BP has repeatedly promised to pay all “legitimate claims” for loss and damage as a result of the Gulf oil spill, now vying for the title fourth biggest oil spill in history at 2.3 million barrels of crude over the past two months. And that’s exactly as it should be. But how can the company pay off all the claims it faces?
Crunching the numbers through a worst-case scenario using the Environmental Protection Agency’s (EPA) Basic Oil Spill Cost Estimation Model results in an estimate that the cleanup and payment for damages will cost about $8.7 billion; double that if the well continues to gush until August. Some other estimates suggest that the cleanup and costs for damages will ultimately add up to $40 billion. BP, the oil company that holds the drilling permit, is responsible for the disaster and has spent $1.5 billion on the cleanup.
BP is essentially self-insured through its ownership of what is known as a captured insurance company, Jupiter Insurance, which can make a maximum payout of $700 million per incident to its parent. And while the amount is not known, BP also has some insurance through Lloyd’s of London. Possibly the best news for those damaged by the spill is that BP cleared $14 billion in profits last year. Given the magnitude of the current losses, why is it that BP carried so little insurance?
Oil spill liability is a complex patchwork of private and public insurance schemes. On the private side, energy companies banded together to set up two industry-owned Bermuda-based mutual insurers, Oil Insurance Ltd. (OIL) in 1971, and Oil Casualty Insurance Ltd. (OCIL) in 1986. OIL insures its petroleum company members up to $250 million per occurrence against such risks as property damage, well control costs, and third-party pollution liability. In 2009, OIL’s assets totaled over $6 billion. OCIL offers excess liability insurance, that is, the insurer pays off when a company’s liabilities exceed those covered by other policies. OCIL’s assets totaled just over $1 billion last year. So even if BP had decided to join these mutual insurers, their entire capitals would not be enough to pay off the Gulf spill damages.
Let’s take a look at the public sector. In 1990, both houses of Congress passed with nearly unanimous bipartisan support and President George H.W. Bush signed the Oil Pollution Act in the wake of the Exxon Valdez oil spill in Alaska. The act created a $1 billion Oil Spill Liability Trust Fund paid for by an 8 cent per barrel tax on oil produced in or imported into the United States. The trust fund makes payments to people damaged by a spill and then seeks repayment from the parties that are responsible for it.
The 1990 act also set a $75 million cap on liability on damages to natural resources and economic losses suffered by private parties resulting from offshore drilling spills. However, drillers are responsible for all cleanup and containment costs. The cap does not apply if a company is found to have violated federal regulations or engaged in gross negligence (an issue that will certainly be litigated in this case). Apparently, Congress made a political decision to set the liability cap low for two reasons. First, because smaller drilling companies would not have been able to afford the insurance that would enable them to operate. Congress wanted competition in offshore oil production. And second, because producing oil domestically, even if risky, improved U.S. energy security.
Now the federally approved liability cap doesn’t look like such a good idea. On June 9, Brookings Institution Senior Fellow Michael Greenstone, testifying before the House Committee on Transportation and Infrastructure, argued “the cap creates incentives for spills.” Why? Because if drillers believe that their liability is limited, they will engage in riskier activities than if they feared that they would be responsible for all the costs if things go wrong. While acknowledging that we cannot know whether this incident would have occurred without the cap, Greenstone asserts, “The cap effectively subsidizes drilling and substandard safety investments in the very locations where the damages from spills would be the greatest.” In other words, the liability cap is a good example of government failure. Government failure occurs when government intervention causes a more inefficient allocation of goods and services than would occur without the intervention.
Unfortunately, government subsidies to risky activities like the Oil Pollution Act's liability cap occur throughout our economy. For example, the Price Anderson Act limits liability for nuclear power accidents to $10 billion and federal flood insurance encourages people to build houses along vulnerable coasts and on flood plains.
Going forward, the liability cap should be removed. This would align the future incentives of drillers and their insurers to take into better account the risks of offshore oil production. Lifting the cap would also mean higher gasoline prices for consumers and job losses in the oil industry. Ultimately, insurance markets may well tell oil drillers that with current technologies deep water drilling is just too risky.
Ronald Bailey is Reason's science correspondent. His book Liberation Biology: The Scientific and Moral Case for the Biotech Revolution is available from Prometheus Books. This column first appeared at Reason.com.