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December 8, 2012

From Earthquakes To Climate Change, Why Our Biases Under-Prepare Us For Risk

Climatographer Team

This blog post was originally published by Dr. Mark C. Trexler in ThinkProgress.org on November 29, 2012.

As a risk management professional, I worry about getting caught unprepared for risk events I should have reasonably foreseen.  So we have mini survival kits in each car, we’ve scanned all the family photos so they can’t be lost in a fire, and we have taken photos of everything we need for potential insurance purposes (all stored off-site).

And then there’s “The Big One” – the 9.0 earthquake the seismologists say is overdue here in the Pacific Northwest, which would (or, more accurately, will…..) wreak absolute havoc on infrastructure (and, in all likelihood, my house, which is built on the side of a hill).  We’ve made sure that the house is properly bolted down, so it might not simply surf down the hill, and we’ve purchased earthquake insurance.

Our next project was to put together the recommended emergency kit with water, food, and other critical supplies for the aftermath of the earthquake.  We certainly hope that FEMA will be at the door soon after an earthquake, or at least make food and shelter available nearby.  But if The Big One hits, we could easily be on our own for days or weeks (sound familiar in the aftermath of Super Storm Sandy?).  Given that fact, how can I as a responsible risk professional be without an earthquake emergency kit?

Unfortunately, the problem is a little more complicated than simply recognizing the risk of a major earthquake.  A freeze-dried food salesman related the following comment he had heard at a recent home show: “Why should I buy your freeze-dried foods?  I have guns.  In an emergency I’ll just come and take your food!”  That puts a whole new spin on managing earthquake risk!  No longer is it just the earthquake, it’s the social fallout, and the impact of the social fallout on the utility of the risk management measure being considered.

Do we need to add guns and ammunition to my earthquake kit, and learn how to use them?  That’s an entirely different risk management calculation.  Maybe we should drop the whole idea of worrying about that earthquake preparedness kit, and assume it will work out for the best.  Because after all, even in the worst case we won’t be in any worse shape than our neighbors.

What’s interesting about this chain of thinking about personal risk management is how closely it parallels a lot of corporate thinking about climate change and corporate climate risk.  It’s common to hear the following explanation for the relatively low priority often given to climate risk (whether policy risk or actual climate impacts):

  •  “If and when climate policy or climate events become really material to us, policy-makers will realize that we (e.g., electric utilities) are so important that we’ll be made whole by taxpayers or ratepayers. Spending a lot of time now worrying about climate risk isn’t likely to benefit shareholders (and could even penalize them if we’re later told that because of our preparations we don’t qualify for the future assistance being given everyone else).”
  • “If something really bad were to happen in terms of climate change or climate policy, something that we couldn’t be made whole from, then we probably couldn’t have adequately hedged for that risk anyway given financial and decision-making constraints.  And in any case, everyone else including our competitors will also be in a really bad position, so it’s unlikely to really affect our long-term competitive position.”

These lines of thinking have little to do with whether climate risk is real, just as my decision-making on an earthquake kit might have little to do with whether earthquake risk is real. Instead, it has to do with decision-makers’ own perceptions of whether managing such risks makes sense in light of other tradeoffs and constraints.  If a good deal of support is available when bad things happen, incurring the costs of pro-active risk management today may deliver little benefit.  If that support isn’t available when really bad things happen, plausible pro-active risk management today might not make much of a competitive difference anyway.

Managing risk is rarely free, and aggressive risk management can look pretty costly when compared to other priorities looking for funding!  At a personal level, even as a risk professional, if I have the choice between an earthquake kit that will be taken from me at gunpoint when I need it, and a vacation cruise today that I’ll be able to look back at with fondness for all my remaining years, maybe that cruise is the better way to spend limited dollars!

These are the kinds of calculations and prioritizations that individuals and organizations make when it comes to risk management.  What this means is that any given risk management response cannot be interpreted solely through the lens of the hazard itself.  A lack of aggressive corporate action on climate change could reflect a basic lack of climate change understanding, or perhaps even environmental bad faith, but it is more likely a reflection of self-interest as perceived through the filter of decision-maker incentives and the decision-makers’ perception of risk.  So if decision-making incentives discourage risk management, just as current flood insurance programs can incentivize rebuilding  (sometimes repeatedly) in flood-prone areas, then we shouldn’t be surprised when decision-makers engage in levels of risk management that appear suboptimal from a societal perspective.

Understanding the incentives facing corporate decision-makers across companies and sectors in managing risks is probably the best predictor of the risk management measures we should expect to see (and is the basis of the entire game theory literature).  Looking for ways to influence those incentives in favor of the outcomes stakeholders and society might prefer is much more likely to deliver the wished-for results than simply bemoaning corporate inaction.

This is not to suggest that companies shouldn’t, even purely on the basis of self-interest, be engaging in more active strategies to manage climate risks.  Through the evolving field of behavioral economics and seminal work like Daniel Kanneman’s book Thinking Fast and Slow (Farrar, Straus and Giroux, 2011), we are beginning to understand in more detail just how important a whole range of cognitive biases are to our perception and management of risk, and how severely those biases can divert us from accurately prioritizing and quantifying complicated risks.

Corporate executives are just as prone to these cognitive biases as anyone else, and they’re the ones making decisions about climate risk management.  As a result they could be telling themselves a biased story about self-interest.  Some, for example, are likely to be significantly under-estimating the potential competitive advantage available to them, as well as over-estimating the costs.  Some are over-reliant on past experience to assume they’ll be made whole in a future crunch, forgetting that other industries have suffered the consequences of public (and judicial) opinion catching up with the science in areas like smoking, asbestos and hazardous waste.  Some are over-emphasizing the conclusion that in a real crisis they’ll be no worse off than their competitors.  If their competitors are (proverbially) dead, how great a decision-making criterion is that really?

These are all conclusions it can be very easy to reach given how our brains actually function, but they can lead companies astray in effectively quantifying and prioritizing both the relative risks they face and the risk management strategies that are likely to be in their real (rather than initially perceived) self-interest.

The bottom line is that there’s still quite a bit of work to do in better understanding and perhaps modifying the incentives to which decision-makers are responding, and in better understanding, quantifying, and communicating corporate risk to the benefit of corporate decision-making.

Thinking about Super Storm Sandy, for example.  It might not make a lot of sense to have told Port executives in advance that they’d lose their bonus if their Port is shut down by a hurricane.  Such an outcome may simply be beyond their control.  But what if they were told that their bonus would be increased by 10 percent for every day that their Port is up and running before a nearby Port?  And what if they were provided with a much more customized understanding of the consequences they personally could face from future hurricanes (in terms of job security and other variables) and of ways to manage those consequences?

Decision-makers would likely be a lot more likely to look at risk in more detail, setting the stage for better risk-based decision making.  Much of this comes back to the incentives decision-makers face, and the importance of perceived risk.

By the way, we did put together that emergency earthquake kit.  Even if we might not turn out to be any better off than everyone else, having the kit in place will put us in a much better position out of the starting gate.  That’s where I want to be regardless of the possibility of other risks down the line. (Did you know that fire extinguishers can make pretty good defensive weapons?)

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Climatographer Team

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