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The Costs and Benefits of Deepwater Drilling Regulation

The Deepwater Horizon oil spill released nearly 200 million gallons of oil in the Gulf of Mexico and is likely to be the single most costly oil spill off the U.S. coast. Offshore oil production in the Gulf represented 8.7 percent of our annual oil consumption before the drilling moratorium, and that number is projected to exceed more than 10 percent over the next 20 years—a significant contribution from domestic sources. How should policymakers balance the costs of regulating offshore drilling to reduce damages against the benefits of domestically produced oil?

In their paper, “Understanding the Costs and Benefits of Deepwater Oil Drilling Regulation,” RFF researchers Alan Krupnick, Sarah Campbell, Mark A. Cohen, and Ian W.H. Parry provide a framework for examining the costs and benefits of alternative policies for managing deepwater drilling activities. They argue that using a cost–benefit framework provides policymakers with a coherent approach from which they can judge the benefits of regulation (including reduced environmental damages from spills and potentially reducing overall oil consumption, which would reduce damages from air pollution, congestion, and accidents) against its costs (including foregone profits to the oil industry, reduced security from an increased oil import share and possibly more land-based drilling).

Although a catastrophic spill such as the Deepwater Horizon incident is a visible outcome of drilling, oil spilled during extraction operations actually accounts for a very small fraction of all oil spilled (about 1.2 percent of all oil spilled off U.S. waters on average). The bulk of oil found off the North American coast comes from natural seepage (62 percent) and consumption activities such as urban runoff and recreational boating (32.8 percent). Despite the fact that, on average, oil drilling operations are a relatively small part of the problem, the Deepwater Horizon spill released the equivalent of 100 percent of the average annual oil spilled off U.S. waters, highlighting the devastating impacts of such catastrophic spills.

The authors note that when conducting a cost–benefit analysis of regulation designed to prevent oil spills, it is important to start with a thorough understanding of the incentives firms already face to prevent spills. While existing liability laws already provide a powerful incentive, past history suggests that firms do not fully bear the social costs that catastrophic spills impose. For example, the 1989 Exxon Valdez Alaskan oil spill damages have been estimated to range between $5.5 billion and $9.5 billion—and possibly more, once the cost of cleanup, natural resource damages, economic costs, and health impacts are tallied.

Despite liability laws that generally require compensation by responsible parties, the cost to Exxon has been estimated at around $4.4 billion, considerably less than the damages caused by the spill. While BP has already paid more than this as a result of the 2010 Deepwater Horizon spill, it is also likely that external damages will exceed the amount BP ultimately pays. If further analysis confirms this gap between damages caused and what firms ultimately pay, this might provide justification for further regulation or increasing the liability limits and financial responsibility requirements for firms that spill oil.

Find more oil and gas, risk, and governance research and analysis from RFF here.

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