Of course no one really knows what happened at the BP Deepwater Horizon drilling platform or why. We don't know what analyses were performed, or why the decisions were taken that ultimately led to an environmental disaster of potentially unprecedented dimensions. Unlike the spill created by the wreck of the Exxon Valdez in Alaska, the BP disaster occurred in an area that will be directly visible by tens of millions of people, and unlike the destruction of Kuwait's oilfields by retreating Iraqi forces, the damage from the BP disaster will be visible for years to come.
How did this happen? It now appears that BP officials, of whatever rank and whatever position in the corporate hierarchy, decided to "take the risk" of expediting some operations, in order to get the well back in production faster. They weighed the certain loss associated with delaying the oil stream and the profit stream that early drilling would generate, against the possible but very small chance of catastrophic loss if safety procedures were bypassed. Executives appear to have chosen to expedite getting the well back on line quickly, and to have accepted the small chance that the safety systems would fail. When BP considered a possible small chance of very large losses from failure, and balanced it against the certainty of small losses from delaying resuming operations, accepting the risk of potentially catastrophic losses seems to have won out.
But how did rational people make this decision? Modern finance theory teaches us that corporations should be risk neutral, and indeed business school education now ensures that most corporations are run as risk neutral.
What does this mean? It means that if a corporation gets to choose between a 1% chance of losing $100 or a 100% chance of losing $1 it should be indifferent between the choices. If it has a 1% chance of losing $100 or a 100% chance of losing $2 it should take the small chance of high loss ... quite simply, the sure cost of $2 every time is twice as great as the expected cost of losing $1 one time out of one hundred if things go wrong. Firms that take the risk, and lose $100 once every hundred times they take the gamble, lose only half as much as risk averse firms, which pay $2 every time they face the same decision.
The same analysis holds if the quantities are doubled, or if they are multiplied by 100 million, or if the probabilities and quantities are adjusted proportionally.
Which means that if BP believed that delaying drilling would cost $20 million with certainty, and if BP believed that the environmental damages -- cleanup and settlements with fishermen, resort owners, and other affected parties -- would total $4 billion, BP's actions might be considered rational. All we need to do is to assume that the chance of catastrophic failure was believed to be less than 0.5% and that the cost of cleanup would be no worse than the cost of cleaning up Alaska's Prince William Sound.
This analysis might make sense to BP, and to the idea of risk-neutral corporate finance. But it cannot be seen as complete. What is the cost to me of never seeing a Louisiana Brown Pelican except in a zoo or bird park? What is the market value of the quality of life of thousands of Louisiana Bayou residents, who chose to forgo directly measurable wealth for the intangible joys of living where their families have lived for generations? What is the market value of damage to wetlands and marshes from Louisiana to the Florida Everglades? What is the market value of the hundreds or thousands of intangible elements of quality of life that affect tens of millions of residents and tourists, and will do so for years to come?
Clearly, firms have difficulty in incorporating intangibles into economic decision analysis. Surely, no energy company has worked longer or harder to create an image as a green, socially responsible corporate citizen, and yet this does not appear to have altered BP's short-term tactical decision making in the Gulf.
The solution is not to arbitrate for years or to battle for years in state and federal courts on what the true cost of these intangibles is, and thus to calculate who gets what in compensation, although for the BP Deepwater Horizon that will certainly be both necessary and appropriate. The solution going forward is to help ensure that no other off-shore driller makes the same "rational" calculation.
A simple change would be to incorporate a massive penalty cost into the driller's calculation of the price of drilling disasters.
This is, of course, not a simple as it sounds. A cost that was too high, or that was imposed arbitrarily any time there was a drilling accident, might make off-shore drilling economically impossible. Few but the most committed environmentalists want that. But a penalty cost that was imposed any time a conscious decision led to a drilling disaster would prevent many avoidable disasters.
If the expected additional punitive costs in our hypothetical example were $5 billion, the amount of the punitive damages initially assessed after the Exxon Valdez disaster, it is quite likely that the rational executives at BP would have chosen a course of action that would have avoided the spill that threatens much of the gulf today.
This is clearly not a spiteful policy, but a forward-looking and economically rational policy. All of us -- the manatee and pelicans, the shrimpers and resort owners, the tourists and the residents, and even BP management -- would be better off today if a policy like this had been in place.
Professor Clemons teaches strategy, information technology, history, and the analysis of complex decisions at the University of Pennsylvania. Dr. Barnett consults in strategy, marketing, and consumer behavior. The two have collaborated on a wide range of projects, from the behavior of consumers using online search and the impact of modern communications technology on employee behavior to the economic future of China and directions for future Middle East foreign and military policy.
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