 1991a, b [1982 data])8.
The inputs tallied in the input-output tables include the purchase of intermediate goods,
materials, and services from other industries as well as the use of labor by the subject industry.
In particular, the direct requirements matrix identifies the value of each input, including labor,
that is required to produce a one-dollar value of output for a subject industry. From discussions
with the EPA technical contractor on this effluent guideline project, the "Heating, Plumbing, and
Fabricated Structural Metal Products Industry" (BEA Industry Classification 40) was identified as
the industry with output that most nearly matches the types of equipment needed for compliance
with the pharmaceutical industry effluent guideline. From the direct requirements matrix, the
7The $153.0 million is the one-time outlay for purchasing the capital equipment estimated to
be needed for compliance with the regulation and is not the annual cost of the capital
equipment. In the economic impact analysis, the capital outlay is annualized over a 16-year
period (including a one-year lag between equipment purchase and operation attributable to
installation) and the resulting value, which is part of the total annual cost of compliance, is much
less than the $153.0 million value.
8The 1982 tables are the most current information on the interindustry input-output structure
of the U.S. economy.
7-17
-------
labor input, titled, Compensation of Employees, accounts for $0.31016 of each dollar of output
value from the Heating, Plumbing, and Fabricated Structural Metal Products Industry.
Multiplying labor's share of output value (031016) times the value of equipment purchases for
complying with the rule yields labor's contribution to manufacturing the compliance equipment,
measured in terms of gross compensation.
The estimated total costs of acquiring compliance equipment is $153.0 million. However,
this includes costs for facilities that will close in the baseline, regardless of regulatory cost. After
baseline and postcompliance facility closures and firm/facility failures are accounted for and their
compliance costs excluded, the total capital cost of purchasing the equipment is $133.4 million.
Only 90 percent of these costs are for the equipment itself. The remaining 10 percent is for
installation (see Section 7.2.2.2 for more details). Thus total expenditures on equipment are
$120.0 million. Labor's contribution is estimated to be $37.2 million ($031016 percent x $120.0
million).
The manufacture of compliance equipment is considered a one-time event that occurs at
the beginning of industry's compliance activities. Accordingly, the labor requirements for
manufacturing compliance equipment should be viewed as a one-time requirement. Elsewhere in
this economic impact analysis, the labor effects associated with facility impacts are presented on
an annual basis, with the expectation that these job effects would persist over the period of
analysis. Accordingly, for consistent assessment of the possible labor requirement effects from
manufacturing compliance equipment, it was necessary to annualize the one-time labor effect.
Consistent with the annualization procedures elsewhere in the economic impact analysis, the one-
time labor compensation value of $37.2 million was annualized over a 16-year period at a social
discount rate of 7 percent as recommended by OMB (OMB, 1992). The social discount rate is
used rather than the industry discount rate because the social impacts are being assessed here,
and not impact on industry. The resulting annual value of gross labor compensation in
manufacturing compliance equipment is $3.9 million.
7-18
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Conversion to Fulltime Employment Equivalent Basis
To convert the gross payment to labor to FTEs, the payment to labor was divided by an
estimated yearly labor cost. The yearly labor cost is based on the same labor cost, $27.74 per
hour, used in the engineering cost analysis to estimate the cost of operating compliance
equipment. The $27.74 per hour is a comprehensive labor cost including an allowance for fringe
benefits (e.g., holidays, vacation, and various insurance) and payroll taxes, and was calculated in
1990 dollars. Assuming a 2,080 hour work-year, the gross annual labor cost per full-time
employment position is $57,699. On a one-time, one-year basis (i.e., not annualized), the $37.2
million labor outlay for manufacturing compliance equipment is estimated to require 645 FTEs.
On an annualized basis, the $3.9 million of gross labor cost for manufacturing compliance
equipment is estimated to require 68 FTEs.
7.22.2 Direct Labor Requirements for Installing Compliance Equipment
EPA estimated the direct labor requirements for installing compliance equipment in a
parallel manner to that used for analyzing the labor requirements for manufacturing compliance
equipment. Each component of the calculation is discussed below.
Cost of Installing Compliance Equipment
The cost of installing compliance equipment was estimated in conjunction with estimating
the purchase cost of compliance equipment. Specifically, on the basis of the kind, scale, and cost
of compliance equipment assessed for a facility, the technical contractors estimated an
installation cost for the equipment. The installation costs are calculated based on the assumption
that installation is typically equal to 10 percent of the total capital cost. This assumption is taken
from Peters and Timmerhaus (1980), which states that installation costs are typically 6 to 14
percent of fixed capital costs for new plant construction or construction of additions to existing
7-19
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facilities.9 The estimated installation costs averaged about 10 percent of the purchase cost of
the compliance equipment ($133.4 million) for a total of $13.3 million.
Labor's Expected Contribution to the Equipment's Value
The BEA industry group that EPA used as the basis for estimating labor's share of cost
in installing compliance equipment is the "Repair and Maintenance Construction Industry" (BEA
Industry Classification 12). In this industry group, gross payments to labor account for $0.42233
of each dollar of output value, as recorded in the direct requirements matrix for the national
input-output tables. Multiplying labor's share of value (0.42233) by the estimated total
installation cost ($133 million) yields a gross labor cost for compliance equipment installation of
$5.6 million. Like the purchase cost of compliance equipment, the installation cost is a one-time
outlay and, accordingly, an annualized value was calculated using the 16-year amortization period
and the 7 percent social discount rate. The resulting annual value for the labor cost of installing
compliance equipment is $0.6 million.
Conversion to Fulltime Employment Equivalent Basis
Conversion to an FTE equivalent basis is based on the same yearly labor cost, $57,699, as
used in estimating the labor requirements for the manufacturing of compliance equipment. On a
one-time, one-year basis, 98 FTEs are estimated to be required for installing the equipment
needed to comply with the selected regulatory options based on the $13.3 million gross labor
cost. Annualized over 16 years, the corresponding labor requirement for installing compliance
equipment is 10 FTEs.
'Personal communication with Radian Corp. (May 20,1994); This engineering text was used
to help develop many of the costs analyzed in this EIA, especially for developing distillation
treatment equipment costs.
7-20
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722.3 Direct Labor Requirements for Operating Compliance Equipment
The technical contractor estimated the annual labor hours required to operate
compliance equipment as the basis for assessing the annual operating and maintenance costs of
the pharmaceutical industry regulatory options. On an FTE basis, the estimated annual labor
requirement for operating compliance equipment is 1.8 million hours per year. Thus 889 FTEs
will be created annually for the maintenance of compliance equipment. This value is assumed to
recur annually over the period of analysis (16 years). The corresponding total annual estimated
payments to labor is $51.3 million (1990 dollars).
722.4 Total Direct Labor Requirements
Summing the three components yields the total direct labor requirements for complying
with the proposed pharmaceutical industry effluent guideline as represented by the selected
regulatory options (see Table 7-7). On an FEE basis, the estimated total annual labor
requirement is 967 FTEs. The corresponding total annual estimated payments to labor is $55.8
million (1990 dollars). To the extent that these labor requirements manifest as new labor needs
in the U.S. economy, the 967 FTEs have the potential to offset employment losses that might
otherwise occur because of the rule.
7.23 Estimating the Secondary (Indirect and Induced) Labor Requirement Effects
In addition to direct labor effects, the pharmaceutical industry effluent guidelines might
also generate labor requirements through the indirect and induced effect mechanisms thereby
generating secondary employment. The secondary effects associated with an economic activity
are analyzed by using multipliers. Multiplier estimates generally vary with the industry in which
the direct economic activities are expected to occur and with the economic characteristics of the
location of the direct activities.
