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Archive for the ‘Cost Benefit’ Category

Catastrophic Understanding

Posted by Danny Morris on April 30, 2009

A little while back, Josh asked the question ‘how do catastrophes factor into our calculations?’ He asked the question in the context of cost-benefit analysis, but it’s a critical question for almost every facet of climate change research. The journal Nature used this week’s issue to shed some light on the subject. Since you have to pay to access Nature, I recommend the short but informative rundowns of the content from Environmental Capital and RealClimate. According to these studies, if we as a global society want to avoid catastrophe climate change, then we need to cap the world’s emissions at 1 trillion tons of CO2. Considering that we emitted one-third of that in the past 9 years, we could be in for a rough ride.

Science models can only tell us (to a degree of certainty) where to expect a greater chance of catastrophe, but how can we translate that into economic analysis. There are a couple ways to do it. First, you can use a low discount rate to better internalize the possiblity of a major disaster. Discount rates are often huge sticking points for economists arguing about each other’s models (take Bill Nordhaus vs. Nick Stern, for example) and there’s still no consensus as to what is the ‘correct’ rate.

Second, you can use risk analysis to better understand how bad disasters can be. A recent paper by Carolyn Kousky and Roger Cooke of RFF (which you really should read) does an excellent job of laying out some of these risk considerations, and it definitely provides some food for thought. The three major risk considerations are:

  1. Micro-correlations – The events of El Nino years are a good example. If you look at events in isolation (heavy rains and mudslides in Cali, poor fishing seasons in Peru, etc), they might not be noticeable, but that would lead you to underestimate your risk of major damages . If you take the broader picture though, you can see that disasters can be correlated and you can accordingly adjust your risk assessments.
  2. Fat tails (of a bell curve/normal distribution) – Basically, extreme outcomes are more likely. Disasters and extreme events compound on each other to create fat tails, which increases solvency risk of insurance, meaning that you might have way more damage than you can afford. A good example of that is Florida with their Citizen’s Property Insurance Corp., which has $3 billion to cover its $450 billion worth of exposure.
  3. Tail dependence – Tail dependence is essentially the likelihood that bad outcomes occur together. It is distinct from micro-correlations and fat tails, and they explain it much better than I can, but it relates to the idea that insurance lines can be independent of each other until there is a disaster, at which point they become dependent.

If you don’t account for these issues, you can severely underestimate your risk related to climate change. Cost-benefit analyses seem to have a pretty difficult time incorporating these factors, but there is still much research to be done on this front. It could be a while before we have reliable methods for incorporating catastrophes into our modeling. I don’t know about you guys, but I’m still miles and miles away from fully understanding this stuff. At least I can tell the difference between weather and climate, so I got that going for me, which is nice.

Posted in Climate Change, Cost Benefit, Insurance | 1 Comment »

Guest post: Michael Livermore on cost-benefit analysis

Posted by Daniel Hall on October 27, 2008

We’ve got a special guest post today from Michael A. Livermore.  He is the Executive Director of the Institute for Policy Inegrity (IPI), and the author, along with Richard L. Revesz, of Retaking Rationality:  How Cost-Benefit Analysis Can Better Protect the Environment and Our Health.

The Perfect Storm

Our next President will face triplet crises on the economy, environment, and energy.  A fiscal crisis teetering on recession, uncontrolled greenhouse gases, and oil-rich dictators profiting from sky-high prices at the pump.  With these three major storm fronts rolling in and threatening to collide, we’d better be prepared with a good plan.  And I don’t think evacuation is an option.

Navigating the course

These problems will not be solved by piecemeal policies. To steer us out of this mess, the next administration will need to use regulation and government oversight.    One interesting by-product of the wreckage on Wall St. is that many folks are taking a second look at regulation. But if we’re going to regulate, no one is going to be interested in a 1970’s redux.  We need smart, nimble, and well-balanced rules to tackle the problems of the 21st century.

In the new policy brief, from the Institute for Policy Integrity, we prescribe a way for McCain or Obama to accomplish this.  Task Number One:  the new administration will seriously need to upgrade the way they do cost-benefit analysis.

Since the days of Ronald Reagan, cost-benefit analysis has been required for all significant regulation.  But over the past three decades, industry and antiregulatory interests have had too much freedom to shape these studies.  Many significant biases now exist in how cost-benefit analysis is used and how it is performed, resulting in lax or a lack of regulation or government oversight.

Our policy brief prescribes specifics on how the next administration can balance the scales.  For example, oftentimes, “countervailing risks” of regulation are given significant attention, while “ancillary benefits” are given short shrift.  For example, the increased risk due to smaller cars is often counted as a cost of fuel efficiency rules, but the reduction in greenhouse gases is ignored or undervalued.  Last year, the Bush Administration lost a legal challenge over its light truck fuel-efficiency rules because it did not count the benefits of climate change reduction.  Failing to account for ancillary benefits results in deflated estimates of net benefits, which ultimately reduces regulatory stringency.

The policy brief also recommends a new procedure that would allow groups that are affected by agency inaction to petition the central reviewer and use cost-benefit analysis to show that the agency should be acting.  In this way, cost-benefit analysis can serve not only as a check on regulation, but also a prod to move agencies forward that are stuck in a rut or overcome with inertia.

One of the most offensive inefficiencies of current usage of cost benefit analysis is that it is often not used in the context of deregulatory decisions.  When the Bush Administration proposed changing how power plants were treated under the Clean Air Act’s new source review program—changes that would have massive economic, public health, and environmental consequences—no cost-benefit analysis was done because the agency claimed the regulations were not “significant.”  Recently, new rules from the Department of Labor that could lead to more toxic workplaces were also not subjected to cost-benefit analysis, although they are likely to have significant consequences over the long term if they are adopted.

Finding safe harbors

With sound use of reformed, fair cost-benefit analysis, the next administration can successfully navigate this storm, leaving ideological decision-making and special interests politics in the dust bin of history.  Smart economic policy, smart energy policy, and smart environmental policy are mutually reinforcing.  And since we literally can’t afford to ignore any one of them, we will need to decide carefully how to address all three together.

Posted in Cost Benefit, Government Policy | Leave a Comment »