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March 2023
AAM Magazine
March 2023
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Flexibility is key

By Michel-Alexandre Cardin and Joseph Cherian*   
  • Asia
  • Global
Costly net zero projects require innovative valuation and financing options

Our essay published in this magazine earlier this year analysed the financial feasibility of governments and firms around the world achieving lofty climate science and net zero targets within a certain deadline.1 We predicted this will lead to a situation like in infrastructure, where there is a massive funding gap between approved projects and the available financing. 

We also discussed the likely (mis-)valuations on the cost side, due to the standard MBA textbook approach of using net present value (NPV) to estimate costs. NPV is based on the time value adjusted costs incurred and revenues recognised over the project period under consideration. It doesn’t consider the flexibility option, which is a net zero planner’s ability to adjust investment decisions, or defer an investment to a later date. 

In this new essay, we propose valuing net zero projects using real options analysis (ROA), which by design has the ability to accommodate changes to the valuation process that may arise due to uncertainties related to the global economy, net zero targets and climate science. As we argued before, the classic corporate finance textbook approach that includes NPV is, unlike ROA, unable to accommodate such features. ROA is also directly applicable to net zero projects that are risky and irreversible. 

Predicting the future is often a fool’s game. But when trillions of dollars are at stake – as in the case of the estimated net zero costs – we have to start by using all the financial tools and expertise available.

Adding value

An important principle in ROA theory is that flexibility can add significant value to irreversible investment projects, which includes net zero. This fact has been observed in countless studies since Professor Stewart Myers coined the term “real options” in the 1970s to recognise the value of flexibility (or options) for “real” investment projects. This was by building upon the seminal work by Professors Fisher Black, Myron Scholes and Robert Merton with respect to financial options analysis. 

Flexibility adds value because it helps projects to capitalise on upside opportunities while reducing their exposure to downside risks. The net effect is that it improves the expected economic performance of investment projects in the long term. 

Flexibility also contributes to better climate sustainability because it encourages the use of resources in a more considerate way, i.e., deploying production capacity only if and when needed, thus reducing unused capacity, waste and pollution. It also contributes to better resilience by enabling systems to adapt, change and reconfigure to regain similar production levels as before disruptions, such as blackouts due to droughts or severe climate events.

In essence, the ROA theory can help decision-makers and business leaders to better assess the benefits and costs of a transition to net zero, and also contribute to reducing costs and increasing the potential benefits in the long term. 

An important challenge, however, is to “engineer” flexibility in net zero projects. This means recognising ahead of time the main uncertainty that faces a project, crafting relevant strategies and technologies to deal with it, and designing the system so it can adapt pro-actively to changing market, environmental and regulatory conditions. For example, designing a gas-fired power plant to not only accommodate today’s electricity needs but also to readily switch to green or low-carbon hydrogen once this fuel is more widely available and economically viable. 

Key requirements

Investments in research and development are often cited as an important source of value and flexibility to deal with an uncertain future, which is certainly the case for net zero infrastructures projects. But it requires a change in mindset to recognise the value of flexibility and integrating modern financial techniques like ROA. This means:

  • Policymakers and business leaders have to recognise that without explicit considerations of uncertainty and risk, any benefit-cost analysis, including textbook NPV, is doomed to be wrong. Professor Sam Savage pointed this out eloquently in his 2009 book that dealt with the flaw of using averages in decision making under uncertainty – how individuals and firms consistently underestimate risk by looking at averages and leaving out the range of possible outcomes;
  • They must recognise flexibility as a powerful tool to deal with uncertainty, without which much value is left on the table;
  • Project designers and engineers must recognise the need for a different approach to engineering net zero projects. This approach has to embed optionality more systematically, and recognise the ability to change in early conceptual design; 
  • They must keep track of those engineering options over time so they are not lost, and devise systematic mechanisms that recognise when is the right time to adapt;
  • There must also be recognition that recent advances in ROA and flexibility in systems design research enable more systematic engineering of flexibility and the quantification of its value in large scale, irreversible projects so that more enlightened investment decisions can be made.2 

No need to reinvent the wheel

Costly projects require innovative financing solutions, particularly as they apply to “global public goods”. These include net zero projects that aim to eliminate greenhouse gas emissions from human activities that are causing climate change. 

Consulting firm McKinsey & Co has already set alarm bells ringing with its January 2022 report declaring that approximately US$9.2 trillion in annual project spending is required to achieve net zero emissions by 2050. 

As Tharman Shanmugaratnam, Singapore’s globally respected senior minister, astutely observed in a recent International Monetary Fund commentary: “To fund these investments to achieve net zero carbon emissions – to the tune of an estimated $100 trillion to $150 trillion over the next 30 years – we must embark on public-private collaboration on a scale never before adopted. Public sector finances will not be able to meet these needs on their own.”3 

It’s never a good time to reinvent the wheel during a perfect long storm. The Managed Co-Lending Portfolio Programme (MCPP) of the International Finance Corporation, the World Bank’s investment arm, is a perfect vehicle to replicate for public-private net zero collaboration. 

The MCPP is a syndications lending structure with credit enhancement, utilised for infrastructure projects. It enables the IFC to co-invest in a portfolio of loans with institutional investors from the public and private sectors. Indeed, the IFC recently announced the launch of its MCPP One Planet facility, which comprises a portfolio of emerging-market senior loans aligned to the Paris Agreement. 

Good due diligence by a trusted global institution coupled with proper credit enhancement from a long-lived sovereign authority could encourage global pension funds, insurance companies, private equity funds, hedge funds, endowments, foundations and family offices sitting on trillions of dollars in assets to participate in a MCPP type investment vehicle. This is due to the first loss warranty available, which makes the MCPP structure akin to investment grade. 

Indeed, the long-term nature of net zero financing also makes MCPP suitable for pensions and insurance companies facing asset-liability management or liability-driven investment mandates and constraints.

Existing net zero targets are so exorbitant that they could end up being a pie-in-the-sky pursuit. That is no reason not to try to reduce carbon emissions that are harmful to the existence of our planet and ourselves. But in order to do so, forecasters and consultants first need to get their net zero project costs and calculus right. And innovative public-private financing structures should be explored to fund them.

We have made so much progress in the world of finance, investment and risk management over the last 50 years. There is no excuse not to draw on our learnings and apply it to carbon reduction in the context of spending on the global public goods for the next 50 years.

* Michel-Alexandre Cardin is associate professor in computational aided engineering at Imperial College London and director of the Strategic Engineering Laboratory at the Dyson School of Design Engineering. Joseph Cherian is practice professor of finance at the Asia School of Business and Cornell University (visiting).

Funding net zero: Getting a grip on climate change, Asia Asset Management, June 2022, Vol. 27, No. 6 (print & online editions), by Joseph Cherian and Yogi Thambiah

2 M. A. Cardin, A. Mijic, and J. Whyte, "Flexibility and real options in engineering systems design Handbook of Engineering Systems Design," ed: Springer, 2022.
“Confronting a Perfect Long Storm”, by Tharman Shanmugaratnam, IMF Finance & Development Commentary, June 2022.