Who should pay the costs of the oil spill?

A story on CNN-Money today by Steve Hargreaves asks “What will BP really pay?” I think a more fundamental question to ask at this point is “What should BP pay? And should no one else?” As the story explains (emphasis added):

NEW YORK (CNNMoney.com) — The Gulf oil spill is going to cost billions to clean up, a tab BP has publicly pledged to pay in full.

But thanks to the unpredictable nature of the oil slick and the legal maze surrounding maritime law, what BP will pay and to whom is very much an open question…

Start with the costs. Estimates to clean the spill and compensate other parties for the economic damage run from $2 billion to $14 billion. One politician even said it could run into the hundreds of billions…

…which is a lot of money, too much for even BP to cover (whose profits were (coincidentally) around $14 billion last year).

BP’s public pledge notwithstanding, there are limits on what the government can make them pay, and the question is what can be done about it. Policymakers are starting to realize that if the costs are paid through anything more than a simple one-time fine on BP only–which BP would just have to “suck up” (pun intended)–that the burden of those costs will be spread (emphasis added):

BP’s liabilities may be capped by a federal rule that limits the payouts for economic damages stemming from an oil spill to $75 million. Once that threshold is reached, a federal fund kicks in, covering an additional $1 billion. The federal fund is paid for by a 8-cents-a-barrel tax on oil produced or imported into the United States…

To ward off any confusion, lawmakers in the House and Senate have introduced bills raising the liability cap from $75 million to $10 billion, an initiative they’ve dubbed the “Big Oil Bailout Prevention Act.” Lawmakers say there’s precedent for making the law retroactive: Witness the Superfund, which forced polluters to reimburse the government for toxic cleanup.

Given the public outrage over the spill, and the fact that it’s an election year, the bills stands a good chance of passing.

But not everyone thinks it’s a good idea. If the cap is increased, Nelson predicts that it will only raise the cost of buying insurance for all companies producing offshore oil.

“You’re going to pay for that at the gas pump,” he said.

There’s certainly an appeal to covering the costs of cleaning up (or trying to clean up) the oil spill entirely through a fine levied solely on BP, but that’s only on fairness and public-perception grounds. Such a fine would be an example of what economists call a “lump-sum tax”–a tax which could not be avoided by changing behavior, in this case because it’s based on something that already happened. (Any tax on anything that happened in the past–any “retroactive” tax–is a lump-sum tax.) Economists generally like lump-sum taxes, because they don’t distort economic decisions. And when such a tax cannot be avoided by changing economic behavior, the burden of such a tax is also unable to be shifted to other participants in the taxed market. In the case of the BP oil spill (perhaps better called an “explosion”?), this probably seems good and “right” on fairness grounds, at least to most of the American public who aren’t directly employed by or invested in BP.

But it turns out that on economic efficiency grounds, the fact that a tax or fine on BP alone would amount to a lump-sum tax that would not get passed along to any of the other participants in the BP marketplace or the oil market more generally is a bad thing. Because the BP oil spill reveals more than any lack of adequate quality and safety controls in BP’s production operations. It reveals more generally the risks associated with oil production, risks that translate into large social costs that go unpriced in the oil market. It is a classic case of a “negative externality,” where the social costs of producing and consuming a good exceed the private costs paid through market prices. In such a case, economic theory says that intentionally distorting market prices through public policy–in the case of a negative externality, through a tax representing the excess of social marginal costs over private marginal costs–would improve economic efficiency.

The BP oil spill provides us a new and very in-your-face lesson: that the excess of social costs over private costs (the “external costs”) associated with fossil fuels go beyond the “biggie” of global warming via the consumption (burning) of fossil fuels–a very long-term phenomenon that is very difficult to predict the economic and social costs of (and hence is easy for us to ignore). The BP oil spill reveals that there are more immediate and clear (and very visual and quantifiable) social costs associated with fossil fuels in terms of the risks to the environment on the production/extraction side of the market. So now there are at least two major reasons why for economic and social efficiency, fossil fuels should be taxed: (i) because of the external costs associated with global warming resulting from the consumption of fossil fuels; and (ii) because of the external costs associated with the risky extraction strategies used in the production of fossil fuels. And both these reasons suggest that there is no way that the right policy response to the BP oil spill–from an economic efficiency, maximize social welfare standpoint–is just to “fine the hell out of BP” (alone) and run BP (alone) out of business. (Even from a fairness perspective, it’s not at all clear that this kind of accident couldn’t have happened with any other company’s well.) 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.

Unfortunately, politicians won’t see it that way. Even pro-environment types in Congress were cold to President Obama’s climate change proposal last year that would have raised gasoline and other fossil fuels prices. (Psst: That’s how climate change policy is supposed to work, by the way, and the President’s proposal was a good one.) The U.S. isn’t in the practice of taxing fossil fuels; in fact, we’re in the habit of subsidizing the oil and gas industry via tax preferences. We get that wrong in two ways: we increase the deficit, and we worsen the economic inefficiencies (and just plain environmental damage) associated with fossil fuels. Now with the BP disaster to more clearly and immediately remind us that we’ve been getting this all wrong, we should be trying to make those two wrongs two rights. This should motivate policymakers to implement smart climate change policy–i.e., a policy that would actually raise fossil fuel prices (that all of us pay) and raise revenue for deficit reduction (or to avoid deficit increases)–as soon as possible.

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