Integrating Social and Political Risk Into Management ...

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Integrating Socialand Political RiskInto ManagementDecision-Making

By

Tamara Bekefi andMarc J. Epstein

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MANAGEMENT ACCOUNTING GUIDELINE

NOTICE TO READERS

The material contained in the Management Accounting Guideline Integrating Social and Political Risk Into Management Decision-Making is designed to provide illustrative information with respect to the subject matter covered. It does not establish standardsor preferred practices. This material has not been considered or acted upon by any senior technical committees or the board ofdirectors of either the AICPA or the Society of Management Accountants of Canada and does not represent an official opinion orposition of either the AICPA or the Society of Management Accountants of Canada.

S T R A T E G Y


Integrating Socialand Political RiskInto ManagementDecision-Making

By

Tamara BekefiHarvard UniversityandMarc J. EpsteinRice University

MANAGEMENT ACCOUNTING GUIDELINE

Published by The Society of Management Accountants of Canadaand The American Institute of Certified Public Accountants

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Copyright © 2006 by the Society of Management Accountants of Canada (CMA-Canada).All rights reserved.Reproduced by AICPA by arrangement with CMA-Canada.

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ISBN 0-87051-656-6

INTRODUCTION

The corporate risk landscape has shiftedsignificantly in recent years. Larger andmore varied risks than ever previouslythought have been seen in companiesand countries who had believed theywere immune from those risks. Rapidlyincreasing globalization poses a commonchallenge—how to integrate the socialand political risks of governmentinstability, political corruption, businesscorruption, child labor practices, anti-corporate sentiment, terrorism,environmental pollution, and others, intomanagement decisions. To date, no

adequate methodology for integratingthese issues into risk management hasbeen found.

Developing and implementing anappropriate model for decision-makingand measurement of social and political risks is critical for improvingorganizational performance by moreeffectively (a) anticipating, evaluating,preparing for, and mitigating risks,and (b) managing alternatives.Toeffectively manage risk and improve the resource allocation process, risksmust be measured and integrated into ROI calculations.

INTEGRATING SOCIAL AND POLITICALRISK INTO MANAGEMENT

DECISION-MAKING

CONTENTS EXECUTIVE SUMMARY

Today risks are both larger and morevaried than ever previously thought.Theyare far broader and have been seen incompanies and countries that thoughtthey were shielded.With globalizationincreasing rapidly, a common challenge ishow to integrate social and political risksof political instability, political corruption,business corruption, child labor practices,anti-corporate sentiment, terrorism,environmental pollution, and so forthinto management decisions.

This publication building on the modeldeveloped in the Management AccountingGuideline “Identifying,Measuring, andManaging Organizational Risk forImproved Performance” provides thetools, techniques, and specificity neededto aid managers to more effectivelyintegrate social and political risks intotheir decision making processes.

INTRODUCTION 5BACKGROUND 6CURRENT PRACTICES IN

IDENTIFYING AND MEASURING SOCIAL AND POLITICAL RISK 8

INTEGRATING SOCIAL AND POLITICAL RISKS INTO GENERAL RISK MANAGEMENT 10• RISK IDENTIFICATION 12• ASSESSING AND MEASURING

SOCIAL AND POLITICAL RISK 24• MANAGE AND MONITOR

POLITICAL AND SOCIAL RISK 32• COMMUNICATING SOCIAL

AND POLITICAL RISK 39CONCLUSION 41APPENDIX 1:REAL AND PERCEIVED RISK 44APPENDIX 2: POLITICAL RISK

CONSULTING FIRMS AND THEIR OFFERINGS 46

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These calculations can be applied to day-to-dayoperational decisions and capital investmentplanning, such as choices about plant location.Robust decisions under both circumstances arepredicated on sound identification of risks, theirassessment, and their mitigation and avoidance.We know, for example, that a wide array ofpolitical and social issues in both the developedand developing world can often cause a majorimpact on profits in an organization’s homecountry.These risks affect all types oforganizations, including for-profit, non-profit,global, domestic, and large and small enterprises.

