Climate Change Resilience and Adaptation

In a speech to Lloyd’s of London, the Governor of the Bank of England Mark Carney warned that the catastrophic impact of climate change will be felt well beyond the typical horizon of investment and political cycles, imposing a cost on future generations that the current generation (community and decision makers alike) has little incentive to avoid.  Traditional valuation methods exacerbate misaligned investment horizons among project stakeholders leading to significant under investment in projects that could foster climate change resilience and adaptation.  The DNPV method is used as an alternative approach to classical DCF models that can consistently translate technical assessment of physical risks (e.g., flooding, drought, sea level rise) into financial terms by quantifying in monetary terms the potential exposure of physical assets (e.g., roads, waste water, energy plants) to climate-related hazards and allowing decision makers to quantify the benefits of investing in resilience.  

Climate Change Mitigation (Renewable Energy)

To curve greenhouse emissions, energy from renewable sources have been successfully added to the energy pool. However, the proliferation of renewable energy projects have introduced a unique class of risk: unwanted energy supply. Different from other sources of energy, there is very little control in the energy production from renewable sources (e.g., amount of sun for solar power plants, amount of wind for wind power plants, amount of water for run-of-river hydropower plants); thus introducing another source of risk in the energy production.  DNPV allows investors to quantify and seamlessly integrate market risks (e.g., commodity prices) with non-market risks (e.g., amount of radiation, wind, or water) into the financial evaluation of renewable energy projects and, more importantly, to align project risk assessments performed by technical experts with risk management implemented by business executives.

Temporary/Permanent Business Interruption

The number of non-market risks that threatens an organization’s bottom line are diverse (e.g., hurricanes, draught, earthquakes, climate change).  Organizations not only face the costs associated with remediating the consequences of these risks which in itself can be significant but also it may result in temporary/permanent business interruption further stressing the organization's bottom line. For instance, a powerful earthquake may damage the dam integrity of a hydropower plant that may impair the plant's ability to generate energy while the dam is repaired.  In addition, because some of these physical risks may be prone to litigation from various stakeholders, litigation can further upset an organization's reputation, labor relationships, shareholder attitudes and ultimately, an organization's credibility.   Because DNPV consistently translates technical risk into financial terms, the proposed method enables investors to better understand their exposure to market and non-market risks and how these risks affect their investment performance.  DNPV helps investors reduce risk, allocate limited resources, develop defensible decisions, and integrate non-market risk into their mainstream financial decisions.

Public Private Partnerships

Because the application of standard financial analysis is predicated upon increasing the discount rate to account for risk, the value of cash flows that occur far in the future can be substantially reduced and, as a result, projects that delay generating positive cash flows for several years may not be favored. The economic impact of unduly penalizing long-term projects is not trivial especially at the present time when the public sector with limited resources is seeking to attract private funding to invest in infrastructure (e.g., energy, solid waste, waste water) through public/private partnerships (PPPs) which are often characterized by long-term contract lasting typically between 30 to 50 years and sometimes as long as 99 years.  The ability of DNPV to separate the time value of money and risk allows distant future revenues be properly accounted for without the artificial distortion introduced by typical DCF models. Moreover, the ability of DNPV to parse risk across time and risk classes allows PPP stakeholders to allocate risk and rewards in a more transparent and equatable manner.  

Asset Valuation of Traded Securities

The boom-and-bust cycles have become a key characteristic of today’s capitalist economies. The duration and magnitude of these cycles can be significant for products that require long-lead time and intensive capital to develop (e.g., extractive commodities, energy generators) and, as a result, they may find it difficult to reach equilibrium between supply and demand.  Although cyclic performance amplifies market volatility of traded securities, assets and corporate valuations should not be subjected to the same price volatility.  The problems is associated with the time-bias effect introduced by DCF models that emphasize near term events and neglects long term ones amplifying the effect of cyclical prices. During boom cycles, DCF valuations emphasize near term high profits and neglect future, but unavoidable, lower (even negative) profits. During bust cycles, DCF emphasizes the value of near-term lower (negative) profits and neglect future higher profits.  For publicly traded securities, DNPV shows that long term valuation should indeed remain relatively stable and should not be significantly affected by daily quoted market prices allowing investors to define a reliable long-term investment strategy.  DNPV also provides a reliable methodology that allows investors to assess a company’s individual performance separate from the wider industry.