1
MEMORANDUM
Date:
September
24,
2004
To:
316b
Rulemaking
Record
From:
Anne
Jones
and
Ian
Cadillac,
ERG,
Inc.
Subject:
MODU
Cost
and
Impact
Calculations
1.
Introduction
To
determine
impacts
on
MODUs,
ERG
uses
post­
tax
costs
of
compliance
assigned
to
existing
MODUs
by
EPA
(
U.
S.
EPA,
2004b)
to
compare
to
post­
tax
cash
flow
and
net
income
for
representative
MODUs
for
which
financial
data
were
collected
using
EPA's
316(
b)
survey
of
oil
and
gas
facilities.

In
the
Economic
Analysis
(
EA)
report
(
U.
S.
EPA,
2004a),
EPA
calculates
the
post­
tax
aggregate
compliance
costs
for
MODUs
as
a
simple
percentage
of
pre­
tax
costs,
assuming
all
MODUs
would
be
subject
to
a
35
percent
marginal
tax
rate,
the
maximum
corporate
tax
rate
according
to
IRS
rules
(
IRS,
2002).
For
additional
accuracy
in
developing
costs
to
be
applied
to
MODUs
in
the
economic
impact
analysis,
however,
we
use
a
more
sophisticated
method
for
calculating
post­
tax
costs.

This
memo
describes
the
approach
we
use
to
calculate
the
post­
tax
costs
of
compliance
using
a
standard
post­
tax
cost
calculation
model,
which
has
been
employed
numerous
times
in
many
effluent
guideline
economic
analyses
(
see,
for
example,
U.
S.
EPA,
2002).
This
model
allows
the
marginal
tax
rate
to
vary
depending
on
the
earnings
of
a
surveyed
firm
and
allows
an
accelerated
depreciation
on
the
capital
expenditures.
It
calculates
the
present
value
of
the
compliance
costs
after
accounting
for
a
more
precise
tax
shield
on
these
expenditures.
It
also
caps
the
amount
of
tax
shield
available
to
a
firm.

ERG
uses
a
second
model
to
calculate
the
present
value
of
net
income
and
the
present
value
of
cash
flow,
based
on
the
survey
results
for
the
8
respondents
that
provided
financial
data
on
their
MODUs.

Section
2
of
this
memo
discusses
the
details
of
the
post­
tax
calculation
model,
and
Section
3
discusses
the
impact
calculations.
Section
4
details
the
general
impacts.
Individual
facility
results
are
CBI,
so
these
are
only
revealed
in
Table
1
of
the
CBI
version
of
this
memo.
For
the
public
version,
Table
1
has
been
withheld.

2.
Post­
Tax
Compliance
Cost
Calculation
Model
2.1
Overview
of
Model
Inputs
Figure
1
is
an
example
of
the
method
used
to
calculate
the
present
value
of
future
compliance
costs.
Inputs
to
the
model
come
from
four
sources:
1)
the
capital,
permitting,
monitoring,
and
operating
and
maintenance
(
O&
M)
costs
for
incremental
pollution
control
developed
by
EPA,
2)
financial
data
taken
from
the
316(
b)
survey
of
MODUs
and
3)
secondary
sources.
The
model
calculates
two
types
of
compliance
costs
for
a
MODU:
2
#
Present
value
of
expenditures
 
before­
tax
basis
#
Present
value
of
expenditures
 
after­
tax
basis
The
model
is
defined
in
terms
of
2003
dollars
because
EPA
compliance
costs
are
reported
in
2003
dollars.
EPA
used
the
GDP
Deflator
to
adjust
316(
b)
survey
financial
data
from
2000,
2001,
and
2002
to
2003.
The
GDP
Deflator
is
a
quarterly
series
that
measures
the
implicit
change
in
prices,
over
time,
of
the
bundle
of
goods
and
services
comprising
gross
domestic
product.
Table
1
shows
GDP
Deflator
values
from
2000
to
2003.
From
2000
to
2003,
the
total
change
in
the
deflator
series
was
5.7%
(
105.7/
100.0).

Table
1
GDP
Deflator
Year
Value
%
Change
2000
100.0
2001
102.4
2.4%

2002
103.9
1.5%

2003
105.7
1.6%

Source:
U.
S.
BEA,
2004.

Pollution
control
capital,
monitoring,
and
permitting
costs
are
estimated
in
2003
dollars
or
converted
to
2003
dollarsand
are
used
to
project
cash
outflows.
MODUs
do
not
incur
incremental
O&
M
costs.

