Adaptation to climate change: Extreme events versus gradual changes

Global climate change will lead to increased frequency and severity of extreme weather events, on top of the gradual changes in temperature and precipitation. We develop a real options model of adaptation to climate change, capturing the different effects of gradual changes, represented by a Brownian motion process, and extreme events, represented by Poisson jumps with a hyper-exponential jump size distribution. We compare adaptation decisions under the increased frequency, severity, and tail thickness of extreme events as well as gradual changes. We find that while the adaptation incentives are higher in response to gradual changes, the probability of carrying out adaptation activities is higher in response to extreme events. The catalyst effects of extreme events become more significant when the tail distribution of the extreme events becomes heavier.