7-21
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A range of multipliers was used in this analysis to illustrate the possible aggregate
employment effects of the effluent guideline. A recent EPA study used multipliers ranging from
3.5 to 3.9 to calculate the possible indirect and induced employment effects of direct activity
investments in general water treatment and pollution control (EPA, 1993). A study of "clean
water investments" commissioned by the National Utility Contractors Association (NUCHA;
Apogee Research, Inc., 1992) documented total employment effect multipliers ranging from 2.8
to 4.0. Using the high and low values for these multipliers, the indicated aggregate employment
effects associated with the direct labor requirement of 967 FTEs would range from 2,708 to 3,868
FTEs.
A more conservative assessment of these possible employment effects would recognize
that the three categories of labor requirements analyzed in Section 1.22 are likely to have
different indirect labor demand effects. In particular, the direct labor demands for
manufacturing and installing compliance equipment result from additional economic activity in
those industries. Accordingly, it is reasonable to expect that the additional economic activity in
manufacturing and installing equipment will translate into increased activity in the industries that
are linked to the direct effect industries and, hence, lead to additional labor demand in those
industries through the indirect effect mechanism. In contrast, the increased labor demand in the
pharmaceutical industry for operating compliance equipment does not result from increased
economic activity in that industry. As a result, increased labor demand in the pharmaceutical
industry resulting from the effluent guideline might not translate into increased labor
requirements in the industries that are linked to the pharmaceutical industry. In this case, the
appropriate employment multiplier for the equipment-operations component of direct labor
requirements should exclude the indirect effect mechanism and include only the induced effect
mechanism. Multipliers cited in the NUCHA study referenced above suggest that a multiplier
based only on the induced effect mechanism might fall in the range of 2.4 to 2.9. Using this
lower multiplier range for the equipment-operations component of direct labor requirements and
the higher, 2.8 to 4.0 range for the manufacturing and installation components, the estimated
7-23
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aggregate employment effects of the pharmaceutical industry effluent guideline would range from
2,35210 to 2,890U FTEs.
Primary employment gains estimates might be high because the 967 FTEs per year that
are gained might not actually create new jobs. Many facilities and firms, even when they remain
viable after compliance with the guidelines might need to cut back on production. These
potential cut-backs create slack time for the workers who might then divert their time towards
maintenance of the compliance equipment. Because data do not exist to estimate the number of
production hours, the number of production hour losses due to production line closures and
other production reductions cannot be estimated. It is, perhaps, more realistic to assume that
gains at the facility level (for operating and maintaining pollution control equipment—889 hours)
do no more than offset similar losses in production hours. More realistic primary gains are
therefore estimated at 78 FTEs.
Thus the lower end of the employment gams range might not be low enough. In the
worst case, it is assumed that the lower end of the range for induced labor effects relating to the
manufacturing and installing of equipment (2.8) is applied, and only this labor component is
counted as primary employment gains (78 FTEs). At the high end of the range, the primary
labor gains for all labor components are counted and the high-end multipliers are used (2.9 for
operating labor and 4.0 for manufacturing and installation). These assumptions produce
employment gains range between 218 and 2,890 FTEs.
7.3 NET EFEECT OF EMPLOYMENT LOSSES AND GAINS
In the worst case, the primary employment gains (78 FTEs) are expected to partially
offset employment losses (91 FTEs). Primary and secondary gains of between 218 and 2,890
FTEs are expected to offset to some extent the primary and secondary loss of 541 FTEs
estimated in Section 7.1. The net effect on employment therefore might range from a loss of 323
1078 x 2.8 + 889 x 2.4.
"78 x 4 + 889 x 2.9.
7-24
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FTEs to a gain of 2,349 FTEs. The net employment impact is negligible when compared to
national-level employment and will have no impact on national-level employment rates.
Under the alternative regulatory scenario (in-plant steam stripping/distillation), the
number of losses are the same, but the number of gains are slightly higher because of the
somewhat greater expenditures on equipment and installation (see Appendix C). A total of 83
FTEs (annual) would be expected to be added as a result of equipment manufacturing
requirements. A total of 13 FTEs (annual) would be expected to be added as a result of
installation needs and the number of FTEs for operation remain the same as in the selected
scenario. Thus, total gains under the alternative scenario would be 96 to 985 FTEs. Primary and
secondary gains would be 269 to 2,962 FTEs. Thus, the net effect of the alternative regulatory
scenario might range from a loss of 272 FTEs to a gain of 2,421 FTEs.
7.4 REFERENCES
Apogee Research, Inc., 1992. A Report on Clean Water Investment and Job Creation. Prepared
for National Utility Contractors Association, March 1992.
BEA, 1991a. The 1982 Benchmark Input-Output Accounts of the United States. U.S. Department
of Commerce
BEA, 1991b. "Benchmark Input-Output Accounts for the U.S. Economy, 1982." In: Survey of
Current Business, July.
BEA, 1992. Regional Multipliers: A User Handbook for the Regional Input-Output Modeling System
(RIMSII). U. S. Department of Commerce, Washington, D.C.
OMB, 1992. Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs.
Circular A-94, Oct. 29,1992.
Peters and Timmerhaus, 1980. Plant Design and Economics for Chemical Engineers. Third
edition.
U.S. EPA. 1993. U.S. Environmental Protection Agency. Job Creation Fact Sheet. Office of
Water, internal document, February.
7-25
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SECTION EIGHT
ANALYSIS OF FOREIGN TRADE IMPACTS
Pharmaceutical products are traded in an international market, with producers and buyers
located worldwide. Changes in domestic pharmaceutical production due to the effluent
guidelines might therefore affect the balance of trade. Exports might decrease as previously
exported products are no longer manufactured, and imports might increase as domestic
purchasers seek new sources of Pharmaceuticals discontinued as a result of facility and/or
company closures.
These foreign trade effects are the focus of this section of the EIA. The total change in
value of U.S. pharmaceutical exports resulting from the guidelines is estimated. The significance
of this change is then scrutinized by comparing it with total value of current U.S. pharmaceutical
exports. Ideally, the analysis would extend to consideration of changes in imports, as well as
additional export losses from facilities experiencing impacts short of closure, such as product line
closures. Analysis of these issues, however, would require an international market model. This
is beyond the scope of the current analysis.
Section 8.1 presents the methodology used to estimate the change in the value of exports
and evaluate the significance of this impact. Results of the analysis are presented in Section 8.2.
8.1 METHODOLOGY
For facilities expected to close that exported a portion of their pharmaceutical production
in 1990, the value of 1990 pharmaceutical exports is estimated. The estimate for each facility is
obtained directly from survey data: the total value of pharmaceutical shipments reported by the
facility is multiplied by the percentage of pharmaceutical shipments exported and these values
are summed across closing facilities to obtain an estimate of the total value of U.S.
8-1
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pharmaceutical exports no longer produced. This value is then compared to the total value of
U.S. pharmaceutical exports produced in 1990.
The analysis assumes that none of the decreased production of exported pharmaceutical
products is replaced by alternative U.S. products. This "worst-case" assumption is very
conservative and is likely to overestimate the reduction in exports. If the impact on foreign trade
is not significant in this worst-case scenario, then more realistic scenarios would also indicate no
significant impacts. Likewise, increases in imports are assumed to be equivalent to the decline in
exports (consistent with the zero cost-passthrough assumption used in the facility- and firm-level
impact models). The existing balance of trade is then adjusted to reflect the increase in the
value of imports and decline in the value of exports. A comparison of pre- and post-regulation
trade balances will reveal the extent of the regulation's impact on the U.S. balance of trade.
