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Real Option Analysis as a Tool for
Valuing Investments in Adaptation to Climate Change

Peter Linquiti and Nicholas Vonortas
The Center for International Science and Technology Policy
George Washington University

1. Overview
The challenge of adapting to climate change is a daunting one, particularly for developing
countries. Climate-driven impacts will likely be substantial while investments in adaptation will
be limited by resource constraints and competing demands from other development priorities. In
this analysis, we explore whether a real option paradigm that explicitly recognizes uncertainty
and maintains future flexibility can provide an investment strategy that developing countries
would find beneficial. We use a Monte Carlo model to test the strategy for two coastal cities in
developing countries and find that, under certain circumstances, a real option strategy has the
potential to reduce the costs of adapting to climate change.
2. Introduction
2.1. Global Context
Even if global greenhouse gas (GHG) emissions are reduced in the near future, continued
warming of the climate now appears unavoidable, leading the Intergovernmental Panel on
Climate Change (IPCC) to conclude that at least some adaptation to climate change will be
necessary (IPCC, 2007a). Particularly in low-income countries, decisions about adaptation will
be made in the face of scarce resources and competing social and economic development
priorities (IPCC, 2007d). The difficulty of such decisions will be exacerbated by the high stakes
involved. The World Bank estimates that adaptation to 2!C of warming could cost developing
countries between $70 billion to $100 billion per year by 2050 and that such costs are likely to be
very unevenly distributed across regions (2010). At the same time, the consequences of climate
change will fall heavily on developing countries, not only because of limited resources, but also
because so many are located in low-latitudes, where climate impacts are expected to be more
severe (Mendelsohn, Dinar, & Williams, 2006).
Decisions about how best to adapt to climate change will be made in an environment of
substantial uncertainty. In its latest report, the IPCC noted at least 18 key uncertainties in our
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understanding of the causes and effects of climate change (IPCC, 2007c). Global emissions of
greenhouse gases in the coming decades, for example, will be driven by difficult-to-forecast
forces such as the extent of development in countries around the world, the state of the global
macroeconomy, choices among existing and new technologies by consumers and firms, and
policy measures implemented either multilaterally or within specific countries. Similarly, while
scientists are becoming more adept at characterizing the relationship between greenhouse gas
emissions and climate impacts, significant uncertainty remains about the nature, magnitude, and
regional distribution of a broad range of impacts including sea level rise, extreme weather events,
water scarcity, eco-system impacts, and changes in agricultural productivity, disease patterns,
and human migration. Finally, as the impacts of climate change manifest themselves,
individuals, firms, communities, civil society, and governments will make hard-to-predict
choices about how to adapt to changes in the planets climate.

Made autonomously or as
purposive policy, such choices will reflect available technical options, resources, capabilities,
and competing priorities and likely be driven by a mix of economic, political, and institutional
considerations. In short, when it comes to adaptation to climate change, uncertainty is
significant and pervasive across multiple dimensions.
Current uncertainties notwithstanding, however, our collective scientific understanding of
global climate change and its potential impacts has improved markedly in recent years (National
Research Council, 2010). The IPCC began its series of extensive peer-reviewed assessments of
the relevant scientific literature in 1990. The latest assessment, released in 2007, contains
several instances in which IPCC observes that important uncertainties are being reduced over
time (IPCC, 2007b). For example, the Panel now describes as unequivocal the conclusion that
the climate is warming, whereas back in 1990, natural variability could not be ruled out, forcing
the Panel to conclude that the unequivocal detection of the enhanced greenhouse effect from
observations is not likely for a decade or more (IPCC, 1990). Similarly, the Panel now
characterizes the relationship between greenhouse gas emissions and observed global
temperature increases as very likely, while in 2001, the relationship was characterized simply
as likely. Other areas where scientific progress has been made, relative to the 2001
assessment, include:
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large amounts of new and more comprehensive data, more sophisticated analyses
of data, improvements in understanding of [climate] processes and their simulation
in models, and more extensive exploration of uncertainty ranges (IPCC, 2007b, p. 2).
Given the global resources being devoted to climate change research, it seems reasonable to
assume that progress in reducing scientific and other uncertainties will continue. The IPCC, for
example, recently launched its fifth global assessment of climate change intended to synthesize
the latest scientific literature. It will be completed by 2014 (IPCC, 2010). As a result, our
understanding of important scientific phenomena and of the impacts of localized climate change
is likely to improve. Even if, going forward, scientific research yielded no new insights (a
seemingly unlikely scenario), the simple passage of time would allow for additional direct
observation and measurement of the impacts of climate change.
Todays policymakers thus face a dilemma. Should they make irreversible investments in
adapting to potential climate change? Or should they take the risk of delaying action until
uncertainty has been reduced and actual climate impacts are being felt? Perhaps there is a
middle course in situations where investments made today create the opportunity, though not the
obligation, to take a future action to adapt to climate change. To resolve this dilemma,
policymakers require a framework for systematically considering the costs and benefits of these
three possibilities.
In our view, the ideal framework for making adaptation decisions in developing countries
would comprise several elements. It would explicitly incorporate uncertainty about the future
conditions that will ultimately determine the value of todays adaptation investments. It would
also recognize that such uncertainties are likely to diminish over time, thanks to both
improvements in forecasting techniques and the passage of time over which actual climate
impacts can be observed. The decision-making paradigm ought to recognize that many
investments in adapting to climate change are not now-or-never investments, but rather that the
flexibility often exists to expand, contract, or otherwise modify such investments. In addition,
the framework should recognize that adaptation investments are rarely all-or-nothing
investments, but instead are choices along continua of costs, risks, and benefits. Finally, the
framework ought to recognize that delayed investment in adaptation may create additional risk of
climate-driven damages now or in the future. We concur with Weyant when he notes that:

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Climate change is a long-run problem that will provide us with many opportunities to
learn and to revise our strategy over many decades. Thus, it is best conceived of as a
problem requiring sequential decision-making under uncertainty rather than
requiring a large, one-shot, bet-the-planet decision (Weyant, 2008, p. 88).
2.2. Characterizing Investments in Adaptation as Real Options
This paper explores whether a real options paradigm can provide a useful framework for
making policy decisions in such situations. In this section, we begin with a brief explication of
the key concepts underlying real option analysis, move to a quick review of the literature in this
field, and then conclude by framing the research questions that motivate this analysis.
2.2.1. Conceptual Explication
Real options are similar to financial options in that both give the option holder the right, but
not the obligation, to take a future action if doing so is advantageous based on future conditions.
For a financial option, the opportunity for action typically involves a time-limited right to buy or
sell a financial asset such as a share of stock or a commodity contract for a specified price. By
contrast, the term real options refers to cases where the underlying asset is a real asset such as
land, natural resources, a business opportunity, valuable information, or enhanced protection
against hazards. Real options exist when future outcomes are uncertain, the uncertainty is likely
to be reduced over time, the flexibility exists to take action in the future as the uncertainty is
resolved, and the action can reduce costs or increase benefits when it is taken (Triantis, 2003).
Real option analysis has been applied in myriad contexts including, among others, corporate
research and development, oil and gas exploration projects, mergers and acquisitions, real estate
development projects, and public sector research and development (Shockley, 2007), (Triantis,
2001), (Vonortas & Desai, 2007).
If a real option exists but is not properly valued, the traditional decision criterion of
maximizing net present value may yield a suboptimal choice (Copeland & Antikarov, 2003),
(Shockley, 2007), (Triantis, 2003). In the typical cost-benefit analysis, uncertainty is captured
through the use of expected values which reflect the mean values of the stochastic distributions
that describe the relevant uncertainties. The effect of this approach is to attach a now-or-never
quality to the investment choices; this quality is appropriate if indeed no flexibility exists to
adjust todays decision in future time periods. If, on the other hand, decision-makers can adjust
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the investment in the future (e.g., expand, contract, or abandon it), then the standard net present
value framework will tend to under-value this flexibility.
In characterizing the potential contribution of real option analysis to the proper valuation of
investments under uncertainty, it is helpful to distinguish the process of framing options from the
process of valuing them. In many cases, simply framing a decision as a choice among
alternatives, some of which entail options, can go a long way toward improving the quality of the
decision. Decision trees are often used to map out complex option-based investments by
defining sequential decisions to be made over time, as new information becomes available and
uncertainty is reduced. Corporate users of real option techniques across industries in the U.S.
report that, beyond putting a number to an investment choice, option analysis represents a way of
thinking that allows entire organizations to be more rigorous in their characterization of potential
business opportunities (Triantis, 2001).
When it comes to option valuation, a quick look at a modern finance textbook reveals that
there exists a large body of relevant literature, dating back to the development of the Black-
Scholes-Merton (BSM) model in the early 1970s (Hull, 2009). In addition to the BSM model,
other popular valuation techniques include binomial option pricing, risk-adjusted decision trees,
and Monte Carlo analysis (Triantis, 2003). The restrictive assumptions of the BSM model often
cannot be met when valuing real options, so one of the other three techniques is typically used.
Several parameters drive the value of an option real or financial including the present value
of the underlying asset, the uncertainty of that present value, the time interval from the initial
decision to the subsequent decision, the cost that would be incurred at the subsequent decision
point, and the discount rate (Copeland & Antikarov, 2003).
There are a number of potential investments in adaptation to climate change that have option-
like characteristics. For example, research and development of new cultivars that would be
suitable to a changed climate can create an option for the agriculture sector in a vulnerable
country. If the climate changes as expected, the new cultivars can be quickly deployed (i.e., the
option would exercised). If the climate remains relatively unchanged, then the new cultivars
would not be used (i.e., the option would be allowed to expire worthless). In this case, the R&D
cost can be viewed as the purchase price of the option and the cost to deploy the new cultivars
would be the exercise price. Similarly, a firm operating in a vulnerable coastal zone might buy
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property at a higher elevation. If significant sea level rise occurs, the vacant land would give the
firm the option (though not the obligation) to relocate its operations out of harms way. The cost
of the land would be the purchase price of the option and the cost of relocation would be the
exercise price.
2.2.2. Prior Literature
There exists a small body of literature that links real option analysis to investments in
adaption to climate change.
1
Despite these early efforts, however, the potential application of real option analysis to
adaptation projects appears to have received only limited attention from key policymakers
responsible for the United Nations Framework Convention on Climate Change (UNFCCC). For
example, in preparation for the 16
th
Conference of the Parties to the UNFCC in late 2010, one of
the Conventions subsidiary bodies issued its analysis of how best to analyze the cost and
benefits of adaption investments. The report makes a passing reference to the suggestion of
some participants that real option techniques be used to better characterize uncertainty. This
Guidance issued by the national government in the United
Kingdom, for example, suggests that option analysis be used to appraise adaptation projects that
entail uncertainty, flexibility and learning potential (H.M. Treasury, 2009). The U.K. guidance
document includes a case study of a real option analysis of potential flooding in the Thames
Estuary in the coming century. The Environment Department at the World Bank has also noted
the potential relevance of the real option framework to adaption projects and, in a 2009 Guidance
Note, describes the application of the framework to an irrigation project in Mexico (World Bank,
2009). In its Synthesis Report on the Economics of Adaptation to Climate Change, the Bank
also makes a brief reference to real options as a practical approach for addressing uncertainty
in investments in adaptation (2010, p. 100). Real option analysis has been applied to adaptation
to climate change in the rain-fed agriculture sector in Yemen (Scandizzo, 2010), in the
residential housing sector in the Mekong Delta of Viet Nam (Dobbes, 2010), in the agriculture
sector in Australia (Hertzler, 2007), and in flood management strategies for the Thames Estuary
(Woodward, Gouldby, Kapelan, Khu, & Townend, 2010).

