Large infrastructure projects, such as the building of roads and sea ports, require significant investments. These are often risky and irreversible. Although decisions regarding such projects are taken with a view to the future, they are still static: all decisions are taken in the present, and the infrastructure cannot be adjusted to future changes. To increase the flexibility of these systems, researchers are elaborating a valuation method that allows for future decisions.
“This method is called real options,” says researcher Sigrid Schenk at Rebel Group Advisory. “The real options concept implies that new decisions may be needed in the future, based on new information. If that is the case, it may be wise to invest in having these options, even at the onset of a project.”
As an example, Schenk highlights so-called phased investments. “Take the building of a bridge, for instance. Under today’s circumstances, it may be sufficient to build a two-lane bridge. If you predict that future traffic may call for four lanes, however, you may want to build a wider bridge today, even though it only has two lanes on it, allowing for the expansion of the road at a later stage. This is cheaper than building a cheap, two-lane bridge today and having to replace it with a larger bridge in the future.”
Incorporating real options may be more expensive in the short term, but it introduces the concept of flexibility. And that, as Schenk points out, represents a monetary value. “Flexibility will eventually pay off,” she says. “Some businesses have already discovered this. If Shell, for instance, opens up a new oil field, it will perform a few test drillings before it builds a massive oil platform. The test drillings are costly, but they may also prevent a very expensive oil platform being built at a less profitable location.”
Schenk and her colleagues now hope to apply this principle to public investments in infrastructure. “There is a public interest in a government that is able to be as efficient as it possibly can be with public money,” she emphasises. “I am convinced that real options can play an important role in this regard. We are now studying a number of cases from the public infrastructure domain, and hope to build models that will lead to optimised network investment.”
