Increasing Marginal Utility

A blog so good it violates the law of diminishing marginal utility.

Strict Liability for Fracking

I was first author on a policy study published by the Beacon Hill Institute, Strict Liability for Fracking: Risks Should Fall on Wall Street, Not Main StreetThe executive summary reads,

A new method of oil and natural gas extraction offers promise as a way to keep energy supplies abundant and costs low.  This method, commonly known as “fracking,”  hydraulically fractures shale rock formations by injecting enormous quantities of water and smaller quantities of chemicals underground to access trapped oil and natural gas.  However, environmentalists have raised concerns that fracking could contaminate aquifers and cause earthquakes, posing prospective danger for communities concerned with businesses experimenting with new technologies under their homes.

The potential for these negative externalities, particularly extreme events such as significant earthquakes poses liability concerns as to who is responsible for damages.  If a firm with limited liability can declare bankruptcy before paying for all the damages caused by fracking, it may have the incentive to partake in excessively risky behavior.

The economically efficient solution to potential damages caused by fracking is to enforce a strict liability standard for such potential risks. This standard holds anyone engaging in fracking to pay all third-party damages that may happen, regardless of whether or not they had any expectation of them happening. This standard forces costs caused by fracking, namely earthquakes and the contamination of aquifers to be incurred by such firms. Profit-maximizing behavior becomes socially optimal under this institutional arrangement.

We recommend requiring firms to be underwritten by well-capitalized financial firms who can shoulder the burden should an extreme disaster hit. In instituting this very simple and unobtrusive regulation, lawmakers avert the principle cause behind the failures of “capitalism” in the 2008 financial crisis: privatizing gains and socializing losses. The key for good behaviors by markets are getting the incentives right, and that means privatizing both gains and losses. This is the basis for conceptualizing the risks of fracking in terms of who must pay when something goes terribly wrong.

The immense social benefits available in the form of cheap power demonstrate the importance of attaining good policy for fracking. Preliminary analysis conducted by the Yale Graduates in Energy Study Group suggests consumer surplus – that is, benefits for those purchasing natural gas – is in the scope of $100 billion per year. Using a statistical method which takes into consideration the possibility that fracking may cause an event like a severe earthquake, we still find that potential benefits outweigh actuarial costs. And this cost-benefit analysis ignores the institutional arrangement proposed in the paper. If strict liability with an insurance requirement in place were to be implemented, society (except the financial firms and firms using fracking methods) would only be in a position to receive benefits from fracking, since anyone harmed by fracking would be made whole by the courts. With the correct institutions in place, fracking offers tremendous benefits at minimal costs.

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