Using real options analysis to evaluate the impacts of climate change on water security

In this paper the applicability of using Real Options Analysis to understand and measure the impacts of strategies deployed to counter the effects of climate change in a river catchment, are explored. The advantages of Real Options Analysis over the traditional discounted cash flow approaches are detailed. In addition, two limitations of the approach (the problems associated with assessing the very long time periods involved in climate change and the lack of estimated probabilities with which to assess various options) are identified. In terms of assessing the long term impacts of climate change, it is suggested that the analysis should be split into three manageable time horizons of 30 years each. While the results of doing this are not strictly comparable with the current ideas of a discounted cash flow, they are internally logically consistent with a Real Options Analysis and as a consequence should afford policy makers with the opportunity of comparing strategies. With respect to the problem of not having an objective measurement of the probabilities of climate events occurring, it is believed that incorporating the output of a dynamically downscaled global climate model into the yield function of the analysis may prove beneficial. Thus, any uncertainty is internalised and can be simulated directly on the outputs. The method outlined in this paper will be applied to evaluate water security in the Krishna Basin in India.