Real Options Analysis

Submitted by Michael Rastall | published 20th May 2013 | last updated 3rd Dec 2013
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Introduction

Real Option Analysis is a decision support tool that can provide quantitative economic information on uncertainty and risk in cases where there is flexibility on the timing of investment decisions and some potential for learning.

Real options analysis (ROA) quantifies the investment risk with uncertain future outcomes. It is particularly useful when considering the value of flexibility with respect to the timing of the original capital investment, or adjusting the size and nature of investment over a number of stages in response to unfolding events.

Ideal problem types

The approach is most relevant to large, capital intensive investments such as dyke flood protection or dam-based water storage. It is primarily a technique for project level rather than aggregate analysis.

Where has this tool been applied?

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.

Strengths and Weaknesses

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.

Process of applying this tool/method.

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.

Why is this method useful for the field of climate adaptation?

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. 

Useful resources

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.