Investing smartly in adapting to climate change

Until the world stops or slows down greenhouse gas emissions, we won’t know how severe the effects of climate change, such as rising sea levels and extreme weather, will be. A new framework could help communities when they make often irreversible climate adaptation decisions under this uncertainty—so they don’t spend so much to service unnecessary debt and don’t spend so little that they’re left unprotected.

Graeme Guthrie, a New Zealand economic researcher, suggests that the framework says that adaptation decisions such as stormwater upgrades are mainly made by local authorities with limited analytical resources, so it is designed to be easily used at a local scale.

The scale of public investment required to successfully adapt to climate change will depend on the magnitude of that change. For example, communities will need to increase the capacity of their stormwater systems to handle heavy rainfall, but they don’t know how much additional capacity will be required. The situation facing Dunedin is typical. NIWA estimates that a 1 in 100 year rainfall event will see 141mm of rain fall in a 24 hour period. By 2090, this estimate increases to 148 mm under RCP2.6 and 172 mm under RCP8.5.2 The requirements for Dunedins stormwater system and the amount of new investment required depend crucially on the climate scenario that is unfolding.

Uncertainty about the magnitude of climate change will remain high for many years (decades, according to some experts), before gradually falling as scientists learn more about climate change. If climate change is less severe than communities expect, they may end up spending too much on adaptation. if it’s more severe than expected, they may not spend enough. The nature of adaptation investments makes these errors extremely costly to society. Many adaptation investments will be irreversible, so if communities build too much, they will be left servicing debt used to build capacity they will never need. On the other hand, if communities don’t build enough, they’ll either be stuck with high flood costs in the future or have to invest again — with all the added costs that entails. The final option—that communities delay investment until they have a clear idea of ​​how much capacity will be needed—will leave communities underserved in the meantime.

There are no low-cost customization options, but some options are less expensive than others. Policy makers should choose adaptation options that minimize the total cost to society, where that cost includes the capital spent on adaptation and the cost to the community when floods and other weather events occur.

Real options analysis (ROA) is an ideal decision support tool because it can handle the flexibility built into investment programs, such as the ability to accelerate, delay, or rescale investments. It uses mathematical techniques originally developed for pricing specific types of financial securities and uses them to calculate the values ​​of the various investment options available to decision makers. Of these options, perhaps the most important is the option to wait, learn more about the magnitude of climate change, and then invest. The investment is socially optimal only if the payoff from the investment is greater than the value of the option of waiting.

This paper, which has been published in Journal of Economic Dynamics and Control, presents a new real options framework that incorporates current uncertainty about climate change and how that uncertainty may change over time. It uses this framework to explore how best to upgrade an urban stormwater system in response to future climate change. Optimal investment policies can be expressed in many equivalent forms, but the most useful one involves the benefit-cost relationship. Whenever an investment can be made, we can calculate the ratio of the present value of the future benefits of the project to the present value of the future costs. If this ratio is high enough, then it is optimal to invest. Standard cost-benefit analysis leads to investment as soon as this ratio is greater than one, but this paper shows that such a policy is too aggressive. It is usually optimal to wait until the benefits of a project are far greater than its costs before the investment is truly optimal—at least 60% higher for the base case considered in the paper. The investment criterion is even more demanding when economic conditions are more volatile, when expected economic growth is faster and when climate change is expected to be more severe.

Much of the adaptation spending will finance relatively small projects under the jurisdiction of local authorities. These authorities have the local knowledge and motivation necessary for sound decision-making, but many of them have limited analytical resources. This is unfortunate because real options analysis can be complex and resource intensive. Not widely used, especially for relatively small projects. If society is to retain the benefits of local decision-making, then decision-makers need approaches that are simple enough to be useful for evaluating small- and medium-scale adaptation decisions, but retain a degree of economic rigor. This paper proposes such an approach.

The hardest part of ROA is calculating the option price of the hold. The alternative approach developed in this paper uses tools familiar to most practitioners to calculate an approximate put option price. The alternative rule involves replacing the fully optimal price of the delay option with its value, assuming that the investment is delayed until the best fixed future date, which requires a standard cost-benefit calculation for each possible future investment date. The approximate selection value is the maximum of these values. A decision maker using this alternative rule invests when he has no fixed future investment date implies a greater net present value than immediate investment. Investment is significantly delayed after the date at which the benefit-cost ratio equals one, but still occurs earlier than in the optimal investment policy.

For at least the next few decades, the acceleration of investment compared to the optimal investment time is moderate. The welfare losses resulting from using this simple rule are remarkably small, typically only a few percent of the welfare level if the full ROA is used instead. These welfare losses are only significant if economic conditions are very volatile, expected economic growth is low, and climate uncertainty will decrease rapidly. However, for typical projects in typical circumstances, it appears possible to capture most of the full ROA benefits using simple techniques that will stretch limited analytical resources further.

This paper is the first result of a larger project supported by the Deep South Challenge as part of the “Living With Uncertainty” programme. The second stage of this project, which is ongoing, explores richer option structures and evaluates the performance of even simpler alternatives against full ROA.