Corporate risk management : an organisational perspective

1 Introduction 1 1.1 Introduction 1 1.2 Why Managing Risk Is Important 1 1.3 General Definition of Risk Management 2 1.4 Background and Structure 3 1.5 Aim 4 1.6 Scope of the Book 4 2 The Concept of Risk and Uncertainty and the Sources and Types of Risk 7 2.1 Introduction 7 2.2 Background 7 2.3 Risk and Uncertainty: Basic Concepts and General Principles 8 2.4 The Origin of Risk 9 2.4.1 Dimensions of Risk 11 2.5 Uncertainties 12 2.6 Sources of Risk 14 2.7 Typical Risks 17 2.7.1 Project Risks 17 2.7.2 Global Risks 18 2.7.3 Elemental Risks 18 2.7.4 Holistic Risk 18 2.7.5 Static Risk 19 2.7.6 Dynamic Risk 19 2.7.7 Inherent Risk 19 2.7.8 Contingent Risk 20 2.7.9 Customer Risk 20 viii Contents 2.7.10 Fiscal/Regulatory Risk 21 2.7.11 Purchasing Risk 21 2.7.12 Reputation/Damage Risk 21 2.7.13 Organisational Risk 22 2.7.14 Interpretation Risk 22 2.7.15 IT Risk 22 2.7.16 The OPEC Risk 23 2.7.17 Process Risk 23 2.7.18 Heuristics 24 2.7.19 Decommissioning Risk 25 2.7.20 Institutional Risks 25 2.8 Perceptions of Risk 25 2.9 Stakeholders in an Investment 26 2.9.1 Stakeholder Identification 27 2.9.2 Stakeholder Perspectives 28 2.9.3 Stakeholder Perceptions 28 2.10 Summary 29 3 The Evolution of Risk Management and the Risk Management Process 31 3.1 Introduction 31 3.2 The Evolution of Risk Management 31 3.2.1 The Birth of Risk Management 31 3.2.2 Risk Management in the 1970s – Early Beginnings 32 3.2.3 Risk Management in the 1980s – Quantitative Analysis Predominates 32 3.2.4 Risk Management in the 1990s – Emphasis on Methodology and Processes 33 3.3 Risk Management 35 3.4 The Risk Management Process – Identification, Analysis and Response 35 3.4.1 Risk Identification 38 3.4.2 Risk Quantification and Analysis 40 3.4.3 Risk Response 42 3.4.4 Selection of Risk Response Options 45 3.4.5 Outputs from the Risk Response Process 45 3.4.6 Risk Management within the Project Life Cycle 46 3.4.7 The Tasks and Benefits of Risk Management 47 3.4.8 The Beneficiaries of Risk Management 48 Contents ix 3.5 Embedding Risk Management into Your Organisation 50 3.6 Risk Management Plan 51 3.7 Executive Responsibility and Risk 52 3.8 Summary 53 4 Risk Management Tools and Techniques 55 4.1 Introduction 55 4.2 Definitions 55 4.3 Risk Analysis Techniques 56 4.3.1 Choice of Technique(s) 56 4.4 Qualitative Techniques in Risk Management 56 4.4.1 Brainstorming 56 4.4.2 Assumptions Analysis 57 4.4.3 Delphi 57 4.4.4 Interviews 58 4.4.5 Hazard and Operability Studies (HAZOP) 58 4.4.6 Failure Modes and Effects Criticality Analysis (FMECA) 59 4.4.7 Checklists 59 4.4.8 Prompt Lists 59 4.4.9 Risk Registers 59 4.4.10 Risk Mapping 61 4.4.11 Probability–Impact Tables 61 4.4.12 Risk Matrix Chart 63 4.4.13 Project Risk Management Road Mapping 63 4.5 Quantitative Techniques in Risk Management 63 4.5.1 Decision Trees 63 4.5.2 Controlled Interval and Memory Technique 65 4.5.3 Monte Carlo Simulation 65 4.5.4 Sensitivity Analysis 