Avoiding poor investment outcomes with real options

The Department of Treasury and Finance recently released technical guidelines on real options analysis (technical guidelines). This is a great innovation from the Victorian Government. Unfortunately, real options analysis can appear complicated. This Aither insight provides some practical advice on how to realise the potential gains from real options analysis.

The Victorian Government’s Investment Management Standard requires that “if the uncertainty identified is significant, and the proposal is asset-related, the Department of Treasury and Finance expects departments to undertake real options analysis to inform business case development”.

There is a strong rationale for this requirement. The future is difficult to predict and even seemingly sound investment decisions can turn out badly, adversely affecting community wellbeing and reputations. This is especially relevant with substantial lumpy infrastructure investments. Real options analysis can reduce the probability of making investments with poor outcomes.

We have seen the practical value of real options analysis in our work on urban water and coastal adaptation. With real options analysis we are able to capture the value in deferring the construction of infrastructure (such as seawalls or desalination plants) until further information about the extent of climate change becomes available. This reduces the likelihood of building infrastructure that is not required, often generating large savings. This is not possible under traditional approaches.

Real options analysis is relevant for investments with the following characteristics:

• flexibility (such as the ability to defer or stage the investment)
• unrecoverable costs
• sufficient uncertainty (the outcomes could be positive or negative, depending on which future eventuates)
• learning (uncertainty is reduced over time)
• How can real options analysis be implemented?

The detailed implementation of real options analysis is unavoidably technical. Decision trees are a good option for problems with a small number of decisions, uncertainties and time periods. Aither’s optimisation models can account for small and large real options problems, seamlessly incorporating flexibility, unrecoverable costs, learning and uncertainty.

While the detailed implementation of real options analysis requires economic expertise, communicated effectively, the insights should be intuitive and accessible to a general audience.

Real options analysis has the potential to help governments make appropriate investments at the right scale and right time, potentially avoiding billions of dollars of costs at the national scale.