The failings of BP
Before the mobs take out Tony Hayward, the CEO of BP, to have him tarred and feathered, let’s tale a look at what BP did wrong, if anything. It is always easy to criticize with hindsight. But what we need to do in this case is place ourselves in the position of BP’s senior management team at the time they decided to drill the well in the Gulf in order to determine whether they did anything wrong.
I will give BP’s management the benefit of the doubt that when they made the decision to proceed with the investment in this and other deep-sea wells, they estimated the probabilities of various “catastrophic” events and the potential costs associated with each. Let me also assume that BP did estimate the probabilities with as high degree of accuracy as possible given the data available, and that the decision was the right one from a corporate value maximization point of view. However, we live in a 0-1 world where either the event does not occur or it does, regardless of the a priori probabilities estimated for such events.
Assuming BP made the right decision originally, then what is the problem?
How did BP handle the possibility of a catastrophic outcome with enormous costs? This is obviously an insurance issue. All companies face various risks when making decisions, and all companies should try to insure themselves as best they can against these risks. That is why there are insurance markets and derivatives.
BP had two choices. The company could have purchased coverage from one or more insurance companies who would have passed on most of the risks through re-insurance. Re-insurance greatly reduces the likelihood that if a payout has to be made, the primary insurer will be unable to cover the losses. The insurance companies would have demanded that BP take certain precautions, probably many more than they were required to do by the U.S. regulators, to reduce the likelihood of a blow-out, as has occurred (the 0-1 world).
BP instead chose to self insure. This might have been a reasonable decision if BP had better information about the risks, the company had a greater incentive to take precautions to reduce the likelihood of catastrophic events, and the company had put in place contingency plans to limit the magnitude of the losses. There is nothing wrong with self insurance as a long as a company fully understands the consequences of its decision and has the financial strength to cover all potential losses. BP appears to have the financial resources to do so in this case.
Thus, what is the problem? It appears that BP did not take extra precautions to reduce the likelihood of a blow-out, or develop contingency plans to limit the resulting damages. Indeed, it seems as if the company took short cuts that increased the probability of a blow-out, and obviously the company had no contingency plans in place.
The short cuts, while regrettable, do not seem to have violated existing regulations. Nevertheless, BP’s board should have asked senior management whether any insurance company would have accepted the standards the company satisfied. If not, regardless of meeting the regulatory standards, the board should have insisted that the company meet the more important insurance standards. I doubt that the board asked these questions.
Furthermore, there is no excuse for BP to not have developed the contingency plans. Where was the board?
BP is like many companies in downplaying the need for contingency plans. Things do go wrong. There are risks in all decisions. Companies must insure against risks and part of the insurance involves developing appropriate contingency plans. Such plans are even more critical when the probabilities of catastrophic events cannot be measured with any degree of reliability because of a lack of data, as happens to be the situation in this case.
So take Tony out back, but also take all of the directors as well.
The opinions expressed in this blog are personal and dod not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.