Instrument taxonomy

1. Instrument taxonomy Non-market-based, Decentralized policies

2. Economic incentive-based policies • Establishment of property rights • Liability laws • Market-based (future lecture)

3. Property rights • Owner decides how the asset is to be used • may stop any unauthorized use • may negotiate with anybody else who wants access to that resource • We typically assume that owners maximize their payoffs or profits from the asset. • But what if there are externalities involved which spill over property lines? Is there still a role for government action to address externalities? Consider the Coase Theorem….

4. Liability Laws -- Compensation • Holding entities liable for environmental damages which arise from their actions by requiring compensation be paid • internalizes a previously ignored externality. (at least to some extent) • Involves an economic incentive

5. Liability Laws -- Compensation • Suppose a liability law is enacted such that emitters must compensate for (total) damages. • What level of emissions will they choose? • Is this the efficient level? • What is the compensation amount? • If plaintiffs must take defendants to court to be paid, legal costs will be incurred (i.e. if transactions costs are present) • What will happen to the level of emissions? Not clear cut…

6. Liability Laws • Might be preferred when potential polluter precautionary behavior is difficult or costly to monitor • E.g. oil spills • Episodic • Probability of incident depends on many different actions taken which are costly to verify. • Oil Pollution Act of 1990: • details acts for which compensation is required and how to determine amounts of compensation.

7. How fully are damages internalized? • Firms do not always “fully bear the social costs that catastrophic spills impose.” • E.g. 1989 Exxon Valdez Alaskan oil spill • Estimated damages: $5.5 billion -- $9.5 billion (“possibly more, once the cost of cleanup, natural resource damages, economic costs, and health impacts are tallied”) • Estimated cost to Exxon: ~$4.4 billion

8. Oil spill prevention policy and the Deepwater Horizon The following slides draw largely from: Cohen, M. A. (2010). Deterring Oil Spills: Who Should Pay and How Much? Resources for the Future Backgrounder, http://www.rff.org/RFF/Documents/RFF-BCK-Cohen-DeterringOilSpills.pdf. Hargreaves, S. (2010). BP's $70 billion whipping. CNNMoney.com, June 1. Mouawad, J. and J. Schwartz (2010). Cleanup Costs and Lawsuits Rattle BP’s Investors. New York Times, June 1. Richardson, N. (2010). Deepwater Horizon and the Patchwork of Oil Spill Liability Law. Resources for the Future Backgrounder, http://www.rff.org/RFF/Documents/RFF-BCK-Richardson-OilLiability.pdf.

9. Impacts • The incident, April 20, 2010: 11 deaths and an oil leak of tens of thousands of barrels of oil per day (final estimate: 4.9M bls(Hock, 2010)) • BP shares down ~25% relative to other large western oil companies (Financial Times, 2/24/12) • ~$86B billion in shareholder value lost • Argument: concern that clean up costs, lawsuits, and added restrictions from the spill, will erode earnings potential • U.S. Attorney General Eric Holder announces a criminal probe into the spill. • The selloff accelerated • BP profits: • 2009: $17B • 2010: -4.9B ($20B projected before spill) • 2011: $23.9 billion • 2012: $17.1B • 2013: $13.4B Hargreaves (2010) (Carolyn Cole, Los Angeles Times / June 4, 2010)

10. A Taxonomy of Oil Spill Costs—What are the Likely Costs of the Deepwater Horizon Spill? (Cohen, 2010)

11. Oil spill policy • Patchwork: • Ancient traditions of maritime law + major overlay of modern statutes • Mixture of civil liability and criminal regimes • Different claimants with varying types of damage claims are treated differently • Liability: primary method of prevention • Significant regulatory requirements exist as well Richardson (2010)

12. Three core principles: 1. strict liability • Responsible party strictly liable for all cleanup and damages (Cohen, 2010) [responsible even if not culpable] • No need to determine the cause of the spill • Generally efficient: • negligence standard requires considerable resources to investigate and prove • built-in incentive for firms to invest in better prevention technologies • Makes sense where (Richardson, 2010) • precautions can best be taken by one of the parties • large numbers of third party victims make bargains between the parties difficult or impossible

