The economics of nuclear accident law

ELSEVIER

The Economics o f Nuclear Accident Law MICHAEL TREBILCOCK AND RALPH A . WINTER

University of Toronto, Toronto, Canada E-mail: [email protected]

Statutes restrict the application of c o m m o n tort law to accidents at nuclear power plants in Canada, the U.S., and other countries. The statutes transfer to the operator of a nuclear plant liability that would otherwise be placed on input suppliers and in return limit the liability of the operator. This essay addresses the impact on safety incentives of nuclear accident law, with broader implications for the design of incentive systems that combine regulation and liability rules. © 1997 by Elsevier Science Inc. I. Introduction

The c o m m o n law of torts determines the civil liability for most accident costs. For accidents at nuclear power plants, however, statutes in many countries severely restrict the application of tort law. The Nuclear Liability Act (NLA) of Canada, for example, imposes two main restrictions: (1) it transfers to the operator of a nuclear power plant liability that would otherwise be assumed by upstream suppliers; and (2) "in return for the b u r d e n placed on the operator ''l it limits the operator's liability to a m a x i m u m of about $55 million (U.S.). In many other countries, statutes impose either or both of these two restrictions. In the United States the Price-Anderson Act limits operator liability to $200 million and assigns approximately the next $6 billion dollars in liability to operators in the industry not involved in the accident. This paper evaluates the economic effects of these restrictions, comparing the safety incentives u n d e r the existing laws to an optimal liability regime. We focus to SOlne extent on the Canadian Nuclear Liability Act, because it has a m o n g the tightest restrictions on liability, with an industry liability limit of less than 1% of that in the United States. O u r more general aim is to consider optimal liability in an incentive system that combines regulation and liability. Nuclear power is a natural case study of

We thank Douglas Allen, Da~4d Friedman, Aldan Hollis, Theresa McClenaghan, George Priest, Sam Rea, Norm Rubin, Xiadong Zhu, and participants in the 1994 American Law and Economics Association meetings for helpful discussions, without claiming that they would agree with eveR,thing in this paper. Two referees offered especially helpful comments. I"Review of the Nuclear Liability Act," report by the Interdepartmental Working Group, to the Atomic Energ3' Control Board, (November, 1991), p. 1.

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such a system because safety in n u c l e a r power p r o d u c t i o n is r e g u l a t e d m o r e intensively than in any o t h e r c o m m e r c i a l activity. 2 C o r r e s p o n d i n g to the two m a i n features o f the n u c l e a r liability statutes, two general incentive issues arise. T h e first pertains to a basic p r o p o s i t i o n in the economics of tort law: that a h i g h e r share of accident costs will improve an agent's incentives to avoid the accident. Does this c o n t i n u e to h o l d in a r e g u l a t e d environment? An a r g u m e n t frequently advanced against increased liability for n u c l e a r accidents is that safety is m o r e efficiently achieved t h r o u g h regulation or that c u r r e n t regulation is so strict that increased liability is unnecessary. We show that the basic p r o p o s i t i o n o f tort law can be e x t e n d e d . For a wide range o f types of care, full strict liability d o m i n a t e s limited liability given any regulatory safety standards on care. These include care standards so strict that the probability o f a n u c l e a r accident, d, is less than the probability o f an accident, p*, in a first-best world. In this case, an increase in the nuclear o p e r a t o r ' s liability has two effects: It reduces the probability o f an a c c i d e n t below d, i.e., even f u r t h e r from the first-best probability, a n d increases social welfare. 3 T h e s e c o n d c o m p o n e n t o f the NLA, the c h a n n e l i n g o f liability t h r o u g h the n u c l e a r p l a n t o p e r a t o r , raises the g e n e r a l issue o f the optimality o f m a n d a t i n g , o r even allowing, transfers o f liability from one a g e n t to a n o t h e r as part o f a set o f liability rules. 4 In a world with zero transactions costs, negotiations a m o n g tortofeasors a n d potential accid e n t victims m e a n that statutory transfers o f liability have no effect on a c c i d e n t risks [Coase (1960)]. T h e same care a n d activity levels will be established t h r o u g h negotiations whatever the initial assignment o f liability. Moreover, these levels are efficient, so that allowing private contracting, such as the voluntary transfer of liability, is optimal. But suppose that a g r o u p o f tort-feasors can contract a m o n g themselves b u t n o t with victims, a n d f u r t h e r m o r e that o n e of the tort-feasors has a tight limit on liability. T h e private gain to transferring all liability to the a g e n t with limited liability is clear; such a transfer extends the liability limit to a t r u n c a t i o n o f the total liability for the group. T h e social loss from the transfer is equally clear. In maximizing the value to the contracting g r o u p o f the liability protection, the transfer minimizes the incentives to take care. In short, we reject the c o m m o n view that the two main c o m p o n e n t s o f the NLA are parts of a fair trade-off in which the o p e r a t o r is c o m p e n s a t e d with a r e d u c t i o n in the m a g n i t u d e o f liability for the b u r d e n of accepting a larger scope o f liability. T h e limit on liability inefficiently d a m p e n s incentives to take precaution, a n d the s e c o n d comp o n e n t o f the Act, the c h a n n e l i n g o f liability, exacerbates the inefficiency by magnifying the gap between the private a n d social costs of an accident. We p r o p o s e as an optimal liability scheme the following: full strict liability for the operator; j o i n t a n d several liability with u p s t r e a m suppliers, with the u p s t r e a m suppliers' liability b e i n g restricted to a negligence standard; m a n d a t o r y liability insurance to be p r o v i d e d by the m a r k e t to some extent, a n d above this a m o u n t by the government.

2The constitutionality of the Nuclear Liability Act was recently challenged a n d u p h e l d in Canada: Energy Probe v. Canada (Attorney General) (1994) 17 O.R. (3d) 717 (Ontario General Division). T h e two authors testified as experts for the plaintiffs in this case. 3For a b r o a d e r range of care types, increasing o p e r a t o r liability is not necessarily optimal at any set of values for regulatory care standards, but is part of an optimal regulation-liability rule package. 4The c h a n n e l i n g of liability f r o m the upstream suppliers codifies a transfer that would very likely be effected anyway in the voluntary contracts between the parties. T h e issue is not just w h e t h e r the transfer o f liability should be m a n d a t e d but w h e t h e r the transfer should even be allowed.

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We would propose allowing the "hold harmless" clauses prevalent in existing contracts between suppliers and operators, which are clauses providing for the transfer of liability from suppliers to the operator. 5 These clauses can be justified on the basis of the best-placed decider principle of optimal tort liability. But the liability beyond what would be covered by the operator's assets and insurance in the event of an accident should, we argue, revert back to the supplier in the event of supplier negligence. Recent literature considers the optimal mix of regulation and liability rules for generating incentives to undertake efficient precaution against accidents [Kolstad et al. (1990); Shavell (1984a, 1984b, 1987); Wittman (1977)]. The articles most closely related to ours are those of Kolstad et al. (1990) and Shavell (1984a), which recognize that ex ante regulation and ex post liability rules can c o m p l e m e n t each other in that their joint use can correct the inefficiencies of using either alone to correct an externality. O u r model departs from this literature in a n u m b e r of ways, including an extension to the case where the injurer's wealth in the event of an accident is small, and the safety incentives operate t h r o u g h the mandatory provision of liability insurance. The liability insurance market in this case represents an ex ante market mechanism for establishing safety incentives that operates in parallel with government regulation. That is, in contrast to the literature's ex ante-ex post distinction made between regulation and liability incentive systems, where these systems govern incentives for avoidance of catastrophic accidents they represent, in combination with the private liability insurance market, parallel ex ante incentive mechanisms. To the extent that the government cannot duplicate all information gathering by private markets, the efficiency of care as well as activity levels is e n h a n c e d by full liability. Section II of this paper offers some background facts on nuclear power regulation and current legal liability and on the nuclear liability insurance market. In Section III, we develop the a r g u m e n t for full liability by starting with the simplest tort scenario--in which the efficiency of full liability is relatively uncontroversial--then consider in sequence the dimensions in which nuclear accident risk departs from the simple model. This is extended to incorporate regulation and liability insurance market in Sections 1V and V. Section VI analyzes the impact of the channeling of supplier liability. The concluding section summarizes the discussion. An Appendix develops more formally some of the arguments offered in the text. II. Background: Existing Regulation and Liability Regulation o f Nuclear Safety

Nuclear power is p r o d u c e d through fission, specifically t h r o u g h the splitting of an atom of Uranium-235 by a free neutron. The splitting of an atom releases additional free neutrons. The power o f a reactor depends on the n u m b e r of free neutrons in the reactor's fuel, or the "neutron flux." Maintaining an adequate n e u t r o n flux is the key to the production of power and preventing excessive fission is the key to the safety of power production. The rate of fission is controlled by a n u m b e r of devices in a power plant: the use of water (or heavy water) to absorb neutrons, neutron-absorbing rods that are inserted or removed from the reactor, and the concentration of neutron-absorbing chemicals in

5These clauses are r e d u n d a n t if the N u c l e a r Liability Act r e m a i n s in effect, since the Act i m p l e m e n t s the s a m e transfer o f liability as the clauses.

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the heavy-water m o d e r a t o r . In addition, a n u m b e r o f safety devices o p e r a t e i n d e p e n dently of the p r o d u c t i o n process, i n c l u d i n g multiple automatic a n d i n d e p e n d e n t shutdown systems. T h e final backstop to off-site d a m a g e is the c o n t a i n m e n t system, which involves the large silo-shaped buildings that one sees on reactor sites. Safety at nuclear plants is, o f course, n o t an issue simply in the design a n d initial construction o f a plant, b u t in the operation, safety protocols, a n d o n g o i n g design changes. (~ Safety protocols are continually reassessed by n u c l e a r o p e r a t o r s a n d regulators. The sources of risk o f a n u c l e a r accident include: design errors, errors in construction, h u m a n errors in operation, errors or failure in c o m p u t e r systems or in m o n i t o r i n g or d e t e c t i o n systems, failures from the r u n n i n g o f aging e q u i p m e n t , a n d risks c r e a t e d by externally initiated events such as natural disasters or malicious interventions. Estimates or j u d g m e n t s of the probability o f a n u c l e a r power p l a n t accident, which are u n d e r t a k e n as part o f the risk assessment a n d safety design o f reactors, vary enormously. Estimates by industry experts, regulators, a n d industry critics of the probability o f an accident l e a d i n g to large off-site e x p o s u r e t e n d to be between 1 in 104 reactor-years a n d 1 in 107 reactor-years. 7 T h e risk o f 1 in 106 is sometimes described as a goal for safety standards; a risk of I in 105 for a catastrophic a c c i d e n t is estimated by the U.S. General A c c o u n t i n g Office. s With 109 n u c l e a r reactors in the U n i t e d States, the figure of 1 in 105 c o r r e s p o n d s to a probability o f an accident in a 50-year p e r i o d of a b o u t 5%. T h e three most significant accidents at nuclear power plants to date have b e e n the accidents at Windscale in the U n i t e d Kingdom, T h r e e Mile Island in the U n i t e d States, a n d Chernobyl in the Ukraine. T h e T h r e e Mile Island i n c i d e n t involved partial m e l t i n g o f the reactor core, but the c o n t a i n m e n t system p r e v e n t e d significant off-site exposure to radioactive material. Liability to third parties totalled a b o u t $50 million (1986 dollars), nonetheless [Warren (1993)]. In the case of Chernobyl, the core m e l t e d a n d the c o n t a i n m e n t failed. Dozens of lives were lost quickly, a n d by some estimates h u n d r e d s o f thousands will e x p e r i e n c e p r e m a t u r e d e a t h because o f exposure. T h e domestic financial costs alone have e x c e e d e d $20 billion, a n d the total costs are o f course far higher. Estimates of possible d a m a g e from a n u c l e a r accident in N o r t h America, as cited in n u c l e a r safety studies, run into the tens o f billions o f dollars. For example, in a statement in the U.S. Nuclear Regulatory Commission's (1985) r e p o r t on the PriceA n d e r s o n Act, the commissioners' "worst-case" scenario was a $10 billion loss in physical assets, before i n c l u d i n g any deaths or health effects. 9 The design, construction, a n d o p e r a t i o n of n u c l e a r plants are r e g u l a t e d in C a n a d a by the Atomic Energy Control Board a n d in the U n i t e d States mainly by the N u c l e a r Regulatory Commission. T h e regulatory process is ongoing, involving continual reassessment of safety protocols a n d design a n d m o n i t o r i n g o f the o p e r a t i o n o f n u c l e a r plants. T h e staff o f the regulatory b o a r d m o n i t o r the o p e r a t i o n o f n u c l e a r plants continually a n d o n g o i n g changes in design a n d safety protocols are the c o n s e q u e n c e o f

(~At the Bruce Station A north of Toronto, fbr example, eight major ( > $1.0 million) safety-related design changes were undertaken by Ontario Hydro between 1988 a n d 1993. "Nuclear Safety Costs," Ontario Hydro Rebuttal to Plaintiff Expert Testimony, Nuclear Liability Act challenge, July 1, 1993. 7These estimates are calculated in detailed probabilistic risk assessments, which estimate the probabilify of a sequence of safeguards against an accident flailing simultaneously. 8U.S. General Accounting office, July 1986 (GAO/RCED-86-193BR), discussed in HObert (1987), p. 15. °See also Dubin a n d Rothwell (1990), p. 75.

