Challenges grow more sophisticated

Political risk is re-emerging and changing its shape with the rise of national oil companies and sovereign wealth funds whose actions may be driven by political considerations rather than commercial ones. Kirsten Parker and Rafael Gomes discuss the strategy that organisations should take in seeking to manage the risk

Political risk, the potential for political developments to hinder or help business, had a low profile in the 1980s and 90s, but the re-emergence of ‘national champions’, such as state-owned companies seen as strategically important for governments, is creating fresh challenges.

We have seen this most significantly in the oil industry. National oil companies such as Sonatrach (Algeria), Petronas (Malaysia), and NNPC (Nigeria) have increased their equity stakes in joint ventures. The strategy of Russia’s Gazprom has been closely aligned to the country’s foreign policy. For example, Gazprom increased gas export prices to Ukraine four-fold in 2006, in order to exert pressure during an election period. Russia’s allies such as Belarus were spared the price hikes.

In a similar vein, Venezuela’s PDVSA provides a major share of financing for the government’s social projects, and has been instrumental in providing refining capacity for President Chavez’s allies. By contrast, there is evidence that many state companies, such as Brazil’s Petrobras, are driven primarily by commercial incentives rather than political strategy, which adds complexity to the risk environment. Outside the oil sector, national mining companies, such as Uzbekistan’s Goskomgeologia, state banks, such as the Industrial and Commercial Bank of China, and sovereign wealth funds like the Qatar Investment Authority are also emerging as influential market players.

As new politically-affiliated actors (re-)emerge, so the mechanisms of political risk multiply. In the 1970s, a government might have deployed the army to expropriate company assets. Today, political risk insurers can receive claims of expropriation because new environmental taxes were enacted, or because money transfers were delayed.

The risks were felt recently in Ecuador, Democratic Republic of Congo (DRC) and Venezuela. In Ecuador, the government cancelled 587 of the country’s 4,112 mining concessions, accusing companies of failing to pay an environmental conservation tax. In the DRC, the government suddenly began to enforce local value-adding processing rules for minerals in order to raise revenue, but companies had insufficient capacity for the task. As a result, some regions’ minerals exports were suspended. Finally, companies have claimed that they were deprived of financial capital, even in the absence of formal capital controls, in Venezuela, where the Foreign Currency Administration Commission (Cadivi) often informally delays currency transfers.

One reason why the political risk environment is likely to continue to diversify is that the institutions that historically acted as global policy anchors: the IMF, World Bank, and WTO, have experienced a major decline over the past decade. For over 50 years, these organisations held governments in many developing countries to a set of policies that promoted investors’ interests, in exchange for development loans. There are many reasons why their influence has declined. Debt relief and high commodity prices have improved borrowers’ foreign exchange positions and enabled many, such as Brazil, to write off their debts ahead of schedule. Newly wealthy donors, such as China and Venezuela, do not request policy reforms in exchange for loans.

And yet, political risk is not just an emerging market issue. In recent years, we have seen large shifts in financial regulation in Western Europe and the US, tax reform for North Sea oil exploration in the UK, and strikes at Canadian nickel mines.

Insurance and good connections

To address these issues, companies have traditionally managed political risk by sharing risk assessments across departments, hedging with financial instruments, especially political risk insurance, and developing local contacts. Yet, as the world changes, it becomes very difficult to manage political risk solely with insurance or good connections. Regulatory expropriation, for example, often does not qualify for an insurance claim. Key decision-makers are diffused across government agencies and companies, making due diligence a more technical and drawn-out task.

A good starting point in this climate is to develop an intelligence collection plan (ICP) that sets out in detail which risk indicators to monitor. For an issue like regulatory expropriation, an ICP should identify not only what would drive a government to adopt new regulation, but also how changes would be felt. An ICP not only outlines what questions to ask, but also helps divide responsibilities for monitoring the risk environment across the organisation.

This structured intelligence collection then informs a quantitative risk register or a cash-flow model. It enables companies to analyse how well diversified their political risks are across countries, and how political risk compares to other important risk classes, as part of an integrated enterprise risk management (ERM) process. From a political risk perspective, planning is most effective when it is set against scenarios that are selected according to likelihood, and tested against high-impact, low-probability events. In this way, scenario planning can reveal not only best-response strategies, but also build capacity to adapt to political shocks.