Climate Risk as a Market Failure

Is our ongoing exposure to climate risk a market failure? How well do we price shifts in future availability and quality of natural resources essential for our economies and ecosystems? Can we price resilience?

Market failures occur when resources are not allocated in an (economically) efficient manner — that is, we do not maximize their benefit for the activity or product in question, or for one use relative to other potential uses.

Critical economic resources like coal, rare minerals, and petroleum have long been a source of speculation and see dramatic changes in pricing, including in futures markets. Their pricing is sensitive to what we know about consumption and availability patterns. As debates about scarce resources such as the Simon-Ehrlich Wager show, with effective information, markets are often able to compensate in creative ways, such as reducing dependency on a scarce resource, finding new sources of scarce materials, and/or increasing use efficiency.

Climate risk is challenging to account for from an economic perspective. Often we have a limited, highly uncertain understanding of direct physical risks for a project, institution, or investment in question; attributing risk to climate change is difficult to model or observe, and economics as a discipline has a strong tendency to undervalue uncertainties and alternative scenarios. The uncertainties around climate impacts on the water cycle are dramatic and high. How do you act decisively to such vagaries? The answer is you can’t, and for many decision makers the cost of keeping options open to address a potentially broader range of changes is not a good buy. Limiting information — willful blindness? — is a widespread reaction if the models don’t seem to show clear patterns. Moving to other types of indirect risks — reputational, governance, operational, strategic, financial — are even harder to attribute directly to climate change.

Resilience is different (and more ambitious) than simply de-risking of course. So if water serves as a key medium for resilience, then market failures (and successes) with water will also influence how we approach resilience. Here, I am referring to resilience to mean the ability to weather both shocks and stresses and to reorganize systems and even shift goals as conditions evolve over time. Resilience implies seeing a system as a system, so that you can anticipate systemic threats.

Water as a medium for resilience has a lot of flaws. It’s often a public good (at least in part), so we may not have strong incentives to husband or replenish water sources. We care about water’s role for many uses that do not have a clear or meaningful financial value. And water is often hidden, either literally in the sense of being out of sight in an aquifer or reservoir of unknown or plastic size, unseen in the sense of being unmonitored and unmodeled (or badly measured and modeled), or masked and embedded within other essential systems and services, such as in energy, server farms, manufacturing processes, or food and agriculture systems.

As a result, water is not usefully priced and measured as a “futures” market or from an options perspective. And thus we’re not pricing water or resilience. Markets don’t work well with water now, much less future water. And resilience doesn’t register as a market.

These conditions could change if we could more directly measure resilience. And we might also value water differently if we had high confidence about how much water we might have in the future.

In practice, the best approaches I have seen to date explore alternative scenarios, such as in a software platform called GCAM. Given a particular set of climate conditions, for instance, what energy sources (or adjustments to specific investments) provide the best grid resilience? What are the costs of disruptions or failures for a given level of resilience? And how will that level of resilience interact with other choices? GCAM has been used by the World Bank to explore alternative approaches along these lines (and other sectors besides energy) for some of their Climate Change Development Reports (CCDRs). Water resources are critical in these analyses, since water is both highly sensitive to usage patterns and climate change and highly variable in projections for future conditions. GCAM can be used as a stress test for alternative scenarios, at least at a high level. In effect, GCAM is helping countries and investors more effectively see water as a flow rather than as a stock and as a set of tradeoffs, where resilience is the ability to thrive despite shifts in flow.

John H, Matthews

Corvallis, Oregon, USA