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Fallout of nuclear and financial meltdowns

by Georg Zachmann

BRUSSELS — The metaphors used during the financial crisis of 2008-2009 — earthquake, tsunami, meltdown, black swan and fallout — are back with a vengeance, but now they are being recycled literally. In fact, the financial crisis and the nuclear crisis at the Fukushima nuclear-power plant in Japan share at least four similarities:

* The “black swan” metaphor suggests that these events reflect difficulty in correctly assessing risks in complex systems.

* Regulators proved unable to forecast and prevent the crisis.

* The “fallout” is potentially cross-border in nature.

* The costs incurred by the imprudent companies will be partly socialized.

The 9.0-magnitude earthquake that struck Japan is, of course, a highly exceptional event — an event so rare that its probability cannot be well assessed with models based on limited historic data. Events with very low probability but high impact — so-called tail risks — have also been at the heart of the financial crisis.

One cause of the financial crisis was financial institutions’ appetite for selecting (and in some cases, creating) products with above-average returns in normal times but excessive losses in exceptional cases. Old nuclear power plants in seismic zones have a similar payoff structure. Moreover, both the financial- and nuclear-risk models seem to not have correctly appreciated the correlations between different risks.

While financial institutions tried to mitigate risks by bundling subprime mortgages, Fukushima’s cooling system was able to cope with either a blackout and an earthquake, or a tsunami. But, in both cases, the failure probabilities were correlated, and their joint occurrence led to catastrophe.

Both nuclear and financial meltdowns tend to leave behind fallout. In the Japanese case, only wind and the lack of a land border prevented a major impact on neighboring countries. In continental Europe, many reactors are within 161 km of another country’s territory. So a nuclear accident in Europe would likely have cross-border consequences.

But, like financial regulation, nuclear regulation in the European Union, even with its Euratom treaty, is still essentially national. And, given the deep disparities in nuclear power’s importance for European economies, consensus on regulatory harmonization is hard to reach.

France, for example, will remain dependent on its nuclear-generating capacity, which will continue to account for the largest share of its electricity. Italy, on the other hand, might wish for a zero-nuclear risk environment, as it does not produce electricity from nuclear power but is surrounded (within about 160 km) by one Slovene, one Swiss and six French nuclear-power plants. French reluctance to subject its nuclear plants to European regulation determined by its nuclear-skeptical neighbors is comparable to British efforts to prevent major European harmonization of financial-market rules, owing to the importance of its financial sector.

Another similarity between Japan’s current crisis and the recent financial crisis is that the false risk assessment was largely due to the asymmetric distribution of social welfare and individual cost implied by more effective risk mitigation. Both Lehman Brothers and Tokyo Electric Power Company were able to increase their profits as long as the risk they were willing to accept did not materialize. Their management certainly benefited as long as everything went well. When crisis hit, however, the cost of the meltdown exceeded the companies’ equity and thus had to be socialized.

So there is a structural failure in coping with complex private activities that risk leading to large societal damage. In fact, this is well understood — and is the reason why we have regulators for most such systems.

But, prior to both Japan’s nuclear crisis and the financial crisis, regulators were unable to prevent the risk. America’s SEC did not require more capital or halt risky practices at the big investment banks. Japan’s nuclear regulator did not enforce stricter security rules.

There are several reasons for this regulatory failure, including the inability to acquire and process all relevant data, the political difficulty of enforcing strict judgments, and the difficulty of modeling tail risks. Consequently, relying on low failure probabilities, national policies, the caution of private actors, and monitoring by regulators seems to be insufficient to prevent catastrophe. So what should be done?

As in finance, ensuring that the originator of a risk pays the cost seems to be the most sensible approach. If each nuclear-power plant was obliged to insure against the risk that it imposes on society (within and outside the country of its location), it would face the true economic cost of its activities.

In this ideal world, insurance for individual plants would be linked to factors that can and cannot be influenced, such as location in a densely populated area and the local population’s risk averseness. Furthermore, risk assessment should be linked to individual plants’ risk factors, such as location in a seismic zone, secondary containment, safety redundancies, etc. Plants in densely populated areas with lower safety standards, for example, would face higher insurance costs, which could lead to a self-selected phaseout of the riskiest plants.

Implementation of such a scheme is unlikely, however. First, it is virtually impossible to assess individual plants’ risk profiles correctly. Second, such a scheme would impose large costs on only a few companies in a few countries. Their governments would fight hard to protect these companies from being required to pay for the societal risks that they represent.

This likely outcome mirrors the initiative for a European or global banking fund to insure against the next financial crisis. In both cases, however, perfect insurance could nonetheless serve as a valid benchmark to guide the choice of policies to implement.

Moving toward this benchmark could be aided by two measures: first, a phaseout of nuclear power plants not according to their age, but to their risk profile, however schematically this is calculated; and, second, introduction of mandatory cross-national insurance for nuclear accidents. Under such a scheme, the Soviet Union in 1986, for example, would have been required to pay for the costs that the Chernobyl accident imposed on European farmers and health care systems.

Implementing these improvements will be difficult, to be sure. As with the financial sector, however, crisis can be the mother of reform.

Georg Zachmann is a research fellow at Bruegel. © 2011 Project Syndicate