August 2, 2010
Abstract: Current law states that oil or gas companies do not have to pay more than $75 million in liability costs for accidents they cause—no matter how great the damages. Republicans and Democrats agree that the cap is too low. But simply raising it to another artificial level, or eliminating it entirely without other reforms, is not the easy answer, tempting as it might seem. A higher cap, or none at all, means very little as long as crucial safety, regulatory, and liability issues continue to be ignored, and public concerns are unaddressed. Government regulatory oversight is necessary, but liability insurance must be privately managed, with claims assessed and paid out by an independent administrator. Safety and preparedness measures must also be independently reviewed and approved. Above all, taxpayers must be protected from footing the liability costs for industry-caused disasters. The Heritage Foundation provides a comprehensive plan for responsible and commonsense measures to ensure offshore oil and gas safety, keeping the public informed and government bureaucracy in check.
The Deepwater Horizon oil spill in the Gulf of Mexico has brought a number of important policy issues regarding offshore drilling to the surface. One contentious issue is the extent to which offshore oil and gas operators are held liable for any accidents they may cause. Republicans and Democrats agree that the current liability cap of $75 million is too low. Members of Congress have called to raise the cap to $10 billion or remove it entirely.
The problem with these approaches is that they do not address the fundamental problem of the current system: It does not sufficiently align risk and liability with individual behavior. It starts with a very low liability cap and then forces all participants to contribute to a government-mandated trust fund to pay for damages. The result is a system that socializes risk by spreading the costs across the entire industry, creating a divide between behavior and financial risk. Simply raising the cap without more comprehensive reform would fail to fix the systemic problems and could effectively shut down offshore drilling entirely if activities are made unreasonably and artificially burdensome.
Instead of simply increasing or removing the cap, Congress and the Administration should develop a new approach that accurately assigns risk to all offshore operations, including exploratory drilling, production, and tanker movements; holds operators fully liable for their actions; and guards against frivolous lawsuits. Such a system should rely on market-based mechanisms and be built around private insurers and professional risk assessors.
Specifically, such a regime should include:
All three pieces—insurance, safety standards and inspection, and preparedness and response will work together to reduce the likelihood that a future spill will occur, and reduce the economic and environmental damage if it does occur.
Oil spill costs should be regarded as consisting of two basic types: cleanup costs and liability costs. First, under current law, the responsible party must pay all cleanup costs. This approach is correct and needs no reform. Second, the liability costs are the costs incurred by individuals, businesses, and communities that suffer as a result of the oil spill. Under U.S. law for offshore facilities, the responsible party (in the Deepwater Horizon case, BP) is directly responsible for no more than $75 million of these costs. Liability costs above $75 million up to $1 billion are funded by the Oil Spill Liability Trust Fund (OSLTF). The OSLTF is financed by an eight-cent-per-barrel tax on imported and domestic oil.
The $75 million cap is waived if the responsible party is found to have acted with gross negligence or willful misconduct, an issue which has not yet been resolved regarding BP. Even so, BP has repeatedly stated it will pay all costs incurred by the oil spill. Although the current system seems to be working in terms of BP financing the full costs of its mistakes, the problem is how it impacts normal operations and procedures elsewhere in the industry. The Oil Pollution Act of 1990 addresses liability for onshore and offshore oil and gas operations. While this paper focuses only on offshore operations, its principles and concepts could apply to the oil and gas industry broadly.
A New, Market-Based Approach
Congress should reform the Oil Spill Liability Trust Fund and remove the $75 million liability cap, replacing it with a new system that accurately assesses the risks of offshore oil and gas operations and appropriately assigns those risks to industry operators. Companies must demonstrate to federal regulators an ability to insure against the liability risk associated with specific offshore oil and gas operations (exploration, extraction, and transportation, etc.) in federal waters. Private risk assessors will determine liability-coverage requirements for specific activities and federal regulators will certify that liability requirements are met. The means for meeting liability-coverage requirements will not be limited, but may include self-insurance, insurance pools, dedicated assets, or private insurance policies. The federal government will create a private, tiered insurance framework and administrative process to manage claims. The central element of the insurance framework will be a private and voluntary pooled insurance fund for claims above $1 billion. The claims process will ensure that legitimate claims are paid fully and efficiently while protecting responsible parties from frivolous lawsuits.
