Vol. 3 :: No. 11 November, 2001 (Kartik-Mangsir)

Management

Risk Management Strategies in

Infrastructure Finance- I

A project involves various risk factors right from its conceptualization to physical and financial structuring, implementation and operation. Risks associated with a project are construction risk, operating risk, market/ output risk, input supply risk, transportation risk, financial risk, regulatory risk etc. Various players associated with a project are expected to share these risks. These players are sponsors, contractors, operators, input suppliers, output buyers, lenders etc. As investors’ returns and debt repayment are spread over a long period of time and risk increases with time, moreover technological complexity, number of players, price sensitivities of inputs and outputs etc., add to the risk of a project. Hence, it is essential to assess the risks involved critically. Various risk management strategies can be employed to mitigate the risks and distribute them among various players involved in the project based on who is best suited to take a particular risk.

Contracts, Quantitative Risk Management Strategies, use of Financial Derivatives and Regulation play key roles in managing these risks.

The Appropriateness of Regulation as an Effective Risk Management Strategy

Laws and rules are elements of regulation, and thus it can be considered to be a set of rules, laws and principles that are legally binding, which are enforced by a court of law or a quasi-judicial body. Regulation is an effective instrument for risk management in infrastructure projects. One of the main features is that it has the backing of sanctions, and if used in certain instances it may reduce the levels of risk associated in infrastructure projects. For example, it is possible to moderate the risk of price increase in telecom for end-users, where prices are maintained at competitive levels in the amidst of an "effective regulator." Legal sanctions and the ability of these tools to compel a result, are characteristics that make regulation an attractive instrument in risk mitigation.

Regulation primarily deals with the macro environment relationships to specific projects. Regulation was primarily the function of the legal system in the country but increasingly specialized independent regulation and regulators are being promoted for economic and environmental regulation in the infrastructure sectors.

However, unlike contracts and quantitative methods such as VaR and financial derivatives, there are a number of factors contingent on the manner in which the regulators are enforced that dictate the effectiveness of these instruments as risk mitigating tools. Contingent factors of transparency, accountability and good governance may explain the preference to opt out of using independent regulators in developing countries. For example, the power sector in Sri Lanka has private sector participation, and it is an unregulated market. This has led to contentious issues on the suitability of the price mechanism and future competition in the electricity markets in Sri Lanka. Ideally, infrastructure projects should be regulated via independent, separate systems of rules and regulation, leading to the presence of more than one regulator in the domestic utility market. Regulations and regulators are best suited to mitigate risks faced by local government and the consuming public.

The nature of pre construction risks in power and toll road projects are best mitigated via the contracts, that detail the obligations of each of parties of the projects. In contrast, environmental standards and laws that focus on maintaining gauges in the domestic sites are examples of national laws applied to mitigate certain construction risks. However, as indicated above, whether or not it is successful is dependent on the enforcement of the law. Hence at this stage of the project development the prejudices associated with the domestic legal system may influence the effectiveness of this risk-mitigating tool. Two possible ways in which its effectiveness is reduced:-

1. Inefficiencies in the legal system including lengthy delays in procedure, etc

2. The personal prejudices of the judiciary.

In contrast during the operating phase of projects the role for regulation as a risk-mitigating tool is a minimum. The effective use of financial derivatives and use of contracts are more effective in allocating the risk upon those willing to bear it. It is the market risks that are important from an independent regulators point of view, specifically in areas of tariffs and competition. The overall perspective of the regulator is from the point of the consumer, who is a stakeholder, and is not represented until very late in project development.

Independent regulation has a critical role in development and operation of projects. It lays out the ground rules in which contracts and other risk management options can operate. They also address political and policy issues that are critical to enhancing investor confidence in infrastructure industries. An independent regulator ensures the twin utilitarian goals of competition and greater consumer welfare at a lower cost. In any event the mere presence of a regulator is insufficient, there is a need for regulations to be applied by an independent regulator accountable and responsible for its decision making process. Further contingent factors include transparency with respect to methodology by which tariffs are set in market.

v The co-ordination issues and issues of uncertainty when there is more than one regulator making decisions for the utility. For example, California government intervention in the market. Hence if regulations and regulators are to be successful there is a need for a clear line of authority.

v Developing nations will be compelled to include independent regulators for all of the areas of restructure in infrastructure, as a result of globalisation. It is conceivable that future foreign investment in this area will be tied in with a need to harmonise market behaviour / performance of developing nations with markets of developed nations.

v Clarity and certainty of the regulatory regime which ensures that risks are clearly defined and understood.

Taking into consideration the brief outline of the features of regulation and the role of independent regulators, certain limiting features of this management strategy may be overcome by coupling this application with other risk management tools such as Contracts, Quantitative Risk Management techniques, etc.

Shrestha is Chartered Accountant at Nepal Bangladesh Bank Ltd.

For twenty years a large shipping company had difficulty filling one of its top jobs. It never had anyone really qualified for the position. And whoever filled it soon found himself in trouble and conflict. But for twenty years the job was filled whenever it became vacant. In the twenty-first year a new president asked: What would happen if we did not fill it? The answer was: Nothing. It then turned out that the position had been created to perform a job that had long since become unnecessary. Management is always a decision-making process.

