Managing catastrophic risks and climate change

By Graciela Chichilnisky
March 18, 2010

Graciela Chichilnisky-Graciela Chichilnisky is the Architect of the Carbon Market of the Kyoto Protocol and the author of ‘Saving Kyoto‘, New Holland Publishers, UK, 2009.  Chichilnisky is a Professor of Mathematics and Economics at Columbia University in New York, Director of Columbia Consortium for Risk Management and Managing Director of Global Thermostat Inc. The opinions expressed are her own.-

We live surrounded by uncertainty. Tsunamis, the eruption of super- volcanoes, violent floods and storms, asteroid impacts that eliminate entire species as the dinosaurs that went extinct 60 millions years ago, the recent 8.8 earthquake in Chile, not to mention the global financial crisis.  Some disasters are worse than others, but they all have one thing in common. They are catastrophic risks.    This means risks that occur very rarely – but when they happen they have truly major consequences.

How should we prepare for the unknown catastrophe – how should we manage catastrophic risks?

In our daily lives we tend to weigh risks by their probability of occurrence. In this view, a 10 percent risk of losing your home is half as important as a 20 percent risk.  This approach is reasonable and prudent and it is how bankers evaluate financial risk of a non-performing mortgage and how the U.S. Congress evaluates budget risks. It is a simple and reasonable approach that was first conceptualized by John Von Neumann as he developed the foundations of risk management that rules our lives today.

But it is the wrong way to evaluate and manage catastrophic risk.

A catastrophic risk is so rare that it can be badly underestimated when we weight the losses by its probability. The global financial crisis of 2009 was one in a 100-year event, and we ignored it because it is so infrequent.  This is a bad mistake, since preparing for a catastrophe can prevent the worst from happening.

New Orleans is a painful reminder of this. Chile’s recent earthquake led to less fatalities than Haiti’s even if it was much more powerful – because the Chileans were well prepared. Preparing for the inevitable financial crisis as it was coming could have spared many people the loss of their homes and the many financial bankruptcies that rocked the world’s financial systems.

So, how to manage catastrophic risks? Here is how. Do not weigh the event by the probability of its occurrence. Consider the worst case scenario and protect against it. The decision of how much to spend should be weighed of course by other considerations – since we all operate within budgets -  but knowing for a fact the frequency of the event and discounting for it is the wrong approach.

Take the case of global warming. The entire world seems stuck in trying to decide the un-decidable – is global warming going to happen, yes or no?

This is the wrong question.

Of course it is worth finding out, if possible, whether climate change is happening. Scientists are doing this right now and we should make every effort to elucidate the question fairly and openly.  But it may be impossible to do so right now since the science is very new. In any case, it does not matter. This is the wrong question for managing the potentially catastrophic risks of climate change.

Everybody I know insures their home against fire, and in fact accident insurance is mandatory for drivers. Yet the probability that one’s home goes up in fire in the near future is rather low – less than one percent in most cases. This is significantly lower than the probability of catastrophic climate change.

Yet everybody buys fire insurance for their homes, a costly form of insurance that bank mortgages require. According to people in the most sceptical nation – the USA – the probability that humans are inducing climate change is almost 25 percent.  We seem to be stuck in requiring a majority to be convinced before we act.

Yet with a 25 percent change of a home fire it would be considered irresponsible and antisocial not to buy fire insurance.

For the same reason we must insure against climate change, and it is irresponsible and antisocial not to do so. Why are we not doing so? Because we underestimate rare events, that’s why.

Of course, the question is cost. How much does it cost to insure against climate change? This is an important question that has been considered by many, and the answer seems to be between one percent and 2.5 percent of the value of the asset – the world economy.

This compares very favourably with the premium we pay for catastrophic risk insurance of homes and buildings – as shown in the book Saving Kyoto I co-authored with Sheeran Kristen.

The issue requires clarification, because with the carbon market that the author created within the Kyoto Protocol in 1997 – international law since 2005 – the net cost to the global economy of protecting against climate change is zero. Some lose and some gain but the net cost is zero.  Since protection against climate change takes the form of investment on renewable energy – which is desirable for other unrelated reasons such as energy security – protecting against climate change today is an obvious solution that cries for action.

This blog can provide step by step solutions to achieve this goal, while helping economic development in the world economy and decreasing the wealth gap between industrialized and poor nations – a win-win solution all around

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