25 Standard Deviation Moves

A Reuters Breakingviews commentary in today’s New York Times makes some interesting arguments about the consequences of the BP oil spill on the energy industry. The commentary draws parallels between BP and the financial implosion that led to Lehman Brothers bankruptcy. ". . . flawed risk management, systemic hazard, and regulatory incompetence" are cited as the common causes, and business models that did not take account of the possibility for "25 standard deviation moves". These factors will inevitably lead to government intervention and industry consolidation as the estimated $27 billion in claims (a current estimate for the BP spill) is ". . . a liability no investor will be comfortable taking, . . ."

While much of this commentary makes sense, we think it is missing a big part of the picture by not focusing on the essential need for much more rigorous safety management. By all reports, the safety performance of BP is a significant outlier in the oil industry; maybe not 25 sigma but 2 or 3 sigma at least. We have posted previously about BP and its safety deficiencies and its apparent inability to learn from past mistakes. There has also been ample analysis of the events leading up to the spill to suggest that a greater commitment to safety could, and likely would, have avoided the blowout. Safety commitment and safety culture provide context, direction and constraints for risk calculations. The potential consequences of a deep sea accident will remain very large, but the probability of the event can and should be brought much lower. Simply configuring energy companies with vastly deep pockets seems unlikely to be a sufficient remedy. For one, money damages are at best an imperfect response to such a disaster. More important, a repeat of this type of event would likely result in a ban on deep sea drilling regardless of the financial resources of the driller.

In the nuclear industry the potentially large consequences of an incident have, so far, been assumed by the government. In this respect there is something of a parallel to the financial crisis where the government stepped in to bail out the "too large to fail" entities. Aside from the obvious lessons of the BP spill, nuclear industry participants have to ensure that their safety commitment is both reality and public perception, or there may be some collateral damage as policy makers think about how high risk industry, including nuclear, liabilities are being apportioned.