The threat of a Eurozone collapse, the possibility of the US defaulting on its sovereign debt and the Arab Spring protests throughout North Africa and the Middle East all took shape rapidly and with little advance warning. Among finance professionals, no one is arguably more aware of these types of political risks – and how suddenly they can arise – than infrastructure investors.
Infrastructure managers rely on a number of opinions to form an impression of a particular country’s political risk – most of them based on extensive research, advice from consultants and past experience. There’s also a strong element of GPs making a ‘gut call’ on a particular jurisdiction. However, that element of the analysis is receiving some pushback today, according to market sources.
“We are trying to get beyond looking at political risk as perception-based,” says Vit Henisz, professor at the Wharton School of the University of Pennsylvania. “In the past there was some sense that this was what people would call a ‘tummy test’; something very unscientific and just trying to get a sense of whether this is below or above your comfort zone and how much to adjust the threshold risk of return.”
A report from Merchant International Group, a risk consultancy, drew similar conclusions after researching some 7,500 multinational companies and their exposure to political risk. “A huge amount of financial resource and management time is lost each year as a result of inadequate research and analysis prior to embarking into a non-domestic market,” the report said. It stressed that the techniques employed for “identifying and evaluating hidden risks will need to become more sophisticated.”
In order to move beyond the “tummy test”, an increasing number of infrastructure managers are creating specific political risk-based scenarios when sizing up investment opportunities – for instance, working out what happens to an infrastructure investment’s bottom line if the government introduces a windfall tax, as was the case recently in the Australian mining industry.
To build these scenarios GPs are conducting and/or gathering qualitative research, often from real-world scenarios that mimic the risk they are attempting to quantify. This method plots the expected frequency, severity and degree of exposure of various risks on a graph, with probable frequency on the horizontal axis and expected severity on the vertical axis.
A GP also might use a discounted-cash flow analysis to work out how much revenue a project would lose if it was closed due to, say, strike action. This can be accomplished by using numbers pulled from a real-world protest that took place at a similar project in the country. GPs find the right numbers to use by gathering data from subsidiaries, partners, industry associations and local organizations.
Taking a step back, GPs must of course first decide if a country is even too risky to invest in. So how are GPs moving past their initial ‘gut feel’ here?
“We look at different countries and what their general sovereign reputation is for retrospective changes that damage international investment. That means: ‘Will the jurisdiction respect the rule of law or make retrospective changes that eliminate the equity of someone having made a good faith decision to invest in that jurisdiction?’” says David Scaysbrook, managing director and head of clean energy and infrastructure at Capital Dynamics.
While Scaysbrook says he only invests in developed economies (where sovereign risk is relatively lower), he stresses a good deal of research must still be completed to feel comfortable about these ‘safer’ jurisdictions. He highlights renewable energy credits (RECs) as an example of governments in developed countries having the potential to renege on their promises.
Of course one way to assess this risk is to see how governments acted in the past, but that’s something that can be easier said than done. A starting point for many in the infrastructure space is the US State Department’s bilateral relations fact-sheet, which provides an overview of the current political atmosphere in many countries. Research can also be gathered from third-party consultants who specialize in assessing political risk, such as the PRS Group who produce reports where probabilities are assigned to different regime scenarios, covering an 18-month and five-year time horizon.
At minimum, sources say it’s prudent to track how a particular government intervenes in the economy by reviewing things like equity restrictions, exchange controls, changes to fiscal or monetary policy and external borrowing liabilities. These metrics can serve as proxy points for a government’s overall level of political risk.
But to properly quantify political risk, some infrastructure managers are using scorecards on issues such as judiciary independence, corruption and government turnover. For instance, a government viewed as highly corrupt could be assigned a 10 in a possible scale of 1-10 using listings that look specifically at corruption, such as those produced by non-profit advocacy group Transparency International.
Some GPs take this a step further by dividing a country’s political risk indicators into four subcategories: government, society, security and the economy. What they’re doing is first calculating ratings for each subject, then aggregating them to create a national stability rating that can range from ‘failed states’ to ‘maximum stability’. Such scoring is helpful, because it enables a comparison between countries, say sources.
GPs are also utilizing spreadsheets and software simulations to help quantify political risk. Specifically, GPs first identify a range of risks, political or otherwise, and then assign them a rating of high, medium or low. Each risk is also given a corresponding probability number of actually happening (for example a protest happening in the next six years). Much like how casino game software is used, GPs upload this data into a spreadsheet application, such as Crystal Ball which uses Monte Carlo simulations, to generate values for each type of risk. With all this, hundreds or even thousands of simulations can be run in a matter of minutes, and forecasts are generated for each point in the pre-determined range (high, medium, low) of risk.
The big caveat here though is that this type of research cannot actually provide any meaningful answers about what kind of impact a country’s political risk should have on the financial evaluation of an infrastructure project, warn sources.
It is also an important caveat to remember that all the number-crunching in the world won’t save a GP from some element of subjective analysis, adds Scaysbrook. “Everything is still based off of staff analysis of the available data.” The danger here is some element of the unknown will always accompany an infrastructure investment. And insurance can only protect GPs so much, mostly because as coverage becomes more detailed (and risks become more nuanced) the price of insurance increases in tandem.
The ‘tummy test’ may therefore never be fully absent from the analysis. Nor should it be, necessarily. But infrastructure investors are certainly devising new ways to test their instincts.