Scholarly article on topic 'Planning Flood Risk Infrastructure Development under Climate Change Uncertainty'

Planning Flood Risk Infrastructure Development under Climate Change Uncertainty Academic research paper on "Economics and business"

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Abstract of research paper on Economics and business, author of scientific article — Nishtha Manocha, Vladan Babovic

Abstract Policymakers and engineers today are faced with a difficult task of planning for large scale infrastructure that can cater to the climatic and socio-economic changes that the future will bring. As the performance of these large infrastructure systems is sensitive to uncertain climatic parameters, it becomes difficult to “lock-in” a particular capital intensive and rigid infrastructure system as the best solution to tackle climate change. To address this problem, a new approach based on adaptation pathways and adaptive policy making approach is increasingly gaining traction. It enables decision makers and engineers to address unforeseen uncertainties by adapting the system consistently to new futures as they unfold. Albeit this approach provides an overview of the different available options, it does not help to choose the best pathway that should be followed in current time to deal with uncertainty. This study extends this approach; by identifying the preferred pathway that should be selected from the range of possible developed pathways. The methodology employed also highlights the benefits of using Real Options Assessment as a valuation tool capable of quantifying the value of flexibility that new design concepts instil in infrastructure systems.

Academic research paper on topic "Planning Flood Risk Infrastructure Development under Climate Change Uncertainty"

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ScienceDirect Procedia

Engineering

ELSEVIER Procedia Engineering 154 (2016) 1406 - 1413

www.elsevier.com/locate/procedia

12th International Conference on Hydroinformatics, HIC 2016

Planning Flood Risk Infrastructure Development under Climate

Change Uncertainty

Nishtha Manochaa, Vladan Babovicb*

a,bNational University of Singapore, 21 Singapore 119077,Singapore.

Abstract

Policymakers and engineers today are faced with a difficult task of planning for large scale infrastructure that can cater to the climatic and socio-economic changes that the future will bring. As the performance of these large infrastructure systems is sensitive to uncertain climatic parameters, it becomes difficult to "lock-in" a particular capital intensive and rigid infrastructure system as the best solution to tackle climate change. To address this problem, a new approach based on adaptation pathways and adaptive policy making approach is increasingly gaining traction. It enables decision makers and engineers to address unforeseen uncertainties by adapting the system consistently to new futures as they unfold. Albeit this approach provides an overview of the different available options, it does not help to choose the best pathway that should be followed in current time to deal with uncertainty. This study extends this approach; by identifying the preferred pathway that should be selected from the range of possible developed pathways. The methodology employed also highlights the benefits of using Real Options Assessment as a valuation tool capable of quantifying the value of flexibility that new design concepts instil in infrastructure systems.

©2016 Publishedby Elsevier Ltd. Thisisanopenaccess article under the CC BY-NC-ND license

(http://creativecommons.org/licenses/by-nc-nd/4.0/).

Peer-review underresponsibilityofthe organizing committeeofHIC2016

Keywords: Real Options; Adaptation Pathways, Uncertainty, Climate Change

CrossMarl

* Corresponding author. Tel.: +6565163610; E-mail address: nishtha.m@u.nus.edu

1877-7058 © 2016 Published by Elsevier Ltd. This is an open access article under the CC BY-NC-ND license

(http://creativecommons.org/licenses/by-nc-nd/4.0/).

Peer-review under responsibility of the organizing committee of HIC 2016

doi:10.1016/j.proeng.2016.07.511

1. Introduction

Traditional water resources planning and analysis methods are based on requirements that are unrealistically deterministic [1] Under such considerations, the most common practice consists of three phases. First, the 'best estimates' of the future are outlined based on central estimates of climate change and extrapolations of current socio-economic scenarios [2]. Then, according to those predictions, system designers generate design concepts and select design parameters that enable the system to perform optimally under the predictions. Economic evaluation of the design is then conducted, of which standard methodology, like discounted cash flow (DCF) analysis, optimization, and scenario planning, is applied to achieve the best optimal design [3]. Essentially, this approach that civil engineers use to design infrastructure for the future can be summarized as "predict then build". Thus these built systems only cater to a specific subset of possible futures. If the realized future is different from the most likely scenario identified in the first stage of the planning process, the system will most likely to fail to meet its specified objectives.

