Making Better Decisions about Risk
Never is the fear factor higher for managers than when they are making strategic investment decisions on multibillion-dollar capital projects. With such high stakes, we’ve seen many managers prepare elaborate financial models to justify potential projects. But when it comes down to the final decision, especially when hard choices need to be made among multiple opportunities, they resort to less rigorous means—arbitrarily discounting estimates of expected returns, for example, or applying overly broad risk premiums.
There are more transparent ways to bring assessments of risk into investment decisions. In particular, we’ve found that some analytical tools commonly employed by oil and gas companies can be particularly useful for players in other capital-intensive industries, such as those investing in projects with long lead times or those investing in shorter-term projects that depend on the economic cycle. The result can be a more informed, data-driven discussion on a range of possible outcomes. Of course, even these tools are subject to assumptions that can be speculative. But the insights they provide still produce a more structured approach to making decisions and a better dialogue about the trade-offs.
Some of the tools that follow may be familiar to academics and even some practitioners. Many companies use a subset of them in an ad hoc fashion for particularly tricky decisions. The real power comes from using them systematically, however, leading to better decisions from a more informed starting point: a fact-based depiction of how much a company’s current performance is at risk; a consistent assessment of each project’s risks and returns; how those projects compare; and how current and potential projects can be best combined into a single portfolio.
Assess how much Current Performance is at Risk
Companies evaluating a new investment project sometimes rush headlong into an assessment of risks and returns of the project alone without fully understanding the sources and magnitude of the risks they already face. This isn’t surprising, perhaps, since managers naturally feel they know their own business. However, it does undermine their ability to understand the potential results of a new investment. Even a first-class evaluation of a new project only goes so far if managers can’t compare it with the status quo or gauge the incremental risk impact.
Evaluate each Project Consistently
Once managers have a clear understanding of the risks of their current portfolio of businesses, they can drill down on risks in their proposed projects and eliminate the need—and the temptation—to adjust net present value or risk premiums arbitrarily. What’s needed is a more consistent approach to evaluating project economics and their risks, putting all potential projects on equal footing. The project team specifies the basic economic drivers of the project, but the central strategic-planning and risk departments prescribe consistent key assumptions, help to assess and challenge the risks identified, and generally ensure that the method underlying the analysis is robust.
Prioritize Projects by Risk-Adjusted Returns
The reality in many industries, such as oil and gas, is that companies have a large number of medium-size projects, many of which are attractive on a stand-alone basis—but they have limited capital headroom to pursue them. It isn’t enough to evaluate each project independently; they must evaluate each relative to the others, too. Managing risk (and return) in capital-project and portfolio decisions will always be a challenge. But with an expanded set of tools, it is possible to focus risk-return decisions and enrich decision making, launching a dialogue about how to proactively manage those risks that matter most in a more timely fashion.
Determine the best Overall Portfolio
The approach above works well for companies that seek to choose their investments from a large number of similar medium-size projects. But they may face opportunities quite different from their existing portfolio—or they must weigh and set project priorities for multiple strategies in different directions—sometimes even before they’ve identified specific projects. Usually this boils down to a choice between doubling down on the kinds of projects the company is already good at, even if doing so increases exposure to concentrated risk, and diversifying into an adjacent business. Plotting the options in a risk-return graph allowed managers to visualize the trade-offs of different combinations of upstream and downstream portfolio moves.
We work closely with owners and contractors to achieve higher lifecycle returns for their large capital projects, in less time and with greater predictability, by moving from traditional management to a activity-focused project approach for end-to-end project delivery.
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