The Simplicity of Climate Change Adaptation Economics
There is a lot of literature out there that deals with the question of how to assess climate change impacts and adaptation practices. Researchers call for a different set of metrics to measure and quantify impacts and adaptation.
We argue that climate change can be quantified with existing methods. Climate change results in weather events with varying degrees of extremity, impacting businesses and the biosphere alike. Those impacts have a probabilities of occurrence that can be modelled using appropriate statistical profiles to obtain event frequencies and amplitudes. Uncertain events are encountered by every business every day and can be quantified by applying, for example decision trees to calculate expected values for both company value and investment decisions. This is the main principle of CAW’s proposed complementary methods of Adaptation Strategy Valuation (ASV™) and Adaptation Real Options Analysis (ARO™). ASV is based on a forecast of free cash flows, discounted by risk-adjusted discount rates to derive company value or net present value of a proposed investment. The risk-adjusted discount rate are calculated by applying uncertainties to the key business drivers, due to extreme weather events that impact the bottom line. These uncertain business drivers, are inserted into a Monte Carlo Simulation to yield the net cash flows of each year and their probability distribution with the standard deviation as their main characteristic, used to calculate the discount rate for each individual year. The sum of the discounted cash flows is the value of a company or the net present value (NPV) of an investment after deduction of the investment needed.
Adaptation practices are investments into the future to decrease vulnerability to climate change. To assess them, the above simple and widely used method is applied. If the NPV of an adaptation investment is positive, the investment creates value and a rational investor would pursue this opportunity. If the NPV is negative, one would not invest at this point in time. There might however be value in retaining the option to invest at a later stage, when climate change impacts have a higher certainty and/or once the NPV turns positive. This option value can be quantified with a real options analysis, based on the Black-Scholes model, which is widely applied in the derivatives market. The higher the uncertainty of value the more valuable is the option.
ASV™ and ARO™ are complimentary. If ASV™ yields a positive NPV for a certain investment, one would invest. If the NPV is negative one would calculate the value of an American call option, whose value is a determination of how much money we can spend on retaining or preparing for the exercise of the defined option, by using the standard deviation, calculated in the ASV™ approach.
The above is as simple as it gets. There is no need for new methods or new metrics. The guiding principle is the fact, that businesses have to be profitable, hence climate change adaptation should add value to the bottom line.
CAW is helping clients to apply the above by translating climate change impacts into uncertainties of business drivers, to draft and value an appropriate adaptation strategy and to define and value real options embedded in the individual adaptation strategy.
Contact us to find out more.