Risks Of Regulation

A bit dated but still very relevant.

Regulation; the four letter word of the business world.  Many people see regulation as a protective shield from the ‘dangers’ of the businessman; a way to protect people, property and the environment.  The oil industry is one of the most heavily regulated enterprises in the United States.  Despite being intended to protect us; these regulations failed catastrophically on April 20th, 2010 when the Deep Water Horizon oil rig suffered a mechanical failure resulting in an explosion which sank the rig two days later(1).  Yet, when the disaster happened, we were met with pleas for more government oversight and more red tape.  The regulations on that industry, both in the Gulf Mexico and throughout the country, helped cause the Deepwater Horizon disaster and removing them would help prevent similar disasters in the future.

Regulations in the Gulf of Mexico begin with the Minerals Management Service (MMS).  Created in 1982 due to the Federal Oil and Gas Royalty Management Act the MMS “both regulates the [gulf oil drilling] industry and collects billions[of dollars] in royalties from it”(2, 3).  The MMS’s responsibility to regulate includes monthly inspections, issuing safety documentation, and issuing safety citations(3).  Royalty collection is based on number of barrels of oil removed and varies from well to well.  The MMA also provides  “royalty relief“ to a number of rigs based on previous legislation. Until November of 2000 the royalty relief was issued based on the Outer Continental Shelf Deep Water Royalty Relief Act of 1995, better known as DWRRA.  This act “relieves eligible leases from paying royalties on defined amount of deep-water production”.  At depths over 2,526 feet oil companies did not have to pay the United States royalties on 87.5 million barrels of oil, between 1,312 and 2,625 feet the relief was 52.5 million barrels and between 656 and 1,312 feet the relief was only 17.5 million barrels.  While this act expired in the year 2000 it was replaced by an incentive program that allowed royalty relief to be “specified at the discretion of the MMS”(4).  This incentive program provides more relief if a drilling site is “more expensive to access” even if it is at the same water depth as another rig receiving less relief (2).  The royalty relief system provides incentives for Oil Rigs to operate in deep waters, especially those classified as “Ultra-Deepwater” by reducing the royalties paid on those sites(5).

While not specific to the gulf, there are a variety of moratoria on drilling throughout the country.  These moratoria take two forms.  The first set, known as “leasing moratoria” are general bans on drilling in select areas , the second set are temporary bans due to specific incidents.  Since   the fiscal year 1982 congress has denied funds to the MMS to “conduct leasing for the specified Outer Continental Shelf areas”.  Currently there is a “blanket moritorium” on leasing in effect “through 2012” that covers a large portion of both the East and West coasts( 2).  One of the largest bans on drilling however exists in the Arctic National Wildlife Refuge(ANWR).  Located in the “northeast corner” of Alaska over ten million acres of land are off limits to drilling.  In this wildnerness it is estimated that there exists “between ten billion and sixteen trillion barrels of oil” that could supply twenty percent of U.S. demand for nearly thirty years(6).  The most recent temporary bans have been a result of the Deepwater Horizon disaster.  A “30-day pause in offshore drilling” followed the sinking of the Horizon rig(11).  This did not only cover BP’s rigs but all offshore drilling “based on water depth”(7).  That ban was removed by a federal court, but was replaced with a revised ban that will be in effect until November, 2010(7).

Beyond physical limitations on drilling there are also economic regulations.  There are a number of federal subsidies and tax breaks for the drilling industry.  David Kocieniewski says that “examination of the American tax code indicates that oil production is among the most heavily subsidized businesses”.  These tax breaks occur for a number of reasons.  Many are simply to lure oil companies to American shores, others were “born of international politics” or “date back nearly a century”(8).  Beyond that the United States government has put “Liability Limits” on drilling operations.  The Oil Pollution Act of 1990 limits an oil companies liability for damages to only $75 million dollars.  Any remaining damages, up to $1 billion, are payed through the Oil Spill Liability Trust Fund.  This fund is “financed primarily through a fee on imported oil”(1).  Senator Robert Menendez from New Jersey recently introduced bill, S. 3305 which would raise that cap to $10 billion(9).

