ws 6 background document adaptation conference nov 2010

8/4/2019 Ws 6 Background Document Adaptation Conference Nov 2010

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Adaptation to the changing climate:time to intensify effortsBrussels, 23-24 November 2010

Background document for Workshop 6:Limiting budgetary and fiscal implications

of climate change: optimising andmaximising private and public adaptationcapacity

Text1 based on the study by

Egenhofer C., J. Nez Ferrer, A. Loeschel, A. Dannenderg, D. Osberghaus, A. Behrens, A. Georgiev, J.Mortensen, P. Heller (2010), The fiscal implications of climate change implications, PART I and PART II,

Study for the Directorate General Economic and Financial Affairs, European Commission, Brussels.

http://ec.europa.eu/economy_finance/publications/external_studies/ex_study1_en.htm

1 This summary has been prepared by Jorge Nez Ferrer, co-author. He is an Associate Research Fellow of the Centrefor European Policy Studies, CEPS. Responsibility of any errors and deviations from the original study can only beattributed to him.
http://ec.europa.eu/economy_finance/publications/external_studies/ex_study1_en.htmhttp://ec.europa.eu/economy_finance/publications/external_studies/ex_study1_en.htmhttp://ec.europa.eu/economy_finance/publications/external_studies/ex_study1_en.htm


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ContentsAbstract ............................................................................................................................................................. 3

1. Introduction ............................................................................................................................................... 3

1.1 Questions for structuring the workshop debate ..................................................................................... 3

1.2 Introduction ............................................................................................................................................. 4

2. Understanding when to undertake adaptation actions ............................................................................ 4

3. Understanding the drivers of fiscal implications ....................................................................................... 6

3.1 Degree of exposure to climate events..................................................................................................... 7

3.2 Level of protection already in place in areas at risk ................................................................................ 9

3.3 Level of state liability ............................................................................................................................. 10

3.4 Potential fiscal impacts of autonomous adaptation ............................................................................. 11

3.5 Cross border effects of climate change ................................................................................................. 11

3.6 Fiscal capacity of the state and the role of the EU ................................................................................ 11

3.7 Policy implications to minimise impacts of fiscal cost drivers............................................................... 12

3.7.1 Measures to reduce negative fiscal implications of exposure ....................................................... 12

3.7.2 Measures to reduce negative fiscal implications of state liability ................................................. 13

3.7.3 Measures to reduce negative fiscal implications of suboptimal autonomous adaptation ............ 13

3.7.4 Measures to reduce negative fiscal implications of cross border effects ...................................... 14

3.7.5 Measures to ease limitations on the fiscal capacity of some member states ............................... 15

4. Understanding the magnitude of the budgetary and fiscal burden of adaptation ................................. 15

5. The use of insurance markets to improve climate change adaptation ................................................... 17

5.1 Types of insurance ........................................................................................................................... 19

5.1.1 Mandatory natural hazard insurance ............................................................................................. 19

5.1.2 Index-based insurance .................................................................................................................... 20

5.1.3 Specific agricultural insurance solutions ........................................................................................ 20

5.1.4 State as insurer of last resort ......................................................................................................... 22

5.2 International pooling ............................................................................................................................. 23

5.2.1 Reinsurance .................................................................................................................................... 23

5.2.2 Catastrophe bonds ......................................................................................................................... 24

5.2.3 Weather derivatives ....................................................................................................................... 24

6. Conclusions .............................................................................................................................................. 24

References ....................................................................................................................................................... 26


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ADAPTATION TO THE CHANGING CLIMATE: TIME TO INTENSIFY EFFORTS Brussels 23-24 November 2010

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Abstract

Climate change will increasingly impact economic activities positively or negatively. Most studiesconverge that in Europe as a whole, negative impacts will exceed positive ones. It is also clear thatthe significance of the changes will vary considerably between countries and regions, but that allwill face larger variability in the impact, i.e. regions expected to benefit on average will also facelarger weather uncertainty and thus larger fluctuations in fiscal implications (direct damage costs or

tax revenue changes) compared to today

Workshop 6 looks at the budgetary and fiscal implications of adaptation to climate change, which iscomposed of direct costs and indirect costs and benefits. The direct costs are caused by stateinvestments in anticipatory measures or reacting to impacts; indirect costs and benefits arisethrough the impacts on the economy and the effects on fiscal revues. The magnitude of the fiscalimplications varies depending on the policy mix. Given fiscal constraints and the expected negativeimpacts of population ageing, it is important that adaptation actions are optimised in format andtiming. This means understanding the potentials and limitations of autonomous private adaptationand the areas where state interventions are necessary to cost effectively limit negative impacts to theeconomy (and/or maximise positive impacts). This will require a review of state regulatory andfiscal mechanisms and a review of the central role of the private insurance sector. This is a complextask, especially in view of the large uncertainties on the kind and magnitude of impacts.

1. Introduction

1.1 Questions for structuring the workshop debate

1) What are the direct and indirect fiscal implications of climate change?2) How can negative fiscal implications be prevented through appropriate adaptation measures?3) What fiscal instruments are available?4) What is the role of the private sector in adaptation and in particular of the insurance sector?5) What are the main unresolved issues (& questions) that affect the potential effectiveness of

relevant instruments to address adaptation needs and the

6) What role does the EU have to play with regard to climate adaptation based on the subsidiarityprinciple, taking into account cross border implications and equity considerations?


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1.2 Introduction

Climate change will have an effect on the European Union. The repercussions will be regionallyvaried, with impacts on several sectors in the economy. Climate change has the particularity ofbeing global with respect to the source of emissions and local with respect to the consequences(whether positive or negative). The source of emissions are linked to the most basic actions ofhuman activity, from energy consumption to farming, while the impact of climatic changes are

broader, affecting, inter alia, economic activities, land use, biodiversity, public health and watersystems. This means that for the first time in history there is a need to align large parts of fiscal andregulatory policy with environmental concerns, from the local to the national and supranationallevel.

Weather impacts will hit agricultural production, the tourism industry and public health, be itnegatively or positively; they will also increase or reduce the risks of river floods or droughts, aswell as hit the hydroelectric power stations and the cooling systems of other generators. Sea levelrise will also pose considerable threats to many coastal areas. Studies on those large impactsabound, and show large differences in the quantification of impacts and their time scale. Even if wewere able to quantify the effects of climate change under a business as usual scenario, , a number of

fundamental questions emerge on the policy approach.

The principal question is

How do we respond to maximise welfare while minimising the fiscal implications?To answer this question we need to understand the potential autonomous adaptation capacity ofindividual actors. One of the first fiscally costs effective response is to gear autonomous adaptationto minimise socio-economic damages (or maximise benefits) limiting negative fiscal costs.

Studies tend to only address costs of climate impact and mainly a business as usual scenario.

Adaptation costs analysis also focuses on direct costs and often reactive, i.e. as a response to aclimate impact. From a policy making point of view, the results have largely been unsatisfactory.Time scales of impacts do not allow for present policy planning and uncertainties are large anddifficult to develop an appropriate cost benefit analysis for actions. Studies which are operationalfor policy-making today are missing and this needs to be resolved.

This paper is summary of the work undertaken by CEPS and ZEW2 for the European Commissionon fiscal implications for Climate Change (Egenhofer et al. 2010), we can find some importantmessages to take home and develop into effective policies, while the ground work for future actioncan be planned ahead.

2. Understanding when to undertake adaptation actionsThe Egenhofer et al. (2010) study analyses the behaviour of economic agents and how to alter it toreach a social optimum level of adaptation. It focuses on the rational economic decision-making inthe face of climate change by individual agents, taking into account their profit maximisingobjectives, the existence of market failures and uncertainty. This is central to optimising plannedresponses by the state.

