The BP Oil Spill’s Lessons for Regulation
Kenneth Rogoff
CAMBRIDGE – As the damaged BP oil well continues to spew millions of gallons of crude from the depths of the floor of the Gulf of Mexico, the immediate challenge is how to mitigate an ever-magnifying environmental catastrophe. One can only hope that the spill will be contained soon, and that the ever-darkening worst-case scenarios will not materialize.
The disaster, however, poses a much deeper challenge to how modern societies deal with regulating complex technologies. The accelerating speed of innovation seems to be outstripping government regulators’ capacity to deal with risks, much less anticipate them.
The parallels between the oil spill and the recent financial crisis are all too painful: the promise of innovation, unfathomable complexity, and lack of transparency (scientists estimate that we know only a very small fraction of what goes on at the oceans’ depths.) Wealthy and politically powerful lobbies put enormous pressure on even the most robust governance structures. It is a huge embarrassment for US President Barack Obama that he proposed – admittedly under pressure from the Republican opposition – to expand offshore oil drilling greatly just before the BP catastrophe struck.
The oil technology story, like the one for exotic financial instruments, was very compelling and seductive. Oil executives bragged that they could drill a couple of kilometers down, then a kilometer across, and hit their target within a few meters. Suddenly, instead of a world of “peak oil” with ever-depleting resources, technology offered the promise of extending supplies for another generation.
Western officials were also swayed by concerns about the stability of supplies in the Middle East, which accounts for a large proportion of the world’s proven reserves. Some developing countries, most notably Brazil, have discovered huge potential offshore riches.
Now all bets are off. In the United States, offshore drilling seems set to go the way of nuclear power, with new projects being shelved for decades. And, as is often the case, a crisis in one country may go global, with many other countries radically scaling back off-shore and out-of-bounds projects. Will Brazil really risk its spectacular coastline for oil, now that everyone has been reminded of what can happen? What about Nigeria, where other risks are amplified by civil strife?
Oil experts argue that offshore drilling never had the potential to amount to more than a small share of global supply. But there now will be greater concerns about deep drilling in any sensitive environment. And the problem is not just with oil. The big news in energy these days is the revolution in technology for tapping shale gas. With important reserves near populated areas, governments will need to temper their enthusiasm and think about the balance between risks and riches.
The basic problem of complexity, technology, and regulation extends to many other areas of modern life. Nanotechnology and innovation in developing artificial organisms offer a huge potential boon to mankind, promising development of new materials, medicines, and treatment techniques. Yet, with all of these exciting technologies, it is extremely difficult to strike a balance between managing “tail risk” – a very small risk of a very large disaster – and supporting innovation.
Financial crises are almost comforting by comparison. Speculative bubbles and banking crises have been a regular feature of the economic landscape for centuries. Awful as they are, societies survive them.
True, people who thought, “This time is different,” before the recent Great Recession were proven wrong. But, even if we are not getting any better at dealing with financial crises, things have not necessarily been getting worse, either.
Perhaps the G-20 government leaders have not done quite as brilliant a job plugging the hole in the financial system as they claim. The raging sovereign-debt problems in continental Europe, and the brewing ones in the US, Japan, and elsewhere are proof enough of that. But, compared to British Petroleum’s efforts to plug its deep-sea oil hole, the G-20 leaders look omnipotent.
If ever there were a wake-up call for Western society to rethink its dependence on ever-accelerating technological innovation for ever-expanding fuel consumption, surely the BP oil spill should be it. Even China, with its “boom now, deal with the environment later” strategy should be taking a hard look at the Gulf of Mexico.
Economics teaches us that when there is huge uncertainty about catastrophic risks, it is dangerous to rely too much on the price mechanism to get incentives right. Unfortunately, economists know much less about how to adapt regulation over time to complex systems with constantly evolving risks, much less how to design regulatory resilient institutions. Until these problems are better understood, we may be doomed to a world of regulation that perpetually overshoots or undershoots its goals.
The finance industry already is warning that new regulation may overshoot – that is, have the unintended effect of sharply impeding growth. Now, we may soon face the same concerns over energy policy, and not just for oil.
