Stuff happens

Several people have asked me to comment about the oil spill.  Obviously I am not really qualified—but when has that stopped me before?

Other bloggers have already expressed some of these views, but for what it’s worth here’s my take on things.

1.  BP stock has fallen quite a bit.  I don’t know how much, but I assume their losses are in the $10s of billions.

2.  The environmental damage in massive, probably in the $10s of billions.

3.   BP and the firms they hire are very technically sophisticated.  They probably know as much about how to prevent these accidents as anyone else.

4.  It’s been widely noted that people and institutions become complacent about risks when accidents haven’t happened for a long time.  People have pointed to the Titanic, Three Mile Island, the Challenger, and other similar accidents.

So where do we go from here?  The knee-jerk reaction in Washington and among more liberal economists is “more regulation.”  I don’t have any problem with that view in principle; (I favor government attempts to address externalities) but I just don’t see how the facts match the proposed solution.  It seems to me that there are two possibilities, neither of which call for regulation:

1.  The financial losses to BP are the same order of magnitude as the damage to the environment.

2.  The damage to the environment is an order of magnitude or more bigger than the losses to BP.

In case one it seems to me that we need to simply accept the fact that “stuff happens.”  And hope this will be a wake-up call for the offshore oil drilling industry to be more careful.  In case 2, I think we should just throw in the towel and give up on off-shore drilling.  Or perhaps give up on it in the bigger and deeper wells that are potentially so damaging.  (I assume that smaller wells in shallow water are easier to cap.)  My hunch is that case one is more plausible, but I have an open mind.

I just don’t see an in between case where regulation can do much good.  The oil companies already have a strong incentive to avoid these problems, and the engineers in the oil industry are extremely talented, probably more so than those who would be regulating them.  So it really comes down to a simple issue: is this a “market failure” where incentives are way out of line, or just the sort of really bad event that occasionally happens.  If there is a market failure here, I’d say shut down all the wells that are potentially this dangerous, don’t even waste time on regulation.

By this point my liberal critics have given up reading and are scrambling to write posts about how clueless those Chicago economists are in their reflex opposition to regulation.  But you know I always like to tack on something unexpected, like an O’Henry story.  So here it is:

The lesson of the BP fiasco is that we don’t need more regulation of off-shore drilling, but we do need more regulation of electrical power and biotech.  More specifically, we need the government to start strategizing about what to do if there is a massive solar flare that wipes out the power grid east of the Mississippi for months on end.  Or what happens if Craig Venter’s evil twin develops a deadly virus that spreads like the common cold.  If we are to have more regulations, I’d rather we have our regulators think about the time bombs that everyone is ignoring, rather than problems that the oil companies are probably already hard at work addressing.

What would that regulation do?  I don’t know.  Perhaps send more satellites into space to warn us of solar flares.  Of more dress rehearsals of shutting down the electrical grid if there is one.  Or stockpile transformers.  For bio-tech we might want to divert some of the money used on research to cure diseases, into research on how to prevent man-made plagues.  Perhaps we could stockpile vaccines that might offer limited protection against certain types of plagues.  Again, this isn’t my area, but from articles I’ve read we seem woefully unprepared for crises that would be 100 times worse than this oil slick.  I used to assume that the government had some sort of secret agency of geniuses that strategized all these dangerous possibilities, like in James Bond movies or Mission Impossible.  But I outgrew that naivete years ago.

I suppose it is more fun to bash the oil industry than think about two billion people dying from a human engineered plague.  But perhaps it’s time we stopped going with our gut, and started thinking more rationally about the dangers that our high technology society seems to be rushing toward with little forethought.

Stuff happens?  Yes, and maybe that means we are overreacting to the oil spill.  But that’s not what worries me.  Even if increased regulation of oil drilling does no good, it also does comparatively little harm.  What worries me is the “stuff” that may happen in areas that we don’t even seem to be thinking about.  Areas where we can’t afford a single accident.


Tags: , ,

 
 
 

36 Responses to “Stuff happens”

  1. Gravatar of Hillary Hillary
    7. June 2010 at 18:31

    The problem isn’t the regulation, the problem is enforcement. If it’s true that safety protocols weren’t followed the people who cut corners should be tried for murder.

    The thing that scares me is Petrobras is getting ready to start offshore drilling without JV partners. The oil companies aren’t popular right now, but the engineers with experience in offshore drilling all work for them.

  2. Gravatar of jsalvatier jsalvatier
    7. June 2010 at 18:48

    Last time I checked (about a week ago) it was down about $47 billion. I haven’t seen an estimate for how much the oil will cost, so I don’t know how that compares.

  3. Gravatar of Niklas Blanchard Niklas Blanchard
    7. June 2010 at 18:59

    “In case 2, I think we should just throw in the towel and give up on off-shore drilling. Or perhaps give up on it in the bigger and deeper wells that are potentially so damaging. (I assume that smaller wells in shallow water are easier to cap.) My hunch is that case one is more plausible, but I have an open mind.”

    Deepwater Horizon isn’t even a particularly deep well:

    The MC 252 well is located in 5,067 ft of water about 50 miles from the coast of Louisiana. The total depth of the well was 18,360 ft below sea level (13,293 ft below the sea floor). This is not an unusually deep well nor was it drilled in exceptionally deep water compared to many other wells in the Gulf of Mexico. The Gulf drilling depth record was set earlier this year at more than 30,000 ft below the sea floor.