2 Centre for European Economic Research, Mannheim, Germany


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As mentioned earlier, there are two types of adaptation to climate change - autonomous and plannedadaption - which can then be either anticipatory or reactive. Autonomous adaptation is defined asthe unaided and unguided actions of private individual agents; this may also entail collective actionas long as it is not emerging through a public policy intervention. Planned adaptation involves theintervention of the state to address market failures in the adaptation process, issues like equity,security of supply of public goods or essential goods and services. Anticipatory actions are those

that prepare for future impacts, while reactive actions are taken at the moment of or after theclimatic impacts.

Policy interventions to assist adaptation should take place when autonomous adaptation issuboptimal and social costs are higher. This may be because the optimal adaptation for a profitmaximising individual is lower than the adaptation required for a social optimum, or simplybecause the individuals do not have the means to cover the adaptation costs they have to bear. Othercauses of suboptimal adaptation are imperfect information and moral hazard, which driveindividuals not to adapt sufficiently.

There is a complex relationship between climate change impacts, socio-economic impacts and fiscal

policy implications. From a fiscal and economic policy perspective, the objective of a planner is tomaximise social welfare while minimising the negative fiscal implications. This requires anunderstanding of the autonomous adaption taking place and the market and policy failures thatemerge from those actions, as well as other potentially unacceptable impacts on society, affectingfor example equity. In the Egenhofer et al. (2010) report, the theoretical framework is presentedconcentrating on the use of cost benefit analysis and more extended tools derived from costs benefitanalysis to help understand the difference implications climate change adaptation measures canhave on policy formulations.

For the policy-maker, the most difficult issue to address is the uncertainty of the timing andmagnitude of impacts and how those translate into fiscal effects. Policy intervention may lead to an

inefficient result with negative impacts to the economy if adaptation measures are either too smallor too ambitious. Different options have also different implications for fiscal costs and governmentrevenues. The potential impacts of extreme events are seen in the study as important and presentlyunderestimated, and policy-makers need to consider the kind of actions needed for very lowprobability but very high cost events. Those cases are difficult to predict and generally absent fromstudies on climate change impacts, which often only look at gradual changes and average impacts.

One of the most complex issues in the analysis of climate impacts is timing. When should anadaptation measure take place? Models diverge strongly on the size of impacts and also the timingof those impacts. Based on a cost benefit analysis under uncertainty, the net present value of anaction integrates the impact on the value of the action under different risk levels, the costs and

benefits of early or delayed action and the influence of maintenance costs.

This has a considerable influence on decisions. In a normal cost benefit analysis, a decision toundertake an investment is taken when the present value is equal or higher than the costs. This doesnot hold under uncertainty of the timing of impacts. Given the uncertainty of expected regionaleffects of climate change, the benefits of an investment (the present value) both by private orpublic actorsin an adaptation project, have to exceed the costs by an additional positive amount(so-called hurdle rate), in order to justify the investment. This amount above the investment cost iscalled the option value not to invest but to wait and to delay the project. The optimal solution ofthis problem includes the comparison of investment costs and present values at all possible timeslots, i.e. it has to be taken into account that the investment is possible at different moments. Usingthe option to wait, an investor can possibly gain new information about future benefits (but also


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about better adaptation techniques which may reduce costs) and can adapt his behaviour to changedconditions. The higher the uncertainty on the timing of an impact and the larger the timedistribution of the risk of an event, the higher the option value will be3. Real option effects can workinto the opposite direction, too: cheap options for adaptation or mitigation may disappear or becomemore costly as climate change intensifies over time. Therefore, appropriate analysis of an adaptationstrategy has to incorporate this aspect too.

Crucial in the decision to undertake planned adaptation actions is to understand the potential forprivate adaptation. The study has concentrated considerably on one of the cornerstones for managerisk by private actors, and these are the insurance markets. Functioning insurance markets arecentral to limit the liability of the state and ensure optimal adaptation. Public authorities need toexplore further the use of those markets and the potential of public private partnerships to blendtheir benefits with the needs for state coverage of extreme events, such as state guarantees forexcessive uninsurable damages. This could also include the creation of supranational reinsurancemarkets to support, at EU level, national insurance schemes in case of large damages across largeterritories. The way insurance is offered will be crucial to avoid moral hazard, which is clearlypresent across a number of countries, whenever state guarantees provide a disincentive to take

private insurance, shifting private insurable costs unnecessarily to the state budget. Localgovernment authorities may also avoid taking the necessary precautionary actions because theyanticipate compensation for damages from the state or even from the EU.

There is palette of options for insurance systems that could be efficiently deployed which have beenanalysed in the Egenhofer et al. (2010), report. Member states and the EU have to review theirpolicy framework in this respect, in order to ensure that the private-public insurance combination isthe most appropriate and least costly to the economy and the public finances.

3. Understanding the drivers of fiscal implications

Studies on climate change discuss the impacts of climate change and general costs, but rarely

analyse how these then reflect as fiscal implications. The size of fiscal impacts are determined bythe following drivers:

1) Degree of exposure to gradual and extreme climate events2) Level of protection in areas at risk already in place, i.e. preparedness3) State liability for damages4) Potential and impacts of autonomous adaptation and remedial actions5) Cross border effects of climate change6) Fiscal capacity of the member states and the role of the EU

3 Example: An adaptation measure costs 100 today and has the expected value of 110 (in present value). However, dueto uncertainty of I,pacts also the benefits are uncertain, the benefits only occur if the event takes place, i.e. a climateimpact. Uncertainties can be expected to reduce over time as information improves, also new more cost effective waysto address the problem may arise over time. The policy-maker may conclude that despite the positive outcome, realising

the project later may increase the value of the intervention by over the 10 net present value.


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Figure 1. Drivers of fiscal impacts

Apart from the Egenhofer et al. (ibid) study, no other attempt seems to have been made tosatisfactorily address the way in which those parameters affect the state budget and in particular itsstability. This study offers a first attempt at classifying those fiscal risks. From the case studiesundertaken and other literature reviews, it is clear that fiscal consequences are not negligible. Anumber of predicted climate changes and in particular extreme events can severely hit the fiscalstability of a number of member states.

3.1 Degree of exposure to climate events

Impacts and costs from climate change will depend strongly on the exposure of the individualcountries to climate change. The case studies show important differences between the memberstates, which are in line with the broader findings of other studies, such as PESETA by the JRC

published in 2009.

The case studies identify the climatic changes which will cause impacts to the economy, which are:

Changes in average temperature in the seasons and expected increase in temperatureextremes

Changes in precipitation patterns Changes in snow cover Changes in water systems: river flow changes (flood and draught risks); groundwater level

changes

Coastal region impacts: sea level rise and flood risks.

Level of Exposure to

climate change impacts

Level of protection in

areas at risk already in

place, i.e. preparedness

Potential fiscal impacts of

autonomous adaptation

State liability for

protection and damages

from extreme events

Fiscal capacity of the

member states and EU

assistance

Cross border effects of

climate change

Direct

budgetary

effects

Indirect

budgetary

effects

Budgetary

balances

Costs of protection; repair

and maintenance of public

infrastructures

Impacts on economy

and tax revenues

Impacts on social

costs

Costs of damage

repair and

compensation


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Some regions are particularly vulnerable to one or several of those changes, which can lead toimportant costs of state intervention to mitigate direct impacts, but also affect social transfers,changes in state revenues, etc. In areas where exposure to negative impacts is high, appropriatemeasures to reduce the negative impacts of climate change can considerably reduce the economicand fiscal effects of the events. Ensuring an adequate level of autonomous and public anticipatoryadaptation becomes a key determinant.

Sea level rise is expected to threaten important economic centres on the Atlantic coast, the NorthSea and also in the Mediterranean. Studies have shown very different levels of protection in equallyexposed regions. For example, most of the Atlantic and North Sea coast is highly exposed but at thesame time generally also highly protected by existing infrastructures. For example, in Germanyexisting infrastructures reduce strongly the costs of further protection. In the Mediterranean,protection from sea level rise has never been a central issue. While not exposed to the same level ofextreme sea surges as on the Atlantic coasts, peninsulas like Italy with a very large coastline and alarge share of the population and economic assets concentrated along the coastline are highlyexposed to the gradual rise of the sea level. Only Venice is developing a defensive strategy, but thatpre-dates climate induced sea level changes, as it originates from the land subsidence under the city.

