The explosion of the Deepwater Horizon drilling rig has dealt a heavy blow to BP. Finding its very integrity and sustainability threatened, the company witnessed its stock market value plummet. Today, its shares are worth about half of what they were before the disaster. However, the heavy penalty that BP will have to face could paradoxically have a positive impact. By highlighting the financial risks of inadequate management of environmental hazards, it could make investors more aware of the environmental factor. And, it could push governments to adopt measures reminding investors of their obligations, if required.
Each week, the figure rises with the regularity of a metronome. From one billion in June, to two billion, then three, and now more than six billion dollars. The expenses incurred by BP for repairing the damage caused by the Deepwater Horizon blast have reached unprecedented amounts. And this is just the beginning. BP has made a provision of 32 billion dollars in order to bear the entire cost. Under pressure from American authorities—determined to make the company pay up—the flagship company of the British petroleum industry had to sell off a considerable part of its assests in order to finance, among other things, the 20 billion dollar victims compensation fund. BP has already announced the transfer of nine billion dollars worth of assets in North America, Egypt, and Colombia. As a result of this colossal blow, the company saw its stock market value fall to half of its original value. And to top if off, it has been the subject of hostile take over bids rumors.
If BP has reached this point, it’s maybe because it has been going down a dangerous slope for recent years—as is the case for many companies in the oil industry. Due to the overriding importance of financial performance and the decrease in conventional resources, companies tend to take increased risk. This behavior is detrimental to both human safety and the ecosystems overlying the precious deposits.
Predominance of Financial Ratios
Even though BP had already received several warnings about its security measures, the conditions that led to the disaster were not necessarily unusual. According to Rodolphe Durand, coordinator of the “Corporate Strategy and Policy” department of HEC Paris, the business school of ParisTech, this catastrophe is indicative of deep-rooted industry trends. “During recent years, the ever-growing importance given to financial ratios in assessing corporate performance has driven several companies to reduce assets that they held in order to enhance these ratios … For highly capital intensive companies operating in the energy or transportation sector, the general trend—as was the case of BP—consisted of sub-contracting by outsourcing assets.” So, according to Durand, the cascading effect of sub-contracting increases risk: accountability gets spread over the entire sub-contracting chain.
But above all, the oil spill in the Gulf of Mexico may be the collateral damage of excessive cost reduction, a policy practiced by a number of companies. It explains certain decisions taken by BP during drilling, which are being examined by investigators today. The representative Henry Waxman, who questioned the chief executive of BP, Tony Hayward, when he appeared before the American Congress, has pointed this out. Among other things, Waxman highlighted the choice of dangerous architecture used for the end section of the well. This decision was taken against in-house recommendations highlighting the risks associated with gas leaks and proposing an alternative—one that would have cost a mere 7 to 10 million dollars more. The costs that BP now has to bear make this sum look almost paltry in comparison. But just a few months ago, this purely financial calculation was far from evident.
A Political Intervention that Changes the Whole Equation
The potential cost of the risks taken by oil companies was until now partly limited by a 1990 American law. The Oil Pollution Act put a ceiling of 75 million dollars on compensation that might be demanded for financial losses (e.g., harm to business activity, damage caused to private property) in case of oil spills. Furthermore, the magnitude of the required compensation is highly dependent on the exceptional depth at which the incident occurred. BP’s management, as well as investors, thus had litte reason to believe that an ecological disaster could jeopardize the company so suddenly.
Even after the Deepwater Horizon blowout, and in spite of forecasts of an unprecedented oil spill, BP’s stock market value did not show a sudden drop. “Initially the slide was rather gradual,” Durand points out. “It’s only when Obama banged his fist on the table that the CEO of BP became weaker and more stringent measures were undertaken to stem the leak … And that’s when the stock market value really plumetted.”
Most observers emphasize that the financial blow experienced by BP is linked to a highly specific context. First and foremost, the oil spill took place in the United States, where authorities are capable of coming down heavily on the company. Moreover, society today is more aware of the fragility of the environment. The damage caused by the oil spill left an imprint on people’s minds and impelled the American authorities to adopt a firm stand of an unprecedented nature.