67 4.5.5 Probability–Impact Grid Analysis 68 4.6 Quantitative and Qualitative Risk Assessments 70 4.7 Value Management 71 4.7.1 Value Management Techniques 73 4.8 Other Risk Management Techniques 74 4.8.1 Soft Systems Methodology (SSM) 74 4.8.2 Utility Theory 77 4.8.3 Risk Attitude and Utility Theory 78 4.8.4 Nominal Group Technique 79 4.9 Country Risk Analysis 80 4.9.1 Country Risk Sources – the Checklist 80 x Contents 4.9.2 Political Risk 81 4.9.3 Financial Risk 86 4.9.4 Organisational Usage of Risk Management Techniques 87 4.10 Summary 88 5 Financing Projects, Their Risks and Risk Modelling 89 5.1 Introduction 89 5.2 Corporate Finance 89 5.3 Project Finance 91 5.3.1 Basic Features of Project Finance 92 5.3.2 Special Project Vehicle (SPV) 92 5.3.3 Non-recourse or Limited Recourse Funding 92 5.3.4 Off-balance-sheet Transaction 92 5.3.5 Sound Income Stream of the Project as the Predominant Basis for Financing 93 5.3.6 Projects and Their Cash Flows 93 5.4 Financial Instruments 95 5.5 Debt 96 5.5.1 Term Loans 96 5.5.2 Standby Loans 97 5.5.3 Senior and Subordinate Debt 97 5.6 Mezzanine Finance Instruments 98 5.6.1 Bond Ratings 99 5.6.2 Types of Bonds 100 5.7 Equity 103 5.7.1 Ordinary Equity and Preference Shares 103 5.8 Financial Risks 105 5.8.1 Construction Delay 105 5.8.2 Currency Risk 105 5.8.3 Interest Rate Risk 106 5.8.4 Equity Risk 106 5.8.5 Corporate Bond Risk 106 5.8.6 Liquidity Risk 107 5.8.7 Counter-party Risk 107 5.8.8 Maintenance Risk 108 5.8.9 Taxation Risk 108 5.8.10 Reinvestment Risk 108 5.8.11 Country Risk 108 5.9 Non-financial Risks Affecting Project Finance 109 5.9.1 Dynamic Risk 109 Contents xi 5.9.2 Inherent Risk 109 5.9.3 Contingent Risk 110 5.9.4 Customer Risk 110 5.9.5 Regulatory Risk 110 5.9.6 Reputation/Damage Risk 110 5.9.7 Organisational Risk 110 5.9.8 Interpretation Risk 111 5.10 Managing Financial Risks 111 5.10.1 Construction Delay 111 5.10.2 Currency Risk 112 5.10.3 Interest Rate Risk 113 5.10.4 Equity Risk 114 5.10.5 Corporate Bond Risk 114 5.10.6 Liquidity Risk 114 5.10.7 Counter-party Risk 115 5.10.8 Maintenance Risk 115 5.10.9 Taxation Risk 116 5.10.10 Reinvestment Risk 116 5.10.11 Country Risk 116 5.11 Risk Modelling 116 5.12 Types of Risk Software 119 5.12.1 Management Data Software Packagers 119 5.12.2 Spreadsheet-based Risk Assessment Software 119 5.12.3 Project Network-based Risk Assessment Software 119 5.12.4 Standalone Project Network-based Risk Assessment Software 120 5.13 Summary 120 6 Portfolio Analysis and Cash Flows 123 6.1 Introduction 123 6.2 Selecting a Portfolio Strategy 123 6.3 Constructing the Portfolio 124 6.4 Portfolio of Cash Flows 125 6.5 The Boston Matrix 125 6.6 Scenario Analysis 126 6.7 Diversification 126 6.7.1 Diversification of Risk 128 6.8 Portfolio Risk Management 129 6.8.1 Bundling Projects 130 xii Contents 6.8.2 Considerations 133 6.8.3 Bundling Projects into a Portfolio 133 6.9 Cross-collateralisation 134 6.10 Cash Flows 134 6.10.1 Cash Flow Definition for