In response to deeply uncertain nature of this planning paradigm, various approaches have been developed over the years to help engineers and policy makers to build robust, adaptive plans. One such approach based on adaptation pathways and adaptive policy making approach is increasingly gaining traction. The development of dynamic adaptive pathways provides a sequencing of promising actions that can be used by decision makers as a guideline for making decisions under uncertainty. It provides information on which actions and decisions should be taken now, which can be deferred, to ensure that the preferred pathway can be followed and the predefined objectives can be met [4]. Albeit this approach provides an overview of the different available options, it does not help to choose the best pathway that should be followed in current time frame to deal with uncertainty.

To make investment decisions for infrastructure, a large part of the decision process involves the assessment of the economic feasibility of the project. Large infrastructure projects such as those required for water management on a citywide scale, have implementation costs that amount to millions of dollars. The above stated approaches enable engineers and decision makes to shortlist a subset of the solutions required to battle climate change from a scientific perspective but give little guidance on their economic feasibility.

This paper aims to extend the adaptation pathways and adaptive policy making approach, by valuing the different pathways developed. It is necessary to determine the preferred pathway or the baseline pathway, as decision makers have to select one option (among the multiple available ones) to implement at current time. Pathways that are not selected in the current time frame remain active as options in case the future turns out to be incompatible with preferred plans. To account for the uncertainty and to value the flexibility generated by the Dynamic Adaptive Policy Pathways (DAPP) approach, the assessment is undertaken employing Real Option Analysis [5-7]. A NPV assessment is done to compare the benefits of using ROA over NPV.

2. Why Real Options

The traditional approaches that are used in the economic valuation of infrastructure projects such as Discounted Cash Flow (DCF) based approaches, including Net Present Value (NPV), Cost Benefit Analysis (B/C ratio) Internal Rate of Return (IRR), and payback period, are inherently flawed to analyses projects with future uncertainties. In particular, Net Present Value, the central paradigm for decision making of large investments, is constrained to pre-committing today to a go or no-go decision. It uses information only available today [8] thereby, systematically under-valuing projects that include future decisions stages. By assuming one cash flow scenario from the beginning, NPV rules out the possibility of these adaptations and therefore, does not take into account the value creation of flexibility.

Real Options Analysis (ROA) is able to take in into account and value uncertainty and flexibility. Choosing a different pathway at a time in future when more information about the uncertain driver is available, allows one to limit the downside of making a wrong decision, and capture the upside of new information and opportunities. This flexibility can be translated into an economic gain which can be captured by ROA. A Real option is 'the right—but not the obligation' to adjust the infrastructure system in ways likely to be more resilient, and continue to function as expected in the face of change. As such, these options represent physical choices about the system that can provide the flexibility to deal with uncertainty. There are two types of real options: real options

"on" and system and real option "in" a system [3]. The notion of real options "on" a system lies closer to the financial options foundation of real options [9-11] and includes options to defer or abandon a project, or switch to another project. Real options "in" a system are built into the design of a system, for instance making allowance for future expansion, and require thorough engineering knowledge.

To demonstrate the value of using real options in the selection of a preferred pathway, adaptation pathways developed for a hypothetical case study, called the Waas [2] were used as a starting point.

3. Methodology

The Waas case study [2] was inspired by a river reach in the Rhine delta of the Netherlands (the river Waal). Over the past few years, there were two flood events, which flooded four dike rings in total. The total damage over the past 25 years was estimated to be 2,810 billion Euros. The Waas population considered the first flood event as a matter of bad luck that could be prevented in the future by means of control and engineering policies. After the second flood, people realized that climate change may have an influence, and that a control approach may not be sufficient to guarantee safety in the long run. Thus there arose a need to develop flood prevention policies. At the starting point policies were required to be designed in such a manner so as to improve the state of the system in a manner that the future adverse impacts are reduced or prevented. Subsequently, future policies would be based on how the future unfolds wherein policies can be implemented in each time step.

