How Do We Nudge "Behavioral" Decision Makers to Adapt to Emerging Climate Risks?

 An excellent new NBER Working Paper titled “Mandated vs. Voluntary Adaptation to Natural Disasters: The Case of U.S Wildfires” has been published.  The authors have assembled a great data set to document that building codes cause upgrades of properties such that subsequent wildfires cause lower damage to property.  This is a highly optimistic adaptation paper and it puts Government at the center of achieving adaptation progress.  The authors argue that building codes are a binding constraint such that in the absence of this constraint that people would have chosen to build lower quality structures that would have exposed them to more fire risk.

A direct quote from the paper’s abstract:  

“Despite escalating disaster losses and predicted increases in weather-related catastrophes, takeup of protective technologies and behaviors appears limited by myopia, externalities, and other factors. One response to such frictions is to mandate adaptive investment.”

In this blog post, I will offer a few thoughts related to my research agenda on the microeconomics of climate change adaptation.  

First, I am thrilled that more and more young scholars are working on this topic. I am not surprised that their work highlights our economy’s impressive adaptation capacity. 

Second,  I love this intellectual tension that posits that behavioral economics can explain under-investment in resilience.  In my 2015 paper, I discuss the broad issue.

1. Kahn Matthew E., 2015. “Climate Change Adaptation Will Offer a Sharp Test of the Claims of Behavioral Economics,” The Economists’ Voice, De Gruyter, vol. 12(1), pages 25-30, August.

 My main point is to discuss the role of the insurance industry here. In my co-authored 2017 Harvard Business Review piece, we argue that the insurance industry could be the “adult in the room” here if insurers are allowed to risk price and to “price gouge” when risks rise.   Suppose that fire risk is rising in a fire zone.  In the absence of government regulation, insurance prices for real estate will rise there.  An insurer could embrace the Ehrlich/Becker paradigm and offer a non-linear contract that lowers the fire insurance premium if the property owner takes specific precautions.  In this case, real estate developers who build new homes in the fire zone would take these safety enhancing steps in building the homes because they can sell the home for a higher price.  Why?   The present discounted value of insurance premium expenditures will be lower for the safer homes.  In my 2021 RMS interview, I expand upon these themes.  

I view government building codes and the insurance industry’s non-linear pricing to be substitutes in building up our resilience to increasing climate risk.  Since the government regulates insurance and effectively subsidizes risk taking (by putting limits on insurer “price gouging”), building codes are needed to raise the average quality of the housing stock in risky places.  

Read this New York Times piece titled

California Bars Insurers From Dropping Policies in Wildfire Areas

Finally, a theme I discuss in my 2021 Yale Press book is that home owners are “amateurs”.  Frank Wolak and I discuss this in our 2013 energy paper.  If more people rent their homes then professional managers would manage more of the housing stock and these profit maximizers will have the scale of assets to invest in human capital to better understand the emerging risk. If professional management companies operated our assets, then the case for the need for government mandated building codes would be weaker.

Permit me to suggest a new research topic on endogenous adaptation innovation.  Building codes serve as a commitment device. If innovators in the home construction sector see that there are new building code mandates, this acts as a “Big Push” commitment device.  Such innovators now have an incentive to invest their time to learn how to make safer homes and this shifts the production possibility frontier.

Why do so many people live in the fire zone?  If we up zone in cities, then fewer people will live in areas that face increased fire risk. Read Enrico’s great New York Times piece.  

UPDATE:  I do have a question about durable capital.  Building codes affect the quality of the flow of new housing constructed in the risky area. I do not believe that building codes affect the stock of existing homes that have not burned down.  The average risk at a point in time is a weighted average of the risks faced by both sets.   In slow growing areas, the building codes will not achieve average risk reduction for a long time.

In contrast, insurance pricing that incentivizes self protection would impact all homes immediately . So, I claim that using insurance prices will more quickly flatten the climate damage function than relying on binding building codes for new homes.