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Government as Risk Manager: Should We be More Worried?

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The Productivity Commission (PC) recently released a draft inquiry report into ‘Natural Disaster Funding Arrangements’ in Australia. For those that don’t know, the Productivity Commission is an Australian Government independent agency that provides advice on economic reform. To my knowledge, I’m not sure if other national governments have a similar agency. The only one that comes close is the OECD, but that is a multilateral agency. The PC has a strong reputation of furnishing ‘frank and fearless’ advice to successive Australian Governments. So it is with some interest that I read this report. I have worked on the role of government in managing risk, so I was interested to learn the PC’s perspective on natural disaster risk management.

The report defines natural disasters as “naturally occurring rapid onset events that cause a serious disruption to a community or region, such as flood, bushfire, earthquake, storm, cyclone, storm surge, tornado, landslide or tsunami” (p. 6). The PC pulls no punches in letting us know what it thinks about current funding arrangements:

Current government natural disaster funding arrangements are not efficient, equitable or sustainable. They are prone to cost shifting, ad hoc responses and short-term political opportunism. Groundhog Day anecdotes abound.

So, I think the PC thinks the Government needs to fix natural disaster funding arrangements. The most worrying part of the report is how governments at both national and state levels expend more funds on recovery rather than mitigation. For example, from 2002-03 to 2014-15 the Australian Government’s natural disaster spending comprised of 4%, or ($0.6 billion) on pre-disaster (i.e. risk mitigation) while the rest was used for disaster recovery and relief (i.e. $13.2 billion). Given the potential human and economic losses from natural disasters, wouldn’t prevention be better than cure?

The PC certainly thinks so. It thinks part of the problem is that governments are not required to explicitly state natural disaster liabilities. By making these liabilities transparent, it gives governments a tangible financial incentive to reduce natural disaster liabilities. It also provides governments an incentive to budget sufficient funds to fund the liabilities. Some Australian Government agencies rejected the PC’s suggestion as impractical because it would be difficult to calculate the cost of responding to these liabilities. The PC rejected these concerns because at least some natural disasters occur on a reasonably predictable basis. By not explicitly quantify natural disaster liabilities, the government is effectively exposing tax-payers to unfunded and uncapped liabilities.

The PC’s recommendation to explicitly budget for natural disaster liabilities would seem to be an eminently sensible solution. It shifts the focus towards prevention and preparation. If implemented, this recommendation could reduce the loss of human life and the economy from natural disasters. It is frightening that the budget doesn’t already incorporate natural disaster liabilities. Unfortunately, this is consistent with the way accounting standards view natural disasters. That is, because the expected costs from a natural disaster are not an obligation, the organisation does not need to make explicit provisions for natural disaster costs incurred. In fact, accounting standards only recognise the costs after an event. Given that governments don’t have to explicitly make provisions for natural disaster liabilities or other costs arising that are not obligations, what other risks have governments ignored that we should know about?

The one big economy-wide risk that jumped to my mind was the risk of financial sector collapse. The Australian Government provides for a range of guarantees for the financial sector as discussed here and in the budget itself. So, the Australian Government is clearly aware of the risks and has even stated that under the Financial Claims Scheme (FCS), it is liable for up to $692.3 billion if all covered financial institutions collapsed. According to the Australian Accounting Standards (the standard under which the Budget was prepared), contingent liabilities should be recognised with an appropriate provision (see paragraphs 27-30). But according to note 18 for Statement of Risks, there is no explicit provision for the FCS. Maybe, the Australian Government thinks its sufficient to state that it will recover any funds from the assets of the failed institution or by levying the rest of the financial sector. However, no explicit rationale was given for the lack of provisions for the FCS. That may be the case, but wouldn’t it be in the interests of the financial sector to know how much they might have to pay if an institution failed? Wouldn’t that give the sector an incentive to manage risk more appropriately if they knew the scale of the liabilities? Surely with all the financial engineers in the financial sector, one of them could develop a model that could estimate the extent of the liabilities.

Another example of risks that have not been explicitly estimated are the liabilities from rehabilitating mines. Australian States and Territories all require that mine operators prepare a rehabilitation plan as a condition of their mining license. Mine rehabilitation is required to ensure there is no risk of contamination (e.g. of drinking water) to the surrounding community and environment. However, it is not unheard of for a mining operator to declare bankruptcy and not fulfil their rehabilitation obligations. This is becoming more of a risk now with the current drop in the iron ore price approaching break-even point for many iron ore miners. The risk is that Western Australia, as Australia’s largest mining state, could face a slew of mine bankruptcies which may impose an unexpected call on the state’s budget in order to safely close the mines. The Western Australia Department of Mines and Petroleum think this could be $4-6 billion, but they’re not sure because they don’t collect this data. Understanding the scale of the liability would help prepare the Western Australian government for this contingency. Unfortunately, they may be caught unawares if iron ore prices fall below $US100 per tonne.

Unfortunately, it would seem that the problem that the PC identified is wider than they envisioned. I’m not arguing that we should regulate everything to manage the risk away. What I’m pointing out is that we don’t even know how much losses the risks could inflict. Unfortunately, accounting standards (at least in Australia) may actually contribute to the problem by not requiring more rigorous treatment of contingent liabilities that are not a contractual obligation. If you don’t measure it, you probably won’t manage it. If you or your organisation is worried about a particular risk, it may not be enough to state it in your annual report. Try and calculate what provisions need to be set aside to manage it if it is likely to eventuate. That way, you have something tangible to manage.