Mitigating negative consequences of unexpected environmental shocks

Abstract

The frequency of unexpected weather shocks has been increasing due to climate change. Weather shocks lead to significant damages: the US experienced over 289 disasters with damages over a billion dollars between 1980 and 2020; and the European Union incurred over $535.2 billion in damages in total, between 1989 and 2019. Given these increasing weather shocks, it is critically important to understand how users of environmental resources respond to the increased frequency of weather shocks and resulting damages. In particular, the issue of potential feedback from severe weather shocks on efforts to mitigate climate change has not been studied in detail. We explore this feedback process using a contractual mechanism, based on Payment for Ecosystem Services (PES) for forest conservation, an important approach policymakers adopt to fight deforestation and climate change. From a strategic viewpoint, PES mechanisms are essentially a principal-agent game in which the principal pays the agent under a contractual agreement that requires the agent to perform (or not perform) a certain action. We use an incentivized experiment, conducted live with undergraduate students and online through Amazon’s MTurk service, to examine if and how PES contract violations change in presence of insurance and inspection. We find that inspection reduces contract violations by 12–15%, but provision of insurance for potential weather shocks (droughts) does not impact contract violations. Interestingly, the possibility of droughts decreases contract violations, indicating that the existing institutional framework and policies can offer an important safety net for the agents during times of uncertainty, while simultaneously protecting environmental resources.