Portfolios 136 6.10.2 Reasons for Choosing Cash Flow Curves 138 6.10.3 Projects Generating Multiple IRRs 139 6.10.4 Model Cash Flow 139 6.11 An Example of Portfolio Modelling 140 6.11.1 Financial Instruments 141 6.11.2 Development of the Mechanism 142 6.11.3 Spreadsheets 142 6.11.4 A Portfolio of Oil and Gas Projects 143 6.12 Summary 149 7 Risk Management at Corporate Level 151 7.1 Introduction 151 7.2 Definitions 151 7.3 The History of the Corporation 153 7.3.1 Equity Capital of a Corporation 155 7.4 Corporate Structure 156 7.5 Corporate Management 157 7.5.1 The Corporate Body 159 7.5.2 The Legal Obligations of Directors 159 7.5.3 The Board 160 7.5.4 The Composition of the Board 161 7.6 Corporate Functions 161 7.6.1 Corporate Governance 163 7.7 Corporate Strategy 166 7.8 Recognising Risks 168 7.9 Specific Risks at Corporate Level 170 7.10 The Chief Risk Officer 171 7.11 How Risks Are Assessed at Corporate Level 172 7.12 Corporate Risk Strategy 172 7.13 Corporate Risk: An Overview 174 7.14 The Future of Corporate Risk 174 7.15 Summary 175 8 Risk Management at Strategic Business Level 177 8.1 Introduction 177 8.2 Definitions 177 Contents xiii 8.3 Business Formation 177 8.4 Strategic Business Units 180 8.4.1 The Need for Strategic Linkages 180 8.4.2 The Wrappers Model 181 8.4.3 The Business Management Team 184 8.4.4 Strategic Business Management Functions 184 8.5 Business Strategy 186 8.6 Strategic Planning 187 8.6.1 Strategic Plan 187 8.6.2 Strategy and Risk Management 188 8.7 Recognising Risks 189 8.7.1 Specific Risks at Business Level 189 8.7.2 Typical SBU Organisation 189 8.8 Portfolio Theory 191 8.8.1 Modern Portfolio Theory 191 8.8.2 Matrix Systems 193 8.9 Programme Management 195 8.10 Business Risk Strategy 197 8.11 Tools at Strategic Business Unit Level 197 8.12 Strategic Business Risk: An Overview 198 8.13 Summary 198 9 Risk Management at Project Level 201 9.1 Introduction 201 9.2 The History of Project Management 201 9.2.1 The Early Years: Late Nineteenth Century 201 9.2.2 Early Twentieth-century Efforts 201 9.2.3 Mid Twentieth-century Efforts 202 9.2.4 Late Twentieth-century Efforts 202 9.3 Definitions 203 9.4 Project Management Functions 204 9.4.1 The Project Team 206 9.4.2 Project Risk Assessment Teams 208 9.4.3 Project Goals 208 9.5 Project Strategy Analysis 209 9.6 Why Project Risk Management Is Used 210 9.7 Recognising Risks 211 9.7.1 Specific Risks at Project Level 212 9.7.2 What Risks Are Assessed at Project Level? 213 9.7.3 Project Managers and Their View of Risks 215 9.8 Project Risk Strategy 216 xiv Contents 9.9 The Future of Project Risk Management 216 9.10 Summary 217 10 Risk Management at Corporate, Strategic Business and Project Levels 219 10.1 Introduction 219 10.2 Risk Management 219 10.3 The Risk Management Process 219 10.4 Common Approaches to Risk Management by Organisations 221 10.5 Model for Risk Management at Corporate, Strategic Business and Project Levels 223 10.6 Summary 229 References 231 Index 241