1. ‘Real Options’ Framework to Assess Public Research Investments Nicholas S. Vonortas Center for International Science and Technology Policy & Department of Economics The George Washington University WREN Spring Workshop June 6, 2008

2. Public R&D Program Evaluation Ex-AnteEx-Post Priority Settings Impact Appraisal Monitoring Evaluation Innovation System (features, Institutions, etc) C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

3. Valuation Deficit Capital budgeting and strategic planning have historically been treated as two distinct domains of resource allocation. Capital budgeting deals with measurable returns (profits/cash flows) of a project. It abstracts from more intangible strategic benefits associated with the project. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

4. Valuation Deficit This distinction has resulted in a chronic ‘valuation deficit’ between the calculated value of strategic, long-term projects and their ‘true’ value. The deficit is due to the oversight by the conventional analytical models – such as the Net Present Value (NPV) and Internal Rate of Return (IRR) – of: (a) the inherent strategic value of the project; and (b) the flexibility associated with active management to alter the project's trajectory once undertaken. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

5. Valuation Deficit NPV Static DTA/Options Option Premium C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

6. Valuation Deficit Several factors are inadequately treated in the traditional approaches, including:  Uncertainty of the outcome  Timing of the investment  Irreversibility of committed resources  Inaccurate use of the discount rate C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

7. Valuation Deficit NPV Static DTA/Options Option Premium C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

8. Valuation Deficit NPV and conventional risk/benefit analysis penalize long-term projects to an extent that these projects cannot be justified as part of the portfolio Therefore, technology, and especially, science project offices would love to have their portfolio supported by revolutionary approaches that can enhance their budgets while justifying them through Real Options NAS attempt and failure to come up with a really solid cost- benefit analysis ending up with fuzzy concepts. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

9. ‘Real Options’ Drawing on recent advances in finance, a ‘real options’ methodology has been under development the past few years as a new way to approach the ex ante appraisal of R&D investments. Corporate America uses ‘real options’ regularly to evaluate their risky ideas and projects. Energy exploration and pharmaceuticals have been pioneering sectors. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

10. Real Options: Advantages The ‘real options’ methodology allows combining capital budgeting and strategic planning. Its relative strengths are particularly important for the ex ante appraisal of highly risky, long-term R&D investments. The ‘real options’ methodology has significant potential for creating a very valuable, rigorous analytical complement to the established expert review procedures. Expert reviews and options appraisals of R&D programs should complement, leverage, and enhance each other. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

11. Compound Real Options for R&D R&D projects generally involve multiple phases with or without overlapping. If the investment is made in a phased manner, with the commencement of subsequent phase being dependent on the successful completion of the preceding phase, it is known as sequential investment. [Stop Gate] Each stage provides information for the next thus creating an opportunity (option) for subsequent investment in a new technological area. Such projects can be valued using the techniques of ‘Compound Options’, also known as ‘Option on Options’. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

12. Compound Real Options for R&D The Options approach allows one to estimate the maximum funding level that could be spent on the R&D initially…. followed by a clear quantitative estimate of how much funding would be acceptable for the second, third, etc. stages of the Program before it goes into the market for commercialization. In effect, at every stage one determines the option for the next stage. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

13. Compound Real Options for R&D By explicitly recognizing the ‘choice to invest’ aspect of earlier-stage R&D projects, this mechanism greatly enhances the ability of decision-makers to justify long-term R&D investments made by the public sector. For instance, an early R&D investment by the public sector in an emerging technological area may be considered the mechanism for enabling (establishing the option for) the private sector to undertake the follow-up investment required to innovate in that area. Moreover, by differentiating among the various stages in an R&D program, this mechanism allows the use of more appropriate discount rates that better reflect the differential risks of technologies in various stages of development. C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y

14. Data Requirements The necessary variables for the calculations include: Value of technological advancement X (private and social returns) Interest rate (Cost of capital), (OMB discount rate in US?) Number of investment phases in the R&D project Expected cost per investment phase Time periods to completion for each phase Probability of success in each phase Investment required for commercialization (capital cost such as plant, etc.) C ENTER FOR I NTERNATIONAL S CIENCE AND T ECHNOLOGY POLICY T h e G e o r g e W a s h i n g t o n U n i v e r s i t y