Spreading the burden

By Eric Crampton 09/03/2013

The Christchurch Earthquake has the government looking at earthquake standards for older buildings. This could all wind up being rather expensive.

A former adviser to the Reserve Bank and World Bank says the cost of bringing in tougher tests for earthquake-prone buildings would far outweigh the benefits.
Economic consultant Ian Harrison said he had analysed proposals put forward by the Ministry of Business, Innovation and Employment on building standards, and it showed the cost of the tougher regime would be 50 times the benefits.
In Auckland the cost was 1762 times the benefit.

So, how much strengthening is enough?

Let’s start with an easy case: your own owned house set back in a yard. If you own the house and live in it, it should be your own business as you’re bearing the risk. Maybe we can complicate it where we think that people are bad at thinking about these kinds of risks, but even then it’s hard to make a case for doing anything beyond requiring engineering reports on the houses, putting the information on the LIM, and maybe putting a little warning sign at the door for houses found to be particularly risky so that visitors know what they’re getting into.

Let’s complicate it a bit. You have a two-story brick townhouse built abutting the sidewalk: if the facade comes down, your house will kill people. What standard should there apply? The people inside own the house and have come to their own assessment of the risk, but not so the people on the sidewalk. Or the people in buses traveling down the street beside it. Ideally, we’d want earthquake reinforcement up to the point where the cost of an additional unit of safety provided is equal to the expected cost of the risk imposed: the likelihood of the facade coming down multiplied by the damage done if it does. How can we set a rule that induces the appropriate cost internalisation? Here, I’d expect we do best by relying on insurance: require building owners imposing this kind of risk to carry liability insurance sufficient to pay the current value of a statistical life for each person killed by their building in case of earthquake. In a competitive insurance market, premiums for this policy will reflect the actual value of the risk imposed, and building owners will then have incentive to make improvements that are cost-effective. And given how insurers have behaved since the 2011 earthquakes, we’d likely need some very bright-line rules about which bits of sidewalk count as being which building’s problem. We’d possibly also need stock and pillory for insurance officials wanting to spend years arguing the toss about whether a stone from one building is what pushed the victim into another building’s zone.

Let’s add a further complication: the house is heritage listed and the owners are prohibited from making improvements that would detract from the heritage amenity provided, or at least it’s awfully hard. Upgrading these buildings isn’t going to be cheap. Heritage amenities are real; there is a real case for local government subsidy of these amenities. But we really need to shift to having that amenity be guaranteed by annual on-budget payments going to those providing the heritage amenity rather than mandates around permissible building modifications.*

What about rental properties? There, I can see a decent case for requiring the engineering reports on suspect properties, along with mandates that a simple version of the report be made available to tenants about the property’s real risks. It would certainly be the case that there would be some low-rent buildings that are pretty risky. But it would also be the case that the tenants there preferred living in the riskier building than paying the higher rent for an upgraded building: I’d be rather surprised if upgrading costs imposed on landlords through mandates didn’t wind up being passed through as higher rents. It’s easy to make the sad-story case of someone ‘forced’ by poverty to choose a lower quality rental building and how we need to consequently mandate tight standards, but solving that with building regs is just a form of trying to solve an income problem with a price control. If we cared about getting more lower-income rental properties to market, we’d be easing back on the zoning controls that inflate the price of land.

Commercial properties or those visited by the general public are a bit more complicated. The risks of entering any particular building are far from obvious. There are three basic potential approaches. We could mandate adherence to some standard. We could use a liability rule making the building owner liable for deaths caused by his building falling on those inside (requiring insurance sufficient to cover the liability, as suggested above for streetside homes). Or, we could inform those entering the building of the building’s risk by way of “Earthquake Grade” signs mimicking the restaurant grades.

But standards are insufficiently sensitive to actual imposed risk.

And liability rules would prove really rather expensive for any building that often hosts a large number of people – it’s very easy to imagine that many people would voluntarily, and in full knowledge of the risk, choose to enter a building that would have been demolished as too expensive to insure under a liability rule. We only want a liability rule where we think that people are incapable of making rational risk assessments when in possession of full information about the risks, or where it’s exceedingly expensive to provide that information. But they should beat nation-wide regulation where different parts of the country have different actual earthquake risk.

Finally, I’d expect that locals would quickly figure out how much weight to put on Red/Yellow/Green-light earthquake risk signs. When I was up at a conference in Wellington last year, the building had a big “Earthquake risk” sticker on it. Had I known at the outset that the Law & Economics Association was choosing to host his event in such a place, I’d have declined to attend – I am rather disinclined to walk into any brick unreinforced building in Wellington barring very large side-payment. Online maps of earthquake building risks would quickly sort things out.

There’s a good case for having liability rules or standards for buildings that the public is forced to attend by the state: courtrooms, prisons, public licensing offices and the like. We can’t use a revealed preference argument around risk acceptance for those venues. But for other buildings where entry is voluntary, what’s wrong with mandating signs advising the public that “Engineering assessment suggests this building has (very low, below average, average, above average, seriously high risk) of falling down in case of earthquake. Entry is at own risk.”

I’d expect that optimal policy would mandate liability insurance for risks imposed on passers-by, regulation for buildings whose collapse would block essential traffic routes (or, equivalently, liability equal to the full actual cost imposed in such case, with insurance premia then doing the work), and warning signs for entry into buildings.

It would make me awfully sad if Oamaru’s historic district had to be torn down to meet earthquake regs where Oamaru’s actual risk perhaps isn’t all that high. Competitive insurance quotes could sort that out more effectively than can nationwide regulation.

* And if you’ve not been following the utter madness in Christchurch, read this and weep. Because their destroyed house was in a heritage zone, all the heritage from which is now flattened and gone, this couple is banned from putting up the house they want on their property [article, editorial]. The planners won’t revisit the heritage zone regs until 2014-2015. As for the dictatorship downtown