Irreversibility and Restoration in Natural Resource Development

We extend Real Option Theory to evaluate natural resource development projects that may bring negative net bene ts and require costly restoration. Based on a new concept, irreversibility cost, we show that the degree of irreversibility becomes an endogenous choice, rather than an exogenously given economic constraint. The xed cost of restoration has continuous impacts, over and above the widely recognized xed e ects, on the level of development and restoration (and the marginal q). Further, the value of the project may not necessarily be convex in the underlying random variable, and discounting may in fact encourage the pattern of developing now and restoring later. The standard tool of project evaluation, the Net Present Value criterion, seems applicable to natural resource projects, such as a hydroelectric dam or clear-cutting land for agriculture. But as Arrow and Fisher (1974) argues, resource project evaluation has to account for restoration di culties in case of project failures. This feature has generated a rich literature on investment decisions under uncertainty and irreversibility, or Real Option Theory (ROT). The major argument of ROT is that facing irreversibility and uncertainty, it may pay to delay the investment and wait for information to avoid the downside risk. Thus, conventional project evaluation leads to too early or too much investment. The assumption of absolute irreversibility in ROT is in most cases too strong, given resource restoration e orts currently going on around the world. Fish population reduced by a dam may be restored by decreasing the capacity of or even destroying the dam. Clear cutting forest may endanger valuable species, and restoration involves reforestation to preserve these species. Most of the ROT literature focus on the timing of investment and do not allow variable project size. We call this 0-1 approach since the decision for the current period is either full (the \1") or no development (the \0"). The major conclusion of the 0-1 model is that increased uncertainty tends to delay the investment. Pindyck (1988) considers variable project size but does not allow costly restoration. He concludes that increased uncertainty reduces the level of investment. This paper aims to extend ROT to allow for restoration of natural resource projects that may result in negative environmental bene ts. Irreversibility is not assumed, instead economic optimization determines the extent of restoration and whether zero restoration (irreversibility) is see Arrow and Fisher (1974), Henry (1974), Dixit and Pindyck (1994), Epstein (1980), Freixas and La ont (1984), Ulph and Ulph (1997), and Kolstad (1996). There are e orts to restore the Everglades in Florida, the San Francisco Bay Delta in California, the Rhon River in France, the Pearl River in China, and the Hula Lake in Isreal, among others. Destroying the Elwha dam in the state of Washington has been studied seriously as a way of restoring the ecosystem and sheries in the Elwha River area. They include Arrow and Fisher (1974), Henry (1974), Capozza and Li (1994), McDonald and Siegel (1986), Majd and Pindyck (1987), Dixit and Pindyck (1994) and a series of papers by Pindyck.