The current liability system distorts the ex ante risk of oil and gas operations in two fundamental ways: (1) The artificially low cap of $75 million established 20 years ago does not fully or directly capture the risk of offshore operations; and (2) Rather than placing responsibility with the responsible company, the OSLTF shifts responsibility to the entire industry and, ultimately, the federal government, thereby reducing the incentive for individual companies to operate safely.
The Role of Private Risk Assessors. Private risk assessors, not bureaucrats and politicians, should determine the liability associated with covered activities. These professionals maintain the specialized knowledge and expertise to accurately assess the risk of offshore oil and gas operations. They use many variables, such as safety records and depth and pressure of wells, to calculate their conclusions. Private insurers can then use that information to determine the premiums required to insure against potential liabilities. Removing the process from government control will help to ensure more objectivity.
Accurate Risk Assessment: More Innovation, Less Risk. By not assigning proper responsibility for risk, the $75 million liability cap can decrease the value of safe operations. Congress should be wary of a fix that mandates one safety technology or procedure over another or a set of blanket safety standards for the entire industry. Such mandates reduce the incentive for companies to innovate and create new technologies. Accurate risk assessment and holding each company liable for that risk increases the incentive to reduce risk—each company will have a financial incentive to continuously strive for safety improvements—thereby resulting in more innovative approaches to safety and preparedness.
A 3-Part Plan for Safe Offshore Gas and Oil Operations
1. A Tiered Insurance Program. Congress should establish an insurance and claims process that fully assigns risk of offshore oil and gas operations to the responsible party and allows victims to be fully compensated, while protecting companies from frivolous lawsuits.
A $1 Billion Threshold per Accident. Liability of up to $1 billion per accident, indexed for inflation, would be the responsibility of the operator. To remain in operation, the liable party must demonstrate to federal regulators an ongoing ability to meet the up to $1 billion liability threshold in the event of an accident. This requirement could be met through individual private insurance or pools, or by some other means, including the pledging of company assets and pooling of resources among individual companies. Assets identified and pledged against the $1 billion threshold must remain unencumbered for the duration of the exposure, meaning they could not be used as collateral in another financial transaction.
Industry-Funded, Privately Managed Insurance Under Government Oversight. The second level of insurance would be a voluntary insurance pool with a placeholder target of $10 billion funded by responsible parties to cover legitimate liability claims above $1 billion. The final target should use the total liability costs of the BP oil spill as a point of reference. Any remaining funds from the Oil Spill Trust Fund should be transferred to this pool. Participating companies would fund the pool through fees (or premiums) paid per barrel of oil produced, or per barrel imported. This premium would vary based on a safety rating from an independent safety organization on a case-by-case basis for each company. (The proposed creation of such an organization is described below.)
In a free market, industry players unable to cover their own economic liability would likely have created a pool voluntarily, but government-created caps and the trust fund have eliminated the need to do so. The private pool would be different from the current government-run system since it would foster incentives to balance risk, unlike a government-run system indifferent to markets. This would be done through the creation of an independent safety organization and its ability to influence insurance premiums based on a company’s safety rating.
2. Organization for Offshore Safety Operations. In addition to a private risk-insurance-based system, the oil and gas industry should establish an independent Organization for Offshore Safety Operations (OOSO) to promote safety. While Congress should not compel the creation of OOSO, industry would be well served by establishing it since it would improve safety standards as well as public perception of offshore drilling safety. OOSO would resemble the Institute of Nuclear Power Operations (INPO), created after the partial meltdown of the Three Mile Island nuclear reactor.
OOSO would have three primary roles:
After the incident at Three Mile Island, President Jimmy Carter created a commission led by Dartmouth College president John Kemeny. The commission recommended that the nuclear industry establish a program that shares best-practices safety standards and conduct independent evaluations on the industry’s operations. As a result, the nuclear industry created INPO to “promote the highest levels of safety and reliability—to promote excellence—in the operation of commercial nuclear power plants.”
