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The role of traditional discounted cash flows in the tragedy of the horizon: another inconvenient truth

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Abstract

Providing decision makers and the investment community with transparent methods to value investments in resilience and adaptation measures to protect physical assets from climate change impacts is becoming increasingly critical. To address this need, this paper introduces and utilizes the decoupled net present value (DNPV) valuation methodology. DNPV is a robust method that can incorporate climate change risk into investment analyses. This paper also discusses how the widespread use of traditional valuation methods such as net present value combined with risk-adjusted discount rates introduces a pernicious time bias effect that magnifies stakeholders’ misaligned interests and investment horizons, leading investors, both public and private, to significantly underinvest in resilience and adaptation. Furthermore, because traditional valuation methods cannot correlate physical risks (e.g., loss of revenue due to physical damage or lost access to an asset) with discount rates, investments to reduce climate change risks are largely considered as expenses that make the investment less attractive. The DNPV method addresses this issue and offers a viable alternative that can consistently and transparently quantify all risks (market and non-market) in terms of cash flows. This allows investors and stakeholders to quantify in monetary terms the potential exposure of physical assets to climate-related hazards and assess the effect of decisions to invest in resilience and adaptation measures. With the aid of a simple numerical example, the DNPV method is used to illustrate how such actions can be treated as quantifiable risk reduction investment opportunities that result in better investment decisions.

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Notes

  1. Typical real rates (i.e., net of inflation) used by development banks to evaluate project financial feasibility.

  2. Put options for traded securities provide investors with a protection against market prices drop; essentially, a put option is equivalent to an insurance product.

  3. A more realistic approach would be to take into account weather predictions of flooding risk with time. For this discussion, the increase risk was assumed constant throughout the analyzed period.

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Acknowledgments

The authors are grateful to Dr. Ranjiv Gupta of Freport-McMoRan (formerly of Geosyntec Consultants) and Ms. Stacey Swann of Climate Finance Advisors for their kind input of the initial draft of this manuscript and their valuable comments.

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Authors and Affiliations

  1. Geosyntec CAT Advisory, 1220 19th ST NW Suite 210, Washington D.C., 20036, USA

    D. Espinoza & J. Morris

  2. Vanderbilt University, Nashville, TN, 37212, USA

    H. Baroud

  3. Inter-American Development Bank, Washington D.C., 20577, USA

    M. Bisogno

  4. Columbia Business School, New York, NY, 10027, USA

    A. Cifuentes

  5. Université de Sherbrooke, Sherbrooke, QC, J1K-2R1, Canada

    A. Gentzoglanis

  6. PIMCO, London, W1U 3AH, UK

    L. Luccioni

  7. Sustainability Strategic Advisors, London, SE8 5JB, UK

    J. Rojo

  8. Mississippi State University, Starkville, MS, 39762, USA

    F. Vahedifard

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  1. D. Espinoza
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Correspondence to D. Espinoza.

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Espinoza, D., Morris, J., Baroud, H. et al. The role of traditional discounted cash flows in the tragedy of the horizon: another inconvenient truth. Mitig Adapt Strateg Glob Change 25, 643–660 (2020). https://doi.org/10.1007/s11027-019-09884-3

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