UD2G
ALFRED
P.
WORKING PAPER
SLOAN SCHOOL OF MANAGEMENT
RISK AND LARGE-SCALE RESOURCE VENTURES
Horst Siebert
WP #1816-86
MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
50 MEMORIAL DRIVE
CAMBRIDGE, MASSACHUSETTS 02139
RISK AND LARGE-SCALE RESOURCE VENTURES
Horst Siebert
WP #1816-86
I
Risk and Large-Scale Resource Ventures
Horst Siebert*
Large-scale resource ventures are characterized by high set-up
costs,
a
gestation period of five, seven or ten years and
period of operation in which the benefits of
a
long
project come in.
large-scale ventures require an innovation
Very often,
a
in
tech-
nology such as the development of offshore-oil platforms and exploration,
drilling,
and transportation under arctic conditions.
environmental impacts may occur, and in some cases,
Moreover,
irreversibilities may exist
Finally,
in
the competing uses of nature.
private and social benefits may diverge.
Future bene-
fits must be weighed against the initial costs,
with benefits
occurring at
Benefits and
a
later date and being discounted.
some of the costs are uncertain.
gy,
to
initial,
disruptions,
Risk relates to the technolo-
operating and closing costs,
to price and revenue and
point of view to changes in taxation,
from
a
to environmental
private firm's
regulation or even ex-
propriation. All these different types of risk account for the
possible outcome that the huge initial financial outlays may be
lost,
In
i.e.
the different
types of risk make up financial risk.
this paper we look at the role of risk in large-scale pro-
jects.
At
the outset,
risk
is
defined and different types of
risk for large-scale projects are described.
We then discuss
the
impact of risk on the profit of
mine when we consider
a
a
single agent who is owner and sponsor at the same time. We then
analyze approaches to risk management and risk shifting when
second agent is introduced.
If we allow for more than
and for different types of risk,
as
a
two agents
risk allocation can be described
complex net of contractual arrangements.
Finally,
some limits
of risk shifting are pointed out.
The meaning of risk
Risk means that the implications of
mined ex ante.
Variables affecting
or factor prices or technological
the occurance of
a
decision cannot be deter-
a
a
decision such as product
relationships are random,
specific value of
a
variable depends on
of nature which cannot be controlled by an individual
variables of interest to the agent diverge from
a
i.e.
state
a
agent.
The
mean on both
sides with the mean being defined as the expected result or as
the mathematical variance of possible results.
Normally,
assumed that the agent can attribute probabilities to
of outcomes,
i.e.
dom variables.
he or she knows
a
a
it
is
variety
density function for the ran-
Probabilities assigned to the variables may be
based on objective observations, such as past experience or
a
multitude of observations, or they may reflect personal judgements.
The variance of
a
specific variable may be relevant to one agent,
but not to another.
Consequently, risk can only be defined with
respect to the objective function of an agent. The variance of
the price of
a
natural resource may mean
resource-extracting firm or for
a
different risk for
a
consumer;
or
it
a
implies diffe-
rent risks for producers with a diverging risk attitude. Moreover,
the relevance of a variance in a specific variable depends on the
set of constraints of an agent.
a
natural resource has
a
A
given variance in the price of
smaller risk for
a
country,
if the coun-
try not only exchanges the resource against consumption goods but
if
it
has accumulated financial assets.
Or assume that a resource
country uses part of the resource in production at home. Then the
probability of
a
fall
in
the resource price will hit
the country's
export earnings, but industrial activity at home may be stimulated
due to lower resource prices.
In
the capital asset pricing model,
the relevance of the constraint set for the definition of risk
pointed out by the fact that the relevance in the variance of
is
a
specific variable depends on the portfolio of an agent. More spethe risk of an investment
cifically,
of an economic decision)
or profit
is
or more generally
(an asset
measured not by the variance of income
from the specific investment but the variance of income
from the portfolio caused by that investment.
Risk is primarily
dependent on the covariance of the return to the specific investment with the return to the total investment of
instance,
a
a
portfolio.
For
fire insurance has an uncertain outcome the payment
varying between the value of the houses in the case of fire and
zero (Lind 1982,
p.
60).
this risky investment makes the over-
But
all portfolio more certain.
The variance of
variable may not be especially relevant for an
a
individual agent due to options of shifting the risk within the
given set of restraints. More important is that the risk of an
individual agent may be shifted to someone else for whom the variance in
a
with weight
variable does not present such
in
the tail
source represents
a
a
for
risk.
falling price of
a
risk for
a
a
a
A
variance
natural re-
resource-export ing count ry
.
similarly skewed probability distribution
is
an
but
,
insurance to
resource- import ing country. The shifting of risk therefore
important method of risk reduction.
relating to public goods,
riable in question is
in
Risk,
can only be shifted if the variance of a variable im-
plies different risk for different agents.
for risk
an
Institutional arrangements of
risk sharing are of utmost importance for risky projects.
however,
is
a
a
i.e.
