Optimal Adaptation to Uncertain Climate Change

Social Science Research Network (2022)

Enormous public investment will occur as communities adapt to climate change. Much of this investment will be irreversible and the future benefits are currently uncertain. The real options embedded in adaptation projects are therefore potentially important and their existence needs to be incorporated into investment decision-making. Standard real options analysis is inadequate for this purpose because the future arrival of information about climate change is unlikely to conform to the stochastic processes typically used in real options analysis. This paper presents a new framework that reflects current uncertainty about climate change and how that uncertainty might change over time. Optimal investment depends on current beliefs regarding the severity of future climate change, how quickly these beliefs are likely to change in the future, and current economic conditions. Most of the net benefits of optimal investment can be captured if investment timing is decided using a simple alternative decision-making rule.