Risks faced by Projects• Governance risk: The governance risk arises out of the board and management performance with reference to ethics, leadership, reputation of the organization etc.• Strategic risk: This risk arises out of an error in strategy adopted by organization. For example, a selection of technology that is not suitable to the organization or choosing a strategy that can change the course of business drastically.• Operational risk: This is a risk of having poor operational systems, poor implementation and process problems related to production and distribution.• Market risk: The risk arising out of competition, fluctuations in foreign exchange rates, raw material supplies, interest rates, credit and liquidity aspects, etc.• Legal risk: This risk is a result of legal and regulatory obligations like contract risks and litigation suits filed against organization.Construction phase risksCompletion risk: Completion risk allocation is a vital part of the risk allocation of any project. This phase carries thegreatest risk for the financier. Construction carries the danger that the project will not be completed on time, on budgetor at all because of technical, labor, and other construction difficulties. Such delays or cost increases may delay loanrepayments and cause interest and debt to accumulate. They may also jeopardize contracts for the sale of the project’soutput and supply contacts for raw materials.Completion risk is managed during the loan period by methods such as making pre-completion phase draw downs offurther funds conditional on certificates being issued by independent experts to confirm that the construction isprogressing as planned.Operation phase risksResource/Reserve risk: This is the risk that for a mining project, rail project, power station or toll road there areinadequate inputs that can be processed or serviced to produce an adequate return. For example, this is the risk thatthere are insufficient reserves for a mine, passengers for a railway, fuel for a power station or vehicles for a toll road.Operating risk: These are general risks that may affect the cash flow of the project by increasing the operating costsor affecting the project’s capacity to continue to generate the quantity and quality of the planned output over the life ofthe project. Operating risks include, for example, the level of experience and resources of the operator, inefficiencies inoperations or shortages in the supply of skilled labor.Process of project risk managementRisk Identification: It is definitely a brainstorming process to uncover the risks associated with the project. Severalideas are taken into account from risk perception of the team members of the project following the documentationprocess that are evaluated properly to uncover the risks inherent to the project. The other alternative way is to paint apicture of the project success. Thereafter, one should move backwards, duly considering the adverse developments thatmay affect the path to achieve success. Once the risks are identified, these may be placed as a sticky note on the processof project schedule, process map, etc.Risk Analysis: In this step, the overall magnitude of the risk and its expected losses are estimated. In order to achievethe best outcome, the risk event drivers are determined and the probable worst impact of the same assessed.Identification of the risk event drivers can be termed as the foundation of the risk management process as it helps us tomitigate the same.Risk Prioritization: In this stage, the risks are compared on the basis of their probability of occurrences as well asthe expected amount of losses, if the worst thing is going to occur in future. The risks are listed on the basis of theresultant product of the above two factors. This steps guides the project manager for the allocation of the resources tomanage the risks actively. Since the resources are limited, the project manager should choose the risks carefully, whichhave the higher impact on the organization.Risk Planning: Once the risks are short listed for their active management, the action plan is also framedaccordingly. The following kinds of actions may be adopted:• Acceptance: It is adopted when the consequences are negligibly small• Avoidance: It is the best way of dealing the risk by taking suitable precautionary measures that may rule out thepossibility of the occurrence of the event.• Transfer: It is another good alternative where the consequences of losses are transferred to a third party like acontractor or insurer at some nominal expenses.• Self-financing: Here, on the basis of the past experience of the organization, a separate fund is built up which isused to meet the consequences for the occurrence of the risk.The actions described above are broadly categorized as the prevention plans and contingency plans. The first one is theproactive one while the second one is reactive one and accordingly the resources should be kept ready to meet the risks.
