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The environment wins when the government designs climate change regulation at the lowest possible cost, because it incentivizes firms to comply.

Dr. David Kelly

The Economics of Sustainability

Faculty member’s work sheds light on compliance with environmental regulations, predicting hurricane damage and more.

It’s little mystery that as the planet heats up, natural disasters become more frequent and more potent. However, budgeting for the mitigation of and response to their damages can be tough for regulators, insurance companies and firms whose activities contribute to global warming, says David Kelly, professor of economics at the Miami Business School.

Kelly is working to improve predictions for these scenarios through complex statistical methods and his most recent papers arrived just in time for some busy hurricane seasons.

In December 2014, a paper Kelly published in the Journal of the Public Economics looked at how to help regulators create environmental standards that make compliance more affordable. Another paper that will be published in an upcoming issue of the Journal of Environmental Economics and Management is aimed at helping insurance companies make better predictions for the reserves they need to cover claims from an especially damaging storm. Used together, he believes his methods could greatly improve economies and livelihoods.

A look at some of Kelly’s findings:

Nudges Move the Needle:

Climate change regulations with the lowest possible cost are most likely to induce compliance.

“The environment wins when the government designs climate change regulation at the lowest possible cost, because it incentivizes firms to comply,” Kelly says. “Unnecessarily expensive regulations generate political resistance, which makes environmental regulation difficult to pass through Congress, and if it does pass, it is often weakened with exemptions.”

Take carbon emissions, for example: To regulate both effectively and at the lowest possible cost, Kelly says, regulation should give firms flexibility as to how and when they reduce emissions. The assumption is that each company’s executives will know how best to reduce emissions in their own organization.

Up until recently, the U.S. government left much of the regulation up to the Environmental Protection Agency, which often put out strict new standards that lacked information about the logistics and costs involved in compliance. That’s in part because companies are generally resistant to telling the government what those costs would actually be.

Kelly’s paper shows that companies are more likely to comply with environmental regulations if they are given a menu of options, which essentially allows them to pay now or pay later. “In this way, you are subjecting the firm to tougher regulations when it is relatively better able to handle it,” he says. This, in turn, clues the government into what this compliance actually costs. “You’re letting firms reveal that to you by their choices,” Kelly explains.

While the EPA’s solution often resulted in lawsuits back and forth between firms and the government, the Trump Administration’s response has simply been to drop many regulations altogether. “What we currently have is not really working in any sense,” Kelly says. “What I often find is that you just need certain types of nudges to change the incentives and then you can get environmental objectives achieved at very low cost.”

But Kelly’s menu-based proposal would require an act of Congress, and he is skeptical any leading political party would put that on the table any time soon. For now, he says, existing sustainability initiatives at companies of all sizes are leading to reduced carbon emissions. The companies benefit by reducing costly energy usage, and at the same time benefit society by reducing carbon emissions. “In many ways, this is ideal, because each firm has the best understanding of where carbon emissions can be more easily reduced, just like in [my] flexible regulation systems,” Kelly says.

The “Fat Tail” of Consequences:

It takes a lot more information than hurricane strength to predict potential damage.

While regulators and firms figure out the best way to mitigate the long-term impact of climate change, insurance companies must continue to plan for the worst-case scenarios. But, from one storm season to the next, it can be difficult to know exactly where a hurricane will hit, and whether the speed of the winds or other factors such as location make a community more vulnerable, Kelly explains.

“A lot of hurricanes come by and do little, if any, damage. And then you see the occasional catastrophe – the Katrinas and the Irmas,” Kelly says. “From a statistical point of view or from an insurance company’s view, that’s hard to deal with.” This is what experts like Kelly refer to as a “fat tail” – historical averages are not good predictors of potential storm damages, which vary widely from year to year.

In contrast, Kelly says, hurricane strength is thin-tailed – new wind speed records are generally set very close to previous records. This means that the wind speed of a really strong hurricane is predictable. It may break a record, but not by much.

So, while the speed of a really strong hurricane is fairly predictable, the damage it will cause is far less predictable, which is a problem for insurance and preparedness. “Even a moderate hurricane strength can cause a lot of damage,” he adds.

A prime example of this lack of predictability is the damage Hurricane Katrina caused to New Orleans in 2005. Most of the damage was a result of the fact that the city sits below sea level and its levees weren’t strong enough to absorb the kind of flooding the storm brought in. “If it had hit a city with more resilience, it wouldn’t have caused so much damage,” Kelly says.

In 2005, Katrina’s damages were estimated at $81 billion; adjusted for inflation, as well as population and income growth, a 2012 estimate put those damages at $96 billion. Kelly says these numbers do not even include damages such as National Flood Insurance claims. That would take the original $81 billion estimate to $108 billion, which would then be adjusted to $125 billion.

In 1926, The Great Miami Hurricane claimed more than 370 lives, and cost $105 million in damages, equivalent to $164 billion in today’s terms. 

Yet, insurance companies have to figure out both what to charge for insurance and what kind of reserves they’ll need to have on hand in case they have to pay a lot of claims. “If you just look at the hurricane damage data using conventional statistics, you’d only get one storm causing damage greater than $105 million per hundred years, which would be ridiculous,” Kelly says.

Given numbers Like Katrina in 2005 and Miami in 1926, insurance companies can only properly set their reserves by crunching more complex data than hurricane strength. They need to account for variables such as the increased potency and frequency of storms, rising sea levels, and the infrastructures of areas prone to hurricanes, as well as population growth, income and inflation.

As damaging storms become more frequent, insurance companies will need ever more reserves to pay out claims. Kelly’s latest paper recommends that insurance companies maintain relatively high levels of reserves to deal with the unpredictability of hurricane damages. He adds that hurricanes Harvey and Irma – two severe storms that occurred after the study period – have reinforced the study’s conclusions.

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