Greedy Goblin

Thursday, July 22, 2010

Risky companies

Paying multi billion dollars for damages is not what any businessman wants. Losing whole installations is neither. There are secondary, tertiary systems to provide security for all kind of disasters. So theoretically there should be no more industrial accidents in the world. I mean if the income is enough to pay for the security systems, you pay for the systems, if it's not, you cancel the whole operation. It's better to put your money to the bank than losing everything due to a disaster.

However disasters happen. The latest large disaster is the Deepwater Horizon's oil spill. More likely than not, one of the largest companies of the World, British Petrol will go bankrupt or split&sold over the incident. All for a the missed maintenance of the blowout preventer. How can companies make such deadly mistakes?

Companies make nothing, because the founding document rarely speaks. People make decisions. Nowadays most managers are not owners of the company, but paid employees. (sick joke: What is the system where employees run companies? Textbook communism.) Employees calculate risks very differently than owners. The difference is that employees play the same game as the players of "modern" MMOs: a positive sum progression game. Too bad that it can't exist in the real world.

Let me explain. The owner can lose value. If I own a car and break it, I'm poorer now than yesterday. The employee can only lose his job. If I break the car of the company, I lose my job, so I won't be more rich than today, but nor poorer than yesterday. This phenomenon distorts the assessment of risk. Let's see the following set of examples:
  • The company saves $1M if it skips the maintenance of the machinery. The manager gets 10% share from the extra profit as bonus. So he'll get 100K. He earns $1M currently, so he will get 10% raise.
  • There is 1% chance that the factory blows up, causing $1B damage in lost assets and damages. Manager gets fired, what is -100% "rise".
  • If the maintenance is done, the manger doesn't get rise, the company don't make $1M profit and there is no risk of damage.
From the employee point of view, the average earning is 0.99*10%-0.01*100% = 8.9% raise on average if he skips maintenance and 0 if does it. With money, it's (0.99*1.1M+0.01*0)-1.00*1M = 89K. From the owner's point of view, the average earning is (0.99*1M-0.01*1B)-1.00*0 = -9.01M.

So the skipping of maintenance is the rational solution for the manager while completely bad for the company. The only way to prevent it would be giving negative payment to the manager in case of damages. If he'd get 10% "share" from the loss too for current year, on the top of being fired, his calculation would be (0.99*1.1M-0.01*100M)-1.00*1M = -0.911M on average. Whoa, I found the holy grail of stopping disasters!

Or not. The problem is that the loss of the manager is hard-capped by his wealth. Even if he would have such contract, it would worth toilet-paper as in the case of disaster, he would get a $100M bill that he could obviously not pay. His loss would be not $100M but "whatever the jury can confiscate during the bankruptcy procedure". The only way to make sure he can pay $100M is him owning $100M. However this case what separates him from an owner who has 10% share of the company?

The bottom line is: the disasters are not exceptions, they are the rule for companies where the managers are not owners. Don't buy shares from companies if you don't plan to run them!

PS: theoretically government organizations can mitigate the risk by introducing fines for being risky. This can work for smaller companies. But for companies like BP where the manager has the phone number of lawmakers, government officials use to look the other way.


Sven said...


Whilst the BP example probably isn't a good one (it is a huge company that can take the losses with some minor adjustments), your general point about the conflict of interest between employees and owners is a fair one.

It's worth noting that the losses for owners are also hard-capped by bankruptcy laws and the existence of limited companies, so the same issue also exists with manager-owned organisations, albeit to a lesser extent. At first sight the solution to this seems simple - remove limited liability status. However, it's likely that this will cause more problems than it cures, as that freedom to take risks is one of the engines of growth of the western capitalist model. It allows people to learn from their mistakes and do better next time.

In other words, corporate disasters are a perfectly natural part of the economy. "Curing" them would cause more problems than it solves.

Anonymous said...

This reminds me of the fuel tank controversy of the Ford Pinto, where it was cheaper to let people die (and pay compensations) then fixing a design flaw.

