Uncertainty, climate change, and irreversible environmental effects: application of real options to environmental benefit-cost analysis

Benefit-cost analysis (BCA) is the foundation of environmental policy analysis in the USA. This has worked reasonably well as a resource allocation tool for conventional environmental problems, although not for climate change. Conventional economic analyses of the 2° C stabilization target usually report modest benefits while costs are significant. Time lags and the discount rate “eat up” distant future benefits while present costs remain high. Modest estimates of benefits, based on expected value, do not reflect possible irreversible outcomes of climate change, and so the policy system tends to ignore these plausible conditions which are often statistical tail risks. BCA on tail risks would show benefits from acting, but typically, the costs might be shown to be much too high. When decisions made under high uncertainty have irreversible consequences, these consequences should be taken into account and properly priced. In this paper, we are proposing that the use of real options analysis can help us better understand values and costs of irreversible decisions and to value the costs of delay or early actions. Real options analysis is the most suitable instrument for estimating economic value of risk to be used in the BCA policy framework.