Markets and climate change

Hurricane Sandy, 
NASA satellite image Oct 28 2012

Whether they admit it or not (and none do), insurance companies are factoring climate change into their predictive models and in turn into the design and pricing of their products. Even though they may profess to being agnostic as to the underlying cause, by extrapolating the increasing frequency of events like hurricane Sandy, the effect on their products is the same whether they attribute the change in weather patterns to global warming or not. This should be good news for the green movement, since the rising cost of insurance, particularity in areas increasingly at risk from rising sea levels and more frequent 'extreme weather events', will indirectly create political pressure for a change in policy towards carbon emission.

However, such optimism may be misplaced. Rather than raise rates generally, or for those most at risk from extreme weather events, insurers are simply excluding these climate change related risks from their policies. Take flood insurance; as the insurance market moves out of insuring those at risk of flooding, the government (at the behest of those at risk it should be noted) is forced to step in. The result is two fold. First, risk is miss-priced since correctly pricing the risk would be political unacceptable. Consequently, it leads to redistribution of wealth (Rush and co. please take note) from those living outside at risk areas to those living in them. I'm subsidizing those who choose to live in low lying areas. The provision of government flood insurance creates moral hazard by encouraging risky behaviour (living on the coast) at a cost below the cost of the associated risk.

Second, in addressing symptom and not the cause, government is now cast as delinquent and unresponsive to the people if it tries to withdraw this subsidy. To those who suggest that markets are the solution to all ills, this clearly illustrates that they are not; market failure, the unwillingness of free market actors to provide products that people want, creates the need for governments to act. The tragedy here is that government's response is incorrectly targeted and ill-conceived.

The consequences are first that nothing is being done to stem the rising tide (literally), and second that pressure will mount on government to do things that are counter productive (wealth transfer and moral hazard), while reducing the pressure to address the real problem.