Uncertainty and Option Value in Land Allocation Problems

Abstract

In this paper we are concerned with modelling techniques for evaluating development and conservation opportunities when dealing with investment decisions involving environmental resources management. In this context, highly characterized by both environmental and economic uncertainty, we emphasize the importance of capturing the flexibility of different investment strategies. In particular, we discuss a discrete model that includes both environmental and economic uncertainty treated using an integrated approach. Decision analysis techniques and option pricing theory are jointly applied to evaluate development versus conservation opportunities. In our analysis, we take into account how uncertainty interacts with two types of irreversibility: sunk costs associated with investment in developing decisions, including environmental and social costs, as well as sunk costs associated with environmental regulation and conservation. The Quasi Option Value, QOV, is used to derive decision rules that account for different levels of flexibility of land allocation possibilities.