Identifying and creating ‘real options’ in adapting to climate change

The potential application of the real options approach to climate-change adaptation measures can be illustrated with a number of hypothetical but realistic examples.

One example is in the construction of a new airport runway. In a hotter climate, longer runways may be required to allow planes to develop sufficient lift to take off safely with full loads. (An alternative may be more-powerful engines, but noise issues may preclude this option.) It would be expensive to build a long runway immediately, and may turn out to be an unnecessary cost if temperatures do not increase as much as initially anticipated. In this situation of uncertainty about climate-change impacts, a ‘real option’ could be the construction of a normal runway, but accompanied by the purchase of additional land at the end of the runway to allow for a possible extension later, if required. In other words, the airport operator does not need to commit the full extent of funding immediately.

Because the additional land can also be leased to short-term users for such things as freight warehouses, car parking, grazing of animals, and so on, the cost of the ‘land purchase’ option can be offset to some extent. But an even more effective approach could be to build a normal runway and purchase only an option to buy the additional land at the end of the runway. That is, enter into a contract with the owner of the land to purchase it within a specified period, for a specified sum, if some specified temperature criterion is met. An option to purchase the land would normally be cheaper than buying it outright.

A similar heuristic could be used to address the problem of flooding in low-lying areas. As an alternative to blocking development in such areas, or building high protective barriers immediately, it may be worthwhile constructing only the base of a wall or embankment, but one that is capable of supporting a, say, 10-metre wall. This approach creates an option to build a high wall later, if required. It also affords the option of building a low wall, and raising it later, if required, or just providing a solid base for sandbagging for occasional emergencies. In other words, the full cost of a high wall is not incurred unless, and until, it is really required, and the base can be used to ameliorate the effects of less extreme weather events as well.

Military equipment often embeds real options. For example, ships may be ‘fitted for but not with’ missile-launching or other capabilities. This approach reduces the initial capital expenditure and affords the military the option of acquiring the most up-to-date equipment at the time that it is actually needed. If it is not needed, little additional opportunity cost is incurred. A similar approach could be applied to transport vehicles. Trains or buses can be ‘fitted for but not with’ larger air-conditioning units, for example, but the equipment would be installed in the future only if increased temperatures warranted the additional expenditure.

Long-lived infrastructure such as a road or railway is particularly suited to the real-options investment approach. For example, there may be considerable uncertainty about the extent to which low-lying land will be more flood-prone in, say, 2050, but a road or railway needs to be built immediately in the area. Rather than constructing roads or railways on expensive raised embankments, or choosing longer alternative routes, one approach may be to purchase additional adjoining land to form a wider corridor. If required in future, the corridor can be used to build levee banks or to place gabions to protect the road or railway from floodwaters. Sunk costs can be minimised if the land is not in fact required in the future, by selling it to housing developers, or leasing it to owners of pipelines, or telecommunications or electricity lines.

Nor do cities or buildings necessarily require the immediate development and use of expensive new materials and designs. Rather than investing immediately in expensive new technology, cheaper options that can buy time include making provision for the future use of shade blinds for windows and walls, increasing the albedo[4] of walls and roofs through painting, or the planting of deciduous vegetation next to or near buildings and along streets. Taha et al. (1997), for example, found that a moderate increase in vegetation could reduce temperatures in California’s South Coast Air Basin by 2–3°C, with comparable results in other studies such as Shashua-Bar and Hoffman (2004). Street trees in particular can reduce the sunk social cost of investment through the positive externality of enhancing the attractiveness of urban areas.

In a rare application of the real-options approach, Nordvik and Liso (2004) model possible responses by building owners to climate change, finding that uncertainty about climate change may reduce rates of conversion (for example, to withstand higher winds) as well as reducing the scrapping of buildings, as well as maintenance effort: that is, the model posits increased economic lifetimes of buildings in the face of uncertainty. Another option may be to build cheaper houses and commercial accommodation with shorter design lives, and to reduce maintenance on them. This approach opens up the possibility of the earlier scrapping of buildings and reconstructing with materials that are more appropriate to whatever climatic conditions prevail at the time. Earlier scrapping of buildings will increase flexibility and options for redesigning whole cities — for example to increase density — should that be found desirable in the future.

Application of the real-options approach is not limited to physical infrastructure. Australian farmers have practised the concept for many years in dealing with a historically highly variable climate. At times of insufficient water availability, farmers who have prepared their land for a cotton crop, for example, may exercise the option of planting sorghum instead. Other potential agricultural options include the operation of several farms in geographically diverse locations, rather than a single farm, and the use of versatile livestock such as the South African Meat Merino (see ABC (2006); and The Prime SAMM Society of Australia) which offers the option of producing either wool or meat, depending on weather and market conditions. The legendary cattle king, Sir Sidney Kidman, effectively created a real option with respect to cattle by acquiring a string of contiguous landholdings north to south across Australia to facilitate movement of his livestock from drought-affected areas to water and pasture elsewhere.

With appropriate input from medical practitioners, real options could also be developed for the health sector. In the case of concerns about the spread of malaria, research itself provides an option, and is preferable to expensive (and possibly misguided) investment in specialised malaria hospitals or training more medical personnel. An example of a real option might be for Australia to fund a specialist domestic or foreign company to undertake research into new anti-malarial drugs in return for cheap drugs to Australian residents in the event that malaria does become endemic.

Care also needs to be taken to incorporate real options into some popular mitigation strategies. An example is government subsidies for solar panels to reduce the use of fossil fuels. Such subsidies may come to be seen as incongruous in the future if predictions of more severe weather events such as the hailstorms in Sydney and Queensland become commonplace, and solar panels suffer extensive weather damage. To ensure continuity of electricity supply, a real option might be to include fittings on the panels during installation to allow later attachment of wire mesh or some other cheap protective device, in case hailstorms do become prevalent in the future.

With sufficient foresight, determination and creativity, it is possible to identify ‘real options’ for other areas of social and economic life that may be affected by future climate change. The identification of flexible options, not the deterministic prescription of ‘obvious’ solutions, should be the preferred approach to formulating adaptation policy.

[4] In general terms, albedo is the ‘reflectivity’ of an object. Black bodies have zero or low albedo, and bright matter such as ice or snow have a high albedo.