Elsevier

Journal of Environmental Management

Volume 161, 15 September 2015, Pages 144-152
Journal of Environmental Management

Review
Real options analysis for land use management: Methods, application, and implications for policy

https://doi.org/10.1016/j.jenvman.2015.07.004Get rights and content

Highlights

  • We review the literature on Real Options Analysis (ROA) in land use investments.

  • ROA is more realistic than net present value in land use change cost estimation.

  • The complexity of ROA methods have been a barrier to their adoption.

  • New simulation methods offer potential for overcoming current technical challenges.

  • We illustrate this potential with a ROA application to a land use policy simulation.

Abstract

Discounted cash flow analysis, including net present value is an established way to value land use and management investments which accounts for the time-value of money. However, it provides a static view and assumes passive commitment to an investment strategy when real world land use and management investment decisions are characterised by uncertainty, irreversibility, change, and adaptation. Real options analysis has been proposed as a better valuation method under uncertainty and where the opportunity exists to delay investment decisions, pending more information. We briefly review the use of discounted cash flow methods in land use and management and discuss their benefits and limitations. We then provide an overview of real options analysis, describe the main analytical methods, and summarize its application to land use investment decisions. Real options analysis is largely underutilized in evaluating land use decisions, despite uncertainty in policy and economic drivers, the irreversibility and sunk costs involved. New simulation methods offer the potential for overcoming current technical challenges to implementation as demonstrated with a real options simulation model used to evaluate an agricultural land use decision in South Australia. We conclude that considering option values in future policy design will provide a more realistic assessment of landholder investment decision making and provide insights for improved policy performance.

Introduction

New markets and policies are emerging which are exerting transformational pressure on land use (Bryan et al., 2013). Diversification of land use—moving away from production agriculture to multifunctional land uses—has been recognised globally as being important for remediating environmental problems and enhancing the sustainability of food and fibre production (Crossman and Bryan, 2009, Lovell and Johnston, 2008, O'Farrell and Anderson, 2010). Many studies worldwide have examined the financial profitability of alternative land uses and the attractiveness of economic incentives through mechanisms such as payments for ecosystem services and agri-environment schemes (Connor et al., 2008, Hein et al., 2013, Wunder et al., 2008). Carbon forestry (Paterson and Bryan, 2012), biodiversity plantings (Polglase et al., 2013), the production of biofuels (Bryan et al., 2010a, Fischer et al., 2010) and bioenergy (Bryan et al., 2010b, Schneider and McCarl, 2003) feedstock may all potentially provide economically viable alternatives to conventional agriculture under the right policy settings. However, the widespread uptake of these alternatives faces many challenges. Psychological inertia, the sunk cost fallacy (Ross and Staw, 1993), the status quo bias (Burmeister and Schade, 2007), along with other factors have all been invoked to explain the reluctance to change. While the decision to adopt an alternative land use or management regimes involve more than purely economic considerations—financial competitiveness is a key component (Lambin et al., 2001, Lubowski et al., 2006).

Capital budgeting is an established process by which organisations evaluate long term investment decisions, typically in new plant and machinery, new products, and in research and development. Discounted Cash Flow (DCF) analysis is one way of evaluating investments using the concept of time value of money. The value of an investment depends on its propensity to generate cash flow. A measure of DCF—net present value (NPV)—has been used widely to assess investments (Bryan et al., 2008, Harper et al., 2007, Paterson and Bryan, 2012, Walsh et al., 2003). However, NPV often has limited ability to account for the value landholders place on managerial flexibility, or the option to wait for further information in the face of uncertainty and risk (Arya et al., 1998)—important considerations in typical land use investment decisions.

A more recent capital budgeting method—real options analysis (ROA)—has been proposed as a better model for valuing investments and describing investment behaviour in the presence of uncertainty (Isik and Yang, 2004, Schatzki, 2003, Song et al., 2011). ROA is applicable when investment decisions are irreversible and where there is the opportunity to delay decisions until more information is gained (Fenichel et al., 2008). This review examines the use and limitations of DCF techniques in evaluating land use and management decisions. We review the application of ROA to land use management and consider the potential for ROA to provide insights into the response to land use change incentives in uncertain contexts. A simulation based real options model is applied to a land use change problem and the implications for policy makers and land holders are discussed.

Section snippets

Concepts

DCF analysis and the calculation of NPV is a practical and widely used method for evaluating agricultural and other investments (Cocks, 1965, Marra et al., 2003). It is based on a fundamental principle of finance—due to inflation, economic growth and risk, a dollar today is worth more than a dollar tomorrow (Homer and Leibowitz, 2013). In DCF analysis, future income streams are discounted and expressed in present value terms (Johnson and Hope, 2012). NPV is the sum of the discounted annual cash

Concepts

The concept of ROA derives from markets for financial options (Borison, 2005, Mun, 2006b). Financial options in commodity markets are derivative securities that take their value from other financial securities known as the underlying asset. In brief, an option provides the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a fixed price by a certain specified time in the future (Chance and Brooks, 2009). There are two primary option exercise styles,

A case study

In order to demonstrate the insight that simulation based real options models can provide, we used a ROA simulation method to analyse how accounting for multiple sources of risk influenced the threshold prices necessary to induce land use change from agriculture to bio-energy feedstock in southern Australia. The risks modelled in this case study are limited to price risk, however the method could be extended to include multiple risk including yields, costs and interest rates using probability

Implications for land use policy and future research

Globally, governments are using public policies to improve environmental outcomes such as greenhouse gas emissions abatement or habitat preservation (Bryan and Crossman, 2013). In an Australian context, several studies have determined the economic viability of forestry under varying carbon price scenarios (Burns et al., 2011, Crossman et al., 2011, Lawson et al., 2008, Polglase et al., 2008a, Polglase et al., 2011, Polglase et al., 2013). DCF analysis used in these studies indicates significant

Conclusion

DCF methods have been widely used to value alternative land uses. DCF methods provide a static analysis that assumes investments are now or never propositions, are reversible, and management remains passive throughout the investment's life. In reality, many investments can be seen as a series of strategic options that unfold over time. Managers often have flexibility in when and how investments are made, and under uncertainty this flexibility can have substantial value. Decisions in land use

Acknowledgements

This work was made possible by the Charles John Everard Scholarship awarded through the University of Adelaide and the support of CSIRO's Agriculture Flagship. The authors would like to thank Dr. Tim Capon and Dr. Andrew Reeson for their suggestions on improving this manuscript. The authors would also like to thank the three anonymous reviewers for their time and valuable suggestions which have improved the manuscript markedly.

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