The Need to Increase Existing Limitations on Responsible Party Liability

¶Liability for damages from spills from offshore facilities is capped under the Oil Pollution Act at $75 million, unless it can be shown that the responsible party was guilty of gross negligence or willful misconduct, violated a federal safety regulation, or failed to report the incident or cooperate with removal activities, in which case there is no limit on damages (see Chapter 8). Claims up to $1 billion above the $75 million cap for certain damages can be made to, and paid out of, the Oil Spill Liability Trust Fund, which is currently supported by an 8-cent per-barrel tax on domestic and imported oil.

¶The Oil Pollution Act also requires responsible parties to "establish and maintain evidence of financial responsibility," generally based on a "worst-case discharge" estimate. In the case of offshore facilities, necessary financial responsibility ranges from $35 million to $150 million. The financial responsibility requirement provides a direct link between the Oil Pollution Act and insurance, as the Act provides that financial responsibility may be "established by any one, or by any combination, of the following methods" if determined by the Secretary of the Interior to be acceptable: "evidence of insurance, surety bond,

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guarantee, letter of credit, qualification as a self-insurer, or other evidence of financial responsibility."

There are two main problems with the current liability cap and financial responsibility dollar amounts:

Lack of Adequate Safety Incentives: A threshold problem with any damages cap that limits liability well below levels that may actually be incurred is that such a cap distorts the incentives of industry participants to adopt cost-effective safety precautions. Decisions regarding safety precautions are made for a variety of reasons, some of which cannot be influenced by policy measures. The relatively modest liability cap and financial responsibility requirements provide little incentive for oil companies to improve safety practices.

Inadequate Damages Compensation: BP's damages from the Deepwater Horizon spill will total in the tens of billions of dollars. The company has already paid claims that measure in the billions, and has waived the statutory $75 million cap. But there is no guarantee that other companies in the future will agree to waive the cap. And if an oil company with more limited financial means than BP had caused the Deepwater Horizon spill, that company might well have declared bankruptcy long before paying fully for all damages. In the case of a large spill, the Oil Spill Liability Trust Fund would likely not provide sufficient backup. Thus, a significant portion of the injuries caused to individuals and natural resources, as well as government response costs, could go uncompensated.

Any discussion of increasing liability caps and financial responsibility requirements must balance two competing public policy concerns: first, the goal of ensuring that the risk of major spills is minimized, and in the event of a spill, victims are fully compensated; and second, that increased caps and financial responsibility requirements to do not drive competent independent oil companies out of the market. A realistic policy solution also requires an understanding of the host of complex economic impacts that could result from increases to liability caps and financial responsibility requirements.

Recommendation F1: Congress should significantly increase the liability cap and financial responsibility requirements for offshore facilities.

To address both the incentive and compensation concerns noted above, Congress should significantly raise the liability cap. Financial responsibility limits should also be increased, because if an oil company does not have adequate resources to pay for a spill, the application of increased liability has little effect: Should a company go bankrupt before fully compensating for a spill, its liability is effectively capped. If, however, the level of liability imposed and the level of financial responsibility required are set to levels that bear some relationship to potential damages, firms will have greater incentives to maximize prevention and minimize potential risk of oil spills30 and also have the financial means to ensure that victims of spills do not go uncompensated.

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¶Legislative attempts to raise the cap and financial responsibility requirements to significantly higher levels have been met with the argument that these changes will cause insurance carriers to drop oil pollution coverage, leading to an exodus of small and independent companies from the offshore drilling market. The counter-argument is that oil companies should bear the social costs of their activities, and if those costs are too large or unpredictable to be insurable, then it is appropriate that these companies exit the market.

¶There is legitimacy to aspects of both arguments. A company should not be able to cause billions of dollars of damage and walk away, simply because its operations contribute to the economy of the Gulf. Nor should smaller companies that can demonstrate the ability to drill safely and to pay for damages resulting from a large spill be forced out of the market. However, smaller companies that cannot demonstrate financial responsibility and meet risk requirements set and monitored by the Department of the Interior or a third party should not be allowed to make others pay for the costs of their accidents.