  4. Gravatar of CJ CJ
    7. June 2010 at 19:04

    Your solar flare link doesn’t seem to be working.

  5. Gravatar of jsalvatier jsalvatier
    7. June 2010 at 19:27

    FYI, the solar flare link does not function.

  6. Gravatar of Morgan Warstler Morgan Warstler
    7. June 2010 at 19:27

    I’m depressed that we haven’t seen a swarm of start-ups all being prominently discussed:

    1. agile deep water robots
    2. material to absorb oil
    3. biofreak stuff to chew oil up
    4. software to expose all regulator communication to real time sunshine

    Thats what annoys me, in a time of crisis the media should be smart enough to race to private industry and say, “now that this is a future predictable problem, how can you fix it?”

    Only invention solves. Only small business invents. The lead writes itself.

  7. Gravatar of rob rob
    7. June 2010 at 19:31

    @Hillary,

    Petrobras has plenty of experience drilling offshore Brazil (where the environmental regulations are stricter than the US, not that that matters).

    Deepwater drilling didn’t suddenly become more dangerous because of this disaster, so no great need to fear that any wells drilled soon are likely to have problems. It could happen, but it would be like lightening striking twice in the same place.

    For the past 10 years there has been constant drilling in the deepwater Gulf of Mexico. BP has been the most active, which is the only reason I would give for this incident being more likely to have happened under their watch.

    If we stopped drilling in the deepwater it would be tantamount to stopping oil exploration in the US (because most of the shallow stuff has been found), in which case we would just import more oil and more oil tankers would head for US shores. Historically much more oil has spilled from tankers than from wells. Admittedly, most tankers are double-hulled now and thus safer whereas the wells are getting deeper. So maybe tankers are safer than wells now, but the net risk of spills may not be diminished by a lot.

    There would be more opportunities for shallower exploration wells if more of the US coast were opened to drilling, but we all know that won’t happen now.

    Living in Houston, I’m wondering what’s about to happen to the local economy if the drilling moratorium continues. The main reason Houston is here is to drill wells.

  8. Gravatar of Joe Joe
    7. June 2010 at 21:02

    Profesor Sumner,

    Seeing as how it me or someone else asked for this post (though, another epic post on your views of regulation versus torts versus 100% versus large bonds being posted which is what Jeff Miron proposed, is better, since I’m trying to develop a libertarian theory of regulation…), I’ve got a new one.

    Recently at the Cato Institute, Mark Calabria mentioned an interesting new article on the labor market, which I think you’d find extremely interesting….

    http://www.cato-at-liberty.org/2010/06/07/the-obama-labor-market/

    http://www.nber.org/papers/w15979

    I just thought the debates you’ve all been having on economics would find this interesting. I have no opinion though

    Best,

    Joe

  9. Gravatar of DanC DanC
    7. June 2010 at 21:28

    Posner in the Washington Post on the same topic

    http://www.washingtonpost.com/wp-dyn/content/article/2010/06/04/AR2010060402023.html

  10. Gravatar of rob rob
    7. June 2010 at 22:36

    Who killed Kennedy? Everybody.

    Who spilled the oil? Everybody.

  11. Gravatar of ssumner ssumner
    8. June 2010 at 04:27

    Solar flare linked fixed—I’ll respond to the comments later today.

  12. Gravatar of Keeping Score at Home Keeping Score at Home
    8. June 2010 at 05:10

    BP has lost approx 80.2 bil in market share (from it’s 52wk high). How does one begin to calculate the lost economic activity (fishing, tourism and x) and environmental clean-up costs?

  13. Gravatar of edeast edeast
    8. June 2010 at 05:18

    If the course of action depends on the order of magnitude of damages. How do you price ecological damage?

    I think E.O.Wilson did some work on the value of biodiversity, I’m just wondering if subsuming the food pyramid, the earth will become more brittle. The pnas, had a special out in december on the effects of shearing, of the earth system. Also there might be a limit to how much heat we can handle.

  14. Gravatar of Indy Indy
    8. June 2010 at 05:34

    Let’s say you were in favor of the government “doing something” (or, more accurately, ‘doing more something’) about low-probability-but-high-cost catastrophic events like this.

    Maybe tougher regulation, maybe research and development, maybe an enhanced liability and penalty mechanism, maybe ‘carbon-taxes’ or some equivalent, or an inspection regime, or maybe training and maintaining a large corps of experienced crisis-response units who are specialized in the particular crisis and able to respond to it at the appropriate scale.

    So there’s an allocation problem buried in there somewhere. Let’s assume completely unrealistic levels of knowledge. You would have a range of realistic “budgets”, you would have some estimates of the expected values of the cost of a disaster, the direct cost of government effort, the indirect cost of the lost benefit of suppressed risky economic activity, and so on.

    And the optimal solution to all the trouble in the world would be to make all the marginal-net-benefit-of-additional-government-interventions equal.

    So, some things to note:

    1. We have nowhere near the amount of knowledge it takes to solve this problem. We might not agree on the way to measure “net benefit” and we can’t even know about the “unknown unknowns”, like the coming self-awareness of Google’s latest project which will try to kill us all.

    2. We kinda/sorta do it in practice anyway, since we have to decide what to do and what not to do, and we have to decide how much to spend.

