23rd March 2011

Of meltdowns and fallouts: What do the financial and the nuclear crises have in common?

by Georg Zachmann on 23rd March 2011

The metaphors used for the financial crisis have reappeared in the news. Earthquake, tsunami, meltdown, black swan and fallout have been used to describe both the (possible) events in the financial markets in 2009 and in Fokushima recently. It might just be the journalists searching for powerful visual language. But maybe there are some revealing structural similarities. I would argue that apart from being perceived as catastrophic, both events have at least four similarities: (1) As indicated by the “black swan” metaphor they are in part due to the difficulty in correctly assessing risks in complex systems. (2) The “fallout” in both cases is potentially cross-border in nature. (3) The cost incurred by the imprudent companies will be partially socialised. (4) Both events feature an inability of regulators to forecast and prevent the crisis.

(1) There is one reading of the nuclear accident that highlights that a 9.0-magnitude earthquake is an extremely exceptional event. As such events occur only rarely their probability cannot be very well assessed with models based on limited historic data. Events with very low probability but high impact have also been at the heart of the financial crisis. One reason for the financial crisis has been the appetite of financial institutions for selecting (and in some cases also constructing) products that have above-average returns in normal times but excessive losses in exceptional cases. As we have now seen, old nuclear power plants in seismic zones have a similar payoff structure. Another similarity is that both financial and nuclear risk models seem to not have correctly evaluated the correlations between different risks. While financial institutions tried to mitigate risks by bundling subprime mortgages, TEPCO’s cooling system was able to either cope with a blackout and an earthquake or with a tsunami. But in both cases the failure-probabilities were correlated and their joint occurrence led to catastrophe.

(2) Both nuclear and financial meltdowns tend to have a fallout. In the Japanese case, only the wind and the lack of a land-border prevented a major effect on neighbouring countries. In continental Europe, many reactors are within a 100-mile range of another country’s territory. So a nuclear accident in Europe would possibly have a cross-border dimension. But, like financial regulation, nuclear regulation is still essentially national, even in the EU with its Euratom treaty. As the economic importance of nuclear power plants is very different across member states, consensus on regulatory harmonisation is hard to reach. France will continue to produce the largest fraction of its electricity from nuclear power plants, and will seek to preserve its nuclear sector; Italy might have a much higher appetite for risk mitigation as it does not produce electricity from nuclear power but is surrounded (within about one-hundred miles) by one Slovene, one Swiss and six French nuclear power plants. The reluctance of the French government to include its nuclear plants into a harmonized European regulatory framework could be compared to the British efforts to prevent major European harmonization of financial market rules because of its important financial service sector.

(3) Another similarity between both events is that the erroneous risk assessment was largely due to the asymmetric distribution of social benefit and individual cost of more effective risk mitigation. Lehman and TEPCO were able to increase their profits as long as the risk they were willing to accept, voluntarily or thoughtlessly, did not materialize. Their management certainly benefited from this as long as everything went well. When the crisis struck, however, the cost of the meltdown exceeded the equity of the companies and had thus to be socialized. The question that arises is whether there exists a structural failure in coping with complex private activities that risk leading to large damages for society. The simple answer is yes. In fact this is well understood and is the reason why we have regulators for most such systems.

(4) In both cases, however, the corresponding regulators were not able to prevent the risk. The SEC did not require more capital and try to halt risky practices at the big investment banks. The Japanese nuclear regulator did not enforce stricter security rules. In fact, regulators systematically fail to prevent some of the events. There are several reasons for this regulatory failure: The inability to acquire and process all relevant data, the political difficulty in enforcing strict judgements and the aforementioned difficulty to model tail risks are some of them.

Relying on low failure probabilities, national policies, the caution of private actors and the monitoring by regulators seem to be insufficient to prevent catastrophe. So what should be done? As in finance, insuring the risk and making the originator of the risk pay seems to be the most sensible approach. If each power plant had to insure the risk it imposed upon society (within and outside its country of residence) it would bear the true economic cost of its activities. In this ideal world, the insurance premium of each individual plant would be linked to certain influenceable and non-influenceable factors such as location in a densely populated area and the risk-aversion of the local population. Furthermore, the risk assessment should be linked to individual plants risk factors such as location in a seismic zone, secondary-containment, redundancies etc. Consequently, plants in densely populated areas with lower security standards would face higher insurance cost. This could lead to a self-selected phase-out of the most risky plants.

The implementation of such a scheme is highly unlikely. First of all, it is virtually impossible to correctly assess the risk profile of individual plants. Secondly, such a scheme would impose large costs on only a few companies in a few countries. Governments will fight hard to protect these companies from being required to pay for the risks they impose on domestic and foreign society. This likely outcome is reminiscent of the initiative for a European or global banking fund that would have collected money to insure against the next crisis.

Nevertheless, in both cases, perfect insurance could serve as a valid benchmark for any policy implemented. Recommendations could thus be: (1) nuclear power plants should not be phased-out according to age but to their risk profile (however schematically it is calculated). And (2) cross-national insurance for nuclear accidents should be mandatory. Under such a scheme the Soviet Union in 1986 would have been required to pay for the costs the Chernobyl accident imposed upon European farmers and the health system. Implementing these improvements will be difficult enough, but as for the financial sector, crisis is the mother of reform.