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  • Report n° 7: The Stern review

Report n° 7: The Stern review

  • Table of contents
    • Three key elements on the nature of climate risks
      • Problems in assessing the cost of natural disasters

Problems in assessing the cost of natural disasters

Working on disaster consequences is fraught with several specific difficulties.
In particular, in economic equilibrium models, which by design cannot represent short time-scales, extreme events can only be taken into account through a fall in mean productivity.
But disasters mainly affect the life and well-being of people, and destroy productive capital and buildings. Modelling disasters by reducing productivity or destroying capital would only be the same if the impact of disasters could be "averaged" over long periods.
Yet that would only be possible if the impact of disasters was linear compared to the event's intensity, which is clearly not the case (see New Orleans after Katrina, RMS, 2005).

In order to make up for this underestimation, and represent natural disasters in a manner consistent with observations, short-term constraints in direct consequences and reconstruction rates need to be considered. Without these constraints, the damage inflicted by all disasters, even the most severe, would be repaired in a few months which is contradicted by actual case observations.
(e. g. the 1999 storms in Europe, the 2002 floods in Central Europe, and the 2004 hurricane season in Florida). There are strong financial constraints applying to reconstruction, particularly but not exclusively in poor countries, as well as technical constraints, such as the lack of qualified workers and building equipment. We have numerous empirical examples of the existence of such constraints which are also responsible for what is called "demand surge", i.e. price inflation for the goods and services required for post-disaster reconstruction.
These constraints may considerably increase the total cost of an event. For instance, operating losses during actual reconstruction time must be added to the cost of a ruined factory.
Similarly, in the housing sector, the destruction of a house which takes a year to be rebuilt has a total cost equal to the replacement cost of the house plus lost value relating to one year of "housing service". The value of production losses in the widest acceptance can be very high in several sectors, specially when basic needs are at stake (housing, health, jobs, etc.).
Applied to the economy as a whole, the difference can be huge for large scale disasters.

These constraints may provide an explanation for "poverty traps" in which some poor countries seem to be caught: since they are poor, they have a low capacity for reconstruction after each disaster.
Because they have such a low capacity and are widely exposed to dangerous events (tropical hurricanes, floods, droughts), successive disasters may hinder them from accumulating infrastructure and capital and therefore from developing their economy which would improve their post-disaster reconstruction capacity.
Development agencies recently acknowledged the problem when they asked for risk management to be consistently included in development projects.

These constraints may also make the economy highly vulnerable to an increase in disaster intensity and/or frequency.
The impact of climate change could well lead to an extension of these poverty traps.
This is not inevitable however since specific economic adaptation may increase reconstruction capacities and ease constraints. Mention can be made of changed regulations for the insurance industry (e. g. Solvability 2 in the EU), the development of government-funded insurance schemes (e. g. the Florida Hurricane Catastrophe Fund or the "Cat-Nat "system in France), and the spontaneous growth of production capacity in the reconstruction industry in response to rising demand and the increase in interregional and international aid, which should extend from the emergency period to the whole reconstruction period.
The way in which some of the private and public economic actors manage escalating risks will, to a large extent, determine their macroeconomic cost.