Real Options Analysis of Climate-Change Adaptation: Investment Flexibility and Extreme Weather Events

25 Pages Posted: 8 Feb 2019 Last revised: 29 Jul 2019

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: July 29, 2019

Abstract

Investments in climate-change adaptation will have to be made while the extent of climate change is uncertain. However, some important sources of uncertainty will fall over time as more climate data become available. This paper investigates the effect on optimal investment decision-making of learning that reduces uncertainty. It develops a simple real options method to value options that are found in many climate-change adaptation contexts. This method modifies a binomial tree model frequently applied to climate-change adaptation problems, incorporating gradual learning using a Bayesian updating process driven by new observations of extreme events. It is used to investigate the timing, scale or upgradable design of an adaptation project. Recognition that we might have more or different information in the future makes flexibility valuable. The amount of value added by flexibility and the ways in which flexibility should be exploited depend on how fast we learn about climate change. When learning will occur quickly, the value of the option to delay investment is high. When learning will occur slowly, the value of the option to build a small, low-risk project instead of a large high-risk one is high. For intermediate cases, the option to build a small project that can be expanded in the future is high. The approach in this paper can support efficient decision-making on adaptation projects by anticipating that we gradually learn about climate change by the recurrence of extreme events.

Keywords: climate change, adaptation, real options, cost-benefit analysis, learning options

JEL Classification: G31, Q54, R42

Suggested Citation

Guthrie, Graeme, Real Options Analysis of Climate-Change Adaptation: Investment Flexibility and Extreme Weather Events (July 29, 2019). Available at SSRN: https://ssrn.com/abstract=3323549 or http://dx.doi.org/10.2139/ssrn.3323549

Graeme Guthrie (Contact Author)

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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