The oil industry needs to set up a similar organization. Consistent monitoring of offshore operations would significantly reduce a company’s ability to cut corners. If OOSO found that a company did cut corners, it would apprise federal regulators of its findings.
Not only would OOSO prevent governmental regulatory overreach that could drive offshore operations to other countries, it would increase safety levels, thereby reducing the insurance premiums paid by the industry. A system of peer review and self-preservation would further reduce the risk of an accident and catch warning signs that were ostensibly missed during the Deepwater Horizon accident. Although an oil spill of the Deepwater magnitude is extremely rare, the current disaster in the Gulf of Mexico roused public fears of offshore drilling. If professional and credible, OOSO would greatly relieve the public’s environmental concerns associated with oil and gas exploration and production.
Like INPO, OOSO would be structured much like a normal business, with a board of directors that includes members of industry, academia, and potentially other sectors. The board should be chaired by an industry leader. OOSO would also have an active advisory council composed of engineers and scientists with relevant knowledge. Moreover, OOSO should have the ability to create accreditation programs and education courses that would increase the operational safety of offshore laborers. Training accreditation for new workers may also be recognized by insurance companies and would be another way to keep premiums affordable.
OOSO’s relationship with BOEMRE, which manages natural gas, oil, and other mineral resources offshore, would be critical. OOSO would not play an advocacy role, but instead provide complementary and timely safety information to BOEMRE. This could include tracking and monitoring real-time safety data that would provide a backstop to previously undetected problems. Biannual safety evaluations by OOSO should be shared with BOEMRE to allow federal regulators to make better decisions about future sales of leases for oil and gas exploration and production. Evaluation programs as well as analysis and information exchange programs will enhance operational and safety performance and assist BOEMRE without creating additional government bureaucracy.
3. Demonstrated Response and Preparedness. Whatever the specific mistakes and systemic flaws that led to the explosion on the Deepwater Horizon rig, the oil industry and federal government must demonstrate that they can handle and contain a major spill much more effectively than they have thus far. This means that the industry and government would have to go above and beyond current safety standards (such as blowout preventers) as well as the prevention planning mandated in the 1990 Oil Pollution Act, which predominantly focused on tankers. Adequate response capabilities will reduce the economic and environmental damage of an oil spill, and help to mitigate public concerns over oil and gas exploration. The demonstrated response and preparedness would require the oil and gas industry to:
The demonstrated response and preparedness would require the federal government to:
In addition to the three-part plan (which would reform the Oil Pollution Act of 1990), Congress should:
The immediate priority for Congress and the Administration should remain the environmental cleanup and determining the cause of the explosion on the Deepwater Horizon rig on April 20, 2010. By simply raising or eliminating the liability cap, Congress is trying to solve a puzzle without all the pieces. Instead of reactively creating another arbitrary cap, Congress should wait to see how much the Gulf oil spill is likely to cost and allow private insurers to assess the true risk of offshore oil and gas operations.
Congress should create a liability system that clearly identifies risks and allocates associated liabilities, ensures that those engaged in the industry can meet their potential liabilities, protects industry from frivolous lawsuits, and assures the public that both environmental and economic damages from an oil spill can be addressed in full. The oil industry should create an independent safety organization that would provide an incentive for oil companies to explore and implement new safety and prevention mechanisms. While such an organization would greatly reduce the likelihood of spills in the future, the industry also needs to demonstrate a clear and full ability to respond competently in the event of a spill. These reforms would keep oil and gas operation safe, the public informed, and overzealous regulators in check.
—Nicolas D. Loris is a Research Assistant in the Thomas A. Roe Institute for Economic Policy Studies; Jack Spencer is Research Fellow in Nuclear Energy in the Roe Institute; and James Jay Carafano, Ph.D., is Deputy Director of the Kathryn and Shelby Cullom Davis Institute for International Studies and Director of the Douglas and Sarah Allison Center for Foreign Policy Studies, a division of the Davis Institute, at The Heritage Foundation.
Neil King Jr., and Keith Johnson, “BP Relied on Faulty U.S. Data,” The Wall Street Journal, June 24, 2010, at http://online.wsj.com/article/SB10001424052748703900004575325131111637728.html (July 30, 2010).