Given the huge financial stakes involved, achieving global consensus will be difficult, as the Copenhagen climate-change fiasco proved. The advanced countries, which can best afford to restrain long-term growth, must lead by example. The balance of technology, complexity, and regulation is without doubt one of the greatest challenges that the world must face in twenty-first century. We can ill afford to keep getting it wrong.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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canadave 12:32 02 Jun 10
Prof. Rogoff, I think comparing these two crises is quite a stretch. After all, the financial crisis was the product of greed, distorted incentives and poor regulation, while the oil spill is simply the product of shoddy engineering. BP likely didn’t intentionally under-engineer the rig to save costs because incremental costs to do the job properly would have been nominal … they just messed up (or rather the designers of the rig did). I agree that there is a need for vigilance in both engineering and regulation; however, this really isn’t anything new, nor does it seem to present a greater danger today than it did over the last several hundred years. There are just a lot more of us to be affected by our lapses.
mikeikon 02:58 02 Jun 10
Regulation misses the point; we are never going to have a perfect world where people don't make mistakes and disasters don't happen. This cannot and should not be the goal of society, as it will never, ever work. The best we can do is to set up society in such a way that it puts responsibility in the hands of those closest to what they're responsible for and gives them the incentive to do the job right. That system is free market liberalism. It won't eliminate disasters, but it will minimize them as best as they can be minimized.
Carlsson 04:08 02 Jun 10
For the first time that I know, I agree with Chuck Schumer. He wants to repeal the limits on liability imposed under the 1851 Shipowner's Limitation of Liability Act. Clearly, such limits cause moral hazard. What's a measly $27 million to oil drillers?
I don't think regulation is the answer. Had offshore oil drilling been owned and operated by the government, we'd see less and more expensive oil, and since the govt pays none of the liabilities we'd likely see even more slipshod management and more accidents. Go figure -- under those conditions, what possbile reason can there be for believing that better/more/detailed/intrusive regulations could prevent more spills? So unlimited liability for private firms is the answer, with proper insurance paid for at Lloyd's of London.
ReubenD 04:56 02 Jun 10
In agreement with the last two posts. There is a major underlying similarity between the recent financial crisis and the BP oil spill: misaligned incentives. There wasnt an incentive for BP to contain the tail end risks because of the limitations on liability. If you read Alan Greenspan's "The Crisis" he notes tail end risks and misaligned incentives were two major underlying factors in the recent crisis.
The question therefore becomes: how can we align incentives to ensure firms manage tail end risk?
With such a limited knowledge of the oil industry it would be presumptuous for me to comment here. Becoming properly informed on the answer to this question should be the next goal of any government. Internalisation of things like this is something I am sure most economists from both the left and right would agree upon.
JBaird 05:42 02 Jun 10
The lesson we should be learning is how to produce energy in a constructive manner.
The greatest source of terrestrial energy is the sun and its greatest terrestrial storehouse is the ocean with the downside of this thermal buildup being thermal expansion of the oceans and the melting of polar icecaps.
A recent Nature article, “Robust warming of the global upper ocean” points out that the average amount of energy the ocean has absorbed over the period 1993 to 2008 is enough to power nearly 500 100-watt light bulbs for each of the roughly 6.7 billion people on the planet. This amounts to 330 TW whereas the total annual world energy consumption in 2006 for all primary energy sources was only 15.8TW.
It has been pointed out the ocean’s thermal inertia makes atmospheric warming essentially irreversible for the next thousand years even if we immediately stopped adding CO2 to the atmosphere.
The First law of thermodynamics dictates that, "the increase in the internal energy of a system is equal to the amount of energy added by heating the system minus the amount lost as a result of the work done by the system on its surroundings."
The way therefore to dissipate some of the heat the oceans have and are absorbing is to covert this energy to work as would be accomplished by producing electrical energy by the process of ocean thermal energy conversion.
As this power would be produced offshore a good way to bring it to market is to use it to electrolyze water to its component gases hydrogen and oxygen.
