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Jun 2010
The Perfect Spill: Solutions for Averting the Next Deepwater Horizon
National Oceanic and Atmospheric Administration (NOAA)
In this satellite image, oil in the Gulf of Mexico reflects sunlight back into space. (Some of the reflection could be caused by plankton blooms and other features.)

“If we refuse to take into account the full cost of our fossil fuel addiction—if we don’t factor in the environmental costs and national security costs and true economic costs—we will have missed our best chance to seize a clean energy future.”
–President Barack Obama, Carnegie Mellon University, June 2, 2010

The continuing oil spill from the Deepwater Horizon is causing enormous economic and ecological damage. Estimates of the size and duration continue to escalate, but it is now the largest in U.S. history and clearly among the largest oil spills on record.1

As efforts to plug the leak and clean up the damages continue, it is not too soon to begin to draw lessons from this disaster. We need to learn from this experience so we can prevent future oil spills, reevaluate society’s current trajectory, and set a better course.

One major lesson is that our natural capital assets and other public goods are far too valuable to continue to put them at such high risk from private interests. We need better (not necessarily more) regulation and strong incentives to protect these assets against actions that put them at risk. While the Obama administration’s demand for a trust fund to compensate injured parties is appropriate, it arrived only after the fact. Common asset trusts and new financial instruments like assurance bonds would be better able to shift risk incentives and prevent disasters like the Deepwater Horizon.

The Costs: Damages to Natural Capital Assets

The spill has directly and indirectly affected at least 20 categories of valuable ecosystem services in and around the Gulf of Mexico. The $2.5 billion per year Louisiana commercial fishery has been almost completely shut down. As the oil extends to popular Gulf Coast beaches, the loss of tourism revenue will also be enormous. In addition, the spill has damaged several important natural capital assets whose value in supporting human well-being is both huge and largely outside the market system. These nonmarketed ecosystem services include climate regulation via the sequestration of carbon by coastal marshes and open water systems, hurricane protection by coastal wetlands,2 and cultural, recreational, and aesthetic values. Since the time of the Exxon Valdez spill, we have developed better techniques to estimate the value of the damage to these public assets.

A recently released study estimated the total value of these ecosystem services for the Mississippi River Delta to be in the range of $12-47 billion per year.3 Based on the flow of these services into the future, the value of the Delta as a natural asset was estimated to be in the range of $330 billion to $1.3 trillion, far more than the total market value of BP ($189 billion) before the spill. Unlike BP, ecosystem service values are outside the market. They continue to produce benefits unless an action like the spill damages them.

The value of the loss of these ecosystem services for the entire Gulf will always be difficult to estimate with any precision. In addition to the Mississippi Delta, the spill will also probably affect a large fraction of the Gulf’s open water systems and the coasts of all of the states and nations bordering the Gulf: Florida, Alabama, Mississippi, Louisiana, Texas, and perhaps even Mexico and Cuba. Once the spill has been stopped and the extent of the damages assessed, we will have a better idea of these costs. In the meantime, the best we can do is to try to put the expected magnitude of the damages in rough perspective.

If we assume that the Mississippi River Delta will be the most affected region and that there will be a 10 to 50 percent reduction in the ecosystem services provided by the Delta, this amounts to a loss of $1.2 – $23.5 billion per year into the indefinite future until ecological recovery, or $34 – $670 billion in present value (at a 3.5 percent discount rate).

Dealing with Risk

Our current approach to dealing with the risk of private interests damaging public environmental assets is to assign liability to the private interests, but with the burden of proof on the public. The public must demonstrate damages after the fact, claim compensation, endure a lengthy judicial process, and finally hope to recover just reparations. In addition, the total liability is often limited. For example, in the U.S., the Oil Pollution Act of 1990 limits the liability for oil spills to $75 million,4 and the Price-Anderson Act limits the liability for nuclear power plant accidents to $10 billion. The Exxon Valdez oil spill resulted in an estimated $3.4 billion in fines, compensation, and cleanup costs, and a court settlement of $2.5 billion in punitive damages that took decades of lawsuits after the incident and was ultimately reduced by the Supreme Court to $500 million in 2008.5

In many other parts of society, we require private interests to buy insurance to deal with the risks they impose on the public. For example, purchasing automobile insurance is now mandatory, and assurance bonds are often required from building contractors. Requiring assurance bonds or insurance forces private interests to internalize the risk of their activities before any damages occur. It gives them strong financial incentives to reduce risk, since it is their own money that they stand to lose.

The Deepwater Horizon incident, like the banking crisis, resulted from inadequate attention to the risks that the public was left to bear. Precautionary measures were known but not taken. Investments in safety devices (like the acoustic blowout preventer) were not made. Corners were cut. Short-term private profits motivated taking high risks with public assets.

The fundamental problem is that while private interests are ultimately liable for damages to public assets, they are only held accountable long after the fact and only partially. This gives private interests strong incentives to take large risks with public assets—far larger than they should from society’s point of view.

Costanza_oil2.png
National Oceanic and Atmospheric Administration (NOAA)
Oil from the Deepwater Horizon accident has reached the Florida Loop current, which goes through the Florida Straits before feeding into the Gulf Stream Current.