1
There also exists a literature, not reviewed here, that addresses real option analysis of measures to mitigate climate
change.
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suggestion did not, however, find its way into the set of recommendations put forth to the Parties
(Subsidiary Body for Scientific and Technological Advice, 2010).
2.2.3. Research Question
In this context, we define our core research question as follows: To what extent would
framing adaptation investments as real options lead to better use of scarce resources in
developing countries? We take as given a policymaker whose objective is cost minimization.
We ignore the prospect of significant benefits from climate change and consider two types of
costs. The first is investments both capital and recurring in adaptation measures and the
second is the value of the economic damages that result from climate change despite those
investments in adaption (i.e., residual damages). We assume that policymakers are interested in
these impacts over time and hence seek to minimize the cost of adaptation investments, A,
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where n is the period over which the investment is analyzed, C
i
is the capital expenditure in year
i, O
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damages that occur in year i, and r is the discount rate. In turn, if a particular decision-making
strategy can be shown to lower these costs (i.e., minimize A), we would argue that it offers
policymakers the opportunity to make better use of the resources available for adaptation to
climate change.
We assume that policymakers are risk-neutral when solving this minimization problem,
meaning that they attach the same utility to each dollar considered in their analysis. Planners
would thus treat as equivalent a dollar spent with certainty on the cost of a capital investment and
a dollar spent in the form of an increase in the expected value of future damage anticipated to
result from climate change. We thus use a notionally risk-free rate of 3% for r.
Our approach here is consistent with the general principle that government policymakers,
investing on behalf of large numbers of taxpayers across multiple diverse projects throughout the
economy, ought to be risk-neutral (Arrow & Lind, 1970). Two caveats, however, must be kept
in mind. First, as a practical matter, if planners in developing countries do in fact display risk
aversion when making decisions about adapting to climate change, then any simulation of their
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behavior needs to reflect such considerations, irrespective of the conclusions of the academic
literature. Second, even in the literature, concerns about the routine application of risk-neutrality
to public decisions have been identified. For a general overview of such concerns, see
Boardman et al. (2006). Particularly relevant here is Weyants observation that there may need
to be some premium [added to the discount rate] to reflect that climate change is a big enough
potential problem to make even whole economies risk averse (2008, p. 90). We anticipate
returning to the issue of risk-neutrality in future work.
We also recognize that many of the potential impacts of climate change forced migration,
changes in disease patterns, poverty, loss of life, social disruption defy easy monetization.
Accordingly, the calculation of the expected value of residual damages from climate change has
both a qualitative and a quantitative component. In order to skirt this issue in our analysis below,
we confine ourselves to two non-economic impacts loss of life and population displacement
and attach a monetary value to both, solely for the purposes of more clearly illustrating our
proposed methodology.
In this analysis, we test the potential value of a real option framework for the specific case of
adapting to sea level rise. We chose sea level rise as our focus for several reasons. First, there is
substantial uncertainty about the rate and ultimate magnitude of sea level rise (IPCC, 2007b),
(Lowe & Gregory, 2010), (Rahmstorf, 2010). Second, storm surges are typically recognized as
the event during which rising seas are most dangerous; such surges even in the absence of
climate change have historically exhibited substantial variability. Third, from a cost-benefit
perspective, the assets to be protected from sea level rise economic resources and vulnerable
populations are not static, but evolve over time, thereby introducing a dynamic element into the
calculation of potential damages. All of these uncertainties combine to make adaptation to sea
level rise a phenomenon particularly well suited to real option analysis.
Consider, for example, Figure 1 which frames coastal planning as a one-off decision where
the height of the flood defense is selected once at the outset of the planning period. Though a
simplified example that portrays continuous variables (sea level rise and the value of vulnerable
assets) as discrete, this decision tree illustrates the dilemma faced by coastal planners: a
traditional case of decision-making under uncertainty. Insufficient protection may lead to
inundation while excessive protection may lead to wasted resources. In addition, the more
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Figure 1
Applying One-Off Decision Making to Coastal Defense Planning

Chose
PelghL of
uefense
ln ?ear 1
Plgh
Plgh SL8
Plgh AsseL value roLecLed
Low AsseL value roLecLed
Low SL8
Plgh AsseL value
Cver-
roLecLed
Low AsseL value
Cver-
roLecLed
Low
Plgh SL8
Plgh AsseL value
lnundaLlon:
Plgh Loss
Low AsseL value
lnundaLlon:
Low Loss
Low SL8
Plgh AsseL value roLecLed
Low AsseL value roLecLed
none
Plgh SL8
Plgh AsseL value
lnundaLlon:
Plgh Loss
Low AsseL value
lnundaLlon:
Low Loss
Low SL8
Plgh AsseL value
lnundaLlon:
Plgh Loss
Low AsseL value
lnundaLlon:
Low Loss
lnvesLmenL ueclslon uncerLalnLles CuLcome

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valuable the vulnerable assets, a parameter that may change over time, the more beneficial are
investments in protection. Framed this way, the rational approach for a risk-neutral decision-
maker is to assess the probabilities of future events and then select the coastal defense with the
lowest expected value cost. As an alternative, Figure 2 re-frames the decision problem as a real
option in which multiple decisions are made over time as uncertainty is resolved and more
knowledge becomes available about both sea level rise and the value of vulnerable assets and
populations. The contrast between Figures 1 and 2 demonstrates why planning for sea level rise
might be enhanced by application of a real option paradigm.
Figure 2
Applying Sequential Decision Making to Coastal Defense Planning

?ear 1: SelecL
PelghL of
uefense
?ear 1+x:
ueclde
wheLher Lo
8alse uefense
?ear 1+2x:
ueclde
wheLher Lo
8alse uefense
?ear 1+3x:
ueclde
wheLher Lo
8alse uefense
?ear 1+4x:
ueclde
wheLher Lo
8alse uefense
Cngolng 8educLlon ln
uncerLalnLy AbouL Sea
Level 8lse & value of
vulnerable AsseLs
x = number of years beLween perlodlc plannlng declslons.