    3. The optimal solution is not a perfect solution – major disasters would still occur occasionally causing some major damage (though it’s hard to convince people that this is an inevitable feature, not a “failure” , of an optimal government system which can never guarantee the absence of problems.

    It’s not obvious to me, for example, that one deep-sea drilling platform spill every 30 years or so is not the “optimal” solution, or not worth the economic, employment, and national-security benefits we derive from pursuing that energy-source. That oil is valuable for a reason.

    4. Because we have to make decisions without adequate guidance for rational allocation – we end up doing it irrationally based on our idiosyncratic preference and political instincts.

    Everybody’s got their pet version of Dick Cheney’s “1% Doctrine” or, in other language, a “Precautionary principle” for a particular subject. Maybe a 1% chance Saddam will give WMD to terrorists who will take it to New York is worth a major war to some people. Maybe a 1% chance a deep-sea oil rig will leak for months is worth a total ban on this activity to other people. Maybe a 1% chance of catastrophically deadly global climate change is worth a slow return to the neolithic lifestyle / population levels to yet others. Maybe a 1% chance of a horrible recession is worth NGDP targeting. Who knows.. 😉

    But it seems that people aren’t generally risk-tolerant or risk-averse in these matters. They tend to focus more on the risks caused by their own “bad guys” (greedy corporations, terrorists, whatever…) and they would like to ignore, discount, even ridicule the risks harped on by “the other side”.

    I’m not sure we can really do much better than impose tort-like liability incentives for private actors to mitigate foreseeable harms, and maintain a large, flexible, and adaptable reserve of manpower and resources which trains for the most likely scenarios, but tries its best to “deal with” unexpected disasters as they happen. I don’t think there is good “preventative medicine” for most national-scale catastrophes.

  15. Gravatar of Sunny Sunny
    8. June 2010 at 06:28

    In a way you are asking for regulation, when you say “give up on it in the bigger and deeper wells that are potentially so damaging.” It will take a lot of regulator’s ink to define “potentially so damaging.”

  16. Gravatar of Ed Dolan Ed Dolan
    8. June 2010 at 06:31

    “The oil companies already have a strong incentive to avoid these problems.”

    I think this is an oversimplification. We shouldn’t focus on the incentives of the oil companies as entities, but on the incentives of individual decision makers within the companies and their contractors. I think that there are many points in the system where decision makers have incentives to “gamble with other people’s money,” that is, adopt strategies with negatively skewed risk profiles, in the hope of reaping rewards for themselves in normal times, and sticking others with all or part of the downside costs in the rare cases when disaster strikes. Some examples:

    (1) Shareholders are in this position to the extent they are protected by limited liability. They get the full upside of BP profits, but if the spill bankrupts the company (no longer inconceivable, remember Union Carbide?) the bondholders (not to mention the shrimpers) get stuck with the residual loss

    (2) What are the executive compensation plans like? Didn’t Lord Browne, who allegedly also neglected safety (the refinery disaster) leave with a big golden parachute? What does Hayward’s compensation plan look like? I suppose no one knows.

    (3) Subcontractors are alleged to have made some of the troubling decisions, like what kind of cement to use, how to interpret tests and warnings, etc. Did they do so in part in the expectation that they would pick up bonuses for keeping or beating a schedule, while the liability would fall mostly on BP in case of catastrophe?

    (4) Mid-level decision makers–engineers, shift bosses, etc.–may have taken risks in the hope of bonuses or promotions. For example, they may have felt pressure to keep up a schedule, thereby cutting technical corners or ignoring warning signs. Such people do not bear the full weight of the loss if their decision causes a disaster. Criminal liability for such people could be a consideration, but it is rarely applied. For example, just yesterday some local Indian managers of Union Carbide were given criminal sentences in the Bophal case, after 26 years (!) of litigation, but the charges had been reduced from homicide to negligence.

    Theoretically, regulations can help offset these incentive problems, but there is a problem here too–how to prevent capture of the regulators? How to keep their incentives aligned right?

    For more on this theme, see a post on my blog yesterday, “What Oil Spills and Financial Crashes Have in Common: Gambling with Other People’s Money.”

  17. Gravatar of Matthew Yglesias » Agency Problems and Corporate Misconduct Matthew Yglesias » Agency Problems and Corporate Misconduct
    8. June 2010 at 07:28

    […] would seem to be Scott Sumner’s case number one in which additional regulation is unnecessary because “The financial losses to BP are the […]

  18. Gravatar of Hillary Hillary
    8. June 2010 at 08:32

    @Rob

    I’m only tangentially connected to the industry, so my impressions may not be correct. I’ve heard Petrobras is trying to exploit the Tupi Field on the cheap, rejecting all the bids on an RFQ, that sort of thing.

  19. Gravatar of scott sumner scott sumner
    8. June 2010 at 08:41

    Hillary. Yes, if they violated regulations, then that suggests regulation is no more effective that after the fact penalties. I don’t know if they did.

    jsalvatier. Thanks, my hunch was right.

    Thanks for the info Niklas.

    CJ, Thanks, I fixed it.

    Morgan, I like the regulator eavesdropping idea.

    rob, Good points. I agree that continued drilling is probably the better option.

    Joe, Thanks, I’m working off a huge backlog, but I’ll try to work it in.

    Dan C, Thanks, Posner is a great economist but a lousy macroeconomist. At one point he says that higher rates in the early 2000s might have caused a recession. We were in a recession, they would have caused a depression. Yes, that would have prevented the housing boom, but at what cost?

