Technical Policy Briefing Notes - 4
Real Options Analysis
The Application to Adaptation
Policy Briefs
Real Options Analysis
The Application to Adaptation
ROA
has been widely cited as a possible decision support tool for
adaptation as it aligns closely with the concept of iterative decision
making. The MEDIATION project has reviewed the application of ROA to
adaptation.
A key value of ROA is that it provides an economic analysis of investing now versus waiting, and the economic value of flexibility, which allows a comparison of the additional marginal cost (or lower initial benefits) of added flexibility and future learning.
ROA can also be used to support initial enabling steps to help secure projects for future development, even if they are not expected to be cost-efficient on the basis of traditional, static CBA/CEA appraisal.
In considering the application to adaptation, the ROA investment framework is most likely to be supportive of projects that have some combination of substantial near-term benefits, and the ability to scale-up or down in line with learning regarding potential upside benefits or downside risks. This will be the case for example when there is an existing adaptation deficit that the immediate investment can reduce, such as current flood risks. It is also relevant to adaptation in situations where projects proceed on a similar timescale over which information will be gained about likely climate impacts (and therefore benefits of different project options).
However, the framework will tend to suggest that there is value in delaying projects that are focussed on long-term benefits with highly uncertain outcomes, given the expectation of valuable information arising over coming years and decades regarding climate impacts.
The approach is most relevant to large, capital intensive investments such as dyke flood protection or dam-based water storage. Capacity building, no-regret or soft options are generally only likely to be evaluated in ROA to the extent they are necessary initial steps in keeping open possible future investment options.
The theoretical basis for the application to adaptation has been outlined (e.g. HMT, 2009) but the application to real world decisions is complex (see box).
A key value of ROA is that it provides an economic analysis of investing now versus waiting, and the economic value of flexibility, which allows a comparison of the additional marginal cost (or lower initial benefits) of added flexibility and future learning.
ROA can also be used to support initial enabling steps to help secure projects for future development, even if they are not expected to be cost-efficient on the basis of traditional, static CBA/CEA appraisal.
In considering the application to adaptation, the ROA investment framework is most likely to be supportive of projects that have some combination of substantial near-term benefits, and the ability to scale-up or down in line with learning regarding potential upside benefits or downside risks. This will be the case for example when there is an existing adaptation deficit that the immediate investment can reduce, such as current flood risks. It is also relevant to adaptation in situations where projects proceed on a similar timescale over which information will be gained about likely climate impacts (and therefore benefits of different project options).
However, the framework will tend to suggest that there is value in delaying projects that are focussed on long-term benefits with highly uncertain outcomes, given the expectation of valuable information arising over coming years and decades regarding climate impacts.
The approach is most relevant to large, capital intensive investments such as dyke flood protection or dam-based water storage. Capacity building, no-regret or soft options are generally only likely to be evaluated in ROA to the extent they are necessary initial steps in keeping open possible future investment options.
The theoretical basis for the application to adaptation has been outlined (e.g. HMT, 2009) but the application to real world decisions is complex (see box).
Box 2: Moving
to practical applications of real option analysis
An example of how complex real option analysis can be in practice is demonstrated with the study of Jeuland and Whittington (2013), who applied real option analysis for a water resource planning case study in Ethiopia along the Blue Nile, looking at the planning of new water resources infrastructure investments (for five large dams, each with different relative characteristics) and their operating strategies in a world of climate change uncertainty. Their analysis considered flexibility in design and operating decisions over the selection, sizing, and sequencing of new dams, as well as reservoir operating rules, using a simulation model that included linkages between climate change and system hydrology, with testing of the economic outcomes of investments in new dams.
This required three linked models for stochastic runoff generation, hydrological routing, and Monte Carlo simulation of economic outcomes for the different project alternatives (looking at 7,350 simulation experiments comprised of 350 planning alternatives × 7 runoff scenarios × 3 water withdrawal assumptions). For each of these a separate hundred-year sequences of stochastic inflows were passed through the system. The 100 resulting sets of physical outcomes were then used as inputs to a cost-benefit model in which 5,000 Monte Carlo trials were applied to yield distributions of net present value (NPV) for each experiment. The results indicated that there was no single investment plan that performed best across a range of plausible future climate conditions. The value of the real options framework was its use in identifying dam configurations that were both robust to poor outcomes and sufficiently flexible to capture high upside benefits should favourable future climate and hydrological conditions arise.
An example of how complex real option analysis can be in practice is demonstrated with the study of Jeuland and Whittington (2013), who applied real option analysis for a water resource planning case study in Ethiopia along the Blue Nile, looking at the planning of new water resources infrastructure investments (for five large dams, each with different relative characteristics) and their operating strategies in a world of climate change uncertainty. Their analysis considered flexibility in design and operating decisions over the selection, sizing, and sequencing of new dams, as well as reservoir operating rules, using a simulation model that included linkages between climate change and system hydrology, with testing of the economic outcomes of investments in new dams.
This required three linked models for stochastic runoff generation, hydrological routing, and Monte Carlo simulation of economic outcomes for the different project alternatives (looking at 7,350 simulation experiments comprised of 350 planning alternatives × 7 runoff scenarios × 3 water withdrawal assumptions). For each of these a separate hundred-year sequences of stochastic inflows were passed through the system. The 100 resulting sets of physical outcomes were then used as inputs to a cost-benefit model in which 5,000 Monte Carlo trials were applied to yield distributions of net present value (NPV) for each experiment. The results indicated that there was no single investment plan that performed best across a range of plausible future climate conditions. The value of the real options framework was its use in identifying dam configurations that were both robust to poor outcomes and sufficiently flexible to capture high upside benefits should favourable future climate and hydrological conditions arise.
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