Newman & Jarchow: Looking Beyond the Horizon in Oil Spill Liability

As the tragedy that is the Deepwater Horizon oil spill enters its third month, increasing attention is being paid to preventing such a disaster from ever happening again. Achieving this goal while preserving the 200,000 jobs tied to offshore oil drilling in the Gulf of Mexico appears to be an intractable problem.

It is not.

[IMGCAP(1)]For a solution, we need look no further than the nuclear-power industry's Price-Anderson Nuclear Industries Indemnity Act. This forward-thinking legislation provides billions of dollars in liability coverage and focuses financial incentives where they belong — on safety — accomplishing several commonsense objectives.

First, the act establishes strong financial incentives for making safety job one. Each nuclear facility is on the hook for up to $300 million in damages to others and up to $1 billion in cleanup costs at the facility itself in the event of an accident. The cost of insuring this liability is a function of safety, thereby strongly linking profitability and safety.

More importantly, the entire nuclear industry is on the hook for more than $10 billion of third-party liability if an individual facility's coverage is exceeded.

This shared, $10 billion second-tier insurance is critical because it increases the chances of a loss for every company in the industry. Now companies must be concerned with not only their environmental, health and safety performance, but also that of their peers. This has led to the formation of the Institute of Nuclear Power Operations, which promotes safety and reliability through accreditation, plant evaluations, training and information exchange.

The second principal benefit of the Price-Anderson Act is that it requires the industry — rather than the taxpayer — to cover its risks. Both the initial $300 million and the $10 billion from the industry are provided by a combination of private insurance and insurance pools funded by the industry itself. Thus, risks are properly priced into the business, as they should be.

Finally, the Price-Anderson Act creates enormous insurance capacity without bankrupting the industry. It does this through retrospective premiums for the second tier rather than through prospective premiums. That is, the nuclear industry only funds the second tier when an accident actually happens. Each facility must demonstrate to the Nuclear Regulatory Commission's satisfaction that it has the ability to make good on its obligation by posting a bond or letter of credit, or through other means. The government also has the ability to act as a buffer for the second tier by funding it immediately in the event of an accident and then recouping its costs from the industry over time.

This insurance scheme can be applied to the oil industry with only minor modifications.

As in the nuclear industry, the cost of insuring oil spill liability should be paid by the oil industry, not the taxpayer.

As in Price-Anderson, each oil and gas operator should pay to insure its environmental, health and safety liability up to a preset amount. Operators with best-in-class safety practices should enjoy materially lower premiums.

Similar to Price-Anderson, all oil and gas operators in a given region (like the Gulf of Mexico) should provide a second tier of liability insurance that is sufficient to handle an oil spill. However, since the oil industry is more fragmented than the nuclear industry, the premiums for this tier should be both prospective and retrospective. The prospective premiums would be in the form of a fee on production and drilling in the region, similar to the Oil Pollution Act of 1990 that imposes an 8-cent per barrel fee on production to fund an Oil Spill Liability Trust Fund. As in Price-Anderson, each operator in a region would have to post a bond or some other instrument to make good on its retrospective premiums.

Finally, any legislation should be strengthened by providing insurers the means — not just the incentive — to promote safety. Regulations should not only provide that no drilling can occur without insurance, but insurers should also have the authority to cancel the insurance at any time if it is dissatisfied with any change to a pre-approved drilling program.

One can easily imagine how useful a properly capitalized and incentivized insurer would have been for averting the Deepwater Horizon tragedy. Surely, insurance would not have been available in deep water until technologies were developed for immediately and completely containing a blowout. A response such as "no cement bond log, no insurance; no insurance, no drilling" from a risk manager with an undiluted interest in safety would have been a better response than, "Well, I guess that's what we have those [blowout preventer] pincers for ..." during that fateful meeting 11 hours before the well blew out.

Looking beyond the horizon, then, it is clear that adaptation of Price-Anderson to the oil industry is the way forward: It creates strong incentives for, and enforces, safety. It foists the cost of insuring oil-spill liability on the industry. It creates shared responsibility for oil-spill liability, and it creates huge insurance capacity. Equally important, it will preserve the vibrant economic milieu and generator of hundreds of thousands of jobs that is the U.S. oil and gas industry.

Howard Newman and Craig Jarchow are managing directors of Pine Brook Road Partners, a private equity firm investing in energy businesses.

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