    Indy, I agree with much of what you say.

    You said;

    “It’s not obvious to me, for example, that one deep-sea drilling platform spill every 30 years or so is not the “optimal” solution, or not worth the economic, employment, and national-security benefits we derive from pursuing that energy-source. That oil is valuable for a reason.”

    I agree for oil spills, but that’s not what I am talking about at the end of my post. I am talking about events that we can’t afford to let happen once. And I think there are some very clear things we can do, at least in the case of solar flares, we just aren’t doing enough of them.

    In some cases tort law may be enough incentive, but not in others.

    Ed Dolan, A couple points:

    Regarding bankruptcy, that was one possibility I had in mind when I discussed the possibility that the environmental damage might be much greater the the losses to the company. So I agree with you there.

    Much of your “agency theory” argument applies equally well to government. Let’s suppose BP hires a driller from a smaller company that can’t absorb much in losses. That company might have an incentive to take lots of risks, but its also true that BP has an incentive to regulate the small company they hire. Indeed BP has the same incentive as the government.

    I know someone who works for a big oil company, and my impression is that they are very careful and skilled operations. The leaders of the companies don’t want them to take reckless risks. So I am not convinced that the agency problems are all that severe here, certainly no worse than the agency problems associated with government regulation (which are legendary.) I would also point to the fact that in areas where we do have good data (OSHA) the evidence suggests that regulation doesn’t reduce accidents.

  20. Gravatar of scott sumner scott sumner
    8. June 2010 at 08:49

    Keeping score, I have no idea. Do you know of any estimates?

    edeast, I realize that estimating the ecological damage is very difficult. But it doesn’t really affect the argument in this post, because effective regulation is equally dependent of getting those estimates right. If the value of biodiversity were “priceless” then we shouldn’t regulate drilling, we should ban it.

    Sunny, Agreed, I meant regulation of how to drill.

  21. Gravatar of Ed Dolan Ed Dolan
    8. June 2010 at 09:12

    Scott, all this agency stuff is very interesting, and it is at the heart of the issue, for sure. A couple of comments on your comments:

    First, yes, BP has “an incentive” to monitor their contractors, but is the incentive adequate–isn’t their incentive to monitor subject to some of the same limitations as their incentive to take risks on their own?

    Second, I’m sure most people that work for oil companies are careful and skilled. BTW, I used to work for a regulatory agency (the ICC), and I found, contrary to my libertarian prior beliefs, that nearly all of my colleagues were competent, energetic, honest, and public spirited. Still, there are incentives built into the structures that can undermine the work of all those skilled, careful folks. My then boss, Darius Gaskins, recognized this. His solution: he worked energetically, and eventually successfully, to euthanize the whole agency.

    Third, I think it is true, as you say, that top executives don’t want their subordinates to be reckless. That can be the case even if the execs themselves may have incentives to take excessive risks (due to golden parachutes, etc.) If risks are taken, the top execs want to decide themselves exactly which risks. The problem is, incentive systems within the company may not work, so the engineer on the job, in pursuit of a bonus for meeting a schedule, takes risks the boss doesn’t want her to take. It is very much like the rogue trader problem. Societe General was a risk-taking bank, but that does not mean top execs wanted Jerome Kerviel to take the specific trading risks he did. The trouble was, the internal incentive system within the bank motivated JK to do things top management did not want him to do. (At the management layer in between, some insiders say JK’s immediate supervisors winked at his violations of trading rules as long as he was winning.)

  22. Gravatar of OGT OGT
    8. June 2010 at 10:41

    On the orders of magnitude issue, let us say that this disaster, from a single oil rig, cost $35 billion in damages to both the environment and BP. If the test is to align the potential social cost and the potential cost to driller, doesn’t this imply that we can only have companies that are properly bonded and insured up to whatever amount would be estimated to reasonably cover possible damages?

    Otherwise any small firm owning and operating say a sinlge well would have wildly distorted incentives in regards to environmental safety.

  23. Gravatar of rob rob
    8. June 2010 at 12:14

    @Ed,

    Safety statistics are one of the key measures oil companies use in choosing contractors. They know the potential financial risks of an accident. Safety = money in the business.

    @OGT,

    You make a good point. BP will likely be able to afford this but what if this happened to a company like Hess with a market cap of only $16B?

  24. Gravatar of rob rob
    8. June 2010 at 12:57

    “The problem is, incentive systems within the company may not work, so the engineer on the job, in pursuit of a bonus for meeting a schedule, takes risks the boss doesn’t want her to take.”

    This is a fair point, but there is the incentive to make internal incentives work. In this case, many have pointed out in the media that the rig was costing BP a half million dollars a day, creating the incentive to hurry. That may sound like real money, but they had just made a major discovery worth billions. It seems unlikely the engineer was going to get a big bonus for hurrying it. If so, then yes, a really stupid incentive was in place — but it’s more reasonable to assume it wasn’t.

  25. Gravatar of Bonnie Bonnie
    8. June 2010 at 19:22

    I’m no expert on this subject, but I’d like to present some information regarding the application of agency theory. It’s interesting, but may apply only to the point that the equipped emergency systems would be expected to deal with the ultimate disaster on a rig — a blowout. These are said to be automatic prevention systems.