8.2 RESULTS
The impact of effluent guidelines on pharmaceutical exports and the U.S. balance of
trade is negligible. As discussed in Sections Five and Six, no facilities are expected to close as a
result of the selected regulatory options and only one firm/facility (a B/D indirect facility) is
expected to fail. As can be seen in Table 8-1, this firm has pharmaceutical exports totaling $76
thousand. The loss of these exports has virtually no effect on U.S. pharmaceutical exports,
which, according to the U.S. Department of Commerce, totalled $5.7 billion in 1991 (see Section
Three). Results are the same under the alternative regulatory scenario.
8-2
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TABLE 8-1
LbSS IN FOREIGN SHIPMENTS FOR SELECTED
OPTIONS (Thousands of 1990 $): POSTCOMPLIANCE ANALYSIS
Facility
Subcategory
Exports
Lost
Total
Exports
%of
Total
A/C
B/D
$0
$0
$65,249
$9,175
0.00%
0.00%
A/C
B/D
$0
$76
$443,450
$431,834
0.00%
0.02%
A/C
B/D
$0
$0
$2,444
$846
0.00%
0.00%
TOTAL
$76
$952,998
0.01%
* These numbers reflect those foreign shipments projected to
remain following the baseline analysis.
Note:
1. Analysis assumes no foreign shipments are lost for certified
facilities.
2. Analysis excludes 12 facilities (1 A/C direct discharger,
1 B/D direct discharger, 1 A/C indirect discharger, 8 B/D
indirect dischargers, and 1 A/C zero discharger) because of
lack of financial data.
Source: ERG estimates.
8-3
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SECTION NINE
REGULATORY FLEXIBILITY ANALYSIS
9.1 INTRODUCTION
The Regulatory Flexibility Act requires the federal government to consider the impacts
on small entities (as defined in 13 CFR Part 121) as part of rulemaking procedures. The goal of
the analysis is to ensure that small entities potentially affected by a new regulation will not be
disproportionately burdened. Small entities have limited resources, and it is the responsibility of
the regulating federal agency to avoid, if possible, disproportionately or unnecessarily burdening
such entities.
The effluent guidelines and standards for the pharmaceutical industry will affect how
small firms in this industry treat their wastewater. Section 9.2 discusses the analyses that must be
undertaken according to EPA guidance; Section 9.3 presents the analyses required for an Initial
Regulatory Flexibility Analysis (IFRA), Section 9.4 presents a profile of the affected small firms;
and Section 9.5 determines the aggregate and firm-level impacts on small firms.
9.2 SUMMARY OF EPA GUIDELINES ON RFA REQUIREMENTS
EPA guidelines now require EPA Offices to perform Regulatory Flexibility Analyses
(RFAs) for regulations that have any effect on any small entities. Formerly, EPA determined
whether an RFA should be performed by determining whether the rule in question had a
significant economic impact on a substantial number of small entities. When using this approach,
EPA spent time trying to determine whether the rule did have a significant impact on a
substantial number of small entities. With the new approach, EPA can bypass much of this
preliminary analysis and proceed to address the impacts on the affected entities.
EPA's approach is divided into two stages: an Initial Regulatory Flexibility Analysis
(IRFA), performed for a proposed rule, and a Final Regulatory Flexibility Analysis, (FRFA),
9-1
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performed for a final rule. This EIA is being prepared for a proposed rule, so an IRFA must be
performed at this time.
The IRFA is divided into six requirements:
• Explain why the Agency is considering taking action.
• State succinctly the objectives of, and legal basis for, the proposed rule.
• Describe and, where feasible, estimate the number of small entities to which the
proposed rule will apply.
• Describe the projected reporting, recordkeeping, and other compliance
requirements of the proposed rule, including an estimate of the classes of small
entities that will be subject to the requirements and the type of professional skills
necessary for preparation of reports or records.
• Identify, to the extent possible, all relevant federal rules that might duplicate,
overlap, or conflict with the proposed rule.
• Describe any significant alternatives to the proposed rule that accomplish the
stated objectives of applicable statutes while minimizing the rule's economic
impact on small entities.
Specific analyses suggested by the guidelines for characterizing impacts include the
following:
A closure analysis (at the firm level) using ratio analysis (see Section Six). To
characterize impacts for this IRFA, this section summarizes the information in
Section Six, comparing the relative post-regulatory health of small firms with that
of larger firms.
A discounted cash flow analysis examining the consequences of the annual costs
of compliance. This analysis investigates the impacts on cash flow by determining
the present value of total compliance costs at a firm as a percentage of the
present discounted value of cash flow (in this EIA, net income is used as a more
conservative estimate of income—see Section Five for a further discussion).
A socioeconomic analysis, if the number of affected firms leads to changes in:
employment conditions, income, social service expenditures, tax revenues, and/or
balance-of-trade levels.
9-2
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The first two items are discussed in Section 9.5. Many of the socioeconomic impacts are,
however, expected to be minimal because of the very small number of firms affected by the
regulation (a small subset of the pharmaceutical industry only). However, potential impacts on
communities are discussed in Section Seven and distributional impacts, including the potential for
increases in payments by state and federal governments for Medicare and Medicaid, are
discussed in Section Ten.
9.3 IRFA INFORMATION REQUIREMENTS
9.3.1 Reasons for Taking Action and Objectives of and Legal Basis for the Proposed
Rule
The Federal Water Pollution Control Act Amendments of 1972 established a
comprehensive program to "restore and maintain the chemical, physical, and biological integrity
of the Nation's waters" (Section 101[a]). To implement the Act, the U.S. EPA is required to
issue effluent limitations guidelines, pretreatment standards, and new source performance
standards for industrial dischargers.
932 Estimates of the Affected Population of Small Businesses
A basic step in conducting an IRFA is to estimate the affected population. Small firms
are defined in 13 CFR Part 121 either by their employment size or their revenues. In SIC 2833
and 2834, small firms are defined as those employing 750 or fewer persons; in SIC 2835 and
2836, those employing 500 or fewer persons are defined as small. For simplicity, this IRFA
designates all pharmaceutical firms as small if they employ fewer than 750 persons. For greater
awareness of where impacts are occurring, this analysis further breaks down small firms into
employment groups. These groups are as follows:
• 0-18 employees
• 19-99 employees
9-3
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• 100-499 employees
• 500-750 employees
• > 750 employees
This analysis therefore will consider all categories except the > 750 category as small for
the purposes of identifying the affected small business population.
The numbers of firms in each grouping are presented in Table 9-1. These numbers
reflect all firms in the survey universe including those expected to fail in the baseline. As the
table shows, out of 1901 firms in the survey universe, 76 percent are small firms.2 The largest
percentage of firms are in the 100-499 employees size group (37 percent of all firms in the survey
universe).
9.3.3 Projected Recordkeeping and Reporting Requirements
The proposed effluent guidelines for the pharmaceutical industry are revisions to existing
effluent guidelines, thus most recordkeeping and reporting requirements are not incremental to
existing guidelines. The exception is new monitoring requirements. The costs of monitoring
have been estimated by EPA's technical contractor and are reported on a per-facility basis (EPA,
1995). Monitoring costs to industry total $9.0 million annually and average 15 percent of the
total annual compliance cost for the selected options (computed as a median of firm-by-firm
percentages among firms incurring compliance costs). Costs for monitoring by size of firm are
shown in Table 9-2. As the table shows, large firms incur the largest proportion of monitoring
costs (61 percent of total monitoring costs). Monitoring costs are a larger share of total annual
1This number differs from the number of firms analyzed in Section Six because three firms
with insufficient data were dropped from the Section Six analysis.
