Rethinking the economics of extreme events

by
Marc Lee
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Review of Worst-Case Economics: Extreme Events in Climate and Finance by Frank Ackerman

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Long ago economics was termed “the dismal science,” but in recent years that title has arguably been passed on to climate science, with its regular and dire warnings that humanity needs to rapidly transition off of its use of fossil fuels for energy. In the face of such calls to action, progress has been frustratingly slow. The 2015 Paris Agreement offers some hope, as does the small-but-growing share of renewable technologies, but by and large countries are not doing enough to meet Paris’ grand aspiration of keeping temperature increase between 1.5 and 2 degrees above pre-industrial levels.

Our collective inability to rise to the climate challenge may be related to our inability to imagine the consequences of inaction. Humans tend to think about immediate threats to our well-being, whereas climate change is a slow burn without clarity about how it will play out spatially and temporally. We understand that tipping points with irreversible consequences lie ahead, but do not really know at what point those critical thresholds will be crossed.

Worst-Case Economics steps into this fray by providing a refreshing look at the state of the economics discipline and how its standard toolkit leaves us poorly equipped to address two pressing concerns of the 21^st century: financial crises and climate crises. The book aims to infuse recent lessons of the former into the latter.

Over the years I have greatly admired Frank Ackerman’s work on cost-benefit analysis, the social cost of carbon, and the economics of climate change. This book compiles much of that analysis under one cover, but goes beyond by critically examining how economists think (or don’t think) about extreme events.

Ackerman shines when dissecting the core assumptions of neoclassical economics, the dominant academic form of the discipline. His critique begins with 19^th century economic models emulating classical physics and the concept of equilibrium. But while physics moved on in the 20^th century, economics did not. So we are left with theoretical models that require an array of simplifying assumptions that abstract away from the nature of real-world economic problems. In the simplified neoclassical view of the economy humans are assumed to be rational, self-interested maximizers, who are unswayed by advertising, fashion or the behaviour of their peers. There is no market power, insider information, nor external costs imposed on third parties (like carbon emissions).

To be fair, each of these limitations has been explored in the economics literature, but usually only as one-offs, while still upholding the other standard assumptions. Ackerman points out that it is precisely these deviations from the model – bounded rationality, susceptibility to social pressures, imperfect markets – that are central to understanding financial or climate crises.

That said, Ackerman may be putting too much blame on economics, and not enough on the failure of politics to implement adequate climate policies. Climate change is a collective action problem that requires governments to step in, but this fundamentally conflicts with conservative values and the free market worldview of the right.

One area where economists have had a disproportionate effect on the public climate conversation is around carbon taxes. The economics of carbon taxes goes back to the Arthur Pigou looking at smokestack England in the 1920s, and the idea that there are external costs imposed onto third parties from certain market transactions. In the case of carbon emissions the fix is to “internalize the externality” through a price on carbon.

Ackerman comments that “ ’getting the prices right’ is an incomplete response to climate change and other complex environmental problems.” We don’t actually know when certain tipping points will be reached, and poorly understand the value of expected damages. We can develop estimates from models but they are riddled with uncertainties about the future. At one extreme, the “dismal theorem” proves the value of carbon reductions to be literally infinite if we accept worst-case scenarios that destroy the sources of human well-being or that undermine the ability of the human race to survive.

Standard cost-benefit analysis is particularly ill-suited for addressing extreme risks in Ackerman’s view. Even under ideal circumstances, attempting to put a dollar value on human life or suffering is a task that is fraught with difficulty. For finance and climate, cost-benefit analysis has limited utility because it looks at potential outcomes in terms of averages, and does not consider low-probability events with catastrophic implications. It is one thing to assess risk when dealing with well-defined problems with an accumulated evidence base from past events; quite another when uncertainties abound and climate change itself affects the probabilities and magnitudes of damages.

In place of neoclassical approaches, Ackerman shows that financial crises are far more common than would be expected from a “normal” distribution (i.e. the standard bell curve). The same non-linear relationship is likely for climate extremes meaning our standard practices greatly understate the likelihood of extreme events. Such extreme weather events are already becoming our new normal: heavy precipitation events that overwhelm storm sewers; heat waves causing premature death; and, extreme dry conditions fueling forest fires.

Insurance is central to a response. Ackerman notes that people are risk averse and so are willing to pay for a proposition that is likely to lose them money on average in order to guard against a truly catastrophic outcome. It would be interesting to scale this thinking globally to events larger than private insurance companies can handle: regional crop failures or disasters that displace millions of people.

Likewise, developing scenarios can help us make decisions. But when all we can know is what the worst-case scenario might look like, the precautionary principle should guide our decision-making. Ackerman invokes the war-time mobilization as a model for rapidly dealing with climate change.

The book’s linkage to our growing understanding of financial crises provides much interesting fodder. But the analogy is imperfect: economic thinking based on periodic financial crashes does not ultimately translate well into the climate discussion of crossing irreversible and catastrophic tipping points, such as changes in the Earth’s ocean circulation system, the collapse of the Amazon rainforest, or the loss of Greenland’s ice sheet.

It may just be that rigorous mathematical economic models are not suitable for these lurking disasters. Ackerman concludes by stating: “There is no fixed formula for good policy decisions about the greatest risk, no calculation that leads automatically to the right answer. Politics, ethics, and judgment inevitably enter the decision-making process, along with science and economics.”

In other words, just get on with it. The future is at stake and we can, and must, do better.