It is clear that awareness of risks is lower due to the much lower impacts of tidal waves, but there isa need for the authorities of countries in the Mediterranean to analyse the implications a sea levelrise can bring to coastal areas.

Costa et al. (2009) have estimated the costs of protecting EU coastal areas and have pinpointedcountries with high exposure, which would find the costs too high to bear. While the benefits of aproper protection at EU level are considered high in the studies like PESETA, studies by Costa etal. (2009) and the IMF (2008) estimate that for smaller and poorer EU member states such as inCyprus, Malta or Estonia, the costs may be too high. In Estonia, the protection of the coastlinehighly exceeds the benefits in terms of GDP costs at the level of 2007. Following a purelyeconomic logic, it would therefore be rational to abandon large stretches of Estonia to the sea.

The Mediterranean countries are in general highly exposed not only to sea level rise, but even moreso to drought, leaving aside the reduction in snow in mountain ranges in Spain and Italy that willaffect winter tourism. High exposure to drought will have large direct impacts for the agriculturalsector and water infrastructures. Infrastructure costs, and rises in extreme summer temperatures canincrease social costs such as health costs as well as reduce productivity.

One of the only areas where fiscal implications have been directly researched has been for sea leveland river flood protection. This is due to the public nature of the infrastructures, which are mostlybuilt and maintained by the state, and to the high state liability in responding to the damages causedby extreme events. However, most studies do not look beyond the direct costs and to the longer

implications of changes and catastrophic events which may damage the growth rate of the economyfor long periods of time.

Many areas of Europe are highly vulnerable to changes in river flows, affecting large areas,including many economic centres, and bringing a real risk of unsustainable fiscal impacts fromrepeated extreme events. Several countries are highlighted as being at large risk (hot spots) withpotentially important budgetary costs from river flow changes, in particular floods. Poorer Centraland Eastern European countries are facing potentially unsustainable costs, and even richer memberstates such as Austria are pinpointed as hot spots of extreme flood events and associated large coststo be incurred by the government. The example of Austrias political and fiscal crisis after aflooding in 2002 may be a pointer that extreme events put even the public finances of economically

more advanced European countries under strain. Some projections by Mechler et al. 2009 for the


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end of the century show that almost all of the EU Member States with below average per capitaGDP have a potential flood damage risk higher than 1% of GDP annually (Figure 2).

Figure 2. Maximum average annual flood risk across EU countries (% GDP)

Note: This is not loss ofGDP, but loss measuredin terms ofGDP. Losses relate to assets, while GDP relatesto income generated from those assets.Source: Adapted from Mechler et al. (2009, p. 9)

The impact of Hurricane Katrina in the US has also been a clear signal of the risks ofunderestimating the costs of extreme events. In New Orleans potential damage costs were estimated

at US$ 16 billion before the event, while just the direct damage alone to dwellings, governmentbuildings and public infrastructure reached US$ 27 billion. An aid package of over 100 billion hadto be unblocked to assist the city.

Other impacts that can have large local repercussions are changes affecting the snow cover inEuropes mountains, which will affect the tourist sector, at times positively, but in some regions itcan damage strongly the local economy. Similar cases arise for droughts affecting the agriculturalsector in several Mediterranean areas. These localised impacts may have budgetary implications, inparticular for transfers due to increases in unemployment.

3.2 Level of protection already in place in areas at risk

The level of existing protection, as well as existing levels of awareness, influences the costs ofclimatic impacts considerably. An already high existing level of preventive measures and the betterawareness of the population and governments can reduce future costs of adaptation to sea level risesignificantly. This has been documented in the case study for Germany by Egenhofer et al. (2010),but for other European countries this may not be the case. A sea level rise is expected to implyeither a costly development of coastal protection in many member states or a difficult retreat fromthe sea, shifting settlements and infrastructures away from the coastline. In Italy, fortunately and forreasons independent to climate concerns, existing laws restricting construction close to the sea frontwill reduce some of the costs.

Nevertheless, the projected increases in the sea level are at times too high to avoid considerablecosts of protection even in well equipped areas. In the Netherlands the sea level rise over this

Maximum Average Annual Damage in % of GDP

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.61.8

2

AT BE BG CZ DE DK EE ES FI FR GR HU IE IT LT LU LV NL PL PT RO SE SI SK UK

Countries

Percentoflossto

GDP


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century might go beyond the technically possible with the present dikes system. The Dutch statetherefore ordered a study by a special commission that presented in 2008 a plan to create newdefences, mainly through an extensive beach nourishment programme, which would expand theterritory into the sea (Deltacommissie, 2008). Given the uncertainty surrounding the future sea levelrise, the Commission recommends to build protections based on the upper limits expected, giventhe large consequences of any shortcoming in the protection level. To give an order of magnitude,

the Delta programme was planned to start from 2010 onwards at an annual cost of 1.2 to up to 1.9billion a year until 2050 and of 0.9 to up to 1,8 billion after 2050. The constant maintenance ofthe infrastructure means that these costs do not decrease over time.4 It is interesting that the annualexpenditure estimated by the Deltacommissie for the reinforcement of their protection aloneexceeds by far most estimations of studies undertaken for the EU as a whole, which puts intoquestion existing methods of estimation in the top down EU-wide analyses.

3.3 Level of state liability

The theoretical framework and the case studies of the Egenhofer (ibid.) report pinpoint as a majorfiscal cost the liability of the state in compensating victims from extreme events. The state is inmany countries expected to cover the costs of natural catastrophes, be it by floods or droughts.

However, private insurance schemes, combined with an appropriate regulatory environment and alimited liability of the state for damages beyond the insurable threshold, would reduce the fiscalconsequences of extreme events considerably and needs to be explored extensively.

The lack of private insurance against natural events is highlighted as a problem in the cases ofdamages from a sea level rise, from river flooding and from droughts, in particular for theagricultural sector. For housing, compulsory insurance against natural hazards has been introducedin a number of countries, but is surprisingly absent or very limited in some member states. Forexample, there have been attempts to impose a certain level of compulsory insurance for naturalevents in Germany, but failed for political reasons and apparently lack of understanding by policy-makers (Schwarze and Wagner, 2009).

For most countries the state bears the totality of coastal protection, but there are exceptions. This isthe case of Finland where there is a shared responsibility of landowners. Nevertheless, the stateliability is still estimated at 90%. Interesting are the cases of Denmark and Malta, where stateliability of coastal protection falls to 50%. Here the liability of the state for building coastalprotection is limited. This encourages private owners to seek insurance and invest in protection, atthe same time reducing the level of moral hazard caused by an expectation of state intervention.

A specifically problematic situation arises when state liability is too high in relation to the nationalbudget in case of extreme events. This is a problem in smaller and poorer countries. In thosecountries, the economy does not have the size to face the risks of extreme events through private

insurance, often because the law of large numbers cannot be applied and too large a share of thepopulation is at risk of the same event to balance out gains and losses. A solution at EU level willneed to be sought.

4The Deltacommissie performed a cost-benefit analysis to take a decision on the construction. According to the

Commission, 65% of the Netherlands is an area at risk from sea surges. This means that about 1800 billion of the

nations wealth is at risk (National wealth is estimated to be five times the GNP of the country). The estimated

damages from flooding with the present protection until 2040 are expected to reach between 400 to 800 billion in

direct and indirect damages and a cumulated 3700 billion by 2100. The study was aware of the mistakes done in New

Orleans in estimating the costs of exposure.