Generally, risk can be described as any event oraction that will adversely affect an organization’sability to achieve its business objectives andsuccessfully execute its strategies. Risk relates tothe probability that exposure to a hazard willhave negative consequences. Social risk relatesto the potential impact of, for example, disease,damage to the environment, infringement of therights of indigenous peoples, and challenges bystakeholders due to negative perceptions ofbusiness practices—all of which can jeopardizea company’s value. Political risk can generally beunderstood as execution of political power thatthreatens a company’s value.The distinctionbetween social and political risk is, however,often blurred, and different sectors in variedlocations can be affected differently by eitherkind of risk.

Societal perceptions of the connectionsbetween a company and particular social andpolitical risks can cause enormous costs tocompanies, regardless of the company’s directinvolvement in the issue. Whether society isreacting to a real or perceived risk, it may takeaction, including consumer boycotts, leading toloss of sales or increased regulation thatnegatively affect a company,whether by (a)increasing its costs, or (b) prejudicing itsachievement of business objectives or its abilityto carry out its strategies. [Note that I havebrought in language similar to that used in definingrisk earlier.].Thus,managing these types of risksis critical,whether they are real or perceived.(For further discussion of real and perceivedrisks, see Appendix 1.)

Public perception of companies has proven tobe an important component of risk. Researchfollowing anti-World Trade Organizationprotests in Seattle showed that investors drovedown the market capitalization of companieswithout a reputation for corporateresponsibility on average by $378 million per

company, but did not penalize firms reputed tobe socially responsible. (Schneitz and Epstein,2004). This demonstrates the significant positivefinancial impact of a reputation for managingsocial and political risks well.

[The now deleted sentence doesn’t identify who is concerned. I altered the second sentence.]Companies must more clearly recognize theimportance of (a) integrating a broader set ofrisks into management decisions, and (b)developing expertise in measuring the impact ofsocial and political issues on financialperformance.This clearer recognition requiresmanagers to include measurement of social andpolitical risks in ROI calculations. Currently,companies that do consider these issues oftenrelegate them to a footnote in the reporting ofinvestment decision and do not include them incalculating ROI.That effectively gives a zerovaluation to risks that can negatively affectcorporate earnings, shareholder value, andbrand value.

Some businesses are prone to social andpolitical risk because of the location of theirfacilities, their product and customercharacteristics, the nature of their employmentrelationships, or industry characteristics, etc.Well-known examples include Nike,Wal-Mart,and Shell, as well as the notorious social risksassociated with industries like mining, footwear,apparel, toys, and chemicals. Also, varying socialand political risks, and degrees of risk, affectcompanies located in specific countries orregions of the world. More globally, devastatingterrorism attacks such as September 11, 2001have dramatically increased risk, resulting notonly in a terrible impact on individuals andgovernment, but also an overwhelming impacton businesses.Corporations hoping to properlymanage risk require more analysis, evaluation,preparation,mitigation, and response planning.

This Guideline, aimed at CEOs,CFOs, and othertop managers, provides a model for identifyingand measuring social and political risk, andincluding these risks in ROI calculations, tocreate a more robust enterprise riskmanagement (ERM) system. This modelingforms one small part of ERM, simply by includingpreviously ignored risks.

BACKGROUND

In a recent Management Accounting Guideline(“Identifying,Measuring, and ManagingOrganizational Risk for Improved

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Performance”),Marc J. Epstein and Adriana Rejcdeveloped a model and measures for improvingthe identification and measurement of risks toimprove management decisions. It built on newlycreated requirements for the assessment of riskof the Sarbanes-Oxley Act of 2002 in the U.S., andsimilar new regulations in other countries. It alsobuilt on work by the Committee of SponsoringOrganizations (COSO) of the TreadwayCommission and the recently issued EnterpriseRisk Management Framework, by furtherspecifying the necessary tools for identifying andmeasuring a broad set of organizational risks.More importantly, though, it focused on improvingthe quality and effectiveness of both operationaland capital investment decisions, through moreeffective management of organizational risk.

Epstein and Rejc demonstrated that increasedmeasurement of a broader set of risks isnecessary, both to meet recent regulatoryrequirements and to improve managerialperformance and stakeholder confidence. Theyprovided a risk assessment model, illustrated inExhibit 1,which builds on the 2004 COSOEnterprise Risk Management—Integrated Framework,and provides a scheme that classifies risk into fourbroad categories—strategic, operational,reporting, and compliance.

• Strategic risks relate to an organization’s choiceof strategies to achieve its objectives.

