Benefits and Limitations of Real Options Analysis for the Practice of River Flood Risk Management

Decisions on long-lived flood risk management (FRM) investments are complex because the future is uncertain. Flexibility and robustness can be used to deal with future uncertainty. Real options analysis (ROA) provides a welfare-economics framework to design and evaluate robust and flexible FRM strategies under risk or uncertainty. Although its potential benefits are large, ROA is hardly used in todays' FRM practice. In this paper, we investigate benefits and limitations of a ROA, by applying it to a realistic FRM case study for an entire river branch. We illustrate how ROA identifies optimal short-term investments and values future options. We develop robust dike investment strategies and value the flexibility offered by additional room for the river measures. We benchmark the results of ROA against those of a standard cost-benefit analysis and show ROA's potential policy implications. The ROA for a realistic case requires a high level of geographical detail, a large ensemble of scenarios, and the inclusion of stakeholders' preferences. We found several limitations of applying the ROA. It is complex. In particular, relevant sources of uncertainty need to be recognized, quantified, integrated, and discretized in scenarios, requiring subjective choices and expert judgment. Decision trees have to be generated and stakeholders' preferences have to be translated into decision rules. On basis of this study, we give general recommendations to use high discharge scenarios for the design of measures with high fixed costs and few alternatives. Lower scenarios may be used when alternatives offer future flexibility. Plain Language Summary Worldwide, large amounts of money are needed to protect growing populations against increasing flood risks. Decisions on flood risk management measures are often difficult because the future is uncertain, resulting in possible over- or underinvestments. Integrating flexibility or robustness in the decisions are two different ways to deal with this. Real options analysis (ROA) can help to design and evaluate robust and flexible strategies but is hardly used. We examine benefits and limitations by applying ROA to a realistic case study in the Netherlands. We develop robust dike investment strategies and value the flexibility offered by room for the river measures. The ROA for the realistic case study needs a high level of geographical detail, a large number of future scenarios, and the inclusion of stakeholders' preferences. Limitations are the complexity, the recognition and quantification of uncertainty, and the mapping of possible decisions in time. ROA provides relevant insights for policy makers which can not be reached with standard cost-benefit analysis: first: use high scenarios for the design of measures with high fixed costs (like dikes), and second: the value of flexibility due to room for the river measures increases with uncertainty.