Climate Change: Legal, Financial, Economic and Risk Management Issues

By Tapen Sinha

Human activities have accelerated the process of climate change. Since dealing with climate change requires collective action across countries and across regions, their often-divergent incentives make such action difficult to achieve. Our only remaining option is to take collective global action through adaptation and mitigation.

Climate change is a fact of life in the 21st century. The contribution of human beings accelerating this climate change through the emission of greenhouse gases is undeniable. What is less understood is that climate change will not affect all countries and all regions in the same adverse way. The impact on the low and middle-income countries will be harsher than the countries that are already developed. As a result, the so-called “North-South Divide” will get larger. This fact also explains why some countries are less concerned about climate change than others. While developing countries (largely in the South) are more likely to be hit by climate change, they are also the countries likely to produce more greenhouse gases per capita because they lack the technology and resources to effectively deal with these gases.

What can be done about climate change? Can we take mitigating and adaptive measures? The answer is affirmative. To understand this, we need to delve into legal, financial, economic and risk management perspectives.

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We need to clarify what exactly is meant by “climate change”. There are two (related) issues:

1. In the future, there will be a further rise in temperature;

2. The variability of temperature distribution will also increase. If we know there will be a steady rise in temperature, it is easier to deal with. The rising variability of the temperature distribution, however, is much harder to deal with.

 

Climate Change Regulation and International Economic Law

The fundamental problem of climate change is a well-known issue called the “The tragedy of the commons.” Suppose we have a pasture open to all. The herdsmen will graze as many cattle as possible on the common ground, leading to overgrazing of the land. In the end, everybody would suffer. It is rational for one herdsman to graze his cattle a little more, but collectively it is counterproductive. Yet, no individual herdsman has an incentive not to overgraze. Similarly, for each country, using cheaper, but nonetheless greenhouse gas-producing technology, is rational. But for the world as a whole, it spells disaster. The first truly global problem of chlorofluorocarbon refrigerant emissions was resolved at little economic cost. Unfortunately, reducing greenhouse emissions will not be cheap. In the words of the Nobel Prize-winning chemist Robert F. Curl:

“Greenhouse gas reduction is a classic ‘tragedy of the commons’ problem with two nasty adjuncts. From the point of view of the individual or nation, my activities producing emissions profit me, but these emissions will in the future hurt everyone in an uneven way. The future aspect raises the question, ‘What does the present owe the future?’ The uneven aspect raises the selfish issue of ‘My country can mitigate and adapt to the consequences. Why should I care about what happens elsewhere?’”

The way forward for countries willing to tackle the greenhouse gas problem is to take unilateral measures.

This aspect of climate change explains why multilateral negotiations through the Kyoto Protocol, and subsequent negotiations, have not produced any agreement about limiting greenhouse gas emissions. There are countries like the Maldives, Kiribati and Palau that are in danger of disappearing completely. There are countries like Bangladesh, where a rising sea level would threaten a good part of the densely-populated areas. On the other hand, a rising temperature would expand cultivable areas of Canada and Russia. It would make the arctic circles navigable all year and reduce cost of trade between North America with East Asia. It also explains why, within a country like the US, there is no agreement on climate policy. Most benefits of limiting greenhouse gas emissions would be in the long run, but costs would be more heavily felt in the present and in the immediate future.

The way forward for countries willing to tackle the greenhouse gas problem is to take unilateral measures. For example, the European Union has issued a directive to restrict the EU airspace, meaning that all airlines will need to hold permits to cover their CO2 emissions for flights operating in the EU airspace. This will apply not just to the airlines of the EU countries, but all countries around the world.

In addition, a country could require “environment safe” safety standards and labeling on products sold in the country. If the consumers in these countries buy such products, it would force non-environmentally safe product producers to comply. We have seen this kind of measure in action in the case of “dolphin safe” tuna. These unilateral measures are perfectly compatible with the existing World Trade Organisation (WTO) rules.

 

Adaptation Strategies at the National and the International Level

For the governments of many countries, adaptation strategies are so far nonexistent. This state of affairs is true not only for the developing countries: for example, during the “Status of State Climate Adaptation Plans” conference in the US in 2013, there were only fifteen states out of fifty that had any plan at all. This is the status in a developed country. Unsurprisingly, in developing countries, adaptation is not even on the radar of the policymakers.

At the international level, an Adaptation Fund was established to finance concrete adaptation projects and programs in developing countries who are signatories to the Kyoto Protocol, and that are also particularly vulnerable to the adverse effects of climate change. The Adaptation Fund finances projects and programs to help developing countries adapt to the negative effects of climate change. It has funded projects in two dozen countries, with a total commitment of $166 million, with about one quarter of it spent by the end of 2012.

 

How Insurance can Reduce its Economic Costs

Insurance companies can aide understanding of the climate change problem. Insurers are beginning to share their expertise in data collection, catastrophe modeling, and risk analysis in order to track trends in weather-related data. These activities can be used to address problems posed by climate change. Insurers are building forward-looking risk models that take climate change into account – for example, the movement of the rainfall index over the past century can be used to create a rainfall index for the future. For planning and for insurance, such modeling will not produce unexpected losses if the models have no systematic bias. This modeling is essential for the survival of the insurance industry itself; if a 100-year flood becomes a ten year flood, insurance companies will have insufficient capital to confront such risks in the long run.