2The number of small firms might be overestimated. Because of data limitations in the
Section 308 survey, firm size was computed on the basis of total employment at each firm's
facilities plus 10 percent of that total facility employment (see Section Seven for the method used
for computing nonfacility employment at firms). Many firms, however, could own other
nonpharmaceutical facilities or other pharmaceutical facilities that are not covered by the
proposed effluent guidelines. Thus, total employment at one firm could be underestimated.
9-4
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TABLE 9-2
INCREMENTAL RECORDKEEPING AND REPORTING COSTS
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
# Firms with
Nonzero
Compliance
Costs
9
26
47
17
40
Total
Monitoring
Costs
$105,215
$984,005
$1,623,545
$844,635
$5,478,385
% of Total
Industry
Monitoring
Costs
1%
11%
18%
9%
61%
Total Pretax
Compliance
Costs*
$527,596
$8,025,577
$11,725,311
$9,668,052
$83,456,895
Monitoring Costs
as % of
Compliance Costs**
1.2%
16.7%
25.4%
19.8%
10.2%
All Firms <= 750
All Finns
99
139
$3,557,400
$9,035,785
39%
100%
$29,946,536
$113,403,432
20.0%
L 14.8%
* Pretax compliance costs are ammalized at 11.4%.
** Percentage calculated as the median of monitoring costs divided by compliance costs for each firm in
the group rather than average monitoring costs divided by average compliance costs. Analysis does
not include firms with zero compliance costs.
Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.
Source: ERG estimates based on Radian Corp. estimates of capital and operating costs for pollution control
equipment (including operating costs).
9-6
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compliance costs at small firms (20 percent) than at large firms (10 percent). The highest
proportion (25.4 percent) of monitoring costs as a percentage to compliance costs is experienced
among firms in the 100-499 employees size group. In general, however, small firms do not
appear to be disproportionately affected by recordkeeping and reporting requirements compared
to large firms, since small firms incur only 39 percent of total industry monitoring costs yet make
up 76 percent of the affected industry. Monitoring costs as a percentage of total compliance
costs are much lower (6.7 percent for all firms) under the alternative regulatory scenario (steam
stripping/distillation) because monitoring costs do not change but compliance costs are greater
(see Appendix C).
9.3.4 Other Federal Requirements
EPA is aware of no federal rules that duplicate, overlap, or conflict with the proposed
effluent guidelines for the pharmaceutical industry.
9.3.5 SigniGcant Alternatives to the Proposed Rule
For A/C direct dischargers EPA did not select the lowest-cost option because incremental
impacts from BAT-A/C#2 compared to BAT-A/C#1 were negligible. For B/D direct
dischargers, EPA determined that impacts from more stringent options would not be measurably
greater than those from the least costly option. However, the Agency also concluded that
existing levels of pollutants of concern were sufficiently low in this group's discharges that the
selection of the lowest-cost option not only guaranteed the lowest possible impacts on small firms
but also still met the stated objectives of the Clean Water Act. A no-action alternative would
not meet the stated objectives of the Act.
For indirect dischargers EPA selected the least costly alternatives under consideration
short of not regulating these discharges. These alternatives are considered the least expensive
option for indirect dischargers (small or large) that meet the stated objectives of the Clean Water
Act (the no-action alternatives would not meet these objectives).
9-7
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Because some firms in the smaller size groups already achieve a level of pollution control
equivalent to that in the proposed effluent guidelines and because impacts overall are low for all
size groups (see discussion in Section 9.5) impacts, while slightly more noticeable among certain
small firms, are not considered excessively disproportionate.
Thus the Agency believes the stated objectives of the Clean Water Act are met with this
proposed rule, while the impacts to small firms have been considered, where possible.
9.4 PROFILE OF SMALL PHARMACEUTICAL FIRMS
Tables 9-3 through 9-5 provide general information about the financial condition of small
pharmaceutical firms in the Section 308 survey as compared to large firms (all firms are
considered here, not just the financially healthy firms). As Table 9-3 shows, median total assets
and liabilities rise with size, as does median net income. In general, small firms tend to have
lower ROA than large firms, although the 500 to 750 employees size group has a considerably
higher ROA than firms with over 750 employees. The poorest performing groups are the 19 to
99 employees and the 100 to 499 employees size groups, which have a median ROA of 4 percent.
Predictably, average pharmaceutical costs and revenues tend to rise with the size of the
firm (see Table 9-4). Pharmaceutical revenues comprise 60 percent of total income in large
firms, whereas in small firms the proportion rises as high as 87 percent in the 500 to 750
employees size groups, indicating that these firms hold fewer diverse interests than firms in other
size groups. A diversity of holdings can minimize impacts from the proposed effluent guidelines
for the pharmaceutical industry. The less diverse holdings among the 0 to 18 and the 500 to 750
employees size groups make these firms somewhat more vulnerable to impacts from the
proposed effluent guidelines.
Table 9-5 profiles values of shipments and exports by size of firm. The proportion of
shipments exported shows no clear tendency to increase with size, with the 19 to 99 employees
size group averaging the highest percentage of exported shipments (4 percent exported), although
9-8
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TABLE 9-3
PROFILE OF PHARMACEUTICAL FIRMS BY SIZE:
FINANCIAL INDICATORS ($0001990)
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
Median Total
Assets
$892
$8,755
$72,347
$268,217
$823,484
Median Total
Liabilities
$294
$6,921
$34,549
$48,406
$268,484
Median
Net Income
$42
$282j
$1,926
$21,054
$136,560
Median
BaseROA
6%
4%
4%
15%
10%
All Firms <= 750
All Firms
$54,355
$95,340
$17,259
$34,549
$882
$2,469
5%
5%
Note: Analysis excludes eight firms because of lack of financial data.
Source: Section 308 Pharmaceutical Survey.
9-9
-------
TABLE 9-4
PROFILE OF PHARMACEUTICAL FIRMS BY SIZE:
PHARMACEUTICAL COSTS AND REVENUES ($0001990)
Employment
Size of Firm
0-18
19-99
100-499
500 - 750
>750
Median
Pharmaceutical
Costs
$368
$5,961
$20,050
$58,744
$166,763
Median
Pharmaceutical
Revenues
$898
$6,217
$24,665
$159,698
$367,568
Median
Total
Revenues
$1,068
$12,790
$60,263
$326,652
$911,056
% Pharmaceutical
Revenues to
Total Revenues*
78%
50%
58%
87%
60%
All Finns <= 750
All Firms
$9,210
$25,281
$21,304
$39,768
$46,595
$80,189
64%
64%
Footnotes:
* Median for each group is based on percentage calculated for each firm in the group rather than
median pharmaceutical revenues divided by median total revenues.
Note: Analysis excludes seven firms because of lack of financial data.
Source: Section 308 Pharmaceutical Survey.
9-10
-------
TABLE 9-5
PROFILE OF PHARMACEUTICAL FIRMS BY SIZE:
SHIPMENTS AND EXPORTS ($0001990)
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
Median
Exports
$0
$184,594
$48,321
$897,835
Median
Value of
Shipments
$611,594
$7,244,567
$24,485,315
$120,707,495
$2,395,200] $242,835,603
Exports as
% of Value
of Shipments*
0.0%
4.0%
0.2%
1.1%
1.1%
All Finns <= 750
All Finns
$75,716
$104,860
$15,155,041
$33^622,023
0.8%
1.0%
Footnote:
* Median for each group is based on percentage calculated for each firm in the
group rather than median exports divided by median shipments.
Note:
1. Analysis excludes three firms because of lack of financial data.
2. Analysis excludes finns with certified facilities.
Source: Section 308 Pharmaceutical Survey.