All of these laws and regulations have one thing in common.  They increased the probability of a catastrophic oil spill in the Gulf of Mexico.  Each regulation increased the risk of such a spill in some way and when combined they resulted in the disaster that is causing massive destruction in the Gulf today.  The Minerals Management service was organized to be the overarching regulatory body for the Oil Industry.  Why did it fail in its duty?  Why did “spills from offshore oil rigs…in U.S. waters more than quadrupled this decade” despite the MMS’s oversight(10)?  This question was answered by economist Walter Block in his book The Privatization of Roads & Highways (12).  Quoting Cecil Mackey, former Assistant secretary of transportation, he says:

“As the more obvious regulatory actions are taken; as the process becomes more institutionalized; as new leaders on both sides  replace ones who were so personally involved as adversaries in  the initial phases, those who regulate will gradually come to reflect,     in large measure, points of view similar to those whom they regulate.”

Quite simply, the MMS adopted the views of the Oil Industry completely negating their ability to regulate it.  Congressman Nick J. Rahall confirms this saying “MMS has been asleep at the switch in terms of policing offshore rigs”.  Using numbers supplied by the MMS in the prior 64 months before the incident “25 percent of monthly inspections were not performed”(3).  Are we to believe another agency would be any more efficient?  Bureaucracy and corruption are not the only things to blame however; legislation played a vital role in this disaster as well.  DWRRA, for example, incentivized the risk to drill in deep waters.  Under DWRRA the greater the depth being drilled the greater the royalty relief amount.  These waters are inherently less safe to drill in.   It is easy to compare the difficulties in dealing with a site 5000 feet below the ocean against one 500 feet below the surface.  These incentives were made worse when DWRRA expired.  Under the new program “the most economically risky projects would receive the most relief”, safer projects on the other hand would receive “little or no relief”(4).

While acts like DWRRA incentivize the risk of deepwater drilling the greater incentive to drill in the Gulf of Mexico is simply that there are so few places to drill in the continental United States.  The United States Exclusive Economic Zone extends “200 nautical miles” from all of it’s shores(2).  Yet, much of this area is off limits to drilling.  The “blanket moratorium” issued by former President George H.W. Bush in 1990  restricts drilling in “all unleased areas offshore Northern and Central California, Southern California except for 87 tracts, Washington, Oregon, the North Atlantic coast, and the Eastern Gulf of Mexico coast”.  The Gulf of Mexico is the only economically viable offshore area left for them to drill.  This of course pales in comparison to the Arctic National Wildlife Refuge.  Most of the 10-million-acre area is not even adjacent to the ocean, surely drilling on land or in shallow water is much safer than drilling 5000 feet under the ocean(6).  Beyond helping to cause the spill in the first place the government is increasing the risk of future disasters.  The temporary ban issued in response to the Horizon spill “neither improves safety nor mitigates risk”(11).  By forcing drilling to stop you immediately cause a number of problems.  Reentering a location is as dangerous, if not more so, than the original drilling operation.  Experienced workers have been fired, laid off, or relocated and will need to be replaced with less experienced ones.  Equipment in worse quality will be all that remains when the moratorium ends(11).

The economic regulations were the proverbial straw that broke the camel’s back.  A single tax break for the Deepwater Horizon oil rig covered “70 percent of the rent” or “$225,000 a day”.  Or, as policy analyst Sima J Gandhi describes it “We’re giving tax breaks to highly profitable companies to do what they would be doing anyway”(8).  These breaks are not only an unfair advantage, they incite these companies to make riskier choices.  If the potential cost of the Deepwater Horizon rig wasn’t offset by these breaks it may not have been economically viable to drill in such a dangerous location.  On top of the lower cost of the initial operation; the Liability Caps ensured that any potential risk was marginalized by the government.  The $75 million limit that has been in effect since 1990 was a message to the industry to attempt increasingly risky drills(1).

The oil companies should be liable for the full cost of any damages done by their rigs.  The worry that “operators and nonoperators in the U.S. Gulf of Mexico will be unable to obtain adequate protection from insurance” is totally unjustified (1).  If the site is not economically viable then there is no reason to drill there.  If BP and Transocean knew they would have been liable for all damages they would not have received a citation for “not conducting well control drills as required and not performing ‘all operations in a safe and workmanlike manner'”(3).  There would have been an incentive to spend money on safety, training and equipment instead of the incentive to take risks knowing they would be protected.  Or as one lawyer explained the situation “arbitrary liability caps are just not reasonable.  You cannot decide the expense of a disaster before it happens.  Liability caps allow companies like BP to avoid bearing the responsibility for the full cost of the damage they inflict”(9).

