Real Options for IFRS-S1 and S2 2024 Mandatory Disclosures: An Alternative Approach to Capital Budgeting Valuation

Abstract

The new financial standards, IFRS S1 and S2, have not only modified the way financial reporting is presented to diverse stakeholders but have also increased uncertainty. These changes make traditional valuation methods inadequate. This article proposes the development of a valuation framework using Real Options Valuation (ROV), which incorporates the disclosures required by S1 and S2 as inputs to the valuation model. The framework proposes a quarterly decision rule for deferring investments, parameters aligned with the new sustainability disclosures, and notes in the financial statements proposed as voluntary reporting. The results show that, under regulatory uncertainty and its associated implications, the deferral option is a more effective technique than the Net Present Value method. For professionals responsible for the valuation process, the proposed model serves as a practical guide for applying the ROV within the capital budgeting process. For investors, it provides an additional element of transparency through disclosure and alignment with other existing accounting standards. This work lays the groundwork for future empirical applications as companies adapt to the implementation of new accounting standards and their associated reporting.

1. Introduction

Technological advances, constant innovation, and global economic conditions have made the development of industries and companies advance by leaps and bounds. These rapid and unexpected changes have made the business environment unstable, so traditional models cannot quickly adapt to this new reality (Calle Fernández & Tamayo Bustamante, 2009). However, project valuation presents complexities when creating financial models to add value to the company, and it becomes even more challenging to make informed decisions when market conditions are riskier due to new financial regulations, which reveals a gap in connecting sustainability disclosures with valuation methods that incorporate managerial flexibility under uncertainty. This paper, therefore, proposes a model for capital budgeting valuation in an uncertain and flexible scenario related to postponing investment, following the principles of IFRS S1 and S2, using Real Options Valuation (ROV), and the guiding research question is how ROV compares with static NPV in capturing uncertainty and flexibility in investment decisions. The central argument is that, unlike traditional discounted cash flow models, ROV provides a more substantive and decision-useful framework for capital budgeting that can help firms decide not only whether to invest but also whether to continue, postpone, or cancel projects, thus shifting sustainability reporting from symbolic compliance to substantive accountability. Recent studies support this perspective, for example Martello et al. (2024) propose a real options analysis framework that considers uncertainty in adaptation costs, flood severity, and flood losses and how they impact performance outcomes, Lee et al. (2023) develop a real options model with reinforcement learning for uncertain policy environments, and A. C. Martins et al. (2023) explore the uncertainty of expected returns by adopting the real options analysis method for renewable energy projects in Brazil. These contributions make it clear that the empirical application and relevance of ROV use in sustainability contexts are increasing, and this trend is likely to intensify now that it will become a compliance requirement.

All stakeholders in the economic world are now, more than ever, considering new factors that can affect business operations, among which climate change and its implications stand out, so investors and firms are looking to adapt to climate change requirements, and accounting and financial reporting standards are not immune to these new market trends and needs and have therefore evolved to adapt and create new standards that impact all companies and markets. Companies are concerned about compliance with the new financial standards due to legal issues and reputational risk related to accounting standards around climate change. For these reasons, appropriate compliance is essential, adding to certain benefits such as early adoption, which can create higher firm value and better liquidity (Gao et al., 2019). Unlike other accounting standards updates, this is the first time investors and company management will use these standards to report and analyze the risks and opportunities that sustainability factors imply (Pearce, 2008), and emphasizes the importance of considering ecological sustainability in infrastructure planning, as well as the need to identify cost-effective sustainability strategies for capital projects (Swilling, 2006). The study is therefore innovative because the standards S1 and S2 will be applicable and mandatory for the first time in 2025, and the need for a project valuation model that adapts to this new reporting reality, encompassing not only financial but also sustainability factors, is vital to provide certainty to investors, while the proposed disclosure framework can be a relevant complement to the S1 and S2 norms. The remainder of the paper is structured as follows: Section 1 presents the research gap and outlines the study’s contribution; Section 2 presents the conceptual framework and methodology, including the justification of the binomial model; Section 3 provides a practical development of the model and how the volatility can be calculated; and Section 4 discusses the theoretical and practical implications, while also highlighting the limitations and future research directions.

1.1. Definitions and Scope

The authors seek to avoid ambiguities and, therefore, consider it optimal to clarify various technical terms within this study.

Capital Budgeting: The process by which companies plan, value, select, and carry out long-term investment projects.

Project Valuation is a key process in capital budgeting, where assumptions are used to determine the impact of investment projects on a company’s value. To determine this future value, techniques such as Net Present Value or ROV are used.

The central concept of this article is ROV, a technique for valuing companies’ investment projects. This method, unlike others, has the advantage of incorporating flexibility to postpone, expand, contract, and even abandon an investment project. These situations can be realistic, especially in an uncertain environment.

In the following sections, the authors will use the term Underlying Asset Value (UAV) to refer to the present value of the cash flows that a project is expected to generate over its lifetime. In this same context, the authors use the term Strike Price (SP) to represent the initial outlay required for an investment to be carried out.