This no longer hold
social risk.
If the va-
public good like air quality, variance
that variable "must be consumed in equal amounts by all"
(Sa-
muelson 1954) and risk cannot be shifted.
The analysis of the
impact of risk overlaps with the discounting
of future benefits and costs.
of risk
requires
thus making
to
a
a
As
a
rule of thumb,
the existence
risk premium in addition to the discount rate
project less profitable. But this rule only relates
risky benefits whereas risky future costs require
tion of the interest rate,
a
substrac-
and the rule only holds under very
specific assumptions (Lind 1982,
p.
67).
Moreover,
the discount
rate chosen determines the impact of risk of future periods.
From the above interpretation of risk,
the paper has
First, which are the variables of large-scale
lines of attack:
ventures that show specific variance? Second,
a
three
to what
extent can
single agent adjust to the variance in these variables? Third,
by which measures can the risk of large-scale ventures be reduced
if more than one agent
is
considered and what is the role of risk
sharing?
Types of risks
The decision problem of
a
private resource firm
in
the case of
a
large-scale venture boils down to the question whether the initial
financial outlay.
period profits
can be recuperated by the present value
A,
which are discounted with the discount rate
where
T
6t
n
TT
(t)
dt
The firm maximizes the present value of profits
Q
=
-
A
+
n
(1)
H
5
of
subject to
a
of constraints such as
set
the finite stock of re-
capacity constraints of production, operating cost
sources given,
functions etc. Typically,
the firm initially chooses
the level of
capacity and the extraction profit over time. Nearly all the factors
influencing the viability of
demand,
such as costs,
large-scale resource venture
a
the price of substitutes are associated
or
with different degrees of uncertainty. Thus,
different types of
risk can be distinguished.
The cause of the uncertainty problem of large-
Financial risk.
scale ventures
divisible,
is
large-scale ventures are technically in-
that
that very often they cannot be developed step by step
and that they require a huge initial outlay that
the risk of being lost.
dom variable.
If
faced with
is
The present value of profits
the firm provides
Q
is
exposure to
the financial
risk may threaten the existence of the firm if the project
is
a
risk of financial ruin.
ran-
the financial outlay itself,
for instance from retained earnings,
There
a
fails.
Moreover, heavy financial ex-
posure may impede access of the firm to financing
in
the future
thus limiting its options for growth (Walter 1986).
The financial outlays
involved in some large-scfle resource pro-
jects are shown in Table
1
and
2.
Table
1.
Setup Costs for Large-Scale Energy Ventures
(in billion U.S. dollars)
Project
Setup Costs
Locat ion
40-50
Alaska Gas
Pipeline
4800 miles
Alaska Midwest
German/Russian
Gas Pipeline
3600 miles
West SiberiaRep of Germany
15
Athabasca
(Tarsands)
Alberta
13
Planned but
shelved
Under const ruct ion
.
Canada
,
State of the
Project
Cancel led
during
p
Woods ide
(
Gas
Northwest Shelf,
lann ing phase
11.9
Produc ing
10
P
10
Cancelled
during
Aus t ral ia
Liquified
Natural Gas
N
Rundle
(Shale Oil)
Austral
i
ger i a- France
i
a
lanned
pi ann ing phase
Norway Gas Deal
Trans-Alaska
Pipel ine (Oil)
789 miles
North Sea
8.2
Prudhoe Bay-Valdez,
Alaska
Planned
8
Constructed
Ekof i sk
North Sea
6.7
Producing
Colony Shale Oi
Colo rado
6
Cancelled
Northwest Dome
Quatar
6
Planned will
be developed
at 1 ower level
5.5
Produc ing
of
5.5
PI anned
Trans-Canadian
Pipeline (Oil)
North SlopeChicago
5.3
Not available
Brent Field
North Sea
(United Kingdom
5.2
Producing
(Gas)
Upper Zakum
Field
Abu Dhabi
Oil
Coal
Refinement
Fed.
Rep.
