Climate Change: Policy Problem or Natural Fact?

Thursday, May 30, 2013

Confronted with social problems, we often call for policy solutions. Problems are not always problems, however. Sometimes they are natural facts, and resistant to human made laws.

The case of sex discrimination is illustrative. According to the economist Victor Fuchs, “substantial gender inequality” persists after decades of “major antidiscrimination legislation” and “massive social change.”

Fuchs offered this observation almost 25 years ago, suggesting that the subject of his study is especially resistant to policy solutions. In a recent peer reviewed article, I asked how much of this persistence might be explained by biological forces. This study suggests that a consequential proportion of male-female differences in winning promotions can be rationalized by a sex difference in risk taking. The article does not dismiss discrimination. Rather, it highlights how even well intentioned policies can constrain economic opportunity when they try to change laws that may be more firmly grounded in nature than human-made institutions.

Conversations about whether climate variation is increasing may be ignoring a related conundrum. In his recent book, the Nobel Prize winning physicist Robert Laughlin argued that it doesn't matter whether we exhaust carbon-based fuels over 50 or 500 years when considered in terms of geologic time. Any such period, according to Laughlin, constitutes “the bat of an eyelash as far as the earth is concerned.”

Scientific studies by Laughlin and others suggest that environmental benefits from clean energy policies are much smaller than is frequently assumed. In these models, rather than being a problem that human-made laws might solve, climate change is largely a fact of economic and natural laws. Laughlin observes that, “the earth doesn’t care about any of these governments or their legislation.”

Facts do not bend to policy. When policies nevertheless try, they create considerable risks for social welfare. And when those risks are realized, winners of a negative sum proposition can double down on impotent solutions. The politics of clean energy may be producing more votes than value, damaging both the economy and environment by diverting scarce resources to unsustainable activities.

Markets can do better. According to David Riker, founder of the New York-based Storm Exchange Inc., when “volatility is the issue, nothing is better than financial markets at valuing the risk and spreading it out.” Insurance markets, for example, can diversify exposures to climate variability while encouraging people to move out of harm’s way in an economical manner. In both cases, insurance can help us adapt to a planet that may have a climate mind of its own.

Dynamic insurance markets spark innovation in how we manage climate variability. For example, WeatherFlow Inc. blanketed the hurricane prone southeast with durable private weather stations, and now collaborates with Risk Management Solutions (RMS) to turn data from these stations into a new type of catastrophe or “cat” bond.

Unlike conventional insurance policies, which can require a time-consuming and sometimes contentious damage assessments before relief payments are made, these bonds make payments as soon as wind velocity reaches a mutually agreed upon and easily verified speed. According to WeatherFlow and RMS, the “insured is paid days after the event rather than waiting for months to settle a claim.”

Other financial markets can offer similar benefits. Temperature is not the only source of climate variability. Changes in when, where, and how much rain falls, for example, are also important. Chicago’s CME Group helps businesses in the agricultural, travel, and other sectors trade their exposures to such variance. It does so by bringing counterparties to the table that are less directly exposed and thus better able to diversify the variance. The resulting efficiency gains benefit the market maker as well as parties to the exchange.

To the extent that “the earth really doesn’t care” about policies to advance clean energy, our climate variation “problem” may instead be a fact. Productively managing variability, whether in nature or business, is important for creating economic opportunity. Financial services like insurance can go far in helping us succeed on this important margin. And since a growing economy demands conservation in the sense that we make more with less, an efficiency-enhancing financial market approach to climate variability can also improve environmental quality.

(Photo Credit: Gerlinde Photography - Michael Hopkins)

Through 20 years of experience in business, policy, and academic research and teaching, Dino Falaschetti (PhD, MBA, CPA) managed Fortune 100 audit-engagements and corporate finance operations, created insightful business analytics and litigation support strategies, and helped develop productive policies for the White House and state legislatures...
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