Furthermore, insurance can promote loss prevention through risk mitigation. Managing risks and controlling losses is central to any insurance business. The insurance industry has been setting up fire departments and advocating building codes for natural and man-made hazards for a long time; after the Great Fire of London in 1666, for instance, Nicholas Barbon started an insurance company to offer protection against fire. He also innovatively proceeded with the following:

1. He started differential rates for different building material used: 2% of the rent if the houses were made of bricks and 5% if they were made of wood.

2. He hired the watermen from the Thames to work as part-time fire fighters.

The first of these acts encouraged the building of brick houses in London. The second act created an eventual fire department for the city when it became clear that fire hazard has properties benefiting the public: saving houses from fire, whether they bought insurance or not, also helps others.

In the modern, more contemporary era, insurance companies have been giving rebates for households with fire insurance if they do not use halogen lamps. It is well known that halogen lamps are fire hazards – thus, for the insurance companies, the avoidance of using halogen lamps reduces fire hazards. As a byproduct, it substantially reduces the use of electricity for households, thereby reducing greenhouse gas emissions.

Insurance contracts can design policy exclusions to instill behaviours that reduce greenhouse gas emissions and make appropriate efforts to prepare for the impacts.

Furthermore, insurance companies can encourage risk-reducing behaviour. Insurance contracts can design policy exclusions to instill behaviours that reduce greenhouse gas emissions and make appropriate efforts to prepare for the impacts. For example, so-called “pay-as-you-drive” insurance products are offered by insurers that recognise the link between accident risk and distance driven. In this case, the insurance company can now do this cost effectively because it can use the GPS in the cars to monitor activities with very little cost. It encourages people to drive less. This, in turn, co-benefits the environment.

Insurance companies are also promoting innovative products. Insurance companies are offering special rates for “green buildings” and products that cover risks associated with energy efficiency or renewable energy projects. This encourages the construction of more efficient buildings in the future, as well as retrofitting old buildings to become more energy efficient.

Insurance companies are, moreover, offering climate protection improvements. Insurance companies that also have banking operations are engaged in financing projects that improve resilience to the impacts of climate change and contribute to reducing emissions. Several companies are providing preferential mortgage rates for energy efficient appliances and home upgrades. Some companies are offering ‘Clean Car Credit’ financing for low-emissions vehicles.

In addition, the so-called “carbon risk disclosure requirement” is being encouraged by insurance companies that insure business entities. The carbon risk disclosure requires a company to disclose information related to risk factors, and calls for management discussion and analysis. This issue got a boost with the 2009 position paper of the Securities and Exchange Commission, which stated that businesses “should consider the impact of existing climate change legislation and regulation, international accords or treaties on climate change, indirect consequences of regulation or business trends, for example new risks for the company created by legal, technical, political and scientific developments, and the physical impacts of climate change.” Canada has had similar requirements since 2008. In addition, in the near future, Canada will make such disclosures obligatory rather than voluntary.

 

Climate Change as a North-South Problem: the Developed Versus Developing Countries

Often the developed countries are portrayed as the villains of the problem of climate change. Developing countries, on the other hand, are often seen as the victims. This is not necessarily the case. The developing countries – which, in the course of the next century, will also become developed – have a critical role to play. We illustrate this issue with the example of the fuel subsidy.

In order to discuss the fossil fuel subsidy issue at a disaggregate level, we need to understand the living conditions of the poor in developing countries and their dependence on fossil fuel. At the end of 2010, there were 1.3 billion people in the world who did not have electricity at all. In addition, there were another two billion people who did not have a reliable supply of electricity. Almost all of them live in developing countries. In addition, there are 2.7 billion people in these countries who still rely on the traditional use of biomass for cooking purposes.

There are fundamental justifications for fossil fuel subsidies (either at the level of production or at the level of consumption) in the developing world. They include the fact that subsidies are needed to help the poor gain, or maintain, access to minimum living standards. Unfortunately, studies have found that fossil-fuel subsidies are regressive – that is, they benefit higher income groups who can afford consumption. The reason for this is simple: poor households in developing countries do not have direct access to subsidised energy. They do not have electricity, natural gas-fuelled cooking facilities, nor do they have vehicles that use gasoline or diesel. Moreover, low-income households spend less (in absolute terms) on energy than higher-income households. Subsidising fossil fuel consumption is an extremely inefficient way to alleviate poverty. The World Energy Outlook of 2011 estimated that of the $409 billion spent on fossil-fuel consumption subsidies in 2010, only $35 billion, or 8% of the total, reached the poorest income group (the bottom 20%).

 

Conclusions

The problem of climate change encompasses many different disciplines. Science and technology can help us identify the problem. They can also help us to alleviate the problem. Unless the legal, economic and incentive problems are addressed, the solutions for the problem cannot be properly addressed.

About the Author

TapenSinhaPhoto2014Tapen Sinha is the AXA Chair Professor of Risk Management and Insurance at ITAM, Mexico, and Special Professor at the University of Nottingham Business School. He is a member of the Mexican Academy of Sciences and the National Academy of Social Insurance. In 2013, he published The Role of Climate Change in Global Economic Governance, co-authored with Dr. Bradly Condon.

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