It is of utmost importance to note, especially in relation to the company’s economic issues, that unlike the financial instrument called options, where a premium must be paid to have the right to buy an asset, real options in valuation projects do not require any outlay other than that necessary for the investment being valued.

1.2. Research Gap and Contribution

The real options literature has proven helpful for investment decisions under uncertain scenarios; however, due to the novelty of the new IFRS S1/S2, ROV variables and IFRS requirements have not yet been fully linked. This article provides three new features: (i) an S1/S2 mapping as a variable selection for the ROV Model; (ii) a quarterly decision rule that compares ROV to NPV over a time horizon; and (iii) a voluntary disclosure framework (aligned with IFRS 13/IAS 36) that connects the variables used in the model with the required sustainability disclosures. This article extends beyond conceptual knowledge, guiding the valuation of capital projects in uncertain environments.

IFRS S1 and S2 have the potential to improve the quality of sustainability reporting, although there are challenges associated with their implementation. The implementation of these new financial reports is expected to provide clear guidance for companies in preparing transparent and accountable ESG reports, to support better decision-making by stakeholders (Wahyuni, 2025). The arrival of the new IFRS will be particularly interesting as this is the first time that financial and sustainability reporting will be integrated into a company’s corporate reporting. Given the relatively short timeframe since its introduction, there may be limitations in assessing the full impact or implications of these standards (A. Pratama et al., 2024). G. S. Pratama et al. (2025) argue that the sustainability reporting ecosystem shaped by IFRS S1 and S2 requires accounting research to provide conceptual and methodological support for its implementation.

Recent studies show how sustainability reporting has reshaped corporate disclosure practices. (Paoloni et al., 2025) demonstrate how Italian SMEs face inequalities in climate disclosure, leading to the need for structured guidelines. Nicolò et al. (2024), through a bibliometric analysis, point out the increasing relevance of value-based research in accounting and reporting domains. Two different research papers (Nicolò et al., 2023; Raimo et al., 2022) reinforce two key ideas: first, they show how the integrated report can reveal corporate contributions to the Sustainable Development Goals, and, in addition, corporate governance practices with risk reporting help to have a more solid and transparent governance that obviously results in investor confidence. To complete this review of recent studies, Vitolla et al. (2019) emphasize the pressure that certain interest groups exert on companies and how that pressure becomes decisive in the quality of integrated reports.

All of this together demonstrates that although the new S1 and S2 standards have a design focused on improving transparency in sustainability issues, effective implementation requires methodological tools, such as what the authors of this paper propose, that allow reports to provide valuable financial information.

To address the identified gap, this study seeks to answer the following research questions:

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Does the ROV model involve any payment of an upfront premium like financial option contracts?

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How do we practically use the ROV model to facilitate the integration of risk identification in the IFRS S1 and S2 sustainability disclosures requirements?

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What are the core issues organizations encounter in the ROV model application for the scenario of regulatory uncertainty and sustainability reporting?

2. Materials and Methods

2.1. Background and Relevance of the IFRS—S1 and S2

In 2024, IFRS S1 and S2 became effective for annual reporting periods beginning on or after 1 January 2024 (IFRS, n.d., IFRS S1 General Requirements for Disclosure of Sustainability-Related Financial Information). These new financial standards will help investors and other decision-makers by providing more relevant information on the sustainability of companies. However, while they will be helpful, they pose a significant challenge at the corporate level due to their novel nature and the increased risks and uncertainty they entail.

For nearly 40 years, the International Accounting Standards Board (IASB) and its predecessor, the International Accounting Standards Committee (IASC), have been working to develop a set of high-quality, understandable, and enforceable International Financial Reporting Standards (IFRS) to serve equity investors, lenders, creditors, and others in globalized capital markets. When the IASB took over from the IASC in 2001, few countries adopted International Accounting Standards (as IFRS was then called). That all changed—and quite dramatically—with two events. First, in 2000, the International Organization of Securities Commissions (IOSCO) endorsed IFRS for use in cross-border securities offerings worldwide. Then, in 2002, the European Union body decided to require IFRS for all companies listed on a regulated European stock exchange starting in 2005. Those events initiated a snowball effect, where roughly 100 countries now require IFRS or a national word-for-word equivalent for all or most listed companies (Pacter, 2013).

Over 150 jurisdictions, including the G20, have adopted these standards (Asumadu, 2018) due to their near-global adoption and benefits, such as improved quality of financial statements (Daske & Gebhardt, 2006).

The IFRS Foundation is a public interest organization established to develop high-quality, understandable, enforceable, globally accepted accounting and sustainability disclosure standards. Two standard-setting boards developed these standards: the International Accounting Standards Board (IASB) and the International Sustainability Standards Board (ISSB), which was created in 2021 (IFRS Foundation, 2018).

