Comparing the Applicability of Adaptation Strategy Valuation and Real Options
The uncertainty facing a business essentially reflects the degree of randomness in the factors that affect its outcomes in terms of profit and stability. Often, such factors are driven by macro-level economic, policy, and climate-related drivers that filter down to the company. Although companies generally have strong grasps of the conventional market spread of risk facing their assets and the regulatory uncertainties facing their industries, many approach the stochastic risks posed by climate impacts by either ignoring them, treating them as static, or assuming (hoping?) that they can be technically fixed sometime down the road. Climate-savvier companies can use strategy valuation, an important approach that takes inherently stochastic variables into account, to increase their resilience to these risks. By applying strategy valuation, companies can take additional control of their risk “portfolio” by placing climate risk on the same footing as better-understood classes of risk in projecting their bottom line, promoting planning confidence.
Another principal alternative valuation strategy is the use of iterative decision-making involving “decision trees” in which branches representing choices are arrived at over time, allowing decisions be delayed until critical information is available. Such Real Option analysis tools have been adapted from the financial markets for application to the generalized valuation of discounted returns under time-evolving uncertainty. Like Strategy Valuation, Real Option analysis can be used by companies to make decisions that can reflect changes in the situational, technical, and even climate “landscapes” (which often reflect advances in the overall understanding of such systems).
The right tool for the right job
Given the choice, the decision-maker employing alternative valuation tools manage climate risk must still decide to use either Strategy Valuation or similar analysis, a delayed-choice approach applying Real Option analysis, or some combination of the two. While there is no straightforward rule for making this choice, an examination of how the respective methods are constructed and the factors each measures and outputs can be informative (see table).
Climate Risking through Strategy Valuation Approach
From the comparison table above, the Strategy Valuation method is notably better equipped to handle direct, medium-term effects that might be of interest to a company that is attempting to connect their assets at risk (vulnerability) to known climate change factors that are happening right now, enabling adaptation choices over a five- to ten-year time frame. This is because the SV approach calculates annual cash flows based on risk-based discount rates calculated for each year and, to avoid complexity, generally folds all future terms into a “terminal value.” Although there is nothing wrong with this from a strictly conventional valuation standpoint, by terminating a risk series calculation after only five or ten years one risks losing the impacts of longer-term and varying climate elements in the risk valuation. Thus, we consider SV to be more appropriate to the class of situations involving slowly changing and near-term impacts.
Climate Risking through Real Options Approach
Particularly over the mid-to-longer time horizon, climate risk changes not only in terms of the envelope of impacts but also through the introduction of unsuspected impact modes. An example of this is last winter’s extreme cold snap in North America. Although the mechanism driving this event---the disruption of the polar jet stream through heating of the troposphere---was technically understood, state decision-makers were and planners were fundamentally caught off guard by the magnitude of the impacts, as witnessed by the prolonged “freeze-out” of the Texas energy grid. From a conventional planning frame, this must be considered a black swan event.
The point is that we will be surprised again and again as the climate system continues to produce unanticipated shocks. Certainly for the planning horizon reasons described above, approaches that allow the financial model to “learn” over time can be better suited to the valuation of longer-term project vulnerabilities. In this regard, Real Options analysis has an advantage over Strategy Valuation in that it provides a mechanism for deferring key decisions on adaptation, which can allow the planner to alter their strategy when fundamentally new information becomes available. In addition to providing a framework for managing black swan events, this allows the planner to take into account the evolution of expert and scientific opinion on climate change and its impacts.