Decoupled net present value: protecting assets against climate change risk by consistently capturing the value of resilient and adaptable investments

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ABSTRACT

There is growing awareness that traditional valuation methods based on discounted cash flows using constant risk-adjusted discount rates struggle to account for climate-related risks when assessing long-term investments in physical assets and infrastructure. Worst yet, such methods fail to consider numerous financial benefits accruing from investment in resilience and adaptation, categorizing such expenditures as sunk costs that reduce investors’ returns. Such traditional valuation methods encourage investors to postpone or forgo entirely investing in resilience and adaptation. The decoupled net present value (DNPV) method incorporates risk and risk-reduction measures into project valuations in clear and compelling financial terms. By quantifying both (i) risk exposures of assets to hazards and (ii) the reduction of such exposure through up-front investments, DNPV recasts the financial impact of risk-reduction measures. Thus, the benefits of risk-reducing investments such as adaptation and resilience can be fully valorized in project-level accounting, removing a significant barrier facing such investments today.

KEYWORDS:

• Valuation
• DNPV
• Long-term investments
• climate change risk

Disclosure statement

The Coalition for Disaster Resilient Infrastructure (CDRI) reviewed the anonymised abstract of the article, but had no role in the peer review process nor the final editorial decision.

Notes

1. RCP4.5 is one of the four scenarios of greenhouse gas (GHG) emissions considered by the Intergovernmental Panel on Climate Change (IPCC). * [email protected].

2. This clearly not the case when dealing with future risky expenditures: risk should make expenditures more costly whereas TMV should reduce it.

3. The reduction factor, F, used in standard DCF is a function of time (t) and discount rate that varies from 1 at t = 0 down to 0 for t = α and it is given by a simple expression F(α, t) = (1 + α)^−t.

4. For instance, the U.S. Office of Management and Budget (OMB) recommends federal agencies use for project valuation α = 7%, which corresponds to the average pretax real rate of return of private capital in the U.S. market (OMB 2003). Using this constant discount rate for a period of 60 years (two generations), the value at the end of the period of an asset/liability would be less than 2% of today’s value.

5. For those familiar with the real options literature, the cost of risk can be equated to the option premiums.

6. This is also consistent with everyday experience of people toward risks. In general, people are willing to accept smaller revenues or higher costs in exchange for reduced risk. For instance, insurance are willing to reduce its premium (i.e., accept lower revenues) or offer higher coverage (i.e., accept potential higher expenditures), if homeowners install flood protection systems in their homes.

7. The magnitude of the risk-free rate depends upon the maturity of government securities. In general, the risk-free rate increases with longer maturities.

Additional information

Funding

The Article Publishing Charge (APC) for this article is funded by the Coalition for Disaster Resilient Infrastructure (CDRI).

Notes on contributors

David Espinoza

David Espinoza, holds a Ph.D. in civil engineering and is a Senior Principal at Geosyntec Consultants. He advocates explicit inclusion of physical risks such as climate change, earthquake risk, and other natural phenomena in asset valuation. He developed the DNPV methodology (www.dnpv.org).

Javier Rojo

Javier Rojo, collaborator in the development DNPV method, has a Master’s degree in Civil Engineering and holds an MBA from New York University’s Stern School of business. He has over 25 years of experience in engineering, project finance, and project and business management.

William Phillips

William Phillips, P.Eng., ENV SP, is an Associate and Senior Consultant at Mott MacDonald. His work focuses on climate resilience and the quantification of physical risks in infrastructure investment. He is an author of the Physical Climate Risk Assessment Methodology (PCRAM).

Andrew Eil

Andrew Eil, Head of Climate Risk for North America with Tata Consultancy Services (TCS). He is a consultant and author specializing in climate change policy and capital markets, climate risk and resilience investment, and development finance.