Financial sustainability disclosures have evolved significantly since the early 1990s (Lamberton, 2005). This standard emerged due to the rising requirements of stakeholders requesting information related to environmental performance and corporate social responsibility (Gutterman, 2023). Several frameworks and standards have been created to disclose more information about non-financial performance measures, including the Task Force on Climate-Related Financial Disclosures and the Sustainability Reporting Guidelines (Johnston, 2018; Lamberton, 2005). The Global Reporting Initiative (GRI) and Dow Jones Sustainability Index (DJSI) are widely used, but differences in their approaches highlight the need for further standardization (Christofi et al., 2012).

The need for standardization at an international level is one of the most important issues for the Standards Board (ISSB), which issued its first two global sustainability disclosure standards, IFRS S1 and S2, in June 2023. These standards set out general requirements for the disclosure of sustainability-related financial information for the needs of capital markets and provide climate-related disclosures (Köse & Çetin, 2024) as well as establish, for the first time, a common language for disclosing the effect of climate-related risks and opportunities (IFRS, 2024).

While IFRS S1 provides a set of disclosure requirements designed to enable companies to communicate with investors about the sustainability-related risks and opportunities (including climate-related disclosures) they face over the short, medium, and long term, the IFRS S2 sets out specific climate-related disclosures. It is designed to be used with IFRS S1 (International Sustainability Standards Board, 2023).

2.2. Risks and Financial Standards

Organizations face various challenges in implementing new accounting and financial standards. The issues include potential impacts on key financial performance indicators, such as Return on Equity and Return on Assets (Saiful et al., 2023), changes in debt ratios (Firaz et al., 2022), and changes in risk management policies (Lins et al., 2007).

New standards might require substantial improvements to information systems and internal controls (S. Arnold, 2009), which may increase operational risks. At the implementation level, organizations face challenges in continuing with dual reporting systems (S. Arnold, 2009). The issuance of such new standards can change the economic impact on a firm (Lins et al., 2007) and impact the extent of asymmetric information prevailing in the market (Panaretou et al., 2013). In addition to the above, organizations may also face issues related to incorrectness, fraudulent practices, and unfavorable legislative developments (Semenova et al., 2021).

It must be clear that industry-specific analysis is crucial for evaluating sustainability performance and identifying unique risk profiles; this is because there are differences in how companies use natural and other social resources when bringing their goods and services to market and in the manner they impact society and the environment, without leaving aside the risk that a new IFRS entails that can create crash risk (frequency of extreme negative stock returns); so it varies between industrial and financial sectors (Herz & Rogers, 2016). The experiences and personalities of managers also affect the managers’ interpretations of risk, which differ across industries, suggesting the need for differentiated risk measures (Pablo, 1999). Therefore, firms are faced not only with a new accounting standard but also with the way they analyze it and perceive the risk of implementing it.

The development of new accounting standards involves risk in sustainability because it was precisely this risk and the need for information on sustainable measures that gave rise to the new IFRS S1 and S2.

Sustainability risk management has become a key issue in the modern corporate landscape. It recognizes that environmental, social, and governance (ESG) factors are pivotal in shaping a company’s long-term viability. Sustainability risks encompass a broad spectrum of issues, ranging from climate change and resource scarcity to labor practices and supply chain disruptions. These risks can have a significant impact on a company’s financial performance, reputation, and stakeholder relationships (Bâtcă-Dumitru et al., 2022).

Many of the most critical business and economic risks are directly linked to environmental and social issues. The risk concerns reputation and, even more importantly, innovation capability and legislative change in inevitably more sustainability-driven markets (Schulte & Hallstedt, 2018).

Evidence suggests that high environmental and social risks may compromise corporations’ financial stability and increase their default risks, resulting in default costs (Cohen, 2023). Specific financial numbers may not be as relevant for non-public companies. However, companies can experience severe losses due to social, ecological, or ethical problems that exist within their supply chains (Hofmann et al., 2014).

2.3. Real Options Valuation

The history of valuation projects and capital budgeting has undergone significant evolution over time. The industrial revolution in the late 18th and early 19th centuries created a demand for capital budgeting processes and techniques (Haka, 2006). Capital budgeting refers to the process by which managers make decisions about long-term investments or capital expenditures to determine whether they are worth pursuing by their organizations, always considering the long-term goals of the entity. When these goals require investment, the finance team must plan, analyze, select, and manage capital investments.

Advanced capital budgeting practices involve methods and techniques that consider cash flows, risk, and the time value of money, such as the internal rate of return (IRR) and net present value (NPV) (Verbeeten, 2006). The timing of capital budgeting decisions is also a key factor (Hall, 2000). The capital budgeting process typically includes four stages: identification and development of investment proposals, financial evaluation of projects, implementation of projects, and project review (Batra & Verma, 2014).

It is essential to note the distinction between capital budgeting and project valuation, as they are often used interchangeably in the financial industry, although they are distinct concepts.

Capital budgeting involves the process of planning, evaluating, selecting, and managing long-term investments by organizations (Verbeeten, 2006). This process involves the appraisal of the practicality of various investment projects through the systematic allocation of resources to maximize profitability and reduce risk while considering the time value of money. Project valuation, on the other hand, forms the core element of capital budgeting with a focus on the appraisal of the value of specific investment projects.

