Are you brave enough?

Economic analysis of adaptation to climate change on an agricultural project

Gretel Gambarelli

IUCN (formerly World Bank)

Co-author: Mike Toman

World Bank

IFAD, 16 March 2011

Outline

Introduction Economic analysis of adaptation:

challenges and possible solutions Dealing with uncertainty: beyond CBA Summary and conclusions

Outline

Introduction Economic analysis of adaptation:

challenges and possible solutions Dealing with uncertainty: beyond CBA Summary and conclusions

4

Source: Adapted from IPCC 2007.

What do we have to prepare for?Unsuccessful mitigation

Unavoidable warming

Successful mitigation

Adapting to climate change: the example of agriculture

Adaptation classification

Examples

Autonomous / private

Sectoral Change crops, crop calendars, irrigation schedules

Economy-wide

Market adjustments in crop prices reflect new production levels / scarcity

Planned / public

Hard “Climate proof” infrastructure: irrigation systems, rural roads, …

Soft Seasonal climate forecasts, capacity building, research and extension on drought resistant crops, local institutions, economic incentives for efficient water use

Is investing in climate change adaptation economically justified?

At the global/sectoral level: a few studies attempting to estimate Optimal adaptation-mitigation policy mix Total adaptation costs, under a specified

temperature increase (EEA 2007, World Bank 2010)

At the national level: some cost and cost-benefit studies (i.e., Carraro ed. 2009 for Italy)

At the project level: generally poor economic analysis

Outline

Introduction Economic analysis of adaptation:

challenges and possible solutions Dealing with uncertainty: beyond CBA Summary and conclusions

Evaluating adaptation at the project level: the cost-benefit approach

1. Estimate economic costs without the project (= damages or impacts of CC under the hypothesis of no adaptation)

2. Estimate future economic benefits with adaptation (= “avoided damages” + additional benefits)

3. Estimate costs of investing in adaptation 4. Sum up all costs and benefits discounted to

the present and calculate NPV if NPV> 0 adaptation is economically justified

[Basic assumption: future GHGs are exogenous]

Economic analysis of adaptation at project level: main challenges

2. Future economic benefits with adaptation

a) Low vs. high regret adaptationb) Hard vs. soft adaptation c) Additionality d) Investing now vs. waiting

UU

U

3.Investment costs

a) Costs of autonomous adaptationb) Additionality c) Investing now vs. waiting

U

U

1. Costs without adaptation

a) Future CC impactsb) Autonomous adaptation

UU

4.Discounting a)Discount rate for long term benefits U

Step 1: Evaluating the costs of CC on agriculture (1/3)

Alternative 1: Agronomic models

Alternative 2: “Ricardian” approach

Farm value = f (farm characteristics, soil type, climate variables, etc.)

2. This information can be used to estimate how climate change affects agriculture productivity after farmers have adapted to it

1. Estimates how climate variables affect land values

Step 1: Evaluating the costs of CC on agriculture (2/3)

Applications (World Bank)

AGRONOMIC RICARDIAN

India (nationwide): Climate change impacts in drought and flood affected areas

Africa, China, Brazil, India, Egypt, etc. (nationwide)

Morocco (nationwide): Adaptation to climate change in the agriculture sector

Bangladesh (nationwide): Implications of Climate Change on food security: adaptation responses

China (project level): Mainstreaming climate change adaptation in irrigated agriculture

Step 1: Evaluating the costs of CC on agriculture (3/3)

Alternative 3: Probabilistic methods

May be applied to impacts of extreme events, but a better grasp on probabilities is a pre-condition

Loss

Exceedance Probability

Without adaptation

With adaptation

Step 2: Estimating BENEFITS of adaptation

• Very similar challenges to standard agricultural projects, but uncertainty plays a bigger role if the project comes “with regret”• Benefits of hard adaptation more straightforward than soft adaptation• Consider co-benefits and negative spillovers

•E.g. improved agricultural land management practices to prepare for CC can also lead to reduced erosion/siltation and carbon sequestration• E.g., increased irrigation upstream may limit water availability downstream

Step 3: Estimating COSTS of adaptation

1. Estimate WHAT you need.e.g.: “gap analysis“, participatory approaches, etc.

2. Estimate “HOW MUCH” you need. You can use ad hoc models, or “educated guesses”

3. Look at UNIT COSTS of specific adaptation measures. E.g. through analysis of past projects that financed the same types of interventions

Need just a rough figure (e.g. for accessing int’l CC financing)? Review & compare projects’ costs!

Steps 2 & 3: Investing now vs. waiting

Waiting to invest in adaptation may in some cases avoid capital lock-in, reduce investment costs, or increase economic benefits Ex. Dam with right capacity

But the contrary may also be true: waiting to invest in adaptation can cause irreversible losses Ex. Loss of ecosystems (desertification), loss of

lives (more frequent and more intense extreme events)

Traditional CBA does not help decide when it is optimal to invest in the presence of uncertainty

Step 4: Discounting (1/3)

Standard DR: shorter-term costs of adaptation dominate over longer-term benefits of reduced CC impacts

The effect of discounting on Marginal Benefits

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

0 4 8

12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96

years

Marginal Benefits (MB) MB with Fixed Discounting MB with Variable Discounting

Arguments for low discount rate for long-term benefits: Intergenerational equity (Stern 2007) “Risk reduction premium” of adaptation

investments

Arguments against low discount rate for long-term benefits: Lowering discount rate for specific projects can

distort capital budgeting Arguments for low DR are relevant at the global

or national level, less so at the project level

So what?