Indrigis said...

The company saves $1M if it skips the maintenance of the machinery. The manager gets 10% share from the extra profit as bonus. So he'll get 100K. He earns $1M currently, so he will get 10% raise.
The only way to prevent it would be giving negative payment to the manager in case of damages.

Actually, one way of preventing the disaster would be giving the manager a negative payment in case of breach of procedure. Like, 1% of potential loss from every procedure not followed. Thus, skipping the maintenance earns him a 10M fine.

Then, no bonus should be directly associated with savings for the company. The sin of the system is that anything that can be done poorly for the sake of a bonus will be done poorly. If the company works well, employees get bonuses. If the company doesn't, they don't. And in either case going over the budget should be justified. Going under the budget should be investigated for traces of using poor materials and services. And fined appropriately.

You can see an extreme version of the "Bonus from savings" in any country with sufficient corruption. Like, on average, the budget for building 1 kilometer of the MKAD (the highway around Moscow) is around $120M. Which is roughly ten times more than for the same highway in Europe. The quality of the construction, though, is LOWER. This is caused by the fact that 100% of the savings (say, $115M saved for a kilometer) go into shadow bonuses for everyone involved, not back into state budget =)

So, as long as the company is willing to take the risk of skipping maintenance, it's managers are not to be blamed, as they only did the logical thing - increased their bonuses. The owners are to blame, because they gave the lower-tier managers a legal opportunity to put the company at risk.

Vinnz said...

Don't buy shares from companies if you don't plan to run them!
...and on the other hand, if you get a managerial position in a company, sell your shares.

Squishalot said...

The BP example is a fine one. It had the potential to be a significantly bigger loss than it currently looks to be (even if they could absorb that as well).

Gevlon: "The employee can only lose his job. If I break the car of the company, I lose my job, so I won't be more rich than today, but nor poorer than yesterday."

This, unfortunately, is based on the theory that there is no 'friction' between jobs, that you can seamlessly be fired from one job yesterday, and start a new job today. Unless you were preparing to be fired, the practical reality is that you do lose out to some extent, even if it's a lesser loss (relative to financial position) than the company.

But your overall message is correct - there is an inequity in the payoffs that result in an incentive to overlook things that can cause mistakes.

Decbou said...

Take into account NPV of future salary cash flow that the employee won't receive. He is actually poorer if he is fired. Especially if he is blacklisted from his expertise sector. Sure he could go work at wallmart or wash car at a crossroads but there is still a NPV loss.

Anonymous said...

I disagree about your manager example. Skipping the maintenance will get him a small rise maybe, but the risk is that if there is an accident because he didn't make the maintenance and he is identified as one of the responsible of the disaster, it will be hard for him to get a new job in a similar company. And the same for the Raider: if he makes a drama in a high end Guild, it will be hard to find another one if they happen to know this player's history.


Gevlon said...

Loss of future good employment opportunities just risk minion-level employees. A manager, especially a high one is not personally responsible for anything, as every action he decides is carried out by minions.

If he is not stupid (and by climbing that high he proved it), his name is nowhere to be found on incriminating documents. He will order nobody to skip maintenance. He will simply fire half of the maintenance crew and demand the other half to do the whole job. They will fail of course, but it's them who failed. He can show a document where he ordered maintenance that was not done or not done properly.

Of course the half-crew should have rejected his order reporting in official papers that they are unable to comply with their limited resources. But they will never do that because:
* they fear of being fired as they have no savings and mortgage
* they are social minions who are not used to think and obey without question

Balazs said...


I am working in the same industry as BP, (but not for them) so obviously i follow the news i and tendencies in the industry. Now I must agree with you point on the conflicting interests of managers and the companies. I must say that it is not so black and white in my opion. Many managers have shares as compensation from the company, so if the company goes bankrupt they lose a lot as well. ON the other hand if it does go bankrupt (and it is under your management) good luck finding a job in the same industry or same kind of position.