The process usually involves the consideration of the forecasted cash flows of a specific project and the application of various valuation techniques such as Net Present Value (NPV), Internal Rate of Return (IRR), and other relevant methods to assess the financial viability of the project in the context of capital budgeting (Biondi & Marzo, 2011). In essence, while capital budgeting encompasses the broader strategic decision-making process of allocating resources to various investment opportunities based on financial criteria, project valuation is a specific aspect of capital budgeting that involves assessing the value of individual investment projects to inform decisions on whether to proceed with the project or not.

Based on the content from Baker and English (2011), project valuation plays a crucial role in determining whether to accept or reject a project. Adopting sophisticated valuation practices has evolved, with the discounted cash flow (DCF) method as the dominant approach in evaluating capital investment projects over the past 5 years. Despite the continued use of non-discounted cash flow (DCF) methods, their usage has decreased with the rising use of other DCF methodologies (Bennouna et al., 2010). Key sophisticated capital budgeting methods widely used include Net Present Value (NPV), Benefit/Cost Ratios, and Internal Rate of Return (IRR), all of which essentially consider the time preference of money (Gitman & Forrester, 2009).

Despite the prevalent use of Discounted Cash Flow (DCF) techniques, cases of misapplication were reported in the United Kingdom, the United States, and Canada, possibly causing wrong investment decisions (Bennouna et al., 2010). Real options analysis has emerged as a significant development, emphasizing the need to complement traditional evaluation methods with real options to determine the true Net Present Value (NPV) (Bennouna et al., 2010).

According to Siziba and Hall (2021), the more sophisticated valuation methods in capital budgeting include the ROV technique, which is derived from financial option valuation in derivative markets. It is important to remember what a financial option is. “An option provides the holder with the right, but not the obligation, to buy or sell an asset, subject to certain conditions, within a specified period” (Black & Scholes, 1973). For having this right, the buyer of the contract must pay a premium.

Real Options Valuation (ROV) approaches encourage decision-makers to appreciate the inherent flexibility surrounding future investment opportunities that underline projects, thereby encouraging a more extensive analysis of uncertainties and possible future outcomes. However, despite the advantages that ROV approaches offer for investment decision-making optimization, they are often characterized by high computational intensity and complexity, which may discourage some practitioners who prefer less complex and easily understandable approaches, such as DCF and non-DCF methods, due to their simplicity and ease of application.

G. C. Arnold and Hatzopoulos (2000) state that the best valuation method is to use multiple criteria for evaluating a proposal. Management needs to consider different indicators and multiple methods to evaluate the results comprehensively. When different indicators align and agree, it indicates a reliable proposal assessment, signaling a favorable investment decision.

Every investment project’s uncertainty also has a concept that other evaluation methods do not contemplate irreversibility. The NPV rule fails to recognize irreversibility as a cost, the opportunity cost of the money being invested, and the cost of giving up flexibility by committing resources irreversibly (Brach, 2003).

In the event of uncertainty and the need for investment, for example, due to a new financial regulation, companies would have the right but not the obligation to make such an investment. They could also have the right to invest more in the future or reduce the amounts allocated due to changes in the legislation. For this reason, real options are one of the best valuation methods in times of uncertainty.

The first thing to evaluate is the uncertainty related to the project. If there is no uncertainty, management can decide today, and there is no option value. Conversely, higher uncertainty creates future management opportunities, reflected in a higher option value (Anderloni, 2011).

Several authors advocate using real options as a valuable method for project valuation, emphasizing its ability to incorporate managerial flexibility and uncertainty into decision-making. Many authors are mentioned in the work of Hairong Gui (2011); one example is Amram and Kulatilaka’s work, which mentions that “real options are an important way of thinking about valuation and strategic decision-making.” McDonald (2006) suggests that real options form a sophisticated understanding of value on the dimension of investment choices beyond conventional valuation techniques. Trigeorgis (1993) mentions the crucial role of real options in capturing the value of flexibility.

The term “real options” was first coined by Stewart Myers in 1977, who recognized that traditional discounted cash flow (DCF) methods often undervalued investment opportunities by ignoring the flexibility and strategic options available to managers in uncertain environments (Brach, 2003).

Brennan and Schwartz were innovators in using real options to value projects in the natural resources industry, demonstrating how real options can be used to value the ability to defer or abandon investments based on current market conditions (Zhang, 2009). Additionally, their use is seen in the pharmaceutical industry, where they help to value investments in research and development projects (Ford & Wu, 2005). In a similar vein, real options have been used in the energy industry to value investments in renewable energy projects, especially with the high impact of uncertainty in decision-making (Gonçalves & Colombo, 2023).

It is important to note that early applications of real options arose in natural resource investment (Trigeorgis, 1993). When the theory matured, it found applications across various sectors, including pharmaceuticals, telecommunications, and infrastructure (J. Martins et al., 2015).

Table 1. Types of options according to the investment project decision.