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negotiations between m a n a g e m e n t in the operator's safety division and the regulatory board. Designers, suppliers, and subcontractors are subject to regulatory restrictions on designs but are not regulated directly. The assurance of safety in the provision of suppliers and services from these other parties is the responsibility of the nuclear operator, l°

Liability and Liability Insurance for Nuclear Accidents Canada. Canada has 22 nuclear power plants. The NLA provides for (1) A limit of $75 million (about $55 million U.S.) on the total liability of a nuclear operator for damages arising from all third-party claims after a nuclear accident. W h e n cumulative damages seem to exceed this amount, the access of nuclear accident victims to courts is suspended. (2) Power on the part of the Atomic Energy Control Board to prescribe mandatory liability insurance up to the $75 million limit for each nuclear facility. Whatever part of this liability insurance is "not available" from an approved insurer is provided by the federal government. (3) Absolute liability on the operator for damages to third parties arising from a nuclear accident, up to the stated limit. The liability of non-operators (suppliers, manufacturers, and design consultants) is transferred completely to the operator. (4) An absolute limitation period of 10 years after a nuclear accident for the c o m m e n c e m e n t of claims by victims of a nuclear accident. A limitation period of 3 years is established for the time between manifestation or discovery of injury and filing of a claim. And (5) the creation of a claims commission when an accident occurs, if it seems that the claims will exceed $75 million or if the Governor-in-Council determines it to be in the public interest. The claims commission would hear all claims and r e c o m m e n d how to pro-rate the limited compensation fund. The minister may then authorize payments, but total awards cannot exceed $75 million unless otherwise authorized by Parliament. n United States. The United States has 109 nuclear power plants. The Price-Anderson Act in the United States limits the liability of an individual operator in the case of an "extraordinary nuclear occurence" to $200 million per r e a c t o r - - m o r e specifically the Act requires this a m o u n t of financial security in equity or i n s u r a n c e - - a n d provides for a second level of coverage in the form of retrospective liability of $75.5 million per reactor for an accident at any reactor in the United States. ~z The resulting total industry liability limit is approximately $9 billion. The liability limit for an on-site accident for an operator with 8 reactors is therefore 30 times higher in the United States than in Canada, and the industry liability limit is more than 150 times higher. In the U.S. statute, legal liability of input suppliers is not channeled to the operator as it is in Canada and other countries [Nuclear Energy Agency (1994), p. 82]. The

l°Nuclear plant operators in C a n a d a are currently organized as crown corporations. We focus, however, on the case where the o p e r a t o r is a private, cost-minimizing corporation. Even for Canada, this is not a strong restriction for several reasons: T h e incentive effects of liability insurance on precautions are the same for a private corporation as for a crown corporation; it is unclear that nuclear operators will continue to be g o v e r n m e n t corporations; and there is no basis in law for e x e m p t i n g g o v e r n m e n t corporations or agencies f r o m tort law. A n o t h e r i m p o r t a n t abstraction in o u r discussion a n d m o d e l is that we assume a single safety regulator, ignoring the fact that safety regulation a n d siting decisions, for example, may be u n d e r t a k e n by different regulatory commissions. l l T h e Act does not require such an authorization n o r does it provide any m e c h a n i s m for it. raThe $75.5 million liability would be paid over time, with a m a x i m u m of $10 million in any one year.

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required financial security of the operator, however, would be used for p a y m e n t of damages n o t covered by the assets of a supplier f o u n d legally liable for an accident.

Nuclear Accident Liability in Other Countries The law governing n u c l e a r accident liability in western Countries a n d J a p a n has historically b e e n similar to the C a n a d i a n statute, b e i n g based on or reflected in the Paris Convention signed in 1960 a n d the Vienna Convention of 1963.13 In particular, the c h a n n e l i n g of liability to the operator a n d the offsetting protection for the operator of limited liability have b e e n part of the law in other countries. More recently, however, the laws have diverged as some countries have increased or eliminated the limit on liability. Switzerland, Germany, a n d J a p a n have eliminated the statutory limit on liability of n u c l e a r operators.

Liability Insurance Coverage and the Nuclear Liability Insurance Market Currently, liability insurance in Canada is provided for the $75 million liability by a consortium of 60 insurers, the Nuclear Insurance Association of Canada (NIAC). Coverage is currently o b t a i n e d in the market for the most i m p o r t a n t types of risks ("Class A risks") but n o t for other types of risks such as personal injury other than bodily injury ("Class B risks")fl 4 These latter risks are insured by the government. The NIAC administers the g o v e r n m e n t insurance, collecting the premiums; c u r r e n t g o v e r n m e n t p r e m i u m s are less than 1% of the p r e m i u m s collected by the NIAC. An u n d e r s t a n d i n g of the n u c l e a r liability insurance market is i m p o r t a n t for our analysis. W h e n potential tort-feasors have asset values that are small relative to the size of potential liability damages, as the operator's n e t asset values would be in the event of a major n u c l e a r accident, then both the insurance a n d the incentive roles of tort law d e p e n d o n the availability of liability insurance. Nuclear liability insurance, like other forms of property-liability insurance, is reallocated o n the reinsurance market, which is world-wide. (Nuclear liability is reinsured only to other n u c l e a r pools.) T h e r e are at least 30 n u c l e a r pools established world-wide, typically on a national basis, which offer n u c l e a r liability insurance directly a n d through reinsurance: [B]ecause risk assessment, survey requirements, documentation and claims control have been centralized, the Pool offers an opportunity for smaller insurers to participate in a class of business which might not otheta~'isebe available to them... [WJell over one thousand individual insurers world-wide will participate either directly or as a reinsurer in any major nuclear risk. Every,major insurer participates in a nuclear Pool where one has been established and eveo' Pool participates in each major risk.~5 Some observers have c o m m e n t e d o n the small a m o u n t of n u c l e a r liability insurance coverage o b t a i n e d in the market relative to the potential damage from a n u c l e a r accident.~6 This has a demand-side explanation in the small limits o n liability imposed by statutes in most developed countries. Some countries have increased or removed the ~SSee Nuclear Energ3, Agency (1994), p. 3. 14The difference between personal injuries and bodily injuries is that the latter are restricted to injuries for which concrete clinical evidence exists (e.g., radiation burns) and the former includes psychological harm. ~SG.C. Warren, "Insurances for the Nuclear lndustly", May 1, 1993, evidence in E n e ~ Probe et al. v. C a n a d a (1994). Mr. Warren is the Chief of the British nuclear liability insurance pool. J%ee, for example, Tyran a n d Zweifel (1993).

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TABLE 1. Insurance for nuclear third-party liability, selected countries (millions of U.S. dollars)

Country Switzerland Germany Japan United States United Kingdom Canada Spain Italy

Operator liability

Private insurance

Gov 't insurance

Unlimited Unlimited Unlimited Limited Limited Limited Limited Limited

382 343 241 200 39 28 9 7

382 343 --397 26 427 63

l i m i t s o n liability, a n d t h i s p r o v i d e s u s w i t h e v i d e n c e o n h o w i n s u r a n c e c a p a c i t y w o u l d respond to a similar change in Canada: Switzerland is the prime example of a country which has, in fact, followed this pattern, whereby limits are up-dated in a regular assessment pattern [and now removed] and it is perhaps not surprising that this country has succeeded in attracting the highest amount of insured capacity for liability risks anywhere in the world. [Warren (1993), p. 18]. Table 1 provides a listing of the private insurance coverage available in various c o u n t r i e s . As t h i s t a b l e 17 i n d i c a t e s , t h e m a r k e t f o r liability i n s u r a n c e r e s p o n d s to t h e i n c r e a s e d d e m a n d t h a t r e s u l t s f r o m h i g h e r liability. III, The Optimality of Strict Liability

The Basic Principle T h e o p t i m a l i t y o f s t r i c t liability f o r p r o d u c e r s is well k n o w n u n d e r a h y p o t h e t i c a l s e t o f a s s u m p t i o n s . W e s u m m a r i z e t h i s b e n c h m a r k c a s e , t h e n a r g u e f o r s t r i c t liability f o r nuclear operators by considering in turn each of the main possible differences between nuclear power production and the benchmark. None of these differences justifies a d e p a r t u r e f r o m u n l i m i t e d s t r i c t liability. T h e b e n c h m a r k c a s e is t h e f o l l o w i n g . A n a g e n t p r o d u c e s a s i n g l e c o m m o d i t y , a n d i n d o i n g s o c r e a t e s a n a c c i d e n t risk. T h e p o t e n t i a l a c c i d e n t v i c t i m s a r e t h i r d p a r t i e s , i.e., not consumers of the commodity. They cannot negotiate with the producer, so that Coasian irrelevance cannot be invoked, and furthermore the victims have no role in r e d u c i n g t h e risk o r p o t e n t i a l m a g n i t u d e o f t h e a c c i d e n t . T h e p r o d u c e r h a s u n l i m i t e d

17The data in this table are from Tyran and Zwiefel (1993) and are as of June 1992, with the exception of the Canadian figure of $28 million (U.S.), which is from Warren (1993)'s figure of $39 million (Canadian). The $26 million in government insurance is the difference between the liability limit of $54 million ($75 million Canadian) and $28 million. In the event of an accident, government funds beyond those amounts listed could be available, and in some cases are explicitly provided for by statute [See Nuclear Energy Agency (1994) ]. Note that in addition to the $200 million insurance coverage, the U.S. operators of large power reactors must maintain private insurance to pro~fide funds for the second-stage retrospective liability of up to $75.5 million per reactor for an accident at any reactor in the industry. Thus, the amount of insurance coverage that is available to cover damages fi-om a single catastrophic accident is over $7 billion.