• Operational risks relate to (a) threats fromineffective or inefficient business processes foracquiring, financing, transforming, and marketinggoods and services, and (b) threats of loss offirm assets, including its reputation.

• Reporting risks relate to the reliability, accuracy,and timeliness of information systems, and toreliability or completeness of information foreither internal or external decision-making.

• Compliance risks address the inadequatecommunication of (a) laws and regulations,(b) internal behavior codes and contractrequirements, and (c) information about failureof management, employees, or trading partners tocomply with applicable laws, regulations, contracts,and expected behaviors (Epstein and Rejc, 2005).

Their risk assessment model serves as a basis forthe following discussion of social and political risk,which falls predominantly in the strategic andoperational segments of the Epstein and Rejcclassification. This Guideline builds on theprevious guideline by Epstein and Rejc, providingneeded tools and techniques so that managerscan more effectively integrate social and politicalrisks into their decision-making. It will illustrate

Exhibit 1: Risk Classification Scheme

OOppeerraattiioonnaall RRiisskkss SSttrraatteeggiicc RRiisskkss RReeppoorrttiinngg RRiisskkss

Economic risks Industry risks

Strategic transaction risks

Social risks Technological

risks Political risks Organizational

risks

Environmental risks

Financial risks

Business

continuity risks

Innovation risks

Commercial risks

Project risks

Human resource

risks

Health and safety

risks

Property risks

Reputation risks

Information risks Reporting risks

CCoommpplliiaannccee RRiisskkss

Legal and regulatory risks

Control risks

Professional risks

RRiisskkss

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why it is important for companies to understandsocial and political risk, and how to measure itfor more effective risk management.

Although identifying and classifying risks arecritical first steps, it is essential to managementpractices that their impacts on the firm bemeasured.The previous guideline emphasizesthe importance of assessing risks, both interms of their cost if they materialize, and thebenefits flowing from appropriate riskresponse.Of particular relevance tounderstanding,measuring, and managing socialand political risk is the capability to quantifytheir potential impacts.

We build on the previous guideline by describinghow companies can more effectively integratesocial and political risks into operational andcapital investment decisions, including how toidentify and measure them.The enhanced model also provides specific guidance thatpermits ROI calculations to include a formal and explicit assessment of these risks.Thisassessment will improve resource allocationdecisions and risk management, both of whichare the responsibility of senior corporatemanagers and boards of directors.

CURRENT PRACTICES IN IDENTIFYING AND MEASURINGSOCIAL AND POLITICAL RISK

Companies face complex political and socialchallenges.They are wide-ranging and havedifferent impacts on organizations, depending onsector, geographic location, and type ofoperation. Further, consideration of risk issubstantively different if a company is consideringopening a new venture or tackling challenges toexisting operations. Previously, corporate riskwas more narrowly focused on internal financialcontrols and corporate frauds.Now, identifying,measuring and seeking preventive or mitigationstrategies to address social and political issueshave become crucial to firms functioning invarious countries.All companies are struggling tomake business decisions that integrate financialinformation with insight into social and politicalconcerns that can seriously affect their projectsand bottom lines. Integration of social andpolitical risks into the financial equation has,however, remained a challenge.

Qualitative Approaches

Techniques to evaluate and communicatepolitical risk have been emerging since the mid-

1970s,when multinational firms, particularly inthe extractives and banking industries, built in-house teams employing political scientists andformer CIA and U.S. State Departmentpersonnel.These teams looked at riskassessment qualitatively, producing detailed localbriefings that outlined challenges in variouslocations.While providing sound insight intopolitical instability and risks, these local briefingsdid not capture the cost of risk, because theyfailed to connect the issues to the business orexplain their potential negative impact. For thisreason, the briefings did not enable executivedecision-makers to integrate these insights intobusiness assessments. In fact, importantinformation contained within those briefings wassometimes relegated to a footnote in thedecision-making process.

Quantitative Approach

From the qualitative model emerged efforts toquantify political risk, to make it more relevantto corporate management.To accomplish this,various methods were developed.