On the other hand the owners of these companies, the shareholders have a pretty solid interest in not going bankrupt, and they should do whatever is deemed necessary to achive this. Put comittees in place to supervise safety matters for example.

I would like to briefly touch on the interest of governments as well. Yeah BP goes bankrupt, they are liable until a certain point for their damages and will pay a lot of money to clean it up. What if all the money and resources of BP are nothing compared to the damages? Than the govermnets will have to pay for the cleanup, as it would effect the economy, environment, and thus the people living there. Furthermore pension funds are usually amongst the shareholders of these companies which gives an even wider spread to the issue. Look at Enron back a couple of years. They had an accounting system which was creative enough and without control to make thousand of people lose their jobs, their pension, their lifeline basically in a matter of days. The outcome is Sarbanes-Oxley Act. Would you think that something similar can be the outcome of this incident? I certainly do.

Anonymous said...

The idea of the manager taking a cut in pay is an interesting but legally would not work ... at least in South Africa. Companies here are limited by labour law as to how they can reduce someones salary for events within the company. I am sure it is similar all around the world. And employment contracts would not negate that right, just as much as signing a murder contract doesn't legalise murder.

Bobbins said...

The companies name is BP not British Petroleum.

It is a bad example however because the it has become a political football.

In your example you mention solely BP. However the subcontractors involved in the project seem to escape all blame in the incident. The state which profits from risk (and the oil industry is risky!) suddenly becomes upset when there is an accident and yet profits hugely of the revenues.

BP is a lesson in scapegoating and bandwagon jumping. The main and only concern at this time should be cleaning the mess up. The americans are having major internal problems with its economy which the are dealing with by protectism.

American is the most (not least) protectionist country in the world!

Anonymous said...

As an aside - Textbook Communism is where the employees own the means of production, not just run them, that's textbook capitalism. In the case you describe, every one of the employees in a 'communist' company would be thinking about the risk to them if the company were to lose a million dollars, which would inform them more than if they were just employees. This is, of course, if communism were to be applied rationally.

Anonymous said...

Removing the bonus also works. That way, he wins 0$ in either case, but loses his job when disaster strikes.

Anonymous said...

This type of problem is one of the most discussed Corporate governance topics.

For those interested:

Anonymous said...

Stock options or grants are frequently used to align the managers' interests with the owners. They have their own problems, but it does help address the principal-agent problem.

Strutt said...

/clap at the example, as i live in florida and the spill is about to be on my door step.

I agree with you post 100%

especially the part about them haveing the Lawmakers number :)

Anonymous said...

Skipping the maintenance will get him a small rise maybe, but the risk is that if there is an accident because he didn't make the maintenance and he is identified as one of the responsible of the disaster, it will be hard for him to get a new job in a similar company.

Unknown said...

BP is so big it has no external insurance policy covering the issue, but will not go bust over this minor spill. It lost more human lives in a blow out in Texas a few years before getting the gulf licence.

However, Transocean, the owner of the Deepwater Horizon rig which caused the gulf spill was insured on the Lloyd's of London market by a consortium of syndicates. BP will try and claim against that policy, and the syndicates will try and get out of any liability.

When the Piper Alpha platform blew up in the North Sea in 1988 the losses from that incident cost Lloyd’s £8 billion between 1988 and 1992.

Because Lloyd's is a huge insurance and re-insurance market for spreading risk, the only result of the gulf spill might be a rise in home and car insurance across the EU of about 1% for maybe 4 years. If BP succeed in the claim against Transocean's insurers.

Gevlon said "disasters happen" - which is why in a sophisticated capitalist economy insurance and re-insurance markets spread the risk. Think of them as GDKP pots.

Gevlon said "Don't buy shares from companies if you don't plan to run them". Should read "Research the shares you add to your share portfolio before investing. Check that the company in who's stock you are spending your money is adequately insured against risks".

Littlebear (Stonemaul US) said...

Anonymous Bobbins said...

The companies name is BP not British Petroleum.

BP = British Petroleum. The same way Kentucky Fried Chicken = KFC.