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3.4 Potential fiscal impacts of autonomous adaptation

The fiscal impacts will strongly depend on the adaptive capacity (anticipative or reactive) ofindividuals and on the kind of adaptation actions they undertake. Autonomous adaptation, asidentified in the theoretical framework, will be driven by their private utility-maximisationobjectives and their assessment of risks. Individual adaptation behaviour will often not be in linewith the required behaviour to maximise social welfare due to the differing social and individual

objectives. This is not the only aspect that will cause a socially suboptimal adaptation by individualactors; market (and policy) failures and moral hazard will also play an important role.

Some of the adaptation actions by individuals may in the future result in negative fiscalimplications. A fairly obvious case is the expansion of residential areas in zones at risk of flooding.This may happen due to the absence of laws, the lack of information of those moving to the zone,an underestimation of the risks by individuals and also a component of moral hazard when damagesor remedial actions are expected to be covered by the state. In case of an extreme event the costs tothe state from direct damages and social transfers may be considerable, while this could be avoided.

Another case with fiscal implications is the increasing use of air conditioners in areas suffering

from a rise in summer temperatures. The power-hungry cooling systems may strain the energy grid,which can cause disruptions in the power sector. Water shortages may also affect the turbines of thepower stations. In Greece, during a heat wave, the country experienced a serious blackout.

Serious issues emerge from the indirect impacts of climate change if individuals are unable to adaptto them. Unemployment caused by economic impacts, health deterioration due to new diseases, in-or outmigration can all affect the states budgetary expenditures considerably. For example, whenregional economies are being hit seriously some important activities become impossible (e.g. wintersports tourism, farming, etc.). While there may be a tendency to subsidise the region, the stateshould be proactively assisting the diversification of economic activities, through awarenesstraining, and programmes to facilitate job change and even planned migration to avoid socio-

economic costs to increase.

3.5 Cross border effects of climate change

There are two cross border effects of climate change to be considered. One is caused by residualcosts from actions in another country. In the EU, adaptation measures in rivers upstream may affectanother country downstream. Another clear fiscal impact is aid transfers to development countriesto adapt to climate change, but technology transfer from donor countries partially mitigates theimpact.

However, these are not the only impacts which may cause fiscal effects. In the case studies forGermany and Finland (Part II of Egenhofer et al., 2010) a reference is made to trade impacts, i.e.reductions in demand of exported products due to climatic impacts abroad. Negative effects on theeconomies of importers may reduce exports. The revenue implications for the country and for thestate can potentially be large. Finally, climatic impacts abroad may cause immigration pressure insome EU countries, with its associated costs.

3.6 Fiscal capacity of the state and the role of the EU

Fiscal implications will clearly be larger, the smaller the fiscal strength of a member state. This isparticularly important for poorer member states. The financial impact of either building thenecessary infrastructure or reacting to counter the impacts of an extreme event can be very high inrelation to the state budget of poorer member states. For a river flood hotspot of Central and Eastern

Europe, the costs of repairing the damage of floods and protecting the riverbanks can be aconsiderable burden for the state (see earlier Figure 2). But the fiscal strength of a country is not


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only a problem for the poorer member states, wealthier countries may be threatened too by extremeevents. High fiscal pressure, and projected growth rates that are being downgraded, are reducing thefuture room of manoeuvre for states to support adaption to climate change.

In general, the gradual changes caused by climate change are considered manageable from the pointof view of direct budgetary costs. However, for costs caused by extreme events and related indirect

effects on growth and thus government revenues, impacts are not necessarily manageable.Furthermore, indirect effects of gradual climate change and also impacts in other countries can alsothreaten fiscal stability. A few impacts have been identified as having particularly strong negativefiscal implications. Those are primarily related to the risks of floods due to sea level rise, increase insea surges and changes in river flows.

Fiscal capacity is not only affected by direct costs, but also by the costs of social and economicimpacts. Climatic impacts may damage important economic activities, generating an increase inunemployment and thus social costs, while reducing the tax revenues. In combination, the fiscalpressure can be extremely damaging. Larger countries can usually counter balance the negativeeffects with benefits of climate change in other areas. This is the case of a large country like

Germany were losses from winter tourism may be recovered by improvements in other areas ofGermany benefitting from warmer weather, creating changes in the pattern of social transfers butnot necessarily a cost to the state. The smaller the country, the smaller the capacity tocounterbalance the effects of climate change.

The study has identified cases (e.g. Estonia, Cyprus, and Malta) where there may be a need ofassistance from supranational funds (i.e. the EU) to help those countries develop the appropriateprotection and response capacities.

Another aspect relevant to fiscal stability is the increase in the temperature variability and thus ofextreme events. It is generally expected that the various economic sectors will see larger income

variability. In areas were the state intervenes to assist in extreme events, it may find itself incurringconsiderable costs with a higher occurrence than planned, creating budgetary problems.

3.7 Policy implications to minimise impacts of fiscal cost drivers

There are a number of general recommendations that follow from the identification of the drivers tofiscal implications. There are different policy actions available to address climate impacts, but thereare clearly some effective solutions which in turn reduce negative fiscal implications or increasethose which are positive. This section addresses the options for each identified driver.

3.7.1 Measures to reduce negative fiscal implications of exposure

Appropriate balance between hard and soft protective measures: The fiscal implications from

exposure to severe climatic impacts can be reduced by the appropriate combination of hard and softpublic adaptation measures. Hard measures are those directed at blocking the threats, while softmeasures are based on strategic retreat from areas at risk and the creation of buffer zones usingexisting natural features. There are a number of examples in Europe of both types of adaptation.Land use management and regulation can go a long way too in reducing unnecessary exposure torisk by individual actors.

Decisions of what measures to use should be taken based on appropriate cost benefit analysestaking into account the value of the area to protect, using traditional cost benefit tools such ascontingent valuation methods.


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Invest in research and development: Research and Development has also been pinpointed as a toolto reduce costs of future protection for a modest investment. New technologies can strongly affectthe final cost of adaptation methods.

Help individual actors in the economy to adapt: Governments should be attentive not to use publicpolicy to preserve intact present structures and activities, but to rather understand how to take

advantage of opportunities created by the changed conditions and accept that there will be a shift ineconomic activities and infrastructures. Governments should avoid protecting and subsidisingdeclining activities but concentrate on fostering new alternative employment opportunities as part ofan adaptation strategy and manage the transition.

Make supranational provisions for catastrophic events single countries cannot handle alone: Thereare areas in the study that call for collective action in the EU. The main issue of concern is theexistence of risks against which some small countries cannot ensure themselves. Small countriesmay be unable to respond to a catastrophic event, and/or do not have the financial means needed todevelop an optimal protection. This raises the issues of EU solidarity measures, e.g. an emergencyfund for extreme events. This should be restrictive enough to avoid that local authorities and

member states, counting on EU support, lack the incentive to taking their own necessaryprecautionary measures.

3.7.2 Measures to reduce negative fiscal implications of state liability

Expand insurance markets: As already mentioned, there is a case to expand insurance markets, withthe state intervening only for damages beyond an insurable threshold. Compulsory natural hazardinsurance would allow private insurance to sufficiently spread the risk and have enough customersto cover risks more efficiently. In very small countries the spread of risk may not be sufficient, thusinternational solution with reinsurance or schemes covering more than one country could offer asolution.

Land and water use regulation: Land use management is central to ensure that areas at risk are notused inappropriately. The study reveals that individuals tend to underestimate risks, and asymmetricinformation and moral hazard can cause behaviour that puts people and capital at risk. Constructionstandards can also assist in reducing future damage costs. Water markets also require some control,ensuring that prices reflect water scarcity and that infrastructures are appropriate to limit waste,leakage and efficiently control its use and distribution.

Providing appropriate Information: There is a clear indication that lack of awareness and imperfectinformation does influence affects autonomous adaptation negatively, such as an underestimation ofrisks in the decisions of individuals. Information is a very cost effective way of reducing riskybehaviours.

Review state liability: The case study of Finland indicates that there is a limit even in the provisionof protective infrastructure from extreme sea level surge events. It is important for the state toensure that risk taking behaviour is discouraged by ensuring, where possible, that individuals do notundertake risky actions in the expectation that the state will then intervene.