• Scorecards: Indicators of potential politicaland social risks, such as judiciaryindependence, corruption, and governmentturnover,were evaluated and assigned anumerical score. For example, a governmentviewed as highly corrupt could be assigned a10 in a possible scale of 1-10.Then, dependingon the methodology, the scores from theseindicators were aggregated or the statisticswere analyzed to generate a final measurethat reflected the political risk of a country.An indicator listing that looks specifically atcorruption,Transparency International, ranksthe world’s countries on the basis ofperceived levels of corruption. Anotherpolitical risk consulting firm divides itsindicators into four subcategories—government, society, security, and theeconomy—first calculating ratings for eachsubject, then aggregating them to create anational stability rating that can range from‘failed states’ to ‘maximum stability’. Suchscoring is helpful, because it enables acomparison between countries. It falls short,however, of being directly useful to businessdecision-making, because the risks are notconverted into monetary terms. (SeeAppendix 2 for a listing of companies thatprovide such data).

• Statistical analysis: Probability analysisrequires risk personnel to identify probable

issues and quantify them. Staff considers eachrisk and assigns a rating of high,medium,orlow, and expected values, as well as acorresponding probability for an occurrence, allprobabilities associated with a single riskequaling one.The data is then loaded into aspreadsheet application, such as Crystal Ball,which uses Monte Carlo simulations.CrystalBall is an analytical tool that automaticallygenerates equations to capture uncertainty,such as the cost of a coup to the company. Ituses the Monte Carlo simulation model,whichmimics the random chance of casino games,generating values for variables that have aknown range of values, but an uncertain valuefor a particular time or event. Hundreds oreven thousands of simulations can be run in amatter of minutes, and forecasts are generatedfor each point in the pre-determined range(high,medium, low) of risk.The results showproject managers either the most sensitiveissues on which to concentrate—sensitivityanalysis—or a cumulative probability curveindicating the potential economic performanceof a project—based on a pre-constructeddecision tree that indicates key decisions anduncertainties.Although this methodologyinvolves quantification and the consideration ofpotential risk impacts, the outputs of thesecalculations,which include charts, graphs, anddynamic models, cannot be integrated intofinancial evaluations.This is because they donot generate an ROI number, a political/socialrisk beta, or any monetary results that can beincluded into financial calculations.

• Scenario-based methods: Risk mapping is one method popular with corporations.Thismethod plots the expected frequency, severityand degree of exposure of various risks on agraph,with probable frequency on thehorizontal axis and expected severity on thevertical axis. (Birbeck, 1999).Calculations aremade according to the following formula:

Exposure = (event) x (hypotheticallikelihood) x (hypothetical consequence)

The benefit of such modeling is that it allowsmeasurement of various types of risk,andenables managers to visualize where to allocateresources for risk management. In addition,mapping is a valuable communication tool,providing a comprehensible visual review ofexposures, though they are not usually expressedin monetary terms.For this reason,mapping ascurrently practiced does not provide a link to thefinancial statement,or to the ROI calculation that

is critical for comparisons between possibleproject options. With some modification,including assignment of monetary values to thehypothetical consequences,however,axis pointson such a risk map could correlate to financialdata and be integrated into ROI calculations.

• Adjusted Discount Rate & Cost of Capital:One method of integrating social and politicalrisks issues into financial modeling is theinclusion of social and political risk in a discountrate or cost of capital calculation that flows intocash flow calculations.This can be done bycreating a social discount rate that employs theweighted average cost of capital (WACC) andthe traditional capital asset pricing model(CAPM).This is done in three steps:

1. calculate the cost of equity;

2. develop the risk-free rate (RF) by assigningthe long-term government bond rate;

3. develop a risk-adjusted “beta”, based on thedifference between the return earned byinvestors in an industry and the averagereturn earned by investors in the market asa whole.

When dealing with markets that may exhibithallmarks of social and political risk, this adjustedWACC accounts for social and political factors.

However, this method is difficult to implement.Todate, the calculations for a risk-adjusted beta haverelied largely on the standard country risk ratingsmethodology generated by political risk consultingfirms (see Appendix 2 for more detail on thesefirms). Although useful as a theoretical methodology,such point-based risk ratings as the basis for betacalculations are too broad to achieve the neededobjectives.These ratings are neither industry-,project-, nor company-specific, though social andpolitical risks affect companies and their reputationsdifferently, even if they operate in the same country.To be really useful as a basis for a social/political riskbeta, the country risk ratings generated by politicalrisk assessment firms require customization toparticular companies, locations, and projects.