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n e t worth. Alternatively, the p r o d u c e r can p u r c h a s e liability insurance so that there is n o possibility that the p r o d u c e r is j u d g m e n t - p r o o f if assigned full liability, a n d the liability insurance m a r k e t has as m u c h i n f o r m a t i o n a b o u t care a n d risks as the producer, so that the insurance contract involves no moral hazard. Finally, the tort system does n o t involve significant transactions costs. U n d e r these assumptions, strict liability for the p r o d u c e r elicits efficient care decisions a n d efficient activity level decisions. Strict liability internalizes the costs o f the a c c i d e n t to the transaction that is g e n e r a t i n g the risk. 18 Care decisions are efficient u n d e r strict liability because the p r o d u c e r bears the full social costs a n d benefits o f increased care. T h e activity level, o r quantity o f the c o m m o d i t y purchased, is efficient because the m a r k e t price for the c o m m o d i t y reflects the full marginal social cost o f p r o d u c t i o n , i n c l u d i n g the costs o f accidents. T h e p r o d u c t is c o n s u m e d u p to the p o i n t where the marginal social value o f c o n s u m p t i o n equals the marginal social cost. A negligence rule, if feasible, c o u l d g u a r a n t e e efficient care decisions b u t would leave activity levels (the p r o d u c t i o n o f the good) too high because the m a r k e t price would n o t internalize the accident costs that r e m a i n [Shavell (1982)]. A limit on the liability o f the p r o d u c e r u n d e r strict liability in this b e n c h m a r k case leads to inefficiency in b o t h activity a n d care, as the accident costs are n o t fully internalized. Only full strict liability guarantees efficiency. Strict liability for n u c l e a r o p e r a t o r s has an established legal basis. H a z a r d o u s substances were the first "pocket" o f strict liability in Anglo-American law, u n d e r Rylands v. Fletcher. 19 Rylands v. Fletcher holds that an individual who brings to his p r o p e r t y a substance that c o u l d cause h a r m if it escapes is strictly liable for the damages caused by its escape. 2° T h e m o r e controversial issue is w h e t h e r the e x t e n t of liability s h o u l d be limited within the scope o f strict liability, a n d it is this aspect on which we focus. 21 T h e following aspects o f n u c l e a r power p r o d u c t i o n must be c o n s i d e r e d in applying this basic principle: • T h e externality in n u c l e a r power p r o d u c t i o n that c a n n o t be internalized t h r o u g h Coasian negotiations. • T h e role o f accident victims in r e d u c i n g the risk of an accident. • T h e possibility o f a second-best a r g u m e n t for subsidizing n u c l e a r energy p r o d u c t i o n , based on externalities in the p r o d u c t i o n of o t h e r forms o f energy. • T h e inefficiencies in the tort system as a vehicle for c o m p e n s a t i n g a c c i d e n t victims. • T h e intensive regulation o f safety at n u c l e a r power plants. • T h e fact that in the event o f a n u c l e a r accident, the n e t worth of an o p e r a t o r is likely

aSlt does not m a t t e r which side of the transactions bears the liability, if consumers of the p r o d u c t are fully informed. Strict liability on consumers, or shared with consumers, has the same c o n s e q u e n c e as strict liability on the producer. 19Rylands v. Fletcher (1868) L.R. 3 H.L. 330. Z°Rylands v. b~tcher has b e e n applied to water, gas a n d electricity as well as to ultra-hazardous substances [Solomon, Feldthusen, a n d Mills (3rd ed.), Cases and Materials on the Law of Torts (1991), p. 663]. 21The effiency advantages o f strict liability over negligence are particularly strong in a context such as nuclear accidents, where (1) incentives are g o v e r n e d by a m i x e d regulation-liability system in which agents, regulators, a n d courts may have different information; a n d (2) safety technology is a d v a n c e d a n d changing. U n d e r (1) those dimensions of care for which liability, as o p p o s e d to regulation, is relied u p o n to g e n e r a t e correct incentives are precisely those for which regulators' costs of m o n i t o r i n g are h i g h - - a n d therefore those for which courts' costs o f ex post assessment for the application o f a negligence rule are high. U n d e r (2), strict liability can g e n e r a t e efficient incentives for research into safety, whereas negligence-based rules may stifle this incentive because an a g e n t recognizes that the discovery of a new safety technology will raise the standard of care in the negligence rule.

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to be low, r e q u i r i n g that safety incentives o p e r a t e t h r o u g h m a n d a t o r y liability insurance. • T h e p r e s e n c e o f o t h e r producers, specifically u p s t r e a m suppliers o f services a n d c o m p o n e n t s , with potential influence over accident risk. In this section o f the p a p e r we discuss the first four o f these factors. T h e m a i n items on the list are the effect o f regulation on the optimal liability rule a n d the role of liability insurance; these we consider in Sections IV a n d V, respectively. We e x t e n d the discussion to i n c o r p o r a t e o t h e r p r o d u c e r s in o u r discussion o f c h a n n e l i n g in Section VI, a n d in the c o n c l u d i n g section we discuss the r e m a i n i n g factors.

The Externality T h e externality in the p u r c h a s e a n d sale o f n u c l e a r power is clear. W h e n an individual purchases an extra kilowatt-hour of n u c l e a r - g e n e r a t e d electricity, he or she does n o t c o n s i d e r the i m p a c t that the extra p r o d u c t i o n has on the risk o f accidents to o t h e r parties (some o f w h o m may also be p u r c h a s i n g electricity). Only if these costs are reflected in the price will they g e n e r a t e efficient n u c l e a r energy activity, a n d only if the p r o d u c e r bears the a c c i d e n t costs will the benefits of increased safety be internalized in safety decisions. 22 It may be s u p p o s e d that because most potential accident victims are also consumers o f electricity, Coasian irrelevance applies in the sense that the safety incentives are i n d e p e n d e n t o f the assignment of liability. This is incorrect. T h e i m p a c t on risk o f a c o n s u m e r ' s own p u r c h a s e is n o t b o r n e by that c o n s u m e r alone; a n d the external effects o f the marginal activity are n o t fully internalized u n d e r limited liability. T h e negotiations r e q u i r e d for the application o f the Coase t h e o r e m would require that all consumers o f power, the p r o d u c e r , a n d all potential victims o f n u c l e a r accidents negotiate collectively to d e t e r m i n e efficient safety a n d activity levels. This is impossible. In short, an externality exists that is outside the feasible control o f Coasian negotiations a n d which, therefore, can be influenced by liability rules.

The Role of Victims in Reducing the Accident Risk T h e simple m o d e l assumes that victims have n o role whatsoever in avoiding or mitigating the risk o f n u c l e a r accidents. In reality, victims can move further away from the risk. It c o u l d be argued, therefore, that some liability on accident victims is necessary to ensure m o r e efficient incentives on their part n o t to move too close to n u c l e a r plants. T h e o r y alone c a n n o t tell us where liability is most efficiently placed. O u r first response to this a r g u m e n t is simply to invoke an empirical j u d g m e n t a b o u t the technology of r e d u c i n g a c c i d e n t costs. To take a specific example, a r e d u c t i o n in the e x p e c t e d cost o f an a c c i d e n t at a reactor n e a r a city could be achieved by shutting down a reactor or by moving some of the residents o u t o f the risk zone a n d r e d u c i n g all e c o n o m i c activity a n d life in the risk zone. We assert the f o r m e r is less expensive. Chernobyl is a striking e x a m p l e o f how large the risk zone can be for a single n u c l e a r g e n e r a t i n g station; it is obvious that a p e r c e n t a g e r e d u c t i o n in p r o d u c t i o n at a single station d o m i n a t e s the same p e r c e n t a g e r e d u c t i o n in p o p u l a t i o n a n d e c o n o m i c activity

22If each c o n s u m e r bore directly the liability for m a r g i n a l a c c i d e n t costs attributable to his o r h e r own c o n s u m p t i o n , t h e n the efficient care levels could in theory be elicited, b u t this is impractical.

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in the entire risk zone. T h e implication is that liability should be p l a c e d on the n u c l e a r operator, on the basis of least-cost avoidance. T h e s e c o n d response is essentially a best-placed d e c i d e r a r g u m e n t [Calabresi a n d Hirschoff (1972)]. Mitigating risks requires investment in i n f o r m a t i o n a b o u t the risks a n d technology. Which is the m o r e efficient p a t t e r n o f such investment: research by the nuclear operator, who needs the i n f o r m a t i o n anyway because of the huge potential on-site cost of an accident, or d u p l i c a t e d investment in i n f o r m a t i o n by each potential resident o f a risk zone? Obviously, the former. Residents in n u c l e a r risk zones generally d o n o t think m u c h a b o u t n u c l e a r a c c i d e n t risk when buying homes, a n d this is rational ignorance given the small probability of an accident a n d the cost o f information. Liability should be d i r e c t e d toward the party who is best i n f o r m e d o r for w h o m the n e t social cost o f b e c o m i n g .informed is lowest.

Second-Best Considerations T h e subsidy to n u c l e a r energy that is e m b o d i e d in the NLA diverts energy c o n s u m p t i o n away from alternative sources that a~:e characterized by their own externalities, mainly pollution. We must address the a r g u m e n t that the subsidy may be efficient, r a t h e r than distortionary, because at the m a r g i n the impact o f the externalities in the p r o d u c t i o n of o t h e r energy forms is m o r e i m p o r t a n t than the small risk o f a n u c l e a r accident. We submit that second-best a r g u m e n t s such as this are p r o p e r l y i g n o r e d in the design o f incentive schemes in n u c l e a r energy. T h e only c o h e r e n t policy response to the range o f externalities in various types o f energy p r o d u c t i o n is to m a t c h externalities in each m a r k e t with policies specific to that market. T h e most efficient response to a perceived risk of a g r e e n h o u s e effect from carbon-based fuels, for example, is n o t a subsidy o n the p r o d u c t i o n o f n u c l e a r e n e r g y - - e s p e c i a l l y n o t a subsidy that, like the limit on tort liability, is h i g h e r for m o r e risky m e t h o d s o f p r o d u c t i o n of nuclear energy.

The Transaction Cost Inefficiencies of the Tort System T h e a r g u m e n t for full liability offered in this p a p e r may suggest that we are e m b r a c i n g the tort system as an ideal incentive a n d c o m p e n s a t i o n mechanism. T h e failures of the tort system on b o t h scores, however, are well d o c u m e n t e d , especially with respect to the high transactions costs involved. 23 Defenders o f limited liability for n u c l e a r accidents p o i n t to these transactions costs as a reason for n o t relying m o r e on the tort system to achieve correct safety incentives. This a r g u m e n t c o n f o u n d s two separate issues: the mechanisms for identifying a n d c o m p e n s a t i n g accident victims, a n d the liability for the damages p a i d to victims. Alternatives to the tort system for c o m p e n s a t i o n (and for dispute resolution) have b e e n p r o p o s e d a n d a d o p t e d . O n e alternative m e c h a n i s m for c o m p e n s a t i n g victims o f n u c l e a r accidents, already p r o v i d e d for in C a n a d a ' s Nuclear Liability Act (but only where liability is e x p e c t e d to e x c e e d the statutory limit), is a claims commission to decide u p o n a means of assessing claims a n d allocating compensation. T h e statute could be c h a n g e d to provide the commission with the power to act, in place of courts, before the o p e r a t o r ' s liability is exhausted. In the U n i t e d States, a Presidential Commission was a p p o i n t e d u n d e r the 1988 a m e n d m e n t s to the Price-Anderson Act to study the means of fully c o m p e n s a t i n g victims o f a catastrophic n u c l e a r accident. In its report, the

2:*See especially Priest (1987) and Trebilcock (1987).

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Commission r e c o m m e n d e d that claims be settled t h r o u g h a j u d i c i a l process, relying in p a r t on a p a n e l o f scientific advisors a n d d e s i g n e d to facilitate the quick resolution o f cases. A p p l i c a t i o n of c o m m o n law p r o c e d u r e s , the Commission believed, would result in a difficult a n d p r o t r a c t e d process with possible denial o f recovery o f damages. 24 T h e Commission r e c o m m e n d e d that the trigger for application o f its r e c o m m e n d a t i o n be a finding by the c o m p e t e n t court o f a reasonable l i k e l i h o o d o f claims e x c e e d i n g the first level o f insurance ($200 million), b u t t h e r e is no reason that the trigger could n o t be at a lower level. T h e p r o b l e m of d e t e r m i n i n g a c c i d e n t damages (for example, the probability that a n u c l e a r accident caused a particular case o f cancer) exists with or without limits on n u c l e a r o p e r a t o r liability. T h e same c o m p e n s a t i o n mechanisms are available w h e t h e r the c o m p e n s a t i o n to victims must be p a i d for by m a n d a t o r y n u c l e a r liability insurance, as we argue, or by taxpayers. T h e case for an administrative alternative to the tort system for c o m p e n s a t i n g a c c i d e n t victims does not diminish o u r a r g u m e n t s for full strict liability. T h e key to i m p r o v i n g safety incentives in n u c l e a r power p r o d u c t i o n is the internalization o f accident costs to the suppliers of nuclear power, whatever c o m p e n sation scheme is a d o p t e d .

