A novel illustration of real options analysis to address the problem of probabilities under deep uncertainty and changing climate risk

Abstract

Changing risk profiles over time that are exacerbated by climate change, challenge assessments of the relative value of investing in different adaptation options. There is a growing discourse around methods that are better suited to addressing changing risk and uncertainties for large infrastructure projects — robust decision making (RDM), real options analysis (ROA) and those based on dynamic adaptive pathways planning (DAPP). While such approaches are receiving greater attention in the academic literature, there is a gap in critiques of them in real-life decision practice. Here we present two novel applications from New Zealand of real options analysis that formed part of actual decision processes — a flood risk management plan and a coastal hazards strategy, both based on DAPP over 100years. In both cases, we examined the value of pursuing adaptation options that are flexible under peak river flows, coastal erosion, imminent inundation, storm surge and long-term sea-level rise. From lessons learned we examined three questions relating to ROA: 1) is ROA ‘fit for purpose’ for investment evaluations in situations of both imminent threat and deep uncertainty and its scalability? 2) can ROA address path dependency and move beyond static applications? 3) can ROA be used alongside DAPP to address managed retreat as an adaptation option. We conclude the affirmative for each question and provide a method for using ROA within a DAPP and RDM framework.

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