Political risk can be devastating. Ask the mining companies in the Democratic Republic of Congo (DRC) that have been forced over the past two years to renegotiate their contracts. Ask HSBC, whose headquarters in Istanbul was wrecked by a terrorist attack in 2003. Ask the hedge funds that bet Brazilian stocks would tank after firebrand left-wing president Luiz In?cio Lula da Silva took office in 2003, then suffered heavy losses when the exact opposite happened.
Companies have always faced these kinds of risks: terrorism, civil unrest, regulatory change, the seizure of assets. But the exposure has never been as great as it is today, argues Christa Davies, CFO of Aon Corp., the global risk-management consultancy and insurance brokerage based in Chicago: "People are doing business in more countries--and a more diverse range of countries--than ever before. They might have operations on the ground, or they could be exposed through their supply chains, by sourcing product components or services in certain locations, or simply through the customer base. It absolutely has to be a core consideration in the way people run their business."
Unfortunately, in many cases, it isn't. Political risk analysts claim that while companies have a formal, rigorous approach to the management of other exposures, like currency risk or business continuity, they usually tackle political risk on an ad hoc basis. When the issue raises its head, they'll react by calling up a consultant, buying some insurance or engaging a lobbying firm-but it's rare to find a company that monitors the issue on an ongoing basis, says Corene Crossin, senior consultant with risk advisory firm Control Risks Group in London: "We know of few companies with a central, dedicated focus on political risk. It tends to fall between stools, and the companies who handle it best are those who have a joined-up approach to the issue. Often, the ones that fall victim to political risk are the ones that don't take it seriously, don't recognize it as an issue and therefore don't address it in their business at all or just file it away in one small area like community relations or government relations," she says.
Davies says that Aon is different: "Our view would be that political risk has to be integrated into your overall risk management procedures, and therefore it needs to be managed at the highest level of the company. It certainly is one of the things that I think about, and worry about, and so do all of our finance leadership across the company."
Aon has a bit of a head start, of course. One of its businesses is providing political risk insurance, so the company annually gathers information on the risk profiles of different countries globally, producing a kind of heat map of exposure. In this year's map, current trouble spots in sub-Saharan Africa and the Gulf region glow an angry red, while mature markets like North America and Western Europe are gray-as if to suggest that they're made of some inert, risk-proof material.
That's a mistake, says Ian Bremmer, president of Eurasia Group in New York and author of a new book on political risk and strategic investing. Companies tend to think about political risk as something that affects only emerging market investments, Bremmer says, but the current financial crisis has massively raised the political risks at home, too. "There has been a massive government response to a crisis that is unprecedented in the last couple of generations, and it means that decision-making authority over who wins and who loses is increasingly not in the hands of multinational corporations," he says. "They are no longer the principal economic actors-governments are. This is playing out all over the world, and there has never been a time in the post-war period when political risk has mattered more." s an example, Bear Stearns was propped up and pushed into the arms of a competitor, while Lehman Brothers was allowed to collapse. General Motors and Chrysler were able to wring some support out of the U.S. government, but other companies and sectors of the economy have been left on their own. The new stimulus package calls for a huge amount of infrastructure spending--but who gets the contracts? "It is all about Washington," says Bremmer. "It's not Main Street. It's not Wall Street. It's K Street."
In other words, if you're looking for a political risk-free zone, forget about it. So, what can companies do to manage their exposure? One option is insurance, but that comes with its own drawbacks, as Alan Berlin--formerly president of the international division of oil company Belco Petroleum--knows to his detriment. By the 80s, Belco had been in Peru for about 25 years, investing some $200 million in the country, when its operations were snatched away after Alan Garcia was elected president for the first time in 1985.
Belco had bought what was then considered fairly standard coverage against state seizure of assets from AIG, but even though the company had photographs of armed Peruvian soldiers entering its facilities, the insurer disputed the claim, triggering a lengthy arbitration that was settled in Belco's favor in 1988. The episode has left Berlin somewhat skeptical of the value of insurance: "My feeling is that you should seek to avoid using insurance-find ways to avoid problems rather than dealing with them when they arise," he says.
Insurers, too, recognize that political risk policies are essentially a tool of last resort, but they are useful in some situations, such as when banks require such coverage to arrange financing for a major project. Having an insurer in your corner can be used as leverage when negotiating with foreign powers-especially if the coverage is provided by a government agency, like the Overseas Private Investment Corp., say experts.
A more proactive way to tackle some forms of political risk is to take a local joint venture partner. The idea is to pick a company that is well-regarded by the government and will act as a buffer against the risk of state intervention. In some cases, this is practically compulsory-mining companies that want to extract some of the DRC's wealth of mineral resources, like cobalt or copper, are often expected to team up with one of the five state-owned miners in order to win a license.