IV. Incorporating Regulation In this section we investigate the optimality of full liability in a situation where a tort-feasor is subject to safety regulation. T h e issue is w h e t h e r the basic principle, the optimality o f full strict liability t h r o u g h the internalization of costs, extends to this context. This issue is clearly central in assessing n u c l e a r a c c i d e n t liability, inasmuch as the g e n e r a t i o n o f n u c l e a r power is r e g u l a t e d extensively. It is o f m o r e general interest as well, because most safety decisions are g o v e r n e d n o t by tort liability alone (as assumed in the s t a n d a r d law a n d economics m o d e l of liability rules) b u t also by regulation. 25 T h e starting p o i n t for assessing liability rules is the assumption or recognition that regulators c a n n o t m o n i t o r every safety-related action by the o p e r a t o r of a n u c l e a r facility. T h e r e g u l a t o r can control the initial design features of the reactor, such as the thickness a n d quality of the steel in the c o n t a i n m e n t shield, as well as o n g o i n g design modifications, the r e p l a c e m e n t of c o m p o n e n t s as the reactor ages, the frequency of testing a n d safety protocols, a n d so on; all o f the p r o d u c t i o n processes such as the h e a t t r a n s p o r t system are subject to codes r e q u i r i n g a m i n i m u m quality in material, design, manufacture, a n d installation practices. But the r e g u l a t o r c a n n o t m o n i t o r all decisions or actions of the o p e r a t o r m a n a g e m e n t a n d employees. An o p e r a t o r does n o t simply follow mechanically the r e q u i r e m e n t s of a c o m p l e t e regulatory contract, b u t instead has some discretion in investments a n d in the o p e r a t i o n of the plant. 96 Increased liability e n h a n c e s incentives in the d i m e n s i o n s that c a n n o t be regulated, or

24The findings of the Commission are summarized on pp. 85-86 of Nuclear Ener~' Agency (1994). 2~This paper considers the optimality of liability rules given regulation, but not the converse. On the issue of the optimal mix of regulation and liability, see the articles discussed in the Introduction. 26That the operator has some discretion is illustrated in the fi)llowing quote from a memo, introduced as evidence in the challenge of the NLA. This m e m o is from an engineer in the Nuclear Safety Department of Ontario Hydro to the Technical managers at Pickering and Bruce A & B (Nov. 22, 1991): "Questions have been raised [within Ontario H y d r o ] . . . as to the benefit of Safety Report updates to the stations; some people have expressed opinions that NSD has unnecessarily increased the scope of safety analysis; others have expressed opinions that NSD generates too many design changes because we retain excessive conservatism in our analyses and do not 'sharpen our pencils e n o u g h ' . . .

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for which regulatory standards are inefficiently low. T h e incentives arise first from the agent's desire to p r o t e c t a larger share o f its own assets from the risk o f an accident, a n d s e c o n d from any m o n i t o r i n g or p r e m i u m sensitivity by suppliers of liability insurance b e y o n d regulatory monitoring. We focus on the f o r m e r in this section of the paper. For some types o f care or safety requirements, there are essentially no constraints on the regulator's ability to monitor. This is particularly true for design requirements, a n d physically verifiable restrictions on the o p e r a t i o n o f plants, such as e n s u r i n g that all safety systems are operational. T h e r e g u l a t o r c a n n o t observe all types o f care, b u t some o f those that are observable are observable without error. To u n d e r s t a n d the implications o f this informational condition, suppose for simplicity it characterizes all observable care dimensions. T h a t is, suppose that the regulator's i n f o r m a t i o n on care is "zero-one," in that dimensions o f care are observed without e r r o r o r n o t at all. In this case, full liability is "strongly optimal," in that it holds whatever the strength of regulation, even if the regulation a n d limited liability t o g e t h e r i m p l e m e n t a level of safety that is too h i g h - - i n the sense that the probability of a n u c l e a r a c c i d e n t is lower than the probability that would result from m i n i m i z i n g the c o m b i n e d social costs o f the a c c i d e n t risk a n d the costs o f precaution. An increase in liability will lead to a decrease in the probability o f an a c c i d e n t f u r t h e r below the first-best, b u t will still increase social welfare. To illustrate, consider the following scenario. A single tort-feasor is investing in multiple d i m e n s i o n s o f care (X1 . . . . . Xn) that affect the probability o f an accident. T h e private cost o f an a c c i d e n t to the tort-feasor, P dollars, a n d the external cost o f an accident, E dollars, are b o t h positive. A c c i d e n t victims have no role in p r e v e n t i n g the accident, a n d the tort-feasor a n d the victims are "strangers" [Shavell (1987), p. 48]: They are u n a b l e to c o n t r a c t over the dimensions o f care. But a subset o f the d i m e n s i o n s o f care (Xj. . . . . X~) are observed by the r e g u l a t o r a n d are c o n s t r a i n e d at some e x o g e n o u s regulator), standards. T h e cost o f care is ~ Xi, a n d the probability o f an accident is p( X 1. . . . . Xn). T h e total e x p e c t e d social costs are p( X 1. . . . . X~) ( P + E) + ~ X i. T h e first-best levels o f care, (X*a. . . . . X*~) are those than minimize social costs; the resulting accident risk is p* = p(X~l . . . . . X*~). T h e tort-feasor faces legal liability L in the event o f an a c c i d e n t a n d seeks to minimize e x p e c t e d private costs plus legal liability. T h e p r o p o s i t i o n is that if the liability L is less than the external costs E, then an increase in liability is efficient in that it reduces total social costs, z7 This holds even if some o f the regulatory standards are so strict relative to (X~j, . . . . X*~) that the c u r r e n t risk o f an accident, p(X~ . . . . . Xj_~, XTj, . . . . X*~) at the privately optimal (X~ . . . . . Xj_~), is less than p*. T h e p r o p o s i t i o n follows from the fact that the tort-feasor will increase care only in those dimensions that are u n r e g u l a t e d o r for which the regulatory s t a n d a r d is less than the socially optimal care levels. E x p e n d i t u r e in each o f these care levels is welfare [S]ome commenLs are appropriate regarding the overall approach that NSD follows when updating sections of the Safety Reports. Our basic starting point is to demonstrate the adequacy of existing plant designs and operating p r o c e d u r e s . . . In the course of performing the [safety] analyses, problems arise which may appear to lead to undesirable consequences. Our first approach to resolving these issues is, generally, to refine the analysis by reducing conservatism and by developing and applying more detailed, sophisticated analysis methods. Design and operational procedure changes are, generally, considered as the means of last resort to resolve unacceptable results." (Exhibit, p. 2; Energy Probe et al. v. Canada). (Emphasis added) Z7The proof is given in the Appendix.

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improving. Expenditure in any care dimension for which regulatory standards are too strict is unaffected by the change in liability, because for the tort-feasor the marginal private benefit of increasing care in any such dimension is less than the marginal cost of care. The strong optimality of full liability depends u p o n the zero-one assumption on the regulator's monitoring of multidimensional care. 2s For some care dimensions, such as design specifications, the zero-one assumption on the regulator's information is not unrealistic. For other types of care, such as care in the operating procedures in reducing the risk and consequences of employee errors, a more realistic assumption is that the regulator observes the level of care with some error. In this case, if regulatory standards are excessive in a particular dimension, then increased liability instead of having zero effect could exacerbate the resulting inefficiency. To see this, suppose for example that the optimal level of a particular type of care, XI, is 10; that the current regulatory standard, applied with error, can be met with certainty only if the operator sets X1 = 14; and that the operator decides to set X1 = 12, balancing the costs of increased care with the benefits including the reduced chance of costly regulatory intervention. In this case, an increase in liability towards full liability will increase Xl beyond 12, resulting in even greater inefficiency in care. z9 As we show in the Appendix, however, full strict liability continues to satisfy a weaker concept of optimality: Increasing liability beyond any artificial limit, toward full liability, increases welfare given optimal or weaker than optimal regulatory standards. The imperfection in regulation as an incentive device means that greater reliance on liability is efficient. In sum, full strict liability dominates limited liability in providing efficient incentives for safety even if the existing regulatory standards are excessive in dimensions, such as the physical design requirements of the plant, that are monitored without error. In this sense the most basic principle in the economics of torts--that the assignment of a higher share of accident costs to a single tort-feasor will improve the tort-feasor's incentives to avoid the a c c i d e n t - - e x t e n d s to the case of a mixed tort-regulation incentive system. This is important, because it allows normative statements about existing liability and an optimal liability regime without an assessment of the adequacy of existing regulation. O u r conclusions in this paper are not predicated on an assumption that existing regulation is inadequate. With respect to activity levels, it might be argued that the existence of (possibly excessive) regulation breaks the link between efficiency and strict liability, because one o f the effects of costly regulation is an increase in the market price and a corresponding decrease in quantity produced. This is incorrect. Regulation raises both the market price and the marginal cost of production, but does not in itself eliminate the gap between them; the gap is caused by a liability limit. Regulation does not lead to internalization of social accident costs in market prices. The standard tort analysis carries over to our simple model of multiple care dimensions and regulation not just in the efficiency of care but also in the efficiency of activity levels.

~aWe are grateful to David F r i e d m a n for this observation. 29In this case o f noisy monitoring, the operator's choice of care is always an "interior o p t i m u m , " whereas in the case of zero-one monitoring, the choice can be d e t e r m i n e d strictly "as a c o r n e r solution" by the binding regulatory constraint and therefore be unaffected by increased liability.

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Economics of nuclear accident law V. The Role o f the Liability Insurance Market

Liability Insurance and Nuclear Safety Incentives T h e simple m o d e l of the optimality of strict liability that we reviewed in Section IV o f this p a p e r ignores a s e c o n d aspect of reality b e y o n d the intensive regulation: In the event o f a m a j o r n u c l e a r accident, the net worth o f the n u c l e a r o p e r a t o r would be small or zero even before tort liabilities are considered. 3° T h e limited liability o f the o p e r a t o r could protect it from tort liability a n d as a result prevent any e n h a n c e m e n t o f incentives for greater safety. T h e s t a n d a r d response to the j u d g m e n t - p r o o f n e s s p r o b l e m is to m a n d a t e liability insurance, as the NLA does. T h e insurance must be m a n d a t e d because de facto limited liability inhibits incentives n o t j u s t for safety b u t for the p u r c h a s e o f liability insurance. T h e basic principle o f the efficiency o f strict liability t h r o u g h the internalization o f a c c i d e n t costs extends directly to the case of m a n d a t o r y liability insurance if the insurance is for full coverage a n d liability insurers have the same i n f o r m a t i o n as operators, so that there are no m o r a l hazard or adverse selection problems. T h e accident costs are then internalized within the set o f parties to the insurance contract. 31 T h e dual assumptions that full insurance is available a n d that the insurance m a r k e t suffers no informational disadvantage to the o p e r a t o r are b o t h unrealistic. With respect to the first o f these, liability insurance is n o t available for the m a x i m u m conceivable cost of a n u c l e a r accident. But insurance in a m o u n t s many times greater than the small liability limit u n d e r the Nuclear Liability Act is available in the world market, as is evident in Table 1. 32 G o v e r n m e n t liability insurance is offered for a m o u n t s above that available from the m a r k e t in all western countries with n u c l e a r reactors, as would c o n t i n u e to be the case in o u r p r o p o s e d liability a n d insurance scheme o u t l i n e d in the c o n c l u d i n g section o f this paper. To the e x t e n t that this g o v e r n m e n t insurance can m a t c h the sensitivity of m a r k e t rates to safety innovations (for example, by linking g o v e r n m e n t rates to m a r k e t rates), care incentives are e n h a n c e d toward efficient levels, c o m p a r e d with simple limited liability. If g o v e r n m e n t p r e m i u m s were adequate, activity levels would be efficient. P r e m i u m levels are currently subsidized [Tyran a n d Zweifel (1993)], b u t even low p r e m i u m levels e n c o u r a g e m o r e efficient activity levels than the z e r o - p r e m i u m liability insurance coverage for high losses that is essentially p r o v i d e d by the Nuclear Liability Act's liability limit. With respect to the i n f o r m a t i o n a l assumptions a b o u t the liability insurance market,

"~°Ou the most important safe W margins on which operators and regulators can disagree is how long an aging plant should continue to operate. The net worth of an operator with plants nearing the mothball stage even before an accident may be small. :~We assume, in applying this principle, that the nuclear operator is cost minimizing. That is, given the feasible expenditures on safety, and corresponding insurance premiums that would be faced, the operator will choose expenditures that are offset by reductions in insurance premiums. In reality', the revenues that are received by nuclear operators are determined by rate regulation, which we do not incorporate explicitly into our models or discussion. Regulated operators are less likely to be precise cost minimizers. For our conclusions, however, it is sufficient that there be no bias in the rate-regulation process between compensation for marginal safety expenditures and compensation for insurance premiums. 32This is further supported in Canada by the fact that the Poine Lepreau station in New Brunswick, with a single reactor, is insured for $600 million for on-site damage [H6bert (1987), p. 21], This insurance is purchased from NAIC, the same group providing nuclear liability insurance.