In addition, from a practical perspective, sea level rise is a substantial threat to developing
countries, as evidenced by a recent World Bank review of global vulnerability to sea level rise
which identified very heavy potential losses that are much more concentrated in some regions
and countries than others and a concentration of highly vulnerable large cities at the low end of
the international income distribution (Dasgupta, Laplante, Murray, & Wheeler, 2009). More
specifically, an estimated 11 million people live in port cities in low income countries that are
threatened by coastal flooding (Nicholls, et al., 2008). Of course, the threat to coastal areas does
not originate solely in climate-induced sea level rise; other drivers include development patterns
that put populations and economic assets in harms way, local land subsidence, inadequate
warning systems, failure to invest in sufficient protection measures, and natural (non-climate-
induced) variability in sea levels and storms. Two well-known examples make the point: the
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catastrophic flood in Galveston, Texas in 1900 and the equally catastrophic North Sea Flood of
1953, neither of which presumably was materially influenced by climate change.
Rigorous economic frameworks for planning coastal defenses appear to have emerged in the
Netherlands in the late 1950s (Hillen, Jonkman, Kanning, Kok, Geldenhuys, & Stive, 2010).
Van Dantzig first identified the management decision as a cost minimization problem where the
lower risks created by enhanced protection must be balanced against the increased costs
associated with such protection. While van Dantzigs framework envisioned a single decision at
one point in time (and thus did not comprise a real option framework), Eijgenraam extended the
framework in 2006 to consider periodic improvements in coastal defenses in response to ongoing
economic development and changes in sea levels. Such a paradigm is conceptually consistent
with the real option approach we take in this study.
3. Methodology
In order to assess the potential value of learning and flexibility under conditions of climate-
induced uncertainty, we compare various strategies that a policymaker might pursue in planning
for coastal defense of a city threatened by rising sea levels. We do so using a Monte Carlo
simulation model that provides a simplified representation of the physical, economic, and
decision-making processes likely to drive the results of these strategies. A key advantage of a
Monte Carlo approach is that, unlike many option valuation methods, it can accommodate
multiple sources of uncertainty and does not require that such uncertainties fit any particular
statistical distribution (Triantis, 2003).
We use the model to analyze two cities, one in a riverine delta area (Dhaka, Bangladesh) and
the other on an ocean coast (Dar-es-Salaam, Tanzania). While the data used in the model are
loosely based on these cities, readers are cautioned that a number of analytic simplifications and
data imputations mean that our results should not be seen as identifying a recommended course
of action for either city. Instead, our analysis is meant to evaluate the relative merits of
alternative investment strategies for dealing with the uncertainties of climate change.
3.1. Strategies Analyzed
We analyzed three investment strategies for constructing coastal defenses. To set a baseline,
however, we first examined a no-action scenario under which policymakers make no investments
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in defending against rising sea levels. In this baseline scenario, inundation and its consequences
are driven solely by natural processes, unimpeded by policy intervention. In contrast, each of the
three strategies contemplates at least some investment in coastal protection. Like Figure 1, the
first strategy is an inflexible one, and hence, not a real option. It assumes a single decision
made as part of a planning process for a 100-year time frame about the optimal height of the
coastal defense structure. The other two strategies create options by permitting policymakers the
flexibility to increase the height of the defense at multiple points during the 100-year period. In
the first of the real option approaches, which we call the Sense & Respond strategy, planners
would rely on local observational evidence about changing conditions and increase the defense
height based on that evidence. Similar to Figure 2, in the second real option strategy, which we
term the Predict & Respond approach, planners are assumed to periodically examine current
and predicted conditions over the time left in the 100-year planning horizon to decide whether to
raise the height of the coastal defense. Each of the three strategies, and the method by which it is
operationalized in the analysis, is described in more detail below.
3.1.1. Inflexible Strategy
Under the inflexible strategy, policymakers make a single decision at the start of the 100-year
analysis period. In doing so, they select the height of the coastal defense based on an
optimization strategy intended to minimize the present value of the sum of the protection costs
and the expected value of the residual damages that occur despite the presence of the protection.
Planners are assumed to choose a protection height ranging from 0 to 10 meters, in one-meter
increments. Protection costs are assumed to be known with certainty while planners estimate the
expected value of the residual damages based on the best available information about the rate of
global sea level, the incidence and magnitude of storm surges that threaten the vulnerable city,
and the evolution of economic assets and exposed populations on the land-side of coastal
defenses. For purposes of this analysis, decision-makers are assumed to value an avoided fatality
at $0.163 million in Dar-es-Salaam and at $0.170 in Dhaka.
2

2
Unless otherwise noted, all monetary values used in this analysis are expressed in real terms, as 2009 US$.
These values reflect Millers
review of 68 studies of the value of statistical life (VSL) conducted across 13 countries and his
finding that the typical value is about 120 times per capita GDP (Miller, 2000). Per capita GDP
in Tanzania is $1,362 (purchasing power parity basis) and is $1,416 in Bangladesh (World Bank
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Databank, 2011). We are not aware of estimates of the value of a displaced person in developing
countries; hence, we simply assume the value to be 2.5% of VSL. We are not suggesting that
these values would or should be applied during such analyses; rather, we use these illustrative
values only to capture the high likelihood that planners will consider more than just the size of
the vulnerable economic assets in planning for coastal defense.
Under the inflexible strategy, planners are assumed to estimate for each possible height of the
coastal defense structure, the investment costs and the expected value of the damages for each
year in the 100-year analysis period. The option with lowest net present value (at a 3 percent
discount rate) is then selected. It is possible that planners would chose not to construct any
coastal defenses if doing so were the cost-minimizing choice.
The simulation model then determines the consequences of the planners decision. Because
of the stochastic nature of the model (and, more importantly, of future climate conditions), actual
events sea conditions, vulnerable assets and populations, and the extent of inundation are
likely to vary from the assumptions made by planners in each iteration of the model. Hence,
costs and damages actually simulated over the 100-year period need not (and typically would
not) match the planning assumptions made by decision-makers in the first year of the model
simulation.
3.1.2. Real Option: Sense & Respond Strategy
The Sense & Respond strategy gives local planners the option of raising the height of the
coastal defense in any year during the 100-year analysis. They are assumed to continuously
observe maximum sea levels in relation to the height of the existing coastal defenses. Such
observations, rather than predictions about future sea levels, are assumed to drive ongoing
decisions about whether to raise the height of the defenses. More specifically, this strategy
assumes that if the maximum sea level observed over the course of one year exceeds a specified
percentage (in this case, 75%) of the height of the existing defense, the defense is raised in the
subsequent year. The incremental increase in height is assumed to be the higher of 0.5 meters
and 150% of the observed maximum sea in the prior year. Under this scenario, planners may
raise the height of the coastal defense several times over the 100-year analysis (or they may
never raise the height, in the event that observed sea levels never increase enough to trigger
construction of additional defenses).
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3.1.3. Real Option: Predict & Respond Strategy
The Predict & Respond strategy is similar to the Inflexible Strategy in that it endeavors to
minimize the sum of the protection costs and the expected value of the residual damages, with
population impacts monetized as before. It differs, however, in that the minimization analysis is
done periodically throughout the 100-year analysis period (in this case, once every 20 years),
rather just once. Planners thus have the option, but not the obligation, to raise the protection
height in years 1, 21, 41, 61, and 81. Unlike the Sense & Respond strategy, this strategy is a
forward looking one. The planning decision is based on extrapolations from observed changes
that have already occurred in sea conditions, vulnerable assets, and vulnerable populations that
are used to predict the conditions expected to occur over the next twenty-year interval. For
example, the decision made in Year 40 would rely on 40 years of observed data to project
conditions for Years 41 to 60. As with the Inflexible Strategy, planners have no assurance that
their predictions of future conditions will prove accurate; however, in this case, planners are
predicting only 20 years, rather than 100 years, into the future. Whats more, these sequential
decisions made over time reflect an increasing quantity of information about how sea levels,
populations, and assets are changing.
3.2. Model
The model is implemented as an Excel spreadsheet, using Oracles Crystal Ball add-in to
execute the Monte Carlo analysis. For this study, the model was run for 10,000 iterations, with
each iteration comprising an analysis of the full 100-year planning period. The model is built on
a simplified representation of the process of defending a coastal city against rising seas. Figure 3
provides a graphic representation of how we have conceptualized the process using a standard
risk assessment paradigm that moves from the source of the risk to the ultimate impacts, along
with potential policy interventions in the form of adaptation to climate change.
The simulation model comprises five basic components. First, the height of existing coastal
defenses in each year which can vary as a consequence of the policy strategy being analyzed
is simulated. Second, the maximum storm surge is simulated for each year and compared to the
height of the existing coastal defense to determine whether any inundation occurs. Third, in the
event that inundation is simulated to occur, impacts on economic assets and vulnerable
populations are calculated. Fourth, the size of populations and economic assets vulnerable to
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Figure 3
Framework for Assessing Adaptation to Sea Level Rise
differing levels of potential inundation is simulated annually, along with changes brought about
by population and economic growth. Fifth, after these processes have been simulated for 100
years within single model iteration, key outputs are recorded and the model moves to the next
iteration, until all 10,000 iterations have been completed. Each of these five model components
is described in more detail below. Figure 4 depicts the simulation of the Sense & Respond
Strategy while Figure 5 depicts the Do-Nothing Baseline, and the Inflexible and Predict &
Respond Strategies.
3.2.1. Simulation of Coastal Defenses
The concept of coastal defenses is used in our model to describe a generic barrier a
seawall or dike of a certain height that is capable of restraining storm surges below that height
and preventing any inundation of assets on the land-side of that defense. The prospect of a
failure of the barrier is not considered; inundation is assumed to occur only if the barrier is over-
topped by the sea. While this is a simplification, we believe it is a reasonable one, particularly
since our model does include costs for the ongoing annual maintenance and upkeep of the coastal
defense.
The height of the coastal defense, as well as all references to sea levels and storm surges, are
expressed relative to the mean local, astronomically-predicted, high tide level over the course of
the year prior to the start of the 100-year simulation. The model includes the height of both
freeboard and constructed defenses. The former refers to the vertical distance between the water
level and the lowest level at which vulnerable assets or populations exist. One can think of
freeboard as we use that term here as the protection afforded by natural beaches, bluffs,