If society does not change investment incentives, private interests will continue to devote vast sums of capital to pursue increasingly risky oil reserves (or financial products) that provide less net energy and maintain our oil addiction—an addiction which simply cannot be physically sustained.

The Solutions

The long-term solutions to these problems require fundamental changes to business-as-usual practices, including:

  1. Assessment and incorporation of the full value of public natural capital assets into both corporate and public accounting and decision-making, as President Obama recommended.
  2. Assessment of the risks and worst-case damages that could result from accidents, based on damages to this more broadly assessed value.
  3. Application of the best science available about the complex linkages between human systems and the rest of nature.
  4. Reversal of the burden of proof and requirement of corporations and other private interests to internalize and monetize their risks to public goods. One way to monetize these risks would be to require private interests to post an “assurance bond” large enough to cover the worst-case damages.6-8 Portions of the bond (plus interest) would be returned if and when the private interests could demonstrate that the suspected worst-case damages had not occurred or would be less than was originally assessed. If damages did occur, portions of the bond would be used to rehabilitate or repair the environment and to compensate injured parties. The critical feature is that the risk to the public asset is apparent to the private interests in financial terms before the fact, not as a liability that may or may not be enforced after the damage occurs.
  5. Finally, it is high time government policy realigned investment incentives for both public and private investment away from greater oil dependency and toward renewable domestic energy sources. Environmental bonding is a good start.

Imagine how this system might have worked had it been in place prior to the Deepwater Horizon incident. What actually occurred is pretty close to the “worst-case” scenario that might have been envisioned before the fact. Our best guess of the potential damages would thus be in the range of $34-$670 billion, as discussed above. Let’s say that a scientific review panel, after assessing the risk in more detail, settled on an estimate of $50 billion. This immediately makes it very apparent to BP and others drilling in deep water in the Gulf of Mexico that they are engaged in a very risky business—several orders of magnitude riskier than the $50 million liability limit previously in force. The size of this bond, for one deepwater well, would be close to one quarter of the total value of the company! What could they do? Either not drill at all or find ways to reduce the size of the risk and the bond. They might be able to do this very cost-effectively if they spent some money on risk-reduction procedures or technology, such as the acoustic blowout preventer costing a mere $500,000. These measures might convince the scientific review panel to change its assessment of the worst-case scenario and reduce the bond. There would be very strong economic incentives for BP to find creative ways to reduce the risks (just what we want them to do!) rather than ignoring the risks and cutting corners.

How could such a system be implemented? A public agency would need to be appointed as “trustee” for the natural capital assets at risk. This could be a branch of an existing government agency or it could be a new quasi-governmental organization or non-governmental organization set up as an independent “common asset trust.” In any case, the mission of the agency would be explicitly to “protect the asset” rather than facilitating its exploitation, and it would have the authority to charge fees for damages to the asset and require posting bonds to cover potential damages.9-11

This change in approach to risk should be extended to several other private activities that put the public interest at risk. Nuclear power should be required to be fully insured. Repealing the Price-Anderson Act that currently limits liability and requiring bonds to adequately cover accidents and future waste disposal costs would accomplish this. It would reveal that nuclear power is extremely expensive. The banking crisis would never have occurred if the banks had been required to internalize their risks rather than literally “banking on them.” We need to reassert the public-goods nature of money and put control of the money supply back in the hands of the government rather than the private banks, which currently create most of the money supply by issuing loans on fractional reserves.12 Recapturing “seigniorage,” the government’s right to control the money supply, could enable a dramatic reduction in taxes.

The Deepwater Horizon incident offers a strong lesson in risk management. Our entire society is taking far too many risks with public assets whose real value we are only now beginning to recognize. By shifting the financial burden of those risks onto the private interests who benefit from them, we can establish the right incentives, shift investment to less risky, more productive pursuits, and create a more sustainable and desirable future.

