Harvey and Irma Could Have a Silver Lining
Since hurricanes Harvey and Irma have unleashed their wrath on the U.S. – 2 ‘thousand year’ and $100+ billion in damage events in one month – the battle lines that have been drawn between climate change believers and deniers could not be more distinct. Irma has literally brought climate change to doorstep of President Trump’s Winter White House. As is often the case, it takes a calamity in a center of power and influence (Miami or Houston versus the Maldives) to focus attention on an issue that millions of people around the world live with on a daily basis. Just as it took about 30 years to move Corporate Social Responsibility from a ‘nice to have’ to a ‘need to have’ in business, being ‘green’ and environmentally conscious is on a similar trajectory. The world’s ability to tackle climate change is the tragedy of the commons of our times and perhaps the greatest risk we have ever faced – and our greatest risk management failure.
Climate change was once managed as an ‘externality’ by risk managers and quants – one so big that they could not conceivably factor it into their pricing models or risk hedging strategies. Today, climate change and the urgent need to find solutions to it, is no longer being treated as an externality, but rather something for which organizations and countries must be prepared. Global leadership, consensus, and above all agility are needed to begin arresting the rate of climate change and improving global resilience to it. For sensible solutions to emerge from governments around the world, the economic costs of climate risks can no longer be ‘transferred’ away by government subsidies and national catastrophe insurance programs that amplify moral hazard – which is risk taking without risk bearing.
A broad commitment among the world’s governments and businesses to quickly raise and diversify spending on research and development on energy technologies is urgently needed. While this would clearly be costly, it is important to remember three things. First, spending to reduce grave risks is reasonable and more cost effective than the alternative. Second, some current climate policies cost a lot more than would a greatly expanded research effort. Third, battling climate change can actually raise money, the best example being well-designed carbon prices, which can boost green power, encourage energy saving, and suppress the burning of fossil fuels more efficiently than subsidies for renewables. The real opportunity cost is for business leaders not to seize this moment. A growing group of entrepreneurs, with Elon Musk being the most notable example, are waking up to this opportunity by creating a breed of Climate Robber Barons.
The first step toward financially de-risking the impacts of climate change on advanced economies is to change the economics. Shared government-sponsored risk pools, such as flood insurance, mis-price these increasingly commonplace catastrophes. The result is that there is little innovation in making human habitation more resilient (where financial wherewithal is not a limitation) while at the same time moving further inland from flood-prone areas. So much of humanity lives near major waterways, oceans and shorelines that they enhance our collective vulnerability. In advanced economies, while government subsidized catastrophe insurance programs help to ease the financial consequences relatively quickly, they also stem the tide of innovation and climate adaptation that could have started when the first flood programs where created in the U.S. in 1968. Similarly, allocating tax dollars to rebuilding flood damaged areas takes financial resources away from tax payers who do not live in such areas, but must in essence subsidize those who do.
During a time when the U.S. economy was largely driven by agriculture and interstate trade through waterways, and there was no extensive transportation alternative by rail or road, the need to be near major bodies of water and flood zones was an economic imperative. Today, however, with an economy that is highly diversified, coupled with multiple modes of commercial transport and global trade, the economic need to be a riparian society is no longer essential.
Similarly, subsidies in wind storm insurance, which would contemplate hurricanes, severe storms and tornadoes, have debased advancements in more wind-resistant or wind-proof housing. The toll from these programs, which year after year and calamity after calamity, have rebuilt homes back to their prior state, mostly of “brick and stick” construction demonstrate another moral hazard. The principle of indemnity in insurance holds that claimants cannot profit from a loss, thus getting the same asset they lost, if the asset was adequately insured in the first place.This naturally begs the question, how long before the next insurance claim is filed by the same claimant in the same home? It also challenges the prudence of continuing to build in disaster-prone areas.
At a minimum, public buildings in Tornado Alley should be mandated per the construction code to have protected basements or safe rooms sufficient to shelter the building’s occupants (this would imply a complex if impossible retrofitting process for existing structures). That there has been little financial incentive to adapt building standards to predictable natural risks is partly driven by the moral hazard created by state-sponsored programs, and the general theme in insurance that merely makes insureds whole again. This gap in building adaptation is also partly driven by the fact that when much of the building and infrastructure stock was developed – the Oroville Dam provides a stark example – large scale or heavily localized climate risks were not in the realm of possibility.
If the U.S. does not take a leadership position in confronting the impacts of climate risk at home, global admonishments about reducing emissions and protecting natural resources will continue to fall on deaf ears. Just as Tornado Alley goes through a predictable annual drama of destruction and reconstruction, Florida and Gulf States undergo a similar repetitive annual drama, made all the more extreme by record-breaking storms like Harvey and Irma. Here too, miscalculating not only the effects but the reconstruction costs following a storm, hurricane or flood, continue to plague the region.
During Hurricane Katrina, the entire city, state, regional and Federal response apparatus froze in the face of what was an entirely predictable calamity. Government agencies did not freeze for lack of resources or knowledge of what to do and how to respond; they froze for the lack of risk agility and the capability to act with the type of speed this era requires. Part of the failure to act is that the system, much like public bailouts of banks, is ‘internalizing’ the consequences of external events. Clearly, there needs to be a model in which aid and disaster relief works with speed – thus the reason to protect organizations like FEMA and its global counterparts. However, reducing moral hazard requires that the price of risk and its consequences are borne by those who create or take the risk in the first place. In this case, climate change is being produced and accelerated by advanced markets. Now advanced markets are beginning to feel the consequences.
Climate change resilience goes far beyond how we get around over long distances and whether we evolve from the internal combustion engine, which seems all but inevitable (albeit a little too late) as countries, including France and China, weigh deisel and petrol vehicle bans. It also includes our financial readiness and the penetration of insurance and other hedging mechanisms, such as insurance-linked securities.
Lloyd’s research shows that a 1% rise in insurance penetration translates into a 22% decrease in the burden shouldered by tax payers following a large loss. While some classes of insurance are more ubiquitous than gravity in advanced economies, underdeveloped or non-existent insurance markets in developing countries greatly hampers post-disaster recovery efforts. Moreover, the lack of insurance penetration across all categories of coverage provides no financial backstop as families that grapple with losing economic breadwinners inevitably slide into hardship or poverty. Increasing insurance penetration, from property programs to life and health cannot only more accurately price climate risk, it can also help shore up redevelopment and individual household resilience.
Financing climate change and natural disasters through a broad-based approach can help improve pre-crisis readiness and post-crisis reconstruction. No matter how innovative pure claims-based solutions are, there is no climate risk management substitute to stopping the accident in the first place. To do this, leveraging financial markets to change behavior through incentives and penalties can have a positive impact on the worst performing advanced market consumers. Globally the disequilibrium of impacts from climate change weigh heavily against underdeveloped countries. Calibrating this imbalance through public-private approaches will help stem the tide of forced migration, terrorism and other global threats in the era of man-made risks.
The message of Harvey and Irma are clear: we no longer have the luxury of waiting to get ahead of climate change. If these storms serve to move climate change to the front of the legislative agenda, there may have been a silver lining to all the damage and misery they have wrought. With this wake-up call, perhaps the U.S. seat at the global climate change table will not remain unoccupied and vital agencies like FEMA will not rely on 11th hour credit lines from Congress to carry out their disaster recovery work.