Climate Change in California

CHAPTER ONE

Economic Perspectives on Climate Adaptation

Scientific evidence has established a connection between economic behavior and climate change, primarily through the use of carbon-based energy sources in pursuit of higher material living standards. Over the last two centuries, domestication of carbon fuels for industrialization has conferred on a large share of humanity living standards that would have been beyond the imagining of their forebearers. Recently, however, we have awakened to the fact that this Promethean gift is changing the natural world in fundamental and adverse ways. This unintended negative externality has given rise to what is often called the "mitigation agenda," a local, national, and global policy dialogue about how to limit greenhouse gas emissions and other anthropogenic contributions to climate change.

Conversely, climate change has begun and will continue to present to the economy and all its participants a broad spectrum of challenges as well as opportunities. The general response to these challenges is referred to as the "adaptation agenda." Although both mitigation and adaptation are essential environmental issues and unified in the context of climate change, it is important to recognize their differences. Mitigation can, and probably should, improve environmental conditions and slow the progress of climate change. Mitigation activities, which are being discussed, negotiated, and promoted at all levels of society, represent a complex agenda of social responsibility and environmental citizenship from the global to the individual level. Because mitigation is causative (i.e., behavior leads to an effect) and this externality is global, cooperation is essential to progress.

The adaptation agenda is fundamentally different because it is responsive (i.e., effects induce behavior) and more localized. Greenhouse gas emissions are a local activity that affects the global environment, but climate change is a global process that affects localities. For this reason, individuals, communities, and even states can debate their role in the mitigation agenda, but everyone has a responsibility to protect themselves from the adverse effects of climate change. Regardless of what we do about emissions, climate change has begun and will continue for generations. The extent of change will depend on mitigation decisions, but adaptation is inevitable.

Effective adaptation requires an understanding of the challenges and opportunities alluded to above. In this chapter, we review the basic economics of adaptation, including its costs and potential benefits. An economist's perspective offers only part of the insight society needs to advance the adaptation agenda, but the concepts presented here can elucidate how a changing climate will create economic risks and rewards. As they always have, these two incentives can be expected to animate human behavior and move society along the path toward economic sustainability. Public agency is also discussed here because it will be essential to facilitate timely, cost-effective, and inclusive climate adaptation. Like private actors, policy makers need incentives to animate and change their behavior, and the concepts we cover below also recognize their essential role and the risks and rewards they face.

In this overview of the basic economics of climate adaptation, we present conceptual principles that provide a foundation for the chapters that follow. Because climate adaptation is localized, some of the lessons from California will be more generally relevant than others. The general conceptual principles, however, should be relevant anywhere. We discuss five topics of special relevance to climate adaptation: uncertainty, costs, timing, fairness, incentives, and institutions.

Uncertainty

An essential consideration for all adaptation decisions is uncertainty and its economic avatar, risk. As we all know from the weather report, uncertainty is endemic to our understanding of climate processes, and climate-economy linkages only compound that uncertainty. We can never expunge uncertainty completely, but individual and social responses to it can be more constructive if better information about events and consequences is available. The importance of this uncertainty for economics is that it complicates decision making and can affect behavior in pervasive and often socially undesirable ways. Throughout this book we argue that one of the main barriers to adaptation is inadequate information available to private and public actors. Generally speaking, the available evidence is not relevant or authoritative enough to support timely and decisive policy.

Uncertainty in the context of adaptation takes six forms:

1. Climate processes

2. Baseline economic resource availability and activity

3. Impacts of climate change on economic resources and activities

4. Institutional constraints and capacity to respond to climate change

5. Technological change

6. Responses to adaptation measures

This book focuses on developing evidence for the third and fourth areas, economic impacts and institutional response, because we believe a stronger analytical foundation, a candid discussion of risks and trade-offs, and greater consideration of the current and future effectiveness of institutions are most needed to advance proactive, sound decision making. At the present time, the vast majority of information about climate change, scientific evidence presented in terms of physical systems, is related to the first category. Financial markets, the insurance industry, and indeed most of the rest of the economy are not managed by scientists, and economic agents need to see climate costs and benefits in material terms if they are to commit resources for adaptation. Government agencies need to understand the costs and benefits of different adaptation options if they are to make decisions that put public resources to their best use.