!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %=

Figure 4
Simulation of Sense & Respond Strategy

lnlLlallze ollcy and
1echnlcal varlables
lnvesL ln
proLecLlon
ln ?ear 0?
lncremenL
P
0
?es
no
lnlLlaLe SlmulaLlon
l = ?ears 1 Lo 100
SlmulaLe Sea Level
SL
l
= SL
l-1
+ CSL8
l
+
LSL8
l
SlmulaLe WorsL
SLorm Surge of
?ear l (S
l
)
non-LvenL"
[SL
l
+S
l
]/[P
l
+l8
0
]<1
Close Call"
1*+SL
l
+S
l
]/[P
l
+l8
0
] *1.0
Cver-1op"
[SL
l
+S
l
]/[P
l
+l8
0
] >1.0
lncur C&M
?es
8eached
?ear 100?
CompuLe & 8eporL
CuLpuLs
updaLe varlables for
nexL ?ear
vulnerable opulaLlon
vulnerable AsseLs
roLecLlon PelghL
Compare [SL
l
+ S
l
]
Lo [P
l
+ l8
0
]
C
l
=SL
l
+S
l
-P
l
-l8
0
no
lnvesL ln uefense:
8alse P by max(0.3,
[1+Sl] * [SL
l
+S
l
]),
lncur CosL Lo 8ulld
value uamage as u=
! (C
l
, v
l
, op
l
, LL)
uecremenL v & op
8ecovery: AsseL
lnvesLmenL = 8elnv
* 8emalnlng AsseLs,
op 8eLurn = 8eop
* ulsplaced ersons
!"# $%&'( )*+(,-(&+.
/,&01(
#$# 23(%*3' 4*,,5+3*6
%&# 7,3 8,9,'
%&'# 7,3 8,9,' :&;,
(%&'# <'+53' 78:
&%&'# 8+-3' 78:
%# =3> ?..%3' 7%*0,
)# ?-(&+. @1*,;1+'6
%#* 73!,(A 43-(+*
+# B.%.63(&+. C%3.(&(A
,&-./# D3'%, +! !3(3'&(A
,0!# D3'%, +!
6&;E'3-,6 E,*;+.
,# D%'.,*35', ,-+.F
+G&- 3;;,(;
!12# D%'.,*35',
E+E%'3(&+.
33# H93-%3(&+.
H!!&-&,.-A
'/4567# I +! '+;(
3;;,(; *,&.9,;(,6 3!(,*
&.%.63(&+.
'/!127# I +!
6&;E'3-,6 E,*;+.;
J1+ *,(%*. 3!(,*
&.%.63(&+.

!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %>

Figure 5
Simulation of Do-Nothing Baseline and Inflexible and Predict & Respond Strategies

lnlLlallze ollcy and
1echnlcal varlables
lnvesL ln
proLecLlon
ln ?ear 0?
lncremenL
P
0
?es
no
lnlLlaLe SlmulaLlon
l = ?ears 1 Lo 100
SlmulaLe Sea Level
SL
l
= SL
l-1
+ CSL8
l
+
LSL8
l
SlmulaLe WorsL
SLorm Surge of
?ear l (S
l
)
no lnundaLlon"
[SL
l
+S
l
]/[P
l
+l8
0
] *1.0
Cver-1op"
[SL
l
+S
l
]/[P
l
+l8
0
] >1.0
lncur C&M
?es
8eached
?ear 100?
CompuLe & 8eporL
CuLpuLs
updaLe varlables for
nexL ?ear
vulnerable opulaLlon
vulnerable AsseLs
roLecLlon PelghL!
Compare [SL
l
+ S
l
]
Lo [P
l
+ l8
0
]
C
l
=SL
l
+S
l
-P
l
-l8
0
no
value uamage as u=
! (C
l
, v
l
, op
l
, LL)
uecremenL v & op
8ecovery: AsseL
lnvesLmenL = 8elnv
* 8emalnlng AsseLs,
op 8eLurn = 8eop
* ulsplaced ersons
!"# $%&'( )*+(,-(&+.
/,&01(
#$# 23(%*3'
4*,,5+3*6
%&# 7,3 8,9,'
%&'# 7,3 8,9,' :&;,
(%&'# <'+53' 78:
&%&'# 8+-3' 78:
%# =3> ?..%3' 7%*0,
)# ?-(&+. @1*,;1+'6
+# B.%.63(&+.
C%3.(&(A
,# D%'.,*35', ,-+.F
+G&- 3;;,(;
!12# D%'.,*35',
E+E%'3(&+.
33# H93-%3(&+.
H!!&-&,.-A
'/4567# I +! '+;(
3;;,(; *,&.9,;(,6 3!(,*
&.%.63(&+.
'/!127# I +!
6&;E'3-,6 E,*;+.;
J1+ *,(%*. 3!(,*
&.%.63(&+.
l=1, 21, 41,
61, 81?!!
no
ueclde wheLher Lo
lncrease P!
?es
! lor Lhe uo-noLhlng 8asellne, Lhls sLep ls omlLLed.
! lor Lhe lnflexlble SLraLegy, Lhls sLep occurs only ln ?ear 1 (l=1).

!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %?

and rocky shorelines. The base of the constructed defense is assumed to match the top of the
freeboard; hence, the total protection height is the sum of the freeboard and the defense height.
Our approach to estimating the costs of coastal defense is based on Yohe et al., who decided
after a review of eight studies to use a unit cost of US$750 per linear foot (1990$) for a 1-meter
high sea defense, and that cost rises as the square of the height (Yohe, Neumann, & Marshall,
1999). We inflated the unit cost from 1990 to 2009, using the U.S. Department of Commerces
GDP deflator for fixed investments in nonresidential structures (U.S. Council of Economic
Advisors, 2011). Thus, the model estimates the capital cost (K) of the coastal defense as a
function of its height, as follows:
K = $5,617 * [H
n
2
H
e
2
] * L
where H
n
is the height of the new structure in meters and H
e
is the height of the existing
structure, if any. L is the length, also in meters, of the coastal defense. Owing to the trapezoidal
shape of the typical defense structure, capital cost rises exponentially with height. The same
algorithm is used to estimate the cost of raising an existing defense as well as constructing a new
structure; in the latter case, the H
e
term is set to zero. Like Yohe et al, we assume annual
maintenance costs for the defense structure equal 4 percent of the historical capital investment.
A similar approach was applied by Ng and Mendelsohn to their analysis of coastal protection in
Singapore (2005).
Visual inspection of the relevant maps led us to assume a length of 75,000 meters for the
length of the coastal defenses in Dar-es-Salaam and 66,000 meters for Dhaka. Based on the
DIVA model, we assumed that the existing height of the protection is 1.5 meters in Dar-es-
Salaam and 3.0 meters in Dhaka (Valfedis, et al.). In both cases, this height was split equally
between naturally occurring freeboard and constructed coastal defenses.
3.2.2. Simulation of Annual Maximum Sea Levels
The maximum simulated sea level in any given year is a function of three variables, one of
which is treated deterministically while the other two are simulated on a stochastic basis. The
first, local sea level rise (LSLR), is simulated to occur at a constant rate each year, irrespective of
ocean conditions. LSLR captures the net effects of changes in location-specific land elevations,
which may increase due to forces such as geologic uplift or decrease due to forces such as
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %@

