Making real options analysis more accessible for climate change adaptation. An application to afforestation as a flood management measure in the Scottish Borders

Abstract

Climate change uncertainty makes decisions for adaptation investments challenging, in particular when long time horizons and large irreversible upfront costs are involved. Often the costs will be immediate and clear, but the benefits may be uncertain and only occur in the distant future. Robust decision-making methods such as real options analysis (ROA) handle uncertainty better and are therefore useful to guide decision-making for climate change adaptation. ROA allows for learning about climate change by developing flexible strategies that can be adjusted over time. Practical examples of ROA to climate change adaptation are still relatively limited and tend to be complex. We propose an application that makes ROA more accessible to policy-makers by using the user-friendly and freely available UK climate data of the UKCP09 weather generator, which provides projections of future rainfall, deriving transition probabilities for the ROA in a straightforward way and demonstrating how the analysis can be implemented in spreadsheet format using backward induction. The application is to afforestation as a natural flood management measure (NFM) in a rural catchment in Scotland. The applicability of ROA to broadleaf afforestation as a NFM has not been previously investigated. Different ROA strategies are presented based on varying the damage cost from flooding, fixed cost and the discount rate. The results illustrate how learning can lower the overall investment cost of climate change adaptation but also that the cost structure of afforestation does not lend itself very well to ROA.