Germany
;
8
Project
Setup costs
Locat ion
State of the
Project
3.5
Producing
2.5
Planned
North Sea (Statf j ord-Emden
2.3
Constructed
Gas Pipeline
1080 miles
Hasse R'Mel (Tunisia-Bologna (Italy)
2.26
Cons t rue t ed
Cathedral
Bluffs Project
(Shale Oil)
USA
2.2
Producing
Gas Pipeline
604 miles
North Sea (Statfjord-Scot land)
2.03
Planned
Brae Field
North Sea (United
Kingdom)
2
Producing
North Sea
2
Produc ing
North Alwyn (Oil)
Field Project
North Sea
1.83
Under con-
Coal Project
Venezuel
1.5
Planned
Tern Field
North Sea (United
Kingdom
1.47
Postponed
Beryl
North Sea (United
K ingdom)
1.29
Produc ing
Austral
1.13
Feasibility
Study
El Cerrejon
Coal Mines
Col umb
Brown Coal
Hambach, Fed.
of Germany
Gas Pipeline
Statfjord
C
i
a
Rep.
Oil Concrete
Platform
Field
Roxby Downs
Uran ium)
(
s
i
a
t
rue t ion
Data collected from newspaper reports and from Walter (1986) and
transferred into U.S. dollars according to prevailing exchange
rates
Data verified on the basis of Financial Times International Year
Book (1984), Oil and Gas 1985.
.
Table
2.
Setup Costs for Large-Scale Ventures in Mineral Industry
(in billion U.S. dollars)
Projects
Locat ion
Setup
Costs
State of the
Project
Carajas (iron ore;
other minerals; costs
estimate including mine,
township, railroad, port)
Brazi
New aluminium smelters
(including hydrology)
(Projected
in several
countries)
2.5-3
PI
Ti tan ium
Aus
2. 12
Planned
Guinea
1.5
Planned
Papua
New Guinea
1.32
Produci ng
Port land
Victoria,
Aus t ral ia
1.3
4.9
Under const ruct ion
t r
al
i
a
anned
(5000 tons/year)
Mi
ergui-Nimba bauxite
OK Jedi
(Go'ld
/
Copper)
Ium i n i um Plant
(500 000 tons/year)
A
,
(Gold)
First stage
constructed;
next two
stages
shelved
Iron ore mining facilities
Wikuna vanadium
Cerro Matoso Nickel
Gunning Bijeh Copper
Pi Ibara,
10
The financial risk is
influenced by other types of risk. Note that
the classification of the types of risk used here does not prevent
over lappings
.
Revenue or price risk. High capital outlays and
a
long gestation
period mandate that the product of the resource-venture
sold in the market over
long period of time.
Thus,
the existence
reduce costs per unit. The project may be faced with the risk
that the product cannot be sold or that
the price
is
uncertain.
Demand may fall off at some point in time either due to
in
being
implies large volumes of production in order
of high fixed costs
to
a
is
a
change
demand behavior or due to new sources of supply. Price may
also vary cyclically (mineral resources).
Cost risk.
a
A
foreseeable trend of cost increase, however, does not repre-
sent a risk.
in
risk arises when operating costs vary irregularly;
Examples are changes in capital costs,
in
wages,
freight rates and technological miscalculations leading to
increased operating costs. Unforeseen environmental impacts may
cause an increase in cost in
a
given setting of environmental
New regulation and additional environmental constraints
policy.
imposed at
point for
a
a
later period in the life of the mine are cases in
variance
closing costs of
a
in
costs.
Cost risk may also relate to the
mine or to the investment costs at the start
when institutional restraints increase time costs for obtaining
a
permi
t
11
Supply risk. Some large-scale ventures such as electricity
plants require
a
permanent stream of inputs and thus face the
risk of supply disruption.
Completion risk. The long gestation periods involved in largescale ventures give rise to the completion risk if unforeseen
technological problems arise,
if the
leading contractor does not
deliver on time or if the process of obtaining
more time than expected.
a
permit involves
If the time schedule can n-o t be hold up,
cost overruns will occur.
To these predominantly economic risks,
technological,
geological,
environmental and political risks must be added.
Technological risk. When large-scale ventures duplicate known
technical solutions,
ing
a
the
technological risk
is
negligible (open-
new copper mine similar to one already existing). When,
however,
an
innovation in size take place or when new technical
solutions have to be found (Antarctic, Sea Bed Mining, North
Sea drilling in retrospect),
Moreover,
the "hard"
the
technological solution may fail.
technology component involves complex inter-
dependencies and the possibility of failure.
Exploration and resource risk.
possibility of failure
mine is operating,
in
A
specific technical risk
exploration. Moreover,
is
the
even when the
the resource stock and its properties
(quali-
12
ty)
under an area of land or sea may not be well known (geologi-
cal
resource risk).
