Paul: My name is Paul Murphy, Managing Director, Gowling WLG, and today we're here with Michael Samis, associate partner at Ernst & Young, and John Seddon, Principal, Control Risks. Today we're talking about the issue of country risk. All of us, and our respective businesses, deal with this issue on a variety of projects. The world continues to remind us, time and again, that it's a very complicated place. We see just within the last week with the US withdrawing from the JCPOA, the impact on Boeing's potential deal for airplanes. We see Total saying that they'll probably have to withdraw from their major project that was scheduled for Iran. So, when we deal with major projects, particularly infrastructure projects, we learn, time and again, all countries aren't created equal. When you put a project in a particular place where you're putting it starts to matter very much. What we've intended to do, in this two-part series, is talk about the topic of country risk. First, at a high conceptual level, and then really in the second session get into some of the analytical tools. In starting with first principles on country risk, John, what do we really mean when we're talking about country risk, and what are the biggest risk categories and considerations when we talk about the subject?
John: I'd say part of the real challenge in all of this is that there's not really any single universally accepted definition of what a country risk is. Different companies look at in different ways. Broadly speaking, the sorts of things that are typically considered are economic factors, political factors, operations factors and then crucially, some social factors. In particular, how some of that can manifest and those social factors and social risk can manifest themselves in operational challenge and even sometimes security challenges. What's perhaps most interesting when considering country risk is that whereas in the past it was quite clear when there was an event. You'd have, perhaps, naturalization or expropriation and it was quite clear when that event occurred and it was quite dramatic. More recently things have shifted quite significantly with those sort of events are comparatively rare, and we have many more cases where companies are impacted by, more in particular, say if we think of the resources sector with issues around permitting, for instance. This can have quite a significant impact on projects and obviously for share prices as well. In some of the impacts we see are at a quite local levels, I mentioned before, some of the social risk issues. But also things like actions of local security forces and how companies and projects have engaged with them and manage them and support the operations.
Paul: Why do companies want to assess country risk early on? What are the benefits and what are some of the shortcomings if they're failing to look at the actual location of where this project is going to be and just seeing it like a project like any other project?
John: It's crucial to look at from a very early stage given that, really, assessment of country risk should form part of strategy formulation and ultimately how a project is structured. Doing it in an iterative way allows a company or project to carefully understand the context in which it's operating, both at national level, subnational level and consider the local dynamics around a project. Also from an early stage consider, perhaps, what sort of controls would be appropriate. Be that in the way the financing is set up. Or perhaps sort of more operational controls through the design construction and ultimately operation of a project.
Paul: You mentioned, in your answer just now, the financing aspect. Do you find that this is something that project developers need to aggressively manage in their dialogue with the banks, in terms of the diligence process, so that it's both something that they're doing internally in assessing their decision to go forward and how they manage the project, but also if they're going out for project financing as one technique, that that's a dialogue not just for themselves but with their lenders as well?
John: It's quite often that it's a high priority item that is carefully considered. What we say, though, and what we find is that some of the ways in which these issues are considered, and then ultimately integrate into the decision making process, perhaps could benefit from greater rigor in terms of how things are modeled.
Paul: Let's talk about a particular sector in sort of assessing the problem a little bit more. When we talk about national resources investments, Mike, how in that sector does country risk play maybe a unique role even differently maybe than other types of infrastructure investments? What do you see in that sector, specifically?
Michael: Obviously, mining being, and oil and gas being, a global business country risk has a big impact on global investments and obviously a big concern for a lot of the oil and gas companies. The issue for them is a number of, I'd say, special characteristics in these investments that make country risk sort of a larger concern. Particularly around the fact that you're investing in removable assets. It's not like you can take your mine, or your gas field or oil field, and move it if a country becomes unstable. There's also issues around large up front capital investments. You're investing a lot of money over a long period to get your project of investment up and running, and the issue will be once you're in there, you're very exposed to possibly losing that capital or not making the returns you were expecting. We do have issues around commodity price cycles where commodity prices are high. These assets will make what seems like excessive profits, so that makes it a target for government actions, particularly around when there's revenue shortfalls. Then the other aspect also is that you may find in a country that there's bias against foreign ownership that can come out in various government actions, and also you may be finding your competing against other countries for very good assets. There's not like there's a lot of great assets around the world so you may find you're dealing with other country champion businesses that may try and take your asset away.
