Technical Policy Briefing Notes - 4
Real Options Analysis
Strengths and Weaknesses
Policy Briefs
Real Options Analysis
Strengths and Weaknesses
A key part of the MEDIATION project has been to identify
the strengths and weaknesses of different approaches. A summary of some
of the key strengths and weakness of the approach is presented below.
The key strength of ROA is the information it provides on major investment decisions, providing a way to assess in quantitative and economic terms the relative benefits of implementing now versus waiting, and so incorporating uncertainty into the heart of the analysis.
It also provides a way to value the economic benefits of flexibility, i.e. to allow an economic appraisal of whether the additional marginal cost of this flexibility (or the lower early benefits from a more flexible project) are offset by the option value for future learning, i.e. for uncertainty resolution. The decision trees used in the method also provide a way to conceptualise the context of adaptive management – indeed this is probably a significant strength of the approach and the transferability for wider application.
The potential weaknesses relate to the need to define probabilities in the decision-tree, which may narrow the potential application of the technique, noting the poorer the estimates of probability, the less accurate will be the results. Strictly speaking ROA considers risk, where probability is defined, rather than uncertainty, where it is impossible to attach probabilities to outcomes (see HMT, 2007).
The approach also requires quantitative information and valuation of all elements of costs and benefits, which may limit the approach to sectors that have non-market components. Since such probabilistic data is not yet available, and quantitative impact data is limited in many sectors, the scope for the practical application of ROA is more limited than often thought.
There is also a need to consider multiple risk points for climate change, and define these in a way that match to the available climate information (e.g. climate averaging periods). Finally, the complexity of the formal economic approach is likely to require expert application and involves significant resources.
However, many of these issues can be addressed through a more informal application of ROA, e.g. through the use of decision trees and more qualitative analysis of information and flexibility.
The key strength of ROA is the information it provides on major investment decisions, providing a way to assess in quantitative and economic terms the relative benefits of implementing now versus waiting, and so incorporating uncertainty into the heart of the analysis.
It also provides a way to value the economic benefits of flexibility, i.e. to allow an economic appraisal of whether the additional marginal cost of this flexibility (or the lower early benefits from a more flexible project) are offset by the option value for future learning, i.e. for uncertainty resolution. The decision trees used in the method also provide a way to conceptualise the context of adaptive management – indeed this is probably a significant strength of the approach and the transferability for wider application.
The potential weaknesses relate to the need to define probabilities in the decision-tree, which may narrow the potential application of the technique, noting the poorer the estimates of probability, the less accurate will be the results. Strictly speaking ROA considers risk, where probability is defined, rather than uncertainty, where it is impossible to attach probabilities to outcomes (see HMT, 2007).
The approach also requires quantitative information and valuation of all elements of costs and benefits, which may limit the approach to sectors that have non-market components. Since such probabilistic data is not yet available, and quantitative impact data is limited in many sectors, the scope for the practical application of ROA is more limited than often thought.
There is also a need to consider multiple risk points for climate change, and define these in a way that match to the available climate information (e.g. climate averaging periods). Finally, the complexity of the formal economic approach is likely to require expert application and involves significant resources.
However, many of these issues can be addressed through a more informal application of ROA, e.g. through the use of decision trees and more qualitative analysis of information and flexibility.
| Key strengths Quantitative and economic analysis of the value of flexibility, learning and iterative adaptive management. Decision trees provide a useful and understandable way to conceptualise and visualise the concept of adaptive management and to frame analysis. Potential for informal application of ROA, e.g. through the use of decision trees and more qualitative analysis of information and flexibility. | Potential weaknesses Data and resource intensive, with high complexity often requiring expert input. Data constraints a potential barrier, especially the need for probabilistic climate information and quantitative impact data. Requirement for quantitative and economic information on costs and benefits likely to limit for non-market sectors or elements. Identification of decision points complex for (dynamic) aspects of climate change, and need to match these decision points to equivalent climate data. |
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