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Climate Change and Free Markets

The President’s Climate Action Plan argues that “(c)limate change represents one of our [sic] greatest challenges of our time, but it is a challenge uniquely suited to America’s strengths.”

If our challenge is indeed “change,” we might do better by turning to America’s strength in financial services rather than its relative inexperience in centrally directing resources. According to David Riker, founder of the New York-based Storm Exchange Inc., when “volatility is the issue, nothing is better than financial markets at valuing the risk and spreading it out.” And America has long been a leader in offering productive financial services.

Competitive insurance markets, for example, can diversify a household’s exposure to variations in climate while economically encouraging people to move away from the possibility of too much harm. On important margins like these, insurance can help us adapt to a climate that may, as the Nobel Prize-winning physicist Robert Laughlin argues, express a mind of its own.

(Unfortunately, people in the insurance sector, and indeed the broader financial sector as a whole, are also tempted to side-step unyielding economic laws to chase the lures of crony capitalism. Chicago economists Raghu Rajan and Luigi Zingales and Hoover Institution’s Russ Roberts offer careful yet accessible explanations of this interaction between politics and economics.)

Insurance markets can also encourage innovations that fundamentally reduce the cost of living with climate variability, whether or not it is increasing. For example, WeatherFlow Inc. blanketed hurricane prone areas of the United States with durable private weather stations, and now collaborates with Risk Management Solutions (RMS) to turn data from these stations into a new type of catastrophe or “cat” bond.

Unlike conventional insurance policies, which can require time-consuming and sometimes contentious damage assessments before offering relief, these bonds make payments as soon as wind velocity reaches a mutually agreed upon and easily verified speed. According to WeatherFlow and RMS, the “insured is paid days after the event rather than waiting for months to settle a claim.”

Other financial markets can offer similar benefits. Temperature is not the only dimension on which climate can vary. Changes in when, where, and how much rain falls, for example, are also important. Chicago’s CME Group offers help to businesses in the agricultural, travel, and other sectors that might benefit from trading their exposures to such variance. It does so by creating a type of dating-service that initiates relationships with counterparties who are less directly exposed to particular perils and thus better able to diversify against associated variances. The resulting efficiency gains benefit the market maker (that is, CME Group) as well as both parties to the exchange.

Recently addressing a Georgetown University audience, President Obama noted that “how we answer [the threat of climate change] will have a profound impact on the world we leave behind not just to you but to your children and your grandchildren.” The administration’s second-term agenda initiates a number of new precautionary measures to guard against catastrophe in that future world.

Instead of opening doors to anonymous opportunity, these measures may be shutting them for all but a favored few. Competitive markets, not centralized authorities, have a much better track record of increasing economic wealth while improving environmental quality.

Top-down policies in the name of climate insurance can compromise both. Financial regulations that exact real costs from opportunists can do better than recent “reforms” that may be stoking the flames of crony capitalism and discouraging responsible money from finding durable environmental solutions.

Originally posted at the Bush Center’s Economic Growth Blog.

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