3.7.3 Measures to reduce negative fiscal implications of suboptimal autonomous adaptation

The main problem with autonomous adaptation is the different between the private objectives tomaximise ones own utility, compared to the needs for a social optimum. The role of thegovernment is to understand the reasons for suboptimal adaptation and induce individuals to changebehaviour such that private adaptation is directed towards a social optimum.


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Provision of adequate information: The first and most cost effective action is the provision ofinformation. Reducing imperfect information and the associated impacts is of paramountimportance. This will ensure that private adaptation will be optimised, leaving other interventionsexclusively geared towards the residual impacts of autonomous adaptation which do not reflect asocial optimum.

Use of regulations: The regulatory arm of the state is extremely important to gear autonomousadaptation. As mentioned, land use and other resource use can be regulated to avoid damagingbehaviour and even to open up new opportunities. It is also possible that climate change frees landfor agricultural production or other activities.

Use of fiscal incentives: Fiscal instruments, such as taxes and subsidies can have an importantinfluence in the choices of individuals. Taxes on damaging behaviour or subsidies to adopt positiveactions are important.

Awareness of the net fiscal effects of incentives: It is clear that subsidies will cause a direct cost tothe state, but the impacts of changes in the tax composition and regulations can have a number of

repercussions. It is recommendable to shift taxes in such a manner as to foster positive adaptivebehaviour and reduce negative behaviour, for example by taxing water consumption in areasaffected by drought, but reducing the taxes on water saving technologies. There is also a need toensure that in balance, the state does not suffer negative budgetary effects, by miscalculating effectson tax revenues or miscalculating the impacts on the economy (and thus on social costs)

3.7.4 Measures to reduce negative fiscal implications of cross border effects

Reinforce coordinated action: The EU is in an enviable position compared to other parts of theworld due to its ability to reach agreements on common standards and compensation across EUmember states and also with neighbouring countries. Coordinated action to ensure minimal crossborder residual costs and a system of financial assistance can help the EU reduce its aggregate and

individual national costs from climate change. The EUs water framework5

and flood6

directivesalready require cooperation and coordination between member states sharing river basins and waterresources.

Coordination of standards: The case studies pointed out that different countries and even regionswithin countries are using different assumptions on the impacts of climate change, dictatingdifferent levels of adaptation and thus also putting neighbouring regions at risk of larger residualcosts. Such differences can be avoided by using similar standards and assumptions. In addition,residual damages that fall on neighbouring countries and regions will normally not be taken intoaccount in cost benefit analyses by local decision-makers, thereby leading potentially to inefficientresponses from an EU perspective; mechanisms at EU level, which ensure that all costs are

accounted for and that the EU (and even beyond its borders) is considered as one territory, canovercome this situation. The EU might need to coordinate cross border financial transfermechanisms that reflect a correct burden sharing of costs.

Integrate use of resources: The expansion of interconnectivity, especially in the energy sector canhelp ensuring that risks in the energy grids of one member state are spread across the EU, thereby

5 Directive 2000/60/EC of the European Parliament and of the Council establishing a framework for the Communityaction in the field of water policy

6 Directive 2007/60/EC on the assessment and management of flood risks


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reducing the probability of blackouts. More will have to be done to discuss the efficient use of otherresources, such as water, at supranational level.

3.7.5 Measures to ease limitations on the fiscal capacity of some member states

Development of a sufficiently strong EU assistance: As we have shown, there are several memberstates in the EU that face fiscal pressures which are excessive in relation to the size of the national

budget, either for putting in place the necessary protection, but also to face catastrophic effects.While the EU may want to reinforce its cohesion policy to assist in the development of thenecessary defences, this raises the question of ensuring rapid support at EU level for extreme eventsin hotspots. Obviously, such assistance would need to be combined with governance rules thatamong other things, avoid moral hazard, i.e. the suboptimal adaptation at national level in theexpectation of a supranational bail-out. Still, a functioning mechanism of financial support seems ofcentral importance.

Integration of EU rapid response mechanisms: To face large impacts in specific hotspots, the EUshould consider further integrating its response capacity, in order to ensure rapid, coordinated andeffective action in the case of catastrophic events. Hurricane Katrina in the US has shown how even

in a unitary nation appropriate response has been time consuming and difficult to set up; in Europea similar magnitude of damages would probably cause a much deeper coordination problem, witheconomic, social and also political costs piling up in the process.

Higher multiannual budgetary provisions for extreme events: The study has highlighted that climatechange will increase the variability in the incomes of economic sectors. Boom and bust cycles inweather-dependent activities such as agriculture and tourism will be more extreme and recurrent.Even in the case of Finland, which is expected to benefit from climate change, income fluctuationsin the different sectors will become much more extreme as climate change progresses. The state willneed to ensure that it has the provisions to react more flexibly and more often, smoothing the fiscalimplications with multiannual budgetary strategies. Flexible labour markets, appropriate and

flexible social systems will be necessary to face this variability, with a higher provision of fiscalresources.

4. Understanding the magnitude of the budgetary and fiscal burden of

adaptation

Studies on the cost of adaptation are rare, limited in scope and often relate only to direct costs ofadaptation measures and the costs of residual damages7often for specific kind of impacts andlocations. Rarely do costs go into second round effects, such as longer term damages to revenues,unemployment or health costs.

Furthermore, those studies that look at overall economic impacts often assume total damage costsby the end of the century providing little guidelines for policy action. Often studies have very littleresolution, i.e. are giving results for such large territories that policy action at local level cannot bederived from them. The Egenhofer et al. 2010 report has reviewed the knowledge gaps in ourunderstanding of climate impacts and costs and the results are discouraging, a lot of investment isneeded in understanding critical areas for intervention. Understanding policy needs requires furtherresearch, to a large extent bottom up, with total impacts based on an aggregation of local impactstudies, as actions will need to be undertaken at local level. The lack of local studies means thattotal impacts reflect an average, hiding the benefits that some regions will enjoy of climate change

7 A residual damage is the remaining damage which has not been avoided by adaptation actions.


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while also underplaying the size of impacts in specific regions. Most importantly, clearertimeframes and expected changes from today up to 2050 need to be better understood.

The ZEW-CEPS study presents case studies for three EU countries, Germany, Finland and Italy toanalyse the regionally varied implications of climate change, the existing estimates of costs andfiscal implications and an assessment of policies.

Germany has undertaken the most detailed studies of climate implications and cost estimations,while in Italy adaptation studies and a national strategy are absent. The way adaptation is addressedin different countries varies, some do not have a single national strategy, but have very activeprogrammes8. The analysis of climate change impacts in the three countries reveals that climatechange is a multi-faceted phenomenon in Europe and that though in both North and South Europetemperatures are expected to rise, other physical outcomes and consequences of this temperaturerise are by no means the same. While by tendency precipitation is projected to rise in Finland, inItaly severe droughts in summer may occur more often. In Finland, expected climate damages aresmall and in some sectors climate-induced gains are even possible. In contrast, in Italy and in someeconomic sectors in Germany, climate change may entail high economic costs, such as capital

losses due to floods and other extreme weather events. Some sectors, such as the tourism sector inGermany, call for more detailed regional studies, because climate change causes economic losses inone region while it creates opportunities for other regions.

As concerns adaptation, the analysis distinguishes between planned centralised adaptation andautonomous adaptation. Throughout the analysed countries it becomes clear that some sectors areparticularly prone to autonomous adaptation, but most autonomous adaptation measures need asupportive framework set by the government. Amongst the different actions, the most cost effectiveand influential is information provision on expected regional climate change impacts. Butinformation provision is far from being sufficient. For some adaptation actions the state is thecentral provider of protective infrastructure and provider of assistance in catastrophic events. The

state also takes on the main burden for the maintenance of transport and other public infrastructure.

