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Key Messages• There is increasing interest in the appraisal ofoptions, as adaptation moves from theory topractice. In response, a number of existingand new decision support tools are beingconsidered, including methods that addressuncertainty.• The FP7 MEDIATION project has undertaken adetailed review of these tools, and has testedthem in a series of case studies. It hasassessed their applicability for adaptation andanalysed how they consider uncertainty. Thefindings have been used to provideinformation and guidance for the MEDIATIONAdaptation Platform and are summarised in aset of policy briefing notes.• One of the tools recommended for adaptationis Real Options Analysis (ROA). Optionsanalysis derives from the financial markets,where it has been used to assess thevaluation of financial options and risk transfer.The same insights are also useful when thereis risk or uncertainty involved with investmentin physical assets, hence ‘real’ options• Real Options Analysis quantifies theinvestment risk associated with uncertainfuture outcomes. It is particularly useful whenconsidering the value of flexibility ofinvestments. This includes the flexibility overthe timing of the capital investment, but alsothe flexibility to adjust the investment as itprogresses over time, i.e. allowing a project toadapt, expand or scale-back in response tounfolding events. The approach can thereforeassess whether it is better to invest now or towait – or whether it is better to invest inoptions that offer greater flexibility in thefuture.• ROA has considerable potential foradaptation, and aligns with the concepts ofiterative adaptive (risk) management,providing a means to undertake economicappraisal of future option values the value ofinformation and learning, and the value offlexibility, under conditions of uncertainty. Itcan therefore justify options (or decisions) thatwould not be taken forward under aconventional economic analysis.• The application to adaptation has often useddynamic programming, which is an extensionof decision-tree analysis. This definespossible outcomes and decision points, andassigns probabilities and estimates expectedvalues.• The review has considered the strengths andweakness of ROA for adaptation. The keystrength of the approach is the information itprovides on large investment decisions,allowing economic analysis of the benefits ofinformation and flexibility under conditions ofuncertainty. The use of decision trees alsoprovides a useful way to visualise the contextof adaptive management. The maindisadvantage relates to the complexity of theformal economic approach, which is likely toneed expert application and significantresources, and the need to input probabilitiesand multiple risk points for climate change.• Previous applications of ROA for adaptationhave been reviewed, and adaptation casestudies are summarised. The majority ofapplications to date have been for largecoastal protection projects, though there isalso an application for large water projects.• The review and case studies provide usefulinformation on the types of adaptationproblem types where ROA might beappropriate, as well as data needs, resourcerequirements and good practice lessons. Thisidentifies that ROA is most useful for largecapital investments (project level), especiallywhere there is a large adaptation deficit or asignificant potential for learning or flexibility. Italso requires good quality data on climaterisks and cost/benefit components. Given thehigh resource requirements, the review alsoidentifies the potential for more informalapplication of ROA, e.g. through the use ofdecision trees and more qualitative analysis ofinformation and flexibility.
Real Options AnalysisIntroductionThere is increasing policy interest in the appraisalof options, as adaptation moves from theory topractice. At the same time, it is recognised thatthe appraisal of climate change adaptationinvolves a number of major challenges,particularly the consideration of uncertainty. Inresponse, a number of existing and new decisionsupport tools are being considered for adaptation.The European Commission FP7 fundedMEDIATION project (Methodology for EffectiveDecision-making on Impacts and AdaptaTION) islooking at adaptation decision support tools, inline with its objectives to advance the analysis ofimpacts, vulnerability and adaptation, and topromote knowledge sharing through aMEDIATION Adaptation Platform (http://www.mediation-project.eu/platform/). To complementthe information on the Platform, a series of PolicyBriefing Notes have been produced on DecisionSupport Methods for Climate Change Adaptation.An overview of all the decision support toolsreviewed is provided in Policy Briefing Note 1:Method Overview, which summarises eachmethod, discusses the potential relevance foradaptation and provides guidance on theirpotential applicability. The methods consideredinclude existing appraisal tools (cost-benefitanalysis, cost-effectiveness analysis and multicriteriaanalysis), as well as techniques that morefully address uncertainty (real options analysis,robust decision making, portfolio analysis anditerative risk (adaptive) management). It alsoincludes complementary tools that can assist inadaptation assessment, including analyticalhierarchic processes, social network analysisand adaptation turning points. Additionalinformation on each method is presented in aseparate Policy Briefing Notes (2 – 10).This Policy Brief (Note 3) provides a summary ofreal options analysis. It provides a briefsynthesis of the approach, its strengths andweaknesses, the relevance for adaptation, how itconsiders uncertainty, and presents case studyexamples. It is stressed that this note onlyprovides an overview: more detailed informationis available in MEDIATION deliverables, andsources and links on the MEDIATION AdaptationPlatform.Description of the MethodThe concepts of real options analysis lieoriginally in the financial markets. A financialoption gives the investor the right, but not theobligation, to acquire a financial asset in thefuture, allowing them to observe how marketconditions play out before deciding whether toexercise the option. This transfers risk from thebuyer to the seller, making the option a valuablecommodity. Options analysis quantifies this valuebased on how much such a risk transfer is worth(Black and Scholes, 1973).The same insights are also useful for investmentin physical assets (hence ‘real’ options), in caseswhere there is risk/uncertainty (McDonald andSiegel, 1986). Real options analysis (ROA)quantifies the investment risk associated withuncertain future outcomes. It is particularly usefulwhen considering the value of flexibility ofinvestments. This might be for example flexibilityover the timing of the original capital investment,or the flexibility to adjust the investment as itprogresses over a number of stages, allowingdecision-makers to adapt, expand or scale-backthe project in response to unfolding events.ROA typically gives two types of result that set itapart from traditional economic analysis. Thefirst affects projects that are cost-efficient undera deterministic analysis. ROA shows thatsometimes it makes more sense to wait for theoutcome of new information, rather thaninvesting immediately. Conversely, the secondtype of result affects projects which may fail adeterministic test of cost-efficiency. Underconditions of uncertainty, it may make financialsense to start the initial stages of the projectwhere these are needed to keep the overallproject alive, in case its fortunes change at alater date and it starts to look like an attractiveinvestment option.ROA has been applied quite widely in the energysector, including analysis of mitigation options,and there are examples in the literature lookingat the uncertainty of investment under climatechange policy (e.g. Hlouskova et al. 2005: Fusset al, 2009; Szolgayova et al 2011). As furtherexamples, Rothwell (2006) examined returns oninvestment in nuclear plant with uncertainty overcarbon prices, while Laurikka and Koljonen1
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Adaptation Turning PointsLeary, D.
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