Uncertainty, Real Option Valuation, and Policies toward a Sustainable Built Environment

Abstract

Real option value can severely hinder investments in energy conservation in real estate. This paper evaluates whether policy incentives to invest now, instead of tomorrow can be tailored to compensate for any option value to defer. A case study reviews a Dutch government subsidy program with the Cox, Ross, and Rubinstein (1979) binomial method. Based on market priced risk, the subsidy properly compensates investors for the real option value they forgo by exercising the option and investing in a solar hot water system. A survey amongst homeowners reveals that private risks are an important part of the perceived uncertainty when investing in energy efficiency and should be included in the model. A practitioners' method is proposed that uses a binomial real option model to design policy incentives and surveys to assess the relevant uncertainties to include in the model. The results displayed in strategy spaces makes intuitive decisions possible.