Smart Agriculture and Real Options Pasquale Lucio Scandizzo The University of Rome «Tor Vergata»

Key findings about real options A real option (RO) is defined as the faculty, but not the obligation, to undertake an action for an expected benefit at a given cost. The (RO) methods are a series of techniques based on the RO notion and of contingent decision making. RO techniques complement and enhance business management, project evaluation and generally decision making, by using more information in a «smarter» way. More recently, RO techniques have become the basis of new «smart» methods of production, aimed not only to evaluate existing ROs, but also to design projects and plans with more ROs built into them.

Real Options for Adaptability Planning adaptation to the unknown is challenging, given the many uncertainties relating to climate change scenarios and socio-economic pathways. Smart agriculture is based on the dual notion of diversification and flexibility, a complementary pair based on the concept of real options. The Real Options Strategy allows for analyzing adaptability and related build up of capabilities rather than being limited to estimating the cost/benefit ratio of adaptation projects.

Diversification and Real Options A different conception of the production process as a series of contingent actions. Depending on the state of the world: Activities as options to deliver different inputs (e.g. soil and nutrient management, harvesting genetic resources); Outputs as options to generate different outcomes (e.g. early or late crops, harvesting, processing and supply chains).

Real Options and Smart Adaptation Principles First, practice no regrets management: preserve and value the potential of a diversified environment. Second, when considering a given investment for adoption, carefully consider “the option to wait” by comparing net expected benefits with investment costs, multiplied by a “hurdle rate. This is a multiple of the investment cost whose size depends on uncertainty. Third , use the capability/real options strategy to invest in adaptability rather than in mere adaptation.

Flexibility and Real Options for Climate Change Climate change (CC) as an opportunity to create real options: (i) coping options that address the damage caused by transitory adverse events; (ii) rebound options that concern actions to recover and gain strength from negative developments/events; (iii) opportunity options that are related to taking advantage of opportunities caused by climate change; and (iv) adaptation options designed for permanent changes in response to CC.

Results from a recent World Bank Study:Yemen (US$ per household)   Investment in human and non human capital that created the options Training, extension, recovering knowledge on traditional techniques Terrace building, barrier construction, contour sloping, land improvements Agricultural research, extension, post harvesting equipment, community infrastructure for marketing and transportation Education, training, information programs on climate change patterns and possible responses Options created Underlying Value (present value of increase in Value Added per farm) Estimates of strike prices (present value of investment) Volatility range Value of Option Hurdle Rate Coping option: changes of practices in response to climate change 13150 8110 0.10 - 0.39 6570 2.0- 3.67 Rebound option: terrace rehabilitation 20570 12690 0.33- 0.7 12480 3.5- 5.31 Opportunity option: high value crops (coffee, fruits and vegetables) 13530 8350 0.10 - 0.33 7190 2- 3.35 Long term adaptation option: education (4 years) 30750 18970 0.10 - 0.3 13740 2- 3.18

Results from a recent World Bank Study: Morocco (US$ per household)   Investment in human and non human capital that created the options Training, extension, recovering knowledge on traditional techniques Terrace building, barrier construction, contour sloping, land improvements Agricultural research, extension, post harvesting equipment, community infrastructure for marketing and transportation Local financial systems Options created Underlying Value (present value of increase in Value Added per farm) Estimates of strike prices (present value of investment) Volatility range Value of Option Hurdle Rate Opportunity Option: Planting fruit trees 7080 3680 0.35 - 0.75 4300 3,5- 5,6 Rebound/ Opportunity Option: Credit extension 12200 6340 0.33- 0.75 7409 3.5- 5.6

Results from a recent World Bank Study: Tunisia (000 US$ per household) Threats from climate change: Rise in temperature, increase in the variance of rainfall Floods, landslides and droughts,   Investment in human and non human capital creating the option Options created Underlying Value (Present value of increase in Value Added per ha) Estimates of strike prices (present value of investment) Range of Option Values corresponding to values of Volatility between 30% and 70% Landscape loss, landslides, soil degradation Alteration of the forest ecosystem, loss of biodiversity, loss of the ecological services provided, such as local climate stabilization, a rebound option for animals and plants in case of extreme events, the preservation of a stable soil structure. Training, extension, recovering knowledge on traditional techniques Research, National park management Coping options: Forest management, watershed and landscape management (increase in non use value), reduction of forest fires 50 40 22 – 29 Research, Extension, Plantation Opportunity options: Improving life conditions, Improving forest production and competitiveness 134.50 120.5 57 -76 Forest pasture and rage improvements Rebound options: Preserving biodiversity, preventing erosion and other environmental degradation 31.66 76 46 – 51

Conclusions : Real Options and Empowerment Real options provide a means to address uncertainty of climate change through “smart agriculture” by focusing on the capabilities created by investment. Projects that create more valuable options are thus to be preferred to projects that create fewer options or destroy some of the options available, even though, for some limited time and within some scenarios, the latter may seem to be preferable on the traditional grounds of expected net present value. Because creating capabilities is a “bottom up “ approach, it entails a form of empowerment by endowing people with valuable real options that they can use under alternative scenarios.