Transcript - Episode 6: What's the economic cost of natural disasters?

Laura Gatz: Hello and welcome to a new edition of our Economics in Business Podcast. I'm Laura Gatz, your host for this podcast series.

Today, I'm joined by economist, James Loughridge, to discuss the economics of natural disasters.  This year has seen hurricanes Harvey and Irma in North America, the Mocoa landslide in Columbia, and flooding in South Asia, which have affected millions of people across nearly all continents this year.  It seems that natural disasters are unfortunately occurring more and more often.

James, you have recently analysed a new data set on natural disasters.  What does the data say?

James Loughridge: Thanks for the intro Laura. So, we looked at the latest data from the Centre for Research on The Epidemiology of Disasters.  It’s important to say that we are looking at the economics of natural disasters, yet at their heart natural disasters are human tragedies due to the loss of life and severe injuries that often occur.

So, we are looking at a very limited aspect of natural disasters, which is the disruption to day-to-day in business and household activities.

The latest data showed that there were at least 348 natural disasters last year, which cost almost 150 billion US dollars in damages. Now, this is damages in the sense of physical property and asset damage and it is a very partial measure as it doesn’t seek to quantify the damage due to loss of life or injury.

So, when we look at then the number of natural disasters over time, we can see since 1970 the average per year has been rising.  It significantly rose up until the late 1990s and the growth rate has flattened off somewhat since then.

Then we also looked at the total cost of natural disasters per year, and as you will expect, this is quite a spiky profile.  We then deflated the data.  So, effectively we’ve removed the effect of inflation, and we also see that there is an upward trend in this, which is somewhat intuitive given the total number of natural disasters has also been rising.

Laura: So, both the frequency and the cost of natural disasters is increasing.  Can you tell us a little bit about what is driving this upward trend?

James: Yes, so we have identified what we think are three key contributors to the increasing number of natural disasters per year.

The first of which is climate change.  The science behind this says as average temperatures rise, the average moisture content in air will also rise, and this leads to an increase in the potential for extreme precipitation events.

Sixteen of the seventeen hottest years on record, according to NASA, have all occurred since 2001.  So we welcome initiatives such as the Paris Climate Agreement, or anything which is set out to tackle climate change.

However, our analysis, for example, in last year’s Low Carbon Economy Index report, showed that while we are making good effort towards decarbonising, we are still falling short of UN targets.

Secondly, urbanisation and rapid population growth is also contributing. Unfortunately, around a quarter of the world population live in high-risk areas, and this problem is even more acute in less developed economies, where unfortunately many people are faced with a trade-off: Should they move to higher-risk areas, where they can often get higher salaries, or should they stay where they are?

And, thirdly, some of this increase could actually just be artificial.  Given the improvements in technology, we could be simply better at recording and tracking natural disasters

Laura: So, given that both numbers are rising - and thanks for giving us a bit of context as to why that’s happening - which is actually rising faster, and what does that mean for the average cost per disaster?

James: Given both the number of natural disasters and the total real cost of natural disasters are increasing, we can also look at the real cost per disaster and the number shows that this has fallen by around a third in real terms since 1970.  However, I would be cautious, Laura, about putting too much emphasis on this number given the volatility of the cost estimates, and also the heterogeneity of natural disasters.  No two disasters are identical.

One plausible explanation for this apparent trend could be the prevalence of preventative measures.  So, for example, as technologies improve, things like early warning systems, which detect weather patterns which precede natural disasters are becoming more and more accurate.

We are also seeing regulation. So, for example, planning laws, which maintain wetlands and flood prone areas, things like that, which are helping mitigate costs.

Laura: We have been talking about the trends in cost per disaster, but what actually does this cost mean in terms of impact on the economy and businesses?

James: So, whenever we think about the impact on the economy, generally what we will use is Gross Domestic Product or GDP.  Now, the academic evidence is mixed on the net impact of natural disasters on GDP.  However, our analysis has shown that really it’s important to differentiate between localised and macroeconomic effects.

Generally, the effects are very accute when we measure locally; however, when we look at the net effect across an economy, quite often it’s much less transparent.

