Technical Policy Briefing Notes - 5
Portfolio Analysis
The Application to Adaptation
Policy Briefs
Portfolio Analysis
The Application to Adaptation
The principles of diversification and the use of portfolios
have high relevance for climate change adaptation. PA helps in
selecting a set of options which (together) are effective over a range
of possible projected future climates, rather than a single option best
suited to one possible future.
The approach has a high resonance with iterative risk management and the preference for portfolios of options over single solutions (IPCC SREX, 2012), recognising that diversification is an important risk management response. Importantly, it can be used to compare alternative portfolios of options against the high uncertainty associated with future socioeconomic and emission scenarios, and across alternative climate model projections.
The use of portfolio theory in the adaptation context requires identification of a range of possible adaptation options, data on the average effectiveness (or expected return) of each option, the variance of each option over the range of climate scenarios, and the covariance of return of each option over the range of climate scenarios. A minimum level of effectiveness also needs to be defined.
In the climate change context, the trade-off is then between the possibility of a high degree of effectiveness in reducing climate risks, and the risk that the adaptation options will fail to be effective over a certain range of climate change.
The choice that is made will then be determined by the level of risk aversion. As in Figure 1 above, a more risk-averse decision-maker is likely to choose a portfolio located between B and C, whilst a more risk-loving decision-maker is likely to choose a portfolio located between A and B.
The approach has a high resonance with iterative risk management and the preference for portfolios of options over single solutions (IPCC SREX, 2012), recognising that diversification is an important risk management response. Importantly, it can be used to compare alternative portfolios of options against the high uncertainty associated with future socioeconomic and emission scenarios, and across alternative climate model projections.
The use of portfolio theory in the adaptation context requires identification of a range of possible adaptation options, data on the average effectiveness (or expected return) of each option, the variance of each option over the range of climate scenarios, and the covariance of return of each option over the range of climate scenarios. A minimum level of effectiveness also needs to be defined.
In the climate change context, the trade-off is then between the possibility of a high degree of effectiveness in reducing climate risks, and the risk that the adaptation options will fail to be effective over a certain range of climate change.
The choice that is made will then be determined by the level of risk aversion. As in Figure 1 above, a more risk-averse decision-maker is likely to choose a portfolio located between B and C, whilst a more risk-loving decision-maker is likely to choose a portfolio located between A and B.
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