Can financial risk management ever have moral superiority over any other discipline after the financial fiascos of recent years? I think yes.
There is one area where risks lurk and the dark corners of uncertainty are often left alone. Infrastructure risk management is the poor cousin of financial risk management. Just because the pigeons have not come home to roost does not mean that everything is rosy. Infrastructure projects go over budget and miss deadlines. Infrastructure risk management if often an afterthought in architecture and engineering projects. So infrastructure project risk management tends not to learn from its mistakes, or from other disciplines. Financial risk management, while still licking its wounds, is no poster child for risk management but it does offer lessons and best practices that will shine a light on infrastructure risks and provide for better project management.
Financial risk management has many lessons to teach infrastructure risk management. I will highlight four in this article:
- Starting by listing frequently encountered risks;
- Documenting and quantifying experienced project pratfalls;
- Mapping project risk connections; and,
- Thinking the unthinkable.
These come from financial risk management’s best practices of:
- Basis instrument risk mapping;
- Using operational, credit, and market risk history and databases;
- Modeling correlations; and,
- Stress testing.
Frequently Encountered Risks
A list of around 40 frequently encountered project risks is a good starting point for any project risk management effort. Some will be sector specific, such as FERC approvals for inter-state energy projects, and some will be common but may vary in relevance by project. But from this starting point, project-specific risks can be documented. Are water quality permits required under environmental permits or air quality permits? Do you need at aviation permits for your construction cranes? Have you covered federal, state, and municipal requirements?
The financial risk analysis maps the risk of financial instruments back to measurable risks. Basis instruments that have a track record and for which volatility can be measured over different states of the world. In the infrastructure world this would be equivalent to looking at the average (as well as best and worst cases) months of delay caused by for a late notice to proceed.
The frequently encountered risks checklist is not meant to be exhaustive, it just meant to get the creative risk juices going and to make sure that no area is neglected.
Government agencies, financial advisors, consultants and project managers should develop and maintain a list of horror stories. How things went really wrong. A database of risks that have occurred and their consequences can quickly be built by automatic scanning of news services or trade journals such as ENR. Just search for “crane collapse” to get a sense of how often these things happen and what the cost and schedule implications may be. Reference class forecasting is an attempt to start infrastructure projects overcoming optimism bias by looking at other projects.
Using information from previous projects similar to the one being forecast. Reference class forecasting for a specific project involves three steps (Wikipedia – Reference Class Forecasting):
- Identify a reference class of past, similar projects.
- Establish a probability distribution for the selected reference class for the parameter that is being forecast.
- Compare the specific project with the reference class distribution, in order to establish the most likely outcome for the specific project.
In the financial sector operational risk databases, the rogue traders hall of fame, are maintained because while to err is human, people have a real knack for really messing up.
In addition to drawing on a well-maintained database of oopses, infrastructure projects need to, as suggested by reference class forecasting, take an outside view and, poll their project experts, consultants, and stakeholders for their experience. What has gone wrong? How did it go wrong? How likely is it to happen here? What will the consequences be? For whom? When might this happen? Tell a story about how it could occur and understand that professionals are wonderful storytellers and these stories can shine a light into the darkest corners of infrastructure project risk.
Risk are linked. That is why risk management is difficult. New links emerge and as a result risk management can never be entirely formulaic. Infrastructure projects often go off the rails, but it is rare that once off the rails things don’t really go wonky. It is bad enough that your ship hits an iceberg but when everyone goes to one side of the ship to see what is happening things get worse.
Infrastructure risks are, at a minimum, linked through the project schedule. A delay in a permit can hold up site access, that may delay right of way acquisition, that then preliminary engineering and design, and this then affects construction, and the in-service date. Mapping of risks to the schedule is necessary and modeling of the interactions that may occur is crucial to understanding project risks.
A broader consideration of probable and less possible links should also be done. Bond and stock prices move in opposite directions. Most of the time. Except, in financial crises, when everyone is depending on them to move in opposite directions. Then they move together. Exploring risk correlations and making these connections is what financial engineers do. Project engineers should do the same.
The Unthinkable (or the Unsinkable)
Stress testing has been around for a long time. As a “Scenario Engineer” in the 1990’s I published weekly stress tests – ways that financial portfolio managers at large financial institutions could test their holdings and risk management processes under extreme conditions.
A library of common stress tests, used for regulatory financial testing, was the practice that was required following the financial meltdown. Infrastructure risk management needs to develop these project stress tests project by project and then contribute them to a common database that other projects can use to take their project risk management for a test drive. Infrastructure project managers have an opportunity to shut the barn door while the horses are still there.
No Moral High Ground But Lessons to be Learned
Just because financial risk management messed up does not mean that infrastructure risk management has to follow in its footsteps. There are lessons to be learned and opportunities to shine a light into infrastructure risk management by: starting from frequently encountered risks, avoiding previous pratfalls, making risk connections, and thinking about the unthinkable. With these best practices in place, infrastructure risk management can start to become a integral and respected part of good project management.