A very similar catastrophe took place in the same region in 1979, though in Mexican waters on the Ixtoc rig. The Mexican public enterprise Pemex spent 100 million dollars to plug the leakage from the well from which oil spewed for 297 days—at an admitedly lesser depth than Deepwater Horizon—and then to clean up the spill. However, it managed to avoid most of the compensation claims being filed in the United States by invoking the sovereign immunity of Mexico (the oil had polluted part of the Texas coast).
As for BP, it had to promise to meet all legitimate demands for compensation—well beyond the ceiling normally stipulated by the law and prior to any legal proceedings. The creation of a blocked account of 20 billion dollars for a victims compensation fund, owing to great pressure from American authorities, is noteworthy for two reasons. In addition to being a record amount, the blocked account mechanism greatly limits any hopes that BP will be able to dispute anything in court. This was a tactic used repeatedly by Exxon during the long-drawn years of legal proceedings following the Exxon Valdez catastrophe. Nineteen years elapsed between the sinking of the tanker in Alaska and the Supreme Court’s final decision pertaining to the case.
Political intervention proved to be a turning point for BP. And it will also be potentially significant for the way these types of catastrophes are perceived in future, explains Diane Laure-Arjaliès of the economics laboratory of the Ecole Polytechnique and author of a thesis on the acknowledgment of extra-financial criteria in asset management. “What Obama does when he says ‘they will pay for it’ can become a textbook example and will have a much wider impact [than the undermining of BP’s finances],” the researcher explains.
A Quantitative Indicator for Investors
Arjaliès’ thesis was based on the observations she made as an expert analyst of socially responsible investments (SRI) at the French insurance company Macif. These analysts are the counterpart of financial analysts for non-financial criteria (i.e., environmental and social criteria for which companies indicate their performance in today’s corporate social responsibility or CSR reports). “For several years, SRI analysts identified risks on BP rigs. But when analysts went to meet their superiors, the latter ask them ‘What is the potential impact?’ At the time, provisions for risks were limited due to the 75 million dollar ceiling.” Under these circumstances, it was difficult to argue the dangers of investing in a company that was having excellent financial results. “You need figures to convince financiers,” Arjaliès concludes.
Today, leading portfolio management companies employ SRI analysts but they still find it very hard to convince others of the relevance of extra-financial criteria. Matthieu Glachant, director of Cerna, the economics laboratory of the Ecole des Mines Paristech and CSR specialist, partly explains this by the lack of standards to calculate the impact of environmental policies. “Lots of people think that it is very difficult to evaluate environmental performance whereas it is much easier to evaluate financial performance.”
On this front, the billions of dollars of loss reported by BP could provide a striking precedent for a mindset shift among portfolio management companies as well as external analysts—”the opinion makers” who work for brokers. As Arjaliès points out, “The catastrophe in the Gulf of Mexico is perhaps an evil for a good. By showing that it may end up being far too expensive, it will provide data, a ‘meter’ [and thus a new standard for the future].”
Investors Could Pay Greater Heed to the Environment
Going beyond examples backed by numerical data, several researchers have deliberated on the links between corporate financial results and environmental policy. An idea seems to emerge: the performance measured on extra-financial criteria helps in getting an overall view of the risks borne by the company and can thus have a significant bearing on its long-term performance.
Some categories of influential investors are more sensitive today about environmental performance, a trend that could pick up momentum from the BP case. “Institutional investors, such as the Pension Reserve Fund in France, seem to be more and more concerned about socially responsible investment issues,” upholds Arjaliès. According to the annual SRI market study carried out by the Novethic fund, an industry expert, institutional investors represented 69% of the market in 2009 and their investments are on the rise. “This provides real leverage because pension funds, institutional bodies, play a prescriptive role. Portfolio management companies, for example, are great followers of these bodies.” This is an interesting revelation when we know that British pension funds account for 25% of BP shareholding.
However, one step still remains to be taken. “These days, shareholders do not hold themselves accountable for the company’s actions,” says Arjaliès, “even though they are partial owners of the company.” As such, they can play an influencial role in share purchase decisions. This positioning was crystal clear in the case of BP. “Shareholders projected themselves as victims of the whole affair, as their dividends were affected.” This behavior appears skewed: shareholders expect a legitimate return on investment from the company. But, they do not believe that it is their role to encourage more responsible practices and feel that they have been wronged when these are found to be lacking.
