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Application of Finance Theory and Real Option Techniques to Public Sector Investments Made Under Uncertainty: Research & Development and Climate Change Open Access

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These essays are thematically linked to a core question: How can real option techniques improve the quality of government decisions about mitigation of and adaptation to climate change? Real option analysis is well suited to situations in which substantial uncertainty exists about future conditions and where managerial flexibility exists to postpone decision making until a point in time when at least some of the uncertainty is resolved. Because it can avoid premature commitment to an investment that, with hindsight, might have been ill-advised, or can create the possibility of a significant upside in the future that may not have been initially available, the flexibility embedded in a real option can have significant value. Moreover, traditional cost-benefit analysis techniques may fail to capture the value of such flexibility. The first essay explores whether real options analysis can improve the decision-making process when it comes to investments in measures to adapt to climate-driven sea level rise in developing countries and shows that a real option strategy has the potential to increase the benefits of proactive adaptation. Results prove to be location-dependent, underscoring the need for location-specific analysis. The second essay contrasts a real options paradigm to more traditional net present value (NPV) methods for group of 19 public-sector research and development (R&D;) projects. The two methods produce significantly different results, with the real option technique valuing these projects between 43 and 255 percent higher than the NPV method. Project rankings also differ markedly between the two methods.The third essay applies a portfolio perspective when valuing public sector investments in research and development, rather than looking at individual R&D; projects in isolation of one another. The R&D; projects studied in Essay #2 are re-analyzed from a portfolio-level, rather than project-level, perspective. Incorporating project relationships appreciably changes the estimated risk of the aggregate portfolio investment, especially when it comes to relationships among projects that are caused by other variables (such as correlations in the price of fuel types) that may not be immediately apparent from inspection of a set of R&D; projects.

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