Abstract
Uncertain future payoffs and irreversible costs characterize investment in climate change adaptation and mitigation. Under these conditions, it is relevant to analyze investment decisions in a real options framework, as this approach takes into account the economic value associated with investment time flexibility. In this paper, we provide an overview of the literature adopting a real option approach to analyze investment in climate change adaptation and mitigation, and examine how the uncertain impacts of climate change on the condition of the human environment, risk preferences, and strategic interactions among decisions-makers have been modeled. We found that the complex nature of uncertainties associated with climate change is typically only partially taken into account and that the analysis is usually limited to decisions taken by individual risk neutral profit maximizers. Our findings call for further research to fill the identified gaps.
Highlights
It is widely recognized that humanity needs to take action to limit and reduce risks associated with climate change (IPCC 2014a, b, c, d, e)
We present a systematic review of studies adopting the real-options approach in analyzing investment in climate change adaptation and mitigation
We briefly present how different studies have modeled decisions to invest in climate adaptation and mitigation actions, and how these studies have taken into account climate uncertainty and risk preferences
Summary
It is widely recognized that humanity needs to take action to limit and reduce risks associated with climate change (IPCC 2014a, b, c, d, e). There have been several global initiatives aimed at tackling and limiting the impact of climate change, e.g. the Kyoto Protocol and the Paris Agreement. These initiatives have resulted in agreements on specific targets, e.g. on the emissions of carbon dioxide, actions to achieve these targets have been limited and, have not been reached (OECD 2018). Substantial uncertainties concerning the future climate and the potential impact of alternative actions may explain why observed mitigation and adaptation activities are limited (Heal and Millner 2014; IPCC 2014e). Uncertainty, in combination with irreversible investments, provides incentives to delay investments since waiting is valuable as it allows for the acquisition of information on future prospects (see e.g., Schou et al 2015; Chesney et al 2017; Hauer et al 2017)
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