Whatever a manager does he does through making decisions. It is the process of locating and defining the problem, developing alternate solutions to the problem, weighing the various alternate solutions in terms of their possible consequences, choosing the optimum solution from among them, and implementing the decision effectively.

Your personal values may affect your decisions. It’d be better once you find out your personality type in decision-making. Here are some:

Do you tend to think that all the brilliant, practical and useful ideas are possessed by others?

Do you heavily depend on others for their ideas, advice and guidance, and do you delegate liberally?

4 If yes, then you possess the receptive or defensive type of personality.

Do you, like the receptive type, also think that valuable ideas are with others, and attempt to secure them by your cleverness?

Do you use their ideas in a way as if they were your own?

4 If so, then you are exploitative or aggressive.

Do you tend to think that you are in possession of most of the valuable ideas, and reluctant to share your ideas with others?

Do you seek to strengthen your position through your decisions?

4 If yes, then you’ve got the hoarding type of personality.

Do you believe in "selling" your decisions in order to gain acceptance?

Do you tend to make decisions that would "look good" to those who can deliver you personal advantages?

4 If so, then think that you are a marketing type of person.

Are you a kind of manager who utilizes his own as well as other’s abilities, insights, knowledge and information in decision-making?

Do you extend and seek cooperation? In doing this, do you permit your subordinates’ opportunities to take initiative and responsibility, and encourage them to utilize and develop their abilities?

Do you also attempt to integrate their personal needs with organizational goals?

4 If yes, then you are productive and you possess the best type of personality in decision-making.

Managers must make decisions, as it is their most important responsibility to their organization. They cannot afford to display an attitude of "sailing around the world without landing", and "talking about a subject without getting it".

The success of an executive depends on his ability to make the right decision at the right time and to pursue its effective implementation.

Some useful guidelines to effective decision-making

v Define the Goals: Define the goals that you seek to achieve by making a decision. The goal of your decision should be derived from your objectives which in turn are a part of the total organizational objectives.

v Ensure that the Decision Contributes to the Goal: Often, an executive seeks to achieve not one but more than one goals through a decision. For example, the goal of a marketing decision may be not only to increase the sales volume but also increase the profit margin.

v Identify the Problem: Identify the real problem and define it. And too much time cannot be spent on this phase. There is no more foolish – and no more time-wasting – advice than to decide quickly what a problem really is.

v Involve Subordinates in Decision-making Process: Your subordinates’ participation can bring not only new insights to the problem, but also elicit their commitment to implement the decision.

v Ensure Successful Implementation of the Decision: Successful implementation of a decision significantly depends on the extent of understanding of the decision and its implications, and motivation of the subordinates who have to carry it. You can be more effective if you successfully weld your subordinates into a team with yourself as the team leader.

v Evaluate the Results: Evaluate the results of the decision in terms of its predetermined goals.

v Be Flexible: Adopt a flexible approach not only in making the decision but also after the decision has been put into implementation. If necessary, modify or discard or replace the decision with another one, which may produce better results.

Try to determine the best solution. If you have done an adequate job, you will either have several alternatives to choose from each of which would solve the problem, or you will have half a dozen or so solutions that all fall short of perfection but differ among themselves as to the area of shortcoming. A blind man, to be sure, cannot learn to see. But it is amazing how much a person with normal eyesight does not see, and how much he can perceive through systematic training of the vision. Similarly, the mind’s vision can be trained, disciplined and developed. And the method for this is the systematic search for, and development of, the alternative solution, may be the best solution to a problem.

There are four criteria for picking the best from among the possible solutions.

Ø The risk. There is no riskless action nor even riskless non-action. But what matters most is neither the expected gain nor the anticipated risk but the ratio between them.

Ø Economy of effort. Which of the possible lines of action will give the greatest results with the least effort, will obtain the needed change with the least necessary disturbance of the organization?

Ø Timing. If the situation has great urgency, the preferable course of action is one that dramatizes the decision and serves notice on the organization that something important is happening. A slow start that gathers momentum may be preferable.

Ø Limitations of resources. Only demanding more of people than they are capable of giving can solve the problem, they must either learn to do more or be replaced by people who can. It is not solving a problem to find a solution that works on paper but fails in practice because the human resources to carry it out are not available or are not in the place where they are needed.

Making decisions can either be time-wasting or it can be the manager’s best means for solving the problems of time utilization. Time should be spent on defining the problem. Time is well spent on analyzing the problem and developing alternate solutions. Time is necessary to make the solutions effective. But much less time should be spent on finding the right solution. And any time spent on selling a solution after it has been reached is sheer waste and evidence of poor time utilization in the earlier phases.

Most decisions have to be based on incomplete knowledge - either because the information is not available or because it would cost too much in time and money to get it. Indeed, the most common source of mistakes in management decisions is the emphasis on finding the right answer rather than the right question.

Some quotes

c Even a decision to do nothing in the face of a problem is also a decision.

c To take no action is a decision fully as much as to take specific action.

c Alternative solutions are no guarantee of wisdom or of the right decision.

c Decision-making is the heart of managing.

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