As a part of the Wass case study, policy options to be considered were designed based on existing plans and potential strategies for flood management in the Netherlands. The following flood risk measures were considered in the study:

Table 1 : Flood Risk Measures considered, Wass case study. Abbreviation Description

DH500 Dike height rise to be able to cope with the 1:500 discharge based on measurements

DH1000 Dike height rise to be able to cope with the 1:1000 discharge based on measurements

DH1.5 Dike rise: adapting to 1.5 times the seconf highest discharge ever measured ('rule of thumb measure')

RfRl 'Room for the river'-Large scale: with extra side channels, the river has more space after a threshold discharge is exceeded

RfRs 'Room for the river'-Small scale: with extra side channels, the river has more space after a threshold discharge is exceeded

An Integrated Assessment Meta Model was developed to assess the performance of these policies in three climate scenarios (established by the Royal Dutch Meteorological Institute) and ten transient scenarios. The three scenarios included:

• The G which has a temperature rise of 1°C in 2100, the wintertime precipitation increasing by 3.6% and the mean summer precipitation increasing by 2.8%.

• The Wp scenario has a temperature rise of 2°C, winter-time precipitation increasing by 14.2%, but the mean summer-time precipitation decreasing by 19%.

• No climate change

For flood management considering a limit for the total damage the sell-by date of each policy option was determined. Pathways over a time frame of 100 years were then generated by using the sell-by date and based on the assumption that, if a policy option no longer meets the targets, it would be necessary to add, or to shift to another policy option [2].

As a result of the study, the following adaptation map was developed:

O 25 30 AO SO 60 TO SO 90 10O

Transfer station to new policy ^^^ Policy effective in all scenarios

| Adaptation Tipping Point of a policy (TerTninal} ~ * Policy not effective in Wp scenario

Fig. 1. Adaptation pathway map for flood management based on the median value for the sell-by date of policy options for all climate realizations in a Hierarchist world. The map indicates several possible routes to get to a desired point (target) in the future Similar to a Metro Map the circles

indicate a transfer station to another policy. The blocks indicate a terminal station at which an Adaptation Tipping Point (ATP) is reached. Starting from the current policy, targets are not achieved after 25 years. After this ATP several options are left, which also have an ATP. In some situations an ATP is only reached in the Wp scenario. After this point targets are only achieved in the case of the no climate change or G scenario (dashed line). After switching to a new policy, the combined effect is different and often delays the moment of an ATP. In such cases more routes via the same policy are indicated with lines in the same color. For policy option abbreviations, see Table 1 [2]

This paper aims to extend the adaptation pathways and adaptive policy making approach, by valuing the different pathways developed. It is necessary to determine the preferred pathway or the baseline pathway, as decision makers have to select one option (among the multiple available ones) to implement at current time. Pathways that are not selected in the current time frame remain active as options in case the future turns out to be incompatible with preferred plans. To account for the uncertainty and to value the flexibility generated by the Dynamic Adaptive Policy Pathways (DAPP) approach, the assessment is undertaken employing Real Option Analysis. A NPV assessment was done to compare the benefits of using ROA over NPV.

The above developed pathways are used as a starting point of this study. Deconstructing Fig. 1, there are 14 possible pathways that can be followed. Please note, mound, floatH and FaC were not considered for the ROA.

Table 2. Available Pathways

PATHWAY STEPS INVOLVED PATHWAY STEPS INVOLVED

1 A 5a MD

2 HB 5b MJB

3a EC 5c MGC

3b EIB 5d MGIB

4a KC 5e MLC

4b KIB 5f MLIB

4c KF 5g MLF

This is explained in detail in the following table:

Table 3. Definition of individual actions in a pathway

OPTION START YEAR END YEAR

A DH 1.5 24 99

B DH 1.5 65 99

C DH 1.5 57 99

D DH 1.5 30 99

E DH 500 24 56

F DH 500 57 99

G DH 500 30 56

H DH 1000 24 64

I DH 1000 57 64

J DH 1000 30 64

K RFRLarge 24 56

L RFRLarge 30 56

M RFRSmall 24 29

Borrowing concepts from the options analysis developed in finance [9] we can apply them to undertake a Real Options Analysis for management of infrastructure systems [12].

Real Options theory views investment opportunities as rights but not obligations. ROA assumes that if one could find a financial option similar enough to the investment opportunity at hand, then the value of the option would approximate the value of the opportunity. Since investment opportunities are usually complex and unique, it is difficult to find an option in the financial market that resembles the investment opportunity; therefore ROA constructs synthetic options that allow the valuing of real investments through arbitrage opportunities. For this to work a there needs to be a correspondence between the investment's characteristics and the variables that determine the price of a financial option. Fig. 2 shows the correspondences making up the fundamental mapping.