Action	Description	Type of Option
Postpone the investment	Suppose the option to delay or defer investment is available. In that case, the company will decide to wait a specific amount of time if the NPV of the project is negative or if future uncertainty is very high.	Call
Expansion	This option is viable for high-growth opportunities, especially during periods of economic boom. The company has the potential to expand and significantly increase its value.	Call
Contraction	In a scenario contrary to the option of expanding, the company may find incentives to reduce its production capacity or size if market conditions turn out to be worse than expected.	Put
Abandonment	This option provides the company the right to sell, liquidate, close, or abandon a project when conditions warrant it. Abandonment options mitigate the impact of inferior investment outcomes and increase the initial valuation of a project.	Put

Source: Own elaboration, 2025.

shows the types of options the firm must consider according to the investment project decision.

Method

The authors focused on theoretical research design due to the relevance of the literature review on IFRS S1 and S2, risk and financial standards, and Real Options Valuation literature. This study structures its methodology into three phases: first, it analyzes how international financial standards have changed alongside companies in response to climate change disclosure. Additionally, the authors reviewed the literature on financial risks and their relationship with accounting legislation.

Second, it explains the relevance of the ROV method in the valuation process due to the project’s uncertainty.

Third, the study proposes an ROV model for capital budgeting, adapting the S1 and S2 norms and their respective variables. This proposal is based on the methodology of financial options, particularly in the binomial valuation model of Cox, Ross, and Rubinstein (Cox et al., 1979). It is the most appropriate when capturing project flexibility and uncertainty that can be presented in response to changing market conditions.

The model’s formulas are summarized as follows:

Call_i,j = max (So – K, e^–rΔt (p ∗ Q_u,j + (1 – p) ∗ Q_d,j))

Put_i,j = max (K – So, e^–rΔt (p ∗ P_u,j + (1 – p) ∗ P_d,j))

where:

Symbol	Definition
S0	Underlying asset value (present value of the projected cash flows)
K	Strike price, representing required initial investment (CAPEX)
r	Risk-free rate (annual, continuously compounded)
σ	Annual volatility (estimated from weighted 10-year ROA)
u	Up factor u = e^{σ√Δt}
d	Down factor d = 1/u
p	Risk-neutral probability for going up p = (R − d)/(u − d)
Qu	Value of the call option in the up branch
Qd	Value of the call option in the down branch
Pu	Value of the put option in the up branch
Pd	Value of the put option in the down branch

The implementation of the above formulas in the study enabled the derivation of a valuation model designed to integrate more variables and concepts relevant to the project, preparing S1 and S2 information.

The suggested approach has been outlined sequentially so that the organization can apply the model, considering all the cash flows, which will inform the decision-making paradigm for running the project or not. Each part of the financial model was analyzed to adapt it to the project valuation elements and assign a specific variable. Depending on the uncertainty of the project, the organization needs to analyze whether it is a call or a put option, and the model can be adapted to each sector or specific business.

2.4. Decision Rule and Benchmarking

The proposed model is applied using a binomial tree with quarterly intervals over 2 years. The result obtained using the real options model is compared with the original NPV, which does not contain flexibility. In Section 3.1, it is explained in detail how the proposal methodology helps to evaluate whether investing is advisable or, if appropriate, to postpone it to a future time, clearly demonstrating the generated value through flexibility.

2.5. Validation and Robustness

Given the inability to conduct empirical validation tests—due to confidentiality issues and the use of specific valuation methods for various public companies worldwide—a validation protocol is suggested as part of future research. This could include sensitivity analysis on volatility, discount rate, and initial investment assumptions, as well as stress tests related to regulatory scenarios.

2.6. Rationale for the Binomial Lattice

The reason the binomial option was selected is that it fits perfectly with the disclosures required by IFRS S1 and S2. The model is transparent, allowing the analysis of each assumption used, which would be presented in the sustainability financial report. Unlike the Black-Scholes model, the binomial model allows valuation of American options, which is necessary to establish a quarterly benchmark. This quarterly selection was necessary to establish a similarity with the financial reports that the company issues at the same frequency, thereby aligning the decision with financial reporting cycles.

These methodological exercises were not applied in the present study, but they constitute a natural path to validate the model. They are also consistent with the recommendations of IFRS 13 and IAS 36, which require the disclosure of sensitivity and scenario analysis as part of company disclosure.

3. Results

3.1. Proposed ROV Model

Based on the binomial financial model, the proposed variables for the ROV model are:

Underlying Asset Value (UAV): For this research, the underlying is going to be the present value of the Free Cash Flows (FCF) from a capital investment project (Anderloni, 2011), but the financial professional must know that other variables can be considered as the underlying, like natural resources (Gui, 2011), intellectual property (Sudarsanam et al., 2006), and market opportunities (Baker et al., 2011).

Time (T): This critical component represents the time left until the option period expires. In this context, investment time is divided into discrete periods (quarters), which allow the valuation of the option at any moment. The longer the period until expiration, the higher the probability of reducing uncertainty, which increases the option value.

Strike Price (SP): This is the initial cost and includes the outcomes related to the investment proposal. The organization would consider exercising the option in situations where the intrinsic value of the underlying asset is higher than the strike price, thus making the investment beneficial.

Discount rate (r): The Weighted average cost of capital (WACC) is the proposal rate for the ROV model.

