Disaster prevention - Social Policy Bonds

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Disaster prevention

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Disaster Prevention Bonds would be a new financial instrument, designed to channel the market’s efficiencies and incentives into avoiding humanitarian disasters in the next 50 years. (They are not the same as catastrophe bonds (see box), which are not designed to reduce the humanitarian impact of the specified catastrophe.)

Disaster Prevention Bonds could be backed by some or all of the world’s governments and issued by an international body like the United Nations or World Bank. These bonds need not bear interest, and would redeemable for a fixed sum once a sustained period of absence of a humanitarian disaster had passed. The type of disaster need not be specified. The bonds would be floated on the open market and be tradable at any time thereafter. The redemption terms would stipulate that they would become worthless the moment an unspecified calamity killed, say, 100 000 of the world’s citizens by a single catastrophic event in any 48-hour period.

Holders of Disaster Prevention Bonds would then be in a similar position to holders of catastrophe bonds: they win if there is no catastrophe. But the bonds’ redemption terms would target impacts, rather than events. So it would not be the occurrence of a catastrophe that triggers the loss to bondholders; but the numbers of people killed (or made homeless) by such an event.

When floated the bonds would fetch a price lower than their redemption value. It could be much lower if investors think the likelihood the required disaster-free period ever being achieved is remote. After flotation, the bonds’ value would vary according to the perceived probability of a humanitarian disaster. Their value would rise if the market saw the probability of a major disaster falling. It is the prospect of such a rise that gives bondholders the incentive to do all they can to avert all kinds of humanitarian disaster, and to do so as efficiently as possible.

How would Disaster Prevention Bonds work?

Even a large number of small bondholders couldn’t do much to prevent a disaster. So the value of their bonds would fall until there were aggregation of holdings by people or institutions large enough to initiate effective disaster-prevention projects. In much the same way as share privatisation issues the world over have turned out, the bonds would probably end up mainly in the hands of large holders, be they individuals or institutions. Even these bodies might not be big enough, on their own, to achieve much without the cooperation of other bondholders. They might also resist initiating projects until they could be sure that other holders would not be ‘free riders’ So there would be a powerful incentive for all bondholders, tacitly or overtly, to cooperate with each other to help solve the targeted problem. They would share the same interest in seeing targeted objectives achieved quickly. They would share information, trade bonds with each other or collaborate on disaster-prevention projects. They could also set up payment systems to ensure that people, bondholders or not, were mobilised to help achieve targeted objectives. This might mean that bondholders pay people not according to how much they actually help contribute to an outcome – which can be difficult to determine – but according to how much bondholders estimate they are contributing to the outcome, or to more measurable variables as spending or outputs. But while there might on those occasions be no direct link between payment and efficiency in achieving the overall outcome, bondholders would have strong incentives to strengthen that linkage where it is worthwhile to do so. If they failed to do that they would not maximise their own rewards from holding Disaster Prevention Bonds.

So bondholders would either trade bonds, or make incentive payments to ensure that any proceeds from higher bond prices, or from redemption, would be channelled in ways most likely to stimulate speedy, least-cost, achievement of disaster-prevention goal. Large bondholders, in cooperation with each other, would be able to set up such systems cost-effectively. The bonds would be worth more to the people who could reduce the risk of disaster most efficiently, who would bid more for them both at flotation and thereafter. Regardless of who actually owns the bonds, aggregation of holdings and the cooperation of large bondholders would ensure that people who help avoid disaster are rewarded in ways that maximise their efficiency.

What could bondholders do? They might decide that the best use of their funds is to highlight the dangers of nuclear war to a complacent public, to lobby for the application and enforcement of stringent building codes in earthquake-prone areas, to improve early warning systems in low-lying coastal regions, or to beef up the more effective existing disaster relief organisations. It would be entirely up to the bondholders to spend their funds where they think they will maximise the disaster-prevention benefit per dollar cost, and to do so entirely without partiality as to where or whom they direct their efforts.  