So, for example, when we compare the US, with its 300 million population and 10 million kilometre squared surface area; to some more smaller and natural disaster prone, such as the Solomon Islands, with a population of 600 thousand, and 30 thousand kilometre squared surface area.  We can see that a storm of the same size impacting the Solomon Islands will have a larger impact on total GDP than it would on the United States

Laura: Good that you mentioned GDP.  As economists, we obviously like to break down GDP into its various components. Could you tell us a little bit more about consumption and investment?

James: Yes, so firstly, consumption is a good example of the differential between localised and macroeconomic events.

So, firstly, if we look at retail sales, in, for example, when we know in advance that a natural disaster is going to strike, often we see a spike in retail sales.  This is followed by a lull during the disasters themselves as any unnecessary travel is cut out, and also opening hours are restricted.

Post-disaster, we will often see a spike again in retail sales. Given the clean-up efforts and often this can completely offset any previous lull.

But then, another component of consumption we could consider, is services spending.  This is quite diverse and different from retail sales.  For example, spending on utilities - if people are displaced and put out of their homes for a week, the week whenever they do go home, they are not going to spend double the amount on water, on electricity, things like that. So, that spending won’t be recouped.

In contrast, accommodation services could actually benefit.  So, nearby hotels, restaurants in the local area, could benefit from increased services spending there.  So, it’s important we consider where exactly the boundaries exist when measuring GDP impact.

And then, secondly, you mentioned investment Laura.  So again, there is a few components of this we could consider.  One of the, I guess, most prominent aspects in light of natural disasters would be residential construction.  So, the building and restorations of homes increases this.  Also, there is business investment, for which again there would be building of offices, factories, machinery, etc., and this can actually lead to a positive impact of higher productivity in some cases, where, for example, old machinery is replaced by newer and more modern materials, and hence productivity increases.  Of course, though, there is an opportunity cost which exists here.

Laura: Interesting point on opportunity cost, James.  Some of our listeners might not be familiar with that concept.  Could you just elaborate a little bit more on what you mean by that?

James: So, when we are discussing opportunity cost in this context, what I mean is, inevitably some of the spending and investment will be spent on replacement rather than expansion or the improvement of the current capital stock.  So, the opportunity cost here is the foregone improvement in productive capacity, and this of course won’t be captured in GDP, which is one of the drawbacks of using GDP as a measure of utility.

So, GDP, since, I guess, The Bretton Woods Conference in 1944, has generally been the main tool to quantify economic performance.  However, in light of natural disasters especially, some of the drawbacks of GDP become apparent.

For example, wealth destruction isn’t captured.  So, the loss of utility from the destruction of assets isn’t captured in GDP.

Secondly, services which aren’t sold aren’t captured in GDP.  So, in light of natural disaster, quite often charities and household production is a key lifeline for people.

For example, Laura, if you gifted your neighbour something, that wouldn’t be sold to them, it wouldn’t be tracked in GDP, but it could have an immeasurable impact on their and their family’s utility.

And, finally there is the opportunity cost, which we touched on earlier.  So, this is spending to maintain the ‘as is’ status as opposed to upgrading existing capital stock.  So, had the natural disaster not occurred, for example, some of this investment could have been spent on expanding capital, or building a second factory as opposed to simply replacing broken and destroyed machinery and offices.

Laura: Talking about the limitations of GDP as a measure of welfare is, I think, a particularly relevant factor in this topic. As you mentioned, natural disasters are a humanitarian issue at heart. Looking forward, how can we reduce the impact of natural disasters in the future?

James: So, I think preventative measures are crucial Laura. For example, technology we touched on earlier, further investment in that to improve the efficiency of early warning systems, for example.  We can also have targeted regulation, which is tailored and appropriate to mitigate risks.  This could be at a macro level, so for example, climate change agreements; or it could be more localised, such as local planning laws.

It is important to say that this is economic cost mitigation and it’s important to also emphasise the great humanitarian benefit of a reduction in the cost of natural disasters, which is possible.

Laura: Thanks James. It’s really good to hear, given the severity of the welfare effects, that preventative measures could be successful in reducing the cost and the welfare impact of disasters in the future. So, thank you very much for your time today James

James: Thank you, it’s been a pleasure!

Laura: It’s been great to have you! Thanks for sharing your findings on such an important humanitarian issue. If you would like to hear more about we discussed today, or hear about other topical economic issues, please head to our website.