Valuing mitigation projects under uncertainty

The cost–benefit analysis of mitigation projects affecting greenhouse gas emissions requires accounting for the present value of the climate damages they avoid. Standard assessments, however, systematically overlook two important sources of risk. First, a project’s emissions impact may be strongly correlated with macroeconomic conditions. For instance, the impact of investments in green public transportation depends critically on passenger traffic and thus on economic growth. Second, it may involve significant option values, as it is the case, for instance, of forest carbon offset projects that effectively postpone irreversible land-use decisions. Properly accounting for these features typically requires complex stochastic modeling, which is often beyond the practical scope of public administrations responsible for project appraisal. We show that ignoring these risks can, however, lead to substantial biases in project valuation—up to 50% in the examples we consider. To address this issue, we propose a simple alternative approach, termed the stress discounting method, in which projects are evaluated across a small set of risk-free scenarios. We show that this method provides accurate pproximations of the present value of mitigation projects subject to correlated risks and option values, though remaining operationally tractable for policy evaluation.