The oil has stopped flowing from the bottom of the Gulf; for now.  The question remains: How can we prevent this from happening again?  There, of course, is no easy answer.  Accidents, mistakes, and disasters can never be guarded against completely.  We can however mitigate the risk involved in those dangerous operations that are needed for the sake of humanity.  The best way to increase the safety of the oil industry is to remove the regulations that incentivize the risks involved in their industry.  Preventing drilling in safer areas, tax breaks, royalty reductions, liability limits; all these things make an already dangerous prospect that much more perilous.  We need to neither help nor hinder these companies, they must succeed or fail on their own merits.

Sources available upon request.

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17 thoughts on “Risks Of Regulation

  1. “The regulations on that industry, both in the Gulf Mexico and throughout the country, helped cause the Deepwater Horizon disaster and removing them would help prevent similar disasters in the future.”

    I want to keep it civil so I’ll just refer to Brandon’s Unicorn’s & Pixie Dust.

    • Well that is the topic I was attempting to prove with the article, if you disagree that is fine, no need to get passive aggressive.

    • Har har.

      Adam,

      For reference, Dr A is referring to this masterpiece I contributed to Dr Delacroix’s now-defunct blog. In it, I destroyed the fallacies put forth by neoconservatives in the name of imperialism. I was going for the kill, so I was a bit harsher than I normally am, but it did the trick. Dr Delacroix’s “arguments” on foreign policy have been thoroughly discredited.

      Dr A,

      Adam’s argument actually has a lot of merit to it. I think he makes a good case for a non-state (“anarchist”) regulatory apparatus that a layman unfamiliar with more theoretical arguments can understand (which is exactly what blogging is supposed to do).

      For example, do you think that the state-sponsored regulations put into place contributed to the incentives that caused the environmental destruction in the first place?

      I think you would have to agree with us, especially given that these regulations were essentially written by the corporations who would be doing the drilling (Rent-Seeking 101).

      It looks to me like Adam is proposing an alternative for regulating how oil is drilled for by corporations. You would agree, at least in principle at this point, that this is a legitimate argument, right? On a sidenote: I just got done reading this short blog post by economist Peter Boettke on institutions that might bolster my lame attempt at explaining how regulations could work in an anarchist framework.

      • You are an excellent diplomat and moderator I rescind my earlier snarkiness.

      • Very nice post; it crystalizes many of my objections to what I sometimes see here, a neglect of the literature on market failure in general and opportunism specifically.

        “In my book, Why Perestroika Failed I argue that in assessing the workability of utopian schemes we must first subject them to a coherence test, and then a test of their vulnerability to opportunism. Schemes that are incoherent are deemed impossible; schemes that are coherent but vulnerable are impractical; and only schemes that are both coherent and invulnerable should be considered in the feasible set of workable utopias.”

  2. @Adam
    I didn’t really take it as snarkiness, I wanted to keep it under the bar so my aggressiveness was as passive as I could make it.

    “There are a number of federal subsidies and tax breaks for the drilling industry. David Kocieniewski says that “examination of the American tax code indicates that oil production is among the most heavily subsidized businesses”.

    I’d LOVE to see all of the subsidies to ALL of corporate America go away. That’s not all you proposed. For example: “This of course pales in comparison to the Arctic National Wildlife Refuge. Most of the 10-million-acre area is not even adjacent to the ocean, surely drilling on land or in shallow water is much safer than drilling 5000 feet under the ocean”. As if the risks are only in the drilling stage.

    Let me be more specific.

    Unicorns: We’ll completely deregulate one of the most oligopolistic industries in the history of the universe and then the invisible hand of market competition will make everything ok.

    Pixie dust: “The oil companies should be liable for the full cost of any damages done by their rigs.” Yup. We’ll just add that on to the long list of tort reforms barrelling through the American legislative and judicial systems.