We therefore propose another method toquantify social and political risk for inclusion infinancial calculations, one that includes integratingthe costs and probabilities of each social andpolitical risk, and calculating an expected value.

Observations

In a recent survey of risk management executives,more than 60% of respondents anticipated acontinuation of “significant external risk” in the


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next five years, based on recent historical events(The Conference Board and Mercer OliverWyman). According to a McKinsey global surveyof business executives,

• Only 3% of the 4,238 executives whoresponded to a poll reported that theircompanies were doing a good job ofanticipating risk.

• 46% of respondents said they have“substantial room for improvement.”

This growing recognition of the need to betterintegrate insight into how social and politicalissues may affect the firm necessitates anadequate methodology to quantify these issuesin a way that supports effective managementdecision-making.

Given the lack of such a methodology to date,most companies largely make capital investmentdecisions and operational choices with aprimary focus on financial risk, as it is mostnarrowly defined. As a result, they fail to make a more comprehensive calculation that couldsubstantially affect decision-making andcorporate financial performance. Currently,there is a tendency to separately treat financialrisk,which has traditionally been measured, andsocial and political risk,which has historicallybeen analyzed qualitatively, and now morerecently quantitatively, to produce weighted riskindicators and maps. In cases where theseissues have been considered, they have oftenbeen relegated to an addendum to theinvestment decisions process and are notincluded in the calculation of ROI.This places azero dollar value on potential risks that candamage profits. As a result, operational andother decisions are often based on quantifiedfinancial factors, simply for methodologicalreasons, leaving key issues,which may havedramatically negative impacts on ROI,unaccounted for.

Many components of risk must be included in acomprehensive risk assessment. Althoughmeasuring some of them is only possiblethrough estimating rather than exactcalculation, all risks can be quantified to someextent. If they are not then included in financial

calculations, the company will ofteninadequately integrate these risks intomanagement decisions and simply gamble thatthey will not emerge.Discussing theimportance of these risks and their potentialimpact is not intended to inhibit investments.Rather, including these risks in calculations aims at creating more informed decisions.The very act of deciding on a number (or arange) to include in calculations means thatdecision-makers are discussing these issues and their importance.There is, however, adanger of declining to invest because hurdlerates were not met due to inclusion of socialand political risks,without senior managementever being aware of it.Therefore, it is critical to share the thinking and decisions made inassigning risk values.This is discussed more fully in a later section.

Further,without fully understanding some of thecomplex risks facing the business, (a) decision-makers may not include pre-emptive measuresinto project planning and execution, and (b)opportunities for growth and profit from day-to-day operations may be lost.

INTEGRATING SOCIAL ANDPOLITICAL RISKS INTO GENERALRISK MANAGEMENT

To manage risk effectively requires:

• comprehending the socio-political andcorporate environments that might affect risk;

• identifying risks;

• evaluating and measuring their potential effects;

• identifying and analyzing possible solutions;

• adopting the most appropriate riskmanagement actions;

• communicating results; and

• monitoring evolving risks.

In this section,we build on and modify the RiskManagement Process model provided in the2005 Management Accounting Guideline1

(Exhibit 2), by including social and political risk,and offering additional tools and techniques toenable companies to integrate these new risksinto management decisions.

1. Epstein,Marc J. and Adriana Rejc Buhovac. Identifying,Measuring, and Managing Organizational Risk for ImprovedPerformance. Risk Management Accounting Guideline.CMA Canada and AICPA. 2005.

I. RISK IDENTIFICATION Complex social and political issues often affectcompany operations. Identifying risks that canaffect company value as the first step inmeasuring and managing political and social risk is therefore important.

Social Risk

Many social issues can affect a company doingbusiness nationally and internationally,whether indeveloping or developed countries. Someindustries are more prone to these risks than areothers. For example, businesses with biginstallations like factories, ports,mines, andrefineries can lead to dissatisfaction and unrest in a local population when:


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Exhibit 2: Risk Management Process

Event Identification

Risk Assessment

Accept Risk

Control Activities

Is Risk/Reward

Acceptable?

Avoid Risk Can Risk Be Mitigated?

