Risk Management

Political risk

Published: Sep 2013

Political risk is a salient issue in international business, with the ongoing turmoil in the Middle East and North Africa; the recent spate of nationalisations in Latin America; and diplomatic incidents, such as the Iranian government’s threats to close the Straits of Hormuz, which negatively impacted a number of large energy multinationals earlier in the year. What is political risk? In basic terms, it can be defined as any political event or decision with the potential to impact negatively upon commercial activities. The risk is often grouped and analysed on macro and micro levels:

  • Macro-level risks are those which impact all businesses operating within a specific region. Such risks are widely discussed in the media, and include political and civil unrest, energy-price volatility, terrorism, and civil or cross-border conflict.
  • Micro-level risks are firm or industry-specific risks. These types of risks are, by their very nature, discriminatory. The category includes the risk of a government nullifying a contract with a certain business, or that a terrorist group will target a certain company’s operations.

Why manage political risk?

Most successful multinational companies (MNCs) now recognise that the way in which political risks are managed can have a substantial impact upon performance. This awareness is particularly acute amongst businesses that have had their fingers burnt by political events in the past.

“I think there is a discrepancy between companies who have been operating in highly volatile, highly opaque markets for a long time and those who have not,” says James Smither, Head of Political Risk at global risk analytics company, Maplecroft. Predicting the types of companies that are going to be good at managing political risks is not always straightforward, Smither cautions, but there does seem to be a strong association between those that pay most attention and those who have had negative experiences in the past. “If you went through a very traumatic expropriation in Iran or Latin America during the 1970s, then you will most likely have very rigorous systems in place to make sure that it doesn’t happen again,” says Smither.

For most companies, managing political risk to avoid the types of negative experience is the priority. But effective risk management can also help businesses to seize new opportunities which otherwise may have passed them by. Anticipating policy developments, for example, might provide a window to gain first-mover advantage in a particular region.

Table 1: Different types of political risk

Risk types Examples
Bribery.
  • Forced hiring of third-party consultants for contract bids.
  • Unforeseen border ‘taxes’.
Capital controls.
  • Limits on profit repatriation.
  • Administrative delays in approving capital transfers.
Contract default.
  • Politically-driven debt default.
  • Politically-driven failure to deliver on a contract.
Expropriation/nationalisation.
  • Confiscation of a plant due to ‘unpaid’ taxes.
  • Forced sale of asset(s) to government buyer at below-market prices.
  • Politically-driven increase in state ownership of joint ventures.
License cancellation.
  • Change to organisation’s license to operate (LTO) ahead of an election.
  • Loss of social LTO ahead of an election.
Protests/strikes.
  • Industrial action and work stoppages at key supplier(s).
  • Anti-government or anti-company protests and road-blocks.
Regulatory change.
  • Complex new environmental or labour standards.
  • Regulatory enforcement authority handed to a state-owned company.
Taxation.
  • Windfall taxes levied over ‘excessively high’ profits.
  • Duplicate tax claims by/between central and local governments.
War on terrorism.
  • Border and road closures due to inter-state fighting.
  • Politically motivated terrorist attacks against foreign investors.

Source: Accenture 2012

Political risk assessment and analysis

Before a company can begin to manage political risk, first it must find a way of identifying and quantifying the different threats it faces, and then analyse how these threats might impact upon strategy and its ability to access and operate in different markets.

A combination of political risk assessment and analysis is typically used for this objective. On the macro-level, quantitative risk assessment considers the general attributes and variables of different political environments. Data from specific countries is aggregated to generate an overall score, allowing them to be comparatively assessed and assigned a graded risk level. A number of risk consultancies offer such indices including the Economist Intelligence Unit (EUI), Political Risk Services and Aon.

Maplecroft’s annual Political Risk Atlas (PRA) includes 50 risk indices for 197 countries which are embedded in interactive maps. The atlas includes short-term risks, such as the rule of law, political violence, and regime stability, in addition to longer-term factors such as economic diversification, resource scarcity and human rights.

For the risk manager or CFO, the changing values of such indices can provide a useful starting point for identifying future risk events. For example, if one wished to look at the probability of large-scale social unrest breaking out in a particular country, you might look at indicators such as youth unemployment or the level of government oppression, where any change could indicate a rise or a fall in the level of risk.

Managing political risk: the four Ts

Now that the risk has been identified and evaluated, companies can begin the process of managing it. As is the case with other types of exposure, there are four main ways for a company to manage political risk:

  • One option is to tolerate the risk – companies may conclude that the level of risk they face is acceptable and decide to proceed as normal, while monitoring it to make sure that it does not increase in the future.
  • On the other hand, if a company decides that the level of risk they face is too high, but wish to continue operating in a particular region or country, then an alternative approach would be to transfer the risk by taking out political risk insurance (PRI) in order to provide a form of financial recourse should the worst happen.
  • The third pillar is treatment. Treatment involves taking actions that will reduce the likelihood of the risk occurring in the first place. That could mean lobbying a government in the hope of achieving a more favourable legislative outcome or, alternatively, taking certain steps to mitigate the impact of a damaging policy decision.
  • In cases where the level of risk is deemed to be unacceptable a decision may be made to terminate a certain activity. What is determined to be an acceptable level of risk may vary between industries and companies. For instance, companies in extractive industries such as mining often have little choice regarding the countries or regions in which they operate. A company which mines for platinum has to go wherever the deposits are, leading them sometimes into more volatile environments.
Diagram 1: Maplecroft’s political risk (dynamic) index 2013
Diagram 1: Maplecroft’s political risk (dynamic) index 2013

Source: Maplecroft TM

Legend Rank Country Rating Rank Country Rating
Extreme riskExtreme risk 1 Somalia Extreme 6 Iraq Extreme
High riskHigh risk 2 DR Congo Extreme 7 Libya Extreme
Medium riskMedium risk 3 Sudan Extreme 8 C.A.R Extreme
Low riskLow risk 4 Afghanistan Extreme 9 Syria Extreme
No dataNo data 5 Myanmar Extreme 10 Yemen Extreme

Source: Maplecroft TM

A growing concern

The ongoing social and political unrest in the Middle East and North Africa has begun to reshape the way companies and investors consider political risk. “The Arab Spring was a sort of ‘9/11 moment’ for political risk,” says Maplecroft’s Smither. “It was a seminal event for companies because even if you were not investing in Egypt or Tunisia, the chances are that your supply chain passes through the Middle East and you would have experienced some form of disruption.” Many of those countries, Smither points out, had been stable for extremely long periods. Their leaders – the likes of Mubarak, Ben Ali, and al-Assad – had in many cases been in power for decades and, furthermore, were seen as friends of the West.

“So that proved to be a big wake-up call for everyone,” says Smither. “People began to realise that just because they know the president of a country and have a good relationship with the administration doesn’t necessarily mean that they are politically safe. What it showed was that even long-standing governments can fall suddenly, leaving companies to deal with a bunch of new faces.”

Lee Garvey, Vice President at Marsh’s Political Risk Practice, agrees with Smither that there has been an upsurge of corporate concern around political risk in recent years. “It is an age-old problem – like with all insurance – people tend to come to market once the house is already on fire.”

Garvey does note signs of a more conscious approach to political risk emerging, with an increasing number of clients now considering the product for all of their investments and projects going forward. “We are seeing clients address political risk in a more proactive rather than reactive way. I think historically that was the case – companies, banks and investors would consider PRI as an afterthought. Now companies are thinking about it as a way to actually enhance the proposition internally with their own credit committees and due diligence process.”

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