Environmental risk. Resource extraction tends to be pollutionintensive or may have
terms of air,
in
land and water pollution
negative environmental impacts. With large-scale ventures representing new technological approaches, not all environmental effects of resource-extraction nay be apparent at the outset. "Un-
expected side effect may evolve during the period of resourceextraction.
The externalities perceived by the
Permit or acceptance risk.
policy maker or by the public influence the institutional setting of resource-extraction.
in
the case of back-
stop technologies in the industrial nations,
some technologies
For instance,
like atomic power plants may have
may not be received,
high,
a
low risk acceptance.
the time costs of obtaining
and the stipulations of
a
a
permit
A
permit may be
permit may be changed over time.
When risk acceptance remains constant over time,
the large-scale
venture will meet the acceptance risk very early
in
process.
in
A
change in risk acceptance, however, will imply
a
change
regulations for resource-extraction and resource use that will
only become apparant at
ing
the planning
a
a
later stage of
a
project thus represent-
risk for the large-scale venture.
Taxation and Regulatory risk.
Taxes such as the corporation
in-
come tax and other business taxes influence the rate of return of
13
large-scale ventures. This
is
especially true for the taxation of
extraction such as extraction license fees, resource rent taxes,
and extraction taxes.
A
change in taxation redefines the condi-
tions for the viability of
a
a
project.
The same argument holds for
change in regulation.
Expropriation risk. Besides taxation, the property rights relating to the extraction of the resource,
represent
a
very
important determinant of large-scale investments. The property
rights for resource-extraction may vary from securely defined
leases auctioned off for the highest bidder via profit sharing
arrangements to nationalized industries relying on foreign technological and management expertise via subcontracts (Barrows
1981)
Government risk.
Finally,
the government may change either by
having
a
cases,
taxation and contracts may be altered.
new party in power or by some type of
a
coup.
In
both
The last three types of risk have also been summarized under the
heading of political risk and if they are specific to
as
a
country
country risk. This term suggests that countries can be classi-
fied according to the constancy of their institutional setting
or resource-extraction
including such factors as taxation,
pro-
fit sharing arrangements and stability of governments and political sys t ems
14
T h e^_ijn p a c_t _o f
In
r
i
s J<_ f o
r_ t h e
^ p o n so r- owner
order to analyze the role of risk for
venture we first develop
a
in one person.
retained earnings.
large-scale resource
the operator and the supplier
Capital for instance is provided from
Assume that this agent faces
risk for his resource,
a
given price
the risk being distributed identically
and independently over time.
of financial
a
frame of reference in which we assume
only one agent being the sponsor,
of capital
as JL _? J-P gle ag ent
The price risk gives rise to the risk
loss.
How will the single profit-maximizing agent react to risk? He
will adjust the profit-maximizing control parameters of his
maximization problem from equation
1
in
such
a
way that the
variance in the resource price becomes less relevant. What are
some of the options available for risk reduction of the single
agent?
Diversification into the future.
If the price risk
buted identically and independently over time,
reduce the impact of
a
is
distri-
the firm can
given variance in price on the present
value of profits by shifting revenue into the future,
i.e.
by
postponing extraction. Future revenues are less risky because
they are discounted and the present value of the risky revenue
is
reduced.
Diversification into the future becomes more in-
teresting with
a
higher discount rate. Of course,
this approach
15
is
more promising if the price risk
however,
reduced over time.
the price risk rises over time,
Thus,
risk.
diversification into the future
a
the risk does not
in
political
only applicable
is
increase over time. Moreover, uncertainty
of a variable may arise in different periods
mine.
Note also
reduction in the present value of the price risk due to
a
discounting may be overcompensated by an increase
if
If,
the increase in the
offset the impact of discounting.
price risk may
that
is
in
the life of the
One may be able to reduce some type of uncertainty at an
early stage (geological resource availability) whereas other
types of uncertainty such as environmental risk may only appear
over time.
Reduction of size of investment.
vestment
not
is
If the
initial size of the in-
determined by technical considerations, an in-
crease in the variance of price would mandate
to be used
for a longer period of time.
a
lower capacity
The longer duration of
the use of the capacity represents a diversification into the
the lower
future;
initial investment reduces the risk of finanif the price risk
cial loss.
Again,
over time,
the firm can adjust by
not by
a
a
longer use of the capacity.
(or political
risk)
lower initial
investment but
A
increases
special case arises if the
project can be partitioned into several stages. Then investment
can be partly stretched into the future reducing the risk of fin-
ancial loss
.
.
16
Portfolio of projects.
