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Managing risks from climate impacted hazards – The value of investment flexibility under uncertainty

Chi Truong, Stefan Trück and Supriya Mathew
Authors registered in the RePEc Author Service: Stefan Trueck ()

European Journal of Operational Research, 2018, vol. 269, issue 1, 132-145

Abstract: Incomplete knowledge about climate change and the related uncertainty in climate prediction makes adaptation inherently difficult. We introduce a real options framework to determine the optimal adaptation to catastrophic risk that takes into account climate change uncertainty. The framework can be used to select the optimal adaptation project from a number of alternative projects or to determine the optimal investment sequence of the considered projects. In applying the model to the management of bushfire risk at a local government area, we find that the framework can significantly increase the value of adaptation investment, above the current net present value, and also improve upon deterministic dynamic models. We also find that it is important to consider sequential investment to preserve investment flexibility under the uncertainty of climate change. When decision makers can afford multiple investment projects, the loss associated with the use of a simple net present value rule can be substantial, and it is important to use a deterministic dynamic model or a real options model.

Keywords: Cost benefit analysis; Climate change adaptation; Investment under uncertainty; Catastrophic risk; Real option (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:ejores:v:269:y:2018:i:1:p:132-145