13. Three core principles: 2. “channeling” of liability • Specifies exactly who is to be treated as the responsible party for liability purposes • Offshore facilities: holder of the drilling permit is the responsible party (e.g. Deepwater Horizon  BP). • Arguments over causation will affect the ability of the responsible party to collect from others • E.g. BP has recovered “$4bn from Anadarko Petroleum, its junior partner in the Macondo project with a 25 per cent stake.” (Financial Times, 2/24/12)

14. Three core principles: 3. liability limits • Traditional in maritime law • Oil Pollution Act of 1990 (OPA): primary American statute governing liability for oil spills • largely in response to last major oil spill (Exxon Valdez) • OPA: liability caps vary by type of spill and type of damage • Offshore facilities like Deepwater Horizon: damages cap at $75M • Applies to both major classes of damage from oil spills: natural resource damages and economic damages to private parties • Only direct cleanup costs are exempt. • OPA limits are an increase over previous (value of vessel) damage caps Richardson (2010)

15. Exceptions to the OPA cap • If spill caused by “gross negligence or willful misconduct” or by violation of federal regulations no liability cap • Must be proved in court • OPA disclaims preemption of state law • LA: state limits mirror OPA • MS, FL, AL: no apparent caps Richardson (2010)

16. Exceptions to the OPA cap: Criminal law • Exxon Valdez • Federal government sought recovery of natural resource damages to Prince William Sound by filing criminal charges • Violated: • Migratory Bird Treaty Act (by causing the death of protected birds) • Refuse Act (by dumping of “refuse” into the navigable waters of the United States). • Restitution to injured partiesthe United States itself in the form of compensation for damages to the natural environment. • Exxon pled guilty, settled, paid significant payments to the federal government (cleanup and natural resources damages) • Might not allow recovery of private economic damages Richardson (2010)

17. Optimal penalty basics • Optimal penalty literature: Gary Becker (1968) • Economic analysis of crime, basic insight: • potential criminals respond to both: • the probability of detection, and • the severity of punishment if detected and convicted • Enhancing deterrence • raising the penalty • increasing monitoring (likelihood of detection) • increase the probability of conviction Cohen (2010)

18. Limits to Liability • Oil Pollution Control Act of 1990 • certain limits to liability in the case of an oil spill • may be breached if there is gross negligence or violations of the law (see “Deepwater Horizon and the Patchwork of Oil Spill Liability Law” by Nathan Richardson). • Arguments for limited liability • Positive externalities to drilling (energy security) • Unlimited liability uninsurable risks that would make drilling too risky • Concentration of drilling industry, dominated by giants. Cohen (2010)

19. “Obama administration Friday (2/21/14) took a step toward raising the amount oil and gas companies are required to pay in the case of a major oil spill.” • “…plans to raise the liability limit for oil cleanup costs and damages from $75 million to $134 million under the Oil Pollution Act of 1990.” • 2010 failed bill: “…would have increased the liability cap to $10 billion. …opposition from other lawmakers, …would lead to a decrease in oil and gas exploration investment in the U.S.” Jennifer Larino, NOLA.com | The Times-Picayune | 2/21/14

20. BP liability and insurance • Current civil lawsuits, under tort law, are not limited or barred by the OPA (Mouawad and Schwartz, NYT, 2010) • involve fishermen, oystermen, landowners, restauranteurs, seafood processors and others • BP is self-insured for the operation (Hargreaves, 2010) • Will shoulder all of the costs of the cleanup and damages • Common for most big oil projects

21. Impacts on BP • LA Times, “BP gets slick in trying to undermine gulf oil spill settlement”, 2/23/14 • Criminal: “BP pleaded guilty to a dozen felony charges and agreed to pay (over) $4 billion in penalties and fines.” • Civil: Plaintiffs attorneys: “BP has belatedly awakened to the fact that its obligations to businesses and individuals may come to billions of dollars more than it anticipated.”

