How the Liability Cap Helped to Cause the Gulf Spill

Rarely has a bipartisan rallying cry been shouted in such starling unison as, "Make BP pay!" Many reasons have been discussed why the liability cap should be lifted. One, however, hasn't received any attention: the cap helped to cause the spill in the first place.

Moral Hazard Strikes Again

If a liability cap had never been put in place, BP and other oil companies would have behaved differently. Since they thought their liability was limited, oil companies participated in a relatively small insurance fund to cover potential damages. This is where the problem began.

Without a net to catch the oil companies if they fell, BP probably would have been more careful. Cheap insurance creates a moral hazard, where you are lulled into believing that your risks are fully covered at a low price. Spending money on additional safety measures becomes a bad business proposition; after all, insurance has you covered.

Indeed, not only does this moral hazard result in behaving less prudently, but it also provides little incentive to put plans in place to respond to disasters. Why bother? No matter how bad the spill gets, you'll only be responsible up to the government cap, which will be covered by your insurance.

Now there are those who claim that the oil companies never would have believed that the liability cap would matter if a really bad disaster hit. But if that's the case, then why didn't they create a bigger insurance pool? Oil Spill Liability Trust Fund only covers up to $1 billion in damages. Surely, the big oil companies would want to spread the risk of a major catastrophe around, rather than take it all on themselves.

How It Distorted the Market

As soon as a liability cap is created, it begins to distort the market. When companies see the risk of undertaking a project minimized, it becomes far more profitable. Think about the analysis they would perform. If the potential downside is limited, the net upside will look better than it should. The cap caused deep water drilling to appear more profitable than it really was. Oil companies should have accounted for the possibility that they could be responsible for tens of billions of dollars in damages with a bad spill, not just $75 million.

Would this have raised the cost of oil for consumers? Sure, but instead, the cap artificially lowers the price of oil. That is, until a spill happens. Then, the price will eventually rise past the natural equilibrium to pay for the associated damages. Consumers can either pay the right price initially, or they'll just have to do so later.

Stop Complaining About Small Firms

The big objection to a liability cap is the affect it will have on small firms. The argument goes: if there's no liability cap, then these small companies will be priced out of the market. Good. These companies never should have entered the market in the first place.

Why would we want to encourage start-ups to enter the oil industry? Competition is generally a good thing, but these companies could have competed outside oil as well. Instead, they might have chosen to invest other energy endeavors like a new wind farm or natural gas exploration. Firms should be driven away from industry segments that contain more risk, not subsidized to take on that risk.

This also explains part of the reason why energy sources other than oil have taken so long to flourish. Washington made it far more profitable to drill by capping the potential costs.

This Is the Libertarian Response

A few days ago, Harvard economist Edward L. Glaeser wondered how libertarians can explain how less regulation would have prevented the spill in the Gulf. This is their answer. By the government becoming too involved in propping up an industry, in this case oil exploration, it distorts the cost-benefit analysis that the private firms would perform.

Moreover, a massive oil spill isn't a run-of-the-mill externality. For example, a pollution externality usually happens gradually and affects people in small, almost unnoticeable ways for many years. It's hard to identify who should be compensated and by how much. As a result, companies don't need to worry about those potential costs, so they don't avoid environmental destruction. That's why the market needs to be regulated by something like a carbon-pricing scheme. Even many free marketers believe this.

With a big oil spill, however, the damage and parties affected are both fairly obvious; this isn't an externality. As a result, this possibility would be taken into account by oil companies exposing themselves to this risk. They might respond by setting aside some money, or paying into a sufficiently large insurance pool, to cover the associated costs. But it's even more likely they'll spend additional money on safety, prevention, and containment measures, since they may be cheaper than enduring an ecological disaster.

An oil spill isn't like global warming, where big carbon emitters can just shrug. In the absence of government support, the market should regulate itself to prevent such events. Otherwise, firms would flirt with bankruptcy every time there is an accident. Investors won't accept that kind of instability. But when the government caps a spill's price tag that basic financial analysis results in a different outcome: prudence and containment become more expensive than the damages the companies would face due to a spill.

Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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