Marshall Islands, Oil Spills, and the Efficient Level of Precaution

July 9th, 2010

Two days ago, BP announced that it has (so far) spent $3 billion on cleanup and containment in an attempt to mitigate the damage done by the explosion of the Deepwater Horizon and the ongoing oil spill in the Gulf of Mexico.  And this is not including the $20 billion it set aside to compensate business owners, fishermen, municipalities, and other parties who are suffering under catastrophic costs from spill-related damages.  This monumental amount of money got me thinking about the Economics of oil spills.  In particular, how does the financial liability associated with an oil spill’s damage effect the level of precaution a company will take to prevent such a tragic event?

In Economics, we refer to these models as the “efficient level of precaution,” which is the market-predicted level of precaution that a company should take to prevent catastrophes (when the benefits outweigh the costs).  This model is often used for nuclear power plants.  Suppose there is a disaster in a nuclear facility and the facility leaks gallons of radiation. The burden of the cost of this radiation is placed on the citizens in the surrounding area; not on the plant.  This is called an “externality” because the costs are external to the responsible party.  However, if the injured parties can get full compensation for the company’s actions (through legal action, for example) then the costs are “internalized” and the company has an incentive to provide precautions against nuclear discharge, to the extent that the precaution costs less than the costs incurred to society.  If such a situation cannot exist, if costs cannot be fully internalized, then the situation necessitates government intervention and oversight.

The same can work for oil spills.  Let’s represent this graphically (you can click on the image to the right to see it in its full sized glory).

In this case, BP has a supply of precaution, provided by the line MCs, which is the cost of precaution.  It slopes upward because the more precaution provided, the higher the cost.  The demand of precaution, meanwhile, is MCd, which indicates the level of costs that will be incurred, given a level of precaution.  This slopes downward because the more precaution provided, the lower the costs will be given a spill.  For example, if BP had invested millions (billions?) in cleanup and containment technology, the spill would have been cleaned and/or contained faster and the cost to society would have been lower.

MCd and MCs meet at point q*, which is the market efficient level of precaution.  But it is pretty clear to me that we were not at that level.  Quite the opposite.  BP has spent $3.2 billion on clean up and set aside $20 billion for compensation, but after the explosion, newspapers reported that a widely-used $500,000 device, which was not installed on the Deepwater Horizonwould have automatically shut down the well and prevented the leak.  So the level of precaution provided was clearly below the efficient one.

This market distortion is also shown by the graph above.  In this case q? is the amount of prevention that was actually provided and, judging from what we know, it clearly lies below the efficient level, q*.  So we have to ask ourselves, why is that?

There are many answers to this question.  And I’m not going to presume to know them all.  One answer could be that BP calculated wrong.  Or that they didn’t calculate at all.

I have a different answer.  It has something to do with the Marshall Islands.

“What?” You say.  “The Marshall Islands has a GDP of $115 million.  That is one  2,000th of BP’s total assets.  How could such a nation be involved?”

The above efficient levels only work if the party responsible for the spill is also the company to pay the damages or if a government agency can effectively oversee the operation.  BP has assumed “full responsibility” for the spill and promised to pay all “legitimate claims.”   This is a good thing.  There is no doubt in my mind BP needs to pay.  But, though the company is facing the costs and the criticism, the claim that BP is the “only” responsible party is not so clear.

While the responsibility is not cut and dry, part of Transocean’s Emergency Response Manual, states that Transocean’s offshore installation manager was “fully responsible” for activities onboard the rig, and BP’s representative was there to “assist.” “For obvious reasons,” the manual said, “only one person can be in charge at any one time.” The manual also said it was the responsibility of Transocean’s driller to shut in the well upon detecting an intrusion of oil or natural gas.

The Coast Guard has officially named both parties responsible.

But Transocean so far has refused to pay any costs.  In fact, Transocean made a $270 million dollar profit from the explosion.  Oh yes, you read that correctly.  The insurance policy on the Deepwater Horizon was worth more than rig itself.  So when it exploded, Transocean made a tidy profit.

Any Economist should be deeply disturbed by this situation.  This is the exactly wrong market incentive.  And there is only one way to correct such a distortion.  That is government oversight, which comes in the form of safety inspections, regulations, and licenses.

Here’s where the Marshall Islands comes in.  As Tax Justice Network reported weeks ago, the Deepwater Horizon was registered in the Marshall Islands, which gave it a different licensing structure than it would have had in the United States.  First, its lower category, dictated by code in the Marshall Islands, permitted fewer staff.  As Douglas Harold Brown, the chief mechanic aboard the Deepwater Horizon, noted:  “Over the years, the manning dwindled down and down. I believe that safety was compromised by this.”

Second, the Marshall Islands licensed the Deepwater Horizon so that Transocean could place an oil drilling expert ahead of a licensed sea captain in making decisions. Chief Mechanic Brown noted that on the day of the explosion “the dual command structure created confusion that delayed an effective response to the growing crisis.”  Such dual command structures would not be allowed on a U.S. flagged ship.

In addition to licensing, this offshore registration affected inspection procedures. As the LA Times reported, “Coast Guard officials confirm that more rigorous inspection procedures apply to the relatively small number of rigs registered in the U.S.  A foreign vessel will be reviewed by the Coast Guard, but the inspection is relatively cursory, relying on inspection reports prepared by outside firms that have been paid directly by the owners of the vessel.”

The LA Times went on to note that “The federal Minerals Management Service, which also has a role in overseeing offshore oil operations, deals only with issues “below the waterline” of the floating rig. It was not responsible for rig staffing, command structure or other above-water operations.”

Economics says that in order for the market to work, the costs must be internalized by the responsible parties.  Which they weren’t.  And if such a situation is impossible, then government oversight must pick up where private interests leave off.  The only problem was that the bulk of the government oversight of a rig drilling over 5 miles below the surface of the Gulf of Mexico was left up to a string of islands in the middle of the Pacific Ocean.

And that, my friends, is what you call a market distortion.

Written by Ann Hollingshead

Follow @FinTrCo