subsidence. In the case Dar-es-Salaam, local sea level rise is assumed to be -1.58 mm per year,
i.e. that local land elevation is increasing (Kebede & Nicholls, 2011). For Dhaka, we assumed
that the historical subsidence rate of 0.65mm per year reported by Milliman and Haq was a
reasonable proxy for future subsidence (1996).
Global sea level rise (GSLR) is treated stochastically, using a two-step process. At the start
of each iteration, the model first selects a single value for the entire 100-year analysis period to
represent the underlying trend in average annual changes in sea levels. This value is drawn from
a normal distribution with a mean of 3mm per year and a standard deviation of 2mm. Then, to
capture annual variability and the noisiness of the climate signal, the actual GSLR in any given
year is drawn from a uniform distribution with a mean equal to the simulated underlying trend
for that iteration and a range that extends plus or minus 50 percent around the mean. This annual
simulation assumes independence of each year from all other years; there is no serial correlation.
The third element in the annual calculation of the maximum sea level is an extreme value
distribution that captures variability in storm surges experienced each year. Information on sea
surges for the two studied cities was graciously provided to us by Robert Nicholls of the
University of Southampton who, with colleagues, studied the vulnerability of port cities around
the world to sea level rise (Nicholls, et al., 2008). Information was provided, as of 1995, on the
surge height associated with four annual recurrence intervals (ARI): 1-, 10-, 100-, and 1000-year
events. The ARI represents expected value of the time interval between surge events that exceed
a given level. Because such events are assumed to be statistically independent, it is possible to
have a 100-year event more than once every 100 years. For purposes of stochastic simulation, it
was necessary to convert the ARIs to Annual Exceedance Probabilities (AEPs). We used the
approach specified by the Australian Governments Bureau of Meteorology (2011) in which:
!&, ! & -.
-&
!/0

We also updated the 1995 surge heights for 15 years of global sea level rise which we assumed
to equal 3mm per year, as well as for 15 years of local sea level rise which, as described above,
differs between the two cities. We next took the four point estimates of sea heights (and the
associated AEPs) and matched them to a Gumbel maximum extreme value distribution of the
following form:
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (&

1$2% !
&
3
4 .
2-5
3
4 .
-.
-$2-5 %
3

where ! is the scale parameter and " is the location parameter. The Gumbel distribution is often
used to characterize flooding events (Kotz & Nadarajah, 2000). Table 1 displays selected values
from the extreme value distribution used in this analysis, along with the values of ! $%& ".
Table 1
Extreme Value Distribution for Storm Surges
Annual
Exceedance
Probability
Annual
Return
Interval
(years)
Annual Maximum Sea
(meters)
Dar-es-
Salaam
Dhaka
0.001 1000 3.30 5.21
0.002 500 3.25 5.06
0.004 250 3.19 4.90
0.010 100 3.12 4.70
0.020 50 3.06 4.54
0.039 25 3.01 4.38
0.095 10 2.94 4.19
0.181 5 2.88 4.02
0.393 2 2.81 3.82
0.632 1 2.75 3.66
!"#$% '#(#)%*%( +,-
0.080 0.225
./"#*0/1 '#(#)%*%( +2-
2.752 3.661

Some scientists argue that climate change may affect the frequency and intensity of storm events,
but we have not endeavored to capture such a phenomenon in our analysis; instead, the
parameters underlying the extreme value distribution are assumed to be stationary for the full
100-year analysis period.
To simulate the maximum sea in any given year, our model integrates these three variables as
follows. First, the cumulative sea level rise to date is computed as the combination of the
deterministic LSLR and the stochastic GSLR observed in previous years. Second, the maximum
sea surge for the year being analyzed is then simulated and added to the cumulative sea level to
yield the maximum sea level to which the coastal defense is exposed. If this level is less than or
equal to the height of the coastal defense (plus the freeboard), no inundation occurs and the
model moves to simulation of the next year. If the maximum sea level exceeds the height of the
defense, then at least some inundation is simulated to occur.
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (%

3.2.3. Simulation of Inundation Events
The extent of inundation depends on the degree to which the maximum sea level exceeds, or
over-tops, the protection height. For example, if the maximum sea is 3.2 meters and the
protection is 2.0 meters, then the difference of 1.2 meters is used to determine the extent of
inundation. The terrain of the vulnerable city is segmented based on its susceptibility to
inundation. The first segment comprises all land area susceptible to flooding in the event of an
over-topping of coastal defenses of 0.5 meters; the second segment comprises lands susceptible
to inundation from an over-topping of 1.0 meters. This framework continues in half-meter
increments, up to the tenth segment which comprises the land area vulnerable to flooding from a
vertical over-topping of 5.0 meters. Continuing the previous example in which the sea over-tops
the protection by 1.2 meters, the model would assume complete inundation of area of the first
and second segments and partial inundation of the area of third segment. Partial inundation is
simulated using linear interpolation; 40 percent of the third segment would be simulated as
flooded because 1.2 is 40 percent of the difference between 1.0 and 1.5 (i.e., the bounds of the
third segment).
The value of the economic assets and size of the human population located within the area of
each of the ten segments in the first year of the simulation is a model input. Again, we are
grateful to Dr. Nicholls for providing the population data for Dar-es-Salaam and Dhaka
(Nicholls, et al., 2008). The data provided were in 1-meter increments; to create the !-meter
values, we used simple linear interpolation. The data also were for populations as of 2005; we
increased each population estimate to 2009 using the World Banks city growth rates (World
Bank Databank, 2011). To estimate asset values within each vulnerable area, we used an
approach sometimes applied by the insurance industry in which assets are estimated at five times
per capita GDP (Kebede & Nicholls, 2011). Table 2 presents the data used by the model.
If a segment in the city is flood by a sea level in excess of the coastal defense, all of the
assets in that segment are assumed to be destroyed, with an asset loss equal to their current
market value. Population impacts are tempered by the prospect of evacuation prior to the
flooding. We assume in our analysis that 75 percent of the population is evacuated and become
Displaced Persons as a consequence of the flood; the remaining 25 percent are counted as
fatalities.
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 ((

Table 2
Vulnerability as a Function of Vertical Quantity (Q) of Over-Topping of Defenses
(First Year of Analysis)

Segment
1 2 3 4 5 6 7 8 9 10
Q (meters) 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
Dar-es-Salaam
Value of
Assets ($m)
125 134 152 169 224 278 374 469 652 835
Population
(thousands)
18 20 22 25 33 41 55 69 96 123
Dhaka
Value of
Assets ($m)
337 1,153 1,358 1,564 1,770 1,975 2,786 3,598 5,873 8,149
Population
(thousands)
48 163 192 221 250 279 393 508 829 1,151
3.2.4. Simulation of Changes in Vulnerability
The size of the populations and assets at risk of inundation do not remain constant in the
model. Instead, they are assumed to vary stochastically over time. The model allows
populations and assets to change at different rates and does so in a stochastic manner. While the
annual average growth rate remains constant over the 100-year analysis period of a single model
iteration, it is initially selected stochastically. Population growth projections were based on data
from the U.N. Population Division (2008). For simulation purposes, we assumed a simple
triangular distribution with a minimum equal to the U.N.s low estimate, a peak equal to the
medium estimate, and a maximum equal to the high estimate. The U.N.s projections cover the
period from 2010 to 2050. We assume the same rate will hold for the future, as well. Table 3
provides the population growth used for the simulation, along with the imputed mean of the
distribution.
Table 3
Annual Population Growth Rate Distributions
(Triangular)
Dar-es-Salaam Dhaka
Minimum 1.910% 0.360%
Peak 2.240% 0.760%
Maximum 2.560% 1.140%
Implied Mean 2.237% 0.753%
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (:

We could not readily identify a credible source for projecting asset growth over the full 100-
year analytic timeframe. Consequently, we simply assume that asset values will grow at an
average of 4% per year, with a standard deviation of 2%. Whats more, we assume that
population and asset growth are co-vary with a correlation coefficient equal to 0.75. To more
accurately capture year-over-year fluctuations in the rates of change, the actual changes in
populations and assets in any given year are drawn from a uniform distribution with a mean
equal to the simulated underlying trend for that iteration and a range that extends plus or minus
50 percent around the mean.
In the year of an inundation, these population and asset growth rates are not applied. Instead,
the process of asset destruction and population displacement determines the assets and
population that remain at the end of that year. Then, in the following year, the model simulates
re-investment and re-population within the city at rates of, respectively, 25 and 50 percent of the
pre-inundation levels. In the event that a segment has been fully inundated, no re-population or
re-investment is simulated in that segment; instead, asset and population growth is directed to
segments that have not been inundated. Two years after inundation, the process of annual
growth described above resumes, though from the lower, post-inundation levels.
3.2.5. Compilation of Results
The no-action baseline and the three alternative investment strategies are simulated
simultaneously within each iteration of the model to ensure that sea levels, along with the
potential size of vulnerable assets and populations, remain constant as each policy choice is
assessed. (Across iterations, of course, the values of these variables are allowed to vary
stochastically.) For each year, the model records the capital and O&M spending on coastal
defenses, whether the protection height has been raised under the Predict & Respond and Sense
& Respond strategies, whether an inundation occurs, and if inundation occurs, the number of
fatalities, displaced persons, and lost economic assets.
At the end of the 100-year analysis period, the present value of costs and damages are
computed using a 3 percent discount rate and the numbers of inundations, fatalities, and
displaced persons are tallied. After 10,000 iterations, statistics are generated on these model
outputs, including means, standard deviations, and medians.