A
firm may diversify its risk by under-
taking projects with different risk characteristics. Thus,
a
high technological risk in one project may be offset by
a
technological risk in another project. Or exposure to
poli-
tical risk or country risk in
pensated by
a
project in
a
developing country may be com-
a
country with
Information and learning. Risk
a
low
lower country risk.
a
due to non-existing or un-
is
certain knowledge. The gathering of information is therefore
an
important method to reduce risk.
geolo'gical or explo-
Thus,
ration risk can be lowered by geological studies before explo-
Technological risk may be reduced by similar
ration starts.
operations on
project
in
a
smaller scale or by simulating the large-scale
computer models.
In
the case of environmental
risk,
good policy to reduce unexpected externalities and
it
seems
to
sincerely check them out at the outset of the planning pro-
cess.
in
It
a
may also be helpful to let local groups participate
the planning process
political risk
of
(open planning)
change in regulation.
a
mulating experience by operating
a
other way to increase information.
i.e.
as
a
in
order to reduce the
Learning,
i.e.
large-scale facility,
For
a
accuis
an-
given level of risk,
given variance in some of the relevant variables such
price,
the sponsor-owner maximizes profit by adjusting his
control parameters to the given risk.
creases paramet r i cal
1
y
.
be affected by the level
Assume now that risk in-
Then the present value of profits will
of risk.
Let a represent
a
measure of
risk such as the variance in the price of the resource or in
17
environmental damage.
Let a
the variance in the price as
increase for instance by increasing
a
random variable for each period.
Then expected period profits become less certain,
ed present value of profits will be reduced.
Thus,
and the expectit
realistic to assume
(a)
Q
Equation
Figure
1
2
is
with
Qa
<
0,
illustrated in Figure
<
1
(2)
is
rather
18
With risk increasing,
reduced.
At
a
level d
and for a
zero,
,
is
the expected present value of profit is
the project
a,
>
the expected present value of profits
is
not viable.
In
Figure
has been assumed that the firm faces
a
variance of the resource price,
the set of risk policy
that
it
1,
given variance such as
a
in-
struments is given and that the firm maximizes the present value
of profits.
The firm then can reduce risk to
a
level a*.
Profit
maximation implies that all avenues of risk reduction open to the
firm are used.
Note that the relation between the present value of
profits and risk
as
is
also influenced by
the stock of resources given,
a
number of parameters such
the capacity constraint and ope-
rating costs per period so that the curve shifts with these parameters
.
Equation
ment
r
2
being defined for
means that
to reduce risk
a
a
given set of risk policy instru-
change in the policy set will enable the firm
and thereby increase profit.
The change in the
policy set may be brought forward by the individual firm as an
innovation,
or
it
tutional setting.
of future markets,
may be produced by variations in the instiFor
instance,
the existence or non-existence
rules for long-run contracts or imperfections
of the capital market
relevant for the firm.
influence the set of policy instruments
19
Risk
_s
h
i
f
t_i
n^
_^i'__?.__^_^ ^_9_Q.?'
^S ?^^
The single agent has not too many options to accomodate risk.
order to analyze how risk shifting works we now introduce
for instance
agent,
of a random variable relevant
Let
x
be
for
a
reduction in the variance
the maximization problem of the
random variable such as
a
second
supplier of capital.
a
Risk reduction can be interpreted as
firm.
a
In
price or cost per period and let f(x)
a
period profit,
revenue,
represent the probabilities
of distribution for a given period prior to the action of the
firm.
Risk reduction takes places if by some action of the firm
the variance in the random variable is reduced so that
longer relevant for the maximization problem, but now
the relevant random variable with
a
x
x^
distribution function
is
denotes
g
We have
g
(xf
This transformation of
figure
in
2
where
a
quadrant III.
=
)
a
(^
[
f(x),
r
no
]
relevant variable is illustrated in
simple linear relationship has been assumed
(x^).
,
20
»(«)
Figure
Thus,
2
risk reduction can be formalized as
a
=
a(r)
,
a
<
0,
a
r
It
is
>
(3)
r r
realistic to assume that applying the policy instrument
implies progressively rising costs with
V
=
v(r)
,
V
<
r
0,
V
>
(4)
r r
Define profits as
G
=
Q
[
a(r)
]
-
v(r)
(5)
T
21
we have
dG/dr
=
Qa
-
a
v
r
(5a)
r
and
d2G/dr2
=
Qoaa2
+
Qaa
r
according to the assumptions.
i.e.
as
in
if Qa ar
figure
>
3.
