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BP oil spill: rethinking how we craft environmental policy

The BP oil spill demonstrates that environmental and social costs must be taken into consideration when forming policy regulating off-shore oil drilling.

By Guest blogger / June 2, 2010

Oil cleanup workers hired by BP walk along the beach in Dauphin Island, Ala., on June 2. Oil from the BP oil spill has started washing ashore on the Alabama coast. The social costs of the disaster must be taken into consideration in any policy changes that emerge.

Dave Martin/AP

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Hard to believe it’s been almost a month since I first wrote about the BP oil spill–which I noted at the time was more appropriately considered an “explosion” and not just a “spill.” (Actually, an “unstoppable gusher” is a still better description, as we’ve since learned.)

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I wrote at the time that the temptation would be to say it’s all BP’s fault and just punish and fine the hell out of BP until we’ve squeezed every last dollar out of them. We would get very angry and shout that BP got us into this mess, so BP would have to fix it. I said then that taking such a position might be emotionally accommodating (it’s always someone else’s fault, not our own), but it wouldn’t be very smart from a public policy perspective. I made the argument that if government has a goal of “maximizing social welfare,” the best policy response would be to recognize this as a classic “negative externality” situation and use the best policy tool we have to address it–some sort of tax or charge on fossil fuels–explaining it this way (emphasis added):

The right policy needs to indeed spread the burden of the costs of cleaning up the oil spill to all participants in the oil marketplace, including those of us who innocently just fill up our tanks with gasoline. Only when the extra social costs of the environmental risks associated with both fossil fuel production (e.g., risk of offshore drilling mishaps) and fossil fuel consumption (e.g., global warming, pollution) are incorporated into the prices all of us face in the fossil fuel markets we participate in, will we be led to make the correct, or at least better, decisions from a social welfare standpoint, not just from our own selfish standpoints. These better decisions include the oil companies using safer production methods (which likely means producing less offshore), and consumers buying less gasoline.

But what I neglected to consider is that a tax or charge on fossil fuels in general would not really get at putting a price on the extra social costs associated with the risky offshore drilling methods. A carbon tax would be able to price the external costs associated with global warming (a cost that quite appropriately should be designed to hit both consumers and producers), but would not put an extra marginal cost on riskier versus safer ways of producing (or more specifically, extracting) oil. That additional social cost needs to be imposed on the producers making the decisions about how to produce the oil, or else the incentives to produce using safer methods (especially if they are more expensive than dangerous methods) won’t be there.

So, I want to make an addendum to the post from almost a month ago. I stick by my position that this is a very public problem in need of a very public (policy not just relations) solution. But imposing higher prices on fossil fuels in general, to correct for the global-warming-type environmental costs, is not enough. To get this right, we need to somehow price the expected marginal external costs of offshore oil production as well, if we determine that that production method in particular indeed imposes social costs that exceed private costs. The lump-sum punitive fine on BP imposed after the incident (as well as what has just happened to BP stock prices, pictured above) may have a deterrent effect on other oil companies who engage in offshore drilling, but it’s not an offshore drilling policy. If the government’s response is just an ex-post fine on BP alone, going forward, oil companies in general will still have the incentive to produce at least expected private cost regardless of potential external social costs associated with potential (but still low-probability) accidents.

It seems to me that in our negligence regarding public policy toward the oil and gas industry, we have greatly underpriced the cost of fossil fuels produced from offshore drilling methods for two reasons: (i) for the potential social costs associated with the global warming caused by the consumption and use of fossil fuels in general, and (ii) for the expected environmental costs associated with offshore oil and gas production in particular. The first problem would be solved by turning to a carbon tax or charge, but the second requires another tax or fee that would be charged to any oil company who engages in offshore drilling based perhaps on the quantity of oil they produce offshore or wells drilled or whatever is best correlated with the imposed social risks. The revenue from these latter fees/taxes could go into some sort of trust fund designed to cover the (large) costs of cleaning up (low-probability) accidents. This sounds a lot like an insurance policy, doesn’t it? But it’s like a social insurance program, because these are social costs and a very public problem.

What I describe above is a public policy approach that relies on creating the right market incentives, correcting how the price system allocates resources in the case of a “market failure.” The alternative or additional public policy tool is regulation. It may be the case that we need both better prices and more “command and control” requiring safer production methods.

I don’t know much at all about the Superfund program, but it strikes me that there may be some similarities there in terms of the “insurance” quality of the system I describe. As explained by the Tax Policy Center, Superfund taxes that went into the Superfund fund expired in 1995, but the Obama Administration’s budget proposes to reinstate them. I’d love to hear from any of you who know more about Superfund regarding any public policy lessons there for the current mess we’re in with this BP disaster.

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