Political risk: when diversification isn't enough.

This year, 2006, is proving to be one of the more challenging, politically-charged years in recent history. Global events have repeatedly threatened to impact multinational business operations--from presidential elections in Mexico, Brazil and Nigeria, to avian flu and rising oil prices sparked by political tensions in the Middle East. Even companies that don't have international operations face some level of political risk simply because chances are good that their customers, suppliers or joint venture partners operate globally.

[ILLUSTRATION OMITTED]

Business leaders realize that to survive, they have to find the most effective ways to work with partners abroad, compete internationally and manage the risks associated with these ventures. The politics of foreign governments and societies touches almost every aspect of business for companies operating globally, from strategic selection of markets to issues such as intellectual property, human resource management, taxation, environmental programs, currency management and more.

As companies expand globally, especially in developing countries, having a formal approach to political risk management becomes critical. In the past, companies assumed that a balance of risk and return could be generated through a diversified portfolio of global operations. Overseas investments in most industries were narrower in size and scope compared with today, and multinational expansion was mostly confined to developed countries or regions.

Companies occasionally experienced reductions in revenue or operating losses resulting from political risks associated with regime change, social unrest, debt defalcation or currency devaluations. In these situations, political risk was a cost of doing business that sometimes occurred in limited ways but rarely proved catastrophic, and could be mitigated through political risk insurance or early identification and use of mitigation techniques.

With today's reliance on international growth--which is often pursued in new and unfamiliar markets--there has been a shift to larger, more uncertain investments that require a more systematic approach to global portfolio management. Systematic political risk management, in contrast to traditional views of country risk, looks beyond, for example, how short-term currency fluctuations and security concerns affect general market conditions to how political conditions influence a specific company's longer-term prospects and volatility in its markets and across the globe.

Portfolio Trends and Challenges

Energy companies' response to tightening in the crude oil market is indicative of the portfolio trend. High oil prices and the efforts of consumer nations to secure future supplies have heightened the stakes, pushing private oil companies to reconsider their portfolios of petroleum reserves. With the run-up in crude oil prices, national oil companies--for example, the Chinese oil companies--have the money and political backing to acquire smaller, more inaccessible fields and larger stakes in existing fields.

As a result, smaller oil-producing states such as Chad, Sudan, Ecuador and Kyrgyzstan can position their production to a single buyer rather than the broader market. In an exceptionally tight market, these small, less stable states become both sources of oil supply and uncertainty.

In April 2006, markets took notice when Chad's President Idriss Deby threatened to shut down his country's 180,000 barrels per day of oil production. Markets also reacted one month earlier when Ecuador's parliament passed a law that substantially increased the government's claim on profits at the expense of foreign firms operating there. These dynamics have put private-sector companies into a position where they must reevaluate their risk tolerances to account for investment in less stable countries and reconsider their risk-weighted portfolio of activities from exploration to retail sales.

Technology companies have a different challenge. They have greater flexibility in where to locate their operations but narrower margins when it comes to both cost and time to market. A hardware and software manufacturer with operations in 120 countries found it difficult to predict which suppliers might face production problems. Though the company performs extensive due diligence on all of its partners, many suppliers are privately owned and located in countries with opaque reporting requirements.

In the absence of financial and managerial transparency, the manufacturer needed a proxy to predict which suppliers might be unable to meet the terms of their contracts. The manufacturer realized that suppliers' ability to meet their contracts could be impacted by social and political factors like civil unrest, changing demands for political patronage and a tightening macroeconomic policy environment.

The company found that by monitoring political hotspots it could forecast which suppliers might run into problems and start the long process of finding alternative suppliers before these risks affected production. Technology companies have greater flexibility to establish alternative sources of supply and manufacturing than energy firms, but they, too, can benefit from assessing the political environment to anticipate change and using that information to build in operational resilience.

Sometimes corporations encounter unexpected political risks, often as a result of changing regulations and legislation. After the Sarbanes-Oxley Act was passed, practices that had once been commonplace or even tax-deductible (as were some forms of bribery in Germany) became subject to greater scrutiny in U.S. courts.

The experience of pharmaceutical companies operating across borders illustrates the risk of doing business in countries--including one's home country--with variable and evolving ethics and compliance standards. Several pharmaceutical companies have been surprised by accusations that international drug marketing practices, which once complied with local standards abroad, fail to conform to requirements in the Foreign Corrupt Practices Act (FCPA). FCPA violations have led many pharmaceutical companies to implement mitigation measures, such as more stringent internal guidelines and costly investigations of their global operations.

The Trouble with Managing Political Risk

A key question of interest to CFOs is: How can corporate leaders predict, measure and monitor political risks? Executives often find these risks so complex and hard to evaluate that they retreat to avoidance or to acceptance of risk. But these responses neither allow business leaders to capture opportunities in new markets nor adequately manage risk across their global portfolios.

For example, one company looking to expand aggressively in China focused on several political issues, including tensions over the Taiwan Straits. The company's main concern was whether escalating pressure on Taiwan from China would prevent the company from exporting its goods.

At the request of management, these issues were being assessed by local employees. But the local employees were heavily influenced by the tenor of the local media and they had limited objective insight into the political issues and their impact on the company's current and proposed operations. Had the company done further analysis, executives would have learned that the Taiwan Straits issue--while often addressed in regional media--is likely a "red herring." Chinese and Taiwanese leaders have too much at stake economically and politically to put the waterway at risk. Yet, the company delayed entry into China and, as a result, lost ground to its competitors.