1
\
vr
for some
r r
T,
V
<
(5b)
r r
If G can be
increased by using
f,
risk reduction can be illustrated
22
It
worth while for the firm to use
is
increase profits. Since
f
reduces risk,
T
levels of profit with risk.
up
to
in
P*
figure
order to
associates
3
The Qr-curve can be interpreted
as
the willingness to pay curve for the shifting of risk,
as
a
In
reality,
demand curve for risk shifting.
fic firms.
to
i.e.
the policy instrument
An
important case
T
can take
a
variety of speci-
point for large-scale ventures is
in
limit the financial exposure of the sponsor and to shift part
of the financial
risk to the supplier of capital.
A
firm may re-
duce its exposure to financial loss and at the same time reduce
its price risk by having a capital
the most simple case,
supplier join the venture.
the financier may provide
a
percentage
In
p
of
initial financial outlays and may receive an equal percentage of
period profits. Under this assumption, equation
5
can be simpli-
fied into
G
figure
3
let
defined for
<
In
(P)
=
(1
-
[a
Q
p)
the policy instrument
p
<
1.
capital.
curves as shown in figure
p*
<
be the percentage
3
can be interpreted
firm to bring in foreign
The firm can reduce its risk and increase the present
value of profits by increasing,
<
f
Then Qr in figure
the marginal willingness of the
as
(p)]
1.
3,
p
from
a
zero-level,
and with
there will be an optimal
p*
with
23
In
figure
though the probabilities ,for future profits of the
2,
project are not affected,
a
the profit expected by the firm shows
different probability distribution around
a
given period. For the firm,
the variance of
reduced,
and it can increase initial
investment,
profit sharing in
profits
is
lower mean due to
a
and shorten the life-time of the mine.^^
capacity,
contribution of equity financing consists
financial loss to the individual agent;
scale venture is reduced,
at
least
in
i.e.
The important
reducing the risk of
the lumpiness of
a
large-
from the financing aspects.
The basic point of risk shifting is that by shifting the risk to
someone else,
the producing firm can increase its profit by re-
ducing its risk. With the risk policy variable
to
the
level of risk a in equation
may also be drawn as
a
function of
3,
a
T
being related
the Qa-curve in figure
as
figure
in
3
The Qa-curve
4.
represents the willingness to pay for the reduction of risk indicating the increase in profits per unit of risk reduction. When
the firm can shift
risk level a*.
only with
a
(curve SS).
It
the risk free of charge,
is
demand side faces
willing to pay
a
give up
a
a
a
price risk and if the
supply risk (risk of disruption),
risk premium BB'
risk going through B'.
terested in
increasing with the level of risk
instance a relates to
a
will choose the
quite realistic that risk will be taken over
risk premium AA'
If for
it
If
lump sum amount AA'
may be
its curve of willingness to bear
the demand side
long-run contract,
it
is
not specifically in-
the resource firm may have to
per unit of risk
the demand side into a long-run contract.
In
in
order to induce
figure
4,
both par-
24
ties derive benefits
from risk allocation analogous to producer's
and consumer's rent.
Figure
Ris^k
In
4
allocation in
a
complex net of contractual arrangements
reality, many agents are involved in large-scale ventures:
the project operator making the investment and operational de-
cisions,
sponsors providing some of the capital,
access to market,
know-how and
contractors responsible for construction,
suppliers of inputs, banks and other financial institutions,
the government defining the right to extract
the resource,
25
granting permits of operation and specifying taxes, as well
as
international organizations and the customer.
The different types of risk are allocated to the different
agents in
a
complex net of contractual arrangements.
The main
question for the role of risk in large-scale ventures
is:
How
are the different types of risk allocated to the different agents
involved? Which institutional arrangement allows the shifting of
risk? Can these institutional arrangements reduce the risk of the
main sponsor,
i.e.
increase his profits and make
a
large-scale
project viable or more profitable.
In
the following we review some of the most
important instru-
ments of risk shifting:
Limits on financial exposure.
putting
a
Financial risk can be reduced by
limit on financial exposure.
This can be achieved by
shifting the risk to equity capital as already discussed and by
establishing
a
vehicle company separating the risk of the large-
scale venture from the sponsor's balance sheet (Walter 1986).
The
financial risk can be further reduced by bringing in additional
sponsors thus spreading the risk on many shoulders.
Shifting financial risk to banks. The project operator can reduce
his
financial risk through project finance. Banks provide part of
the capital
taking over some of the financial risk.
ture periods the price will
be paid,
fall
the banks may loose part
and principal
of their
If
in
some fu-
and interest cannot
investment. Cofinancing
.
