Getting Risk Ownership Right
Introducing systematic risk-management tools, particularly in the supplier-selection process, could help mitigate problems associated with the industry.
February 2015 | by John Livingston
The issue of counterparty risk is increasingly a topic of heavy discussion across all industries. Yet there are large differences in risk-management sophistication: while advanced methods for managing and mitigating risks are applied in both the power and financial-services industries, many other industries still lag behind. Among those still at the initial-transparency stage is the transportation and infrastructure industry, which applies risk-management methods only at a rudimentary level. That’s a problem, because the need for systematic risk assessments and more sophisticated risk management in supplier and contractor selection is obvious.
Rail involves technically complex products, such as high-speed trains and complete signaling systems for subway systems. It also represents large volumes per project, commonly ranging from the delivery of around 20 trains to more than 600 and involving financials of €500 million and more. The long-term nature of contracts (regarding both delivery and possible maintenance agreements) complicates the setup further.
This combination of complex circumstances can lead to severe consequences should a project fail. For example, when the delivery of trains in a Scandinavian country was reportedly more than seven years late and technical problems severely affected their use, compensation totaling €300 million had to be paid to the customer. In another case, the incompatibility of a signaling system with the subway of a European capital city only came to light two years after the contract had been awarded. The result was a retendering of the contract and an estimated additional cost of more than €120 million.
Indeed, the number, spread, and size of recent failure cases in the rail sector is alarming; operational risk is very common, and projects are prone to disruptions. We analyzed more than 20 cases, some of them with a negative impact of more than €350 million. In addition, we examined credit ratings in the rail sector, finding big differences among companies. In particular, we noted that lower-rated rail original-equipment manufacturers (OEMs) pose a greater default risk partly because while large agencies take cash or equity on hand into account when determining credit ratings, they don’t consider the external debt often used by OEMs to finance projects. Paradoxically, the awarding of large projects that result in increased debt burdens may actually put OEMs in a more difficult financial position.
Integrating Ratings and Risk Management
Given the implications and probabilities of supplier defaults in the rail sector, the need to integrate a systematic assessment of credit risk into the supplier-selection process is clear. Various tender-awarding authorities have already started to include minimum rating requirements for provided guarantees, a measure that could help to reduce risk across the industry. Building on this, introducing a minimum rating requirement for suppliers that are submitting tender requests would be one good way to integrate a risk assessment from the start. Doing so would help customers effectively mitigate supplier risk during projects.
A minimum rating could be individually defined in line with the customer’s risk appetite. The main and most important advantage of using a minimum rating would be that it allows customers to control and lower the risk of supplier default during a project. In tenders with a minimum rating requirement, only suppliers fulfilling the defined level of creditworthiness would qualify to submit offers for the projects. This would help mitigate the risk of selecting a supplier with a high default probability. In addition, the use of a minimum rating would also increase the transparency of the relevant supplier pool, improve the efficiency of risk assessment, and facilitate the monitoring of counterparties throughout a project’s life.
Considering the large risks associated with suppliers in the rail sector, we believe there is a clear need to integrate systematic risk-management tools into the supplier-selection process. Customers of large railway projects should take advantage of the risk-assessment methods and systems already being applied in other industries and use them to avoid risks that they actually have the ability to control.