Risk Sharing in a Global Economy Facing Increased Physical Risk from Climate Change
The Adaptive Role Played by Financial Markets
When I was young, I didn’t really like the song “Imagine” by John Lennon and Yoko Ono. It didn’t rock out. It didn’t sound like Led Zeppelin. Now that I’m older, I like it. This entry is a twist on the Lennon/Yoko theme of thinking about how our lives would be affected by introducing different rules.
Let’s start with a simple case of the role that risk sharing can play in a risky economy. Matthew lives in Los Angeles and Jane lives in Chicago. Matthew and Jane each can produce 100 pizzas a day if there is no rain. If there is rain in their respective city, then they produce zero pizza. The probability that there is rain each day in a city is 50% and the probability that it rains in Chicago is independent of the probability that there is rain in Los Angeles.
If Matthew and Jane do not trade together, then each has a 50% chance of producing 0 pizza each day and a 50% chance of producing 100 pizza. The expected pizza produced is 50.
If neither has a storage facility, they would be eager to sign a contract where there are four contingencies;
#1 rain in Los Angeles and no rain in Chicago (in this case , Jane sends Matt 50 pizzas)
#2 rain in Chicago and no rain in Los Angeles, (in this case Matt sends Jane 50 pizzas)
#3 no rain in either city (no transfers of pizza)
#4 rain in both cities (no transfers of pizza)
Under this risk sharing contract, Matt’s consumption of pizza across these 4 scenarios would (#1 50, #2 50, #3 100, #4 0)
Jane’s consumption of pizza across these 4 scenarios would be (50,50,100,0)
If they don’t sign this contract, Matt’s consumption of pizza would be (0,100,100,0) and Jane’s consumption across the 4 scenarios would be (100,0,100,0)
The point of this example is that the ability to sign a spatial insurance contract reduces one’s exposure to place based risk (local rain). Of course, I cheated a little bit by not including transportation costs. I assumed that the pizza could be costlessly shipped from one city to the other.
The only scenario where this insurance fails is if they both experience rain that wipes out their pizza production.
THE POINT here is that this example generalizes. The world economy’s GNP is 100 Trillion per year. Financial markets allow people who live in a particular location such as Miami to diversify spatial risk shocks such as local heat waves and natural disasters. Even a $50 billion dollar storm is tiny relative to a $100 trillion dollar economy.
Given that the death toll from natural disasters continues to decline, a key point in adapting to climate change is to use financial markets and insurance to globally share risk. As I discuss in my 2021 book, if we rent houses and use our money to invest in a globally diversified index fund of stocks then we are less exposed to place based shocks. The rise of Work from Home further protects us as a firm’s productivity isn’t as tied to place base shocks to the location’s headquarters. The key to adapting to climate change is to reduce the safety risk and productivity risk and portfolio risk of place based shocks. Our market economy is evolving to allow us to share more of the risk. On any given day, shocks do occur all over the world but this is a huge world and these shocks tend to wash out in the aggregate. If one area has a bad wheat harvest due to extreme weather, there is another area who has a fine harvest and it gains from the misfortune of its rival. An owner of a diversified wheat producer index fund would not suffer a loss from the place based shock to the place that suffered.
Climate economists have not done enough work on the role of markets in allowing for risk sharing. This matters because climate change will increase the severity of these shocks and this makes risk sharing even more important going forward.
If John Lennon and Yoko Ono allowed me to co-author imagine, I would add the stanza; “Imagine there are complete risk sharing markets. It is easy if you try. Easier adaptation in the face of localized climate shocks.”!