¶One option for keeping competent independents in the market is a mutual insurance pool. Under such an arrangement, individual companies engaged in offshore drilling would pay premiums into a pool, which would pay out damages caused by a company as a result of a spill. A possible downside is that the mutual pool could have the effect of undercutting incentives individual firms might otherwise have to improve safety practices—but this problem could be addressed, for example, by tying premium levels to the financial and safety risk posed by an individual company's activities. This option would allow companies to demonstrate financial responsibility for the cost of spills, at least to the limit paid out by the pool.

¶Another option would be to phase in increases in the liability cap and financial responsibility requirements, which would allow the insurance industry a period of adjustment. Although any increase in liability limits and financial responsibility requirements would test the capacity of the offshore drilling insurance market, over time such a change would almost certainly stimulate an increase in insurance capacity. A phased-in approach would allow Congress to re-assess any concerns about limited capacity in the insurance industry in light of actual experience.

¶Finally, regardless of how insurance is provided, smaller firms could be encouraged to partner with firms with greater financial resources. It should be noted that "joint ventures" between larger and smaller companies already exist; thus a policy change may not be necessary to encourage such arrangements.

The Need to Increase Limitations on Payments from the Oil Spill Liability

¶Trust Fund If liability and financial responsibility limits are not set at a level that will ensure payment of all damages for spills, then another source of funding will be required to ensure full compensation. The federal government could cover additional compensation costs, but

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this approach requires the taxpayer to foot the bill. Therefore, Congress should raise the Oil Spill Liability Trust Fund per-incident limit because the current limits are clearly inadequate.

Recommendation F2: Congress should increase the limit on per-incident payouts from the Oil Spill Liability Trust Fund.

Raising the Oil Spill Liability Trust Fund's per-incident limit will require the Fund to grow through an increase of the per-barrel tax on domestic and imported oil production. An alternative would be to increase the Trust Fund through a surcharge by mandatory provisions in drilling leases triggered in the event that there are inadequate sums available in the Fund. An increase in the Oil Spill Liability Trust Fund's per-incident limit would not provide an incentive to offshore facilities to mitigate risks, because risks are pooled and the Oil Spill Liability Trust Fund is funded by parties other than those who engage in offshore drilling activities. But raising the limit would help ensure that victims have access to compensation without the need to seek further specific funding from Congress, or otherwise burdening the taxpayer.

The Need for Better Auditing and Monitoring of Risk

The Interior Department currently determines financial responsibility levels based on potential worst-case discharges, as required by the Oil Pollution Act. Although the agency's analysis to some degree accounts for the risk associated with individual drilling activities, it does not fully account for the range of factors that could affect the cost of a spill, and thus the level of financial responsibility that should be required. Interior should analyze a host of specific, risk-related criteria when determining financial responsibility limits applicable to a particular company, including, but not limited to: geological and environmental considerations, the applicant's experience and expertise, and applicable risk management plans. This increased scrutiny would provide an additional guard against unqualified companies entering the offshore drilling market.

Recommendation F3: The Department of the Interior should enhance auditing and evaluation of the risk of offshore drilling activities by individual participants (operator, driller, other service companies). The Department of the Interior, insurance underwriters, or other independent entities should evaluate and monitor the risk of offshore drilling activities to promote enhanced risk management in offshore operations and to discourage unqualified companies from remaining in the market.

If liability and financial responsibility limits are raised, increased liabilities will be borne by insurance carriers, which will have a strong incentive to promote new safety techniques and methods, as well as to monitor risk. Insurance carriers might insist on certification of operators by an independent entity devoted to identifying best safety practices and monitoring risk, such as a self-policing safety organization for the oil and gas industry, as

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¶recommended in Chapter 8. Insurers or a self-policing safety organization for the industry also could provide a guard against unqualified companies entering the offshore drilling market.