Emiliano Fajardo Pedraza​
Professor Qin Fan.​
May 15, 2025​
Econ 40​
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The Deepwater Horizon oil spill, also known as the Gulf Oil Blowout, is one of the most
devastating environmental disasters that has happened recently. On the 20th of April, 2010, an
explosion occurred at an offshore oil platform that was led by BP (British Petroleum). As a result
of it, around 4.9 million barrels of oil were released into the Gulf of Mexico. This spill went on
for 87 days, damaging ecosystems, coastal economies, and even the health of those around the
event. Even though BP took responsibility for the cleanup, due to legal caps on liability, which
made compensation very limited. An article by The Economist explains how this event exposed
the problem of the underpricing of fossil fuel externalities, which triggered a reevaluation of
financial risk in offshore drilling.
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This case was very interesting to me since I am a Mechanical Engineering student
focused on sustainability. I am currently an outreach fellow at the US Green Building Council of
Central California, and we work with sustainability efforts on a day to day basis. The most recent
time I have dealt with something similar was when we were examining CEMEX and their
request for an Extension on the drilling project they have going on the San Joaquin River. The
research I did focused on the question: Does the current pricing system for oil reflect the full
social costs associated with fossil fuel consumption? I would argue that oil markets aren't
successful at internalizing negative externalities, which include things like health impacts,
pollution, and disaster risks. Being able to correct these failures would require them to have
stronger regulations and pricing mechanisms.
There are a variety of theories that one can apply to analyze the Gulf Oil Blowout. The first one
that comes to mind is the concept of negative externalities. These externalities happen when the
total cost or benefit of a transaction is not felt by the people involved in the transaction; instead,
those effects fall on others who are not a part of the transaction. When it comes to BP, their cost
for offshore drilling did not take into account the total societal cost others experienced as a result
of the oil spills, air and water quality, and health issues that affected the public. Due to these
conditions, it ended in a market failure where the equilibrium quantity of oil was greater than
what would be socially optimal.
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Thanks to the spill, it revealed a very interesting concept of moral hazard, which is when
companies partake in risky behavior because they know that they will not carry all the
consequences if something were to happen or go wrong. In 1990, a law was passed that capped
the non-cleanup damages at 75 million dollars. Due to laws like these, BP and other oil
companies don’t have any motive or incentive to invest in additional safety measures. Regulatory
gaps like these allowed for excessive risk taking which eventually led to one of the worst
ecologically damaging events in US history.
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Additionally, this case was able to show how government regulation is able to correct
these market failures and prevent future ones. For example, if the cost of oil included a tax that
represented the cost of externalities, it would encourage oil companies to have safer practices
and invest in alternative energy. These interventions are an example of Pigovian taxes, which
focus on aligning company incentives with the welfare of society.
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Another important concept is asymmetric information, which is when one party in a
transaction has more access to information than the other party. In this example, oil companies
have a better understanding of the risks of offshore drilling as opposed to regulators, insurers, or
the public. A gap like this can lead to the underestimation of risks and a lack of safeguards. If we
apply the Coase theorem, we are able to say that when a transaction cost is low and a property
right is clearly defined, then two parties would be able to negotiate and have an efficient
outcome. However, in the real world, there are obstacles like litigation, a lack of transparency,
and trust issues that prevent this from being a reality.
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The Deepwater Horizon incident clearly showed us how a failure to internalize
externalities led to economic inefficiency and harm to the environment. An article from the
Economist argued that this disaster would have led investors and insurers to change how they
went about evaluating oil companies. This complements the idea that when markets begin to
realize the true cost of risk, then their behavior will change.​​
One study shows that stronger liability laws are able to reduce the frequency of oil spills
happening by making the companies liable for any damage.​
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Through my own experience working in sustainability education and advocacy, I have
noticed that there is a disconnect between public understanding and the real cost of fossil fuel
use. I work a lot promoting e-bikes and renewable energy, and have found that many people only
focus on the sole price and convenience of gas and ignore other hidden costs that come with
gasoline use. This mirrors the economic issue at play, which is that without any visible or
immediate consequences, corporations will underinvest in long-term environmental
responsibilities. Another consideration is the role that financial markets play. Before the spill had
happened, deep sea drilling was usually funded through limited recourse arrangements, where oil
companies didn’t own or fully back the platforms. The spill then showed that the investors and
insurers are the ones who are ultimately responsible for all the damages, which can total up to
billions of dollars if a disaster were to happen. As a result of this newfound risk, there was a
reassessment of how projects are underwritten, which then increased the cost of capital for risky
extraction methods. This could lead to a promotion of cleaner energy investments and discourage
high risk drilling. On a global scale, fossil fuel markets are typically influenced by government
subsidies. A lot of governments usually subsidize oil production and consumption, which leads
to prices that are artificially low, which causes there to be an overconsumption of fuel. It is
possible that by eliminating these subsidies, it could help internalize environmental costs and
provide a more accurate price signal, which would then encourage the public to seek alternatives.
Opportunity cost is relevant here because by choosing to subsidize oil, governments are giving
up investing in things like public transportation, clean energy, and health care.
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It is also important to take into account the politics and economics of energy. Oil
companies usually have a lot of influence on regulations, which will lead to regulatory capture.
This is when regulators who were meant to keep things in check instead end up serving their own
interests. This prevents governments from enforcing strong rules or holding companies
accountable for any harm that they cause. This case also speaks to the supply and demand
dynamics that exist in the energy industry. When the cost of insuring and funding deep water
drilling rises, it causes a decrease in supply, thus shifting the market towards a less risky option.
This is a reminder that markets are able to adjust, but only when there are accurate cost signals
present. Behavioral economics could also be playing a role since people and companies don’t
always make rational decisions. This makes it harder to create proper policies that will address
externalities while still working within real-world market behavior. ​
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Finally, the spill brought up some ethical considerations, especially the ones regarding
environmental justice. The communities that were most affected by the oil spill were fishing
families, small business owners, and residents with low income who resided along the Gulf
Coast since they didn't have the proper resources in order to recover quickly. This outcome backs
up the idea that disasters can hurt vulnerable populations, which adds a moral standpoint to the
need for better regulation and risk pricing. The Gulf Oil Blowout showed just how serious the
consequences are for failing to internalize externalities in oil production. Economic theories like
market failure, externalities, moral hazard, and government intervention all provide insight into
how this disaster could have occurred and also how events like this can be prevented. Oil
markets do not show the full cost of environmental damage, which leads to inefficiencies that
need corrective policy to address. A way to address these issues is to have policymakers
eliminate liability caps, impose Pigovian taxes on fossil fuels, and invest in renewable energy.
Although it is very difficult to price externalities, having partial measures can still guide the
market toward socially responsible outcomes. A limitation of this study is that it primarily
focuses on regulation and market behavior in the U.S. when oil is a global commodity. We also
need more real-life information and examples on how oil spills affect health over time and how
well regulations have worked so far. As people become more aware and economies change,
including environmental costs in fossil fuel markets becomes not just economically important,
but morally right too.
References:
The Economist. (2010). Gulf oil blowout: That’s one way to price in externalities.
Bennear, L. (2015). Offshore oil drilling and environmental regulation. Journal of Environmental
Economics and Management.
Kling, C., et al. (2011). The economic impact of the Deepwater Horizon oil spill. Review of
Environmental Economics and Policy.
Viscusi, W. K., & Zeckhauser, R. J. (2012). Reforming Liability Rules for Catastrophic Risk.
American Economic Journal: Economic Policy.