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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (
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: !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 :
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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 <
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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 =
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. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 >
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, ! ! " # $ #% $ #&$' $ % $& #(% $ ) $!&
where n is the period over which the investment is analyzed, C i is the capital expenditure in year i, O i is the operation and maintenance cost in year i, E(D i ) is the expected value of the residual 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 ?
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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 @
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
!"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %& 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %% 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %( 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %: 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). !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %; 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 %< 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,
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Figure 4 Simulation of Sense & Respond Strategy
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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).
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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. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (> 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%. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (? 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. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 (@ 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. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 :& 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. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 :% 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 :( 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. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 :: 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 :; 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 !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 :< 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. !"# %&' (&%% )*"+, - ./* 012314 567# 8"91 := 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. 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