!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (;

4. Results
This section describes the results of our analysis of alternative strategies for adapting to sea
level rise in developing countries. We begin with a summary of the base case results that are
obtained using the input parameters as described in the preceding section. We then evaluate the
sensitivity of the results to variations in the inputs, and present a pair of sensitivity analyses for
each city.
4.1. Base Case Results
Tables 4 and 5 present the results of the simulation for, respectively, Dar-es-Salaam and
Dhaka. Results are shown for the Do-Nothing baseline, along with the three alternative
strategies for investing in coastal defenses. Reported costs all discounted at 3 percent over the
100-year analysis period include the investment cost (both capital and O&M) for coastal
defense, asset damages (the value of assets lost to inundation), and total costs (both with and
without the monetization of population impacts). In addition, the simulated number of fatalities
(not discounted) over 100 years is presented, as well as statistics on the number of years in which
inundation, economic damage, and population impacts occur. Finally, the number of times that
the defense height is increased is also reported.
In the case of Dar-es-Salaam, the Do-Nothing baseline provides the least cost approach. In
large measure, this result reflects the balance between protection costs relative to the impacts of
inundation. It highlights the prospect that in some cases, yielding to a rising sea and suffering
the associated consequences, is less expensive that investing in efforts to prevent inundation. In
other cases, however, vulnerable assets and populations (and anticipated growth thereof) are
sufficiently large to justify investments in protection. In Dhaka, for example, the Do-Nothing
baseline is not the least cost strategy. Even though it entails ongoing investments in maintaining
the existing 1.5 meter defense, doing nothing leads to repeated inundation, more than 57,000
fatalities over the 100-year analysis period, and the highest property damages of any approach.
For Dar-es-Salaam, the Inflexible Strategy, which entails a single investment in the first year
of the simulation, delivers significantly worse results than the Do-Nothing baseline, with
incremental costs of about $6.4 billion. While the Inflexible Strategy does drive down asset
damage and population impacts substantially, these savings are more than offset by an increase
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (<

Table 4
Results for Dar-es-Salaam
3
Do-Nothing Baseline



Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $300.0 $148.2 $448.2 $1,433.0 6.1 100.0 34.9 34.9 0.0
Median $300.0 $148.1 $448.1 $1,431.9 6.2 100.0 32.0 32.0 0.0
Std Dev $0.0 $3.2 $3.2 $24.2 0.3 0.0 20.7 20.7 0.0
Inflexible Strategy

Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $7,878.3 $1.2 $7,879.5 $7,880.2 0.05 0.01 0.01 0.01 1.00
Median $7,878.3 $0.0 $7,878.3 $7,878.3 0.00 0.00 0.00 0.00 1.00
Std Dev $0.0 $29.4 $29.4 $36.7 0.74 0.12 0.12 0.12 0.00
Real Option: Sense & Respond Strategy

Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $10,707.5 $137.2 $10,844.8 $11,756.6 5.34 1.00 1.00 1.00 1.00
Median $10,522.7 $136.7 $10,659.4 $11,567.4 5.32 1.00 1.00 1.00 1.00
Std Dev $1,003.6 $3.4 $1,007.0 $1,029.6 0.13 0.01 0.00 0.00 0.01
Real Option: Predict & Respond Strategy

Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $7,886.1 $0.9 $7,887.0 $7,887.7 0.04 0.01 0.01 0.01 1.02
Median $7,878.3 $0.0 $7,878.3 $7,878.3 0.00 0.00 0.00 0.00 1.00
Std Dev $60.1 $23.4 $64.4 $67.3 0.70 0.10 0.10 0.10 0.13

3
Results are for a 100-year time period simulated with 10,000 iterations. All costs are 2009 US$ millions and represent present values, computed at a 3 percent discount rate.
Population impacts are monetized at $163,490 per fatality and $4,090 per displaced person.
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (=

Table 5
Results for Dhaka
4
Do-Nothing Baseline



Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $1,056.0 $1,320.3 $2,376.3 $11,147.6 57.4 100.0 14.7 14.7 0.0
Median $1,056.0 $1,309.4 $2,365.4 $11,064.4 56.0 100.0 13.0 13.0 0.0
Std Dev $0.0 $83.6 $83.6 $638.8 5.0 0.0 7.6 7.6 0.0
Inflexible Strategy

Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $11,923.9 $33.5 $11,957.3 $11,991.8 1.06 0.11 0.11 0.11 1.00
Median $11,923.9 $0.0 $11,923.9 $11,923.9 0.00 0.00 0.00 0.00 1.00
Std Dev $0.0 $175.4 $175.4 $356.0 5.25 0.34 0.33 0.33 0.00
Real Option: Sense & Respond Strategy

Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $14,312.7 $796.0 $15,108.7 $20,371.7 29.80 1.09 1.03 1.03 1.09
Median $13,532.3 $786.0 $14,333.6 $19,624.8 29.44 1.00 1.00 1.00 1.00
Std Dev $3,547.4 $304.9 $3,769.3 $5,447.5 11.41 0.28 0.17 0.17 0.28
Real Option: Predict & Respond Strategy

Investment
Cost
Damage to
Economic
Assets
Total Cost
Cost with
Monetization of
Population Impacts
Number of
Fatalities (K)
# of Yrs w
Inundation
# of Yrs w
Damages
# of Yrs w
Population
Impacts
# of Yrs w
Increase in
Defense Height
Mean $6,904.3 $455.9 $7,360.2 $8,580.2 17.61 4.83 3.21 3.21 1.60
Median $6,752.7 $345.0 $7,283.5 $8,219.6 13.24 4.00 3.00 3.00 2.00
Std Dev $590.3 $425.7 $501.0 $1,312.3 16.75 4.18 2.50 2.50 0.49