Insurance against knowns and unknowns

Centrally allocated resource allocation can succeed when it's well meaning, has sufficient resources and is dealing with problems whose solutions are easily identifiable and do not conflict too much with powerful interests. Unfortunately, many of the new problems arising from denser, more linked, populations and higher technology are difficult even for a well-resourced government, or indeed any single big organization, to anticipate, let alone do much to forestall. Nuclear war, hurricanes, tsunamis or pandemics are only a subset of a range of and disasters that threaten mankind. Others include the risks arising from new biological advances or scientific experiments that concentrate energy, or natural disasters such as asteroid impacts or volcanic supereruptions.[*] These threats are in addition to the ‘known unknowns’ of more widely understood catastrophes. But a Disaster Prevention Bond regime would encourage people to address all of them.

Democratic governments are actually quite good at identifying broad social and environmental goals and raising the revenue for their achievement, and under a Disaster Prevention Bond regime they would continue to do so. But where governments are less effective is in actually achieving our goals. Disaster Prevention Bonds would let markets do what they do best: allocating scarce resources to achieve broad social and environmental goals at least cost.

As well as their efficiency, Disaster Prevention Bonds mean that there is no need for a handful of experts to try to anticipate the causes of future disasters and to allocate funds according to their views with only today's knowledge at their disposal. Investors in Disaster Prevention Bonds would do this work themselves, without bias, and would be motivated to adapt to new information continuously, during the entire lifetime of their bonds. And in another striking improvement over government-coordinated policies, their initiatives and projects will be diverse: they will have incentives to generate the most efficient solutions to the multitude of potential causes of disaster.

To sum up: the advantages of a globally-backed Disaster Prevention Bond regime:

  • Efficiency, arising from the incentive bondholders to support only efficient projects and to terminate failures – something that governments are often loth to do. There will also be efficiency gains arising from the continuous, publicly available pricing information generated by the market value of the bonds, which would be of immense value in helping decision-makers, public or private sector, decide where to allocate scarce disaster-prevention resources.


  • Stability of the goal: long-term projects could be undertaken safely because the bonds would target a universally desired objective, which is unlikely to be overturned by changes of government or ideological shifts.


  • Impartiality, transparency, and buy-in: disasters would be targeted regardless of the identity of their potential victims. And the bonds would have clear, explicit goals, so that everybody would know exactly what is their intention. This combination of features means they will be easily understood, so their deployment would engender widespread participation and support.


Cascading incentives

Disaster Prevention Bonds would go some way toward offsetting existing incentives, many of which make disasters more likely. Government policies have subsidised fossil fuel extraction and use, probably helping to destabilise the world’s climate. As well, the short-term interests of state-run defence contractors, including suppliers of nuclear technology have far more leverage than those of us who are concerned about nuclear proliferation.

A Disaster Prevention Bond regime could level the incentives playing field. Those who want to avoid a global catastrophe of any kind are, it’s safe to say, in a massive numerical majority, but have few means of channeling our wishes into effective action. We don’t know what to do, and our tendency is to assume that governments will sort it out with the support of hard-working, well-intentioned, but poorly-resourced non-governmental organizations. But the evidence points the other way. Our current system has, in the opinion of many, brought us to the brink of irreversible, catastrophic climate change; and nuclear proliferation, with all its attendant dangers, has proceeded apace. We need the incentives to avoid disaster to be at least as convincing as those that make disaster more likely. Disaster Prevention Bonds could help redress the balance.

In stark contrast to today’s disaster prevention or mitigation measures, Disaster Prevention Bonds would inextricably link rewards to achievement of a targeted outcome. With their efficiency and clear, comprehensible and meaningful goals, Disaster Prevention Bonds could not only minimize the occurrence and impact of future disasters, but help close the gap between governments and the people they are supposed to represent.

[*] Our Final Century?: Will the Human Race Survive the Twenty-first Century? Sir Martin Rees, William Heinemann, 2004, ISBN 0-434-00809-5.

Catastrophe bonds are typically issued by insurers, who stand to lose if a defined catastrophe, like a hurricane, occurs. Investors buy catastrophe bonds for a principal and then receive a high rate of interest. They will also see their principal returned, provided a defined catastrophe does not occur, enjoying a healthy net return. But if the catastrophe does occur then the insurance company retains the principal and uses it pay claimants. Catastrophe bonds were first issued in 1997 and their use has risen spectacularly. They are not designed to reduce the probability of a catastrophe occurring, or its humanitarian impact.

 
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