The detailed country case studies lay the ground for a more systematic approach to a literature-ledreview of adaptation costs. The results of the case studies, complemented by top-down costestimates on adaptation measures in Europe, are listed in an adaptation cost matrix. The purpose isat least two-fold: First, the knowledge gaps become visible at a glance, through sorting the costestimates available in the literature by region, underlying scenarios, time periods, and impactsectors. To date, it is shown that most research is done in the field of coastal protection, while littleis known on public health impacts and on the potentially costly adaptation measures in the transportsector. Furthermore, adaptation of infrastructure in response to the increasing severity andfrequency of extreme weather events may be relatively expensive, but detailed estimates on costs in

the EU are mostly missing. The second purpose of the matrix is the systematic review andclassification of various literature sources. Taking into account time-periods, scenarios andmethodologies, one caninter aliaapproximate total adaptation costs through the compilation ofdifferent sectoral assessments. To date this application is mainly hypothetic there are very fewstudies which are comparable in terms of regional and temporal coverage, scenarios andassumptions; and a transfer of results of one bottom-up-study to another time frame, region orclimate scenario is for great parts a speculative exercise. However, the cost estimates in the matrixshow relatively high adaptation costs in the sectors of agriculture, coastal protection, and transportinfrastructure (and possibly high negative costs in energy demand).

8 For a summary of strategies in different countries: http://www.eea.europa.eu/themes/climate/national-adaptation-

strategies


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The theoretical framework for government intervention in adaptation is used to develop roughestimates for the direct public costs of adaptation. Therefore sector-specific shares of public costsand the total adaptation costs are estimated. Coastal protection and transport infrastructure remainthe impact sectors with the highest public costs; adaptation in the agricultural sector does not play amajor role for public budgets, as the measures can mostly be assumed as privately taken andfunded, while support will mostly be channelled by restructuring existing subsidies. Savings due to

the reduction of heating energy demand may cause significant decreases in public expenditures,albeit only in some regions of the Union (Northern Europe) and under uncertain assumptionsregarding the technical developments. For example, for Belgium, Gobin et al. (2008) presentpositive aspects of climate change in Flanders.

For Europe was possible to estimate to a certain extent the direct costs to the state budget of gradualclimate change (approximately 5 to 15 billion a year depending on the scenario), but the far moreserious impacts from extreme events and indirect effects through impacts on the economy aremissing. Based only on one estimation for Germany by Bruer et al. (2009) the direct public costsonly account for 13% of total estimated fiscal costs. Thus there is a clear signal that yearly averagecosts can triplicate to around 60 billion a year i.e. 1% of total public expenditure for the EU, and

territorially not evenly distributed. For extreme events, there are very few indications of theexpected costs, but studies by Costa et al. (2009), the IMF (2008) and the Dutch Deltacommissie(2008) study on the protection of the Dutch coast give some flavour of the serious costs of damagesfrom flood events in case of no appropriate adaptation.

As a general result of the case studies and the literature review, a considerable lack of data andquantitative cost analyses becomes apparent. The research of adaptation costs is still in its infancy,so statements concerning the budgetary burdens related to adaptation are necessarily still veryuncertain. However, the present analysis identifies the sectors with potentially high public costs andin which sectors more research is necessary.

There is a need to increase the number of bottom up studies with cost benefit analyses of alternativeadaptation options, with a clear identification of direct costs of the infrastructure, the level of stateliability and the long term costs to the economy and the state of inaction.

5. The use of insurance markets to improve climate change adaptationThe insurance sector can play an important role in addressing the uncertainty with respect to localeffects of climate change (OECD 2008). Principally, insurance markets are able to provideprotection against climate-induced losses. The transfer of risk from risk-averse subjects to risk-neutral insurance companies leads to welfare improvements and, if well designed, an efficient levelof precaution. Given an appropriate institutional frameworkin particular a property rights system

and functioning credit marketsinsurance markets will find an efficient reaction to climate change.The effectiveness of insurance markets for climate adaptation may be hampered, though, byinformational problems (adverse selection and moral hazard problems), covariate risks, uncertainty,and a lack of demand. In the following we briefly discuss all these issues and the implicationsthereof.

The Egenhofer et al. report studies the problems facing the insurance markets. One of the centralproblems of state guaranteed intervention in cases of natural events is moral hazard. When the statecoverage is extensive, there is a risk for private individuals to underinsure and to claim in excess ofcosts (see Box 1). State compensation shemes also may lead to insufficient precaution and to


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crowding out of private insurance. Therefore, ex-post emergency relief should be limited to mostelementary protection (see Box 2 for an example).9

Box 1: Natural hazard and insurance in Germany

In Germany, storms cause most of the natural disaster damages (64%) followed by floods(19%), hail (15%), and earthquakes (1%) (Schwarze and Wagner 2002). Only a few naturaldisaster damages are covered by insurance. With the exception of windstorm and hail, theinsurance density is less than 10% in the exposed areas. Therefore damages caused by naturalforces are often compensated by public emergency relief and private donations. For example,Schwarze and Wagner (2003) estimate that the emergency relief and reconstruction

programmes for the flood damages of summer 2002 in Germany (approx. 9.8 billion) have

exceeded the actual damages (approx. 9.1 billion). This results not only in an unnecessarily

large withdrawal of private purchasing power and government investment but alsosystematically reduce the incentive for potential victims to take precautions and to buyinsurance coverage.

Box 2: Moral hazard and insurance in Germany

Moral hazard may lead to an insufficient demand for insurance coverage. One possiblesolution may be the recent approach of the Bavarian state government for natural hazardinsurances for private homes (Bayerische Staatsregierung 2009). The government of thisfederal state in South Germany currently runs an information campaign in order to sensitizeprivate households to the risks of natural hazard damages on homes and contents. Effectively,this campaign is a publicly financed marketing campaign for private insurance. In this contextthe government emphasizes that state relief is only possible in exceptional cases where privateinsurance is not applicable (less than 2 % of Bavarian private households). Although thisspecific approach of the Bavarian state government targets only the market of insurance for

private homes, a comparable strategy may also hold for government intervention in othersectors.

For climatic events private insurance also faces particular limitations for their operations, and that ismainly the non-independent nature of events. In climate events whole regions can be affected, thusthe coverage of natural events is correlated for many of the insured, which affects the capacity ofthe insurance company to cover claims.

For example, if the risks of flood damages are positively correlated within one area. Insurancecompanies then cannot be confident of meeting their costs and they will therefore tend to chargehigher premiums, presuming some degree of risk aversion on their part. In this case, the insurancetakers expected utility will be maximized if they obtain less than full coverage of damages. Thiseffect could be alleviated if (international) re-insurers pooled the risks facing different (national)insurers.

The next issue concerns uncertainty. Extreme weather events are uncertain, i.e. they occur with acertain probability, but it may be that also this probability is unknown. If the insuranceoverestimates the risk then it will charge too high premiums and request too much precaution. Incontrast if the insurance underestimates the risk then it will demand premiums and precaution that

9 As has been discussed by Wildasin (2008) and Goodspeed et al. (2007) in the context of recent US hurricane events,the amount of autonomous adaptation to some climate change-related events may be lower if there is a perception thatex-post, the government will reimburse economic agents for much of the damages arising from such events. Even with

the recognition that there may no full compensation, the ex-ante precaution might not reach the efficient level.


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are below the efficient level. This problem should lessen over time as the parties gather moreinformation about the true risk.

Finally, one often observes that the free market produces a rather low insurance density (Schwarzeand Wagner 2002). The example of Germany (Box 2) indicates that the low level of natural hazardinsurance coverage is mainly due to a lack of demand. There are several possible reasons why the

demand for insurance coverage may be too low: (i) lack of information about risks, (ii) potentialvictims underestimate risks, (iii) anticipation of ex-post emergency relief, and (iv) interactioneffects between distorted demand and insufficient supply. The last aspect is graphically presented inFigure 3. It shows the interconnection between demand and supply to what is known as disastersyndrome. The two factors mutually escalate each others effects. A lower demand for insurancecoverage leads to higher costs due to less risk pooling. As a consequence the supply decreases andthe price increases which further decreases the demand.

