Valuing flood disasters using the life satisfaction approach

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Abstract

This paper argues that life satisfaction data can be used to value natural disasters. We discuss the strengths of this approach, compare it to traditional methods and apply it to estimate and monetize utility losses caused by floods in 16 European countries between 1973 and 1998. Using combined cross-section and time-series data, we find a negative impact of floods on life satisfaction that is sizeable, robust and significant. The estimates are comparable to price discounts found in housing markets. In an exploratory analysis, we find that risk transfer mechanisms such as mandatory insurance have large mitigating effects.

Introduction

Regarding natural disasters, the last years have often been described as anni horribili. The tsunami in the Indian Ocean, Hurricane “Katrina” on the U.S. Gulf Coast and the Pakistan earthquake are the most prominent catastrophes of the recent past. In Europe, floods rank highest among natural disasters. During the past two decades, several extreme floods have occurred in Central European rivers (including the Rhine, Danube, Odra, and Wisla), culminating in the disastrous August 2002 flood in the Elbe River basin and parts of the Danube basin. Likewise, the U.S. Federal Emergency Management Agency (FEMA) calls flooding “America's #1 Natural Hazard” (FEMA, 2004). And more is to be expected! Climate-induced changes in the timing of runoff for several European river basins and small Alpine catchments increase the risk of winter floods (Schröter et al., 2005). Dramatic increases in flood frequency and intensity are also likely in parts of the United States (e.g. Gleick, 1999). Questions regarding the financing of flood protection and prevention strategies are likely to raise in significance on the political agenda.

Preventive measures, and natural disasters themselves, have the characteristics of a local public good or local public bad, respectively. It is commonplace that individuals have no incentive to disclose their true demand for public goods. It is advantageous to understate demand when it positively affects contribution requirements and to overstate demand otherwise. No exception is to be expected in the case of natural hazards. Therefore, it is important to assess the utility losses caused by natural disasters. Moreover, the increase in risk raises the question to what extent risk transfer mechanisms such as (mandatory) catastrophe insurance can mitigate the effects of disasters. The higher the non-insurable psychic costs are, the less relief such a system will provide.

In economics, essentially two avenues have been pursued to elicit people's preferences for public goods: revealed preference methods on the one hand and stated preference methods on the other hand. The former are based on actual behavior and utilize complementary and substitutive relationships between public and various marketed goods to infer the value attributed to public goods from market transactions in private goods. A primary example is the hedonic method (HM). In the case of stated preference methods, individuals are directly asked to value the public good in question; the most prevalent method is the contingent valuation method (CVM). Both avenues have their weaknesses. Revealed preference methods are based on stringent assumptions and crucial elements are inherently difficult to measure. The hypothetical nature of CVM surveys, on the other hand, may entail unreliable results and strategic behavior.

We propose a novel and potentially effective complementary method to value public goods in general and natural hazards in particular, the life satisfaction approach (LSA). A growing literature in economics demonstrates that reported subjective well-being can serve as an empirically adequate and valid approximation for individually experienced welfare or utility. Hence, it is an obvious and straightforward strategy to directly evaluate public goods in utility terms. The partial correlations between the public good and life satisfaction and between income and life satisfaction capture the marginal utility of the public good and the marginal utility of income, respectively. This allows for estimating the trade-off ratio between income and natural hazards. This approach obviates some of the major difficulties inherent in both the revealed preference and stated preference methods. As it is not based on observed behavior, the underlying assumptions are less restrictive and non-use values can – to some extent – be measured. Furthermore, individuals are not asked to value the public good directly, but to evaluate their general life satisfaction. This is presumably a cognitively less demanding task, does not evoke answers considered desirable by the persons asked, and there is no reason to expect strategic behavior.

This paper has three major objectives. First, we present the LSA and discuss some conceptual issues (Section 2). Second, we apply it to measure the utility consequences caused by major floods for 16 European countries in the period between 1973 and 1998 (Section 3). The analysis is based on combined cross-section and time-series data and 56 major flood events. We find that flood disasters have a significant and robust negative impact on people's reported life satisfaction. The effect is monetized by calculating the compensating surplus for prevention of events. These monetized effects lie within the range of estimates found in hedonic housing studies. Third, in an additional explorative analysis, we estimate the effects of different risk transfer mechanisms. We find risk-transfer mechanisms to have large mitigating effects that come close to fully compensating the impacts of a flood event. Consequently, the effects of flood disasters in regions without such a mechanism are larger than the effect in all regions and the effect in regions with such a mechanism is small. Section 4 offers concluding remarks.

Section snippets

The basic concept

Due to extensive work by psychologists, the measurement of experienced utility has made great progress (see the surveys by Diener et al., 1999, Kahneman et al., 1999). We follow the terminology proposed by Kahneman et al. (1997) to differentiate between decision utility as a representation of preferences derived from choice and experienced utility as an interpretation of utility in hedonistic terms broadly understood. Experienced utility is usually measured by survey questions on respondents'

Effects of floods on life satisfaction

In the following, we use the LSA to measure utility losses caused by flood disasters. The main results are based on 16 European countries. In order to show that the results are potentially valid more generally, we briefly report the effects of floods on subjective well-being from repeated cross-section analyses across U.S. counties.

Concluding remarks

The recent development in happiness research suggests that self-reported life satisfaction can serve as a proxy measure for (experienced) utility. Provided that life satisfaction data contain information on respondents' global evaluations of their present life, that the proportion of noise stemming from current affect is sufficiently small, and that problems of interpersonal comparability of utility can be overcome by focusing on groups rather than single individuals, life satisfaction data can

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    We would like to thank [to be completed]. This paper was presented at the annual meeting of the European Economic Association 2006 in Vienna, the annual meeting of the Verein fuer Socialpolitik 2006 in Bayreuth, the annual meeting of the Economic Association of Austria 2006 in Vienna and the International Disaster Reduction Conference 2006 in Davos.

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