More assessment research is also needed to improve the quality and authority of evidence on climate change. This will help overcome an important barrier to effective policy response, disagreement among stakeholders about the facts of climate change and its impacts. Part of our motivation for writing this book was a desire to translate scientific evidence into implications that society can interpret and act upon, namely real and potential economic impacts. Information in this form can support responsible risk assessment and strategic responses to uncertainty. It will also improve the preconditions for cooperative solutions and public agency.

Costs

Two kinds of costs are relevant to economic decisions about climate change: the costs of climate damage and the costs of adaptation. This book is mainly about the former, but better information on what it costs to adapt will also be needed to move forward.

Because climate has such a complex and pervasive relationship with the natural world, with resources, and therefore with the economy, there is a range of approaches to considering the economic impacts of climate change. In some cases, scientific information translates relatively directly into economic variables. For example, temperature-induced changes in crop yields can be converted to changes in expected harvest, and shortfalls can be assessed across a range of expected market prices. In cases where uncertainty is less specific, we need a more indirect approach to risk valuation.

This simplicity can be contrasted with the complexity of more general climate risks, like fire risk to property. Unlike in the case of a farmer planting a specific crop, in this case there is no model of fire incidence, severity, or timing to credibly inform individuals or communities about expected costs that are specific to their circumstances. In contexts such as this, the best we can do is give estimates of total assets at risk and actuarial averages for fire frequency and severity. Given that the past may not be a reliable guide to the future, the insurance industry will need new approaches to risk assessment that provide the public with a better sense of the changing cost of risk.

The problem with this approach reveals another obstacle to effective adaptation decisions: the average versus the marginal cost of risk. To get fire safety incentives right, for instance, property owners should pay for protection in proportion to their individual (marginal) contribution to overall fire risk. Fire defense based on risk pooling and average cost calculations is generally inefficient because of disparities in initial risk and ultimate damages. In a typical fire, some proportion of assets is catastrophically damaged while others are unscathed, with the former usually including a disproportionate number of higher-risk properties. Risk pooling thus effects a financial transfer between these groups. Risk-based pricing, where insurance premiums better reflect individual risks, can provide the right incentives for property owners, but it can be politically difficult to implement.

Pricing resources can be as complicated as pricing risk. In the electric power sector, for example, the fact that we pay time-averaged rates means that no one has an incentive to conserve during peak periods, which will become ever more problematic with the rising use of air-conditioning. On the other hand, average cost pricing allows utilities to smooth a lot of the price variability that might result from extreme weather (e.g., costs may spike in June, but averaging over a year could expunge most of this variation). There may be no clear case for either, but choosing one approach over the other will inevitably constrain the universe of adaptation options.

Clearly, it is difficult to estimate both the total cost of climate damage and how it is distributed across different stakeholders, but this information is essential for guiding both public and private decisions. Determining the other side of the net benefit calculation, the cost of adaptation, is equally challenging. High climate damage costs may arouse people and governments to action, but the appropriate adaptation response will have to be informed by an understanding of what options and resources are available to mitigate adverse climate impacts. Although this study focuses on climate damage estimates, we summarize the main perspectives on measuring adaptation cost for the reader's reference.

Many governments and multilateral institutions have invested substantial resources to better understand adaptation. Four leading examples of the latter are the Intergovernmental Panel on Climate Change (IPCC), the United Nations Environmental Programme (UNEP), the Organisation for Economic Co-operation and Development (OECD), and the World Bank. To illustrate the complexity of adaptation assessment, below is a summary of how each of these institutions defines adaptation cost:

IPCC-Adaptation costs are the costs of planning, preparing for, facilitating, and implementing adaptation measures, including transaction costs.

UNEP-The cost of adaptation is the investment required in adaptation measures aimed at minimizing the damages from future climate hazards.

OECD-The cost of adapting to climate change is the sum of investment costs and operating costs linked to the establishment of adaptation strategies.