Step 4: Discounting (2/3)

Step 4: Discounting (3/3)

Recommendations: For small adaptation projects (effects at the

local scale): Use standard DR by default In order to capture risk reduction premium, add risk-

reduction benefits to the benefit stream (at least heuristically)

Sensitivity analysis of DR

For large adaptation projects (potential to influence the macro-economy): Possible to use a lower or decreasing DR

Economic versus multi-criteria approaches to project assessment Some of the problems discussed above are only

relevant to cost-benefit analysis, requiring: monetization of costs and benefits discounting

Multi-criteria assessment is a possible alternative:

‒ Project alternatives compared across a range of criteria → clear tradeoffs

‒ Non-monetary values can be used → impact of discounting on evaluation greatly diminished

‒ … but different issues arise

Example: evaluating adaptation alternatives for agriculture in East Europe & Central Asia

Combination of Cost-benefit Analysis and other decision criteria in a “Multi-criteria” type setting

Ranking of options according to: net benefits, expert judgment, win-win potential, and farmers’ preferences

From a menu of 60 to 5 national-level and 9 agro-ecological zone level adaptation measures (including options not suitable for CBA)

Outline

Introduction Economic analysis of adaptation:

challenges and possible solutions Dealing with uncertainty: beyond CBA Summary and conclusions

Which uncertainties?

Different models forecast different temperature / rainfall patterns in some areas

Extreme events are becoming increasingly difficult to predict (unknown probability distributions)

Is there a “tipping point”?

Considers stream of future expected benefits Deals with uncertainty only by means of

sensitivity analysis If multiple possible scenarios, how do I make a

decision on the project? What about investments that “insure” me

against future uncertain events?

Traditional CBA falls short…

We need something different!

The traditional CBA approach

Takes into account the economic value of options created and destroyed by different project alternatives

Investing creates options of taking certain decisions in the future – such options have a positive economic value in project evaluation.

Investing may “kill” other options (i.e., the waiting option). These options have a negative value.

The method relies on subjective scenarios and probabilities.

It is challenging to apply.

Economic approach: Real Option Analysis

Example: Real Option Analysis for an irrigation modernization project in Mexico

Traditional NPV vs. Extended NPV

-400

-200

0

200

400

600

800

1000

1200

20% 30% 40% 50% 60% 70% 80% 90% 100%

Volatility

Mill

ion

US

$

NPV NPVes

Source: Scandizzo and Notaro 2008

Assesses how different investments perform under a wide range of possible futures Identifies the determinants of vulnerability of alternative

project options Points to “robust” alternatives that perform well across a

wide range of possible futures

It does not rely on probability functions Good when uncertainty is high, but sophisticated

approach

Non-economic approach: “Robust” decision analysis

Example: investment decisions of a water supply agency in California

Source: Groves et al. 2008

Hundreds of scenarios explore assumptions about climate change, resource-development, urban growth, program costs,...

Scenarios evaluated according to the cost of supplying water to the end users plus the costs of incurring any shortages.

Most important uncertain factors in generating high-cost scenarios identified.

Outline

Introduction Economic analysis of adaptation:

challenges and possible solutions Dealing with uncertainty: beyond CBA Summary and conclusions

Summary: how to improve the economic analysis of adaptation projects? (1/2)

1. Identify relevant climate risks for the project area and promising adaptation options

Estimate impacts of CC without and with adaptation

2. Estimate CC impacts without the project under multiple climate scenarios, taking into account autonomous adaptation to the extent possible

3. Estimate potential reductions in CC impacts under the same multiple scenarios

4. Quantitatively or qualitatively assess any co-benefits and externalities

5. Choose between economic or multi-criteria approach. In case of economic approach, select (and justify) an appropriate DR

Economic evaluation of alternative adaptation investments

7. Consider opportunities that the project may create or destroy, and attempt an economic estimation

Summary: how to improve the economic analysis of adaptation projects? (2/2)

8. “Stress-test” the assessment to identify vulnerable investment alternatives

9. Choose an alternative that is “robust” or has a high “option value”

Conclusions Why investing time and money in good

economic analysis? If carried out early in project preparation it can

provide important information on project design It can help decide whether to go ahead or to

postpone the investment But… often incentives are not there

There are alternatives to the standard CBA Need more and more detailed quantitative

adaptation studies Current methods are very data and model

intensive – can simpler and broad approximations be developed?

ReferencesCarraro ed. (2009) Climate Change and Adaptation Strategies in

Italy — An Economic Evaluation. Il Mulino. Fankhauser, S. (2006). The Economics of Adaptation.

Background Document for the Stern Review.Groves D. G., Knopman D., Lempert R. J., Berry S. H., Wainfan L.

(2008). Presenting Uncertainty About Climate Change to Water-Resource Managers (Technical Report TR-505, Santa Monica CA, RAND Corporation).

Scandizzo P. L. and Notaro C. (2008) Adapting to Climate Change: A Case Study of Project Evaluation through Real Option Theory. Background Report for “Low Carbon, High Growth: Latin-American Responses to Climate Change - An Overview”. By Augusto de la Torre, Pablo Fajnzylber, and John Nash. Washington DC: The World Bank, 2009.

Stern N. H. (2007) The Economics of Climate Change: The Stern Review. Cambridge University Press, Cambridge, UK

World Bank 2010 Economics of adaptation to climate change (www.worldbank.org/eacc)

PUBLICATION "Economic Evaluation of Climate Change Adaptation Projects - Approaches for the Agricultural Sector and Beyond": http://siteresources.worldbank.org/ENVIRONMENT/Resources/DevCC1_Adaptation.pdf

 GUIDANCE NOTE "Evaluate adaptation via economic analysis“: http://climatechange.worldbank.org/climatechange/content/note-7-evaluate-adaptation-economic-analysis

Other guidance notes: www.worldbank.org/adaptnotes

Contact: gretel.gambarelli@iucn.org

Thank you!