But having a joint venture partner is no guarantee of safety. In May 2007, the DRC's government-apparently peeved that fees and royalties had been clinched at a time when commodity prices were low-kicked off a contract renegotiation process with 61 companies that have a mining presence in the country. In some cases, the DRC was asking for the original license fee to be topped up, or for the state-owned joint venture to be given a bigger equity stake. Few-if any-exceptions were made, and companies that dug their heels in were threatened with expropriation, says Chris Melville, the DRC country risk analyst at Control Risks.
The results of the renegotiations have not been made public, but only two contract holdouts are said to be left. Regardless of the details of the new terms, the renegotiation process itself has had a big impact on DRC mining firms: By demonstrating that the government is willing and able to interfere in the sector's profitability, it has scared off potential buyers or investors in DRC mining assets, and companies now find themselves with no exit at a time when commodity prices have slumped. Particularly hard-hit are companies that used the stress of the negotiation process to buy up stakes in other concerns, consolidating their interest in the sector. "A year ago, you would have said that there were clear winners and losers from the contract reviews," says Melville. "But since then, there has been a collapse in copper prices, so the assets have lost a significant amount of value. At the same time, it's difficult to do anything with those assets because the review has increased investor perception of political risk."
Another way to mitigate political risk is to employ lobbyists-a tool that could become increasingly important for companies as a result of the economic crisis, says Eurasia Group's Bremmer. The announcement of revisions to fair value accounting rules in early March, for example, was widely seen as a victory for banking industry lobbyists and a way for banks to relieve some of the pressure on their financials.
Hiring lobbying firms to sway critical decisions in a company's favor may seem like a smart response, but getting the right outcome is easier said than done, says Witold Henisz, associate professor of management at the University of Pennsylvania's Wharton School and an expert on how political risk affects international investments. "There is often a feeling that this is something that can be outsourced-'we are going to hire the best lobbying firm and they are going to manage this for us in Washington'-but while the firm might understand the scene really well, it may not understand the company as well, or be able to really leverage what the company can do," he says. "So there needs to be some kind of bridge between the two and that's something where I really don't see many firms paying enough attention."
For Eurasia Group's Bremmer, the bottom line is that companies need to spend more time trying to understand the precise nature of the risk up front: "There are lots of ways to spend money on risk mitigation," he says. "But mitigation is no use unless you actually understand your risks. And when it comes to political risk, frankly, most of the companies out there don't try to understand it first."
Building Political and Social Capital Key to Overseas Projects
Have you heard about the turtle that moved a power plant? That's not a joke or a song-it's actually part of a deadly serious, and much-praised, attempt to manage the political risks associated with the construction of a huge, multibillion-dollar liquid natural gas (LNG) facility near the mouth of the Congo in Angola.
The project's biggest stakeholder, California-based Chevron, decided early on that getting the deal to work in a poor country that was still recovering from civil war would mean building a good relationship with local communities and the government. So instead of arriving with a fully formed plan and trying to force it through, Chevron took a different tack."We must have had over 200 different meetings since the start of the project with all kinds of different stakeholders-local government, central government, NGOs, local communities, traditional leaders," says Laurentino M. Silva, the Angola-based manager of local issues and government relations for Angola LNG, the company set up to run the project, in which Chevron has a 36.4% stake. "We wanted to be welcomed by the local community, so we reached out and asked what was important to them."
The answer was turtles. And whales. And free gas. And a new village. Chevron and its partners-BP, Total, ENI and state-owned Angolan energy company Sonangol-accommodated all those demands, says Witold Henisz, associate professor of management at the University of Pennsylvania's Wharton School. Despite an environmental impact study showing that the new plant would have no impact on the spawning grounds of marine turtles, the local population was not reassured, so the company agreed to relocate the plant to another part of the bay. There was also concern that the plant's operations would interfere with the migration of whales-an animal that has religious significance to the community-so Angola LNG agreed to stop operations entirely during the migration season. Villagers also wanted free gas (they got it) and if the company was going to build a new village to house construction workers, then why shouldn't the existing village get an upgrade too? Chevron's own engineers rolled up their sleeves, hired some local crews and got to work, making friends and building goodwill in the process, says Henisz.
All of these changes incurred additional costs-so much so that one partner, ExxonMobil, pulled out-but Henisz says Chevron's decisions were shrewdly commercial: "This was all based on a cost-benefit analysis, which included the often ignored benefits of political and social capital. They recognized that these concessions were going to increase the net present value of the project, and so far, they've been right: the project has made every building permit, every construction deadline and is on track to go online as scheduled. That's really quite unusual."
The effort has been worthwhile, says Angola LNG's Silva: "As an Angolan myself, I've seen nothing like this. It's the first time there has been such engagement and we see it as critical to our success. This relationship is going to be a long one, so we wanted it to be good from the start, we wanted to be a good neighbor."