EPA
used
Engineering
News­
Record
(
ENR)
Costruction
Cost
Index
(
CCI)
to
adjust
compliance
cost
estimates
from
July
2002
to
mid­
year
(
June)
2003.
EPA
judges
the
CCI
as
generally
reflective
of
the
cost
of
installing
and
operating
process
and
treatment
equipment
such
as
would
be
required
for
compliance
with
the
316(
b)
regulation.
Table
2
shows
CCI
values
for
July,
2002
and
June,
2003
(
see
the
316(
b)
Compliance
Cost
Model,
DCN
7­
4018
for
the
conversion
of
2002
engineering
costs
to
2003
dollars)

Table
2
Construction
Cost
Index
Year
Value
%
Change
July
2002
6605
June
2003
6694
1.3%

Source:
ENR,
2004.
1The
effect
of
this
assumption
is
to
assume
there
is
no
tax
shield
for
S
corporations
and
limited
liability
corporations
(
LLCs).
S
corporations
and
LLCs
will
see
no
change
in
tax
shield
benefit
because
they
do
not
pay
taxes.
The
persons
to
whom
the
income
is
distributed,
however,
will
see
the
change
in
earnings
due
to
incremental
pollution
control
costs;
there
is
no
tax
shield
benefit.

3
The
cash
outflows
are
then
discounted
to
calculate
the
present
value
of
future
cash
outflows
in
terms
of
2003
dollars.
This
methodology
evaluates
what
a
business
would
pay
in
constant
dollars
for
all
initial
and
future
expenditures.

Section
2.2
discusses
the
data
sources
used
in
the
model.
Section
2.3
summarizes
the
financial
assumptions
in
the
model.
Section
2.4
presents
all
steps
of
the
model
with
a
sample
calculation.

2.2.
Input
Data
Sources
2.2.1
EPA
Engineering
Cost
Estimates
The
capital,
permitting,
and
monitoring
costs
used
in
the
model
are
presented
in
U.
S.
EPA
(
2004a)
and
U.
S.
EPA
(
2004b).
The
capital
cost
is
the
initial
investment
needed
to
purchase
and
install
the
equipment;
it
is
a
cost
that
is
incurred
in
the
first
year
and
then
every
10
years
to
account
for
replacement
costs.
Unlike
capital
costs,
permitting
and
monitoring
costs
cannot
be
depreciated
because
they
are
not
associated
with
property
that
can
wear
out.
Such
costs
are
expensed
in
their
entirety
in
the
year
incurred.

2.2.2
Questionnaire
Data
Corporate
structure
is
derived
from
survey
data
for
the
purpose
of
estimating
tax
shields
on
expenditures.
A
C
corporation
(
corporate
structure
=
1)
pays
federal
and
state
taxes
at
the
corporate
rate.
An
S
corporation
or
a
limited
liability
corporation
(
corporate
structure
=
3)
distributes
earnings
to
the
partners
and
the
individuals
pay
the
taxes.
Unfortunately,
we
do
not
know
either
the
number
of
individuals
among
whom
the
earnings
are
distributed
or
the
tax
rate
of
those
individuals.
For
the
purpose
of
the
analysis,
the
tax
rate
for
S
corporations
and
limited
liability
corporations
is
presumed
to
be
zero.
1
All
other
entities
(
corporate
structure
=
2)
are
assumed
to
pay
taxes
at
the
individual
rate.

Taxable
income
is
the
business
entity's
earnings
before
taxes
(
EBT).
The
value
sets
the
tax
bracket
for
the
MODU.

Average
taxes
paid
is
calculated
from
the
2000,
2001,
and
2002
taxes
paid
by
the
business
entity.
It
is
used
to
limit
the
tax
shield
to
the
typical
amount
of
taxes
paid
in
any
given
year.

2.2.3
Secondary
Data
ERG's
model
uses
a
real
discount
rate
of
7
percent,
as
recommended
by
the
Office
of
Management
and
Budget
(
OMB,
2003).
This
is
a
real
rate,
and
therefore
it
is
not
adjusted
for
inflation.
2EPA
examined
straight­
line
depreciation,
Internal
Revenue
Code
Section
169
and
179
provisions
as
well
as
MACRS
for
depreciation.
Straight­
line
depreciation
writes
off
a
constant
percentage
of
the
investment
each
year.
MACRS
offers
companies
a
financial
advantage
over
the
straight­
line
method
because
a
company's
taxable
income
may
be
reduced
under
MACRS
by
a
greater
amount
in
the
early
years
when
the
time
value
of
money
is
greater.

