The Economics of Climate Adaptation (ECA) Working Group has published a report titled “shaping climate resilient development“.  It is an excellent report and focussed around a series of case studies.  It proposes that decisions on which of the many adaptation options to adopt should be taken using detailed cost benefit calculations.  A sensible suggestion at face value; but there are problems which I’ll describe below.
 
Before I do,  I wanted to note that the report itself considers some of these issues though not quite the way Im describing it below.
 
Lets consider why people buy insurance.  From a cost benefit point of view its an odd product.  How many other products do you pay money for something you expect to be less valuable than the price?
 
It comes down to the word “expect”.  In the context of cost benefit analysis, you compare the expected cost with expected benefits.  The argument is that you chose the option where expected benefits outweigh costs.  So that means you should not choose insurance, right? 
 
We’ll no, probably not.  People buy insurance to protect against extremes.  They are willing to pay more than their expected benefits because, just occaisionally they’ll receive much more back than they put in.
 
Mathematically, the way round this is to introduce the concept of “utility“,  this is just a obscure way of saying “happiness”.  We shouldn’t be trying to maximise expected benefits but to maximise utility.  To aim to be “happier”.
 
This is why insurance works.  An insurer is happier selling you an insurance policy, because, by the law of averages (and providing premiums are based on the level of risk), we expect to make a profit; but simultaneously the policyholder is happier buying it, because they prefer a small guaranteed loss (the premium) against an uncertain very large loss that may lead to financial ruin.
 
Its a classic, win-win.
 
So I like the ECA’s new report; and it does indeed discuss the case for insurance  – but I’d have preferred a more direct discussion of utility.  Cost benefit may not be the best way to consider adaptation;  concepts such as “resilience”,  “no regrets” and “utility maximising” may be far more relevent.   A robust policy in the face of great uncertainty may be far better than an “optimal” one.  Because to truly optimise things you need to be really sure of your facts – and with climate risk we just aren’t.
 
Nevertheless I commend the report to you – it’s case studies are very interesting.

This entry was posted by Trevor Maynard on Monday, December 21st, 2009 at 9:19 am and is filed under Exposure Management.