Aloke Dasgupta

IDBI, Head Office, Mumbai

Risk Management is the name of the Game

- Ad campaign of EXIM BANK for LOC

- From the film Philadelphia

Interrogating Counsel : Do you take
RISKS?
Beckett: In our business we have to
take RISKS.
CALCULATED RISKS.

First things first.

WHAT IS
RISK ?

Entry :

RISK

Definition: chance
Synonyms: adventure, brave, chance,
compromise, confront, dare, defy,
defy danger, encounter, endanger, face,
gamble, hazard, imperil, jeopardize,
jeopardy, meet, menace, peril, plunge,
speculate, tackle, take on, venture, wager
Source: Roget's New Millennium Thesaurus,

Why is
RISK ANALYSIS
at all necessary ?

 Many projects have:

Large investment outlays
Long periods of project payout
Incomplete sharing of information and technology especially
with foreign investors
Differences in the ability of the parties to bear risks
Unstable contracts
Projects may be attractive in aggregate, but are unattractive to
one or more parties due to uncertainties about sharing risks and
returns.

Welcome to the Big Bad World of Risks

for Industrial Projects...

THE UNIVERSE OF RISK

Strategic

Risks

Market demand [more often than not the demand

projections have little credibility].
Operating costs [often underestimated].
Unexpected/ unanticipated capital costs.
Financial Risks
Credit default.
Financial market risks.
Interest rate changes.
Currency/ foreign exchange fluctuations.
Liquidity/ cash flow issues of the off-taker.

THE UNIVERSE OF RISK [contd]

Operational

Risks

Supply chain management.

Information systems.
Key managers.
Hazard

Risks

Property damage.
Legal risks.
Workers' compensation.
Natural disasters.

And pray
how does one
ASSESS RISKS ?

Risk Assessment
Where is the appropriate risk? - identify
[ASK - HOW?]
What causes it ? - triggers
[ASK - WHY?]
Probability of occurrence and its impact
[ ASK - SO ?]
Evaluate how do you contract the risk
Manage the risks
Keep an eye on the risk over the period that you
have to bear them
Establish the risk landscape
Agree & communicate objectives

IMPACT .
How do I quantify ?

SENSITIVITY ANALYSIS
Test the sensitivity of a project's outcome (NPV) to
changes in one parameter value at a time.
"What if" Analysis.
Allows you to test which variables are important (i.e.
as a source of risk).
A variable is important depending on :
A)
Its share of total benefits or costs.
B)
Likely range of values.
Sensitivity analysis allows you to determine the
direction of change of the NPV.
Break-even analysis allows you to determine how
much a variable must change before the NPV turns
negative.

CAUTIONARY NOTES FOR SENSITIVITY ANALYSIS

Sensitivity analysis doesn't represent the possible range of values.
Sensitivity analysis doesn't represent the probabilities for each
range. Generally there is a small probability of being at the
extremes.
Direction of effects
For most variables, the direction is obvious.
A)
Revenue increases
--NPV increases
B)
Cost increases
--NPV decreases
C)
Inflation
--Not so obvious
One-at-a-time testing is not realistic
Once-at-a-time testing is not realistic because of correlation among
variables.
One method of dealing with these combined or correlated effects is
scenario analysis.

SCENARIO ANALYSIS
Scenario analysis recognises that certain variables are
interrelated. Thus a small number of variables can be
altered in a consistent manner at the same time.
What is the set of circumstances that are likely to combine
to produce different "cases" or "scenarios"?
A) Worst case/ pessimistic case.
B) Expected case/ best estimate case.
C) Best case/ optimistic case.
Scenario analysis : probability ? - does not address

MONTE CARLO METHOD OF RISK ANALYSIS

A natural extension of sensitivity and scenario analysis.
Simultaneously takes into account different probability
distributions and different ranges of possible values for key
project variables.
Allows for correlation (covariation) between variables.
Generates a probability distribution of project outcomes
(NPV) instead of just a single value estimate.
The probability distribution of project outcomes may assist
decision-makers in making choices, but there can be problems
of interpretation and use.

STEPS IN BUILDING A MONTE CARLO SIMULATION

Mathematical model : project evaluation spreadsheet.
Identity variables which are sensitive and uncertain.
Define uncertainty
Establish a range of options (minimum and maximum).
Allocate probability distribution
Identify and define correlated variables.
Positive or negative correlation.
Strength of correlation.
Simulation model.
Analysis of results.