22. Impacts on BP • LA Times, “BP gets slick in trying to undermine gulf oil spill settlement”, 2/23/14 • Criminal: “BP pleaded guilty to a dozen felony charges and agreed to pay (over) $4 billion in penalties and fines.” • Civil: Plaintiffs attorneys: “BP has belatedly awakened to the fact that its obligations to businesses and individuals may come to billions of dollars more than it anticipated.” • The Guardian, “BP's Deepwater Horizon bill rises by $200m as profits fall”, 2/4/14 • “BP…forced to set aside an extra $200m (£123m) for the Gulf of Mexico oil spill, bringing the bill so far to $42.7bn.” • “The final figure could be far higher,…latest tally does not take account of additional provisions for economic loss claims from a further legal settlement BP has made…. • “…also waiting for a final US court decision over whether it was considered grossly negligent for the Deepwater Horizon accident.” • “…could add a further $20bn to the final bill….penalties under America's Clean Water Act.” • US department of justice: “BP should remained barred from winning new contracts in the Gulf of Mexico…(has) not demonstrated it was a "responsible" contractor.”

23. Criminal trials against employees… • “…jurors convicted (a former BP employee) of an obstruction-of-justice charge punishable by up to 20 years in prison. • …concluded that he broke the law…when he deleted a string of text messages to and from his supervisor (relating to the amount of oil flowing from the blow out which was greater than publicly claimed)…. • Three other current or former BP employees await trials on spill-related criminal charges. • …(two) manslaughter charges in the deaths of workers on the Deepwater Horizon drilling rig. Prosecutors say they botched a key safety test and disregarded abnormally high pressure readings that were glaring signs of trouble before the April 20, 2010, blowout of BP's Macondo well. • Former BP executive….charged with concealing information from Congress about the amount of oil spewing from the well.” MICHAEL KUNZELMAN, Associated Press, 12/18/13

24. Liability and insurance • Transocean: Owner of the rig • Liability: Seeking the protection of an 1851 maritime law, the Limitation of Liability Act • asking that its liability be held to ~$27M • Insurance: Made a $270M profit from having over-insured the rig (already mostly paid out) [Sunday Times] Mouawad and Schwartz (NYT, 2010)

25. Additional optional slides

26. The role of insurance • Much of the costs of an oil spill are paid for by insurance. • Does this create a “moral hazard” problem? • Reduce the incentive for firms to prevent spills? • Depends upon how the insurance arrangement is structured • Exclusions for negligence or rule violations maintain the incentive for the firm to take certain precautions • Insurers often serve an independent monitoring role Cohen (2010)

27. The role of insurance • Oil Pollution Control Act of 1990 • Public insurance: Oil Pollution Liability Trust Fund • Funded by a per-barrel tax on oil production • Covers damages when private-party liability limits reached (or when responsible party unknown/bankrupt). • All parties pay into the tax and the fund pays for cleanup regardless of the cause • Private incentives for efficient care and precaution? Cohen (2010)

28. The role of firm reputation • Stock prices  represent the market’s best estimate of future firm profitability • IF: price reduction > expected cost of penalties and cleanup  could indicate a “reputation” penalty • Most studies fail to find reputation penalty from environmental violations • Jones, Jones and Phillips-Patrick (1994): impact of Exxon Valdez spill on Exxon • Estimated cost to shareholders: $4.7B - $11.3B • …within the range of estimates of the direct spill cost to Exxon Cohen (2010)

29. The role of criminal law • We have criminalized the spilling of oil (even accidental discharge) • Can be nonmonetary: prison time for individuals, “probation” for organizations • Putting a criminal label on behavior: arguably a signal of moral outrage • perhaps having additional negative reputational impacts • BUT: might have just the opposite effectsignal that the criminal law is arbitrary and reducing the respect for the law Cohen (2010)

30. Deepwater Horizon Timeline and BP share price via Hargreaves (2010)