9-11
-------
total value exported does tend to increase with size (with one exception). On average, exports
are 0.8 percent of shipments at small firms, which is nearly the same as to that for large firms.
Table 9-6 presents the results of the baseline firm failure analysis by firm size. Small
firms tend to be projected to fail in the baseline disproportionately relative to large firms.
Although only 32 percent of small firms are considered likely to fail in the baseline, 45 out of a
total 54 baseline firm failures are expected among small firms, which is over 80 percent of
projected baseline failures. The group with the largest proportion of baseline firm failures is the
19 to 99 employees size group, in which nearly 50 percent of the group is projected to fail.
Firms in the 100 to 499 employees size group also are somewhat weaker than firms in the other
size groups (32 percent of the group is expected to fail). The healthier firms tend to be those in
the very smallest size category and the two largest size categories (500 to 750 employees and
more than 750 employees). This pattern of financial health also can be seen in Table 9-3, which
shows these size groups with the highest median ROA.
9.5 IMPACTS ON SMALL PHARMACEUTICAL FIRMS
Two measures of impact are used to determine whether disproportionate impacts are
occurring among small firms: the firm failure analysis and the discounted net income analysis.
These analyses are discussed below.
9.5.1 Firm Failure Analysis
In Section Six, the EIA examined firm-level impacts by comparing postcompliance
financial ratios to industry benchmarks and calculating the postcompliance change in firm-level
profitability. As discussed in this section, three firms are predicted to experience significant
impacts as a result of the proposed effluent guidelines under the selected options. These firms
would be at risk of financial failure, and, at the very least, would experience difficulty obtaining
financing for wastewater treatment capital investments. (The two firms in question have fewer
than 750 employees). One firm has fewer than 18 employees, one firm has 19 to 99 employees,
9-12
-------
TABLE 9-6
BASELINE FIRM FAILURES BY SIZE OF FIRM
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
Total
'Number
of Firms
17
33
68
24
45
Financially
Healthy Firms
#of
Firms
14
17
46
20
36
%of
Groups
82.4%
51.5%
67.6%
83.3%
80.0%
Firms Likely
to Fail
#of
Firms
3
16
22
4
9
%of
Groups
17.6%
48.5%
32.4%
16.7%
20.0%
All Finns <= 750
All Finns
142
187
97
133
68.3%
71.1%
45
54
31.7%
28.9%
Note:
1. Analysis excludes three firms because of lack of financial data
2. Analysis assumes that firms with certified facilities pass baseline.
Source: ERG estimates.
9-13
-------
and one firm has over 750 employees. Thus, two-thirds of the significant firm impacts are among
small firms. Overall, very few small firms are affected. Out of 97 small firms in the
postcompliance analysis, the 2 failing small firms represent only 2 percent of all small firms. This
result is the same under the alternative (in-plant steam stripping/distillation) regulatory scenario.
The EIA also examined the change in profitability among affected firms as a result of the
proposed effluent guidelines. Change in profitability was measured in Section Six as the change
between baseline and postcompliance annual ROA A change of greater than 5 percent was
identified as a significant impact. As seen in Table 9-7, which breaks out the profitability results
reported in Section Six into size categories, 14 out of 15 of the firms experiencing substantial
declines in ROA are considered small firms, which is 14 percent of all small firms in the
postcompliance analysis (97 small firms, when certifiers are included). Nearly all firms with
declines in ROA greater than 5 percent are in the 19 to 99 or 100 to 499 employees size group.
Only eight small firms (8 percent) would experience a decline of more than 20 percent. Under
the alternative regulatory scenario (in-plant steam stripping/distillation), 18 small firms (19
percent of all small firms) would experience a decline in ROA of more than 5 percent and 9
firms (9 percent) would experience a decline of more than 20 percent (see Appendix C).
9.5.2 Discounted Net Income Analysis
Table 9-8 shows the distribution of present discounted value of compliance costs as a
percentage of the present discounted value of net income (NPV) by firm size.
Except in the 19 to 99 employees size category, the total present value of compliance
costs as a percentage of NPV is, on average, smaller among small firms. It is not surprising that
the 19 to 99 employees size group is more heavily affected since it is one of the weaker groups
financially and has the highest median compliance costs of all small firm groups. In most cases,
the present value of compliance costs is less than 1 percent, on average, of NPV, computed on a
firm-by-firm basis. Furthermore, this percentage is lower for small firms (0.04 percent) than for
large firms (025 percent). Under the alternative regulatory scenario (in-plant steam stripping/
9-14
-------
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9-15
-------
TABLE 9-8
PRESENT VALUE OF COMPLIANCE COSTS AS A PERCENTAGE
OF PRESENT VALUE OF POSTCOMPLIANCE NET INCOME
Employment
Size of Firm
0-18
19-99
100-499
500 - 750
>750
Median
Compliance
Costs (PV)
$0
$385,101
$3,324
$54,327
$1,160,172
Median
Postcompliance
Net Income (PV)
$427,787
$6,883,179
$58,170,339
$432,987,636
$1,432,475,847
Compliance
Costs as %
of Net Income*
0.00%
2.11%
0.01%
0.01%
0.25%
All Finns <= 750
All Finns
$48,836
$84,814
$46,148,682
L_ $102,982,098
0.04%
0.06%
* Median for each group is based on percentage calculated for each firm in
the group rather than median compliance costs divided by median
postcompliance net income.
Note:
1. Analysis excludes three firms because of lack of financial data.
2. Analysis excludes all firms with certified facilities.
3. Analysis includes only those firms that pass both the baseline and
postcompliance analyses.
Source: ERG estimates.
9-16
-------
distillation scenario), small firms have compliance costs averaging 0.1 percent of NPV and large
firms, 0.5 percent (see Appendix C).
The above analyses indicate that although the small firms do bear a large portion of the
firm failures, these major impacts occur among a very small proportion (2 percent) of small
firms. Additionally, the present value of compliance costs compared to the present value of net
income are expected to be smaller, on average, among small firms than among large firms.
Therefore, overall, EPA finds that impacts on small firms are not disproportionate to those on
large firms under either the selected or alternative regulatory scenarios.
9.6 REFERENCES
U.S. EPA. 1995. U.S. Environmental Protection Agency. Development Document for Proposed
Effluent Limitations, Guidelines and Standards for the Pharmaceutical Manufacturing Point
Source Category. Washington, DC, February.
9-17
-------
SECTION TEN
ANALYSIS OF DISTRIBUTIONAL IMPACTS
Up to this point, the EIA has been conducted assuming zero cost passthrough (i.e., that
facilities cannot raise pharmaceutical prices in an effort to recoup regulatory costs). As pointed
out in Section Three, however, the assumption that pharmaceutical manufacturers act as pure
price takers in perfectly competitive markets probably would not hold true in most cases. Many
markets for specific drugs are characterized by monopolistic or oligopolistic conditions in which
manufacturers exercise considerable control over drug prices. The zero cost passthrough model
was employed nonetheless because product-specific demand elasticity data are lacking, and
because this assumption tends to overstate facility impacts rather than understate them (i.e., it
provides for a worst-case scenario of facility- and firm-level impacts).
Conversely, the assumption that facilities will bear the entire cost of incremental
regulatory costs might understate the economic impacts on consumers of Pharmaceuticals. If the
more realistic assumption that manufacturers will raise pharmaceutical prices in response to
increased regulatory costs is employed, then one needs to consider who will be affected by these
price increases and whether higher drug prices will affect certain demographic groups more than
others. For example, the elderly account for very large portion of all drug use. This group,
therefore, might be particularly hard hit by increases in drug prices. It might be reasonable to
assume that the uninsured population will also be particularly hard hit by increases in drug prices
because they have no immediate financial recourse and might have to make difficult decisions
between pharmaceuticals and other daily necessities. Ultimately, state and federal governments
might bear the costs of increased drug prices through Medicaid, Medicare, and other health
insurance programs.