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the basic principle that full liability is optimal carries over to the case where the m a r k e t is less than fully i n f o r m e d , in two senses (both d e v e l o p e d formally in the A p p e n d i x ) : 1.

2.

In the " h i d d e n action" m o d e l d e s c r i b e d in the previous section, full liability is o p t i m a l providing that the liability insurance m a r k e t can observe s o m e d i m e n s i o n o f care that is n o t constrained, or i n a d e q u a t e l y c o n s t r a i n e d by regulation. In this case, increased l i a b i l i t y - - b y internalizing the a c c i d e n t cost to parties to the insurance contract that specifies the a d d i t i o n a l care d i m e n s i o n - - i n c r e a s e s efficiency. W h e r e m o n i t o r i n g by the r e g u l a t o r is "zero-one," then the a r g u m e n t d e v e l o p e d in the previous section o f the p a p e r carries over: Increased liability will lead to increased efficiency in a n y d i m e n s i o n o f care if it has any effect, whatever the c u r r e n t regulatory standard. In a "hidden-information" model, n e i t h e r the r e g u l a t o r n o r the liability insurance m a r k e t have full i n f o r m a t i o n on the o p e r a t o r ' s care o r the effect o f care on a c c i d e n t risk. In .this case, providing the i n f o r m a t i o n available to the liability insurance m a r k e t is n o t r e d u n d a n t given the regulator's information, the liability insurance m a r k e t adds some efficiency in incentives b e y o n d the incentives p r o v i d e d by regulation; the highest efficiency is achieved u n d e r full strict liability.33

T h e r e q u i r e m e n t is thus that the liability insurer m o n i t o r s the safety design changes a n d o p e r a t i o n of the n u c l e a r plant, a n d that this m e c h a n i s m - - b e i n g m a r k e t - b a s e d - offers s o m e additional incentives for safety b e y o n d those e n f o r c e d by g o v e r n m e n t regulation, as well as additional financial penalties for violation o f regulatory standards. T h e assumption is n o t that the market-based m o n i t o r i n g by liability insurers will be as effective as g o v e r n m e n t regulation-based monitoring. T h e r e q u i r e d assumption is m u c h weaker: that i n f o r m a t i o n available to the insurers is n o t a subset o f i n f o r m a t i o n used efficiently by r e g u l a t o r s - - o r merely that this be a possibility. This raises the question of empirical support. If nuclear accidents were like o t h e r accidents, we could look for empirical evidence on the i m p a c t on the frequency of accidents of the m o v e m e n t to u n l i m i t e d liability in Japan, Germany, a n d Switzerland. F o r m a j o r n u c l e a r accidents, this obviously tells us nothing. T h e search for direct evidence on behavior is frustrated by the very conditions o f i n f o r m a t i o n asymmetry faced by regulators. Suppose that the hypothesis that some d i m e n s i o n s of care are u n r e g u l a t e d , b u t affected by liability, is valid. T h e d i m e n s i o n s of care that we would have to observe to test this hypothesis are exactly those that are unobservable to the regulator, a r e g u l a t o r that has an e n o r m o u s investment in inform a t i o n a b o u t safety. Direct evidence of this sort c a n n o t be uncovered. This is a f u n d a m e n t a l p r o b l e m n o t j u s t a b o u t testing the hypothesis, b u t a b o u t the b u r d e n o f p r o o f in cases such as the constitutional challenge to the N u c l e a r Liability Act in Canada. I n d i r e c t s u p p o r t can be sought by asking if liability insurance p r e m i u m s are affected in any significant way by differences in safety. Dubin a n d Rothwell (1990, p. 73) r e p o r t that The insurers adjust premiums for commercial plants so as to reflect size, location (population density and property values), and--following two years of operation-the reactor's probability of having an accident. That probability is based on plant

"~aTheliabilityinsurance market's information signal,s2, is redundant given the regulator's information signal,.~1, if se is a sufficient statistic for (sl, s2) in predicting the accident risk.

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characteristics including radiation exposure, regulatory performance, significant events, and containment integrity. D u b i n a n d Rothwell (1989, p. 205) report that the insurance p r e m i u m charged a reactor can be reduced by 20% or increased by up to 30%, based o n the safety p e r f o r m a n c e of the reactor. Warren (1993, p. 1) reports that internationally, [W]here an operator has been successfullyengaged in nuclear operations for some years, premium rates will be discounted to reflect this experience, and in the widest sense of the word, this premium range could be considered to represent safety culture. The total premium range in countries which employ these techniques could be as much as 35%, ranging from an additional loading of 10% to an eventual discount of 25%. T h e p r e m i u m s for the highest risk reactors can therefore be more than 45% higher than the p r e m i u m s of the safest reactors. O f course, the absolute size of the p r e m i u m s matters as well. In the U n i t e d States, a standard p r e m i u m for the first $160 million of liability is $1 million per reactor. In Canada, the standard p r e m i u m for the $75 million (Canadian) of liability per generating station is $75 t h o u s a n d per reactor. 34 If we used the figure of 45% (from the last paragraph) as the m a x i m u m difference in p r e m i u m s between the safest reactors a n d least safe reactors, then we would arrive at an absolute dollar difference in p r e m i u m s of 45% of $75 thousand, or only $33 t h o u s a n d per year. This represents only a trivial incentive for safety. But the issue is n o t the incentives provided by sensitivity to safety of current liability insurance premiums, which are subsidized a n d entail very small total amounts; it is the incentives that would be provided by insurance p r e m i u m s at full liability, or m u c h larger a m o u n t s of liability. If we suppose that the insurance p r e m i u m for $1 billion (U.S.) of liability would be in the order of five times the p r e m i u m in the U n i t e d States for the c u r r e n t $160 million limit, then a 45% difference in p r e m i u m s between safe a n d risky reactors would a m o u n t to a "safety-bonus" of about $2 million (U.S.) per reactor. To put the figure of $2 million U.S. in perspective, we can compare it to actual safety expenditures at a n u c l e a r plant. For the Bruce g e n e r a t i n g p l a n t n o r t h of Toronto, the average a n n u a l e x p e n d i t u r e o n major ( > $1 million) safety projects over the period 1988 to 1992 was $4.6 million (Canadian).35 The $2 million (U.S.) estimate of the safety b o n u s translates for Bruce, with 6 reactors, into a b o u t $15 million (Canadian) per y e a r - - t h r e e times the e x p e n d i t u r e on major safety projects. These n u m b e r s are crude, b u t e n o u g h to convey the basic point: The potential savings in insurance p r e m i u m s from safety are very significant relative to safety expenditures at n u c l e a r plants. A further indicator of market sensitivity to reactor safety is the variation in the U n i t e d States of b o n d ratings with the assessed safety of reactors. 36 In Canada, g o v e r n m e n t guarantees of operator debt further subsidizes the risk a n d p r o d u c t i o n at n u c l e a r plants. The impact of the Nuclear Liability Act limit on the activity level of n u c l e a r power

S4Thus an eight-reactorstation such as the Pickering,Canadastationwouldpay $600 thousand.The low Canadian premium is attributable to some extent to the significantcomponentof govermnentcoverage of the $75 million liability--privateinsurancepoliciesexclude particularrisksas discussedin SectionIII--at premiumrevenuesthat are less than 1% of the privatepremiums. "~SEvidenceoffered by Ontario Hydro in the constitutionalchallengeof the NuclearLiabilityAct in Canada. 36See"Credit Ratingsfor UtilitiesNow WeighReactor Safety",B. Paul, The Wall StreetJourna~ June 9, 1988,p. 14.

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p r o d u c t i o n may well be m o r e i m p o r t a n t than the i m p a c t on safety. T h e subsidy o n n u c l e a r energy implicit in the N u c l e a r Liability Act in C a n a d a is m u c h h i g h e r t h a n the subsidy in the Price-Anderson Act in the U n i t e d States. Because o f the "second tier" o f insurance u n d e r the Price-Anderson Act, the industry could be liable for m o r e than $6 billion in the event o f an accident. (The owner of the particular reactor destroyed would n o t be liable for m o r e than $200 million, b u t it is the industry e x p o s u r e that is reflected in the price o f the energy a n d that is t h e r e f o r e relevant for activity level considerations.) This is m o r e than 100 times the liability limit for an accident in Canada. T h e federal g o v e r n m e n t provides some part of the m a n d a t o r y liability insurance in Canada, the U n i t e d States, a n d o t h e r countries, even at the c u r r e n t small limits o f r e q u i r e d insurance (Table 1). T h e private insurance providers in Canada, for example, refuse to cover particular types of risks. Nuclear liability insurance is available in any country only in limited a m o u n t s of coverage. (That is, at given p r e m i u m levels p e r d o l l a r o f coverage, only limited a m o u n t s are available.) This p a t t e r n would n o t be observed in an "actuarially fair" insurance market, because the marginal cost of increasing insurance coverage is decreasing, b u t is inevitable in an insurance m a r k e t with aggregate "shocks" such as a n u c l e a r accident, a n d limited wealth on the part o f insurers [Winter (1994)]. National governments m e e t the shortfall in available insurance. This raises the question of w h e t h e r the g o v e r n m e n t has an e c o n o m i c role in providing liability insurance. F o r nuclear accident risks, which involve a very small probability of a very large loss, the private m a r k e t provision of this insurance involves a particular o p p o r t u n i t y cost that is large relative to the actuarial cost of the insurance. Specifically, insurers must m a i n t a i n $1 billion in equity to offer $1 billion in liability insurance. 37 T h e cost is lessened by the fact that an insurer can use the same equity to cover all reactors in the world (the chance o f two simultaneous accidents is extremely small), b u t because it is, ex ante, p r o p o r t i o n a l to the coverage or payout, a n d n o t the p r e m i u m or probability, it may be significant for the kind o f risk that we are discussing. G o v e r n m e n t provision o f insurance avoids this cost in that g o v e r n m e n t s can raise taxes ex post in the event o f an accident; b u t g o v e r n m e n t d i s p l a c e m e n t of suppliers in a private m a r k e t involves its own well-known costs. 3s We d o n o t m a k e a j u d g m e n t h e r e as to the p o r t i o n of liability insurance, if any, that should be s u p p l i e d by government. To argue for u n l i m i t e d liability, it is e n o u g h to p o i n t

aTin a perfect capital market there would be no cost of maintaining this equity, but in reality shareholders of insurance corporations bear such a transactions cost. This cost includes the double-tmxation of corporate income and agency costs. Winter (1991, 1994) analyses the implications fbr insurance markets of this opportunity cost. 3~Despite the recent experience of Lloyd's of London, it is hard to resist the suggestion that nuclear pools be organized with unlimited liability. In this method, each investor or "name" offers the commitment of a particular amount of wealth to be paid in the event of an accident; however, the wealth remains in the possession of the name (although with restrictions against conversion to illiquid form). The name is compensated with a percentage return on the net worth. This avoids almost entirely the transactions cost of maintaining net worth as in the corporate form. The current market premium to coverage ratio of about 1% should be sufficient to attract coverage even given other transactions costs. Surely investors including corporations would be willing to offer coverage to (say) 20 reactors for a 20% return (beyond what their assets are earning already). A similar form of organization is proposed by Tyran and Zweifel (1993). However, these authors focus on the disintermediation aspect of their proposed form, as a means of avoiding cartelization among intermediaries. They take no notice of the high opportunity cost of covering low-probability risks through a corporate organizational form, but instead they attribute market failure in the supply of liability insurance to a conspiracy of insurers: "[T]he insufficient amount of nuclear liability coverage provided by private insurers is not so much the consequence of problems of insurability and risk aversion on the part of companies but rather the reflection of restraints of trade due to cartelization." [Tyran and Zwiefel (1993), p. 434].

