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| How important is understanding one's risk appetite in controlling project investment risk? |
The Theory
Risk appetite is generally defined as the degree of risk that an entity is willing to accept in the pursuit of its goals. In investment terms it is the amount of money one is willing to endow in pursuit of a desired return and in business terms it is the amount of resources one is willing to commit to in the pursuit of an objective. In brief, risk appetite is the degree of tolerance which defines an entities’ behavior.
The Reality
It would seem that surprisingly few organisations have a credible understanding of their risk appetite and even fewer formally assess their risk appetite when making major business decisions. This is particularity true for many organisations which engage in major project investment decisions. A McKinsey Institute survey noted that over 80% of more than 1000 interviewed Board members of Fortune 500 companies, had stated that the organisation they represented’s risk appetite wasn’t clearly articulated. Furthermore, more than 60% stated that their organisation’s risk appetite was not formally reviewed when making major business decisions.
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These are disturbing statistics particularly when one considers the rate at which businesses (and large-complex projects) have failed in recent years. The Global Financial Crises saw more global financial institutions dissolve in a 12 month period than any equivalent period since the Great Depression. This crisis was largely fueled by the financial world’s obvious failure to consider their own risk appetite in the decisions that allowed them to hand out trillions of dollars in unsecured credit so easily.
Of particular significance to this thought piece is that of the seven largest projects engaged in Australia in the past five years ($20-$55 billion), many of them were enabled by their investor's taking noticeably risky, short term positions in search of lucrative, long term yields. A number of these project investor's committed project capital representing the bulk of their company's net worth (going all in), and at least one appeared to exceed their net worth (going over the top).
All seven projects have since run into severe cost and return challenges putting noticeable capital pressure on the owners, eroding shareholder value and seeing tens of thousands of jobs being lost. In at least one case the primary owner had to sell out to another market player before their investment made any genuine return.
Such challenges are not exclusive to Australia's mega projects alone, they have in fact become fairly common across complex project environments world wide, raising the question as to how much due diligence is put into understanding an organisation's appetite for risk taking before making major project investment decisions?There are a number of academic papers and thought pieces available which attempt to explain how important risk appetite is when making effective investment decisions, but the story I like the most is the following;
The Royal Society Experiment
In the early 1980's the Royal Society of London set out to conduct a sociology experiment to help determine whether the best method to predict a desired outcome (such as a major business decision) was to engage in a measurable, objective based approach (quantitative) or an opinion based, subjective approach (qualitative). That is; mathematics versus gut feel or data versus experience?
Although numerous exercises were engaged in this experiment, perhaps the most interesting was the one whereby a research team observed the success ratios of the world’s most prolific professional poker players. These poker players were categorised into “scientists" and "sociologists”, whereby scientists were those who determined their probability of winning through the mathematical percentages of the cards dealt and sociologists being those players who determined their probability of winning by reading the behavioral patterns and “tells” of the other players.
The Findings
After hundreds of hours of observation, the researchers had to conclude that objective and subjective approaches to probability determination cannot be practically separated as even the most mathematically informed persons will ultimately engage in an element of personal subjectivity (or bias) before they make their final decision. In practical terms what this means is; a poker player may accurately calculate that they have a 78% probability of winning the hand based on the cards dealt and the number of players still in the game. However, how much they are willing to bet on this high probability (of winning the hand) will ultimately come down to a personal choice.
The player may choose to bet 30%, 70% or 100% of their available chips, they may even ask permission to bet over the limit and throw in the car, the house and the kid’s college funds. Regardless of what they eventually bet, their probability of winning does not change but how much they are personally willing to wager on this outcome comes down to a personalised decision and not a mathematical one.
Hence no matter how scientific a player’s approach to determining the probability of winning, the ultimate decision on how much to bet is a personal (and therefore subjective) one. This simple observation suggests that in poker; science and sociology cannot be separated. Which in turn begs the question, “What does separate the best poker players from the rest?”
The Conclusion
It was noted that the top poker players found themselves in a similar number of potential winning or potential losing positions as the more average players, however the way they bet in such circumstances was distinctly different. The better players appeared more astute as to determining the optimal bet in any particular hand regardless of whether the odds were in their favour or not.
It was thus evident that the top players were simply smarter betters than their opponents and as a result they were able to win more frequently, regardless of the quality of their cards. Hence the ability to determine the probability of winning was not the primary differentiator between good poker players and average poker players. The differentiator was in fact the player’s understanding of what the optimal bet amount is in any particular circumstance (i.e. understanding their risk appetite).