4
Results are for a 100-year time period simulated with 10,000 iterations. All costs are 2009 US$ millions and represent present values, computed at a 3 percent discount rate.
Population impacts are monetized at $169,960 per fatality and $4,250 per displaced person.
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in investment costs of $7.5 billion. In the case of Dhaka, however, the Inflexible Strategy is
marginally more costly than the Do-Nothing baseline (i.e., $12.0 billion versus $11.1 billion),
but the mix of costs is radically different between the two scenarios. The Inflexible Strategy
entails a much large investment in coastal protection, and in turn yields much lower inundation
damages and population impacts, than does the Do-Nothing Baseline.
The two real option strategies display strikingly different results. In both cities, the Sense &
Respond Strategy has higher aggregate costs than any other approach, including doing nothing.
It also entails the highest level of investment in coastal defense, but fails to deliver a sufficient
reduction in damages to offset the costs of such investments. Largely because the Sense &
Respond Strategy is reactive in nature, investments in protection tend to be made after property
damage and population impacts have already been experienced. In Dar-es-Salaam, for example,
the Sense & Respond Strategy is about $4 billion more costly that the next most expensive
strategy. In Dhaka, it is over $8 billion more costly.
By contrast, the second real option strategy the Predict & Respond Strategy delivers the
best result in Dhaka. While it does not have the best performance on any one parameter
investment cost, economic damages, or population impacts its aggregate performance outranks
all other scenarios. The result is somewhat different in Dar-es-Salaam, where the Predict &
Respond Strategy is essentially tied with the Inflexible Strategy as the second-best performing
scenario. In Dar-es-Salaam, all of the strategies are dominated by the Do-Nothing baseline,
owing to the balance of vulnerable assets and populations relative to the costs of protection.
That notwithstanding, if policymakers in Dar-es-Salaam choose to take action, then the Predict &
Respond Strategy offers results comparable to the Inflexible Strategy, and outperforms the Sense
& Respond Strategy.
It is also instructive to compute the value of flexibility by comparing the Inflexible Strategy
to the better-performing of the two real option strategies (i.e., the Predict & Respond Strategy).
For Dar-es-Salaam, given the model inputs, there is no value to flexibility both strategies
generate the same cost of $7.9 billion. In the case of Dhaka, however, there is substantial value
to flexibility, with the real option strategy costing $3.4 billion less ($8.6 billion versus $12.0
billion) than the Inflexible Strategy a savings of about 28%.
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In sum, depending on local circumstance, the Do-Nothing baseline may provide the optimal
result. In all cases, the second real option strategy (Predict & Respond) outperforms the first real
option strategy (Sense & Respond). It is also comparable to, or outperforms, the Inflexible
Strategy, which makes significant up-front investments in coastal defense, but does not always
yield reductions in economic damages and population impacts sufficient to offset those
investments. In addition, depending on local conditions, a flexible real option strategy may yield
substantial savings relative to an inflexible approach.
4.2. Results of Sensitivity Analyses
In order to better understand the potential value of flexible strategies for adapting to sea level
rise, we developed two alternative scenarios for model inputs, each of which was applied to the
simulation of inundation events in the two cities. The first scenario focused on changes in
conditions on the land-side of the coastal defense. For this scenario, asset values are assumed to
be both more variable and faster growing, with a mean of 5% and a standard deviation of 4% (as
opposed to, respectively, 4% and 2% in the base case). Population growth was assumed to be
more variable, with the two bounds of the triangular probability distribution extended by an
amount equal to half the initial minimum rate (which was 1.91% for Dar-es-Salaam and 0.76%
for Dhaka). The value of a statistical life, and by extension the value of a displaced person, was
increased by 50%. Finally, the cost of constructing and maintaining coastal defenses was
decreased by one-third, yielding a unit cost of $3,745 and an O&M cost of 2.67% of invested
capital. Taken together, this set of changes to the simulation inputs is meant to represent a
situation where the value of protection is both increased and made more variable while the cost
of that protection is lower.
The second alternative scenario focuses on the prospect of more significant climate change
than simulated in the base case. The mean global sea level rise is assumed to be 5mm/year rather
than 3mm/year, and the standard deviation is assumed to be 4mm/year, rather than 2mm/year. In
addition, the extreme value distribution for sea surges was adjusted to increase the probability of
more extreme sea levels. In particular, the scale factor (!) was increased by a factor of five, from
0.08 to 0.40 for Dar-es-Salaam and from 0.225 to 1.125 for Dhaka. The effect of this change on,
for example, Dar-es-Salaam is to raise the height of the 100-year event from 3.1m to 4.6m while
leaving the height of the 1-year event unchanged and the mean surge height about 0.2m higher.
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The height of the 100-year event in Dhaka is increased from 4.7m to 8.9m. Again, the height of
the 1-year event is unchanged; the mean surge height is about 0.5m higher.
In conducting the sensitivity analyses, no changes beyond those described above were made
to the model inputs. Each of the sensitivity scenarios was applied separately; that is, we did not
consider a case where both the land-side changes and climate changes were considered
simultaneously. Table 6 presents the highlights of the sensitivity analyses.
When it comes to the sensitivity analysis of land-side economic factors, we observe that costs
drop in both cities under all strategies, although not for the Do-Nothing baseline. In the Do-
Nothing baseline, there is no new investment in coastal defenses, so unsurprisingly the assumed
reduction in unit construction cost has no impact; instead, the increase in asset values and
populations means that inundation has a higher cost which, in turn, causes the aggregate cost of
the Do-Nothing baseline to rise. In all other scenarios, however, total costs decrease despite the
increase in vulnerability, suggesting that the unit protection costs are an important driver of the
analytic results. In turn, successful research into methods for constructing lower cost, yet still
effective, coastal defenses would be valuable.
When it comes to the sensitivity analysis of greater climate change, results for the two cities
differ markedly. Total costs do increase in both cities under all scenarios, an unsurprising result
owing to the increase in the height and frequency of storm surges, but the effect in Dhaka is
more pronounced than in Dar-es-Salaam. Under the Inflexible Strategy, for example, costs
increase by about 80% (from $7.9 to $14.2 billion) in Dar-es-Salaam, but in Dhaka, costs go up
by about 338% (from $12.0 to $52.6 billion). While cost increases are negligible for two of the
four scenarios in Dar-es-Salaam under greater climate change, costs in Dhaka rise by a factor of
about four in all scenarios, suggesting that vulnerability to higher seas is much higher in Dhaka.
Finally, the sensitivity analyses demonstrate the connection between climate change and the
value of flexibility. In Dar-es-Salaam, for example, we observe no value to flexibility in the base
case or in the sensitivity case where the land-side parameters are varied. In the face of more
significant and variable sea level rise, however, the value of flexibility jumps markedly, to $4.6
billion. The effect is even more pronounced in Dhaka, where the value of flexibility jumps from
$3.4 billion in the base case to over $15 billion in the sensitivity analysis where the climate
changes more significantly.
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Table 6
Sensitivity Analyses:
Total Cost by Scenario
5
Scenario

Dar-es-Salaam Dhaka
Base Case
Increased
Vulnerability
& Lower
Protection
Cost
Greater
Climate
Change
Base Case
Increased
Vulnerability
& Lower
Protection
Cost
Greater
Climate
Change
Do-Nothing
Baseline
$1.4 $1.8 $1.5 $11.1 $14.9 $43.5
Inflexible Strategy $7.9 $4.2 $14.2 $12.0 $6.4 $52.6
Real Option: Sense
& Respond Strategy
$11.8 $7.3 $11.8 $20.4 $16.3 $85.5
Real Option:
Predict & Respond
Strategy
$7.9 $4.3 $9.5 $8.6 $5.9 $37.5
Value of Flexibility
6
$0.0 $0.0 $4.6 $3.4 $0.6 $15.1


5
Results are mean values from a simulation of 10,000 iterations. All costs are 2009 US$ millions and represent the present value of costs incurred over a 100
years, computed at a 3 percent discount rate. Population impacts are monetized as described in the text.