Section
169
provides
an
option
to
amortize
pollution
control
equipment
over
a
5­
year
period
(
RIA,
1999).
Under
this
provision,
75
percent
of
the
investment
could
be
rapidly
amortized
in
a
5­
year
period
using
a
straightline
method.
The
75
percent
figure
is
based
on
the
ratio
of
allowable
lifetime
(
15
years)
to
the
estimated
usable
lifetime
(
20
years)
as
specified
in
Section
169,
Subsection
(
f).
Although
the
tax
provision
enables
the
site
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.
Because
the
benefit
of
the
provision
is
slight
and
sites
might
not
get
the
required
certification
to
take
advantage
of
it,
the
provision
was
not
included
in
the
cost
annualization
model.

EPA
also
considered
the
Section
179
provision
to
elect
to
expense
up
to
$
24,000
if
the
equipment
is
placed
into
service
in
2001
or
2002
(
RIA,
1999).
The
deduction
increased
to
$
25,000
if
the
equipment
is
placed
into
service
in
2003
or
later.
EPA
assumes
that
this
provision
is
applied
to
other
investments
for
the
business
entity.
Its
absence
in
the
cost
annualization
model
may
result
in
a
slightly
higher
estimate
of
the
after­
tax
annualized
cost
for
the
site.

4
Since
companies
operating
offshore
oil
and
gas
facilities
tend
to
be
headquartered
in
states
without
income
taxes,
ERG
assumes
only
federal
income
taxes
apply
to
these
firms.

The
model
incorporates
variable
tax
rates
according
to
the
type
of
business
entity
and
level
of
income
to
address
differences
between
small
and
large
businesses.
For
example,
a
large
business
might
have
a
tax
rate
of
35
percent.
After
tax
shields,
the
business
would
pay
65
cents
for
every
dollar
of
incremental
pollution
control
costs.
A
small
business,
say,
a
small
sole
proprietorship,
might
be
in
the
15
percent
tax
bracket.
After
tax
shields,
the
small
business
would
pay
85
cents
for
every
dollar
of
incremental
pollution
control.
The
present
value
of
after­
tax
cost
is
used
in
the
impact
analysis
(
see
Section
3
of
this
memo)
because
it
reflects
the
long­
term
impact
on
its
income
actually
experienced
by
the
business.

2.3
Financial
Assumptions
The
model
incorporates
several
financial
assumptions:

#
Depreciation
method
is
the
Modified
Accelerated
Cost
Recovery
System
(
MACRS).
2
MACRS
applies
to
assets
put
into
service
after
December
31,
1986.
MACRS
allows
businesses
to
depreciate
a
higher
percentage
of
an
investment
in
the
early
years
and
a
lower
percentage
in
the
later
years.

#
There
is
a
six­
month
lag
between
the
time
of
purchase
and
the
time
operation
begins
for
the
pollution
control
equipment.
A
mid­
year
depreciation
convention
may
be
used
for
equipment
that
is
placed
in
service
at
any
point
within
the
year
(
CCH,
1999,
¶
1206).
ERG
chose
to
use
a
mid­
year
convention
in
the
model
because
of
its
flexibility
and
the
likelihood
that
the
equipment
considered
for
pollution
control
could
be
built
and
installed
within
a
year
of
initial
investment.
Because
a
half­
year
of
depreciation
is
taken
in
the
first
year,
a
half­
year
needs
to
be
taken
in
the
31th
year
of
operation.
Consequently,
the
post­
tax
cost
calculation
model
spans
a
30­
year
time
period.
8
#
The
pollution
equipment
is
considered
10­
year
property.

The
depreciable
life
of
the
asset
is
based
on,
but
is
not
equivalent
to,
the
useful
life
of
the
asset.
The
Internal
Revenue
Service
(
IRS)
establishes
different
"
classes"
of
property.
For
example,
a
race
horse
is
3­
year
property.
ERG
has
determined
that
the
capital
improvements
needed
to
comply
with
the
316b
requirements
would
be
in
the
10­
year
class.
The
model,
therefore,
incorporates
a
10­
year
depreciable
lifetime.
Thus,
for
the
purpose
of
the
calculating
depreciation,
most
components
of
the
pollution
control
capital
costs
considered
in
this
analysis
would
be
10­
year
property.
According
to
IRS
requirements,
pollution
control
equipment
can
be
depreciated,
but
the
total
cost
of
the
equipment
cannot
be
subtracted
from
income
in
the
first
year.
In
other
words,
the
equipment
must
be
capitalized,
not
expensed
(
CCH,
1999;
and
RIA,
1999,
Section
169).

