21
OCT
2015

Why Political Risk Matters

This is the first in a series of articles that looks at human rights risk and how to integrate principles of risk analysis into global business development.

What is political risk and why does it matter to businesses? The following situation is playing out as we speak and exemplifies the problem facing transnational corporations operating overseas.

In 2013, the Rana Plaza building in Savar, Bangladesh collapsed, killing more than 1000 garment workers. The tragedy set in motion significant reputational, compliance and supply-chain impacts on many global apparel brands and retailers who employed local manufacturers at Rana Plaza and elsewhere in that country. Consumers and civil society groups in the U.S. and Western Europe reacted and drew unwanted scrutiny on the products sold by the likes of H&M, Walmart, The Gap and dozens of other businesses. However, while the event was shocking, it was not entirely unpredictable. Bangladesh has few labor protections and they are rarely enforced. Wage rates are extremely low and while that is appealing to the apparel industry, which seeks to keep their costs low, this pressure on local manufacturers ensured that working conditions and building standards were going to be ignored. For companies that failed to account for this eventuality, the financial and reputational costs were significant.

Simply stated political risk is the loss of revenues or assets that result from a range of non-financial risk factors. These risk factors could broadly include governmental, social or economic factors. Historically, political risk is thought to emanate from governmental actions (e.g. taxation, expropriation, corruption) or in this case, human rights risks. However, in recent years, that definition has become much more broad to include a range of societal problems in addition to macro economic effects on a business or industry. For example, community opposition to a mining project in the Andes or the possibility that Russia might invade Ukraine are other examples of political risk not directly related to the internal actions of a government. (The latter example reflects external political forces from a neighboring superpower that can impact businesses.)

For companies entering into a new market or expanding existing operations, political risk factors are sometimes overlooked but cannot be ignored and while some companies rely on internal expertise or undertake a cursory assessment of possible impacts on business, there is a danger that such superficial approaches will miss significant risks that ultimately become a reality. As a starting point, it is important to understand the components of political risk, namely the probability of a risk factor occurring and the impact that such an event will have on a business. The diagram below illustrates how these two aspects of political risk work and sets the stage for developing a fuller understanding of possible problems ahead.

PRA-PID

Obviously, attention should be paid to high probability, high impact risks that a company might face in its business operations in a country or region. Identification of those risks and developing appropriate mitigation strategies are key. However, risks that fall into the high impact, low probability range of risks are perhaps the most dangerous types of risk as it is often overlooked or ignored.

Ian Bremmer discusses these types of events in his book, The Fat Tail describing the term as “the unexpectedly thick “tails” – or bulges – that we find on the tail end of distribution curves that measure risks and their impact. They represent the risk that a particular event will occur that appears so catastrophically damaging, unlikely to happen, and difficult to predict, that many of us choose to simply ignore it. Until it happens.”

The Greek tale of the Trojan Horse describes just the sort of event that, while posing a catastrophic risk for the city of Troy, was unimaginable to its protectors. Who would ever think that soldiers would hide inside a wooden horse and subsequently open the gates of the protected city? Clearly the Trojan army had not given it a thought, to its peril. Modern versions of these sorts of high risk, low probability events occur with some frequency, most notably, the Arab Spring and the subsequent regional upheaval.

Some in business argue that these kinds of risks are simply a cost of doing business but little can be done to account for such events. However, a careful analysis of the political events that lead up to these financially disastrous events can be anticipated, and better informed business decisions can be made to account for these possibilities. This is the essence of political risk analysis. The Political Instability Task Force (formerly the State Failure Task Force) has for a number of years considered a range of factors that increase the probability that a state would fail due to revolution, civil war and other obvious events. In hindsight, the PITF indicators of state instability suggested that the unraveling of many of the Middle Eastern countries could have been foreseen, even though most political risk analysts failed to foresee the dramatic events that continue to unfold today.

In a sense, political risk analysis is a framework for considering non-financial risks to a business enterprise. Combined with a deep knowledge of a country or region and a methodical approach to the subject, political risk analysis can reduce unforeseen costs to a project or business activity.

As a starting point, framing the analysis is vital. Commonly, political risk is understood as country risk. Such an analysis looks at governmental (political), societal and economic factors that individually or in combination could create risks for an enterprise. Consider the following political risks in a particular country. Is the government authoritarian or democratic? Is there a high degree of grand corruption or is it pettier in nature (bribing the port customs officer)? Is there a high level of infant mortality? Is HIV/AIDS on the rise? How unequal is the income distribution in the country? At first glace, all of these questions suggest simple answers but in fact, the answers are far more complex and applying them to a particular business activity may not be straightforward. More importantly, each of these indicators suggests the possibility of political risks that could impact a business enterprise operating in that state.

Several studies have shown that authoritarian governments tend to be less likely to fail than fledgling democracies. Infant mortality is often an indicator of dissatisfaction in society that if left unaddressed, may lead to internal conflict manifesting itself in a variety of ways (See: State Failure Task Force Report: Phase III Findings at 14). Corruption, depending on the amount and at what levels it occurs, can have widely different consequences – hiring the president’s son to facilitate an oil deal is different from paying off traffic cops and can have profound impacts on an oil company seeking an exploratory gas lease in the country. Such an analysis, though important to understanding the political risks in a country is only the starting point. This macro level approach to understanding risk must also be complemented with an analysis of the specific risks to the business in question, its industry and the specific location where it is intending to operate in a country. This micro risk is more likely to be overlooked by companies undertaking an analysis of non-financial risks but is often posing serious if not perilous circumstances to the company, its employees and other stakeholders.

Next installment: How micro risks can impact business operations.

 

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