Risk, Uncertainty and Real Options

We make many choices in daily life that are subject to uncertainty, and this can often manifest as a risk that objectives are not reached or that harm occurs. Sometimes these uncertainties and risks can be understood and managed in relatively simple ways; perhaps through Quantitative Risk Analysis or Monte Carlo simulation. At Naiad, we can help clients determine the most practical and powerful way to carry out their risk management, and combine them with traditional Net Present Value (NPV) or Internal Rate of Return (IRR) models if this is appropriate.

Risk evaluation is particularly challenging however when working with natural environments and systems, which show significant complexity and uncertainty in many aspects including details about remote, inhospitable or even buried locations. Many investment decisions in physical infrastructure and the environment depend on assumptions about these parameters, and where the performance of the investment is sensitive to these assumptions then the investor is exposed to a risk. Such risks may influence either revenues – such as whether there is sufficiently consistent and strong wind flow to generate electricity at a wind farm – or they could influence costs, such as whether a more expensive type of foundation is required due to unstable ground conditions. Uncertainty about the natural environment also affects the regulatory bodies assessing these investments, who must decide the likelihood of adverse environment impacts being caused by the proposed works when they are considering applications for permits and setting their conditions.

photo of wind farm with uncertainty in wind power generation

Traditional NPV-based approaches to project appraisal and risk management assume a purely deterministic management model where decisions are optimised based on the best available information today. However, where uncertainty and variability are significant, then NPV ignores the ability of managers to respond to new information and adjust an investment – perhaps by scaling the investment up or down, or pulling out entirely. If investments can be designed in a way that allows managers to observe, learn and respond to new information acquired over the entire project lifecycle, then they may prove to lead to better decisions being taken. Real Options therefore attempt to incorporate the value of managerial choice, learning and flexibility into project financial appraisal, by representing a whole spectrum of future possibilities and pathways but only allowing the most advantageous ones to be explored.

There are several ways this flexibility can be manifested, but the most common ones are the option to defer, the option to withdraw and the option to expand. Real Options allow modellers to represent these choices, which managers commonly have during the lifecycle of an investment. For example, it may be uncertain whether land will be re-zoned or designated for development in the future. By purchasing today, an investor acquires the option to develop if that re-zoning takes place. The investor therefore needs to know the value of that option today, in order to decide whether to buy the land at today’s price.

A common focus of Real Options studies is on uncertainty in factors that are ‘external’ to a project, such as energy demand, commodity prices or environmental policies, and the use of RO to decide whether to undertake some form of the investment given these uncertainties. However some more recent examples, both academic and applied, have addressed the use of Real Options to manage ‘technical uncertainty’ on the cost or supply-side of projects. For example, Botin et al (2014) applied this concept to mine planning by considering uncertainty in the parameter of ‘dilution’, the contamination of mined ore with non-excludable waste.

Fundamentally, wherever there is scope for value to be created by flexibility and learning in an environment of uncertainty or volatility, Real Options is likely to be able to show advantages over pure NPV in project appraisal. However, the techniques used in RO are derived from financial options valuation and therefore need to be applied with care to real investments and projects. There are particular complications in assessing factors such as volatility and the appropriate cost of capital, which are unambiguous in financial assets but more problematic in real assets.

If you are considering making use of Real Options analysis in your infrastructure or environmental project, please contact Naiad Infrastructure via the contact form on our home page, or email our Principal Consultant directly atian@naiadinfrastructure.com