Portfolios of adaptation investments in water management

This study explores how Modern Portfolio Theory (MPT) can guide investment decisions in integrated water resources management (IWRM) and climate change adaptation under uncertainty. The objectives of the paper are to: (i) explain the concept of diversification to reduce risk, as formulated in MPT; (ii) discuss the conditions for applying MPT to IWRM, and provide examples of these; and (iii) analyze the opportunities and limitations of applying MPT to the design of IWRM and adaptation policies. It is shown that MPT can be applied when a case meets four conditions: (1) there is more than one possible investment at a given time; (2) these investments are subject to risk; (3) there is information about the historical and/or expected return of these investments; and (4) the same conditions do not affect all investments equally, meaning that their returns are imperfectly correlated. Analysis of a case study Noorderkwartier in the Netherlands concludes that MPT can contribute to designing portfolios of combinations of investments in flood risk management—technical measures, spatial planning and insurance—which are robust to uncertainty in long-term projections such as present in climate change scenarios.