This item is the archived peer-reviewed author-version of:
Real option applications in megaproject planning: trends, relevance and research gaps. A literature review
Reference:
Machiels Thomas, Compernolle Tine, Coppens Tom.- Real option applications in megaproject planning: trends, relevance and research gaps. A literature review
European planning studies - ISSN 0965-4313 - Abingdon, Routledge journals, taylor & francis ltd, 2020, p. 1-22
Full text (Publisher's DOI): https://doi.org/10.1080/09654313.2020.1742665
To cite this reference: https://hdl.handle.net/10067/1678910151162165141
Institutional repository IRUA
Real option applications in megaproject
planning: trends, relevance and research
gaps. A literature review
Thomas Machiels,Tine Compernolle &Tom Coppen
ABSTRACT
Abstract
Megaprojects are complex and contain multiple risks and uncertainties. The
dominant ‘predict and control’ planning method mainly ignores risks and
uncertainties, making megaprojects inflexible and vulnerable to unforeseen
changes. Insights and methods from real options theory (ROT) in economics
and finance have the potential to improve planning of megaprojects in three
ways: (a) better management and assessment of risks and uncertainties, (b) a
more transparent and explicit identification and communication of risks and
uncertainties, and (c) a monetary valuation of flexibility. An in-depth literature
review of 42 papers of real options applications to megaprojects serves as a
benchmark to analyse if current real options literature meets these three
expectations. Through this review, we identify the main trends, relevance and
research gaps. While its theoretical relevance is illustrated, three main gaps
impede real options’ practical relevance for megaprojects: the applications
paint an incomplete picture of megaprojects; its mathematical complexity; and
the lack of empirical evidence of real-life cases. Based on a plea for more
interactive research between scholars and planning practitioners, we provide
an agenda for further research as to how ROT can better meet its expectations
and fulfill its potential for the planning of megaprojects.
1. Introduction
The planning of megaprojects is complex and characterized by multiple
sources of uncertainty. To integrate uncertainty analysis within the evaluation
of megaprojects, scholars have put significant attention to the real options
theory (ROT) during the past two decades. ROT rose in the fields of finance
and economics in the 1970s following increased criticism against static and
inflexible methods used in investment decision-making, mainly the cost–
benefit analysis (CBA). In a CBA, discounted future cash flows are calculated
for an investment decision over a certain period. ROT scholars criticize this
method for not properly considering the impact of uncertainties that can alter
these cash flows. These approaches often neglect the value of managerial
flexibility to adapt to future changes (Trigeorgis, 1996).
ROT offers an alternative approach in which real options – relating to real
assets – are valued throughout the decision-making process, so decision-
makers can adapt to future changes by exercising the options they hold. With
roots in finance, the potential of ROT is now increasingly explored in planning
and design of construction projects, and in particular in megaprojects.
‘Megaprojects are large-scale, complex ventures that typically cost US$1
billion or more, take many years to develop and build, involve multiple public
and private stakeholders, are transformational, and impact millions of people’
(Flyvbjerg, 2014, p. 6). Examples include hospitals, wind farms, large-scale
signature architecture, or transport infrastructure (Flyvbjerg, 2014).
Megaprojects’ main challenges are its complexity and multiple uncertainties;
planning for an uncertain future; and inaccurate forecasts and cost–benefit
estimations.
In this paper, we focus specifically on real options applications in large
transport infrastructure, generally the largest subcomponent of megaprojects.
Transport infrastructure is a physical or tangible asset providing essential
services and important for economic growth (Biatour et al., 2017). It
encompasses roads, car parks, rails, ports (shipping), and airports. Transport
infrastructure makes up the bulk of case studies and data sets in megaproject
literature. Therefore, we use the term ‘megaprojects’ throughout this paper
when discussing real options applications in large transport infrastructure
projects.
We question ‘(I) how ROT is applied to megaprojects?’, and ‘(II) to what extent
these applications are solutions for the challenges megaprojects face?’
Answering these research questions allows us to illustrate and facilitate real
option’s potential for megaprojects. We conducted a qualitative and in-depth
literature review (Petticrew & Roberts, 2008) of 42 articles of real options
applications to transport infrastructure projects. While overviews on ROT
applications in transport infrastructure exist (Martins et al., 2015), our analysis
of the literature aims to provide insight on the trends, relevance and gaps of
ROT applications; with the aim to explore the potential of ROT as a method for
adaptive planning in megaprojects.