2.4
Sample
Present
Value
Calculation
Spreadsheet
In
Table
3,
the
spreadsheet
contains
numbered
columns
that
calculate
the
pre­
and
post­
tax
present
value
of
the
costs
incurred
by
the
MODU.
This
spreadsheet
is
an
example
only.
The
MODU
information
is
not
representative
of
any
MODU
in
the
survey.
The
costs
shown
are
the
actual
estimated
costs
for
a
MODU,
however.
Actual
MODU
survey
information
is
used
in
Section
4,
which
is
found
only
in
the
CBI
portion
of
the
Rulemaking
Record.
The
first
column
lists
each
year
of
the
equipment's
life
span,
from
its
installation
through
its
10­
year
depreciable
lifetime.

Column
2
is
the
permitting
and
repermitting
cost
for
the
facility.
The
costs
are
the
same
for
every
facility
and
differ
depending
on
the
year
so
they
are
hard
wired
into
the
model
(
the
costs
are
assumed
to
be
those
for
a
new
MODU
launched
in
2007;
the
variations
in
costs
by
year
are
discussed
in
ERG,
2004).
For
tax
purposes
these
costs
are
expensed
yearly
so
in
the
model
they
are
combined
with
monitoring
costs
to
calculate
the
potential
tax
shield.

Column
3
represents
the
percentage
of
the
capital
costs
that
can
be
written
off
or
depreciated
each
year.
These
rates
are
based
on
the
MACRS
and
are
taken
from
CCH
(
1999).
Multiplying
these
depreciation
rates
by
the
capital
cost
gives
the
annual
amount
the
site
may
depreciate,
which
is
listed
in
Column
4.
Depreciation
expense
is
used
to
offset
annual
income
for
tax
purposes;
Column
5
shows
the
potential
tax
shield
provided
from
the
depreciation
expense
 
the
overall
tax
rate
times
the
depreciation
amount
for
the
year.

Column
6
is
the
annual
monitoring
costs.
Like
permitting
costs,
monitoring
costs
are
the
same
for
every
facility
and
differ
depending
on
the
year
so
they
are
hard
wired
into
the
model
(
see
ERG,
2004).
For
tax
purposes,
these
costs
are
expensed
in
the
year
incurred,
so
in
the
model
they
are
combined
with
permitting
costs
to
calculate
the
potential
tax
shield.
Column
7
is
the
potential
tax
shield
or
benefit
provided
from
expensing
these
costs.

Column
9
lists
a
MODU's
annual
pre­
tax
cash
outflow
or
total
expenses
associated
with
the
additional
pollution
control
equipment.
Total
expenses
include
capital
costs,
assumed
to
be
incurred
during
the
first
year
when
the
equipment
is
installed.
6
Present
Value
of
Cash
Outflows


n
i

1
cash
outflow,
year
i
(
1

real
discount
rate)
i

1
Column
10
is
the
adjusted
tax
shield.
The
potential
tax
shield
is
the
sum
of
the
tax
shields
from
depreciation
(
Column
5)
and
monitoring/
permitting
costs
(
Column
8).
If
the
potential
tax
shield
for
any
year
exceeds
the
3­
year
average
taxes
paid,
the
tax
shield
is
limited
to
the
average
taxes
paid
by
the
company.
In
the
example,
the
potential
tax
shield
in
Year
1
is
$
4,000
plus
$
13,000
=
$
17,000.
This
does
not
exceed
the
average
taxes
paid
over
the
last
three
years
($
5,000,000).
Hence,
the
tax
shield
is
not
limited.
This
approach
is
conservative
in
that
the
limit
is
applied
every
year
when
a
company
may
opt
to
carry
losses
forward
to
decrease
tax
liabilities
in
future
years.
An
alternative
approach
is
to
limit
the
present
value
of
the
tax
shield
to
the
present
value
of
taxes
paid
for
the
30­
year
period.
Should
the
first
approach
appear
to
overestimate
cost
impacts,
the
second
approach
may
be
examined
as
a
sensitivity
analysis.

Column
11
lists
the
annual
cash
outflow
less
the
adjusted
tax
shield
(
Column
9
minus
Column
10);
a
site
will
recover
these
costs
in
the
form
of
reduced
income
taxes.
The
sum
of
the
31
years
of
after­
tax
expenses
is
$
853,000(
2003
dollars).
The
present
value
of
these
payments
is
$
422,000.
The
present
value
calculation
takes
into
account
the
time
value
of
money
and
is
calculated
as:

The
exponent
in
the
denominator
is
i­
1
because
the
real
discount
rate
is
not
applied
to
the
cash
outflow
in
Year
1.
The
present
value
of
the
after­
tax
cash
outflow
is
used
in
the
closure
analysis
to
calculate
the
postregulatory
present
value
of
future
earnings
for
a
site.

