Aloke DasguptaIDBI, Head Office, Mumbai

Risk Management is the name of the Game

- Ad campaign of EXIM BANK for LOC

- From the film PhiladelphiaInterrogating Counsel : Do you take RISKS?Beckett:In our business we have to take RISKS. CALCULATED RISKS.

First things first.

WHAT IS

RISK ?

Entry :RISKDefinition: chance Synonyms: adventure, brave, chance, compromise, confront, dare, defy, defy danger, encounter, endanger, face, gamble, hazard, imperil, jeopardize, jeopardy, meet, menace, peril, plunge, speculate, tackle, take on, venture, wager Source: Roget's New Millennium Thesaurus,

Why is

RISK ANALYSIS

at all necessary ?

Many projects have:

Large investment outlays

Long periods of project payout

Incomplete sharing of information and technology especially with foreign investors

Differences in the ability of the parties to bear risks

Unstable contracts

Projects may be attractive in aggregate, but are unattractive to one or more parties due to uncertainties about sharing risks and returns.

Welcome to the Big Bad World of Risks

for Industrial Projects...

THE UNIVERSE OF RISK

Strategic Risks

Market demand [more often than not the demand projections have little credibility]. Operating costs [often underestimated]. Unexpected/ unanticipated capital costs.

Financial Risks Credit default. Financial market risks. Interest rate changes. Currency/ foreign exchange fluctuations. Liquidity/ cash flow issues of the off-taker.

Operational Risks

Supply chain management. Information systems. Key managers.

Hazard Risks

Property damage. Legal risks. Workers' compensation. Natural disasters.THE UNIVERSE OF RISK [contd]

And pray

how does one

ASSESS RISKS ?

Risk AssessmentWhere is the appropriate risk? - identify [ASK - HOW?]What causes it ? - triggers [ASK - WHY?] Probability of occurrence and its impact [ ASK - SO ?]Evaluate how do you contract the riskManage the risksKeep an eye on the risk over the period that you have to bear themEstablish the risk landscapeAgree & communicate objectives

IMPACT .

How do I quantify ?

SENSITIVITY ANALYSIS

Test the sensitivity of a project's outcome (NPV) to changes in one parameter value at a time. "What if" Analysis. Allows you to test which variables are important (i.e. as a source of risk). A variable is important depending on :A)Its share of total benefits or costs.B)Likely range of values.

Sensitivity analysis allows you to determine the direction of change of the NPV. Break-even analysis allows you to determine how much a variable must change before the NPV turns negative.

CAUTIONARY NOTES FOR SENSITIVITY ANALYSIS

Sensitivity analysis doesn't represent the possible range of values.Sensitivity analysis doesn't represent the probabilities for each range. Generally there is a small probability of being at the extremes. Direction of effectsFor most variables, the direction is obvious.A)Revenue increases ---NPV increasesB)Cost increases---NPV decreasesC)Inflation---Not so obvious

One-at-a-time testing is not realisticOnce-at-a-time testing is not realistic because of correlation among variables.One method of dealing with these combined or correlated effects is scenario analysis.

SCENARIO ANALYSIS

Scenario analysis recognises that certain variables are interrelated. Thus a small number of variables can be altered in a consistent manner at the same time.

What is the set of circumstances that are likely to combine to produce different "cases" or "scenarios"?

A) Worst case/ pessimistic case.B) Expected case/ best estimate case.C) Best case/ optimistic case.

Scenario analysis : probability ? - does not address

MONTE CARLO METHOD OF RISK ANALYSIS

A natural extension of sensitivity and scenario analysis.

Simultaneously takes into account different probability distributions and different ranges of possible values for key project variables.

Allows for correlation (covariation) between variables.

Generates a probability distribution of project outcomes (NPV) instead of just a single value estimate.

The probability distribution of project outcomes may assist decision-makers in making choices, but there can be problems of interpretation and use.

STEPS IN BUILDING A MONTE CARLO SIMULATION

Mathematical model : project evaluation spreadsheet.

Identity variables which are sensitive and uncertain.

Define uncertaintyEstablish a range of options (minimum and maximum).Allocate probability distributionIdentify and define correlated variables.Positive or negative correlation.Strength of correlation.

Simulation model.

Analysis of results.

Whose Risk is it anyway?

If there is RISK then it better not be mine.

RISK SHARINGPROJECT COMPANYBANKSSPONSORSSHAREHOLDERSAGREEMENTCREDIT ENHANCEMENTLOCAL LAWSGOVERNMENTSUPPLIERSOFFTAKERSEPC CONTRACTOROPERATORCONSENTS/PERMITSAGREEMENTSSUPPLYAGREEMENTSOFFTAKEAGREEMENTEPC CONTRACTO&M AGREEMENT

Simply stated...

DETAILED RISK ANALYSIS IS UNDERTAKEN, AND RISK ALLOCATION IS UNDERTAKEN PRIOR TO DETAILED WORK ON PROJECT DOCUMENTATIONA PARTICULAR RISK IS ASSUMED BY A PARTY BEST ABLE TO MANAGE AND CONTROL THAT RISK, RISK SHOULD NOT BE PARKED WITH THE PROJECT COMPANY. TO MAKE SURE THAT ALL THE RISKS ARE PROPERLY ALLOCATED, A COMPREHENSIVE RISK MATRIX SHOULD BE PREPARED. THESE RISKS MITIGATED BY ALLOCATING TO VARIOUS PARTIES THROUGH SUITABLE CONTRACTS

RISK ALLOCATION AND MITIGATION

RISK ALLOCATION AND MITIGATION

CONTRACTING CRITERIA

Contract with lowest cost (highest return if investment occurs) not necessarily best contract.

Efficient contracts may provide :

Better risk shifting -- better distribution of cost across circumstances i.e. given probabilities, change the allocation of risks between participants.Better risk management -- higher project returns or lower total project risk as result of incentives i.e. change the incentive structure to change the probabilities of outcomes.

ZERO SUM VERSUS POSITIVE SUM PERSPECTIVESCost focus is implicitly a zero sum perspective. What one party gains the other loses.

Efficiency perspective is explicitly a positive sum perspective. With right contract one party can gain substantially without corresponding cost to other party.