26
from international organizations
another way to reduce finan-
is
cial risk
Supplier and customer credit. The supplier of an input may provide
a
credit
order to stimulate his sales,
in
case of machinery or when
a
either in the
large-scale venture uses
a
perma-
nent stream of the input (coal in electricity generation).
customer may be willing to provide
future deliveries.
be linked to
In
this case,
The
credit to be paid off by
a
customer credit
likely to
is
long-run sales constract.
a
Shifting set-up cost to the resource country. Price risk and
the financial risk can be shifted by reducing initial outlays
for the' right
extract and then receiving only
to
the price which is random.
In
shifted by moving away from
lump
sura
a
theory,
a
concession with
service contract.
option of risk shifting, however,
In
a
a
large initial
toll per barrel con-
the real world,
likely as
a
contract risk).
this
increases the political risk
of a change in taxation schemes or in the contract
cense bargaining,
portion of
the price risk could be
payment to production sharing,
tract or even
a
It
risk management policy.
is
(obsoles-
therefore rather un-
Moreover,
the historical
change from concession of the 1960's to the more recent forms
of contracts such as the
a
t
o
1 1
-per-bar re 1 arrangement reflects
change in the property rights and in the bargaining position
vis-a-vis risk assignment.
27
Completion guarantees. Completion risk can be reduced by completion guarantees from the leading contractor and by stand-byletters of credit from banks
(Walter 1986).
Avoiding contract risk. Contractual arrangements between resource
countries and international resource firms face the risk of "obsolescence bargaining"
are in
a
(Vernon 1971) due to the fact that the firms
strong bargaining position prior to exploration and in-
vestment whereas their bargaining position is severely weakened
after investment has taken place. Moreover,
in,
there is
a
growing pressure in the resource country to change
the taxation or royalty scheme and thus
This danger of
with revenues coming
to
revise the contract.
change in the contract may be reduced by extrac-
a
tion arrangements such as toll per bar r e
1
'
con t rac t s and the re-
source-rent tax in which the resource country takes over some of
the price risk.
Long-run sales contract.
run sales contracts.
In
Price risk can be reduced by using longthat case,
the variance of the price may
be completely eliminated for some quantity or at
least be reduced,
depending on the specifics of the sales contract. The variance
for the price over the total
reduced.
Future markets,
two years,
play
a
quantity in
though limited
a
given period will be
in
time depth of one or
similar role as long-run contracts. Whereas the
choice of the time profile of extraction and of the initial level
of investment are at
the discretion of the firm,
one can see that
28
the decision on
long-run contracts depends on the willingness
of the partner on the demand side to enter
a
long-run contract
Downstream integration. Under specific conditions,
firm may
a
be able to reduce price risk by vertical integration.
Such an
approach could be followed if downstream products are less volatile in price or more specifically,
would open up
in
a
if downstream activities
secure line of production (chemical products
the case of an oil
producing firm) whose price has
tive correlation with the oil price.
however,
Note,
a
that
negathis
policy requires additional financial outlays, and though the
price risk may be reduced,
Of course,
the risk of financial
loss may rise,
vertical integration may be spread over time thus
allowing the reduction
in
the risk of financial
loss.
Integrated risk management. Although the different types of
separate risks mentioned above partly overlap,
they may arise
simultaneously thus increasing the variance
the present
value of profit. The increase
tal and technological
in
in
the price risk,
in
environmen-
risk eventually augment the variance of
expected profits. Therefore, different policies of risk management may be called for simultaneously.
Institutional arrange-
ments are required that reduce several risks such as the risk
of financial
risk at
loss,
the risk of technological
the same time.
A
case in point
is
failure and price
the Russian German gas
deal where German banks provided the financing,
a
German and other
international steel producers delivered the pipes and other tech-
29
nological equipment and where
a
long-run sales contract reduced
Russia's price risk.
Risk allocation can be interpreted as
arrangements or
a
system of contractual
a
set of risk markets for the different
of risk and among different participants.
tracts are interlinked in the sense of
a
types
The different con-
general equilibrium
model. Successfully shifting completion risk to the leading
contractor implies
an
a
reduction
impact on financing.
stomer or to
a
in
financial risk and may have
Allocating the price risk to the cu-
government also reduces financial risk and re-
quires lower risk premiums to be paid to banks.
the most
important agents,
the different
approaches to risk reduction.
Figure
5
shows
types of risk and some
OTHER
SPONSORS
SPONSOBI
FINANC AL
I
CONTRACTOR
COMLETION GUARANTEE
STANO-BY-LETTER OF CREDIT
GOVERNMENT GUARANTEE
Figure
5
31
Figure
suggests that relatively high transaction costs are
5
involved in organizing the contractual arrangements between
the multitude of agents
involved. With markets for allocating
the risks not clearly established some international banks pro-
vide project financing as
risk management
a
financial package or an integrated
(Walter 1986).
