The Use of Real Option Approach for the Evaluation of Climate Investments

Climate finance refers to flows of resources or funds for activities related to combating climate change, i.e., reducing greenhouse gases (GHGs) emissions or adapting to climate change. This definition can cover many types of investment, and indeed their number is increasing in the fields of both mitigation and adaptation. Such investments entail numerous uncertainties and therefore risks, which can sometimes be reduced. In many cases, uncertainties persist to a large extent as regards to future cash flows. These investments can be assessed using financial methods that take their specific aspects into account, i.e., considering the stochastic behavior of significant variables such as the price of emission allowances, electricity prices in the case of renewables, fossil fuel prices if the project involves replacing or reducing the output of such fuels, sea level rise (SLR) in some adaptation cases, temperature increases, the risk of default on projects, exchange rate risks, uncertainty in the cost of investment and other case-specific factors.Firms that invest in projects of this type clearly expect returns in proportion to the risks that they run.This chapter uses a number of examples to demonstrate the application of techniques developed in the field of finance to valuing investments classified as climate finance. The chapter specifically deals with real option (RO) approach. This approach is tailored specifically to valuing irreversible investments under conditions of uncertainty and can include the case of projects with risk of default.The examples here use market quotes for the variables included in the analysis whenever such information is available.The results show that it is important to factor uncertainty into the valuation of almost all types of investment, but especially so in the case of climate finance investment.