Volatility (V): This is understood through the profitability of a firm because profit numbers indicate the volatility of cash flows and represent the ability of the organization to create value during changing circumstances and external shocks. Unlike volatility that is based only on market information, profits that appear on income statements necessarily include operational risks, cost elasticities, and vulnerabilities to external shocks, thus providing a more tangible expression of financial behavior. As part of the analytical structure of this study, volatility is estimated over 10 years using a weighted average, which assigns more than 50% of its weight to the last 5 years. The rationale for the use of the weighted method is the capacity to capture extraordinary events—such as pandemics, war, global negotiations, or underlying risks—that have had a significant impact on financial results. Profits themselves are subject to the impact of accounting standards, and the link between operational effectiveness and valuation from the market makes them an exceptionally reliable indicator of volatility in the context of real options.

Practical guide for volatility: Take a 10-year series of a firm’s annual profitability metric (e.g., operating margin, ROA, or net profit) obtained from the company’s annual reports and denoted as πt with t = −9, −8, …, −1, 0, where t = 0 is the most recent year. The authors suggest allocating 60% of the total weight to the last 5 years and 40% (0.12 each) to the first 5 years (0.08 each), so ∑wt = 1.

The Weighted Mean is μ(π) = ∑ wt*πt. Values such as −9, −8, −7, −6, … 0 in the weighted volatility calculation refer to selected metrics in percentage, for example, ROA for different fiscal years.

μ(π) = 0.08(π−9 + π−8 + π−7 + π−6 + π−5) + 0.12(π−4 + π−3 + π−2 + π−1 + π0)

The user needs to calculate the difference between the profitability metric and its weighted average, which was previously calculated. The result must be squared and multiplied by its weight, the same ones used in the weighted average, and finally, sum all the results Var(π) = ∑ wt *(πt – μ(π))2. From this result, we obtain the square root, which will be the standard deviation, σ(π) = √Var(π).

Our decision tree will be updated quarterly, so we need to convert the annual standard deviation to a quarterly value σΔt = σπ √0.25 since the year will be divided into four periods.

Up and down factors: The up factor is calculated using this formula u = eσ√Δt, and the down factor d = 1/u. In a zero-uncertainty scenario, the value of the underlying should grow at the rate of the risk-free rate, which is why it is defined by R = erΔt, but in reality, there is a probability that this value will rise or fall due to uncertainty, which is why the user needs to calculate p = (R − d)/(u − d).

So, the proposed model for evaluating the investment project is:

ROV𝑖,𝑗 = max (𝑈𝐴𝑉 𝑢^𝑖𝑑^𝑖−𝑗 − 𝐾, 𝑒−𝑟Δ𝑡(𝑝𝑄𝑢 + (1 − 𝑝)𝑄𝑑))

For every valuation step, the ROV must be compared with the NPV at the valuation time (the one without flexibility to postpone); if this is greater than the NPV, it means that the firm creates value and the right decision is to defer the investment, otherwise it has no sense to delay it. It is recommended that this comparison be made every quarter for 2 years.

3.2. Factors of Uncertainty That Could Affect the Cash Flow of the Investment Projects

Usually, companies face changes related to ESG factors that can affect the quantification of the future cash flow; these could be:

• New or changes in regulation: Regulatory change represents one of the most significant sources of uncertainty in project valuation. This uncertainty arises not only from the introduction of new standards but also from the continuous amendments to existing ones at international, national, and industry-specific levels. Climate-related regulations, such as Standards S1 and S2, exemplify this dynamic environment, where compliance requirements evolve rapidly in response to global sustainability challenges. Firms should place particular emphasis on monitoring regulatory developments and incorporating flexible valuation approaches to ensure compliance.
• An economic crisis derived from external factors such as wars, a healthcare pandemic, international negotiations, potential disruptions from extreme weather events, etc. Economic crises triggered by external factors constitute another critical source of uncertainty that companies must address. These crises often arise from events beyond a corporation’s control and can severely impact supply chains, production capacity, and ultimately, the cash flow generated by the firm. Natural disasters, such as floods, droughts, or wildfires, created a need for the company to integrate risk measures that account for such external shocks.
• New or changes in political statements: Political shifts and changes in governmental statements have increasingly become a significant source of uncertainty. The ideological orientation of policymakers can influence regulatory priorities, trade agreements, and legal frameworks, such that political volatility affects investment security, market access, and operational continuity.
• Internal financial factors such as governance and risk management: Internal financial factors, particularly corporate governance and risk management practices, represent a crucial source of uncertainty. Companies with boards of directors or committees lacking expertise in sustainability may fail to correctly identify and evaluate the risks to which they are exposed, while also overlooking significant opportunities. When governance structures are weak or risk management processes are insufficient, scenario analyses may be superficial or inaccurate.
• Transition risk: Transition risk, arising from the global shift toward low-carbon economies, has become a critical driver of uncertainty. As governments adopt stricter regulations around climate change, companies face increasing compliance costs and potential penalties for failing to meet emissions targets. Meanwhile, the movement of consumer demand towards sustainable products also risks decreasing demand and affecting revenue.