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o u t that the limit on liability in the c u r r e n t law is equivalent in its incentive effects to the provision o f liability insurance at a zero price. Whatever the inefficiencies in the gove r n m e n t d e t e r m i n a t i o n of the "correct price" for coverage, a price that h a d any rational basis at all (for example, a price that was tied to m a r k e t prices for the available private insurance, a n d based on even c r u d e estimates of the u p p e r tail of the distribution o f a c c i d e n t risks) would be an i m p r o v e m e n t . A positive price for g o v e r n m e n t - p r o v i d e d insurance for a c c i d e n t costs above market-provided levels is a m o v e m e n t away from the subsidy i n h e r e n t in the c u r r e n t limited liability law.

VI. The Channeling of Liability T h e s e c o n d m a j o r c o m p o n e n t o f statutes restricting the liability for n u c l e a r accidents is the c h a n n e l i n g o f all third-party liability from u p s t r e a m suppliers o f c o m p o n e n t s a n d services to the operator. T h e c h a n n e l i n g m a n d a t e s a transfer o f liability a m o n g parties who have a contractual relationship. Some transfer o f c o n t i n g e n t accident costs would be achieved without the NLA, t h r o u g h so-called "hold harmless" clauses in o p e r a t o r s ' contracts with suppliers. T h e policy issue is t h e r e f o r e w h e t h e r the transfer o f liability s h o u l d be m a n d a t e d or even w h e t h e r the voluntary transfer o f liability should be allowed.

Transferring Liability: The Economic Principles A n u n d e r s t a n d i n g o f the private a n d social benefits of transferring liability must start with the Coase t h e o r e m . This t h e o r e m provides conditions u n d e r which a transfer o f liability a m o n g tort-feasors o r a c c i d e n t victims is irrelevant to the allocation o f resources, in this case e x p e n d i t u r e s on safety, a n d in general is most applicable when parties a m o n g whom the liability is transferred have a contractual relationship. T h e Coase t h e o r e m in its most basic form states that if all tort-feasors affecting an a c c i d e n t risk a n d all potential victims can contract at zero cost, t h e n care a n d activity levels by all parties will be unaffected by a c h a n g e in liability rule. I g n o r i n g i n c o m e effects, there is a u n i q u e Pareto optimal pattern o f care a n d activity a m o n g all the parties a n d this p a t t e r n will be achieved by contract whatever the initial assignment o f liability for a c c i d e n t costs. Any o t h e r p a t t e r n leaves o p e n gains from recontracting. A slightly generalized version o f the Coase principle is m o r e useful for us. Suppose that only a subset o f agents can contract at zero cost, a n d that contracting with any party outside the g r o u p is impossible. Suppose further that all parties in the contracting g r o u p have u n l i m i t e d wealth (unlimited liability). T h e n any change in the initial allocation o f liability a m o n g parties in the contracting g r o u p (an allocation given by a liability rule) is irrelevant. T h a t is, any two liability rules that attach the same liability to parties outside the g r o u p a n d the same total liability' within the g r o u p in each state o f the world have the same i m p a c t o n care a n d activity levels. T h e parties within the g r o u p will contract on care a n d activity levels so as to maximize their collective wealth, a n d this is u n c h a n g e d with the c h a n g e in liability. T h e private incentive to reallocate liability can result from two factors. First, suppose that the agents within the g r o u p c a n n o t write c o m p l e t e contracts on care levels. T h e n they may reallocate liability so as to achieve a m o n g themselves privately optimal incentives for c a r e - - e s s e n t i a l l y redesigning the liability rule to serve as an incentive mechanism to achieve the g r o u p o p t i m u m . In this case, an exogenous, legal c h a n g e in liability

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assigned to m e m b e r s within the g r o u p is irrelevant when the g r o u p is allowed to "undo" the c h a n g e by reallocating liability a m o n g themselves. 39 T h e s e c o n d a n d m o r e relevant case, however, is where one m e m b e r o f the g r o u p has limited liability. By reassigning all liability to that agent, the g r o u p can minimize their collective sum o f liability costs. T h e cap on the liability to the single a g e n t b e c o m e s a cap on the total liability for the g r o u p o f contracting agents. T h e private gains to the reallocation arise because the reallocation transfers liability to accident victims. T h e social inefficiency of the voluntary transfer is obvious: In minimizing their total liability, the contracting g r o u p also minimizes the incentives for g r o u p m e m b e r s to take precautions. This p r o b l e m is well u n d e r s t o o d in the c o n t e x t o f hazardous waste d u m p s a n d the S u p e r f u n d [Menell (1991)]. T h e transfer to highly leveraged c o r p o r a t i o n s o f assets that are a t t a c h e d to potentially large stochastic liabilities causes a transfer o f accident costs to victims by tightening the limited liability constraints against collecting from torffeasors. T h e transfers are de jure transfers of assets b u t de facto transfers o f liabilities. In the c o n t e x t o f hazardous wastes, g o v e r n m e n t policy has r e s p o n d e d by restricting these attempts to minimize liability t h r o u g h transfers, a°

Application In the c o n t e x t of n u c l e a r accidents, g o v e r n m e n t policy toward transfers of liability n o t only allows b u t mandates the minimization o f liability. T h e "contracting group" in the a p p l i c a t i o n of the principles discussed above is the o p e r a t o r a n d all i n p u t suppliers. T h e conclusions based on the assumption that contracts with parties outside the g r o u p are impossible apply, despite the actual contracts with buyers of energy. As e x p l a i n e d in Section III of this p a p e r , the contracts that would be necessary to invoke the Coase t h e o r e m would require a collective, c o m p l e t e contract with all potential accident victims. T h e p o i n t is simple: T h e liability of the n u c l e a r o p e r a t o r is r e d u c e d to nearly zero relative to the potential cost o f a n u c l e a r accident. T h e c h a n n e l i n g o f all liability to the o p e r a t o r magnifies the effect of the limit by forcing the limit to apply to the totalliability o f the o p e r a t o r plus all i n p u t suppliers. T h e negative incentive effects on b o t h care a n d activity are m a g n i f i e d correspondingly. Direct evidence on the i m p a c t o n care levels o f the statutes is difficult to uncover o r even conceive of. With respect to activity levels, however, it is a c k n o w l e d g e d that the very p u r p o s e of the statutes was to e n c o u r a g e the d e v e l o p m e n t o f the nuclear industry in various countries. In Canada, for example,

:~gAlthough collective recontracting is socially efficient in the basic Coasian framework (where all relevant individuals can contract), it is not obvious w h e t h e r the voluntal~,' reallocation should be allowed w h e n only a subset of agents contract. A conjecture is that the potential for inefficiency d e p e n d s in this case on the relationship across agents between the marginal costs of r e d u c i n g the risk and the average cost of reducing the risk. Agents outside the g r o u p would like to see liability allocated to the g r o u p m e m b e r s with the lowest marginal cost, because this e n c o u r a g e s greater care. G r o u p m e m b e r s , maximizing their collective wealth, are c o n c e r n e d to some extent about eliciting h i g h e r care levels but will t e n d to allocate liability to those with the lowest average cost of achieving a given safety level. This potential conflict, however, is n o t likely to be serious, a n d in the case of unlimited liability there is not a strong basis for prohibiting voluntary transfer of liability a m o n g tort-feasors. For a discussion of the m o r e general issue of when agents should be allowed to trade as part of the design of an optimal m e c h a n i s m , see Holrnstr6m a n d Milgrom (1990). 4 ° H a n s m a n n a n d K r a a k m a n (1991) go f u r t h e r to criticize the basic limited liability protection of shareholders in a corporation as having a significant exacerbating effect on corporate tortious activity.

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Economics of nuclear accident law "The... foremost aim of the legislation was to bring greater certainty to t h e . . , civilian nuclear energy industry. By limiting liabilityto $75 million, the industry could carry on business, secure in the knowledge that it would no longer be subject to a potentially crushing liability, protracted litigation and the prohibitive costs that any kind of meaningful insurance coverage would have carried..." [H~bert (1987), p. 1].

Suppliers o f reactor c o m p o n e n t s a n d materials r e q u i r e d e x e m p t i o n from liability as a c o n d i t i o n o f supply [H6bert (1987)]. We a r g u e d above that absent the limited liability incentive to transfer liability, t h e r e is no strong reason to p r o h i b i t transfers o f liability. I n d e e d , the efficient allocation o f liability, if liability were unlimited, would be with the downstream o p e r a t o r o n the basis of the best-placed d e c i d e r principle: T h e downstream o p e r a t o r has b e t t e r i n f o r m a t i o n a b o u t the level o f a c c i d e n t risks a n d the impact on risks o f different p r o d u c t i o n decisions than any u p s t r e a m supplier, a n d is in the best position to c o o r d i n a t e - - v i a supply c o n t r a c t s - - t h e safety investments of various suppliers. W h e r e individuals have varying i n f o r m a t i o n on accident risks, liability should be assigned to the best-placed d e c i d e r [Calabresi a n d Hirshoff (1972)]. We would therefore have n o objection to the c h a n n e l i n g provision if de facto liability were unlimited. Unfortunately, defacto liability is limited even without the NLA limit, as we have seen, because of the limited wealth o f operators a n d the fact that even g o v e r n m e n t - p r o v i d e d liability insurance will n o t be unlimited. In an optimal liability regime, the c h a n n e l i n g o f liability must be linked, therefore, to a means o f p r e v e n t i n g o r m i n i m i z i n g the effect o f increased access to de jure o r de facto limited liability protection. We discuss this in the n e x t subsection o f the paper.

Optimal Liability for Suppliers of Components and Services O n the basis o f the best-placed d e c i d e r a r g u m e n t discussed above, the c h a n n e l i n g o f liability from suppliers o f c o m p o n e n t s a n d services could l e a d to efficient care if the incentives o f the o p e r a t o r were n o t m u t e d by limitations on liability, o r on wealth a n d the availability of liability insurance. The assignment o f liability to the downstream o p e r a t o r essentially delegates to the downstream o p e r a t o r the regulatory o r policy problem o f i m p r o v i n g the incentives of o t h e r firms in the p r o d u c t i o n chain. This d e l e g a t i o n is efficient u n d e r u n l i m i t e d liability because o f the low i n f o r m a t i o n a l a n d m o n i t o r i n g costs o f the o p e r a t o r - - a n advantage over regulation o f c o m p o n e n t o r service suppliers. T h e d e l e g a t i o n itself creates no additional incentive p r o b l e m s if the incentives o f the o p e r a t o r are aligned with the social interest. A block to the a l i g n m e n t of the o p e r a t o r ' s private a n d social incentives is the asset o r wealth limitation that we have discussed t h r o u g h o u t this paper. G o v e r n m e n t liability insurance would be p r o v i d e d to some e x t e n t above the a m o u n t available in the m a r k e t b u t it is unlikely to internalize fully the a c c i d e n t costs in the o p e r a t o r ' s decision. Relying on the o p e r a t o r to m o n i t o r a n d enforce the safety level o f c o m p o n e n t s a n d service levels--with the suppliers o f these c o m p o n e n t s a n d services b e i n g completely i m m u n e from o t h e r liability or direct r e g u l a t i o n - - i s therefore simply inadequate. A liability system in which the incentives of u p s t r e a m suppliers are d e t e r m i n e d only t h r o u g h their interaction with the nuclear o p e r a t o r c a n n o t deliver a d e q u a t e safety levels. We argue, therefore, that the manufacturers o f c o m p o n e n t s a n d suppliers o f service should n o t be i m m u n e from liability. Instead, they should be liable for d a m a g e s caused by nuclear accidents, u n d e r a negligence rule, with joint-and-several liability with the

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n u c l e a r operator. T h e negligence s t a n d a r d means that the c o m p o n e n t m a n u f a c t u r e r o r service p r o v i d e r would be liable for the costs of a n u c l e a r accident if it could be shown that the accident was due to negligence on the p a r t o f the m a n u f a c t u r e r or service provider. T h e attribution o f an accident to the failure o f a c o m p o n e n t would n o t imply liability if the p r o d u c t were p r o d u c e d with a c c e p t e d technology a n d inspection standards. Joint-and-several liability means as well that the liability claims in the event o f an a c c i d e n t due to the negligence of a m a n u f a c t u r e r may be split in some p r o p o r t i o n between the m a n u f a c t u r e r a n d the operator. In practice, this would likely be determ i n e d in contracts between suppliers a n d the operators. T h e "hold harmless" clauses prevalent in c u r r e n t contracts would allow suppliers to pass on liability to the o p e r a t o r , to the limit o f the o p e r a t o r ' s ability to pay in the event o f an accident. T h e retransfer o f liability to an i n p u t s u p p l i e r in the event of asset a n d insurance d e p l e t i o n would p r e v e n t the use of the c h a n n e l i n g to minimize the total liability for the g r o u p of suppliers a n d the operator. T h e retransfer would e n h a n c e the incentives for safety, b u t n o t to an excessive level of safety.

