NOU 2018: 17

Climate risk and the Norwegian economy

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5 From risk analysis to risk management

Norway is a market economy with a large public sector. There is an interrelationship between the public and the private sector, which implies that there is no sharp distinction between climate risk in the private and the public sector. It is therefore important to adopt an integrated approach to climate risk. Joint climate risk management principles and methods across all sectors – to the extent appropriate – provide the best basis for sound management of such risk for the Norwegian economy as a whole.

Central and local governments have important roles in societal planning. Key roles include decisions on land use and physical infrastructure development. An important question is whether climate change and climate-related risk considerations are accorded sufficient weight in public planning. Central government also carries responsibility for macroeconomic management, which is important for the sound long-term use of society’s resources.

Norway has an open economy. This has brought us large welfare gains. However, Norway’s open economy also exposes us to risks arising in other countries, including climate-related risk. Norway has little scope for managing such risk. It is therefore important to assess how Norway can strengthen its resilience to said risk. Resilience and adaptability are key aspects of a strategy for addressing climate risk in a sound manner – in both the private and the public sector.

In a market economy, the financial sector is of particular importance. Consequently, a key issue is what it will take for this function to be performed well in the transition to a low-emission society. Climate risk having occurred in other parts of the economy may, at the same time, impinge on the financial sector, for example through changes in the value of investments.

Normally, the market is a good mechanism for ensuring efficient production of goods and services. Market price formation serves to balance the supply of, and demand for, goods and services. Demand changes cause price changes, thereby signalling how supply should respond. In a well-functioning market, such price signals will result in efficient allocation of production resources in the economy.

However, markets will not function well in certain contexts. The climate problem is in itself an example of serious market failure; an «externality». The atmosphere is a global public good, with individuals reaping the benefits of free consumption, whilst costs and disadvantages are passed on to the community. This results in excess consumption, which is at the core of the «tragedy of the commons». Various forms of market failure may also inhibit our ability to manage climate risk once it has materialised. It is therefore an important policy priority to identify and correct such market failure, in order to enable market mechanisms to facilitate, in the best possible manner, sound climate risk management in the economy.

The time profile of the climate problem makes it difficult to resolve under the time horizons applied by economic and political stakeholders. Long time lags, cooperation challenges, potential scope, as well as irreversibility, serve to make climate change a challenge different from most other. In order for long-term considerations to prevail, these need to be embedded in regulatory frameworks governing the behaviour of all members of society. This can be challenging.

We recommend a set of general climate risk management principles. The Commission has, from amongst the main climate risk management challenges, placed a special emphasis on various forms of market failure, the long time horizon over which climate risk needs to be assessed, the considerable uncertainty surrounding many aspects of the risk outlook, the fact that many of the assessments rest on a distinctly provisional knowledge base, and the need for uniform and cross-sectoral risk management attaching weight to the importance of resilience when confronted with risk we have little scope for managing. These considerations have led us to formulate a set of general risk management principles for both the private and the public sector, cf. Box 5.1.

Textbox 5.1 General climate risk management principles

  • 1. Comprehensiveness: Use an integrated process in analyses of threats, opportunities and risk factors

  • 2. Framework: Address climate risk in the context of other risks and risk frameworks

  • 3. Appetite: Desired risk level must be based on a broad assessment of benefit, costs and robustness

  • 4. Resilience: Attach weight to resilience in line with the precautionary principle

  • 5. Incentives: Clear links should be established between decisions and implications

  • 6. Standardisation: Risk assessments should be performed as similarly as possible across various fields

  • 7. Communication: Risk management should be based on cooperation, information sharing and transparency

Moreover, the principles form the basis for more specific recommendations. Recommendations for contributing to sound climate risk management decisions can be classified into three categories:

  • a. Thorough analysis: Global appreciation of climate risk is emerging, so more information, improved reporting and an expanded knowledge base are necessary. A comprehensive risk analysis considers various risk factors in context and shed light on uncertainty. The perspective must be expanded from forecasts with partial sensitivities to using scenario analysis in which several elements are changed simultaneously. For Norway it is of particular relevance to perform stress testing of fiscal policy and the petroleum sector.

  • b. Appropriate incentives: A key role for policy is to correct market failure and create appropriate incentives, and a predictable and effective climate policy makes an important contribution to reducing climate risk. It provides public and private sector enterprises with a better basis for establishing their future plans and investment decisions, and facilitates active corporate governance that addresses the long-term nature of climate risk. Furthermore, it gives the financial sector a better basis for performing its role in channelling loans and equity to businesses in the transition to a low-emission society in a sound manner. Misguided investments, poor returns and financial instability are thereby averted. It also paves the way for insurance arrangements to function as they should, and for prevention to be considered in relation to the extent of damage.

  • c. Integrated process: A sound decision-making process adopts an integrated perspective in which climate risk assessments are conducted as similarly as possible across various fields, climate risk is considered in relation to other risk factors, and climate risk management is integrated into existing risk management frameworks in which the peculiarities of climate risk have been taken into consideration. The process should be broad and transparent to give rise to a joint understanding of risk, make affected parties take ownership of risk level preferences and strengthen the resilience of risk management. In addition, risk management must attach weight to resilience in line with the precautionary principle, in order to address uncertainty and potential surprises that are not captured well by the risk analyses.