Mapping art Investment opportunity onto a Call Option

Investment Opportunity Variable Call Option

FYesent value of a project's operating asieti to acquired 5 Stock price

Expenditure required to acquit« the project assets X Exercise price

Lengtn of ilrni ine decision may be deferred — t Time to expiration

Time value of money — 7 Risk-fre^ rate of return

Riskiness of the project assets — i Variance of returns on slock

Fig. 2. Mapping an Investment Opportunity onto a call option (Luehrman 1998) In this study, the real options assessment was carried out using the Black-Scholes Model.

4. Results and Discussions

The cost and benefit data was provided by the author of the Waas case study. The data was available for 3 climate realizations (G, Wp and No climate change) and an average climate realization (All).

NPV analysis for all scenarios is presented in the Fig 3. Please note that the green boxes indicate the best choice based on the employed methodology.

Fig. 3. NPV: All, No CC and G Scenario

Based on the NPV decision rule, the results indicated that all the options could be recommended as appropriate adaptation measures as they all have a positive NPV. This was expected as the initial steps of pathways development already screened out the economically unviable alternatives. Selection of one alternative among the array available is based on maximizing the NPV. The above figures show that in the scenarios No CC, G and Wp, pathway 3a would be the best candidate to be selected for as the preferred pathway. However the NPV performed on the average scenario, identifies path 1 as the preferred pathway.

On performing a real options assessment, the following results are obtained:

Fig. 4. Results of Real Options Assessment

Fig. 4 shows that performing real options assessment, has led to the change in the selection of the preferred pathway. The performance of Pathway 5d is most preferred when uncertainties are accounted for.

As seen in NPV analysis, the use of an average scenario for the assessment does not give the same results as using separate climatic scenarios. This highlights the flaw of averages.

In comparison to the NPV, the value of the pathways assed by Real Options increases significantly for all scenarios. The results of Scenario G are shown below for reference.

Comparlslon of NPV and Options Evaluation, Scenario G

12,000

1 2 3a 3b 4-a 4b 4c 5a 5b 5c 5d 5e 5f 5g

Pathways

Fig. 5. Comparison of NPV and Options Evaluation, Scenario G

The additional value that is depicted in the real options comes from 2 sources, namely the time value of money and the flexibility of the options.

Due to the long time frame over which the assessment is carried out, and the large sum of money in question, the additional value generated accumulates to the values shown. The value of flexibility generated by using real options assessment is captured in the following figure:

Fig. 6. Value of Flexibility

The above shows that in this case, the highest flexibility that can be embedded in the cash flows of the project arise on selection of pathway 5d as the preferred pathway. This pathway entails the creation of a small room for river which can then if required be coupled with increasing the dike height to cope with the 1:500 discharges, 1:1000 discharge and eventually increase the height to adapt to 1.5 times the second highest discharge measured.

It is thus evident that there is a lot of "lost value" that is missed out on when using the standard NPV instead of ROA

5. Conclusion

The development of dynamic adaptive pathways provides a sequencing of promising actions that can be used by decision makers as a guideline for making decisions under uncertainty. It provides information on which actions and decisions should be taken now, which can be deferred, to ensure that the preferred pathway can be followed and the predefined objectives can be met [4]. Albeit this approach provides an overview of the different available options, it does not help to choose the best pathway that should be followed in current time to deal with uncertainty. This study aimed to extend the DAPP approach; by identifying the preferred pathway that should be selected from the range of possible pathways developed using the DAPP approach. It is necessary to determine the preferred pathway or the baseline pathway, as decision makers have to select one option (among the multiple available ones) to implement at current time. Pathways that are not selected in the current time frame remain active as options in case the future turns out to be incompatible with preferred plans. To account for the uncertainty and to value the flexibility generated by the DAPP approach, the assessment is undertaken employing Real Option Analysis. ROA is able to take in into account and value uncertainty and flexibility, as opposed to traditional approaches of economic valuation. Choosing a different pathway at a time in future when more information about the uncertain driver is available, allows one to limit the downside of making a wrong decision, and capture the upside of new information and opportunities. This flexibility can be translated into an economic gain which can be captured by ROA.

Acknowledgements

We would like to thank the Institute of Water Policy, Singapore for their support in undertaking this study. References

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