Whose Risk is it anyway?

If there is RISK then it better
not be mine.

RISK SHARING
SPONSORS

BANKS

SHAREHOLDERS
AGREEMENT

SUPPLIERS

CREDIT
ENHANCEMENT

SUPPLY
AGREEMENTS

OFFTAKERS
OFFTAKE
AGREEMENT

PROJECT COMPANY

OPERATOR
LOCAL LAWS
O&M AGREEMENT
CONSENTS/PERMITS
GOVERNMENT
AGREEMENTS

EPC CONTRACTOR
EPC CONTRACT

Simply stated...
DETAILED RISK ANALYSIS IS UNDERTAKEN, AND RISK
ALLOCATION IS UNDERTAKEN PRIOR TO DETAILED
WORK ON PROJECT DOCUMENTATION

A PARTICULAR RISK IS ASSUMED BY A PARTY

BEST ABLE TO MANAGE AND CONTROL THAT
RISK, RISK SHOULD NOT BE PARKED WITH
THE PROJECT COMPANY.
TO MAKE SURE THAT ALL THE RISKS ARE PROPERLY
ALLOCATED, A COMPREHENSIVE RISK MATRIX
SHOULD BE PREPARED.
THESE RISKS MITIGATED BY ALLOCATING TO
VARIOUS PARTIES THROUGH SUITABLE CONTRACTS

RISK ALLOCATION AND MITIGATION

RISK
CATEGORY
CONSTRUCTION

RISK
- COST OVERRUN

-DELAY/
ABANDONMENT

ALLOCATION
EPC
CONTRACTOR(S
)

MITIGATION
FIXED PRICE, FIXED TIME CONTRACT
(COMPLETION GUARANTEE), LENDERS
ENGINEER

------DO------

SCHEDULE COMPLETION BEFORE

NEEDED, LIQUIDATED DAMAGES,
CHECK EPC CONTRACTORS
CREDENTIALS, PROPER CONTRACT
DRAFTING

-PERFORMANCE
-FORCE MAJEURE
OPERATION

UNDERPERFORMANCE

------DO------

O&M/EPC
CONTRACTORS,
SPONSORS

GUARANTEE/LDs/LENDERS ENGINEER
INSURANCE, CONSISTENCY BETWEEN
EPC CONTRACT AND PPA
LDs IN O&M/EPC CONTRACTS,
CAREFUL DUE DILIGENCE

RISK ALLOCATION AND MITIGATION

RISK
CATEGORY
MARKET

RISK
-OFFTAKE

ALLOCATION
SEB

MITIGATION
PPA

-SEB RISK

GOVT.

CREDIT ENHANCEMENT, LIMITED

EXPOSURE

-QUALITY/
QUANTITY

FUEL SUPPLIER

LDs IN FSA SHOULD MATCH WITH LDs

IN PPA

-TRANSPORTATION

TRANSPORTER

------DO------

-INTEREST RATE

LENDERS

FIXED RATE DEBT/HEDGING

-BREACH OF LOAN
COVENANTS

------DO------

TERMINATION CLAUSES IN LOAN

AGREEMENTS

REGULATORY

NEW LAWS

SPONSOR/GOVT

AGREEMENTS

POLITICAL

CHANGE IN LAWS,
CONTRACT
FRUSTRATION,
ETC.

ECAs/
INSURANCE
FIRMS,

POLITICAL RISK INSURANCE

FUEL SUPPLY

FINANCIAL RISK

CONTRACTING CRITERIA
Contract with lowest cost (highest return if investment occurs) not
necessarily best contract.
Efficient contracts may provide :
Better risk shifting -- better distribution of cost across circumstances i.e.
given probabilities, change the allocation of risks between participants.
Better risk management -- higher project returns or lower total project risk
as result of incentives i.e. change the incentive structure to change the
probabilities of outcomes.
ZERO SUM VERSUS POSITIVE SUM PERSPECTIVES
Cost focus is implicitly a zero sum perspective. What one party gains the
other loses.
Efficiency perspective is explicitly a positive sum perspective. With right
contract one party can gain substantially without corresponding cost to
other party.