2) It is my understanding that this all would have been prevented with the installation of a blowout release valve. Most countries in the world demand this, but the US consider it optional. I find this fact interesting when the American politicians were posturing about what they were going to do to BP, a BRITISH CROWN CORPORATION.

sam said...

Dead on and combined with the fact that most mid to upper level managers only stay at any given company for 1 to 3 years and theres even more incentive to not do the maintenance. Most likely the machinery will break on the next managers watch after you've moved on to the next job and already gotten another performance review. ANd most likely they'll hold that poor bastard responsible

Yaggle said...

I like the Hugo Chavez solution best. Rule with an iron fist and make the oil companies bend to your will. Profits help pay for health care and cheap oil subsidation for the masses. I don't see any of Hugo's oil rigs exploding.

Anonymous said...

Though I do agree that companies have to actively make a goal of aligning their managers with the company, I do not believe Gevlon's oversimplified economic analysis showing that the manager rationally should skip the maintenance is accurate in almost any circumstances.

If the company does not require maintenance, that's their problem, and it's a big one, and one the owners need to fix. But in this case they did require it. For the manager, the primary risk is *not* that the company will go bankrupt and they will lose their job, but that their failure to follow procedure will be discovered, and they will lose their job (or some lesser level of financial penalty). The upside is also way more limited - no manager will almost ever have that direct of an income increase from one expense item, and if so, it would certainly not be something that would slide under the radar like a neglected maintenance.

No, the incentive for your average managers is actually the opposite - follow every procedure, take every precaution, play it safe on every occasion, because the risk of cutting corners is the very present risk of discovery and losing your job, while the cost-saving benefits go to the owners, and only very indirectly filter back to you.

Neglect does not happen because the managers are making rational decisions to save money because all they have to lose is their livelihood. It happens because either the owner's rules and procedures didn't address the issue and the managers had no incentive to stick their neck out for a procedure change (adding fining would only make this way worse), or because despite the manager's knowledge that rationally it is always best for them to follow all procedures to the letter, they get tired and bored and overworked, and long term rational self interest loses out to "I just can't get it all done anymore so screw it and hope for the best".

Anonymous said...

People who make out like it's some kind of sin to call BP "British Petroleum" - the two words which B.P. until recently stood for - look silly. You can make your valid point that America hypocritically, and to its great detriment, engages in protectionism, without that.

Gevlon, I think BP is a pretty good illustration of your point - but you might also want to consider this:

Andru said...


Oh please. Stop kissing Chavez' regime butt.

You probabaly didn't live under a totalitarian regime.

I did.

If ANYTHING can be covered up, it WILL be covered up.

I could present dozens of examples, but let's just stick with a famous one. Chernobyl.

The URSS government kept the lid on the disaster for sevaral friking days, until SWEDEN picked up the radioactive cloud.

Sweden. The country that is well over 3000 km away from Chernobyl.

So yeah. You may not see any of his oil rigs exploding simply because the dissenting journalists get shot, and the others are told to paint a rosy light of the regime.

Cyrell said...

@Andru: Surely, by "dissenting journalists", you mean "employees of the US Central Intelligence Agency charged with starting revolutions named after colors to install US-pandering governments". Perhaps now you understand?

E said...

I agree with your sentiment, but the company isn't called British anything, it is BP, it was changed as it merged with a large American company in the nineties (Amoco, which tend to get brushed under the rug by people wanting to point fingers and ignore the fact the company has a huge American backing also).

But anyway, back to the managers thing, I work in the oil industry for a service company, and I totally agree, when you're offshore, be it on a rig or a boat, you get pushed if the job is need to be done. Its more important for them to do it quick than do it safe, despite the fact they preach about a safety culture, I've seen myself doing successive 24hour shifts with very little sleep while doing things that could break millions of pounds worth of equipment, just as I'm getting pushed to get things done quickly.

The sad state of the matter, is this could have happened to anyone, BP just happen to have been the ones to take the hit, all oil companies put the cost before safety, its just this one went bad most publically.