World Bank-Corresponding to a chosen level of adaptation is an operational definition of adaptation costs. If the policy objective is to adapt fully, the cost of adaptation can be defined as the minimum cost of adaptation initiatives to restore welfare to levels prevailing before climate change. Restoring welfare may be prohibitively costly, however, and policy makers may opt for an efficient level of adaptation instead. Adaptation costs would then be defined as the cost of actions that satisfy the criterion that their marginal benefits exceed their marginal costs. Because welfare would not be fully restored, there would be residual damage from climate change after allowing for adaptation.

Comparing these definitions, even superficially, suggests that they could yield quite different rankings among adaptation alternatives. This reminds us that investments in soft as well as hard infrastructure will be needed for effective response to climate change. Clearly, institutions themselves need to adapt and promote more coherent decision making and dialogue in the face of a momentous emergent challenge to the public interest.

Two final points are worth emphasizing in the context of climate change costs. First, the disaster assessments associated with extreme weather and other events remind us that, in the context of natural processes, the loss function is quite asymmetric. For example, a hurricane predicted to be a major storm may pass by with very limited long-term damage, or it may completely devastate communities. This asymmetry results from threshold processes (for example, flooding, structural failure, and evacuation orders), and it renders risk-adjusted average costs of limited use because they overestimate the cost of most events and underestimate the cost of a catastrophic minority.

Finally, despite much progress that has been made in environmental economics, the value of environmental services from baseline resources still plays only a minor role in climate assessment. We are aware, of course, of our dependence on many amenities of today's world, but we have quite limited means of including these valuations in the baseline comparison for the cost of inaction, let alone the value of set priorities for restoring environmental services as part of the adaptation process. Much more progress is needed if we are to reliably factor these services into a more comprehensive cost-benefit analysis of climate policy.

Timing

In its most general form, climate adaptation can be seen as a form of insurance, incurring (adaptation) costs at one time to avoid (climate damage) costs at another time. Thus, as it does for other risk-based investments, timing plays a central role in adaptation decisions. Of course, with climate change, both the adaptation and damage costs are uncertain, and so is the primary behavioral variable, the discount rate that mediates these two costs in determining the net present value of an adaptation choice. Further complicating this situation is the fact that adaptation can be proactive or reactive, occurring before or after the onset of damages.

This multidimensional uncertainty is a serious impediment to decision making, individual or collective, but human institutions have remarkable capacity to manage complex risks, and financial markets have already actively engaged the climate issue through insurance, venture capital, and other channels. All these developments can be seen as tentative and even speculative, but available evidence, including evidence provided in this book, continues to suggest that very large financial stakes will depend on the course of both climate change and adaptation. Better data on expected costs is certain to strengthen the capacity of markets for hedging climate risk, just as it will support individual adaptation decisions and changes in behavior.

Uncertainty about timing renders adaptation decisions difficult and potentially more expensive to make, thus reinforcing the tendency to defer them. For example, Neumann et al. estimate an uncertainty premium on California seawalls. If we borrow money at 3 percent to build walls ten years before inundation, the project will cost 35 percent more than it would if we could build seawalls the moment they were needed. Extending the margin of safety to twenty years increases the premium to 81 percent of the nominal project cost. At an interest rate of 5 percent, the same safety margins would add 63 percent and 165 percent to project costs. Because sea level is in fact highly variable, subject to the dynamics of waves, tides, and storms, we must accept some degree of uncertainty and its attendant costs, but the question remains: How much?

The third source of uncertainty, the discount rate, has been seen by many observers as a major obstacle to the progress of both the mitigation and adaptation agendas. All agents have their own discount rates, and there are significant disparities between these rates. Financial markets offer some help here, but averaging investor discount rates provides only limited guidance about the opportunity cost of capital and inter-temporal asset comparison. Market interest rates are adequate proxies for discount rates in many other public and private investment decisions, and we do not believe climate adaptation is any exception.

What is likely the greater barrier to financial commitment in this context is actual perception of risk-adjusted, discounted cost. Seismic risk offers a convenient metaphor. In the San Francisco Bay Area, for example, a new bridge is currently being built, even though its predecessor is still standing. This proactive commitment was made because seismic risk is real, and the decision is generally accepted because the public has internalized that risk. Why so with seismic risk but not climate risk? The reason relates to both credibility and timing. Every year residents around the state get gentle reminders that seismic risk is real and present, and thus we have a multibillion-dollar industry in earthquake engineering and retrofitting, but negligible activity in adaptation.