    DeepwaterHorizon had two such mechanisms, one located on the rig and one over the mouth of the well. Early reports indicate the blowout-preveter over the mouth of the well failed and did not close off the well to prevent gases from getting to the rig, and by the time the gases reached the rig they had too high of a velocity for the on-board blowout-prevertner to deal wit it.

    There could be a multitude of causes for the failure of the BP over the mouth of the well, which is porbably at the heart of the disaster. It could be they were in a hurry or it could be an unexpected mechanical failure and I suspect we won’t really know for sure until the unit can be inspected.

    Until then, I don’t think we can know for sure what kinds of remedies will be effective to preventing this kind of disaster. It’s easy to just say we need more regulation, but what kind? Should it be focused on blowout preventers or should it be focused on knowning how to cap a gusher in 5k ft of water?

    Personally, I think banning off-shore drilling is rather drastic when there could be some simple changes to the process to make it safer. I also think that as a matter of ethics, no company should be out there drilling that deep without knowing how to deal with a hole they drilled that far under water should the rig explode. It’s seem like a rather simple concept: know how to deal with it and have all the right tools ready to go or don’t be drilling out there.

    When it comes down to it, I don’t really care that their rig exploded. My heart certainly goes out the families of those killed or injured, but what really tees me off is that they had that broken well head down there gushing oil, didn’t know how to stop the oil. It’s likely the only thing they know now that they didn’t before is what doesn’t work which is helpful to the future, but does nothing special for the present.

  26. Gravatar of TokyoTom TokyoTom
    8. June 2010 at 21:05

    Scott, what you’re rather glaringly missing with your cost-benefit analysis – which blithely ignores the real face of “externalities” – is the institutional setting, which can be summed up as a tragedy of the government-owned and (rather expensively) mis-managed comonns.

    Ed Dolan is exactly right about incentives problems facing BP and regulators, none of whom really directly own the downside risks, which instead are borne by fishermen, oystermen, shrimpers, the tourist industry, those who value wildlife and a clean environment, and those who consume what harvesters catch. Some of these are very marginalized communities, but all face tremendous difficulties organizing and expressing their interests effectively with respect to resources on which their very livelihoods may depend, but in which they have no ownership rights.

    On the other hand, the oil indusrty are very powerful actors, very well organized and represented in the corridors of power and influence (remember Cheney’s secret energy meetings, and that BP was one of Obama’s largest donors?), and are adept at shifting risks to others (though self-damage is possible when catastrophic losses occur). As Ed Dolan rightly notes, this is built into their very nature as a result of the government grant of limited (zero) liability to shareholders, who have disincentives to monitoring too closely or to questioning whether profits come at the expense of others who – because of government ownership – have no effective voice regarding losses they bear.

    It’s hard to feel much sympathy for either the oil cos or government in theis Avatar-like situation, but I don’t mean to castigate either as “evil”. Rather, we simply need to take a close look at the problems of Moral Hazard that our government interventions – from grants of limited liability, to government resource ownership and concomitant inept and occasionally management – have been fuelling.

    Answers lie not in gross CBA analysis, but in letting resources users own the rights to manage and harvest wild resources (which would give them direct claims agains polluters), AND to determine when and where seabed resources are developed. (NOAA’s successful experiments with “catch rights” need to be vastly scaled up.) We would still have oil & gas development, but the fishermen would do a vastly better job of policing the oil companies – who would have to face other resource users with full incentives to protect their livelihoods. (Obversely, oil companies would also be better managers if they had control over the very valuable fish harvest rights in particular blocks, and would manage to in a way that would reflect such value.

    Sincerely,

    Tom

  27. Gravatar of scott sumner scott sumner
    9. June 2010 at 04:18

    Ed Dolan, One thing that regulators can do that companies cannot is impose criminal penalties. That’s the strongest argument, in my view.

    But I am still skeptical about regulation in areas where there are no market failure and you are just relying on agency problems. Compare the EPA and OSHA. There is no evidence that OSHA has reduced on the job accident rates (according to people who have studied the issue.) On the other hand there is massive evidence that the EPA has reduced pollution. I just think that regulation is a very blunt instrument, and is only likely to work where there are clear market failures.

    In any case, I think that tighter regulation in this case would be closing the barn door after the horse has left the barn. Oil companies are likely to be more careful in the future. But it is too late for regulation (which we already had) to prevent this disaster. Tighter regulations two years ago might have helped, but companies will probably tighten up even without that. Where we need tighter regulation is in areas where the disaster hasn’t happened yet, and where the costs would be orders of magnitude higher.

    OGT, Yes. I agree the current system is wrong, as there are liability caps.

    rob, I agree.

    Bonnie, Good points. These are questions that can be asked over and over. The “regulator” (i.e the government), was responsible for the levees in New Orleans. It was widely know that they were grossly inadequate in a hurricane (under many different presidents.) Yet the “regulator” did nothing about it. Does this mean we should turn levees over to the private sector? Most proponents of government activism would say no. My point is that a disaster in and of itself tells us little about whether more or less regulation is needed.

    TokyoTom, You said;

    “Scott, what you’re rather glaringly missing with your cost-benefit analysis – which blithely ignores the real face of “externalities” – is the institutional setting, which can be summed up as a tragedy of the government-owned and (rather expensively) mis-managed comonns.

    Ed Dolan is exactly right about incentives problems facing BP and regulators, none of whom really directly own the downside risks, which instead are borne by fishermen, oystermen, shrimpers, the tourist industry, those who value wildlife and a clean environment, and those who consume what harvesters catch.”