The Public, the Other Influencer of Change
For companies, the arbitrations of the end customer can also be extremely influencial. After the Deepwater Horizon blast, a few customers immediately called for a boycott of BP service stations, most of which are not run by the company but by independent franchisees. Michael Skapinker, a Financial Times columnist who deliberated on this issue, questioned John Kleine, head of the American resellers association of BP Amoco. Kleine says that his members noticed a 5 to 20% drop in sales, with figures varying greatly from one state to the next.
BP’s competitors reacted very quickly after the catastrophe, partly to show that they had learned their lesson, and partly to ward off similar incidents. “Without further delay, they all reexamined their procedures based on the information that they had on the way the events unfolded,” explains Olivier Appert, president of IFP – Energies Nouvelles (the former French oil institute). “What I believe is that oil companies will give even greater importance to industrial safety issues because all of them face similar risks in the Gulf of Mexico, the North Sea, or the Gulf of Guinea.” He has no doubts whatsoever that if a similar catastrophe were to occur, it would put even the biggest oil companies in jeopardy.
According to Durand, there are reasons to believe that a fundamental change is taking place. “It is certain that companies are paying greater heed to problems of this kind. They are working on various scenarios; the ‘sustainable development’ aspect is being taken very seriously at the board level. Members of Boards of Directors are well aware that the world is changing; it is not just communication, it’s reflected at the level of corporate values. And the fact that managers’ attention is being drawn to consequences [in the case of a catastrophe] is bound to make them better informed about these issues.”
With respect to the influence that the BP episode can wield, the researcher weighs his words more carefully. “There is always the possibility that one may say ‘It only happens to others.’ Today, public opinion is more important, but I am not convinced that it can bring about drastic changes or a rethinking of strategy as far as resource allocation goes.”
For everyone, the decisive element in the long term will be the legal framework, as Glachant explains. “In the end, it is public policy that generates financial risks in one way or the other—in the form of civil responsibility or something else.” Public policy determines the extent to which companies are accountable for damages caused by their business, and thus the more or less “sustainable” approach they adopt.
Public Policy, the Real Key to Long-term Change
In the aftermath of the oil spill, American authorities announced that they would raise the limit of financial compensation that could be claimed from companies. According to Appert, “There will be other decisions but they will probably not be taken before mid-term elections in November.” He also highlights the reorganization of Minerals Management Service (MMS) initiated by the American administration.
As early as mid-May, Barack Obama pointed out the dubious nature of the close relationship between oil companies and the federal agency in charge of issuing permits, collecting money owed to the state, and ensuring respect of the environment and safety conditions. The agency will henceforth be divided into three independent entities in order to avoid any conflict of interest between its various functions. Among the other measures, even though restrictions on offshore drilling seem to be one of the most spoken about possibilities, the tightening of requirements related to safety equipment also figures on the agenda of the U.S. Congress.
According to Arjaliès, the impact of more restrictive regulations will be all the more effective if the lessons learned from the disaster will be incorporated therein. Regulations have already evolved to a great extent regarding the impact of industrial activities (other than those susceptible of causing accidents). This concerns limitations on CO2 emissions, of course, as well as more targeted measures at the state level. One example of the latter is the law, voted on in France at the 2nd Environment Round Table (Grenelle de l’environnement), that requires banks to account for extra-financial criteria in their investments. Ultimately, it is at the political level that a change will take place (or not) towards more responsible environmental practices at the corporate level, irrespective of whether it pertains to the oil sector or other industries. This is because a drop in share value and financial losses do not account for everything. Arjaliès knows it: “Markets have a short memory.”
- Les mécanismes du changement institutionnel - Le cas de l'Investissement Socialement Responsable (PhD of Diane-Laure Arjaliès, Université Paris Ouest Nanterre La Défense - ESSEC Business School (28/06/2010))
More on paristech review
On the topic
- Welcome to Macondo: the future of offshore oil spillsBy ParisTech Review on September 27th, 2010
By the author
- FoodTech and personalized nutrition – 1 – From marketing to geneticson December 22nd, 2016
- FoodTech and personalized nutrition – 2 – A mix of cooking and manufacturingon December 22nd, 2016
- When multinationals pivot: three strategies from the food industryon November 7th, 2016