Information &

Communication

Monitoring

Quantify

Magnitude

Assess

Probability Quantify Impact Cost/Benefit

Analysis

Priority/

Rank

Yes No

No Yes

Reduce Risk Transfer Risk Share Risk

Risk

Resp

onse

1

2

3

4

5

6

Generate ROI Model, Integrate Risk

Manage & Monitor RiskC

Respond: Avoid, Insure, Mitigate

Communicate Risks D

Reporting & Decision -Making

The Role of Senior Management

Risk Identification

Risk Assessment & Measurement

A

B

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In Exhibit 3,we illustrate how companies caninclude social and political risk into overall riskmanagement. We include the detailed steps and

analysis necessary to identify and assess politicaland social risk in a manner that is relevant tofinancial decision-making.

Exhibit 3: Social and Political Risk Integration Model

Generate ROI Model and Integrate Risk

Manage & Monitor Political & Social Risk C

Respond to Risk: Avoid, Insure, Mitigate

Communicating Social and Political Risks D

Reporting & Decision-Making


Social & Political Risk Identification

Social & Political Risk Assessment and Measurement

A

B

2. Pan, Esther.“Small Window for Peace in Papua,” Council on Foreign Relations. April 19, 2006.http://www.cfr.org/publication/10484/small_window_for_peace_in_papua.html

3. Seelye,Katharine Q.“Indonesia:Mining Company Notes U.S. Review of Payments to Indonesian Military,” TheNew York Times. January 19th, 2006.

• there is the perception that localexpectations are not being met;

• the surrounding area is being polluted; or

• business is undertaken in a region of generalpolitical unrest,where the military isprotecting a site and using its presence toharass the local population for reasonsunrelated to the business.The local populationcan sometimes associate the company withthese practices, and begin to target it as aproxy for the government or the military.

The experience of US-based Freeport McMoran,which owns a large gold and copper mine inPapua, Indonesia, is a case in point. The companylost approximately $48 million and 20% of itsshare price2 due to clashes with the populationssurrounding the Freeport mine. Tension hadalready mounted in the region because of a

December, 2005 New York Times report thatFreeport,which employs 180,000 people and isone of Indonesia’s largest taxpayers, had paidIndonesian military and police officers close to$20 million between 1998 and 2004, leading toan investigation by the U.S. government andprotests by the local population.3

Further ill-will brewed when poor residents nearthe Freeport mine,with few economicopportunities, began prospecting for gold in thewaste rock from the company’s operations.Citing possible health concerns from exposureto this material, the company moved to prohibitprospecting, positioning private security guardsaround the mine,who allegedly had authority toshoot at prospectors.The local community,however,was suspicious of the cited healthreasons, as it already perceived that a largeforeign company was making huge profits from


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use of its land. Impoverished local residentsbelieved that they were being unjustly preventedfrom sharing, even marginally, in the big company’swealth. In reaction, the community began proteststhat closed the mine for four days—at anapproximate cost of $12 million a day.

Nigeria presents another example of risks that canemerge on the arrival of a large company to arelatively isolated or under-developed area.Thearrival of petroleum companies createdunintended consequences when a sudden influx ofpeople,mostly unskilled, began looking for work atthe oil installation.When no jobs were available,some turned to violent behavior.A number ofunemployed Nigerian youths began attacking oilpipelines, taking personnel hostage, and in onecase, seizing an offshore oil rig, demanding thatthey be given jobs.4

A further potential unintended long-termconsequence of new operations is the focus of thelocal economy exclusively on one industry over along period of time, resulting in dependence onone company, operation, or industry sector.Whenthe company leaves or the industry is no longerviable, the surrounding area is usually economicallydevastated, creating a potential backlash againstthe company by local populations.This hashappened frequently in company towns in the U.S.and abroad, in industries ranging from steel millingto coal mining. For example,Detroit,Michigan sawa tremendous dip in its standard of living when theautomotive industry became less competitive.Some industries are less prone to these risks, butit is critical that companies that must or choose toremain in one location for the long-term,understand and mitigate these risks. In many cases,mitigation calls for both an effective communityrelations strategy, as well as an exit strategy thatdeals with both environmental and economicissues to diminish negative consequences.Riskmitigation is discussed in a later section.

Health, safety, and environmental issues affect allcompanies. Recently, debate has begun onregulating emissions at major U.S. ports. This would create additional unexpected costs for both freight companies and importers andexporters of goods from places like the Ports of Los Angeles and Long Beach.

