The use of real options valuation methodology in enhancing the understanding of the impact of climate change on companies

Abstract

Climate change has in recent years gathered traction on the business, political and social agenda. From the business perspective, research has shown that climate change impacts on company value are uncertain, signifi cant and strategically important. The challenge therefore is for the business community to apply fi nancial valuation models that support the incorporation of the climate change impacts in strategic planning. However, the commonly used discounted cash fl ow techniques in capital budgeting are seen as failing to address the high levels of uncertainties inherent in climate change impacts. Real options thinking has been touted as having the potential to enhance understanding of these impacts via its direct handling of uncertainty, although not much research has been done to demonstrate this. Using an illustrative case study, this research presents an argument for introducing the real options approach, a new method for valuing options of future strategic action by companies in a setting that exhibits climate change impacts. The objective of this research is to contribute to the literature on strategic tools for addressing climate change and ultimately offer some management insights that can narrow the gap between fi nance theory and business practice.

Corporate Strategies for Managing Climate Risks

“…While research into organizational responses to climate change has found that companies are increasingly becoming aware of risks related to greenhouse gas emissions, and many take appropriate response measures (e.g. Kolk and Pinkse, ; Jeswani, Wehrmeyer and Mulugetta, ; Brouhle and Harrington, ; Pinkse and Kolk, ; Tyler and Chivaka, ; Weinhofer and Hoffmann, ; Vespermann and Wittmer, ; Lee, ), our study focuses on the corporate management of climate risks. Our case studies illustrate that the degree of concern over the physical effects of climate change varies between companies.…”

The Effects of Climate Change Policy on the Business Community: A Corporate Environmental Accounting Perspective

“…First, it aims to assist policymakers, investors and managers of corporations in improving their understanding of the link between climate change policy commitments and the corporate response to them. This is in line with a number of authors highlighting the need for such information for improving the decision‐making of managers, investors and policy‐makers for climate change related issues (Pfeifer and Sullivan, ; Tyler and Chivaka, ).…”

“…This information is important for corporations to design essential GHG management practices as well as for public policy entities to improve their knowledge of the effectiveness of their climate change policies on corporate behavior. The success of these accounting models requires suitable financial valuation techniques to determine the effects of climate change on firms' assets (Tyler and Chivaka, ). However, the present informal nature of accounting standards and the differing types of financial and non‐financial information used by current accounting models make the use of such models untrustworthy and complicated for both corporations and public policy entities.…”

Capital budgeting practices: A comparative study between a port company in Brazil and in Spain

“…Other techniques, such as real options valuation have been indicated as having potential to enhance the understanding of impacts by handling uncertainties directly (Tyler and Chivaka, 2011). Studies have shown that companies are reluctant to use real options valuation (Peel and Bridge, 1998;Sandahl and Sjogren, 2002;Block, 2003;Hermes et al, 2007and Truong et al, 2008, although a recent study conducted by Hall and Millard (2010) showed that this methodology is often used in South African companies.…”