The IFRS Sustainability Disclosure Standards emphasize the importance of these risks. IFRS S1 requires entities to disclose sustainability-related risks that could reasonably be expected to influence cash flow, access to finance, or cost of capital over various time horizons. Similarly, IFRS S2 highlights that climate-related risks—including both physical and transition risks—can have direct financial implications, potentially altering a company’s performance and valuation outlook. Given this context, firms must integrate transition risks into their project assessments.

3.3. Illustrative Applications Across Sectors

Due to the confidential nature of the framework and the unique management selection of each company’s valuation methods, a complete empirical application of the framework proposed by the authors is not possible. Instead, illustrative examples were created across three industries to demonstrate how the requirements of IFRS S1 and S2 are aligned and how these inputs will be utilized in the proposed valuation model for real options. The examples are theoretical, but they are beneficial in clarifying their practical application and cross-sector relevance.

To illustrate the application of the model,

Table 2. Example of S1 and S2 Disclosure.

Sector	Key Disclosure Link (IFRS S1 and S2)	UAV	Strike Price	Volatility Driver	Practical Insight
Renewable energy	Carbon pricing and transition policies (S2)	Present value of the projected free cash flows	CAPEX for new plant	Historical stock price variability adjusted for carbon price scenarios	Flexibility to wait until the carbon policy stabilizes
Manufacturing (Retrofits)	Energy efficiency disclosures (S1)	Present value of the cost of savings	Retrofit + shutdown costs	Historical stock price variability	Incentives/tax credits make
Healthcare (regulated equipment)	Regulatory approval and reimbursement risk (S1)	Present value of expected revenues	Cost of acquisition and installation	Historical stock price variability adjusted for approval + reimbursement uncertainty	Flexibility for the project if reimbursement falls below the threshold

Source: Own elaboration, 2025.

presents examples across three industries.

3.4. Simulation and Sensitivity (Pilot)

To validate the model, we created a pilot simulation model using the binomial lattice (American style) with quarterly steps for 1 year. The UAV is assumed to be the present value of the cash flows already discounted at the appropriate rate, so the net present value is calculated by subtracting K, which is the initial investment of a project, from the UAV.

Table 3. Simulation test comparing NPV and ROV with different volatilities and impact for sustainability reasons.

Scenario	UAV (S0)	K (SP)	r (Annual)	Horizon/Steps	σ (Annual)	NPV (=S0 − K)	ROV	u	d	p (Risk-Neutral)	Decision Insight
Base–Low σ	150	120	0.05	1.0y/4q	0.2	30	36.7	1.105	0.904	0.5378	ROV > NPV
Base–High σ	150	120	0.05	1.0y/4q	0.4	30	44.4	1.221	0.818	0.4814	ROV > NPV
Carbon −10%	135	120	0.05	1.0y/4q	0.2	15	24.0	1.105	0.904	0.5378	ROV > NPV
Carbon −10%	135	120	0.05	1.0y/4q	0.4	15	32.4	1.221	0.818	0.4814	ROV > NPV
Carbon +10%	165	120	0.05	1.0y/4q	0.2	45	51.2	1.105	0.904	0.5378	ROV > NPV
Carbon +10%	165	120	0.05	1.0y/4q	0.4	45	56.4	1.221	0.818	0.4814	ROV > NPV

Source: Own elaboration, 2025.

presents a simulation test ran with six scenarios for a 3-month interval each. The base case involved a UAV of USD 150 and an initial investment of USD 120, plus a 5% discount rate, with volatility scenarios of 20% and 40%. The remaining four scenarios had a direct impact on the UAV of +/−10% due to regulatory issues surrounding carbon emissions. The following table shows that for each scenario, the ROV is greater than the NPV, so the choice for postponing the initial investment generates value for the company.

Figure 1 illustrates the sensitivity of the ROV to volatility. The positive slope clearly demonstrates that the value of real options increases with increasing uncertainty, and the difference with NPV also increases as the latter remains static.

3.5. Proposed Voluntary Notes Under IFRS S1 and S2

Currently, the IFRS Sustainability Disclosure Standards do not require organizations to disclose the valuation models used. In our opinion, doing so voluntarily would be highly beneficial for enhancing transparency and building investor confidence. The ability to present the valuation methodology, particularly in contexts of high uncertainty, allows stakeholders to understand not only the financial outcomes but also the resilience of the company’s decision-making process.

This proposal builds upon the disclosure practices established in IAS 16 (Property, Plant, and Equipment), IAS 36 (Impairment of Assets), and IFRS 13 (Fair Value Measurement). Standardized disclosures would require organizations to report in the financial statement footnotes the valuation methods used, the key assumptions applied, and the sensitivity analyses performed to show the effects on the reported numbers of differences in important parameters—like discount rates—by revealing the sensitivity analyses used. By adopting a similar approach to the IFRS S1 and S2, organizations can opt to give more detail on the consideration of sustainability-related risks in the valuation of investments.