VII. Conclusion T h e theme, in o u r analysis o f n u c l e a r liability, is the robustness o f a basic principle in the economics o f tort law: T h a t limited liability leads to i n a d e q u a t e incentives for investing in safety. T h e optimality of full liability is e x t e n d e d from a t e x t b o o k case to the case of a m i x e d regulation-liability system for controlling safety incentives, in which regulation is imperfect, the a g e n t has limited wealth, a n d liability insurers have imperfect information. For some types of care, increased liability is optimal even if regulation is excessive; that is, even if increased liability reduces the risk of an a c c i d e n t f u r t h e r below the probability of an a c c i d e n t u n d e r first-best care levels. More generally, full optimality is p a r t o f an optimal regulation-liability mix. U n d e r limited liability a n d m a n d a t o r y liability insurance, strict liability represents a d e l e g a t i o n to the liability insurance m a r k e t of the control over an agent's safety investment. T h e r e g u l a t o r a n d insurance m a r k e t act as two principals in m o n i t o r i n g a n d i m p o s i n g care standards o n the agent. Liability is r e q u i r e d for efficiency unless the regulator's i n f o r m a t i o n set completely encompasses that o f the insurance m a r k e t - - t h a t is, unless that g o v e r n m e n t can replicate the m a r k e t with equal efficiency. Full liability is optimal. T h e a r g u m e n t for full liability for n u c l e a r accidents does n o t rely on an assumption that the tort system is s u p e r i o r to regulation in governing incentives. T h e issue is n o t one system versus the other. N o r does the a r g u m e n t rely on an assumption that c o m p e n s a t i n g a c c i d e n t vistims t h r o u g h the p r o c e d u r e s o f the c o m m o n law tort system would be m a n a g e a b l e in terms o f transactions costs. W h a t e v e r m e c h a n i s m is used to c o m p e n s a t e victims a n d whatever the e x t e n t of the damages b o r n e by o p e r a t o r s a n d insured against, the Costs o f identifying victims a n d assessing damages must be incurred. Germany, Switzerland, a n d J a p a n have a m e n d e d their laws to remove the statutory limits on the liability of n u c l e a r o p e r a t o r s in the event of a n u c l e a r accident. C a n a d a a n d the U n i t e d States s h o u l d follow their lead.

Appendix This A p p e n d i x elaborates on o u r analysis using several simple formal models.

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Hidden Action, Zero-One Monitoring Following the text, consider a single tort-feasor who is u n d e r t a k i n g e x p e n d i t u r e s on care o f various types. We assume only two types o f care: T h e first is privately observed by the tort-feasor; a n d the s e c o n d is c o n s t r a i n e d by the r e g u l a t o r to be at o r above some level. T h e care levels affect the probability o f an accident. We use the following notation: • T h e e x p e n d i t u r e s are (Xl, x2), a n d the liability assigned to the o p e r a t o r for an a c c i d e n t is L. • T h e probability o f an accident is p(xa, x2), which is decreasing with d i m i n i s h i n g marginal effects in each argument. T h a t is, Pi < 0 a n d Pii > 0 for each i. (Subscripts indicate derivatives.) • T h e private cost to the o p e r a t o r of an a c c i d e n t is P. T h e (external) cost o f an accident is A. • T h e cost of u n d e r t a k i n g care levels (x~, xe) is simply x 1 + x2. • T h e total social costs at (xl, x2) are S(xl, x2) = p(xl, x2) (P + A) + xl + x2. • A policy is a pair (L, 22): a liability a m o u n t a n d a regulatory limit on the observable care dimension. Given the policy (L, 22), the o p e r a t o r o r a g e n t solves min p ( x l , x 2 ) ( P + L) + x 1 + xz,

(l)

subject to ~2 ~> 22, which, assuming that the constraint is binding, is solved at the first-order c o n d i t i o n

p l ( P + L) + 1 = 0.

(2)

O n the o t h e r hand, dS/dx 1 = Pa(P + A) + 1. Using (2) shows that the marginal r e d u c t i o n in social costs at the private o p t i m u m , which equals the marginal decrease in external costs, is given by:

dS --

dxl

Jpriv.opt.

----

p l ( A - L).

(3)

Totally differentiating (2) shows that

dXl

-Pl

dL

(P + L) Pl 1

>0.

(4)

F r o m (3) a n d (4) we have

dS dS dx 1 ~ JP"iv'°pt" - ~ x 1 X - ( P +

_p2 ( A - L), L)pl,

(5)

which is positive whenever L < A, whatever the value o f 2z. In short: PROPOSITION 1: Within the "hidden action, zero-one monitoring" model: Holding regulatory standards constant, an increase in liability toward full liability leads to a reduction in the probability of an accident and an increase in efficiency--whatever the current regulatory standards.

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This paper is about optimal liability given existing regulation. As an aside, however, we consider the relationship between regulation and liability when both are used as instruments in our model. If regulatory standards are chosen optimally instead of held fixed, Proposition 1 of course continues to hold. The problem can then be rephrased as a constrained optimization with both L and the regulatory standard ½ chosen subject to (1) the incentive compatibility constraint; and (2) limited wealth, or a constraint on the a m o u n t of liability insurance. The result is then the following: PROPOSITION 2: Within this model, in an optimal mixed system of regulation and liability, the instrument of greater liability is used to the maximum degree feasible unless regulation alone can achieve the first-best. That is, if regulation is not perfect, then liability should be used as much as is feasible, up to the entire external cost. These propositions extend the standard result about the optimality of full liability. Consider, as an aside, the pattern of optimal regulation as the limit on liability changes exogenously, because of a change in the law. Suppose L < A because of wealth constraints. How will the optimal regulatory standards compare with the first-best levels of ½? The answer depends on a measure of complementarity between the observable and unobservable care dimensions: p~2. This is positive if a tighter regulatory constraint on x2 reduces the effectiveness of x 1 in reducing p. A positive value for Paz is probably realistic for the context of nuclear reactors; for example, stronger standards on containment reduce the marginal value of safe operation procedures. The optimal regulatory problem, taking L as exogenous, is described by the following: min p(xl, x 2 ) ( P + A) + Xl + x2,

(6)

X l ,.X~2

subject to the incentive compatibility constraint: Xl =

arg min p(x, x 2 ) ( P + L) + x + x 2. x

(7)

The constraint (7) can be replaced by the operator's first-order condition (2). The problem (6) then yields the following first-order conditions: p, . (P + A) + 1 + k p u ( P + L) = 0

(8)

P2" (P + A) + 1 + XP12(P+ L) -- 0

(9)

and the constraint (2). Equation (9) implies that the marginal social net cost of increasing :% which is pz • (P + A) + 1 is negative at the optimum, i.e., that x2 is less than the (conditional) first-best level: The regulator reduces x2 relative to the efficient level so as to elicit higher x I from the agent. Only when L approaches A, the full internalization case, is the regulatory standard first-best efficient. 4]

41A natural question is whether an increase in L leads to an increase or decrease in the regulatory standard of care, x2. Total differentiation of the first-order conditions for the regulator's problem and application of Cramer's rule shows that

..... [ (p-I- E)pl 2 -b (r~- L)XP, I2 -~kPl2] dx2/dL~ p H ( P + L)det (P+ L)pH -Pl J Pl2(P + L)det [ (P + E)pl 1 + (P ~- L)~.Plll

L

( P + L)Pll

-~pl21! -Pl J '

238

Economics of nuclear accident law Hidden Action and Noisy Monitoring

T h e m o d e l d e v e l o p e d above assumes that each d i m e n s i o n o f care is e i t h e r o b s e r v a b l e perfectly by the r e g u l a t o r or n o t o b s e r v a b l e at all. F o r s o m e o p e r a t o r decisions, such as the specifications o f p l a n t d e s i g n (e.g., the thickness o f the walls of the c o n t a i n m e n t facility) this is realistic. F o r o t h e r d i m e n s i o n s o f care, such as the o n g o i n g efforts at safety, this is n o t a realistic a s s u m p t i o n . This section e x t e n d s the m o d e l to the case w h e r e care is o b s e r v e d a n d r e g u l a t e d at e x o g e n o u s levels by the r e g u l a t o r , b u t the o b s e r v a t i o n is with error. As before, a s s u m e that an a c c i d e n t occurs with p r o b a b i l i t y p(X1, X 2. . . . . X,,), which is d e c r e a s i n g a n d c o n v e x in e a c h a r g u m e n t , b u t n o w o n e d i m e n s i o n o f care, XI, is o b s e r v e d with error. Specifically Y1 = Xj + ~ is observed, w h e r e ~ is a r a n d o m e r r o r with zero m e a n that is u n k n o w n by the o p e r a t o r at the tie that care decisions are taken. 42 (Assume for simplicity that all o t h e r care d i m e n s i o n s are o b s e r v e d with n o error.) R e g u l a t o r y care s t a n d a r d s m u s t be b a s e d on Y~ a n d the o t h e r care d i m e n s i o n s , a n d are set at ( Yx, X.). . . . . X~). If Y1 is f o u n d to be less t h a t I)1 ex post, t h e n the o p e r a t o r is r e q u i r e d to increase care to the j o o i n t w h e r e ]11 = Y~. T h a t is, the o p e r a t o r faces a r a n d o m care r e q u i r e m e n t 3;1 I> Y~ - ~. I n c r e a s i n g care ex post is a s s u m e d to be m o r e costly; for e x a m p l e , i n c r e a s i n g the safety o f a system a l r e a d y in place is m o r e costly t h a n i n c o r p o r a t i n g the h i g h e r safety level w h e n the system is established. T h e ex post cost o f i n c r e a s i n g care by an a m o u n t A is a s s u m e d to b e M ( A ) > A. T h e cost M( • ) is i n c r e a s i n g a n d convex. Given an e x o g e n o u s set o f r e g u l a t o r y standards, ( 1)1, )~2. . . . . )),,) a n d liability L, the o p e r a t o r ' s o p t i m a l care d e c i s i o n solves the following p r o b l e m : rain (X~,X'2 . . . . .

p ( x 1, X2. . . . .

X,,)" (P + L) + E

X,,)

i

Xi + EM(max[0, 1)1 - e - X1])

(10)

1

subject to X i >! f(i, i = 2 . . . . . n. Social costs are given by the following e x p r e s s i o n n

SC = p ( X 1, X 2 . . . . .

X,~)" ( P + A) + E

Xi + E M ( m a x [ 0 ,

Y, - ¢ - X1] )

i=l

If liability (wealth) is l i m i t e d at s o m e e x o g e n o u s level, t h e n o p t i m a l r e g u l a t i o n is d e s c r i b e d by the m i n i m i z a t i o n o f social costs, with r e s p e c t to ( 1~1, -¥2. . . . . Xn), subject to the incentive c o m p a t i b i l i t y c o n s t r a i n t that X 1 solve (10). T h e following p r o p o s i t i o n s are straightforward: PROPOSITION 3: Within the hidden action model with nozsy ^monitoring, dSC/dL is negative, evaluated at (Ya, X2 . . . . . Xn), /f~(1 is less than the optimalY1 conditional on ( X 2 , . . . , Xn), and positive otherwise. Thus, P r o p o s i t i o n 2 fails with noisy m o n i t o r i n g : A n increase in liability m a y n o w be inefficient b e c a u s e it m a y e x a c e r b a t e the inefficiency o f excessive care levels w h e n r e g u l a t i o n is too strict. (In Section I, w i t h o u t noise, care levels t h a t are r e g u l a t e d at

which cannot be signed u n d e r o u r assumptions. (With first-order conditions e n t e r i n g as constraints in agency problems, comparative statics d e p e n d on third derivatives.) 4ZObviously, the regulator knows that X 1 is nonnegative; we ignore this in the algebra.