Risk Monitoring: It is the final step of the process of project risk management but it is repeated regularly throughoutthe execution of the process of the project. This step consists of the following processes:• How the actions plans for the actively managed risks are progressing.• Removal of the risks that have mitigated effectively or cannot be expected to occur.• Addition to the actively managed risks that has occurred as the execution of the project is underway.Therefore, monitoring of the risks is the repetition of the other risk management processes as the circumstances arechanging with the passage of time. Incorporating risk management into the projects requires a lot of time and effort,even if it is scaled down. One should work in advance in order to avoid the occurrence of the consequences of the risksthat will result in predictable outcomes from the project.Measuring Effectiveness of Risk management MeasuresAn action initiated for managing risks does not mean that the desired results will be achieved. In order to knowwhether the risk management tools and techniques implemented to mitigate the risks have succeeded in achieving thedesired results, organizations need to measure the effectiveness of the risk management measures on a regular basis.One method of measuring the effectiveness is, by comparing the monetary exposure of the project before and after riskmitigation actions. Pre-mitigation exposure can be calculated by multiplying the monetary impact of the risk with theprobability of risk. The amount arrived at can be compared after risk mitigation process. The difference can be seenclearly between the amounts, as the risk mitigation actions will reduce either the probability of risk or the monetaryexposure. This method can be utilized, only if the financial loss or exposure is quantified during initial risk analysis.Another way to measure for all the risks and the cost of mitigation action. After calculating the values, a ratio of thetwo parameters can be calculated to determine the cost effectiveness of the actions taken.While the above two methods measure the risk mitigation pre and post-actions, another way to measure theeffectiveness of the actions is, by reviewing the actions along the progress of the project. While reviewing the projectactivities, organizations need to include the review of project risk mitigation actions invariably. By doing so,organizations can review along with the progress of the project, whether project manager and project teams areperforming their schedule risk management activities as planned. This also enables the management to decide whetherspecific additional assistance needs to be provided to the teams to accomplish the objectives of risk management apartfrom the scope to modify the actions in the light of new developments. With growing complexities in businessenvironment and emergence of new forms of risks, project risk management should be treated as a separate activity andreviewed along the length of the project.Risk Response planningRisk response planning determines the action for enhancing the opportunities and reducing the threats in a project. Thecommon strategies to deal with threats are avoidance, transfer, mitigation and acceptance.(as said before)• Risk avoidance refers to those actions that can nullify the impact of risk events on a project. Project managers can achieve it either by changing the way of carrying activities or by changing the project objectives.• Risk transfer implies that the third party will shield the project from the impact of all or few risk events. The risk transfer approach is a middle path approach, which makes the best alternative less good and the worst alternative less bad.• Risk mitigation approach is possible when the potential impact of the risk is above a certain threshold.• Risk acceptance is about planning for the options that can be considered when the risk arises. Options may be in active or passive forms according to the severity of an event. For active acceptance, contingency plans are developed so that the impact of the risk can be reduced to an acceptable level.Benefits of using risk response planning chart:• Decision can be taken proactively to counter a risk by assuming that it will happen in the future.• Events or risks with high threshold can be minimized.• Events with passive impact can be found out and ignored.• Few risks lie between the passive acceptance and avoidance situations. It is not worth for the company to go for a contingency plan. The identification of those risks to transfer is possible by using this chart.• The risks that are likely to occur many times can be accepted actively and their impact can be reduced.• Risk mitigation can be implemented wherever it is requiredRisk management measures in practiceConservative Estimates of ProfitabilityPreparation of projected profitability estimates, balance sheets and cash flow statements is done with reference to thecost of the project, means of finance, underlying assumptions relating to capacity utilization, schedule ofimplementation, selling price realization, raw material costs, other production costs, administrative and sellingoverheads, depreciation rates, tax rates and tax benefits, etc. These assumptions need to be realistic. This provides a
cushion against the unforeseen events that could influence the projected profitability, negatively. Key assumptions,where the principle of conservatism is applied, are as under:(i) Capacity Utilization: Though a project, if successful, will run at its optimum capacity in the very first/secondyear of its commissioning, as a shield against uncertain future, the following safeguards are taken in the projections a. Inthe case of a new venture, capacity utilization is gradually increased over 3-4 years to reach and then stabilize at anoptimum level based on the actual capacity utilization being achieved in the related industry.b. In the case of expansion by an existing unit, past levels achieved in capacity utilization provide the benchmark forassuming the gradual capacity utilization increase in the new project.(ii) Selling Prices: To begin with, the unit-selling price is taken based on the generally prevailing market price in thecase of a new venture and already realized price by an existing unit in the case of an expansion project. This price isthen discounted for factors, such as, variations in the prices in the past, the need to sell at a lower price due to likelycompetition or to establish the product in the case of a new entrant, fluctuations in prices in case of products whoseprices fluctuate at short intervals, etc.