Oil Producers’ Liability Should Not Be Unlimited

Everyone loves a villain. And with the Deepwater Horizon disaster at the two-month mark, the love knows no bounds, uniting much of the political-media complex in a sticky goo of opportunism, finger-pointing and phony demands for apologies. That BP–having schmoozed the environmental left for years while compiling a dreadful safety record–has emerged as the corporate analogue of an oil-soaked pelican is delicious, but it does not reduce the crucial need for clear thinking in the face of half-baked policy prescriptions.

Take the seemingly unanimous view that liability should be unlimited for oil producers whose operations result in spills, whether on land or water. That may seem reasonable: After all, why should the party causing (massive) damage not pay for it? The answer, however counterintuitive, is that the appropriate policy goal is not merely to minimize the likelihood of a spill (via preventative action on the part of the drillers), but also to induce those potentially harmed to take actions that would mitigate damage in the event of a spill. In other words, we should seek both proactive actions on the part of drillers and mitigating actions on the part of potential victims. The appropriate goal is to minimize the sum of the damage from spills and the costs of avoiding the damage from spills, an insight that helped Ronald Coase to win the Nobel Prize in economics in 1991.

Consider a highly artificial world in which fisherman, the tourist industry and all others harmed by a potential spill disaster could move their operations elsewhere at zero cost. In this case, the appropriate liability for the oil producers would be zero: Offshore drilling would induce all those potentially affected to move elsewhere costlessly (or not to move there in the first place), and any subsequent spill would cause zero economic damage.

Or consider the straightforward problem of construction in hurricane zones. If owners of buildings are compensated fully for hurricane damage, too much poor construction will be undertaken, yielding an increase in damage when a strong storm hits. Since it is impossible to prevent hurricanes, we can avoid some substantial portion of prospective storm damage by limiting development threatened by them. Forcing builders to pay actuarially fair insurance rates would limit construction to that justified economically, even given the risks.

But, you say, hurricanes are natural phenomena, while drilling is not. Not so fast. From a cold-blooded economic perspective, the hurricane damage is caused by man: Without the construction there would be no damage.

It is possible to prevent (or limit) the damage from massive oil spills by limiting drilling or by making appropriate investments in blowout prevention and the like. Similarly, it is possible to prevent some of the damage by reducing other economic activity threatened by spills. The economic question is not whether oil producers “ought” to be fully liable; it is how to limit damage at the lowest total cost through some combination of limited drilling (forgoing valuable oil), large investments in spill prevention (expensive technology), and reductions in other economic activities in potential spill zones (forgoing valuable seafood production, tourism and the like). Are the first two always the cheapest? That is far from obvious. A liability limit in a very rough fashion would have the effect of shifting some of the liability onto those who might be able to make adjustments more cheaply, thus improving the overall efficiency of resource use.

There is the further matter that the government is responsible for some of the damage. Numerous regulatory constraints on drilling on land and in shallow water have increased deep-ocean drilling and its attendant risks, as well as the inevitable spills from ocean tankers. The failure by the Obama Administration to suspend the Jones Act requirements for the use of U.S.-flagged ships–thus preventing foreign ships from aiding the effort to capture the oil in the Gulf–has increased the damage from the current spill. How, precisely, does unlimited liability for drillers improve the incentives of the Beltway.

Clearly, caveats apply. If the government adopts a liability limit too high or too low, the economic outcome might be worse than that yielded by unlimited liability. If the government subjected to political pressures will make those harmed by a spill whole in any event, a limit on liability would serve no purpose. And it is clear that substantial liability for the oil producers is appropriate, in that large investments in blowout prevention and the like clearly are the cheapest way to avoid much of the potential damage from spills.

But substantial liability is not unlimited liability. The argument for limited liability is difficult to make and defend in a world of sound bites. But the unlimited liability stance is a vehicle for demagoguery and the erosion of the rule of law, an unfolding reality that has illustrated yet again that times of heightened popular passion are wrong for policy formulation.

Benjamin Zycher is a visiting scholar at the American Enterprise Institute, and a senior fellow at the Pacific Research Institute. E-mail him at [email protected].