Sea level rise and optimal flood protection under uncertainty

We analyse optimal investment in one of the most important forms of climate adaptation: flood protection. Investments to build and heighten dykes and surge barriers involve considerable adjustment costs, so that their construction locks in the level of flood protection for some time. Investment decisions must take into account both economic and sea level rise uncertainty over a horizon of several decades, where the latter is to a large extent driven by global warming. We put forward a tractable macro-finance DSGE model that includes flood risk. We obtain solutions for optimal flood protection as a function of these uncertainties, costs, and preferences regarding impatience, risk aversion and intertemporal substitution. Sea level rise uncertainty always leads to more flood protection. Economic uncertainty leads to less (more) protection if the elasticity of substitution is greater (less) than one. We illustrate our results with a calibrated case study for the Netherlands.