|'Water-Saving Infrastructure Investment under Uncertainty'
This study employs the real-options approach to evaluate the decision to invest in water-saving infrastructure in the face of socioeconomic and ecological uncertainty in the Wasatch Range Metropolitan Area (WRMA).
An agent, who employs water as an input in the production of a marketable commodity, must determine whether and when to invest in water-saving technology in order to maximize his water-use efficiency and subsequent water savings gains. The agent’s decision to invest in water-saving technology and thus make a switch from his current (inefficient) technology depends on the trade-off between the expected value of the investment, and the cost of investment.
The net-benefit of investing in water-saving infrastructure is estimated by the market-value of any water savings which may accrue to the investor minus the cost of investment. This net-benefit depends on the price of water which is determined by its availability relative to demand. Thus the evolution of investment benefits (V) depends on the evolution of water-price (P) and water-supply (W).
The availability, and hence the price of water is uncertain due to changing hydro-climatic conditions in the region. Both water-price and water-supply are believed to evolve according to a Geometric Brownian Motion (GBM), a stochastic process employed in explaining uncertainty-laden evolutions over time. The two processes are related via a shared Weiner process associated with stochastic changes in water-supply.
Infrastructure investments are considered largely irreversible due to the prohibitive costs of reversal and their limited use and resale value given the specialized nature of the technology. Considering the uncertainty of future water-supplies in the region and the largely irreversible nature of infrastructure investments, the option to delay investment in water-saving technologies may be valuable. By waiting to invest, an investor can observe whether water-prices increase or decrease before committing to the substantial sunk investment cost. This tends to delay investment longer than suggested by traditional cost-benefit analysis.
Carey and Zilberman (2002) apply real-option theory to a farm’s decision to adopt new irrigation technology, and is the premise spurring this more general study.
This study extends Carey and Zilberman (2002) in four ways: First, it generalizes their farm-specific model to allow consideration of infrastructure investments by other agents such as canal company operators. Second, it explicitly considers ecological uncertainty. Using hydrological stream-flow data to estimate trends and volatility in water-supplies that may compromise the ability of water-users to perceive predictable water-supplies, the study investigates how ecological uncertainty from uncertain future water-supplies impacts the potential benefits from investing in water-saving infrastructure and subsequently, the decision to invest in these infrastructures.
Third, it allows for impulse-control where the agent may incrementally upgrade technology, investing where he can make the greatest efficiency-gains first, with possible future expansion. Finally, it considers the impact of policy-induced jumps in investment costs to verify the hypothesis that while policies like subsidies aim to hasten technology adoption, uncertainty about the timing of such policy may delay investment by increasing the value of waiting to invest.
I shall present the general theoretical model and preliminary results.