Hurricane Sandy, Climate Change, and Market Signals

A question that will surely be considered over the coming weeks is whether or not Hurricane Sandy was caused, in whole or part, by climate change. A NYT article has already asked this very question.  

Climate change is defined as a change in a distribution (the climate being a distribution of weather outcomes). Even if our models were perfect, and we knew with certainty that hurricanes were x% more likely to occur this year than last year, we would not be able to say that climate change caused this hurricane to occur, or this hurricane to be stronger than it otherwise would have been. Only with a set of observations can you observe changes to a distribution. 

Compounding this, our models aren’t perfect, and climate data is very noisy. The best that we can say is that, for any given time period in the future, on the East Coast of the US, hurricanes are probably more likely occur (notice there are two qualifications). 

Our climatic models are good, but we don’t have total confidence in them, so we can only say that they are “probably” correct. Second, even if we did have total confidence in them, they don’t make ironclad predictions for any length of time – only probabilistic assertions – so we can only say that hurricanes are “more likely” pr “x% more likely” – not that N hurricanes will occur.  

This is very difficult for the average person to process, and it is very hard to make forward-looking decisions with this type of information. Fortunately, we have mechanisms that are very good at cutting through this type of very noisy, probabilistic data to provide a clear signal: markets. 

One area that will be interesting to observe following this Hurricane is the insurance market, as insurers revisit the premia they charge for wind, water, and fire insurance. If they decide that the threat of hurricanes on the highly populated East Coast is higher in a changing or different climate, than the cost to reinsurers to, in turn, insure themselves through catastrophe bonds or other insurance-linked-securities will drive primary market prices higher. Higher premia for these things will send a signal that it is better (all other things equal) to live or develop elsewhere. 

I have little doubt that markets will evolve to provide the necessary signal; in fact exotic securities are being developed to more directly trade and price this risk. The real question is: given the pace of climate change, and the lifespan of our at-risk capital stock (those in areas exposed to negative impacts of climate change), how much stranded capital will we be left with? Think: agricultural communities where the climate become unfavorable for crops, or communities exposed to high levels of hurricane risk. Did the condo developer on the Jersey Shore correctly price this risk in five years ago? Will she today? The answers to these types of questions will determine, in large part, the extent of climate change’s impact on humanity.