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excessive levels are d e t e r m i n e d as " c o r n e r solutions" a n d t h e r e f o r e unaffected by increased liability.) PROPOSITION 4: Social effi~ciency, if it is unconstrained by an), de facto limit on liability, is

achieved with L = A and Y~ = O. This internalizes the social cost minimization prob~m. Hidden Information and Liability Insurance T h e two m o d e l s d e v e l o p e d to this p o i n t allow explicitly for limited liability. T h e m o d e l s do allow the i n t e r p r e t a t i o n that there is limited liability t o g e t h e r with full liability insurance a n d the insurance m a r k e t is n o t subject to asymmetric information. (The a g e n t in these models can be i n t e r p r e t e d as the o p e r a t o r plus the liability insurer.) T h e assumption that liability insurance markets suffer from no informational problems, however, is a tenuous basis for conclusion that full liability is optimal, because it ignores potentially i m p o r t a n t imperfections in the liability/liability insurance m e c h a n i s m for g e n e r a t i n g safety incentives. We show in this final section that the conclusion does n o t rely o n liability insurers b e i n g fuUy informed, b u t rather that the insurers have some i n f o r m a t i o n that is n o t c o n t a i n e d in the i n f o r m a t i o n available to the regulator. T h a t is, it is e n o u g h that insurers have something to a d d in assessing risks. T h e assessment of risks is a basic function o f insurance markets. If g o v e r n m e n t regulation could duplicate in e v e ~ way the i n f o r m a t i o n assessment a n d m o n i t o r i n g available in liability insurance markets, then of course regulation alone could n o t be i m p r o v e d on. We take as an assumption that it cannot. T h e h i d d e n i n f o r m a t i o n m o d e l starts with an assumption that the probability of an a c c i d e n t is a function p(X, 0) o f the (observable) care of the agent, X, which we take now to be o n e dimensional, as well as an unobselwable characteristic, 0. T h e external cost o f the a c c i d e n t is still A. A liability rule specifies the liability, L, that the a g e n t must pay in the event of an accident, a n d this liability is fully insured t h r o u g h m a n d a t o r y liability insurance. We assume for simplicity than all private costs must also be insured; the case where some of the agent's own wealth is at stake is realistic; b u t we abstract from this source of incentives to focus on the relative voles played by regulation a n d mandatory insurance. T h e marginal social value of increased care, - o p ( X , O)/OX" (P + A) - 1, is assumed to be increasing in 0. T h e r e g u l a t o r a n d the liability insurance m a r k e t each receive a signal a b o u t 0. These signals, s I a n d sz, respectively, are imperfectly c o r r e l a t e d with 0. We assume that (s 1, sz, 0) are all real-valued. We d e n o t e the j o i n t distribution of the r a n d o m variables as f(s l, s2, 0) a n d the c o n d i t i o n a l distributions as h(s~, 0]sj), h(0]#), h(si]sj), a n d h(Ots~, Sj). A h i g h e r value of si is a signal of h i g h e r 0 in the sense of an increasing l i k e l i h o o d ratio: for s'j > s~, h(O]s'~)/h(OIs,) is increasing in 0. Similarly, h(01s'~, s)/h(O[s~, s) is increasing in 0, a n d h(sits'i)/h(si]s,) is increasing in sj. T h e liability rule, L, is set before the regulator's signal, i.e., it must be c o m m o n to all risk types. Then, simultaneously, the r e g u l a t o r sets a m i n i m u m care s t a n d a r d o f X1, a n d the competitive liability' insurers offer a contract that specifies the p r e m i u m as well as a care level X~. T h e contract struck in the liability insurance m a r k e t will be the contract that elicits the privately efficient care (which d e p e n d s on L), conditional u p o n the beliefs o f the m a r k e t a n d the knowledge that the r e g u l a t o r is also setting a m i n i m u m

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care requirement. 4z Once the care requirements are determined, the operator sets X to satisfy both constraints, i.e., the operator sets X = max(3) 1, J(2). The game is one in which two principals impose care levels on a single agent, with the first principal maximizing social welfare and the second principal's objective determined by L. The assumption that the regulator's care requirements and the liability insurance contract are struck simultaneously captures the reality that regulation is not a commitment, taken before insurance contracting and information assessment; nor is the converse true. O n e interpretation of the informational assumptions is that the regulator and the liability insurance market each monitor and observe the operator's "true" care level with error, and the two observation errors differ. The assumption that the two principals cannot simply share information, which they have an incentive to share, is unusual in mechanism-design models. 44 It is intended to reflect the reality that both information-gathering institutions are complex; and that perfect, o n g o i n g sharing of all information is simply not feasible. This is "information-impactedness," in Oliver Williamson's (1985) terminology.

Equilibrium. The beliefs on the part of the regulator and the liability insurance market are Bayesian, i.e., rational, and the equilibrium concept invoked is a Bayesian Nash Equilibrium. The strategy on the part of each principal is a function Xi(si). An equilibrium is a pair of functions [ X~x(Sl), X~I(sl) ] solving the following two equations: X~(Sl)=argminff p(max[Xl(sl)'~(s2)'O])(P+A)xl(s, ) + max[X,(sl),

~2(s2)]h(s 2, olsa)ds2dO

(1 1)

X*z(Sz)=argminff p(max[X*l(sl)'X2(sz)]'O)(P+L)x.~(s2) Xz(s2)]h(Sl, Olsz)dsadO (12) A b e n c h m a r k in describing the equilibrium care levels is f(i(si), defined as the care requirement that principal i would set as a singleprincipal, acting on the basis of the one + max[X]l(sl),

signal si.

Welfare Optima. Three concepts of efficiency or optimality are required for the statem e n t of our results: 1.

The first-best efficient choice of care levels, conditional u p o n the full set of information received by both principals, solves the following problem

4SThe o p e r a t o r chooses an i n s u r a n c e contract that m i n i m i z e s the s u m o f the i n s u r a n c e p r e m i u m a n d the care e x p e n d i t u r e ; because the m a r k e t is competitive, this contract m i n i m i z e s the s u m o f e x p e c t e d liability a n d the care e x p e n d i t u r e . U n d e r o u r a s s u m p t i o n o f full i n s u r a n c e f o r accident costs, the o p e r a t o r ' s p r e f e r e n c e s over contracts d o n o t d e p e n d on its private i n f o r m a t i o n a b o u t risks. This allows us to focus on the interaction between the regulator a n d the liability i n s u r a n c e m a r k e t as two principals. 44In the m e c h a n i s m - d e s i g n literature, e c o n o m i c agents typically have perfect ability to s e n d messages back a n d forth with perfect accuracy a n d at zero cost.

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X**(s,,sz)=argminfffp(Xl(Sl, S2),O)(P+a)~:~,~ + XI(sl, s2)f(s 1, s2, O)dslds2dO. 2.

3.

(13)

O n e can define as well the constrained efficient choice o f care levels as those that solve (13) within the set (X(sa, s2)lX(sl, s2) = max[Xa(sa), Xz(s2)] for some functions Xl(Sa), Xz(sz) ), D e n o t e the o p t i m u m such functions as (X'I (Sl), X~(s2) ). In the c o n s t r a i n e d m a x i m u m , the p l a n n e r is f o r c e d to choose a rule of the form indicated. Clearly, the c o m b i n e d regulation-liability m e c h a n i s m c a n n o t d o b e t t e r t h a n the c o n s t r a i n e d o p t i m u m a n d can achieve this constrained o p t i m u m if (X~(sl), X'2(s2) ) can be i n d u c e d as an equilibrium. Finally, the efficient choice of L minimizes

fff p(max[(2~(sl),

Xz(s2), 0])a + max[(?)l(S~),

f(2(s2)]J(sa,s2, O)dslds2dO

subject to the two incentive compatibility conditions (11) a n d (12). PROPOSITION 5: In the hidden information model, regulation alone can achieve constrained efficiency if and only if s~ is a sufficient statistic for s 2. Otherwise:

1. 2.

the optimal liability is L = A; and the constrained efficient expected social costs are higher than the first-best level unless s~ or s z is superfluous in (13).

T h e n e x t p r o p o s i t i o n shows that the equilibrium choice of X i d e p e n d s on the informativeness o f si relative to sj, j • i. PROPOSITION 6: Suppose that L = A. U n d o the assumptions of the hidden information model, if si is a sufficient statisticforsj, then in equilibrium Xi(si) = Xi(si) and )~j (sj) = 0. I f both signals are informative (neither is a sufficient statistic for the other) then each Xi(si) E (0, Xi (si)). Proposition 5 is intuitive. T h e care levels are b e i n g set by two principals, one of w h o m has as an objective the minimization o f social costs. Social costs are m i n i m i z e d by e n s u r i n g that the o t h e r principal, the liability insurance market, also has the social objective. This is achieved t h r o u g h the full internalization o f costs. T h e two incentive systems working t o g e t h e r d o n o t do as well as a single principal with full information, however, unless o n e o f the systems is fully informed. Proposition 6 characterizes the behavior of two principals acting to maximize the same objective, with different information. If one o f t h e m has full i n f o r m a t i o n (a sufficient statistic for all i n f o r m a t i o n ) , t h e n that one principal ignores the other, who in any case prefers to d r o p o u t o f the picture by setting a constraint that will never be binding. If n e i t h e r principal has full information, each "hedges" against the possibility that its i n f o r m a t i o n is wrong by a d o p t i n g a m o r e conservative constraint than would be optimal c o n d i t i o n a l on its signal alone. We c o n c l u d e by outlining the proofs o f Propositions 5 a n d 6. T h e first s t a t e m e n t of Proposition 5 follows from the facts that when s I is a sufficient statistic for sz, t h e n the solution X** in (13) d e p e n d s on s I alone; a n d that when X~2(s2) in (11) is set equal to 0 the objectives (13) a n d (11) t h e n coincide. S t a t e m e n t (1) in the p r o p o s i t i o n follows from the observation that when L is set to A, the equilibrium i m p l e m e n t s the constrained o p t i m u m , a n d that any o t h e r level o f liability i m p l e m e n t s an e q u i l i b r i u m

Economics of nuclear accident law

242

allocation that satisfies the feasibility condition within the definition of the constrained optimum. Part (2) of the proposition is obvious. To prove Proposition 6, let G(X, 0) =- p(X, 0) (P + A) + X. From the symmetry of the objective flmctions (1 l) and (12) when L = A, it suffices to show that (for any fixed sl),

arg min ffxl

G(max[Xl,

< arg rain XI

X*2(s2)],O)h(s2,01Sl)ds,2dO

(G(X), O)h(O]sl)dO. J

(14)

Let the optimum on the left- and right-hand sides of (14) be )(~ and )(~, respectively. To characterize the optimum )(~', let ~2 be defined by X~(~) = X'~-.From the optimality of X~(sz) we can show that ~*(s2) < 2{" for all s, ~ [0, s~z]. Therefore, ~'~ must satisfy

f ff

OOX1G(X~,

O)h(s>

O]sl)ds2dO=O

(15)

since it is only when s2 E [0, s2] that a marginal change in X~ has any effect. X-~¢satisfies the first-order condition f O/3X 1 G(XI, ^ i~ O)h(O[Sl)dO = 0, which can be written f£~

0__0 G(.~¢ ' O)h(s,~,

Ols,)ds.,dO =

O.

(16)

OX 1

Using h(s2, 0Is1) = h(01s 1, s~) • h(s21sl) these two first-order conditions can be written as the following two equations

f[~[fO__ax, [f

(~(2~, 0 )h(ol s,,

s,~)dO]h(s2lsl)ds20=

(17)

O G(f(~¢, O)h(O[s,,

(18)

We have assumed that O/OX G(X, 0) is an increasing function of 0 and that h(0ISl, s~) is (likelihood-ratio-) increasing in s2; these imply that the inner integral is an increasing function of s2. The assumption that h(s21sl) is likelihood-ratio-increasing in h then tmphes that the left-hand stde of (17) as smaller, maluated at X I.l : Xl, than the left-hand side of (18). The proposition follows from this comparison and the secondorder condition for the minimization on the right-hand side of (14), which is guaranteed by the convexity of p(X, 0). .

.

.

.

T

~

i)-R

References

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