References

  1. Cleveland, C. Deepwater Horizon oil spill [online]. The Encyclopedia of Earth (2010) www.eoearth.org/article/Deepwater_Horizon_oil_spill
  2. Costanza, R, Pérez-Maqueo, OM, Martínez, ML, Sutton, P, Anderson, SJ & Mulder, K. The value of coastal wetlands for hurricane protection. Ambio 37, 241-248 (2008).
  3. Batker, DP, de la Torre, I, Costanza, R, Swedeen, P, Day, JW, Jr., Boumans, R & Bagstad, K. Gaining Ground—Wetlands, Hurricanes and the Economy: The Value of Restoring the Mississippi River Delta (Earth Economics Tacoma, WA, 2010).
  4. This liability limit is not in effect if the spill is deemed a criminal offense, as may be the case for the Deepwater Horizon incident. In addition, the U.S. Congress is currently considering increasing the liability limit, but only to $200 Million.
  5. Maag, C. Supreme Court decision on Exxon Valdez damages a blow to Alaskans. The New York Times (2008). www.nytimes.com/2008/06/26/world/americas/26iht-alaska.4.14027236.html
  6. Costanza, R & Perrings, C. A flexible assurance bonding system for improved environmental management. Ecological Economics 2, 57-76 (1990).
  7. Costanza, R & Cornwell, L. The 4P approach to dealing with scientific uncertainty. Environment 34, 12-20, 42 (1992).
  8. A precedent for environmental assurance bonds is the producer-paid performance bonds often required for federal, state, or local government construction work. For example, the Miller Act (40 U.S.C. 270), a 1935 federal statute, requires contractors performing construction work for the federal government to secure performance bonds. Bonds are frequently required for construction work done in the private sector as well.
  9. Barnes, P. Capitalism 3.0: A Guide to Reclaiming the Commons (Berrett-Koehler, 2006)
  10. Barnes, P & McKibben, B. A Simple Market Mechanism to Clean Up Our Economy. Solutions 1, 30-38 (2010). www.thesolutionsjournal.com/feature_article/2009-01-14-simple-market-mec...
  11. The Obama administration has demanded that an independently administered trust fund be set up with money paid by BP to compensate injured parties. This is a good idea since it takes the details of the compensation for damages out of the hands of the parties causing the damage and removes an important conflict of interest. But it is after the fact and does little to change the risk incentives to prevent future problems.
  12. Daly, HE. From a failed-growth economy to a steady-state economy. Solutions 1, 37-43 (2010). www.thesolutionsjournal.com/node/556
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Comments (4)

Preventing a Ton of Cure: Disaster Preparedness.

Preventing a Ton of Cure: Disaster Preparedness.
http://www.modelearth.org/art01.html

Thank you, Hearthstone - www.ModelEarth.Org

The next bigger set of risks...

You identify a clear flaw in our risk assessment model, increasingly complex and higher risks, with no funding or able methods for accurate assessment.

The problem is bigger than that, though. We have this same flaw all over the place, increasing risks that are no one's job to look into. We are taking them to keep increasing our economic output with ever less human effort (productivity), so the economy can continually grow at "stable" rates.

When you ask the question, what would make a smooth running system, that always worked before, certain to fail completely, you find a 1-1 correlation with our standard model of economic stability. Our economic model is to continually increase our wealth by taking ever greater risks in managing ever faster changing and complex systems for using more physical resources.

The simple physics of that should have told us long ago that the response times needed would be a problem! The only trouble is... physics can only refer to data, and has nothing to say about complex physical physical systems. You can't define them. What turns out to work to apply physical to physical systems, is that you can define ways to point to them. I think my methods work, at least competently, for doing just that, and drawing out quite useful results.

I have a nice general paper on the core theory to appear in Cosmos and History this month.

Fund vs. insurance - how to set tariffs

The article demands payments into a fund as an " ... “assurance bond” large enough to cover the worst-case damages". The article goes on with an example - installation of blow-out preventer in the Mexican Gulf - to reduce the risk. Two thoughts:
1) While this example of the "preventer" would reduce the risk, it would NOT reduce the level of the worst-case damages.
We know this type of situation from nuclear debates: damages so high that it is impossible to insure against (but seem to call for bans to prevent alltogether), and damage frequencies so rare that we can't set reasonable annual insurance premia.
The move of President Obama to press the responsible company into paying a substantial sum into a fund even before legal procedures are set - this could be developed into a new formula for law. The aim of the article's idea, to put a price tag on 'normal' activities even before a large damage occurs, is valid. It's only the focus on the "worst-case damage" which will not easily work. Possibly, it could be possible to define a "highest expected damage", i.e. a risk-based assessment of possible damages.
2) We need to look at the interests being created. The Gulf tragedy was partly due to the non-implementation of the legal control measures. So, any new measure should at the same time be less corruption prone than now. A large fund, however, is extremely prone! I am sorry to say that a tax would probably be less so, as the money is fuelled into known channels. But I am aware that this opens new questions, too.

reducing the likelihood of a spill

While I agree with the authors thesis in its entirety there are some cautionary issues. The use of environmental bonding typically does not work well. Work that my co-author Matt Andersen and I are completing on costs and bonding in Wyoming's oil and gas fields suggests that the way the federal government goes about about bonding makes the bond a sunk cost and not a "promise to pay". The only thing that keeps firms doing some reclamation is reputation damages. Bonds in the oil and gas field are usually not cash bonds. They are usually a surety insurance contract or a lien on equipment (think about the depreciation of the equipment). Moreover the Government allows large companies to post "blanket bonds" that cover the entire state, or nation (in the case of BP). The result is that the average bond value is about 20% of the actual cost of doing the reclamation. Federal Agencies do not have the staff to monitor the 68,000 wells so even if reclamation is "done" there is a distinct possibility that the area is under-reclaimed: "Declare victory and leave".

Our preliminary work so far also suggests that one has to be careful you are not forcing a choice between the bond release and the cost of capital in the industry relative to other areas of investment. If we want companies to develop those fields we need to be careful about the opportunity cost of capital. That said though the lesson we've come away with so far is that we need real cash bonds, and bonds invested in financial instruments to account for the time value of money. The bonds need to be valued at the level the authors are proposing, but we also need a more community based approach at monitoring. The Federal Govt cannot do a sufficient job at monitoring environmental safety and success of these developments.