Download all Technical Policy Briefing Notes in a single ... - Mediation

Real Options AnalysisStrengths and WeaknessesA key part of the MEDIATION project has been toidentify the strengths and weaknesses ofdifferent approaches. A summary of some of thekey strengths and weakness of the approach ispresented below.The key strength of ROA is the information itprovides on major investment decisions,providing a way to assess in quantitative andeconomic terms the relative benefits ofimplementing now versus waiting, and soincorporating uncertainty into the heart of theanalysis.It also provides a way to value the economicbenefits of flexibility, i.e. to allow an economicappraisal of whether the additional marginal costof this flexibility (or the lower early benefits froma more flexible project) are offset by the optionvalue for future learning, i.e. for uncertaintyresolution. The decision trees used in the methodalso provide a way to conceptualise the contextof adaptive management – indeed this isprobably a significant strength of the approachand the transferability for wider application.The potential weaknesses relate to the need todefine probabilities in the decision-tree, whichmay narrow the potential application of thetechnique, noting the poorer the estimates ofprobability, the less accurate will be the results.Strictly speaking ROA considers risk, whereprobability is defined, rather than uncertainty,where it is impossible to attach probabilities tooutcomes (see HMT, 2007).The approach also requires quantitativeinformation and valuation of all elements of costsand benefits, which may limit the approach tosectors that have non-market components.Since such probabilistic data is not yet available,and quantitative impact data is limited in manysectors, the scope for the practical application ofROA is more limited than often thought.There is also a need to consider multiple riskpoints for climate change, and define these in away that match to the available climateinformation (e.g. climate averaging periods).Finally, the complexity of the formal economicapproach is likely to require expert applicationand involves significant resources.However, many of these issues can beaddressed through a more informal application ofROA, e.g. through the use of decision trees andmore qualitative analysis of information andflexibility.Case StudiesThe MEDIATION study has reviewed existingliterature examples that have applied ROA to anumber of adaptation case studies. A number ofthese case studies are summarised in the boxbelow.Key strengthsQuantitative and economic analysis of the valueof flexibility, learning and iterative adaptivemanagement.Decision trees provide a useful andunderstandable way to conceptualise andvisualise the concept of adaptive managementand to frame analysis.Potential for informal application of ROA, e.g.through the use of decision trees and morequalitative analysis of information and flexibility.Potential weaknessesData and resource intensive, with highcomplexity often requiring expert input. Dataconstraints a potential barrier, especially theneed for probabilistic climate information andquantitative impact data.Requirement for quantitative and economicinformation on costs and benefits likely to limitfor non-market sectors or elements.Identification of decision points complex for(dynamic) aspects of climate change, and needto match these decision points to equivalentclimate data.5