Blog post based on an article published in Environment and Development Economics

Natural disasters like the recent floods in Philippines and the tropical cyclone in Japan are just a few examples of catastrophic hazards which can cause loss of life, damage to personal property, business and infrastructure. The severity of these catastrophic events depends on the affected population’s resilience, or ability to recover and to undertake proactive mitigation measures. In many developing countries where financial insurance against catastrophes is often not available the risk from natural hazards, while it cannot be eliminated, can, in some cases be understood in such a way that we can minimize the hazard to human’s life, business and infrastructure.

In this paper we analyze the incentives of firms in developing countries to engage in mitigation investments that reduce the damage caused by natural disasters and investigate how these incentives are affected by financial aid programs. We use the real options theory and consider that the firm productivity is described by a random process exhibiting abrupt downward movements whenever a natural catastrophe occurs. Since the arrival time and the damage size of catastrophes cannot be predicted with certainty, we assume specific probabilistic models. The firm problem is to maximize its value and to choose the optimal timing and size of the investment.

We also analyze the donor’s optimal aid strategy. In particular, we consider how cash aid, that is a cash flow proportional to the profit-loss, and in-kind aid, where a part of the firm’s productivity is restored to a pre-disaster level, affect their investment decisions. We find that both financial aid strategies delay investment in mitigation. However, in-kind aid delays the mitigation investment more than cash aid does. Finally, we also find that the investment size with in-kind aid is larger than the one with cash aid. We illustrate our results using data on a Caribbean island and considering small-scale farmers investing in the construction of a hurricane-resistant small ruminant shelter as a risk reduction measure.

Finally, we provide policy support for international donors. Donors may want to accelerate the adoption of measures reducing the vulnerability of small firms. In this case they should provide relief in the form of cash aid which outperforms in-kind aid and speeds up investment in mitigation. On the contrary, if their aim is to reduce the damage caused by natural hazards, then in-kind aid is preferable.

Read the full article here.

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