This section first investigates the extent to which drug prices could rise assuming perfectly
inelastic demand. Given perfectly inelastic demand, the EIA calculates the rise in drug prices as
the ratio of total compliance costs to total cost of pharmaceutical production in the affected
facilities and in the pharmaceutical industry as a whole (e.g., if compliance cost are 1 percent of
10-1
-------
production costs, then drug prices are assumed to rise by 1 percent). The analysis then
investigates the impacts of increased drug prices on various demographic groups such as the
elderly, the population living under the poverty level, disadvantaged minorities, the uninsured,
and state and federal governments. In the absence of any quantitative data on price elasticities
and existing drug prices, the discussion is necessarily qualitative in nature. The discussion
assumes that pharmaceutical manufacturers are able to pass through all of the increased
regulatory costs associated with the various wastewater treatment options.
10.1 INCREASES IN DRUG PRICES
Table 10-1 shows compliance costs as a percentage of total pharmaceutical costs by
regulatory option. The average ratio for each facility subcategory ranges from 0.2 to 3.4 percent.
For all the selected regulatory options, the ratio of compliance costs to total pharmaceutical costs
is 1.6 percent. Table 10-1 also shows the distribution of the number of facilities by compliance
costs to pharmaceutical costs. As can be seen, 41 facilities (20 percent of all facilities in this
analysis) would incur compliance costs greater than 1 percent of total pharmaceutical production
costs, and three facilities (1 percent of all facilities) would incur compliance costs greater than 10
percent of total pharmaceutical production costs. A little over one quarter of all facilities would
experience no increase in total pharmaceutical production costs as a result of the effluent
guidelines. Under the alternative regulatory scenario (steam stripping/distillation) the percentage
of compliance costs to total pharmaceutical production costs would average 2.5 percent (see
Appendix C).
Reliable data on total U.S. pharmaceutical production costs are not available. Thus, the
EIA cannot precisely compute compliance costs as a percentage of total U.S. pharmaceutical
production costs. Nevertheless, it is clear that if worst-case compliance costs average 1.6 percent
of the total pharmaceutical costs of the regulated sector, this ratio would be significantly lower if
compliance costs were compared to production costs for the entire industry.
10-2
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10-3
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10.2 IMPACTS ON SPECIFIC DEMOGRAPHIC GROUPS
Although in the aggregate, the potential overall increase in drug prices attributable to
increased regulatory costs is minuscule, the potential increase in specific drug prices might have a
significant impact on certain demographic groups. As noted above, three facilities will
experience compliance costs in excess of 10 percent of total pharmaceutical manufacturing costs.
If the drugs produced by these facilities are unique (i.e., protected from direct competition either
through patents or a lack of close substitutes) then these facilities might be able to increase the
price of their drugs in order to offset compliance costs. Table 10-2 presents the result of an
examination of the products produced by facilities that incur compliance costs greater than 10
percent of total pharmaceutical production costs and presents which groups predominantly use
the types of products made at these facilities.
Because of confidentiality, the name or type of drug is not presented. The unknown
category deals with products that might be inputs to drugs rather than drugs themselves (i.e.,
they are primarily reported as chemical names).
As Table 10-2 shows, children (including infants and adolescents), women, and the elderly
are likely to be the major consumers of many of these products. According to Health Insurance
Association of America (HLAA, 1991), the groups least likely to have health insurance are
hispanics (312 percent of whom lack health insurance), young adults 16-24 years of age (203
percent of whom lack health insurance), young adults 25-34 years of age (173 percent of whom
lack health insurance), and African Americans (17.5 percent of whom lack health insurance);
African Americans, hispanics, and children are most likely to be covered by government
insurance, and African Americans, hispanics, and the elderly are least likely to have insurance
related to employment. Government insurance programs tend to spend less on drugs and other
medical nondurables than do private insurers, according to this same source, and about 93
percent of people with work-related medical insurance have some type of drug insurance.
When all these factors are accounted for, it appears that those who lack any health
insurance, those who are covered by government insurance, and those who are covered by
nonwork-related medical insurance might be least likely to have drug coverage. This group
10-4
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10-5
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would include: hispanics, African Americans, the elderly, young adults (16-34), and children
(under 16). When the predominant consumers of the products expected to be affected by
potentially sizeable cost increases are compared to the groups most likely to lack drug insurance,
young adult women, children, and the elderly are likely to be the most heavily affected by
potential cost increases, if such increases can be passed through to consumers.
Because, on average, any potential price increases are likely to be very low (1.6 percent
on average), impacts on mass consumers of drugs such as HMOs, governments, and, indirectly,
third-party insurers, should be minimal.
10.3 REFERENCES
HIAA, 1991. Source Book of Health Insurance Data. Health Insurance Association of America.
Overton, V. Demographics of the Major Users of Selected Drugs. Memorandum dated August
8,1994 (confidential business information).
10-6
-------
SECTION ELEVEN
ANALYSIS OF IMPACTS ON NEW SOURCES
The selected options for new sources are NSPS-A/C#1, NSPS-B/D#1, PSNS-A/C#1, and
PSNS-B/D#1. In all cases, the requirements for new sources are more stringent than those for
existing sources. However, the difference in cost between new source requirements and existing
source requirements for typical facilities are relatively small when compared to the average
facility costs of production. In most cases, existing facilities would be required to retrofit in-plant
steam stripping systems, whereas new sources would have to install in-plant steam
stripping/distillation systems. Because designing in pollution control equipment in a new source
is typically less expensive than retrofitting the same equipment in an existing source, the cost
differential between the selected requirements for existing sources and those higher existing
source options that are technically equivalent to new source requirements should be an upper
limit on the differential annual cost faced by new sources. Where this differential is not
substantial relative to the typical costs of doing business in this industry, no significant barrier to
entry is likely to exist.
The average per-facility compliance costs were investigated to determine what the cost
differentials would be between proposed new source and existing source requirements. The
average per-facility cost differentials ranged from about a $34,000 to a $590,000 difference (for
A/C direct dischargers), depending on the type of facility (see Table 11-1). The maximum
$590,000 difference generates the highest percentage of compliance cost differential to
Pharmaceuticals manufacturing cost—about 1.4 percent of total manufacturing costs and about
3.0 percent of pharmaceutical manufacturing costs. Since this cost differential is likely to be less
than that assumed here, this small premium estimated to be paid by new sources is not likely to
have much impact on the decision to enter the market. Furthermore, these same options, when
applied to existing sources, were found to have nearly identical impacts on existing sources as the
selected options for existing sources. Thus no significant barriers to entry are estimated to result
from the proposed new source requirements.
11-1
-------
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Under the alternative regulatory scenario (in-plant steam stripping/distillation) only BAT-
B/D is less stringent than requirements for new sources. The cost differential between BAT and
NSPS requirements is estimated to be $53 thousand, or about 0.1 percent of pharmaceutical or
total manufacturing costs.