6
Value of flexibility is defined as the maximum of $0.0 and the difference between the cost of the Inflexible Strategy and the cost of the Real Option: Predict &
Respond Strategy.
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4.3. Limitations of Our Analysis
Before moving to a discussion of our analytic results, it is important to quickly take stock of
some of the key limitations to our approach, virtually all of which originate in the simplifying
assumptions made in order to render the analysis tractable. Some of these assumptions relate to
the characteristics of the coastal defense where we assume that construction can be completed
within a single year, that land is readily available for the widening of the base of the defense
when its height is increased, and that the only pathway to inundation is from the over-topping of
the defense rather than its outright failure. When it comes to development patterns, we did not
simulate a behavioral link between policy decisions about coastal defense and the location
decisions of firms and residents. Presumably, a stronger coastal defense system would increase
the propensity to locate in lower elevations while a policy decision to minimize or defer
protection might induce some firms or residents to locate outside vulnerable areas. Finally, we
modeled climate change in a rather simple fashion by, for example, assuming a constant century-
long trend in the annual change in global sea levels (albeit with variability around that central
tendency), by assuming that local sea level change (i.e., either subsidence or uplift) is constant,
by assuming that the parameters underlying the extreme value distribution for characterizing
storm surges are constant, and by assuming no abrupt change in global sea levels as might be
caused, for example, by a sudden collapse of the West Antarctic Ice Shelf.
5. Discussion
5.1. Implications for Local Planning Decisions
Our analysis has several interesting implications for local planning initiatives to defend a
coastal city from rising sea levels. First, real option strategies that provide flexibility have the
potential to materially reduce aggregate costs. This cost advantage originates from two factors.
The first is that, in contrast to an inflexible strategy where the protection height is selected once
at the outset of the policy process, the flexible strategy holds out the chance that in some cases,
sea level rise may not be as significant as initially thought, or that the size of the vulnerable
assets and populations may be lower. In such cases, then, less robust defenses are needed and
investment costs can be lower than with an inflexible strategy. The second source of a flexible
strategys cost advantage comes from the opportunity to defer investment. If planners are able to
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postpone construction costs by even say, twenty years, then the present value cost drops by about
45 percent (at a discount rate of 3 percent).
In Dhaka, the value of flexibility is convincingly demonstrated in both the base case and the
sensitivity case for greater climate change where the Predict & Respond real option cuts costs
relative to the Inflexible Strategy by, respectively, $3.4 and $15.1 billion. Given Bangladeshs
2009 GDP of $208.6 billion (PPP), these savings are material (World Bank Databank, 2011).
Flexibility has less immediate value in the case of Dar-es-Salaam where the Predict & Respond
Strategy yields savings over the Inflexible Strategy only in the case of greater climate change
than simulated in the base case. In that instance, however, the value of flexibility is $4.6 billion
a not insignificant share of Tanzanias PPP-adjusted GDP of $57.9 billion (World Bank
Databank, 2011).
These results are consistent with traditional methods of valuing financial options in which
two of the important drivers of option value are the price of the underlying asset and the
volatility of that price. Increases in either parameter lead to higher option valuations (Hull,
2009). When it comes to sea level rise, the underlying real asset is the protection afforded by the
coastal defenses. As sea levels rise more quickly and large surges become more frequent as
seen in the sensitivity case where the mean annual rise is increased from 3mm to 5mm and the
Gumbel extreme value distribution is scaled up the value of protection increases, making the
real option more valuable. In addition, just like a stock option that becomes more valuable when
the price of the underlying stock becomes more volatile, the value of the real option for
protecting against sea level rise becomes more valuable when the standard deviation of the trend
in global sea level rise is doubled from 2mm/year to 4mm/year. The value of flexibility (i.e., of
the Predict & Respond Strategy relative to the Inflexible Strategy) is highest for both cities in the
sensitivity case with greater climate change.
Another implication of our analysis is that flexibility sometimes comes with a high price. As
clearly demonstrated by the Sense & Respond strategy, if a city postpones investments in coastal
defense until rising seas clearly threaten its existing defenses, it may end up waiting too long to
protect itself and may incur devastating inundations as a result. This risk therefore must be
balanced against the potential cost savings of delaying investments in protective measures.
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This finding underscores an important point: not all real option strategies are inherently
superior to inflexible strategies. The real option strategy must be structured so that the resolution
of uncertainty occurs with sufficient time to allow the option holder to make a well-reasoned
decision about whether to exercise the option. For example, a financial investor holding a call
option on a stock learns about the value of the underlying asset by observing the stock price on
the date of option expiration. He or she can then determine whether exercising the option would
be profitable. In contrast, if a local government holding a real option to increase the height of its
coastal defense learns about the value of the protection only in the aftermath of a catastrophic
flood, then the value of the flexibility must be decremented by the value of the losses incurred.
Finally, we observe that the quality of the information that is being obtained over time the
source of a real options potential to create value has an important bearing on the options
value. The superior performance of the Predict & Respond strategy for example is due, in large
measure, to the increasingly accurate prediction of sea levels over the 100-year analysis period.
In year 61, for example, local planners have 60 prior years of observation to better understand
the trajectory of global sea level rise. This information, however, never enters the decision
calculus under the Inflexible strategy.
Predictions of sea level rise do not, of course, come only from local planners. Indeed, the
scientific community has a vitally important role to play here. While projections of total sea
level rise over the next century are important to decisions about global climate policy, they are
only relevant to local planning decisions if an inflexible, single-investment, strategy is being
considered with the goal of constructing a coastal defense sufficient for a centurys worth of sea
level rise. If, on the other hand, local planners aspire to implement a cost-minimizing real option
strategy, then their information needs are markedly different from those of global policymakers.
The time period for which they need projections of sea level rise would be much shorter
perhaps only 20 to 40 years. Projections over longer time frames would not be needed, since
optional increases in sea level defenses can be used by planners in later years to address
subsequent sea level rise should it actually occur.
Another important piece of information that would enhance the local planning effort is the
rate of local sea level rise. Subsidence, caused either by human activity such as ground-water
withdrawal or by natural process, or increases in land elevation, caused by tectonic uplift or
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sediment deposition, can have a significant on the local consequences of global sea level rise.
The former would exacerbate global sea level rise while the latter would mitigate it. In
conducting the background research for this study, we discovered that reliable data on local sea
level rise in developing countries appear to be sparse.
Especially important for local planning efforts is not just the mean, or expected value, of
potential sea level rise in the next few decades, but also estimates of the nature and width of the
dispersion around the mean. Perhaps the largest challenge in using a real option approach to
constructing coastal defenses is the possibility that such defenses will be over-topped (because
they have been built to a lower height than under an inflexible strategy), leading to inundation.
With information on variability, planners can assess the risk of over-topping prior exercising the
option to raise the coastal defense and balance such risks against potential savings in protection
costs. If information is only available on the central tendency, and not the dispersion, of
expected sea level rise, then this balancing cannot be done.
5.2. Implications for Policy Makers
Beyond the relative economic merits of inflexible and real option strategies for adapting to
climate change, there also exist at least two pragmatic considerations that are relevant to the
choice between the two strategies. The first relates to the in-country institutional capability to
manage a real option strategy and the second involves the practical realities of international
development assistance for adaptation to climate change.
5.2.1. Institutional Capability to Manage a Real Option
The process of a managing a real option strategy is likely to be much more complex than
implementing an inflexible strategy. While ongoing maintenance of the coastal defense would
be needed in either case to prevent deterioration of its protective capability, the inflexible
strategy has a once and forget it character that is lacking for the real option strategy. With the
real option strategy, changes in local sea conditions and in the scientific predictions of future sea
level rise must be monitored on an ongoing basis. Changes in the value of economic assets and
vulnerable populations on the land-side of the defenses must also be regularly assessed in order
to re-calibrate the value of protection. In turn, sequential decisions must be made about whether
changing circumstances warrant a fortification of the coastal defense. If a decision to improve
the defense is taken, another series of activities must be launched: project design, bid
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solicitation, vendor selection, land acquisition (if needed), construction management, and so
forth. For the real option strategy to realize its potential value, the local planning authorities
must have the institutional capacity to execute all these activities successfully and to do so in a
timely fashion. If such capacity is lacking, the result may be an insufficiently robust coastal
defense structure.
5.2.2. Financial Resources for Future Exercise of Option
Beyond these institutional considerations, the use by a developing country of a real option
approach for structuring its investments in adaptation to climate change may have important
implications for international development assistance, such as that provided by the Global
Environment Facility or the UNFCCC Adaptation Fund. Unlike a one-off project to construct a
coastal defense structure, the real option approach contemplates capital investments on an
ongoing basis over several decades. Both funders and recipients of development assistance
would therefore need to address the question of how much funding is necessary and when it
should be disbursed. In short, the same uncertainty that makes the real option approach
attractive creates a dilemma for funders and recipients: the level and timing of funding needed to
exercise the option at various intervals would not be known until much later in time. In contrast,
an inflexible strategy that entails immediate construction of a coastal defense would likely be
more expensive than a real option strategy, but it has the advantage that it can be designed,
financed, and built in a relatively short timeframe.
Most multilateral financial mechanisms are funded in tranches that extend only over a few
years; it is easy to imagine that the need for funding to exercise an option could occur after funds
in a particular tranche have been exhausted. A recipient country might understandably be
reluctant to pursue a real option strategy if there were a chance that the funding for subsequent
improvements in the coastal defense would be unavailable. One alternative might be for the
funding source to put the monies in an escrow account that could be tapped at the recipient
countrys discretion, thereby creating the certainty of future funding to exercise the option. An
interesting codicil to this observation is that, owing to the possibility that the option will not be
exercised (if sea level rise, asset appreciation, or population growth is lower than expected), such
escrowed funds might never be needed. Policies and mechanisms for handling such
contingencies would need to be developed.
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6. Conclusion
6.1. Next Steps
The foregoing analysis suggests several possible avenues for future research. As mentioned
previously, addressing the subject of risk aversion, and whether and how it should be handled in
analyzing adaption to climate change is one area for further investigation. In addition,
addressing the limitations of the simulation model that were described in Section 4.3 above
would make for a more robust set of results, as would applying the model to other locations. We
also anticipate using the analytic framework to better understand the key scientific, economic,
and policy information that is needed to improve the quality of sequential decision making about
adaptation to rising sea levels. Doing so would, in turn, allow us to characterize the economic
value of research to improve the quality of that information. Finally, an understanding of the
degree to which findings drawn from the field of sea level rise can be generalized to adaptation
to other types of climate impacts would be valuable.
6.2. Summary
Developing countries face large potential costs for adapting to climate change and must make
investment decisions in the context of limited resources and competing development priorities.
Accordingly, investment strategies that minimize such costs are particularly valuable. This
analysis demonstrates that, at least with respect to sea level rise, framing and valuing adaption
decisions as real options has the potential to materially reduce costs to developing countries.
This finding is not a universal one because, in some cases, the local relationship among sea
levels, coastal features, protection measures, and vulnerable assets and population means that
there is little value to be gained with a flexible approach. That said, in some locations and under
conditions of high uncertainty, the flexibility to postpone even some adaptation investments until
more information is obtained and uncertainty is reduced, can create substantial cost savings. The
analysis also points to certain types of information as particularly valuable for decision makers,
such as predictions of sea level rise over two or three decades rather than a century or more, an
estimate not just of the central tendency of future sea level rise but also about the potential
variability of that estimate, and the rates of local sea level rise for specific locations. Finally, we
observe that despite the potential economic value of real option strategies, several policy and
institutional issues must be addressed before such potential value can be realized.
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