Irreversible Adaptation and Knightian Climate Uncertainty

Abstract

We model a setting where a firm must choose when to adapt to climate-induced resource scarcity based on objective expectations of climate change (climate projections), and is influenced by both risk (annual variability in climate projections) and ambiguity (inability to assign probabilities to various climate projections). We show that the effect of risk on the timing of adaptation depends on the presence of diminishing returns in the firm’s production technology, while the effect of ambiguity depends on whether there is ambiguity in resource supply trends, instantaneous variance, or both. We then apply our model to the decision to adopt water-saving irrigation technology in California’s Central Valley. Using sixty-four down-scaled climate projections for water availability in the Central Valley, we quantify climate variability and ambiguity facing agricultural firms and solve for the optimal timing of adaptation.

Keywords: real options, ambiguity, multiple-priors utility, water scarcity, climate variability