These sort of perspectives they can cause an outside country risk effect. We see that quite recently in the mining industry. Last year Kesha Mining out in Tanzania was unable to export concentrates and that caused, over the month, a decline in share price of 20%. More recently, with Kinross, they weren't given a permit to expand one of their mines and within a day there was a 20% drop in their share price. These are big issues and companies need to consider them when they're making their investments and have a plan for them.
Paul: Is it fair to say that when we're looking at country risk it's not just a moment in time, but in things like natural resources you're making a long-term play, you're having to project that over long periods of time which complicates the analysis at a lot of different levels because know you're having to factor in political cycles and changes in market conditions. How does that complicate the analysis?
Michael: It definitely does. You're investing over a longer period. You're exploration and development period maybe anywhere from 5 to 10 years. Then you're operating the project from 10 years up to 60 or 70. So you do have to consider that in the way you look at your investments. You're looking at the investment over its entire cycle. That creates an issue about the types of projects you might want to get into. Investing large amount of capital for a very long time in a moderate risk country can actually be more risky than investing a smaller amount of capital in higher risk jurisdiction where your project life is shorter. You have to start thinking carefully about what type of projects do I want to invest in and where in the world? How do we share the risk? All these sorts of issues.
Paul: How do companies generally approach country risk in your experiences? What general policies do they have? Where do they evaluate it? In your experience.
Michael: There's quite a bit of variation between companies, of course. Some companies have very large in-house teams, government affairs, government relations teams, who have this as part of their remit. Comms teams will also play a role, as well as legal teams, in gathering raw information from media, from third parties and so on with quantitative analysis, and synthetic analysis as well, in order to provide a picture of what is going on in a specific jurisdiction or region or what have you. What we often find though is that an analysis is not necessarily translated as effectively as it could be into investment decisions and into how portfolios are managed. I think that's where there's significant opportunity to better manage country risk in a way that is more aligned to how organizations manage other types of risk across their portfolios.
Paul: Given that answer, what do you think are some of the elements that are missing? Do you see that it's an issue of lack of appreciation of the country and its history and internal dynamics and they just see it from afar? Or is it market conditions? Or not having good intel on the ground and maintaining that? What are some of the shortfalls that you're seeing that either companies aren't doing or they think they've maybe done an adequate job but in fact they're missing key elements?
Michael: Well, it is of course, tough to make generalizations. One issue that companies seem to be challenged by, in many instances, is that because there isn't necessarily the means to translate solid analysis into how strategic decisions are made in terms of capital allocations. There's not the, I would say, adequate imperative to get that ground analysis right, and to ensure that there is rights or combination of analysis of national level factors, combined with issues that may have more to do with some of the partners that one organization is working with or maybe some of the local government dynamics or a whole host of other issues. I'd say that with a more nuanced approach to translating those inputs into decision making then that would create a greater imperative to do a more detailed analysis in the first place.
Paul: It seems that a lot of this could be very subjective but then there's probably an opportunity for analytics as well in terms of data driven analysis. How would both of you assess the balance between the subjective things, like projecting the stability of a particular government versus other types of things that could be more data driven, and how should companies maybe combine the two to get a more robust result?
