World Resource Institute

Why Adaptation is the Greatest Market Failure and What This Means for the State

By Paul Steele, United Nations Development Programme (UNDP)

Commentaries were commissioned by the World Resources Report to react to the Expert Perspectives series. This commentary responds to Question 1: Does climate change require new approaches to making decisions?

The papers presented focus on institutional aspects of climate adaption and crucially distinguish between increased climate variability and slow onset climate change.

This note will focus on using economics to analyze these institutional challenges of climate adaptation.  Economics are routinely applied to issues of climate change mitigation. The Stern report argued that climate is the "greatest market failure ever seen and mitigation requires a price on carbon to provide the market with an incentive to make a shift to a low carbon economy.   While there is huge political resistance to a carbon price, even now the more politically viable approach of subsidies for renewables and efficiency has had a major impact.  

But what does economics tell us about climate change adaptation?   What would it take to create a clear market signal for the private sector - from small scale farmers to major corporations - to respond to the need for climate adaptation?  There is a rich body of knowledge on the economics of institutions which can provide answers.  This shows that the market generally will fail for climate adaptation (since there is no policy lever such as a carbon price) and climate adaptation will therefore create a major role for the State: 

  • Climate adaptation information (future weather forecasts, climate modelling etc), like much information, is a "public good" in that research and knowledge can be hard to create property rights around (other than through patents) and hence is under-provided by the market.  This is the rationale for government (i.e. public) investment in climate adaptation research, science and information.  It is also an important distinction with climate mitigation research which can be included as proprietary technologies. Indeed in mitigation it is the patents and transfer of technology which are part of the negotiation process.
  • Climate adaptation insurance may eventually not be a viable market option due to the scale and extent of climate risk.  Insurance is the standard market response to the probability of some future event.  While there are many and growing examples of insurance for increasing climate variability, we cannot insure our way out of climate change.  There are certain locations where the risk of climate variability is steadily increasing, and, taken globally, the risk of climate is affecting so many places at the same time that the normal insurance practice of risk pooling and ensuring non co-variate risks is no longer valid. To put it simply, if all households will be burgled, the market for household insurance will disappear, and as the probability of climate risk grows, the same holds true.  
  • Climate adaptation infrastructure responses through for example relocating infrastructure may suffer major transaction costs in the form of overcoming major sunk costs. One of the most important - and costly- responses to slow onset climate change is the need to relocate and redesign infrastructure, particularly when it is along the coasts. But these decisions are unlikely to be taken by private agents. For example, even if certain private agents think that the city should relocate due to climate exposure, there are enormous fixed costs in the current location of infrastructure and in the transaction costs of coordinating a move.   This task will therefore require the government to subsidise these huge transactions costs and fixed costs of change.  
  • Climate adaptation risks are a lower concern to markets which discount future risks by valuing future costs and gains lower than present ones.   So private individuals and firms are less concerned about the future and adaptation investments are socially suboptimal.  
  • Many climate adaptation interventions rely on ecosystems which are themselves subject to huge market failures in terms of lack of property rights, lack of economic prices and so major under-investment by the private sector.   Such ecosystems investments for adaptation include coastal regeneration, water and soil management, forestry and rangeland management etc.  But these are already subject to market failure so the government has a key role to play here.   
  • Lack of new markets and new private sector lobbies:    Climate mitigation - while it will require massive societal and behavioural change - also includes a series of technological interventions (particularly in energy, transport and industry sector) which can be sold.  There are therefore growing "green economy" industries and exports which create private lobbies to support such mitigation production and consumption. By contrast there are many fewer adaptation related products or technologies.  The most obvious are insurance, humanitarian support for climate disasters and ecosystems management.  But these present much fewer obvious production possibilities than with mitigation.   So unlike mitigation where the private sector has an incentive to advocate, for climate adaptation the private sector has less of an incentive so again the state will have to play this role.       

In conclusion, the mitigation challenge can in principle be partially resolved by the market through an appropriate carbon price. By contrast, adaptation cannot be so easily "internalized",  but will rely on government.  For this reason, and to paraphrase the Stern report, adaptation is perhaps an even greater market failure than mitigation.   It requires government to bear the bulk of the costs.   We have got used to seeing government playing a key role in providing citizens with security and certain public services.  In future adapting to climate change will be a central role for the state, along with all the necessary institutional reforms this will involve.