A space to share some thoughts

The case for Real Options in Agricultural Cost-Benefit Analysis

Investment in R&D project always entails a large proportion of uncertainty. For risk management purposes, investors require an ex-ante cost-benefit analysis (CBA) that will allow them making informed decisions. Under conditions of uncertainty investors require an objective assessment of the possible streams of future value, and a subjective evaluation of the probabilities of realising each relevant stream. Importantly, an investor’s attitude to risk is implied in the choice of CBA models utilised.

The traditionally used Expected Net Present Value (ENPV) investment decision model is based on a single parameter, namely, the probability-weighted average of expected net benefits. This model cannot properly deal with uncertainty in the timing of investments and flexibility in future decision-making processes. This is especially relevant for R&D projects which need to go through several stages of research, development, and lengthy implementation and adoption phases, before we can start measuring the impact of investments that lay far back in time.

ENPV does not distinguish between a small pay-off with a high probability of success, and a low-probability large pay-off, so long as they both have the same expected value.

Many investors are risk averse and concerned with risk minimisation in addition to return maximisation, in which case the ENPV model is clearly inadequate .

Risk reduction is classically managed by maximising the information that goes into the decision-making process. But such information gathering exercises might lead to an opportunity cost losses due to delayed investments for lack of alternative risk mitigation options.

For the reasons outlined above, the private sector has been increasingly using a so-called Real-Options approach to CBA for the evaluation of R&D investments and projects.

Breaking down a potential long-term R&D investment by using a Decision Tree Analysis provides the flexibility to incorporate options into investment decisions at the branching points.

In finance, an option is defined as a right -but not an obligation- to acquire or dispose of an asset on or before some future date, at a specified price. Because there is no obligation attached, an option would be exercised only when profitable to do so. To secure an option the person acquiring it must pay a premium, in our case to buy additional R&D.

It is crucial to conduct sensitivity analyses on the probabilities of success at each branching or decision-making point, including due diligence on any estimates provided by various sources.

For agricultural R&D investments, the Real Options approach provides one potential, targeted methodology to model investments in R&D. While the method has still the potential for refinement, it is well-suited to determine the economic impact of such investments, in any case far better than the traditional ENPV.

Without doubt, agricultural researchers can contribute toward a CBA that more accurately reflects the true economic impact of their efforts by providing additional information that fits into the Real Options Model. Such information may include for example estimates of probability, potential impact, funding sources, and possible side-effects.

From Andoseh et al (2014) The case for a real options approach to ex-ante cost-benefit analyses of agricultural research projects. Food Policy 44:218-226