Demand

State emer-gency aid

Prevention

Costs

Supply

Price Damages

Climatechange

Source: Schwarze and Wagner (2006).

Figure 3: Disaster Syndrome in natural hazard insurance markets

5.1 Types of insuranceBecause of the potential disadvantages of emergency relief compared to insurance-based solutions,different possible designs of insurance for natural disaster damages can be developed. Manyexamples are taken from the German case study, but can apply to other countries.

5.1.1 Mandatory natural hazard insurance

As opposed to emergency relief, a mandatory insurance scheme would allow the insurancecompanies to calculate the amount of compensation based on a large pool of customers anddistributions of risks, because it would guarantee comprehensive demand for and supply ofinsurance coverage, thus reducing the premiums and provide certainty to the insured on what thecompensation level is. Moreover, appropriately designed policies would provide incentives to

exercise the optimal level of precaution. At the same time, the scheme could be open to newdomestic and foreign insurance companies and permit competition within the industry.10Furthermore it should be monitored whether (international) re-insurers offer coverage for theinsurance companies so that they can handle covariate risks. However, also in designing theinsurance mandate, the government has to trade-off likely insurance benefits and possible moralhazard costs which arise whenever private precaution against damages are influenced by thepresence of insurance.

10 For detailed discussion of a mandatory natural hazard insurance see Schwarze and Wagner (2003).


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In Germany the proposal for a mandatory insurance for natural disasters was rejected. According toSchwarze and Wagner (2009) four main reasons were decisive: The failure to recognise the role ofstate guarantees in enabling private insurance, the mistaken legal objections against mandatoryinsurance, the distributional conflicts between central and state governments and the re-electionconsiderations of politicians. A European wide solution is not to be expected, because the insurancesystem differs not only from country to country but also within regions as e.g. in the federal states

of Germany.

5.1.2 Index-based insurance

Climate change tends to cause more frequent and severe extreme weather events (IPCC 2007).Therefore the losses of the past cannot serve as criteria for the risks of future damages.

Especially in the agricultural sector developing an index-based insurance is on the agenda.Traditionally insurance payments are based on the average of former output yields, which serve as abasis for anticipating future crop outputs. This system is also called loss-adjusted insurance,because the assumption is based on the loss of expected outputs, whereas an index-basedmechanism provides verifiable data. The indices are mainly measurable weather variables like

temperature and rainfall. These weather variables are used to make estimates for yield. To getreliable predictions a complex index is needed. Such systems require expenditures to get thenecessary measured values. Furthermore the data is only for small local areas and is not applicableto different regions or cultures. The advantages of such index-based solutions could be seen in theindependent assessment of variables, which cannot be influenced by the farmer. Therefore moralhazard and adverse selection problems could be reduced. Furthermore the ascertainment of damagesis straightforward, because the data only have to be compared to a priori defined threshold value.Moreover costly field visits can be eliminated and therefore expenditures are reduced. Beside thesepossible advantages the measurable factors can make it easier to reinsure the risks.

The implementation of an index-based insurance system might be also possible for

property/building insurances.

5.1.3 Specific agricultural insurance solutions

Within the agricultural sector of the EU ad-hoc payments by the governments are common. Thispractice leads to different problems such as lack of transparency, no guarantee of payment,dependence of availability of a governmental budget, high administrative expenses and the damagebeing only partly covered (Munich RE 2007). To overcome the disadvantages of anticipatedgovernmental relief insurance based mechanisms could be used. One possible solution might be thelimitation of governmental reliefs only to damages which are not insurable. Such strict course ofaction might be difficult to get through especially in the agricultural sector. There are other aspectslike food security and saving the artificial landscape as reasons to provide ad-hoc reliefs.

Another incentive for farmers to insure is the partnership of the government in form of proportionalpayments of the insurance premium. This option was also offered by the European Commission tolaunch a broad discussion on the Common Agricultural Policy (CAP) to deal with the risks inagriculture (EC 2005, SEC(2005)320). There the governmental financial participation should notexceed 50% of the total premium. Poland, Czech, Slovakia and Austria offer such subventions forpremiums of crop insurance (Munich RE 2007 and 2009), whereas in Germany crop insurances areavailable but none with a public-private-partnership design.


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Box 3: SystemAgro by MunichRE

The Munich RE suggests an agricultural insurance concept on a national level which includespublic-private-partnerships. It is called SystemAgro and is based on four basic factors calledBLOC, standing for backing, loss sharing, open and central and uniform. The backing is thesubvention of the premiums by the government, which should give an incentive for the

farmers to insure. Furthermore the government should take a share of insured damages withinyears of extreme losses. Contrary to the current governmental relief aid this loss sharingmechanism includes a legal claim for the farmers to financial support, which is a furthermotivation to insure. The openness to every farmer should secure a high market penetration.The central and uniform structure should guarantee the sustainability and observing the legalrules and the public expenditures. This suggestion includes incentives to insure but on theother hand the government is involved on three levels: first to introduce a law and rules forprovision, second the regular payments of the premium share and third still to help out in caseof extreme damages. If the subventions are as high as the current ad-hoc payments, like theMunich RE demands (Munich RE, 2007), the public expenditures could even be higher as in

the existing mechanism at least on the short run. Therefore the current suggestion is to cutother agricultural subventions and use them instead for financing the shares of the insurancepremiums. This might lead to rejections by the agricultural lobby

Source: Munich RE 2009

All risks coverage for crops

All risks coverage should include all possible natural hazards. Especially in the agricultural sectorsuch insurance solutions are discussed. The damages could range from storms and hail, which are

the content of the most insurance packages, to drought, frost, continuous rain or high tides. Today inGermany there is no possibility to cover all risks with insurance. The insurance companies selectrisks and cultures. Hail insurance is common for the most cultures but for other natural disasters theculture is decisive and for special cultures only hail insurance is available. Similar circumstances ofselection can be found in other European countries. Insurances covering more than one single riskare offered for example in Austria, Czech Republic and Slovakia and include a public-private-partnership, but the insurance is only available for a choice of cultures.

The German Insurance Association made a proposal for crop insurance with all risk coverage toovercome the problems with risk and culture selection (GDV 2008). The suggestion is for commoncultures and excludes special cultures. The main aspect is that the risks are divided into two

categories. The first one includes the risks of hail, storm, continuous rain as well as early and latefrost. The GDV integrates these kinds of risks due to their local effects and their causality to short-term occurrence of extreme weather events. They suggest using the integral franchise method by8% as it is common for insurances against hail. This means that the first 8% of the insured yieldlosses have to be taken by the producer and the further damages will be covered by the insurance.

The Second risk group covers floods, droughts and damage due to frost, ice and snow. The damagesof these risks are extensive and normally not of local or regional nature. The extension and severityof the damage depends also on non insurable factors like soil quality. The GDV intends to usethreshold values, which should be determined for the different kind of risks.


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All risk insurance systems could be combined with the public-private-partnership solution and theindex-based mechanism, but each of the mentioned methods are at a level where more research isneeded to figure out the effects and their interactions.

5.1.4 State as insurer of last resort

Finally, depending on the national circumstances there may be the responsibility of a government to

act as insurer of last resort in case of extreme weather events. The fiscal effects will depend on thedesign of the implemented natural disaster insurance scheme and the role of the government in thisscheme. Given the available information on damage estimates the necessary funds for the formermay be considerable. These costs will presumably increase over time (i) because temperature andtherefore the frequency and severity of natural disasters increase and (ii) because of increasingwealth, population changes, inflation, and changes in settlement behaviour. The design andorganisation of the insurance scheme do also influence the fiscal consequences. If the insurancedensity is low the state has to be prepared to compensate victims for losses caused by natural forces.The financial aid may withdraw important public investments or increase the fiscal gap whichalready exists in some countries due to public debt and demographical change.