    This mischaracterizes what I wrote. I most certainly did take all those costs you mention into account, and suggested that if they were significantly greater than the losses to BP we might want to consider shutting down offshore oil drilling.

    You said;

    “Answers lie not in gross CBA analysis, but in letting resources users own the rights to manage and harvest wild resources (which would give them direct claims against polluters), AND to determine when and where seabed resources are developed. (NOAA’s successful experiments with “catch rights” need to be vastly scaled up.) We would still have oil & gas development, but the fishermen would do a vastly better job of policing the oil companies – who would have to face other resource users with full incentives to protect their livelihoods. (Obversely, oil companies would also be better managers if they had control over the very valuable fish harvest rights in particular blocks, and would manage to in a way that would reflect such value.”

    Nothing I said was in any way inconsistent with this approach. It does run into the Coase Theorem problems of transactions costs, but still might be the best solution.

  28. Gravatar of Zamfir Zamfir
    9. June 2010 at 05:31

    Is market capitalization really the best estimate of the cost to BP? The number we might be interested in is the price someone would have to pay for all stocks BP without spill, minus the price of BP including spill. But market cap is determined by the marginal trades in stocks. It doesn’t tell us much about the value attached to BP stock by people who kept their stock before and after the spill.

    There isn’t really a liquid market, or perhaps even no market at all, for entities the size of BP in their entirety.

    It’s not obivous that the (virtual) price of BP in its entirety has fallen as much as its stock price suggests.

  29. Gravatar of Sudarsan Sudarsan
    9. June 2010 at 06:41

    Hey Scott,
    Now this is a field I can really talk about. Let’s go —

    “1. The financial losses to BP are the same order of magnitude as the damage to the environment.
    2. The damage to the environment is an order of magnitude or more bigger than the losses to BP.
    In case one it seems to me that we need to simply accept the fact that “stuff happens.” And hope this will be a wake-up call for the offshore oil drilling industry to be more careful. In case 2, I think we should just throw in the towel and give up on off-shore drilling. Or perhaps give up on it in the bigger and deeper wells that are potentially so damaging. (I assume that smaller wells in shallow water are easier to cap.) My hunch is that case one is more plausible, but I have an open mind.”

    My hunch is that case 2 is more far more plausible (although I am willing to keep an open mind till the final numbers come in). At best, BP will end up having to compensate for all of the financial damages caused by the spill. Even this is unlikely (in my opinion); as Exxon did not have to have to fully compensate most of the Alaskans for the financial damage (The case is still going on though). There are numerous complaints from the state of Louisiana that BP is already not paying most of the claims it is supposed to (Bobby Jindal has repeatedly mentioned this)

    As for actual compensation for the environmental damage, that simply will not happen. If a thousand turtles and gators are killed from this spill, who does BP have to compensate to (assuming the turtles / gators are not being harvested by fishermen etc). What about the damage to the wetlands? The wetlands actually provide a key regulator for hurricane. (I believe that for every acre of wetlands, the impact of a hurricane or flood to the city behind the wetlands is reduced by 1 foot of water. Rachel Maddow had a great price on this). Will BP pay for future hurricane damage based on how much wetlands is destroyed by this spill (which could mitigate future damage). What about tourism. How much will BP compensate hotels that lose business? My guess is that actual damages would be far in excess of what BP is forced to pay when all is said and done.

    “I just don’t see an in between case where regulation can do much good.”

    No. Regulation and effective enforcement of regulation was the key to preventing this crisis. BP had over willful and egregious 600 safety violation (compared to other oil companies like Exxon and Sunoco that all had less than 10). Yet, the regulators did nothing to cause BP to reconsider it regulatory practices. BP simply paid the minor fines and continued business as usual. Giving regulators the power to cause massive financial damage to BP would have led BP to adopt safer practices (Example: A fine of $100,000 for first 50 willful and egregious safety violations violations. 1 million for the next 50 violations. 2 Million dollars for the next 100 willful and egregious safety violations etc). of course, such a motion would never pass congress with oil companies lobbying millions to prevent it. I am willing to bet my salary that the investigation will show that this accident was preventable with better safety precautions by BP.

    Effective regulatory checks on the oil platform were not done (The Minerals management service gave BP a ‘pass’ on the inspection). The key to this crisis was the lack of regulation and the lack of enforcement of the same regulation. The problem is that the right wing continues to destroy regulatory agencies while not realizing that an effective and smart regulatory service is the key to preventing disasters (It is like shutting down hospitals when everyone is healthy, because hey, everyone is healthy so we don’t need doctors right now. Unless of course a time comes when we have a crisis …).

    “The oil companies already have a strong incentive to avoid these problems, and the engineers in the oil industry are extremely talented, probably more so than those who would be regulating them.”

    Wrong. Humans being don’t work that way. I am an engineer by training. I work in an industry similar to BP. I have worked in process safety in my career. It is the threat of continuous regulation that drives compliance in all safety programs. If I need $10 million for a company to prevent an accident with a 0.0001% chance of happening, it is all but impossible for me to get 10 million from budget approvers. If there is an immediate threat of a regulatory agency shutting the plant down, I can get the money in days.