Climate risk may be just as real, but the public has not fully internalized this, and certainly it is not seen as a present threat. Most climate process research addresses the middle or end of the present century; indeed, much of the published research does not address events prior to 2030 and suggests that most of the damage from climate change would occur near the end of this century. This situation, however, is changing, as more recent evidence suggests that climate change may be occurring faster than originally predicted. More important, we are awakening to the fact that not only averages of natural variables (temperature, sea level, etc.) but variances are increasing as well. Sea level does not rise like water in a bathtub but varies from week to week, hour to hour, and minute to minute because of the combined action of water temperature, tides, and wave action. In turn, these are affected by random storms and other natural processes, with the result that sea level risk will present itself decades before the average sea level rises by one or two meters. Unlike changes in averages, changes in variance are very difficult to anticipate, and it may not be possible to identify and attribute these changes until long after they have begun.

Fairness

Economic fairness can be seen from many perspectives, but the most direct one is probably the distribution of wealth. From this angle, climate change has significant implications for both wealth and fairness across California society. It will be apparent from the research in this book that climate threatens a diverse spectrum of economic assets, but it does so in ways that are unequal across stakeholders. Different parts of the state will experience temperature and sea level effects differently, for example. As with fire, this can make statewide risk pooling inefficient and inequitable, and it may even increase damages by promoting risk taking. Those with the means who invest in adaptation will suffer lower absolute, and perhaps net, costs, reinforcing inequality. Public investments in adaptation will likewise be differentiated in their incidence, benefiting some more than others.

How should these expenses be financed? When thinking about climate impacts, we might suppose that damage costs will fall on all three major players in the economy: households, enterprises, and government. In reality, however, the final bill will be passed through the markets and fiscal systems to households, which will face higher direct costs, combined with higher prices and taxes to cover costs incurred by the other two. The same logic, of course, applies to adaptation costs. The ultimate net costs may fall to the California household, but to estimate them is a very complex cost allocation problem. Our estimates only make piecemeal contributions, but a few general conceptual rules are worth keeping in mind. In a more socially efficient and fair world, costs of climate risk should be borne by those whose behavior gives rise to those risks. Likewise, adaptation costs should be born by those who benefit from the adaptations, whether they are publicly or privately financed.

Other metrics of fairness, such as economic vulnerability, occupational opportunity, and mobility, can all be examined from a climate change perspective. Some of these aspects are discussed in the sector chapters, but conceptual treatment of them is beyond the scope of the present discussion.

Lastly, it is important to recognize feedback between fairness issues and policy making. Distributional effects are very important determinants of policy itself. Whom public spending, goods, and services affect, how, and when are all intimately related to policy formation and implementation. Cost/risk averaging approaches that ignore this heterogeneity are unlikely to provide reliable guidance for the course of adaptation.

Incentives

Because adaptation is a form of behavior, its economic characteristics can be better understood if we examine incentives. For example, if the present value of climate damages exceeds the costs of adaptation that can avert these costs, there is a clear incentive to adapt. In this simple framework, we need only wait until climate change costs reach critical levels and we can expect to see waves of spontaneous private agency working to limit these adverse effects. To the extent that we do not see this, we could assume adaptation costs are too high, individuals rationally discount expected damages for credibility and time, institutional or other barriers stand in the way, or individuals have countervailing incentives of some kind.

The last case is of particular interest, since unfortunately there are many reasons why individual expected costs are inconsistent with social costs. In the private sector, this kind of divergence usually arises from simple stakeholder diversity. For example, a coal company might well calculate a different net benefit from mitigation policy than a kindergarten. These disparities in private interest are commonplace and form a solid basis for public interest initiatives by government, which must implement policies that can redistribute net benefits to compensate adversely affected stakeholders and promote the greater good.

More difficult cases arise from policies that reinforce conflicting incentives or distort behavior. The most important form of such behavioral distortion is moral hazard, which in this context creates incentives to act in ways that contradict the intention of a policy. For example, fire insurance, if it is priced below the marginal cost of policyholders (i.e., the value of their individual fire risk), will promote risk taking. It has been known for at least a century that average cost fire risk pooling promotes this kind of adverse behavior, but this has not stopped the practice.

