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Using an option pricing approach to evaluate strategic decisions in a rapidly changing climate: Black–Scholes and climate change

Author

Listed:
  • Matthew Sturm

    (University of Alaska-Fairbanks)

  • Michael A. Goldstein

    (Babson College)

  • Henry Huntington

    (Huntington Consulting)

  • Thomas A. Douglas

    (U.S. Army Cold Regions Research and Engineering Lab—Alaska)

Abstract

Nature provides critical ecosystem services on which society and businesses rely, but the effort and cost of utilizing those services can change with the climate. Both climatic trend and variance affect these efforts and costs, creating a complex decision space where uncertain future predictions are the rule. Here, we show how these problems mimic option payoffs and demonstrate a modified version of the Black–Scholes option pricing formula (widely used in finance) to analyze these types of business-climate decisions. We demonstrate the method by (1) examining the viability of building ice roads in the Northwest Territories of Canada, where a strong negative warming trend is underway, and (2) applying it to the problem of the ongoing California drought, estimating expected water costs with and without storage. The method is novel and provides a simple and accessible way to make such assessments to at least a first-order approximation. While our focus here is on business situations where decisions are usually based on money, we suggest that a similar approach could be used beyond the business world in examining risk and attributing that risk to climate variance vs. trend.

Suggested Citation

  • Matthew Sturm & Michael A. Goldstein & Henry Huntington & Thomas A. Douglas, 2017. "Using an option pricing approach to evaluate strategic decisions in a rapidly changing climate: Black–Scholes and climate change," Climatic Change, Springer, vol. 140(3), pages 437-449, February.
  • Handle: RePEc:spr:climat:v:140:y:2017:i:3:d:10.1007_s10584-016-1860-5
    DOI: 10.1007/s10584-016-1860-5
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    References listed on IDEAS

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    1. Lenos Trigeorgis, 1993. "Real Options and Interactions With Financial Flexibility," Financial Management, Financial Management Association, vol. 22(3), Fall.
    2. Tucker, Michael, 1997. "Climate change and the insurance industry: the cost of increased risk and the impetus for action," Ecological Economics, Elsevier, vol. 22(2), pages 85-96, August.
    3. Berry Gersonius & Richard Ashley & Assela Pathirana & Chris Zevenbergen, 2013. "Climate change uncertainty: building flexibility into water and flood risk infrastructure," Climatic Change, Springer, vol. 116(2), pages 411-423, January.
    4. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
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    Cited by:

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    2. Xueke Li & Scott R. Stephenson & Amanda H. Lynch & Michael A. Goldstein & David A. Bailey & Siri Veland, 2021. "Arctic shipping guidance from the CMIP6 ensemble on operational and infrastructural timescales," Climatic Change, Springer, vol. 167(1), pages 1-19, July.
    3. Charles Sims & Sarah E. Null & Josue Medellin-Azuara & Augustina Odame, 2021. "Hurry Up Or Wait: Are Private Investments In Climate Change Adaptation Delayed?," Climate Change Economics (CCE), World Scientific Publishing Co. Pte. Ltd., vol. 12(04), pages 1-36, November.
    4. Lee, Sangjun & Zhao, Jinhua, 2021. "Adaptation to climate change: Extreme events versus gradual changes," Journal of Economic Dynamics and Control, Elsevier, vol. 133(C).
    5. Rui Shi & Benjamin F. Hobbs & Huai Jiang, 2019. "When can decision analysis improve climate adaptation planning? Two procedures to match analysis approaches with adaptation problems," Climatic Change, Springer, vol. 157(3), pages 611-630, December.

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