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Stochastic Water Quality: The Timing and Option Value of Treatment

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  • Conrad, Jon M.
  • Lopez, Andres
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    Abstract

    An option-pricing model is developed to rank investments that might improve water quality. The model presumes that two investment options exist that have the potential to alter the stochastic drift of a pollutant. The investments have capital and operating costs and are irreversible once constructed. The stochastically evolving pollutant induces stochastic damage. An option-pricing model provides a criterion for determining when it is optimal to adopt the investment with the highest option value. Option value, in this model, measures the expected present value in reduced damage, relative to doing nothing. If the investments are mutually exclusive, it is possible to obtain closed-form solutions for the barriers which would trigger investment. If the investments can be sequentially adopted, a methodology is developed to calculate option values for all possible combinations of adoption dates. To illustrate the optionpricing approach, a stylized analysis of investments to protect New York City’s water supply is presented. Watershed management dominates filtration and, in the case of mutually exclusive investments, is initiated when the concentration of phosphorus reaches 22.80 μg/L.

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    Bibliographic Info

    Paper provided by Cornell University, Department of Applied Economics and Management in its series Working Papers with number 127675.

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    Date of creation: Feb 2000
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    Handle: RePEc:ags:cudawp:127675

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    Keywords: Resource /Energy Economics and Policy;

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    1. Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, vol. 5(2), pages 241-249, November.
    2. Arrow, Kenneth J & Fisher, Anthony C, 1974. "Environmental Preservation, Uncertainty, and Irreversibility," The Quarterly Journal of Economics, MIT Press, vol. 88(2), pages 312-19, May.
    3. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
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    5. Cukierman, Alex, 1980. "The Effects of Uncertainty on Investment under Risk Neutrality with Endogenous Information," Journal of Political Economy, University of Chicago Press, vol. 88(3), pages 462-75, June.
    6. Reed, William J & Clarke, Harry R, 1990. "Harvest Decisions and Asset Valuation for Biological Resources Exhibiting Size-Dependent Stochastic Growth," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(1), pages 147-69, February.
    7. Octavio A. F. Tourinho., 1979. "The Option Value of Reserves of Natural Resources," Research Program in Finance Working Papers 94, University of California at Berkeley.
    8. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    9. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
    10. Jon M. Conrad, 1997. "Global Warming: When to Bite the Bullet," Land Economics, University of Wisconsin Press, vol. 73(2), pages 164-173.
    11. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
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