Besides lowering the oceans thermal inertia and thus its expansion, producing hydrogen, an energy currency, in this manner reduces the velocity of sea level rise by converting a portion of its liquid volume to gas and only the hydrogen, 1/9th the weight of the water converted, needs to be transport to where energy is needed. There it can be recombined with resident oxygen to produce both energy and water.
Lighter than air hydrogen can also transport itself to the highest point of a desert under its own buoyancy. Water then produced at elevation will flow back into the desert where it can grow crops for food, fuel, shelter and fiber, which in turn can sequester the atmosphere’s excess CO2. Leonard Ornstein, a cell biologist at the Mount Sinai School of Medicine in New York, and NASA climate modelers Igor Aleinov and David Rind have outlined a similar plan to sow the deserts in the Journal of Climatic Change.. They conclude it "probably provides the best, near-term route to complete control of greenhouse gas
mikeikon 06:16 02 Jun 10
JBaird - Make it happen then. If it really works and really creates more energy than it destroys, then it will succeed in the market. So go for it!
JBaird 07:26 02 Jun 10
mikeikon
I am trying my damdest. There are however obstacles otherwise known as entrenched interests.
An interesting parallel has been drawn by R Cohen from the US Dept of Energy concerning the potential of OTEC - "A temperature difference is analogous to a hydraulic head; each degree centigrade corresponds to 427 m of head. Thus, a temperature difference of 21°C would correspond to having the water at a height of 8967 m if 100% conversion efficiency were attainable... Thus, a net 2.5% conversion efficiency would enable a height of 224 m to be attained... It is as if much of the world's ocean water were captured behind invisible "thermal dams" of significant heights."
I fear there is an equally high and just as invisible dam blocking this solution.
Horsparti 09:48 03 Jun 10
Merci pour cet intéressant article. Deux remarques toutefois : i) contrairement aux crises financières les crises écologiques ont un impact physique direct, ii) je ne crois pas qu’il y ait beaucoup de risques de sur-réaction. Voir aussi : http://horsparti.blogspot.com/2010/06/crise-financiere-versus-catastrophe.html
TimRagan 06:40 09 Jun 10
Professor Rogoff, I appreciated your article; I also believe there are large parallels between what we saw behind the global banking crisis and the current BP environmental disaster. As your article summarizes it is all about the risk management profile related to new innovations and our ability/willingness to regulate these effectively in the face of both market uncertainty and pushback/assurances from the businesses themselves.
The banking crisis and the BP crisis are two events that have recently captured our attention, however the history of the modern corporation is littered with these kinds of incidents, all of which can serve as opportunities to rethink how and why we do what we do. My single criticism is that we do not tend to take a holistic look at what is happening and "connect the dots" effectively -- the end result is that we provide very focused, very detailed "band-aid" regulation and rules which over time tend to become viewed (often quite accurately) as "needless red tape", providing business a wonderful rallying point for "streamlining regulation to drive business innovation and (economic) growth".
I'm focusing on this general theme in my Business Detox Project blog (http://businessdetoxproject.wordpress.com/) where my starting point is that by the way we have constructed the modern corporation it is inherently "toxic" to three critical stakeholders -- the natural environment, employees, and its' consumers.
My belief is that it is well within our capability to address/re-engineer these specific toxic aspects so that businesses can continue to be highly profit-motivated (which drives their willingness to innovate) while being fundamentally better aligned with our evolving societal needs.
AlexaT 01:03 16 Jun 10
BP top kill is such a disaster. The project has failed and had cause such a tremendous environmental hazard in the ecosystem. It killed the eco-tourism of the areas affected. It would surely affect food safety and prices in the long term. Aside from that, we should also be more concerned about the distruction of the who ecosystem where everyone else depends for a living. BP appears to be more concerned about the profits than people and environment. I just hope the government is doing all its best to give BP a pnishment they deserve for being responsible for this oil spill. Maybe a prison time not just a payable fine.
gtown2007 03:31 16 Jun 10
Interesting commentary. Found this on a neat frontpage for financial news at www.wallstbeat.com
jaynatae21 12:09 02 Jun 10
I'd like to see this work: See containment solution for BP Oil spill. Why is BP not using this now? http://www.youtube.com/watch?v=Zx2mDYCIW20