Climate Change Adaptation: Evaluating Simple Alternatives to Real Options Analysis

This paper introduces a new framework for evaluating climate-change adaptation projects. This framework incorporates uncertainty surrounding future climatic and economic conditions and allows for Bayesian learning about the magnitude of climate change. The paper uses real options analysis to construct an optimal policy for determining the scale and timing of investment and then evaluates simpler alternative approaches to project evaluation against this benchmark. The performance of standard cost-benefit analysis improves if projects are evaluated less frequently. Rules of thumb involving arbitrary thresholds for the benefit-cost ratio or increments to the social discount rate can capture most of the value of investment flexibility. Approximating the option value of waiting by assuming delayed investment occurs after a fixed delay performs even better, with little increase in difficulty. Basing decisions on a single source of volatility (climatic or economic) leads to even better performance, but the rules are harder to implement.