According to a 2006 survey of executives at more than 100 global companies conducted by PricewaterhouseCoopers and Eurasia Group, 83 percent of those polled said that their companies monitor the local political environment after making an investment in a country. Despite this high number, 73 percent also said that their companies do not have effective political risk management processes in place.

Executives dealing with the complexity of political risk management face a number of problems, including obtaining unbiased information and making sense of the complex web of information that surrounds these risks. Once executives have this information, it can still be difficult for risk managers to ensure that it is used effectively to manage risks and that it flows to the board and senior executive level as well as to managers in the field.

A Systematic Approach to Measure And Manage Political Risk

To overcome these limitations, CFOs, strategic planners and international business executives need to manage political risk in the context of an overall enterprise risk management (ERM) program. An effective political risk management system ensures that new information about the political environment is routinely gathered, disseminated, analyzed and acted upon in a timely manner. It also considers the interdependency and potential magnification of risk due to related factors.

Managing a portfolio of global risks can be likened to managing a portfolio of investments, but with one key difference. While an investment portfolio allows a company to use diversification as a tool to control volatility, the interconnectedness of today's global markets means that diversification alone is not a guaranteed hedge against political risks.

When the flow of gas from Russia into Europe was curtailed in the winter of 2005, homes and businesses across the region suffered from the reduction in energy. An enterprise-wide view of political risk highlights these interdependencies and allows companies the opportunity to manage political risk in the portfolio as a whole to maximize opportunities and economic returns.

How one company responded to Argentina's monetary crisis illustrates how this can be accomplished. The chief risk officer of a global electronics company saved his company millions by actively managing his firm's exposure in the South American nation. His mandate was to spread the company's capital equally across all of the countries where the firm made investments, taking into account market size, growth potential and risk. He was also charged with monitoring those nations where risk levels were increasing so that he could act to reduce potential reduce losses.

The risk manager saw Argentina becoming increasingly economically unstable in 2002 and noted the dwindling political capital of those leaders who could pass economic reforms. He realized that Argentina was heading into a highly inflationary scenario and that his company had to act quickly before it incurred major losses. He realized, too, that shifting investments to another country was not only infeasible, given his time frame, but would not necessarily reduce his risk. For example, increasing investment in Brazil, one of Argentina's main trading partners, would have only deepened his losses.

He notified the company's CFO and treasurer, who worked together to repatriate equity, shift company finances into local currency and, despite higher lending costs, replace foreign debt with domestic debt. As a result, the firm was able to maintain a presence in Argentina throughout the economic crisis without losing its shirt.

A systematic approach to political risk management can help financial executives guide decisions on where to invest in operations, supply chain and consumer markets; whether to increase exposure in specific areas; and when to exit an investment entirely. As with the company in Argentina, political risk information can be used as a red flag that spurs action. It can also be used to estimate the likelihood and impact of an event. These probabilities can then be integrated into economic capital calculations or other risk metrics. Companies can use these metrics to measure risk against earnings or growth objectives, intelligently reallocate capital across business units and modify their overall strategic direction.

A Balancing Act

Every risk management decision is a balancing act, but a well-thought-out approach to political risk management can ensure better alignment between a company's objectives and its risk appetite. The level of political risk in various business units may be acceptable, given their industry and target markets. But those risks could reach unacceptable levels when measured at the entity level.

A startup energy company focused on securing stakes in marginal oil-producing states could find that even with oil at $70 a barrel, the aggregate risks are too high to warrant additional investment. By contrast, a company might find that it is not taking enough risk and, as a result, is not optimizing its potential financial returns.

For the electronics company in Argentina, the best strategy was not to avoid risk but to find ways to stay in the market while mitigating losses. Similarly, the company debating entry into China might have seen that it could afford to take on the risk of new market entry. Whether a firm is looking to manage risk or seek new opportunities, a systematic approach to managing the firm's global portfolio can lead to better and more informed decision making.

Fred L. Cohen ([e-mail]) is the U.S. Advisory Leader at Pricewa-terhouseCoopers for the Consumer and Industrial Products Industry and Global Advisory leader for the Energy, Utilities and Mining sectors, in New York City. Ian Bremmer ([e-mail]) is President of Eurasia Group in New York City.

RELATED ARTICLE: Five Steps to More Effective Political Risk Management

There are a number of steps companies can take to support the development of a systematic approach to political risk management:

* Start at the top. Take responsibility for setting comprehensive guidelines, goals, expectations and measures for political risk at the senior management and board levels. A formal structure for risk assessment should be factored into decision-making about global strategy and ongoing operations.

* Manage political risk to improve performance. Politics can create opportunity just as often as it introduces risk. Executives should keep their eyes open to both.

* Communicate political risk to optimize decision-making. Make the organization aware of risks at every level of the organization.

* Assess risks before taking action to deliver value. Use multiple sources to create a balanced, objective picture of the risks at hand. Use these scenarios to consider how potential outcomes could affect investments when making market entry, growth and exit decisions.

* Use systematic political risk management to protect investments. Begin actively monitoring political risk before the company makes an investment and maintain awareness of the political environment to support ongoing operations.

RELATED ARTICLE: takeaways

* Even companies that don't have international operations face some level of political risk because it's likely their customers, suppliers or partners operate globally.

* Systematic political risk management looks beyond short-term concerns and involves how political conditions influence a company's longer-term prospects and volatility in its markets and across the globe.

* 83 percent of executives responding to a PwC and Eurasia Group survey said their companies monitor the local political environment after making an investment; yet 73 percent said they do not have effective political risk management processes in place.