Why Do We Need a Liability Cap?

By Derek Thompson

Following news coverage can be easy. Understanding some of the terms it uses, less so. In our Flashcard series, The Atlantic explains ideas you may read about but never see spelled out. In this installment, we dig into the case for a liability cap for oil companies.

Gulf-Oiled-Pelicans-June-3-2010.jpg

The News

The BP oil spill has already painted the Gulf of Mexico with an amoebic smear of crude that could cost billions in clean-up costs. But the economic cost to fisherman, restaurants and tourist hubs could run billions of dollars higher. These third parties are known to BP as liabilities.

According to the Oil Pollution Act (OPA) of 1990, passed after the Exxon Valdez accident, oil companies are only responsible for the first $75 million of liability claims from businesses and organizations affected by the the spill. But with the Gulf price tag running into the billions, DC lawmakers are scrambling to raise the liability ceiling. Why have a cap in the first place?

The Gist

The liability cap has nothing to do with direct clean-up costs. BP, or any oil company, has to pay to clean up the Gulf, no matter what. The cap applies to claims made by third parties impacted by the Deepwater Horizon gush (BP holds the drilling permit at Deepwater Horizon, which makes them legally responsible for the spill).

The law caps BP's monetary responsibility to these claims at $75 million. After that, the Oil Spill Liability Trust Fund covers the next $1 billion in damages. After that, it's the taxpayers' mess. Capping liability means capping responsibility, and where the oil company's responsibility ends, the taxpayers' responsibility begins.

Roughly speaking, there are two kinds of liabilities: natural resource liabilities (eg damage to fish population) and private enterprise (eg damage to fisherman profits). The trick is how do you determine where the line of responsibility breaks. We can agree that the fisherman forced to park his bum on dry land for the summer is directly harmed by the spill. What about the restaurants that cannot serve his shrimp? What about their busboys moved to part-time, or their napkin sellers who've seen fewer orders? It's hard to point to the place where the ripples end.

The Debate

The liability cap should go. In fact, it's barely there to begin with.

We cap liability because we want companies to take risks without experiencing the true costs of those risks. This is a recipe for moral hazard. After all, why should a company invest in a $1 million safety innovation that's more expensive than its worst-case scenario liability? Companies like BP that are rich enough to invest in dangerous deep-sea drilling are also rich enough to withstand the greater liability costs (BP's 2009 revenue was $240 billion). If you're a smaller company that can't stand the heat, get out of the mile-underwater reservoir.

It's true that ditching the liability cap might have consequences that aren't all pretty. If we make companies responsible for 100 percent of damages, they might pay more on both safety measures and insurance (OPA's insurance cap is $150 million). That could discourage smaller start-ups and raise the cost of exploration and drilling, which might eventually come back to consumers in the form of higher prices. It could also scare firms away from drilling in risky areas, which is a problem if that's where the oil is. You might persuade companies to leave the Gulf, which hurts those states' economies.

But the fact is that the liability cap already has so many holes that it's practically irrelevant, anyway. First drilling operations are subject to numerous complex federal regulations, and any violation, no matter how small, nixes the cap. Second, states without liability caps, like Florida, Mississippi, and Alabama can already sue past the $75 million mark. Third, penalties paid under criminal law (for example, the Migratory Bird Act Treaty) are not covered by the cap.

Oil companies know the law. They know the liability ceiling is leaky and that major oil spills will run them far past the $75 million mark. Time to kill the cap.

For more Flashcard posts:

The Value-Added Tax

The Contagion Effect

Deficit Spending (Stimulus)

The Oil Spill Liability Cap

Carbon Pricing

This article available online at:

http://www.theatlantic.com/business/archive/2010/06/why-do-we-need-a-liability-cap/58147/