Christian Gollier, and Nicolas Treich, “Option Value and Precaution”, in Encyclopedia of Energy: Natural Resources and Environmental Economics, vol. 2, chapter 159, 2012, pp. 332–338.
Preserving flexibility has a higher value in a more uncertain environment. This common wisdom has long been given a support from the economic literature through the notion of option value. We interpret the Precautionary Principle in the light of this literature on option value. Formally, we examine the impact of incomplete and evolving information on the optimal initial action. Precaution is associated to the intuition that more uncertainty should lead to preserve more flexibility. We show that this intuition is consistent with the “irreversibility effect”. However, such a prescription has a weak economic basis because of the presence of other effects, such as the willingness to transfer more wealth in the face of a more uncertain future. We recognize the high complexity of applying the Precautionary Principle under this approach. We illustrate our analysis for stock pollutant problems, such as the climate change problem. We briefly discuss implementation issues and alternative approaches to the notion of precaution.
Climate change; Cost–benefit analysis; Expected utility; Future generations; Information; Irreversibility; Option value; Precautionary principle; Risk aversion; Scientific uncertainty; Sequential decisions