Financial Markets Fear Even Unlikely Disasters

According to Swiss Re data, over the last ten years the number of natural or man-made catastrophes has doubled since the 1980s. And economic damage inflicted to people and organizations has increased even more. The trend seems irreversible, because of emerging phenomena. First of all global warming, which seems to affect the frequency of hurricanes and other meteorological disasters. Then the growth of world population, which increases demographic density in areas exposed to catastrophic risk, and the increase in value of private and commercial real estate in potentially affected zones. The catastrophic accident at the Fukushima nuclear plant suggests that even intrisically dangerous technologies can exhibit an increase in the frequency of accidents over time, as a consequence of the aging of plants and the increase in watts installed. What defines catastrophic risk is the combination of severity in potential losses and very low probability of occurrence. Psychological research has shown that human beings have a hard time having rational views about this type of events. For instance, a study made a few years ago showed that residents downstream of a dam are certain that a breeching of a dam is impossible; they trust the technical reassurances of the expert and attribute past collapses to unrepeatable errors. However, people erase from their minds only existing dangers, to which they have already been exposed and cannot avoid. To the contrary, catastrophic risks which are novel and avoidable induce a very strong emotional response of refusal, as if the accident were bound to happen. Catastrophic risk is also hard to treat from a scientific point of view. The probability of occurrence should depend on the frequency with which such an event has occurred over a long time-span. But in the case of catastrophes, the event can be so rare that historical data are absent or scarce. The calculation of probability is thus based on engineering, with all the limits humans have in calculating the unpredictable. The parallel between the Fukushima accident and the 2008 banking crisis comes naturally: in both cases, experts had assured that catastrophe was nigh impossible. By definition, catastrophic risk can endanger the very survival of a firm. Because of their magnitude, it is hard to transfer such risks to financial and insurance markets. To go back to the nuclear example, it's well known that the mere cost of building a nuclear reactor can be so large (from 5 to 10 billion euros) to be equal to the stock market value of the company intending to build it. As a consequence, stock exchanges deem nuclear reactors too risky and refuse to finance nuclear plant projects.

Also, government intervention can drive up costs and make the investment unfeasible. In October 2010, the US electrical utility Constellation Energy gave up on building a new nuclear power plant in Maryland after the government had asked for $880-million fee as collateral for a $7.6 billion loan. And this cost does not cover the firms from all the claims for damages to people and organizations it would face in case of a nuclear accident. Thus, the sheer size of catastrophic risk makes it unlikely for it to be managed by private actors, even though the necessary forms of financial and technical collaboration between the private and the public sector haven't even been fleshed out yet.