Evaluation of investment options mitigating catastrophic losses under the impacts of climate change

It is of significant concern that climate change will exaggerate the frequency and severity of extreme events such as: floods, storms, droughts and bushfires. As the value of properties under risk increases due to economic growth, also the probability of catastrophic events may be amplified by climate change impacts. Thus, there is a need for local governments to invest in adaptation measures in order to reduce potential losses from these catastrophic events. However, economic models that help local governments to evaluate those investment projects are currently lacking. Two challenges are faced when evaluating these projects. First, it is difficult to quantify the risk due to the lack of observations on catastrophic events at the local level. Second, investment costs are often lumpy and the investment decisions are irreversible, so that the investment strategy based on the net present value (NPV) criterion is not optimal. Under the uncertain growth of the stock of assets and the uncertain impacts of climate change, the optimal timing of investments into adaptation strategies that reduce catastrophic risks is of major importance. This paper presents a simple economic framework to quantify climate change risks and a real option approach to illustrate the optimal timing of investment strategies for local governments.