In contrast, if the insurance scheme is designed in a way that the density is high, many naturalhazards can be compensated without governmental intervention. In this case public emergencyrelief would be necessary only if damage costs exceed the capacity of insurers and re-insures. Thatis state participation is strictly limited to cover the mega-damages. For example, Schwarze andWagner (2006) propose a market oriented mandatory insurance against natural disasters forGermany (see Box 7). It is important to note that not only does this reduce the need of stateintervention but also damage costs can be expected to be lower in case of high insurance densitybecause appropriately designed insurance policies induce potential victims to take preventivemeasures.


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Box 7: Mandatory insurance scheme against natural disasters in Germany

Schwarze and Wagner (2006) propose a market oriented mandatory insurance

scheme against natural disasters for Germany. For the industry insurance is

voluntary. For households and small enterprises insurance is compulsory. In highly

exposed areas where floods occur frequently (Zone 3) only partial coverage is

provided. With lower risk (Zone 2 and 1) deductibles decrease. Primary insurers mustcontract with re-insurers and the state steps in as insurer of the last resort. State

intervention is strictly limited to mega-damages above a threshold of 8 billion.

Scetch of the insurance scheme (Flood Module)

Residential/Small Enterprise

Compulsory Insurance Voluntary Insurance

Zone 1 Zone 2 Zone 3

Primary Insurer

Industry

On-site analysis

Primary Insurer

DeductiblesDeductibles

Reinsurance Pool

State Coverage

1.Layer (< 8 bill.)

2.Layer ( 8-30 bill.)

Mandatory Re-insurance,

Duty to contract

Source: Schwarze and Wagner (2006).

5.2 International pooling

The provision of risk coverage in very vulnerable areas is more feasible if risks are internationallypooled. Therefore a global market is necessary to diversify losses across the world. The three mainpractices to transfer single risks and pool them are reinsurance, catastrophe bonds and weatherderivatives which are discussed in the following.

5.2.1 Reinsurance

If risks are locally dependent, they might be globally independent and globally insurable (Cummins,2007). This is the case of reinsurance companies. A single insurance company can transfer its risksby reinsurance. The worldwide biggest reinsurance companies are Munich RE and Swiss RE. Thereinsurance system is based on risk distribution by geographical and sectored diversification,including different business fields. Furthermore reinsurance companies reinsure themselves, whichis called retrocession or transfer their risk with other instruments like catastrophe bonds and weatherderivatives.

The two main types of reinsurance are proportional and non-proportional reinsurance. Proportionalmeans that the losses are shared by a fixed ratio between insurer and reinsurer. The non-proportional reinsurance only takes losses, when they exceed a certain amount.


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Reinsuring at EU level could solve the problem of non-independent risks at regional/national level.

5.2.2 Catastrophe bonds

Catastrophe bonds, also called Cat-Bonds, are mainly used by reinsurers to transfer their risks toinvestors. Therefore Special Purpose Companies offer bonds as over-the-counter deals to investors.Common are special bonds called Principal at Risk with the whole nominal value at risk. The

Munich RE suggests that bonds with different risks and probabilities of occurrence of damagemight be useful to satisfy the potential investors (Munich RE, 2007). Investors buy the bond andthen two events are possible: the natural disaster happens or not. In the second case without anydamages the investor will get interest rates and a premium paid by the reinsurer. If no damagehappened after a fixed term then the investor gets his payments back. On the other side, when anatural disaster takes place the investor will not get the interest rates and the premium. Furthermorethe reinsurer will get payments for the damages.

5.2.3 Weather derivatives

In general derivatives are financial instruments that value is derived by other market values ofgoods or assets. Weather derivatives are comparable to other derivatives but are based on the index

weather. At first weather derivatives were mainly used by energy companies to smooth the demandvolatility by protecting against temperature fluctuation. However, weather derivatives are becomingmore and more attractive for other sectors depending on the weather like agriculture and tourism.Munich RE also mentions that it is common practice that organizers of open air events (e.g. sportsor cultural events) try to cover their weather risk by options (Munich RE 2007).

Weather derivatives as a complementary tool to the common reinsurance system can providepositive welfare effects. Cao et al (2003) mention that weather derivatives can improve the risk-return trade-off in asset allocation decisions. Dosi and Moretto (2001) claim that weatherderivatives may provide coverage at a lower cost than standard insurance coverage schemes.However, there are also limitations: First of all weather conditions differ not only between countries

and regions but also between small local areas. It will not be practicable to measure the weathervariables of every single vulnerable area. Furthermore the measurement of the variables of interestshould be taken by an independent institution. Therefore it will be the task of the government toprovide credible data.

The innovative insurance methods may provide incentives for individuals to insure and in a nextstep the international pooling of risks with new systems like catastrophic bonds and weatherderivatives can offer solutions to overcome the convergence of the capital markets and theinsurance and reinsurance sector.

In summary, the regulation and monitoring of the insurance markets play an important role for the

efficient adaptation to climate change. There are several problems that may hamper theeffectiveness of the insurance market. Governments have different possibilities to improve theeffectiveness including soft measures such as information campaigns as well as strongregulations such as a mandatory insurance scheme. In a later section the fiscal implications of theregulation of the insurance market will be explored.

6. ConclusionsThere are enough indications that climate change is de facto impacting us, affecting our economiesand increasing our exposure to extreme events. Extreme events, for example, have steadilyincreased in frequency over the last decades. Some adaptation actions to handle those events todaywill also be of value in the longer term.


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The fiscal implications of climate impacts can be considerable also in the short term, and thevulnerability of our economies to some extreme events may affect the national fiscal stability ofsome member states. Even for member states where the economic impacts are expected to beneutral or positive in terms of GDP, the increased variability of weather events and the increase inthe strength of extreme events means that in specific years, impacts can cause considerable hardshipand important fiscal balance effects.

We know already that the fiscal burden for European states of ageing is a cause for concern, and weare experiencing a severe tightening of the fiscal capacity of the states due to the financial crisis,allowing climate change to cause preventable costs to the economy and the state is running anunnecessary risk.

Appropriate studies are necessary

Fiscal impacts have until now rarely been studied rigorously, and there is a lack of understandingregarding the origin and magnitude of fiscal effects. There are severe knowledge gaps in this fieldthat hamper decision-making. Relevant research focusing in short and medium term impacts with

clearer indications of the trajectory is missing.The drivers of fiscal implications need to be studied

Policy makers need to concentrate on the processes that trigger state intervention or affect theeconomy and state revenues to be able to proceed to well targeted actions which will minimisenegative fiscal implications and maximise welfare.

Autonomous adaptation behaviour needs to be understood

Despite the uncertainties on the future impacts of climate change, appropriate anticipatoryregulatory and fiscal changes can reduce the costs of climate events. In many occasions changes arebeneficiary regardless of climate change.

Apart form the climatic impacts and the adaptation needs that may be identified, the role of thestate is not necessarily to intervene. There are two types of adaptation, autonomous and planned,which may be anticipatory or reactive (i.e. acting to mitigate impacts once those occur). It isimportant to understand autonomous adaptation behaviour to design optimal planned adaptationactions. This includes counteracting autonomous adaptation which may be optimal for theindividuals or entities undertaking it, but suboptimal for society. In some cases existing stateinterventions may need to be reformed or removed to allow a better adaptation of the private sector.

Minimising negative fiscal implications requires better public and private collaboration

There is a clear indication that similarly to areas of ageing of the population, such as pensions, therole of the state as risk insurer for extreme events needs to be reviewed. Many actions have theability to reduce risky behaviour by individual actors, though appropriate information andregulation, thus reducing negative impacts to the economy and direct and indirect fiscal costs ofnegative climatic events. Indirect fiscal impacts are those not created directly by climat

ws 6 background document adaptation conference nov 2010

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