11-3
-------
APPENDIX A
ASSUMPTIONS USED OR CONSIDERED FOR USE
IN THE COST ANNUALIZATION MODEL
A-l
-------
APPENDIX A
ASSUMPTIONS USED OR CONSIDERED FOR USE
IN THE COST ANNUALIZATION MODEL
A.1 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)
The cost annualization model presented in Section Four is based on an assumption that
firms will use the Modified Accelerated Cost Recovery System (MACRS) to depreciate their
pollution control equipment for tax purposes. The Internal Revenue Service Tax Code requires
firms to use either the MACRs depreciation method or a straight-line method to depreciate
assets that were put into service after December 31,1986. MACRS, however, offers companies
an advantage over the straight line method, because a company's income might be reduced under
MACRS by a greater amount in the early years when the time value of money is greater. Table
A-l illustrates the advantage of using MACRS. Although the absolute amount depreciated
under the straight line method and MACRS is equivalent ($614,487), MACRS provides a $9,745
benefit (in present value) because of the timing differences in writing off the investment. The
example in Table A-l uses a midyear convention for putting the equipment into operation, which
assumes only 6 months of depreciation in the first year (as well as only 6 months in the last
year).
A3. TIMING
The second assumption used in the cost annualization model is one of timing. Although,
the midyear convention frequently is used when calculating depreciation (as was done above), it
is not appropriate for the analysis in Section Four. Approximately one year would be required to
build and install most of the equipment considered in the regulatory alternatives. Additional
time might be required for design, permitting, and site preparation. The cost annualization
model, therefore, assumes a 1-year delay from the capital expenditure to the beginning of
operation. As shown in Table A-2, the capital expenditure is listed in Year 1, but depreciation
A-3
-------
TABLE A-l
COMPARISON OF STRAIGHT LINE DEPRECIATION VS.
MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)
Capital Cost (Line A): $614,487
Discount Rate: 1 1.4%
Equipment Lifetime (Line B): 15
Marginal Tax Rates:
Federal 34.0%
State
Overall (Line C)
1
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
Sum
Present Value[a]
2
Annual
Depreciation
(MACRS)
(Line A* 0.05)
$30,724
$58,376
$52,539
$47,315
$42,584
$38,283
$36,255
$36,255
$36,316
$36,255
$36,316
$36,255
$36,316
$36,255
$36,316
$18.127
$614,487
$328,531
6.8%
40.8%
3
Annual
Depreciation
(Straight-Line)
((Line A/Line B)/2)
$20,483
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$40,966
$20.483
$614,487
$304,615
4
Tax Shield
(MACRS)
(Line C* Col 2)
$12,520
$23,788
$21,409
$19,281
$17,353
$15,600
$14,774
$14,774
$14,799
$14,774
$14,799
$14,774
$14,799
$14,774
$14,799
$7.387
$250,403
$133,876
5
Tax Shield
Straight-Line
(Line C* Col 3)
$8,347
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$16,694
$8.347
$250,403
$124,131
Net benefit of using MACRS v.
straight line (Col 4-Col 5) ($year 1)
$9,745
A-4
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A-5
-------
and annual O&M costs are not listed until Year 2 (assumed to be the first full year of
operation).1 The 1-year delay also changes each year's depreciation rates (see column 2).
A3 DERIVATION OF DEPRECIATION RATES
Table A-3 shows the derivation of depreciation rates used in the cost annualization
model. The calculation uses the assumption that a 150 percent declining balance (DB) method
(MACRS) is used, switching to a straight-line method in Year 5 as allowed by Section 168(b)(2)
of the Internal Revenue Code. The switch point is determined by the year in which depreciation
calculated by the straight-line method equals or exceeds that determined by the declining balance
method. More in-depth information on how to calculate a MACRS depreciation rate can be
found in the U.S. Master Tax Guide (Commerce Clearinghouse, Inc., 1991).
A.4 AVERAGE STATE TAXES
The cost annualization model uses an average state tax rate (see Section Four). State
corporate income taxes are presented in Table A-4. As the table shows, the average rate over all
states is 6.75 percent.
AJS ADDITIONAL CONSIDERATIONS
The cost annualization model does not consider how the facility will raise the capital to
finance the new pollution control requirements. A facility could finance its investment through a
bank, take money out of working capital, or issue a corporate bond. In any case, the present
value analysis assumes a cost to the facility of 11.4 percent (the discount rate) to use the money,
whether that amount is paid as interest or is the opportunity cost of the internal funding.
1 Assuming the equipment goes into service midway through the first year, the annualized cost
would decrease slightly because a 5-percent depreciation of the capital investment would more
than exceed a half year of O&M expenses.
A-6
-------
TABLE A-3
CALCULATION OF MACKS DEPRECIATION RATES
Assumptions:
1. Property goes into service at beginning of year
2. 150% double declining balance (DB) method (MACRS)
3. 15-year property
4. Assume $10,000 unadjusted basis
5. Columns 4 and 7 switch to straight-line in Year 5
Year
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Sum
Years Remaining Straight-line 150% DB Rate
At Beginning Rate On Adjusted Baas
Of Year 0/Col 2) (I/Col 2 * 15)
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0.00%
6.67%
7.14%
7.69%
833%
9.09%
10.00%
11.11%
12.50%
14.29%
16.67%
20.00%
25.00%
33.33%
50.00%
100.00%
0.00%
10.00%
10.71%
11.54%
12.50%
9.09%
10.00%
11.11%
12.50%
14.29%
16.67%
20.00%
25.00%
33.33%
50.00%
100.00%
Annual
Depreciation[a]
$1,000
$964
$927
$889
$565
$565
$565
$565
$565
$565
$565
$565
$565
$565
$565
$10,000
Adjusted Basis
atYear£nd[b]
$10,000
$9,000
$8,036
$7,109
$6,220
$5,655
$5,089
$4,524
$3,958
$3,393
$2,827
$2,262
$1,696
$1,131
$565
$0
150% DB Rate
On Unadjusted
Basis[c]
(Col 5/510,000)
10.00%
9.64%
9.27%
8.89%
5.65%
5.65%
5.65%-
5.65%
5.65%
5.65%
5.65%
5.65%
5.65%
5.65%
5.65%
100.00%
[a] Ex: Year 1 = Year 0 in Col 4* Year 1 in Col 6.
[b] Ex: Year 2= Year 1 in Col 6-Year 2 in Col 5
[c] Equivalent to column 2 in Table 4-2.
A-7
-------
TABLE A-4
STATE CORPORATE INCOME TAXES
State
Alabama
Alaska
Arizona
Arkansas
California
Colorado
Connecticut
Delaware
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island
South Carolina
South Dakota
Tennesee
Texas
Utah
Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming
Average:
Corporate
Income Tax
5.00%
9.40%
9.30%
6.00%
9.30%
5.00%
11.50%
8.70%
5.50%
6.00%
6.40%
8.00%
4.00%
4.50%
12.00%
6.75%
8.25%
8.00%
8.93%
7.00%
9.50%
2.35%
9.80%
5.00%
5.00%
6.75%
7.81%
0.00%
8.00%
9.42%
7.60%
9.00%
7.00%
10.50%
8.90%
6.00%
6.60%
12.25%
9.00%
5.00%
0.00%
6.00%
0.00%
5.00%
8.25%
6.00%
0.00%
9.30%
7.90%
0.00%
6.75%
Basis for States
With Graduated
Tax Tables
(Earnings)
$90,000+
$100,000+
$100,000+
Plus Excise Tax
$250,000+
$250,000+
$200,000+
$250,000+
$10,000+
$50,000+
$lM21ion+
$50,000+
Based on Stock Value
$250,000+
Sources: Fortune Magazine, 1991;
State Tax Handbook, 1991.