    @Brandon

    “I think you would have to agree with us, especially given that these regulations were essentially written by the corporations who would be doing the drilling (Rent-Seeking 101).”

    Yes.

    “For example, do you think that the state-sponsored regulations put into place contributed to the incentives that caused the environmental destruction in the first place?”

    Sure. But they weren’t doing anything they didn’t want to do anyway [see the point just above] they were just externalizing the downside risks. As Adam points out “If the site is not economically viable then there is no reason to drill there.” Classic corporate capitalism in the contemporary US. If it works we get the profit, if it doesn’t you bear the cost.

    “It looks to me like Adam is proposing an alternative for regulating how oil is drilled for by corporations.”

    It looks to me like Adam’s alternative for regulating oil [NOT just drilling] is to not regulate it at all. Did I miss some regulations that he would keep?

    Thanks for the link.

  3. Interesting points to be sure. There are serious problems with a lack of transparency and accountability, the revolving door, and unpredictability of chaotic systems. I picked up “Privatization of Roads and Highways: Human and Economic Factors”, and was disappointed to find that it is ideological propaganda in support of the corporatocratic take-over.

      • It would seem just about everything. Just as concentrating a great deal of power in a relatively small, centralized government is a bad idea, so is concentrating capital in handful of national and international corporations. I would be surprised if the corporate sponsors of think tanks like the Von Mises Institute are willing to address this fact.

        Don’t get me wrong, there are substantial problems with regulation across a wide range of sectors. However, many of these problems are related to the fact that so few private interests participate and even have access to influence legislation.

      • The very concept of a “national or international corporation” is antithetical to Block’s philosophy. How can you have a national corporation when there are no nations?

  4. I did not necessarily intend that my comment be understood within the context of a hypothetical absence of nations. Still, the adjectives “national” and “international” communicate a scale which is, I contend, inhuman. It is my working hypothesis that no body should wield the magnitude of power which is currently concentrated in the union of corporate and government interests.
    I would bet dollars to donuts that the regulations cited in this article were developed and supported by corporate interests. But perhaps the real point of contention here is the distinction between an idealized world in which private actors behave in accordance with common moral principles and the practical problem of transforming the current, real world to resemble such.
    This, I believe, gets to the root of the problem, Man’s fallen condition.

    • Catholhu,

      Your observation “that the regulations cited in this article were developed and supported by corporate interests” is agreeing wholeheartedly with what Adam is arguing. The reason regulations are written by corporate interests is because of the state-run regulatory apparatus currently in place.

      Just think: Why on earth would you have a group of, say, medical doctors (or anthropologists) draft up a regulatory apparatus for, say, the banking sector of the economy? It doesn’t make sense, right? (Not that this stopped Mao Tse-Tung or Pol Pot from trying…)

      Your attempt to create a distinction between an “idealized” world and a “real” world (one where you are right and others are wrong, no less) is an interesting and well-known rebuttal, but it doesn’t actually address Adam’s argument that corporate factions prefer state-sponsored regulations because of the potential such regulations have for protectionism and rent-seeking opportunities. This preference for government intervention on behalf of corporations is why libertarians advocate for a strict separation of corporation and state.

      • Excellent, and agreed. This brings us to the parable of the Wheat and the Weeds. Corporations take advantage of government regulations, but governments have intervened on behalf of labor to provide necessary protections. In the absence of government, who will stand up for the “little guy(s)”?

      • Hi catholhu,

        Thanks for calling my attention back to this discussion.

        You bring up a parable of wheat and weeds but all I see is a false dichotomy fallacy of sorts.

        Corporations don’t just take advantage of regulations. Their lobbying efforts are integral to the creation of regulations. This suggests that regulations would exist with or without the government. When government is responsible for these regulations, there is a tendency to use regulations in order to squelch competition. When other organizations are responsible for drawing up regulatory apparatuses, the ability to squelch competition is virtually eliminated.

        I’m not sure if you’ve processed this argument yet. So I must ask: Can you see why state-sanctioned regulations have very different effects than regulations that aren’t created through the legislative process?

        Answering this question will go a long way, I think, towards explaining the fallacy of the wheat and the weed that you initially fell back on.

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