‘Real options’: a cleverer option

A more fruitful perspective on measures for adapting to climate change is that they resemble investment decisions under conditions of uncertainty.

An investor facing the possibility of a high return on an asset can purchase an option, rather than the more expensive share itself. This (financial) option gives the investor the contractual right, but no obligation, to purchase the asset should its value rise above a specified level (‘the strike price’), on or before a specified date. If the market price of the asset rises above the specified ‘strike price’, the investor can profit by exercising the option and so obtain the share at below market price. If the share price remains low, or falls, the investor forgoes the opportunity to purchase the asset because there would be no gain in doing so, but loses only the cost of the option that was purchased. Such options are valuable because they allow an investor to delay a final decision on purchasing a relatively more expensive share until there is greater certainty about the share price.

An analogous possibility often exists in the realm of physical (so-called real) capital. An everyday example of a ‘real option’ might be a couple buying a house, but uncertain about when, or if, they will have children, or how many children. Buying a large house immediately could be unnecessarily costly if they remain childless, or if they delay starting a family for a significant time. But they could buy a smaller, cheaper house on a suitable block of land and extend it later, as required. The smaller house in effect ‘embeds’ an option to extend, but there is no obligation to do so if the family remains small. The couple can delay a final decision on the size (and hence the full cost) of the house until better information becomes available regarding specific family size.

In applying the ‘real options’ approach to decisions made by firms, management theorists often use the term ‘strategic options’ to reflect deliberate commercial strategies to create flexibility in investment decisions where outcomes are uncertain. Raynor (2007), for example, employs this perspective in analysing joint ventures and the entry of firms into foreign markets. Nerkar et al. (2007) apply similar reasoning to the acquisition of patents.

Dixit and Pindyck (1994) explore in detail the methodology for evaluating real options, and the use of such values in cost-benefit and investment analysis. They point out (pp.3–4) that most investment decisions share, in varying degrees, the following key characteristics:

Apart from its greater realism, the real options approach represents an important analytical advance on orthodox Net Present Value analyses that take as given assumed future streams of costs and revenues or benefits. The concept is also readily applicable to the design and evaluation of measures intended to ameliorate the effects of any future climate change.