Oil Spills, Incentives, and the Economic Way of Thinking

Steven Horwitz

Over at Reason this morning, Jesse Walker wonders what an empirical study of this policy, detailed in the New York Times, would suggest about the incentives facing oil companies:

Under the law that established the...Oil Spill Liability Trust Fund, the operators of the offshore rig face no more than $75 million in liability for the damages that might be claimed by individuals, companies or the government, although they are responsible for the cost of containing and cleaning up the spill.

The fund was set up by Congress in 1986 but not financed until after the Exxon Valdez ran aground in Alaska in 1989. In exchange for the limits on liability, the Oil Pollution Act of 1990 imposed a tax on oil companies, currently 8 cents for every barrel they produce in this country or import.

The NYT piece provides a few more details that suggest that this Fund has generally been used for small spills, especially shipping related ones.

Walker's implication, and it's probably right, is that with a liability cap (beyond the clean up costs), the costs of any spill are less than they would be otherwise, giving firms reason, at least on the margin, to be willing to tolerate more risk of such a spill and reducing their expenditures on prevention measures, again at least on the margin.

If this all sounds familiar, it's because it looks like it works much like bank deposit insurance does.  Each bank pays premiums to the FDIC which in turn caps the liability banks face to their depositors if they should fail.  There's a nice long literature on the incentive effects of deposit insurance and the "heads I win, tails I don't lose" nature of the deal.  (I wish I had the equivalent kind of blackjack insurance when I was in Vegas last month!)  It would seem reasonable, without having looked at the empirical data, that this Fund would have similar effects.  And it would also be interesting to explore the history of the Fund and to see whether the arguments for creating it have as flimsy a basis as did the creation of deposit insurance. 

If we're really interested in preventing oil spills and bank failures, punishing to the fullest those who screw up would seem to be a very effective way of doing so.  Why doing so isn't in play in both cases might have something to do with the political pull of large banks and oil companies.  Crony capitalism/corporatism strikes again.

The other interesting reading this morning is this piece by Steve Hayward.  In it, he points out that the long-term trend for oil spills, regardless of the source, is downward, despite increases in both off-shore drilling and shipping by tankers.  So demonstrating that the Fund has made firms more willing to take risks would have to take the form of a counter-factual as the straight numbers suggest fewer spills.

Hayward also makes a really nice observation that would make a great exam question in Intro.  He argues that if the current spill leads to stricter limits or even a ban on off-shore drilling, the result will be more not fewer oil spills.  Why?  (Hint:  think airplanes and cars...)  Because if we reduce our production of domestic oil off-shore, that means a shift toward more imported oil.  And imported oil comes by tanker.  And tankers, it turns out, are much more likely to create oil spills than off-shore drilling. 

What Hayward does not address is whether the damage to humans and the environment are greater for spills from off-shore rigs or from tankers.  Off-shore rigs might create spills less often, but the ones they do create may have more damage than tankers in the open sea.  I don't know whether the data can provide an answer to this question, but it would seem to be relevant to Hayward's otherwise excellent point.

Comments

[Daniel Kuehn]

To be clear - the problem (the incentive problem, at least) is introduced by the insurance with the cap. If we had an FDIC that mandated premiums, covered deposits up to a certain amount, and did not cap the liabilities that banks face above that amount (so that depositers could sue over losses above the amount guaranteed by FDIC), then it may or may not be efficient - but it should not introduce that perverse incentive, right (assuming, of course, that premiums are high enough to cover the insured losses)? Am I thinking about that right?

In other words - the really perverse thing seems to be the combination of the cap and the insurance.

[David Hillary]

Daniel, yes, you are correct that the liability cap makes it worse than deposit insurance, because with deposit insurance, the bank still has to pay its liabilities, and will be restructured or liquidated to recover what it can pay, whereas the oil company remains with the same owners and managers as before. The depositors also face the moral hazard with deposit insurance, as they don't mind lending to risky banks, and the availability of funding creates more of a market for risky banks (i.e. it reduces market discipline).

Interestingly, liquidity regulation can also increase risks (see http://www.lostsoulblog.com/2010/03/submission-summary.html )

[Phil]

Would this argument follow that all liability caps are undesirable? What about in the medical malpractice context?

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