A-8
-------
According to current tax law, if the facility finances the investment using debt, the associated
interest expenses can be deducted, thereby reducing taxable income. The tax shield on the
interest payments thus would reduce the annualized cost of compliance. In contrast, the
opportunity cost of using working capital is not available. Table A-2 illustrates the effect of 100-
percent debt financing. In this case, the annualized compliance cost would drop by
approximately 4 percent due to tax shields on the interest payments. To maintain a conservative
cost estimate, tax shields on interest payments (Column 10) are not considered in the cost
annualization model. If a facility used 100 percent debt financing, the present value of
incremental costs would be further reduced, in the case illustrated, by $31,800.
A final consideration is Section 169 of the Internal Revenue Code which provides the
option to amortize pollution control facilities over a 5-year period (IRS, 1988). Under this IRS
provision, 75 percent of the investment could be rapidly amortized in a 5-year period using a
straight line method. The 75-percent figure is based on the ratio of the allowable lifetime (15
years) to the estimated usable life (20 years) as specified in IRS Section 169, Subsection (f).
Although the tax provision enables the facility to expense the investment over a shorter time
period, the advantage is substantially reduced because only 75 percent of the capital investment
can be recovered. Table A-5 illustrates this tax provision using hypothetical costs. The present
value of the tax shield from depreciation increases only slightly, thereby decreasing the present
value of annualized costs from $101,207 (see Table A-2) to $100,070 (see Table A-5). Because
the benefit of the provision is so slight and facilities might not be able to get the required
certification to take advantage of it, this provision was not included in the cost annualization
model. Its exclusion results in a more conservative estimate of compliance costs.
A.6 REFERENCES
Fortune Magazine, 1991. Fortune Forcast. June 3. pp. 22-23.
Commerce Clearinghouse, Inc. 1991. U.S. Master Tax Guide. Chicago, 1990.
A-9
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APPENDIX B
RESULTS OF SENSITIVITY ANALYSIS USING NO SALVAGE VALUE
IN COMPUTING FACILITY CLOSURES
B-l
-------
APPENDIX B
RESULTS OF SENSITIVITY ANALYSIS USING NO SALVAGE VALUE
IN COMPUTING FACILITY CLOSURES
In Section Five, the EIA presented an analysis of facility closures using the assumption
that salvage value plays a role in the decision for a multifacility firm to close and liquidate a
marginally profitable or unprofitable facility. Using salvage value in a closure model might not
accurately reflect closure decisions. First, salvage value is difficult to compute accurately.
Second, under some circumstances (for instance if the facility acts as a captive to the owner firm,
transferring goods to the owner firm rather than selling goods at market prices) the salvage value
of a single facility might be irrelevant to closure decisions. To determine whether using salvage
value makes any difference in the outcome of the facility closure analysis, this appendix presents
a sensitivity analysis, where salvage value is assumed to be $0 for all facilities.
Table B-l presents the results of this alternative analysis in the baseline. As the table
shows, only 18 facilities, or 6 percent of all facilities in the analysis are expected to close under a
zero salvage value assumption. In contrast, in Section Five, 38 facilities, or 13 percent of all
facilities were estimated to close in the baseline.
In the postcompliance analysis, as Tables B-2 and B-3 show, there is no change from the
results shown for A/C and B/D direct dischargers in Section Five. For the A/C indirects,
however, where no facilities closed under any of the regulatory options in the Section Five
analysis, one, one, two, and four facilities are expected to close under Options #1, #2, #3, and
#4, respectively, when zero salvage value is assumed (see Table B-4). Four B/D indirects also
are estimated to close under PSES-B/D#3 with a zero salvage value assumed, vs. only one in the
Section Five analysis. Under the selected regulatory options, however, only one facility closes
when a zero salvage value is assumed (see Table B-5). This difference in results from the
original analysis is so slight that EPA chose to continue using the standard analysis used in
previous effluent guidelines EIAs rather than to assume that salvage value plays no role in the
decision to close a facility.
B-3
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APPENDIX C
ANALYSIS OF THE ALTERNATIVE REGULATORY SCENARIO
C-l
-------
APPENDIX C
ANALYSIS OF THE ALTERNATIVE REGULATORY SCENARIO
Tables C-l through C-8 present the results of analyses of the alternative regulatory
scenario (steam stripping/distillation) discussed in the main body of this report.
C-3
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C-4
-------
TABLE C-2
POSTCOMPLIANCE ANALYSIS 1 *
ALTERNATIVE REGULATORY OPTIONS
Firms with A/C Direct Facilities
Finns with B/D Direct Facilities
Finns with A/C Indirect Facilities
Finns with B/D Indirect Facilities
Total
Number
of Firms
15
7
53
72
No Significant
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51
71
%of
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100.0%
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AllFinns+
133
1301 97.7%
3
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* This scenario analyzes impacts from regulating A/C Direct facilities under options BAT-A/C#2
and BPT-A/C#2, B/D Direct facilities under options BAT-B/D#1 and BPT-B/D#2, A/C Indirect
facilities under option PSES-A/C#1, and B/D Indirect facilities under option PSES-B/D#1.
** Out of all firms in the postcompliance analysis (133 firms).
+ Number of firms for All Firms might be less than the total firms by subcategory because some
firms have more than one type of facility. Total number of All Firms includes firms that have
nondischarging facilities
Note: Analysis excludes three firms because of lack of financial data.
Source: ERG estimates.
C-5
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C-7
-------
TABLE C-5
INCREMENTAL RECORDKEEPING AND REPORTING COSTS FOR ALTERNATIVE OPTIONS
Employment
Size of Firm
0-18
19-99
100 - 499
500 - 750
>750
# Firms with
Nonzero
Compliance
Costs
9
26
47
17
40
Total
Monitoring
Costs
$105,215
$984,005
$1,623,545
$844,635
$5,478,385
% of Total
Industry
Monitoring
Costs
1%
11%
18%
9%
61%
Total Pretax
Compliance
Costs*
$726,763
$11,281,919
$17,725,628
$15,549,877
$138,878,766
Monitoring Costs
as % of
Compliance Costs**
1.2%
7.8%
9.3%
6.8%
6.6%
All Finns <= 750
All Firms
99
139
$3,557,400
$9,035,785
39%
100%
$45,284,187
$184,162,953
8.6%
7.8%
* Pretax compliance costs are amraalized at 11.4%.
** Percentage calculated as the median of monitoring costs divided by compliance costs for each firm in
the group rather than average monitoring costs divided by average compliance costs. Analysis does
not include firms with zero compliance costs.
Note: These numbers are for all facilities and do not reflect closures predicted by the analyses in this report.
Source: ERG estimates based on Radian Corp. estimates of capital and operating costs for pollution control
equipment (including operating costs).
C-8
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C-9
-------
TABLE C-7
PRESENT VALUE OF COMPLIANCE COSTS AS A PERCENTAGE
OF PRESENT VALUE OF POSTCOMPLIANCE NET INCOME
FOR ALTERNATIVE OPTIONS
Employment
Size of Finn
0-18
19-99
100 - 499
500 - 750
>750
Median
Compliance
Costs (PV)
$0
$817,485
$3,324
$453,882
$1,893,578
Median
Postcompliance
Net Income (PV)
$427,787
$5,675,197
$58,170,339
$432,324,319
$1,430,472,878
Compliance
Costs as %
of Net Income*
0.00%
11.12%
0.02%
0.05%
0.47%
All Finns <= 750
All Finns
$54,327
$597,190
$45,984,357
$102,698,480
0.09%
0.14%
* Median for each group is based on percentage calculated for each firm in
the group rather than median compliance costs divided by median
postcompliance net income.
Note:
1. Analysis excludes three firms because of lack of financial data.
2. Analysis excludes all firms with certified facilities.
3. Analysis includes only those firms that pass both the baseline and
postcompliance analyses.
Source: ERG estimates.
C-10
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