It’s not now or never: Implications of investment timing and risk aversion on climate adaptation to extreme events

• Published in: European journal of operational research Vol. 253; no. 3; pp. 856 - 868
• Main Authors: Truong, Chi, Trück, Stefan
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 16.09.2016; Elsevier Sequoia S.A
• Subjects: Adaptation; Catastrophic risk; Climate; Climate change; Climate change adaptation; Discount rates; Discounts; Financing; Investment; Investment timing; Markets; Net present value; Real option; Risk; Risk aversion; Risk management; Studies; Time measurements; Risk aversion; Climate change adaptation; Investment timing; Real option; Catastrophic risk
• ISSN: 0377-2217; 1872-6860
• DOI: 10.1016/j.ejor.2016.01.044

•We propose a new modeling framework for evaluating climate change adaptation investments.•We analyze investment timing for risk reduction projects, accounting for market risk preferences.•Optimal timing has important impacts on the NPV of projects, especially when investment cost is high.•Assuming risk neutrality when the market is risk averse results in unnecessary investment delay.•More serious climate change, results in higher investment values and earlier investment. Public investment into risk reduction infrastructure plays an important role in facilitating adaptation to climate impacted hazards and natural disasters. In this paper, we provide an economic framework to incorporate investment timing and insurance market risk preferences when evaluating projects related to reducing climate impacted risks. The model is applied to a case study of bushfire risk management. We find that optimal timing of the investment may increase the net present value (NPV) of an adaptation project for various levels of risk aversion. Assuming risk neutrality, while the market is risk averse, is found to result in an unnecessary delay of the investment into risk reduction projects. The optimal waiting time is shorter when the insurance market is more risk averse or when a more serious scenario for climatic change is assumed. A higher investment cost or a higher discount rate will increase the optimal waiting time. We also find that a stochastic discount rate results in higher NPVs of the project than a discount rate that is assumed fixed at the long run average level.