Companies working internationally face oftencostly worker and community health issues for avariety of reasons, including lack of adequatemedical care in certain regions of the world.HIVinfection has become a particular risk forcompanies in the extractive and transportationsectors, both heavily male-dominated,whereoperations attract increased prostitution. Thisincreased level of HIV infection of workers canquickly lead to sickness and eventual death. Leftunchecked, this trend will expose companies thathave trained workers and rely on their skills forproduction to additional costs. Road accidents, akiller that will eclipse both AIDS and war by 2020according to the World Health Organization, alsorepresent a tremendous cost to companies relianton long-haul trucking. 80% of total road deathsoccur in developing countries, often resulting fromovercrowded vehicles and an unsafe mix ofanimals, people and vehicles on the road.Statistically, companies that rely on roads in theseparts of the world will be exposed to loss of theirdrivers or cargo due to unsafe road conditions.Some companies try to mitigate this risk bytraining their own staff and contract drivers, aswell as working with other companies andmultilateral organizations to address road safety.5

Using labor forces—like children and forcedlabor—that certain societies considerunacceptable can put companies at risk. In someareas of the world it is customary that childrenwork, and this is one of the better optionsavailable to them.However, use of child labor hasled to product boycotts by customers opposed tothe practice and terrible publicity. The use offorced labor, a practice that has been exposed inthe supply chain of some companies, can alsocreate great problems, even if the company did not directly employ this labor. In 1996, activistsand Burmese villagers filed a lawsuit against Unocal under the Alien Tort Claims Act (ATCA).The ATCA grants to a U.S. federal courtjurisdiction over a claim,when a non-U.S. citizenor alien sues for a tort committed in violation of aUnited States treaty or other international law. Inthis ATCA case,Unocal was accused of (a)complicity in the Burmese military’s use of forcedlabor to build the Yadana pipeline, of which Unocalwas a junior partner, and (b) allowing Burmese

4.“Nigerian oil fuels Delta conflict,” BBC, January 16, 2006.

5. Bekefi,Tamara. The Global Road Safety Partnership and Lessons in Multisectoral Collaboration:Corporate SocialResponsibility Initiative,Kennedy School of Government,Report # 1—August 2005.

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troops guarding the project to rape,murder, andenslave villagers.The company denied any part inthese human rights abuses, but settled the suitfor an undisclosed amount of money in 2004.6

All of these social issues emerged as risks tocompanies, and some risks took companies bysurprise and came at a great cost.The largest ofthese costs, lost sales and profits, often resultsfrom damage to reputation.Other risks thatpresent a potential monetary liability seempoised on the horizon.One example is climatechange,which may present a potential futuremonetary liability. Although there is still debateon climate change and liability is not a certainty,its likelihood warrants some companies toconsider it by factoring it into decision-making.

Political Risk

Generally, political risk can be understood asexecution of political power in a way thatthreatens a company’s value.Two types ofpolitical risk are relevant to companies doingbusiness internationally: industry- or firm-specific political risk and country-specificpolitical risk.On the one hand mass anti-government protests, then,may not pose apolitical risk to a firm if they do not affect (a) government policies towards business, or (b) the firm’s current or future operations orvalue.On the other hand, changes in the legalframework governing contracts could have asignificant negative impact on the company.Industry- and firm-specific political risk isexperienced by one industry or firm, such asthreats by Bolivia’s President Evo Morales tonationalize the country’s oil and gas sector.Companies including Brazil’s Petrobras andSpain’s Repsol YPF have invested $3.5 billion into

developing Bolivia’s natural gas fields, thesecond-largest natural gas reserves in SouthAmerica.7 Morales’ threats have recently beentranslated into specific actions against foreignenergy companies, beginning with (a) forcedaudits of their financial documentation, and (b)the demand to renegotiate concessionagreements and revenue-sharing from gas fielddevelopment to give the government a majoritystake within six months.

Sector-, provincial-, and country-specific politicalrisk is spread more widely. These risks caninclude a civil war, drastic changes in foreigncurrency rules, or sweeping changes to the taxcode. These types of risks can be generateddirectly from the host country government, oremerge from an unstable social situation withinthe country. Regardless of the source, acompany attempting to understand potentialpolitical risk must recognize the differencebetween (a) political issues that can affectcorporate performance, and (b) dramaticsituations that have no financial impact on thecompany. In addition, companies shouldunderstand the potential reputation damage,and associated costs, related to political risk.