We propose the inclusion of specific notes under IFRS S1 and S2 to achieve the following objectives:

• Describe the valuation model applied, such as the ROV approach proposed in this study, highlighting its theoretical foundation and adaptability under conditions of uncertainty.
• Disclose the key variables and assumptions, with particular emphasis on those that capture transition risks, climate-related risks, and other sustainability-related uncertainties as outlined by IFRS S1 and S2.
• Present sensitivity analyses, like those required under IAS 36 and IFRS 13, to illustrate the potential impact of changes in critical variables (e.g., interest rates, carbon prices, regulatory scenarios) on cash flow projections and valuations.
• Explain the connection between the model and the management of uncertainty, demonstrating how the approach supports dynamic decision-making and enhances the company’s resilience in an evolving regulatory and environmental context.

This framework does not intend to create additional mandatory reporting but rather to encourage companies to adopt a proactive stance in sustainability reporting. Providing this information gives investors clearer insights into how they assess, manage, and mitigate sustainability-related risks.

4. Discussion

4.1. Practical Implications for Practitioners

One of the objectives of this study is to serve as a guide for integrating regulatory uncertainty into project evaluation processes. The inputs required by IFRS S1 and S2 can be used as financial variables for the proposed real options model. The quarterly review provides a real and tangible measure of the company’s flexibility in response to uncertainty, such as new financial standards.

The way investment decisions are made will be strengthened with this model, as it not only seeks to generate value but also improve communication and transparency with investors. The assumptions must be included in the notes to the financial statements using the structure proposed in this article. Companies will not only demonstrate robust valuation and risk management but will also increase transparency and generate market confidence. This proposal is not only a conceptual framework but also practical steps that each company can adopt according to current regional regulations.

4.2. General Conclusions

According to our research questions, it is concluded that there is no real disbursement or payment for the option (as in the financial one). The valuation using the real option model assesses the value creation in the case of postponing the project, considering its flexibility.

In the financial world, it is expected to hear professionals talk about the risk-return relationship and its role in creating a valuation model. However, financial standards are rarely included as a determining factor in reporting the risks to which the company is exposed and the returns generated by any investment.

Nowadays, the evolution of investors has necessitated updates to various standards, and the need for comparable financial information is one of the cornerstones for the birth of international financial reporting standards. When an update is no longer sufficient, new standards are established to meet the needs of all parties interested in these financial reports. Sustainability reporting is a tool that can be used to increase transparency and accountability in issues that traditional financial reporting does not address.

One problem with the traditional NPV approach is that many projects contain embedded options. Conventional methods of business valuation, such as applying a price to earnings multiple, are not effective for new businesses. The project must be valued by estimating future earnings and cash flows under different scenarios. In this situation, real options valuation can be helpful and add considerable value to the company.

A project that is initially rejected can be accepted with a net profit in subsequent periods. So, ROV will help quantify risks and opportunities and incorporate them into an organizational process. It can serve as a framework to integrate non-financial information from various parts of the organization into the investment decision-making process.

The application of the ROV model poses significant challenges to companies. The strength of the approach assumes sophisticated financial competencies and efficient internal systems to forecast variables like volatility, weighted cash flows, and regime environments. The companies will also be unable to access reliable information to capture the sustainability risks. Resistance from organizations to the application of valuation methods and the value added to voluntary disclosure also inhibits the application. Even as the model provides value in the environment of uncertainty, application entails investment in training, information infrastructure, and governance practices aligned with sustainability reporting.

The authors’ conclusions also relate to issues raised in recent literature on sustainability and reporting. Wahyuni and Pratama emphasize the importance of IFRS S1 and S2 in improving transparency. This position aligns with the authors’ proposal regarding the use of real options as a tool to enhance transparency in investment decision-making and reporting. Paoloni et al. (2025) document adoption with inequalities in SMEs; the framework proposed by the authors of this article offers a way to intertwine sustainability risks with capital budgeting and thus reduce the disparities that previously existed in the absence of international financial standards on these issues. Nicolò et al. (2023) and Raimo et al. (2022) establish a clear link between integrated reporting and governance, making these variables a key factor in the quality and relevance of the information reported. The results of this research expand this contribution by showing that flexible valuation models can improve comparability and decision usefulness. In line with Vitolla et al. (2019), who argue that pressure from various interest groups drives the quality of reports, the approach of this article demonstrates that integrating the reports requested by the new S1 and S2 with information on how to value the company’s investment projects transforms external expectations into useful financial information.

It can be concluded that the study creates a bridge between research that has sustainability as its focal point and capital budgeting practices, being not only a descriptive analysis but also offering a framework with theoretical support and relevance for practice.

4.3. Limitations and Future Work

The proposed ROV model provides the structure and guidance for incorporating inputs from IFRS S1 and S2 reports. Some assumptions, such as volatility, can underestimate or overestimate the real risk in the company’s cash flows at a global level, especially for highly leveraged companies at the operational level. The model only contrasts ROV with NPV, so alternative comparisons such as Monte Carlo or trinomial trees are the subject of future research. Of course, the empirical validation in various sectors will increase the robustness and relevance of the article.