(iii) Raw Material Prices: Here again the beginning price is taken based on the generally prevailing market price inthe case of a new venture and the price at which the material is already being purchased by an existing unit in the caseof an expansion project. This price is then revised in the light of considerations, such as likely demand-supply scenario,short interval fluctuations, past trend in the prices and cyclicality of the supplier industry.The above risk management measures in respect of profitability projections result in lower projections. The projectshould withstand, and justify its financing based on these lower projections.Conservative Assumptions in Financial Evaluation CriteriaThese are the assumptions for computing the IRR for evaluating the financial viability of the project and assessing theassociated risk:(i) Project Life: The life of the project is generally taken to be 12 years or even less, depending upon the nature of theindustry, say, where the technical obsolescence is high, except of course for infrastructure ones. The life as estimated asper the technical appraisal is disregarded unless, of course, it is shorter than the assumed norm.(ii) Salvage Value: In the terminal year, that is, at the end of the assumed project life cash inflows are computedassuming the following salvage valuesa. In the case of fixed assets other than land ó5% of the original cost, despite the fact that 95% of the cost might nothave been depreciated over the assumed life and that, generally, due to considerations of inflation and hassles associatedwith the establishment of a new plant, etc. The actual realizable price could be much higher.b. In the case of land, 100% of original cost, though in most cases it will fetch a very high premium after the lapse of 12years or so of assumed project life.The result is that the IRR so arrived at provides a lower value than it could be achieved in real life. The project shouldwithstand, and justify its financing based on, this lower conservatively arrived IRR.Sensitivity AnalysisSensitivity analysis is a further exercise, and at that a very popular one, in risk management. Sensitivity analysisinvolves identifying most critical factors that could lead to risk, quantifying likely variations therein and subjecting theentire financial evaluation criterion, as mentioned earlier, to them. The objective is to see the response of the projectedprofitability to each of these factors and to identify the areas most vulnerable to a project so that the management couldadequately address them while running the operations. There can be no fixed norms for the extent to which thevariation in the critical factors could be quantified. Normally, financial projections are subjected to 5% variation inprojected capacity utilization, that is, quantum of sales, selling prices of finished products and raw material prices.Analysis could also be carried out by combining the effect of two factors depending upon the risk perception of theproject. In case of import- intensive and export-oriented projects, they are subjected to likely foreign exchangefluctuations.
INFRASTRUCTURE PROJECTS Features of the infrastructure projects• These projects need a very high amount of initial outlay e.g. the cost of setting the metro railways in Kolkata or Delhi was/is in the range of thousand crores of rupees.• The gestation period of these projects is relatively longer e.g. for an infrastructure project, the average time required to get a satisfactory return on investment is about 15 years.• The economic life of the infrastructure thus built is also longer e.g. the working life of a river bridge is more than a century.• These projects generally break geographical barrier e.g. road or railways or telephonic connectivity generally brings people nearer irrespective of the geographical distance among them.• In many cases, these projects are undertaken for greater interest of the society e.g. the jobs like, road or railways or telephonic connectivity are generally undertaken for the convenience of the masses.• The risk of technological obsolescence is less. The construction of the infrastructure projects is a matter of great challenge. Thereafter, as long as the facilities are required, it will be useful to the people.• Execution of the project is generally a very complex task. As the projects needs a very high volume of work, for example setting the east-west corridor for a length of more than 2000 kilometers, the erection and execution of the project is complex in nature. A note on infrastructure project financing practice in India Infrastructure projects are mostly being financed by the planned allocation of the Planning Commission of India and partially by the banks. The choice of the project, amount of allocation and time of disbursement are seriously influenced by actions of the political leaders. Therefore, economically unviable projects are also getting financed as these are considered to be socially desirable by the politicians in order to protect their vote bank. Therefore, a large amount of government money will be wasted, causing severe hardship to the taxpayers. It is correct that the government should also have some social goals. But the social commitment should outweigh the business requirements in a country like, India where the industry is sharpen their competitive edge with the support of a better infrastructure. Such growth will lead to higher employment and better standard of living and thereby overall development of the economy. While for the bank financing, the project finance is available for a very short term, while the gestation period for any project is long term to very long term. Therefore, one cannot rule out the possibility of the asset-liability mismatching that may be inconvenient to the lenders as well as the borrower. Infrastructure projects generally need a significant amount of capital investment where the gestation period varies from long term to very long term. Therefore, we are required to find out such a type of liability where the cash flows match the liabilities, ruling out the possibility of asset-liability mismatches. Bank finance or the other debt instruments as presently available in the markets cannot fulfill such requirements. The sponsor should consider equity investment in this context for the development of any infrastructure facilities in any part of the country. Apart from it, the recently formed private insurers as well as the upcoming pension fund providers can be offered some incentives for making investments in this sector – either in the form of equity or debt. Since their liabilities are long term in nature, there will not be any asset-liability mismatch. These investments will help to achieve the growth of the infrastructure facilities in the country while the private players will get a lucrative opportunity to invest in the fund starved sector. The government has to play a key role for the success of the financing requirements by the Indian infrastructure sectors. It is required to formulate clear and consistent policy in this regard. The investors should be properly compensated for the risk assumed by them by making an investment. Wherever possible, the government should also assure the means of getting adequate returns from such investment. Simultaneously, the uniformity of these policies must have to be maintained, irrespective of the ideology of party ruling the country. In this context, the Enron episode, related to the Dabhol Power Company cannot be forgettable as one government run by one party signed the agreement while the successive government run by the another party scrapped the same, causing widespread frustration among the investors.