Using an Option Pricing Approach to Evaluate Strategic Decisions in a Rapidly Changing Climate: Black–Scholes and Climate Change
Climatic Change DOI 10.1007/s10584-016-1860-5
32 Pages Posted: 7 Dec 2016
Date Written: November 25, 2016
Nature provides critical ecosystem services on which society and businesses rely, but the effort and cost of utilizing those services can change with the climate. Both climatic trend and variance affect these efforts and costs, creating a complex decision space where uncertain future predictions are the rule. Here, we show how these problems mimic option payoffs and demonstrate a modified version of the Black–Scholes option pricing formula (widely used in finance) to analyze these types of business-climate decisions. We demonstrate the method by (1) examining the viability of building ice roads in the Northwest Territories of Canada, where a strong negative warming trend is underway, and (2) applying it to the problem of the ongoing California drought, estimating expected water costs with and without storage. The method is novel and provides a simple and accessible way to make such assessments to at least a first-order approximation. While our focus here is on business situations where decisions are usually based on money, we suggest that a similar approach could be used beyond the business world in examining risk and attributing that risk to climate variance vs. trend.
Keywords: climate change, option pricing, climate variance, drought, ice roads
JEL Classification: Q51, Q54, Q25, A12, G13, L72, O13, O18
Suggested Citation: Suggested Citation