TY - JOUR
T1 - Managing risks from climate impacted hazards - The value of investment flexibility under uncertainty
AU - Truong, Chi
AU - Trück, Stefan
AU - Mathew, Supriya
PY - 2018/8/16
Y1 - 2018/8/16
N2 - 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.
AB - 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.
KW - Catastrophic risk
KW - Climate change adaptation
KW - Cost benefit analysis
KW - Investment under uncertainty
KW - Real option
UR - http://www.scopus.com/inward/record.url?scp=85025098902&partnerID=8YFLogxK
U2 - 10.1016/j.ejor.2017.07.012
DO - 10.1016/j.ejor.2017.07.012
M3 - Article
AN - SCOPUS:85025098902
SN - 0377-2217
VL - 269
SP - 132
EP - 145
JO - European Journal of Operational Research
JF - European Journal of Operational Research
IS - 1
ER -