    This is especially true for redundant safety systems. People say “Well, the primary safety system has never failed, why do we need to spend 10 million on a backup”. If you perform an analysis of all the major catastrophes (Like Bhopal Methyl Iso-cyanate leak for example), it is the thinking of “What are the odds of that, we have 100’s of these systems that are working perfectly well” that drives the lax attitudes leading to the disaster. And that could have been prevented with effective regulation.

    Ask any process engineer in any industry, fear of an immediate regulatory backlash is what drives safety improvements most of the time.

    As for your statement about engineers being more talented that regulators, that comes back to how much respect we have for the regulatory system. If the media and the right wing treat the regulatory system like garbage, people don’t respect it and sharp college grads will avoid it. If we have budget cuts in regulatory agencies to the point where regulators get paid squat, the telent of the regulators will be adversely affected. The other thing, the regulatory agencies need more engineers and less lawyers.

    “By this point my liberal critics have given up reading and are scrambling to write posts about how clueless those Chicago economists are in their reflex opposition to regulation.”

    I am not sure if I am a liberal critic per se. but I always read all of your posts. I actually consider myself a utilitarian as well most of the time. Honestly though, when looking at the images from the gulf, less regulation is not the word that pops into my head.

    “The lesson of the BP fiasco is that we don’t need more regulation of off-shore drilling, but we do need more regulation of electrical power and biotech. More specifically, we need the government to start strategizing about what to do if there is a massive solar flare that wipes out the power grid east of the Mississippi for months on end. Or what happens if Craig Venter’s evil twin develops a deadly virus that spreads like the common cold. If we are to have more regulations, I’d rather we have our regulators think about the time bombs that everyone is ignoring, ”

    True, we do need to address all of this. I agree 100%. However, the lesson is that we need better and smarter regulation peroid. Both for BP and in anticipating future disasters.

    “rather than problems that the oil companies are probably already hard at work addressing. ”

    False. We also need to address this or the oil companies may self address this problem perfectly. Then a new technology will come along is 5 years (Ultra deep water drilling maybe). The oil companies will assume it is safe. Regulators will overlook key safety violations and this whole thing will happen all over again.

    “I suppose it is more fun to bash the oil industry than think about two billion people dying from a human engineered plague. But perhaps it’s time we stopped going with our gut, and started thinking more rationally about the dangers that our high technology society seems to be rushing toward with little forethought.

    Stuff happens? Yes, and maybe that means we are overreacting to the oil spill. But that’s not what worries me. Even if increased regulation of oil drilling does no good, it also does comparatively little harm. What worries me is the “stuff” that may happen in areas that we don’t even seem to be thinking about. Areas where we can’t afford a single accident.”

    I could not agree more. Technology needs better regulation. The more the potential for damage, the more careful we should be. Now, as for your point of bashing oil companies, well my opinion is don’t do the crime if you can’t do the time. Or don’t create the biggest oil spill ever if you aren’t willing to get yelled at by everyone.

  30. Gravatar of Doc Merlin Doc Merlin
    9. June 2010 at 08:11

    @Sudarson

    “Even if increased regulation of oil drilling does no good, it also does comparatively little harm. ”

    I completely disagree here, 100%. Regulation very strongly stifles growth and advancement. Nuclear energy is a great example, we didn’t have a new nuke plant in the US for about 30 years because they began regulating it very rightly.

    “I could not agree more. Technology needs better regulation. The more the potential for damage, the more careful we should be. ”

    Sigh… you do realize that this is the oil drilling rig that got an award last year from the regulators for safety?
    The truth is that regulators aren’t actually any good for… regulating.

  31. Gravatar of Doc Merlin Doc Merlin
    9. June 2010 at 08:13

    ‘What worries me is the “stuff” that may happen in areas that we don’t even seem to be thinking about. Areas where we can’t afford a single accident.’

    If we aren’t thinking about it, then regulators would be useless to prevent it. Unforeseen problems are by definition unforeseen.

  32. Gravatar of Sudarsan Sudarsan
    9. June 2010 at 08:35

    @Doc Merlin

    “Even if increased regulation of oil drilling does no good, it also does comparatively little harm. “

    I did not say that Doc, Scott did. I was merely citing him.

    As for your statement about regulation stifling growth and advancement. Sometimes, that is the POINT. For example, if you cannot run a system safely (whether it be nuclear energy or deep sea Oil drilling), then the safety requirements imposed by reasonable regulation cannot be met. If those safety thresholds cannot be met, regulators must require that the technology not be used until safeguards are created or the technology has advanced to the point at which we can perform it safely. Of course this would stifle application of that technology. That would not be a case of ‘stifling growth and advancement’ but a case of prudently holding back a technology application until it can be done safely.

    Now as to your particular example of nuclear energy, I agree with you 100%. Nuclear energy is pretty proven at this point and we can in fact run it safely (France is a good example of this). While there remains the possibility of accidents (Three Mile Island, Chernobyl), I think smart regulations can reduce and perhaps even eliminate this risk (or at least reduce it below the risk that is posed by exploiting other forms of energy and their side effects).

    Doc – you said:
    Sigh… you do realize that this is the oil drilling rig that got an award last year from the regulators for safety?
    The truth is that regulators aren’t actually any good for… regulating.
    Again, that is precisely my point. I already addressed this in my previous post when I said “If the media and the right wing treat the regulatory system like garbage, people wont respect it and sharp college grads will avoid it. If we have budget cuts in regulatory agencies to the point where regulators get paid squat, the talent of the regulators will be adversely affected. The other thing, the regulatory agencies need more engineers and less lawyers.”
    The key is having regulators who do their jobs …and regulate. And having a government that supports them.