3.
IMPACT
ANALYSIS
METHODOLOGY
3.1
Cash
Flow
and
Net
Income
Calculations
Using
data
provided
by
surveyed
MODU
operators,
ERG
used
both
reported
after­
tax
net
income
and
a
calculated
cash
flow
figure
for
each
survey
MODU.
ERG
calculated
cash
flow
using
after­
tax
net
income
as
reported
by
the
respondents
and
adding
depreciation,
depletion,
and
amortization
(
DD&
A)
back
into
net
income,
since
DD&
A
are
not
cash
expenses.
ERG
used
cash
flow
as
an
upper
bound
estimate
of
available
cash
and
after­
tax
net
income
as
a
lower
bound
estimate.
EPA
was
only
able
to
undertake
financial
analysis
for
those
MODUs
with
a
positive
net
income
or
cash
flow
for
the
three
years
of
financial
information
provided
in
the
survey.
ERG
assumes
that
any
MODU
whose
cash
flow
or
net
income
is
negative
over
the
three
years
of
financial
data
availability
is
unlikely
to
be
a
viable
operation
in
the
baseline
and
cannot
be
analyzed
with
respect
to
compliance
costs.

ERG
used
the
cash
flow/
net
income
over
the
three
years
of
data
collected
to
create
a
moving
cycle
of
cash
flow/
net
income
over
the
period
of
analysis.
The
years
of
data
collected
were
2000,
2001,
and
2002,
with
2002
generally
being
a
poorer
year
for
the
industry
as
a
whole.
In
this
way,
ERG
was
able
to
represent
industry
financials
in
both
good
and
bad
years.
The
3­
year
cycle
provides
a
means
for
projecting
the
volatile
oil
and
gas
business
over
each
facility's
30­
year
operating
period,
which
is
expected
to
include
major
swings
in
the
prices
of
oil
and
gas,
the
driving
force
behind
the
MODU
industry.
ERG
assumed
that
cash
flow/
net
income
will
be
flat
on
average
over
the
30
years
of
analysis
and
thus
does
not
apply
any
4
factors
to
increase
or
decrease
cash
flow
or
net
income
over
the
years
of
analysis
within
those
cyclical
movements.
The
cash
flow/
net
income
figures
from
the
survey,
therefore,
repeat
every
three
years
for
30
years.
ERG
then
computes
the
present
value
of
that
stream
of
cash
flow/
net
income
figures
for
comparison
with
the
present
value
of
after­
tax
compliance
costs
for
the
preferred
option.

3.2
Impact
Methodology
and
Results
The
present
value
output
from
the
post­
tax
cost
calculation
model
is
then
input
to
the
cash
flow/
net
income
model
and
used
to
compare
with
the
present
value
of
cash
flow/
net
income
of
the
vessel
as
discussed
above.
If
the
present
value
of
baseline
after­
tax
cash
flow
or
net
income
minus
the
present
value
of
after­
tax
compliance
costs
is
greater
than
$
0,
ERG
assumes
that
the
MODU
will
be
able
to
continue
to
operate
post­
compliance.
If
the
cash
flow
value
becomes
negative,
ERG
assumes
the
MODU
would
no
longer
continue
to
operate.
If
the
net
income
value
becomes
negative,
ERG
assumes
the
longer
term
viability
of
the
vessel
is
potentially
jeopardized.
In
either
case,
such
a
MODU
would
be
counted
as
a
potential
"
regulatory
closure."
This
result
would
be
considered
a
proxy
for
a
finding
of
a
potential
barrier
to
entry.

4.
RESULTS
Due
to
confidential
business
information
(
CBI)
constraints,
ERG
is
not
able
to
provide
detailed
impact
results
on
a
MODU­
specific
level.
The
data
generated
by
the
analysis
and
detailed
impact
results
are
provided
in
Table
3
of
the
CBI
version
of
this
memo
(
DCN
7­
4044).
The
general
finding
of
the
closure
analysis
is
that
no
MODUs
are
considered
likely
to
have
difficulty
operating
on
the
basis
of
the
incremental
costs
of
compliance
with
the
preferred
option
using
either
a
cash
flow
or
net
income
approach.

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III
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b)
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