# 2 Uncertainty and investment

## 2.1 Real options theory

The primary research question we explore is how firms react to uncertainty associated with climate change by adjusting their investment behavior. We adopt a broader perspective by treating temperature uncertainty as a contributor to the overall uncertainty that firms face across various industries. This approach allows us to move beyond sector-specific impacts and focus on how unpredictable weather patterns generate broader uncertainty in firms’ strategic decision-making processes, affecting investment choices, operational planning, and risk management strategies in both direct and indirect ways.

In the firm-behavior theory, the relationship between uncertainty and a firm’s investment has been significantly shaped by the Real Options Theory (ROT), initially proposed by Myers (1977) and further developed by Abel (1983), Bernanke (1983), McDonald & Siegel (1986), Dixit et al. (1994), Abel & Eberly (1996). This theory redefines investment decision-making in the context of uncertainty. Unlike traditional accounting methods for investment decisions, such as the net present value rule—which states that firms should invest when the discounted present value of future cash flows exceeds the cost of the investment—ROT suggests that it might be optimal for firms to delay their investments until they have more information about their economic environment. The theory highlights that uncertainty is a critical factor in such decisions, suggesting that increased uncertainty raises the value of the option to wait thereby reducing the propensity to invest.

The issue of the investment–uncertainty relationship is particularly important in the context of irreversible investments (Baldwin 1982). Such assets, including infrastructure like gas pipelines, cannot be easily reversed or undone without significant costs or losses. Given the high costs associated with undoing such investments, the impact of uncertainty can be substantially more severe. This observation suggests that the relationship between uncertainty and investment may be more pronounced in sectors or firms with a higher proportion of irreversible assets (Pindyck 1990, Dixit et al. 1994).<sup>3</sup> In the broader context of the negative relationship between uncertainty and investment rates, we understand temperature uncertainty as a contributing factor of the overall uncertainty firms encounter in their decision-making. Sudden fluctuations in weather conditions can lead to unpredictable spikes in operational costs, particularly through volatile energy expenses. Additionally, weather-driven disruptions in market dynamics can trigger abrupt shifts in demand or create supply shortages, driving price instability and complicating firms’ ability to forecast future profitability. These unpredictable factors may increase the complexity of long-term strategic planning, indicating that temperature uncertainty could be an important component of the broader uncertainty influencing investment behavior.

## 2.2 Basic model

To establish the mathematical relationship between uncertainty and investment rates, we draw on McDonald & Siegel (1986), which derives the value of the investment option as a function of the project’s

> 3The investment–uncertainty relationship has been extensively tested both at the aggregate (Ferderer 1993, Caballero & Pindyck 1992, Ghosal & Loungani 2000, Huizinga 1993) and the firm levels (Leahy & Whited 1995, Bell & Campa 1997, Bulan 2005, Bulan et al. 2009, Bloom 2014). As surveyed in Leahy & Whited (1995) and Carruth et al. (2000), the general consensus is that increased uncertainty, at both the aggregate and disaggregate levels, leads to lower investment rates.

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