We offer a new decision-making framework for controlling the risk associated with insuring infrastructure projects for climate risk and technology obsolescence. We build tools that utilize insurance linked securities, and are based on the theory of real options.
Catastrophe bonds (also known as “Cat Bonds”) transfer a particular infrastructure risk, physical damage from natural disasters, from the insurer to the capital market. Climate risk changes over time due to anthropogenic factors, but also in an epochal or quasi-periodic regime-like manner over decades and across locations. This regime-like behaviour translates into fat-tailed, long-memory risk that may in some cases be predictable over the near-term.
The obsolescence of installed technology is another significant issue, and the cost sunk into the project cannot be recovered. Policy makers who seek to retire these assets to reduce carbon emissions, may face significant political opposition from owners, which may be publicly owned entities. In some ways these can be thought of as stranded assets, if free market principles were to apply.
The theory of real options may be a useful vehicle to consider the action set of financial and structural options for this class of problems, where uncertainties change and may resolve with time, for both shocks to the system and for the viability of technological options.