    Doc – You said “If we aren’t thinking about it, then regulators would be useless to prevent it. Unforeseen problems are by definition unforeseen.”
    The problem is that we end up falling victim to problems that we should have seen and regulated but we didn’t. A great example is BP again. Any oil process expert or engineer will tell you that it is hardly unforeseen that oil wells can blow up. BP had only a single safety system (the BOP). When that failed, you had a disaster. Again, as a process engineer, I can tell you that having a single safety system when failure can be catastrophic is a bad idea. My point is that a majority of accidents if not all of them are both foreseeable and preventable with smart regulation. Companies and individuals within companies may not be willing to do this (see my post for how process safety works in big companies), but regulators have to step in and force it if required.

  33. Gravatar of Sudarsan Sudarsan
    9. June 2010 at 08:38

    By the way, a small additional point. Europe requires an additional redundant safety system other than the BOP (by law) on undersea wells. American does not require that. BP installs additional safety systems in europe and not in america as required by legislation.

  34. Gravatar of ssumner ssumner
    10. June 2010 at 11:42

    Zamfir, I think the marginal investor is the best way if estimating the value of an asset. I agree that those who hold the stock think it’s worth more, and those who don’t think it’s worth less, but the marginal is a nice happy median.

    Sudarsan, I have an open mind on the environmental costs. But you don’t look at the cost to BP by looking at how many checks they have written so far, but rather the fall in their market cap, which I believe is now over $50 billion.

    I never quite understood the argument for regulation. When regulation fails, as it did here, people say “don’t abandon regulation, make it stricter.” But by that logic why not say “don’t abandon having BP take responsibility for their own affiars, have them do it better.” I am sure that in retrospect the regulators wish they hadn’t given BP awards for safety, and instead had cracked down. But I still very much doubt they would have uncovered this particular problem. But I am equally sure that if BP had it to do all over again, they would also have been more careful. Believe me, BP now regrets their carelessnes. So I don’t see the argument for regulation, BP’s already going to take all the steps that the regulators would ask them to take in future wells. This seems like a perfect example of Monday morning quarterbacking.

    And not to get too political, but under George Bush people like Krugman told us that regulation wasn’t enough, you needed regulation under a president who supported regulation. We needed Obama. Now we have Obama and the same problems that were supposedly caused by weak Bush regulation keep happening. That suggests to me that weak regulation is not the key problem. We expect too much from regulators; in banking, in health care, and in oil drilling.

    You said;

    “Giving regulators the power to cause massive financial damage to BP would have led BP to adopt safer practices (Example: A fine of $100,000 for first 50 willful and egregious safety violations violations. 1 million for the next 50 violations. 2 Million dollars for the next 100 willful and egregious safety violations etc)”

    That’s chump change for BP, you’d need much bigger fines. But it might work if the amounts were big enough.

    You said;

    “If I need $10 million for a company to prevent an accident with a 0.0001% chance of happening, it is all but impossible for me to get 10 million from budget approvers”

    That’s good, that expenditure should not be approved. It’s wasteful if the risk is one in a million. One in 10,000 (i.e without the percent sign) is another story.

    One other thing. If regulator makes companies shape up, how come OSHA didn’t reduce accident rates on the job?

    You said;

    “Effective regulatory checks on the oil platform were not done (The Minerals management service gave BP a ‘pass’ on the inspection).”

    Based on what I read, inspections would not have prevented this disaster. They took a short cut at the last minute. Isn’t that what happened?

    You said;

    “True, we do need to address all of this. I agree 100%. However, the lesson is that we need better and smarter regulation peroid. Both for BP and in anticipating future disasters.”

    But we aren’t going to do all those things, so we’d better prioritize. And biotech is much more of a future threat than oil drilling. The oil comapnies are already scared out of their pants. BP may go bankrupt. There’s nothing regulators could tell Exxon over the next 30 years that Exxon won’t already be doing. Little companies are another story. We need to consider having them buy $100 billion in insurance, or some number like that. Then have the insurance companies regulate them.

    Doc Merlin, I have mixed feelings about nuclear. It is not clear they could survive in an unregulated world. Didn’t they get immunity from lawsuits in case of a huge accident? Today there may be some inherently safe reactors that make sense. I am no expert, and have an open mind on the issue.

    Sudarsan#2, You last point is a good one. That extra safety system would have been better. I was reacting more to the term “regulation” as in constant visits to see how things are going, not broad stardards for what sort of technologies are acceptable.

    I expect that in the future those backup system will also be applied in the US. Do you know why Obama didn’t require them?

  35. Gravatar of Doc Merlin Doc Merlin
    10. June 2010 at 16:03

    “Doc Merlin, I have mixed feelings about nuclear. It is not clear they could survive in an unregulated world. Didn’t they get immunity from lawsuits in case of a huge accident? Today there may be some inherently safe reactors that make sense. I am no expert, and have an open mind on the issue.”

    I believe they were, Scott. It was a payoff to the current reactors companies. They were also made so you had to have a federal board ok any and every reactor and reactor plan every step of the way. This is why we didn’t make any new reactors for 30 years.

  36. Gravatar of scott sumner scott sumner
    11. June 2010 at 04:59

    Doc Merlin, Yes, I agree that there was a lot of regulation.

Leave a Reply