In a supplementary Green Book Guidance of UK (2009), a Real Options analysis is proposed for accounting for the effects of climate change under uncertainty. A "real option" is an alternative or choice that becomes available thorough an investment opportunity or action. A Real Options analysis is suitable for policies, programs or projects which have three core features: uncertainty, flexibility and learning potential. Flexibility is an important factor to be considered in appraising policies, programmes and project, because given uncertainty over future climate, decisions that would be difficult or expensive to revise in future should receive additional scrutiny. Real Options analysis provides a framework to incorporate the uncertainty of climate change and the value of flexibility into decision making.
A Real Options approach follows the same principles as a cost-benefit analysis but with an additional step to account for the value of flexibility in the structure of an activity. Particularly in a quantitative Real Options appraisal, streams of costs and benefits should be compared over time and discounted to generate a net present value (NPV). In addition, a decision tree can be made with information on costs and benefits and probabilities associated with different options. Using a decision tree, the NPVs of a proposal with the option to revise in the future can be calculated, which is different from the standard NPV calculation. Thereafter, a decision can be made based on the NPV considering different options.
ROA can be carried out in a variety of ways. The most relevant (to adaptation) is dynamic programming, which is an extension of decision-tree analysis. This defines possible outcomes, and assigns probabilities to these. The decision-tree defines how a decision-maker responds to resolution of uncertainty at each branching point. Quantifying the value of these decision options then proceeds by assessing all the branches. ROA calculates option values based on the expected value over all branches contingent on making the optimal choice at each decision-point. The optimal decision in turn is evaluated based on all the possible outcomes downstream of that decision in the tree. This ROA value can be compared to a normal appraisal calculation (a probability-weighted average) of the outcomes along each possible branch.
This toolbox entry has been labelled with the following tags:
| Sector: | independent | |
| Spatial scale: | independent | |
| Temporal focus: | independent | |
| Onset: | independent | |
| Role in decision process: | prescriptive | |
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| Adaptation tasks: | Multiple-shot robust decision making (e.g. adaptation pathways) |
A key strength is the economic comparison of investing now versus waiting, and the value of flexibility, i.e. comparing if the additional marginal cost (or lower initial benefits) of added flexibility is offset by the option value for future learning. ROA can also be used to support initial enabling steps to help secure projects for future development (should they subsequently prove to be appropriate) even if they are not expected to be cost-efficient on the basis of traditional, static Cost-Benefit or Cost-Effectiveness appraisal.
However, data constraints are a potential barrier, since a key input to ROA is probabilistic climate information that is combined with quantitative impact data. 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 remains restricted. Further, for adaptation ROA needs to identify decision points in complex dynamic climate pathways and align with climate data (noting that time periods may not align); such identification may prove to be difficult in practice. Finally, the complexity of the analysis is likely to require expert application that constrains its up-take.
ROA has been widely cited as a decision support tool for adaptation and aligns closely with the concept of iterative decision making. A key strength is the economic analysis of investing now versus waiting, and the value of flexibility, i.e. comparing if the additional marginal cost (or lower initial benefits) of added flexibility is offset by the option value for future learning.
To date, the practical application of ROA to adaptation has been very limited. The UK Treasury (HMT 2009) provides a hypothetical example, incorporated into supplementary Government economic adaptation appraisal guidance. This uses decision trees and compares two alternative options: investing now in a single fixed-height sea wall defence, versus investing in a wall which has the potential to be upgraded in the future. The expected Net Present Value (NPV) is assessed under future low and high Sea Level Rise (SLR) scenarios, assuming these are equally likely. The results show the upgradeable wall, able to cope with high-end SLR scenarios, has a higher overall NPV. However, the application of ROA to the real world involves a further step change in complexity.
Jeuland and Whittington (2013) applies ROA to water resource investment planning on the Blue Nile (Ethiopia) - coupling hydrological models to Monte Carlo analysis - to identify flexibility in design and operating decisions for a series of large dams. Their results do not identify a single investment plan that performs best across future climate conditions, but highlights configurations robust to poor outcomes and flexible enough to capture upside benefits of favourable future climates.
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Dixit, A.K., Pindyck, R.S., 1994. Investment under Uncertainty. Princeton University Press, Princeton, NJ.
Copeland, T., Antikarov, V., 2001. Real Options: A Practitioner's Guide. WW Norton & Co.
HMT, 2009. Accounting for the Effects of Climate Change. June 2009. Supplementary Green Book Guidance.
Jeuland, M and Whittington, D., 2013. Water Resources Planning under Climate Change: A "Real Options" Application to Investment Planning in the Blue Nile. Environment for Development. Discussion Paper Series March 2013. EfD DP 13-05.
weADAPT case studies identified for this toolbox entry:
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Accounting for the Effects of Climate Change: Summary of approach, and theoretical consideration of real option analysis
Led by the Environment Agency, the Thames Estuary 2100 project (TE2100) was established in 2002 with the aim of developing a long-term tidal flood risk management plan for London and the Thames estuary.
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Available related training material
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Real Options Analysis
Training material for Real Options Analysis |