John: You're right. It is a challenge to ensure that there is sufficient data underpinning some of these country risk factors. Particularly in some of the more complex jurisdictions in the world it is tough to get that quantifiable indicators. There is certainly value in using those when they are available, but one can't get away from the value that can be provided by people who have very in-depth knowledge and understanding of the political dynamics, in particular in a country in a specific area, and are able to leverage resources that they may have access to in order to understand how different levels of government interface with one another. How maybe a project or a company's operation may adversely, or positively, affect some of the factors that we've been discussing. But of course, looking ahead, there is, we think, significant opportunity to use more data and more analytics techniques to bring greater rigor and to formalize the entirety of the process.
Paul: Mike.
Michael: The other thing, I think the interesting thing about looking at country risk and trying to model it. It's not like we're going in and trying to look at commodity price and certainly where we have large amount of historic price information and financial market information that can help us characterize it. The issue for us going forward when we try to actually model this in some detail, it's going to be taking the qualitative aspect and the experience of people on the ground understanding country structures and local conditions. Issues around international organizations and things and try to translate that into more quantitative assessment. So there's going to be, at a certain level, some subjectivity I guess you could say. That's fine because we can try and use a more quantitative approach too. It provides us a way of some rigor to our thinking and see how things potentially play out in terms of cash flow effects and its impact on the value of your investment and the risk exposures.
Paul: How do you see this sort of traditionally translated in corporate decisions? Is it more of a risk premium so that it goes into the final economic price, or economic valuation, that there's a kicker, if you will, for some additional risk in that country or in that particular line of work? Or is it a no-go decision? You know, go or no-go decision in terms of we're either going to do this or not or is it adding in some mitigation strategies? How do you see companies generally pursue the analysis, once they've taken a look at country risk as a consideration? How, historically, do they tend to translate that into their behaviour going forward?
Michael: I think when we're thinking about some kind of program to manage country risk what we're suggesting is you're going to be going into a little bit more detail and more depth about its impact on your investments so we've been looking at the effect of country risk over the life cycle of the project. There's the upfront consideration about whether we should invest and there you'll be thinking about how we're going to invest our capital. How do we share the risk through different forms of financing or joint venturing and those sort of things? Once we are in country, and we have an investment up and running, obviously you're going to be monitoring it and trying to track potential risk that could impact the value of investment for your shareholders and understand how your investments affected and its exposure. Then you're going to bring that up to the corporate level and understand how all your different investments around the world come together and expose your company overall. It's a process that's in more detail, more depth, where we're trying to understand the cash flow effects of country risk, how that creates a risk exposure for you and then how that comes up to the corporate level and impacts your company overall.
Paul: Based on those comments clearly country risk analysis is not just something that you do as a check-the-box activity before you make your final investment decision. That it's sort of an ongoing, a robust country risk program if you will, would not just be at the front end but you would be considering that issue throughout the life of the project and maybe planning at the beginning, when you're making that investment decision, how you might have in place mitigation techniques over the life of the project or key stages of the project. Is that a fair comment?
Michael: Yes it is because you're really looking for a framework in which to, first off, understand what sort of country risk you're expose to. The different types. The different actors that are out there and how they can impact your project. You then also have to be able to perform analysis around there to get a sense of the importance of the different risks and their potential impact. You also have to think about how, potentially, you might mitigate. What sort of strategies that you might employ. Initially, when you're thinking about how to investment, but then once you are in country. Then lastly, over the life of your investment something's going to happen so you need to be thinking about how you're going to respond. This needs to be a formal program. People have to get prepared for these things. They have to think them through from the start and it's not something that you just summarize as a risk premium. It needs to be more detailed. Has to be thought through and it has to be treated as important impact, or consideration, in your investment.
Paul: And then, presumably, if you're considering these mitigation strategies, or contingency planning, you're then pricing that at some level into your modeling to make that final investment decision at the front end of the project.
Michael: That's correct.
Paul: Well that concludes our first discussion on country risk. Our second stage will move into more of the analytics. Thank you both for your time and look forward to talking to you on the next subject. Thank you very much.
John: Thank you.
Michael: Thank you.