The introductory subsections that follow provide a theoretical background of
megaprojects’ challenges and ROT. In Section 2, our method of an in-depth
literature review is explained, followed by an overview of the results in Section
3, illustrating the main trends. In Section 4, we discuss the relevance and gaps
of real options applications in megaprojects, by connecting the main trends to
the challenges identified in megaprojects literature. We introduce areas for
further research for closing existing research gaps so the relevance and
practical applicability of ROT for megaprojects could increase. The conclusion
summarizes the main statements and contributions of this paper.
1.1. Megaprojects and their challenges
There is an abundance of literature covering megaprojects and their
challenges (e.g. Flyvbjerg, 2017; Priemus & Van Wee, 2013; Priemus et
al., 2008a). Megaprojects are complex, contain many uncertainties and are
‘risk-rich’. The possibility for an unexpected turn of events makes it difficult to
make plans and predictions for decades into the future, and to make (all)
decisions at an early stage. This often leads to inaccurate forecasts about
expected costs and benefits (Flyvbjerg et al., 2005). Frequently returning
inaccurate forecasts lead to cost overruns and time slippages. Nine out of 10
projects have cost overruns (Flyvbjerg, 2014).
Explanations on cost overruns dominating megaproject literature are
economic, psychological, or political in nature (Flyvbjerg et al., 2002).
Optimism bias (psychological) means the initial costs are underestimated while
the benefits are overestimated, because forecasters are overly optimistic, a
form of self-deception or delusion (Flyvbjerg et al., 2009). Strategic
misrepresentation (economic, political) implies that inaccurate forecasts are
deliberately falsified through deception and lying to satisfy politicians and ease
project approval (Flyvbjerg et al., 2009).
However, technical or methodological explanations for inaccurate forecasts
are of equal importance. Many inaccurate forecasts, cost overruns and time
slippages originate from the management method, rather than megaprojects’
complexity itself. Despite the well-known history of inaccuracies, traditional but
deficient methods are still widely used to manage the megaproject process,
predict outcomes, and assess risks. Megaproject management is based on the
dominant ‘predict and control’ approach (Koppenjan et al., 2011), attempting to
reduce complexity. Costs and benefits are predicted in a CBA, which deals
with only one possible future at a time, making it a static and inflexible method.
CBAs often lack an incorporation of uncertainties, ignoring unforeseen
changes and creating an illusion of certainty about the future (Beukers et
al., 2012; Van Wee & Rietveld, 2013). Traditional risk management aims to
push out risks and uncertainties through risk avoidance, risk reduction, or
shifting risks to other parties (Bruzelius et al., 2002). The ‘predict and control’
method, therefore, leaves little room for adaptation (Giezen, 2013), making
megaprojects inflexible and vulnerable to uncertainties. Figure 1 summarizes
Megaprojects’ characteristics, the predict and control approach, and
megaprojects’ challenges in a conceptual framework.
Figure 1. Megaprojects: characteristics, dominant approach and their
challenges.
1.2. Real options theory
ROT offers an alternative addition to the inflexible ‘predict and control’
approach. The theory was a response to the dissatisfaction of academics,
strategists and corporate practitioners with the traditional techniques of capital
budgeting, more specifically CBA (Trigeorgis, 1996), with the articles of Black
and Scholes (1973) and Myers (1977) as two important milestones. CBA
works well for passive investments in bonds and stocks, but less so in
strategic planning (Trigeorgis, 1996). Trigeorgis (1996) described this failure
as ‘their inability to properly recognize the value of active management in
adapting to changing market conditions or properly capture strategic value’ (p.
9).
ROT is applied to investment decisions that are irreversible, where there is
uncertainty about the future benefits and/or costs of the decision, and where
the decision-maker has a choice in the timing of the investment (Dixit &
Pindyck, 1994). Analogue to financial options, opportunities to acquire real
assets can be called ‘real options’ or ‘flexibility options’. The name ‘real options
theory’ refers to an approach involving real assets, projects, or physical
objects, contrary to purely financial agreements such as stock options
(Trigeorgis, 1996). The holder of the option can either exercise or ‘kill’ it by
choosing to invest, or delay the investment and wait for new information to
arrive that dissolves some, but not all uncertainty about future benefits that
might affect the timing of the investment (Dixit & Pindyck, 1994). The holder of
the option will only exercise or ‘kill the option’ when the value of the underlying
asset is higher than its strike price. This option to wait has a value in itself,
which increases the overall benefit of the investment decision. It is important to