The same logic applies to a larger universe of climate risks. Some examples, such as floodplain insurance, are obvious, while others, like public investments to protect beaches, are more subtle. In broader financial markets, moral hazard can be very difficult to eliminate because of public fiduciary responsibility. According to the World Bank, of the nearly one hundred banking crises that have occurred internationally during the last twenty years, all were resolved by bailouts at taxpayer expense. Obviously, this precedence seriously compounds moral hazard. In the case of catastrophic risk insurance, such as that which may accompany escalating climate risk, the same risk of policy distortion is likely to emerge.

Incentives are usually necessary but not sufficient to explain behavior. In the same example, this means that agents will adapt if they can, if they have the resources to invest or can get them through accommodating capital markets. Of course they also need the information to understand both their incentives and adaptation options, and institutions must not obstruct their path to adaptation. Thus we see that sufficient conditions for adaptation may be much more complex than the simple logic of behavior would suggest, and actual capacity to adapt will depend on institutions as well as individuals.

Institutions

If the world were organized by Adam Smith, individual agents would make individual decisions based on individual information, acting on this information autonomously and striving for self-interested profit yet achieving efficient overall resource allocation and many benefits for society as a whole. In these ideal circumstances, there would be no need for collective action or agencies such as governments, producer groups, or labor unions to achieve efficiency. Obviously, we do not live in such a world, and institutions influence nearly every dimension of our lives. The significance of this for climate adaptation is that institutions may facilitate or retard our progress toward a more sustainable economy, reducing or even increasing the costs of climate change and/or adaptation.

Like the other conceptual topics discussed in this chapter, institutional economics occupies academic volumes of its own, so we can only touch on salient features related to climate risk. As has already been mentioned, adaptation is essentially a local issue, while climate change is global. This means that governmental institutions, which span these domains, need some degree of consistency in responding to climate change. Unfortunately, the institutional landscape relevant to climate, mainly resource and regulatory agencies, is very fragmented and has only the most limited policy coordination. This is actually true at most levels of government in the United States, and California is no exception. For example, clean air standards are state policies, while fuel economy is national. Forestry, fishery, and agricultural regulations are largely national, while land use, water supply, fire management, and public health policies are controlled at the county or city level.

Another major institutional challenge is the political economy of interest groups. In Adam Smith's work all economic agents have equal, almost inaudible voices. The real world, of course, is very different, and concentrations of economic interests almost always coincide with concentration of political influence. To the extent that such groups have short-term goals that diverge from effective long-term adaptation, the larger public interest may be undermined. For example, developers might push local governments for development rights in high flood risk areas, as neither is liable for flood damages. This problem need not be seen as an ethical failure but can simply be considered a social distortion that applies different weight to different stakeholder interests. Our political system is sometimes interpreted as assigning equal per capita weights to things such as welfare, opportunity, and entitlement, but the real economy often recasts this through political advocacy financed by stakeholder investment. In the context of climate damage, the most important implications of this problem are structural bias in favor of industry interests and short-term growth objectives. Both of these have historically contributed to higher expected climate risk and moral hazard with respect to the magnitude and ultimate incidence of climate damage costs.

A third important institutional issue relates to the behavior of officeholders, those who help formulate, implement, and enforce policies related to climate change and adaptation. There are fundamental challenges to aligning the behavior of officeholders with longer-term, more inclusive perspectives of present and future generations. Climate change may be happening faster than many people believe, and climate damage may come sooner than most expect, but there are very few predictions of significant adversity that fall within the next election cycle for any officeholder in California or Washington. For this reason, even though action today might reduce adaptation costs for the majority of us, the result is unlikely to affect the next election. Officials are well aware of this, and climate policy is therefore subordinated to decisions that have more immediate impacts, even though these impacts might ultimately be much smaller.

More generally, we can see that, because their tenure is limited, officeholders experience an inter-temporal version of moral hazard, focusing attention and resources on short-term public priorities at the expense of longer-term ones. Any uncertainty about the long-term consequences of their actions reinforces this by weakening their accountability. This will be a problem as long as the evidence is not strong enough to link today's climate and adaptation decisions to tomorrow's consequences.