Real options analysis is an approach to investment planning, appraisal and management, specifically targeted at reducing the risk of investment regret in an uncertain environment, as a way of creating more value. The uncertainties may relate to, for example, demographics, socio-economic conditions, environmental factors, policy and legislation, or technology changes. The real options may include changes in the timing of a project by delaying or staging investment until there is greater certainty, changes in the scale of a project by expanding or reducing capacity to suit changes in demand, switching inputs or outputs to suit changes in demand or supply, abandoning a project, and increasing design flexibility to add greater resilience.
While sometimes seen as an alternative to conventional cost benefit analysis, a real options approach can be complementary. In operational terms, a real options approach may, for example, see a more phased or staged implementation of a project, thereby reducing the present value of the project costs. If the phases or stages of the project are not needed until later, this means that there won’t be much (if any) reduction in the present value of the associated benefits, thereby increasing the present value of the project’s net benefits.
The greatest value can often be delivered through applying real options thinking to a problem. It can assist identifying the problem to be addressed by considering the uncertainties over an investment’s entire life cycle rather than based only on current conditions, and to identify a broader range of options to address the problem that provide more flexibility over time than would be offered through a conventional range of options.
We have applied real options analysis or thinking to a range of problems in uncertain environments including the development of R& D strategies and portfolios, climate change adaptation and mitigation, and long-term investments in infrastructure and defence projects. The underlying thinking about real options also has potential application for both disaster and countering violent extremism (CVE) preparedness.