51st Congress of the European Regional Science Association: "New Challenges for European Regions and Urban Areas in a Globalised World", 30 August - 3 September 2011, Barcelona, Spain
A transportation investment that materially improves links between centres opens up previously unavailable options for new activities. Traditional cost-benefit analysis, that focuses on valuing benefits such as reduced travel time and safety improvements, does not adequately account for increased options for new activities arising from such an investment. Instead, real options theory must be added to the analysis to evaluate the full benefits of the new link. Two inter-related problems with real options analysis for practical use are that: (a) the nature of the options potentially being created are difficult to value, and (b) the standard mathematics of real options analysis is complex. Nevertheless, the intuition behind the role of real options analysis is straight-forward. This paper uses a specific example - Auckland's Harbour Bridge and the Northern Motorway that stretches beyond it - to illustrate the importance of real options analysis. It combines an illustrative, multi-period model of the real options problem, that clearly identifies the option value created by a new investment, with data on the effects of the Harbour Bridge and related investments. The illustrative model highlights that the inclusion of real options factors may either increase or decrease the attractiveness of a proposed investment, and it identifies the type of factors that would lead one to invest even where a standard benefit-cost ratio is less than one. These factors are considered in the context of the Harbour Bridge investments, demonstrating their practical, as well as theoretical, importance.