Real Options: Dealing With Uncertainty in Systems Planning and Design

Abstract

The integration of ‘‘real options’’ analysis will radically change the design of public and private systems. It will change the processes of system design, the way planners deal with uncertainly and risk. It will also change the outcomes, the kinds of elements designers build into the system as they develop it. This paper explains this coming evolution, and presents cases documenting the changes in attitude and the results already occurring. To think in terms of options alters the way one deals with uncertainty. Conventionally, good design minimizes risk. It focuses on increasing reliability and making the best decisions in risky situations. In short, it is reactive to risk. The framework of options thinking, however, recognizes that uncertainty adds value to options. In this context, uncertainty is a driver of value and can be viewed as a positive element. Correspondingly, systems design from this perspective is proactive towards risk. It seeks out opportunities to add value and commits to ongoing processes of information gathering to ensure that options can be exploited at the correct time. Thinking in terms of real options leads designers to build much more flexibility into a system than is common in current practice. For example, they may build duplicate combustion facilities that allow a plant to burn both natural gas and oil, or deliberately develop products that they may never launch. These investments that may be unused are ‘‘options’’; they give the system managers the capability to change the design or product mix, without requiring them to do so. The analysis of real options involves a set of procedures that adapt and extend the options analysis that won a Nobel in economics for its developers. Options analysis is now widely used for contracts on all kinds of widely traded financial instruments (stocks and bonds), commodities (oil, grain, and foreign exchange) and services (electric power, communications bandwidth). The analysis of real options applies the same basic principles, but adapts them to the particular circumstances of systems design, which generally deals with unique projects that lack historical statistics on risk. The analysis of real options enables managers and designers to estimate the value of system flexibility. As this has not been practical before, designers have previously not considered the value of flexibility. Incorporating this capability into systems analyses adds two significant dimensions to design. Public and private operators of major systems will come to recognize: - Large classes of projects as much more valuable than they now seem to be – these include all those that enable further development without committing to it prematurely, such as research, product development, system modularity, exploratory mining, etc.; and - New classes of design alternatives, specifically those enabling managers to adjust the system as needed when relevant information becomes available, that is design alternatives that involve deferral, acceleration and closure of facilities. The paper illustrates the wide range of applications of for the analysis of real options, using documented cases in many fields of engineering. It also refers to the extent possible to companies changing their procedures for system design and management to capitalize on the promise of real options.