So what?
Even the most mathematically informed decision making process will ultimately come down to some form of personal subjectivity and for that reason alone the ability to estimate the potential outcome of a scenario is not as important as understanding one’s own tolerance for dealing with said scenario.
What does this mean for the typical project investor?
There are three primary learnings the typical project investor should extract from this experiment. Firstly; those organisations that wish to ensure they secure a long term winning streak, regardless of the state of the market, need to become masters at understanding and effectively applying their risk appetite to all major investment decisions. Secondly; resource consuming feasibility or scenario analyses may not necessarily be the most effective means of determining whether to make a major investment decision.
In such cases the business is merely conducting a probability analysis and as seen above; understanding the probability of success is not as important as knowing when and how much to commit. Thirdly: effectively understanding and application of personal risk appetite is what separates the top poker players from the herd. The same should be true in business; those who are able to consistently make the more effective and risk aware investment decisions should end up ruling their market.
Case study
About 6 years ago there was a metaphoric project rush in Australia to secure operating licenses, assets and resources for developing mega-project style natural gas plants. This "gas rush" in turn put resource pressure on all the other mining, construction and infrastructure projects that were already in planning and a certain amount of hysteria ensued as investors rushed in where some Angels fear to tread, mostly in an attempt to get in early and remain competitive. Industry players appeared to commit to long term gas leases and multi-billion dollar capital investments in a "you snooze-you lose" like fashion and the end result saw over $150 billion in mega projects and another $200 billion in supporting infrastructure (roads, rail, ports etc.) committed to within a 2 year period of each other.
At one point it was estimated that almost $900 billion of major capital project infrastructure was in play across Australia during 2012/13/14. Many economists and industry analysts raised their concerns as to how enabling so much project infrastructure in such a short period of time would influence labour, materials and general market prices. Some even warned of a potential crash in demand a few years down the road, but nobody else seemed to be that concerned? Whilst most of the industry players mobilised relatively quickly, the Shell Group took a more cautious approach to securing natural gas infrastructure in Australia. They were visibly slower and less aggressive in their investment commitments than the rest of the market and when eventually one of the major players, who did rush in, ran into capital troubles; Shell were in a prime position to step up as their investment Angel.
Shell's recent merger with (acquisition of?) BG Group means Shell are now in a position whereby they could become the most profitable gas operator in Australia despite being the slowest/most cautious of the market entrants all those years ago. This abstract case study is a great example of the benefits of leveraging one's risk appetite; knowing when to hold and knowing when to go all in was the major differentiator between Shell Group and all the other industry players who are now finding themselves in trouble with severe cost escalations and unfavorable market prices.
So to sum this entire thought piece all up in one brief sentence; Effective understanding and application of risk appetite, equals competitive advantage
Related Topics:
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About:
I am an Engineer, Risk Professional and Complex Systems’ Thinker who has particular interest in understanding how the complexity sciences may offer a better means to controlling emergent risks within highly complex, operating environments. I currently consult on how to improve organisational Governance, Risk & Assurance practices so that they may reflect not only the degree of investment at risk, but also the specific environmental complexities in play. I believe that over the past decade in particular, I have accrued deep expertise in my chosen subject matter as evidenced by the fact that I was the head of Program-wide Risk for BG QCLNG and have held Senior Project Risk & Business Advisory roles at both Deloitte and Marsh & McLennan Risk Advisory Practices.
I am also arguably one of only a handful a Risk Professionals who has built a full end-to-end risk management & reporting framework for an organisation of over $25 billion (BG QCLNG). At its peak this was the 8th largest project in the world and is hence a significant indicator of my capability. As a practising complexity & risk specialist, I have worked within two of the world’s largest mining project hubs (BHPB and Rio Tinto), three of the Queensland mega LNG projects (GLNG, APLNG, QCLNG), Australia's largest construction company (Leighton’s/CIMIC),
The State of NSW's largest Infrastructure PMO (I&P PMO), Victoria's Largest Rail PMO (VicTrack), Brisbane's largest city Rail Project (Cross River Rail) and the largest publicly funded civil & infrastructure PMO in Queensland (Brisbane City Infrastructure). Also, as a demonstration of my commitment to my art; I am currently engaged in a PHD by Research whereby I am "Investigating a Complex Systems Approach to Complex Project Risk Management". I believe that the complexity sciences provide a new generation lens upon which to help risk management transition into a future world of complex working relationships and perpetual disruption.
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