2)
The limits of risk shifting
Figure
indicates how
4
agents,
and figure
5
a
specific risk
illustrates
ments and risk allocation among
a
is
allocated between two
net of contractual arrange-
multitude of agents. There are,
a
limits to risk shifting and to institutional innovations
however,
Risk shifting is not
that allow to shift risk more efficiently.
possible if the willingness to pay for the shifting of risk and
the willingness to take over risk against
a
Risk shifting can only occur if the parties
benefit from it.
There must be
a
premium do not match.
involved all derive
rent for the demand side in the
sense that not the total willingness to pay for shifting
is
required as payment in
must be
a
rent
premium paid
risk.
is
a
a
risk
contractual arrangement. And there
for the supply side
in
the sense that
the risk
higher than the internal costs of accepting the
a
32
Consider figure
4.
Risk shifting
curves do not intersect.
In
is
Figure
not possible
4,
the two
if
the variance in
vari-
a
able is assumed given and the question is studied how the given risk can be shifted.
ramet r ically
Increase now the risk of
for instance its price variance.
,
curve in figure
1
willingness to pay
shifts downward implying
is
a
definitely reduced for
rametrically increased risk does not imply
fit with a unit of risk shifted,
figure
likely.
will shift to the left,
4
A
a
project pa-
a
Then,
the profit
lower a*,
o
>
a*
.
i.e., the
the pa-
If
larger gain in pro-
the willingness
to pay curve
in
and risk shifting becomes less
similar result holds if the producing firm has
higher
a
risk aversion.
If the willingness
to accept
the SS-curve in figure
4
risk against
premium
a
will shift upward making
clearing risk allocation less likely. Such
a
the supplier of risk bearing is facing less
which allow him to take over only
a
a
is
reduced,
•
market
situation arises if
favorable restraints
lower level of risk or if he
becomes more risk averse.
Private risk and social risk may diverge.
In
such
a
case,
a
re-
source project may not take into account all risks that accrue
to
society. Consider for instance the case of environmental risk
which due to existing and anticipated regulation
in
the profit calculus of
firm
it
a
firm.
a
whole is not optimal.
not
included
From the point of view of the
shifts the risk to the public,
society as
is
So
and risk allocation
in
for
risk allocation and risk
33
risks related to an externality should be internalized.
shifting,
Social risk cannot be shifted, but it can be reduced by the agent
to whom
attributed.
is
it
Take the risk of environmental dis-
Environmental quality being
ruption.
public good,
a
definition no way to reduce the risk by shifting
person. Only if the assumption of
a
it
there is by
to
another
public good is given up and
a
regional dimension of public goods
introduced,
is
can risk of
different regional public goods be pooled. Note, however,
when properly internalized,
social risk,
ternal measures of
a
firm,
i.e.
that
can be reduced by in-
by pollution abatement.
Conclusions
The viability of
ence of
a
a
large-scale venture
pected profit
a
reduced by the exist-
variety of risks such as price risk,
and environmental risk.
that
is
a
All
technological risk,
these different types of risk make ex-
random variable and give rise to the possibility
the huge initial
financial outlay necessary for setting up
large-scale venture may be lost.
Some of these risks may be re-
duced by internal adjustments such as the time profile of extraction or
the
be shifted.
level of initial
A
investment,
and some of the risks may
demand curve for the shifting of risk is derived.
The resulting risk allocation depends on such factors as the risk
attitudes,
the amount of variance initially given and the options
available to the firm and the supplier of risk bearing to reduce
and transform the risk internally.
In
reality, many agents are
34
involved and risk allocation must be understood as
of contractual arrangements.
scale venture may diverge,
Social risks,
complex net
Private and social risks of
a
large-
and social risk should be internalized
so that social risks are reduced by internal
firm.
a
however,
adjustments of the
cannot be shifted.
35
Footnotes
•
Paper to be presented at the "Global Infrastructure Fund"
workshop on "Global Infrastructure Projects", Anchorage.
I
am grateful
for critical comments by J.
Keck and J.E.
Parsons
^'
In
the familiar (i-a-diagram,
the
for
individual agent,
portfolio
financing)
X
a
thus shifting the position of
(efficient prior to the innovation of project
to
the
tion space between
left
n
Lessard and Paddock,
2>
project financing reduces
(X')
and allowing
a
new transforma-
a
as
shown in the diagram (Agraon,
1979,
p.
305).
and
Note that project financing and the lurapiness of largescale ventures represent an argument for compensatory trade
as
a
specific aspect of
a
financial package which the market
may not be able to provide.
.
36
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Date
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