The distinction between social and political risks isoften blurred.We consider these issues to fallalong a continuum, as illustrated in Exhibit 4.Thesubjects in Exhibit 4 are only some of the mostcritical social and political risks facing globalcompanies today. Although the Exhibit does nottry to list all risks, the wide variety of risks itincludes provides a sample of relevant issues facingcompanies. Each organization should generate itsown list of social and political risks, based on theirrelevance to its business(es) and the businessenvironments in which it/they operate(s).

6.David Baker.“Purchase of Unocal by Chevron Deal puts new sources of gas and crude in the right places forEast Bay oil giant,” San Francisco Chronicle.Tuesday, April 5, 2005.

7.The Economist,December 2005.

Developing a Risk Profile

To effectively manage social and political risksmeans, first and foremost, being able to identifyrisks that face the firm from various sources, andhandle them within a larger risk managementframework.This allows decision-makers todevelop a situation or project-specific risk profilethat will help to (a) reduce unwanted surprises,(b) minimize the negative effects of externalfactors on the business, and (c) maximize the

potential for solutions. Developing a risk profilehas two elements:

1) Identify enterprise risk sources

2) Identify company- or project- relevant socialand political risks

Element 1: Identify Enterprise Risk Sources

When developing a situation- or project-specificrisk profile that includes social and political


15

Exhibit 4:The Social-Political Risk Continuum

Political Risk Social Risk

� Religious, ethnic and language issues � Labor market laws

regarding hiring and firing � Civil unrest

surrounding site � Creation of single

industry economy � Environmental laws � Environmental

impact � Forced labor � Protests against

company by social groups affected by its presence � Armed

insurrection/civil disorder � Fundamentalist/

guerilla movements � Targeted criminal

activity (mafia, militias, etc.) � Terrorism � Perception by

consumers of worker exploitation leading to protests, boycotts, and lawsuits

� Cultural protection legislations (e.g. France) � Language laws (e.g.

Quebec) � Selling “unhealthy”

items (e.g. tobacco products, ‘junk’ food, alcohol) � Same-sex partner

benefits � Civil unrest

surrounding site � Unskilled labor

seeking work; targeting company when not employed � HIV infection

resulting from solicitation of prostitutes � Failure to meet

community expectations � Forced labor � Road accidents � Occupational health � Infringement on

indigenous lands � Child Labor � Protests against

company by social groups impacted by its presence � Boycott of firm due

to: anti-globalization or anti-Americanism � Targeted activities of

advocacy groups

� Trade restrictions (e.g. South Korean tax audits for foreign car buyers) � Endemic

corruption � Engagement with

national military (for security) � Executive instability

/ frequent regime change � Foreign currency

exchange rate changes � Foreign war � General corruption � Inadequate

regulatory enforcement � Internal war � Nationalization � Predatory

government � Weak legal system

16

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issues, it is critical to be aware that these issues are experienced quite differently,depending on a firm’s sector, industrycharacteristics, product(s), customers,geographic location(s), and employment.Identifying the sources of risks is also helpfulfor the following reasons:

• Identification helps refine the list of issuesthat could affect one’s company,

• Response strategies will be more effective ifthe sources of risk are known, permittingmanagers to address the issues at their source.

Exhibit 5 illustrates some of the sources of riskthat may help to formulate a risk profile.

Companies in different sectors can facesignificantly different risks, as well as attractingdifferent outside scrutiny on diverse issues. Therisks that emerge from such scrutiny haveaffected companies, and in many of the first

cases, companies were surprised to be accusedof socially unacceptable behaviors:

• The oil, gas, diamond, and gold industries havebeen accused of adverse environmentalimpacts, human rights abuses, negative effectson local communities, and sometimes ofcolluding with corrupt governments indeveloping countries. These industries alsoface issues simply because of their operatingenvironments. An extractive company mayundertake new operations in countries withunstable political environments wherecorruption may be rampant; the judiciary may be too weak to enforce contracts; andinfectious disease may wreak havoc on skilled labor.These challenges would likelynot emerge if the company were beginning a project in North America. Extractivecompanies may be forced to operate in anunstable environment, as they must go where

Exhibit 5: Enterprise Social & Political Risk Sources

Media

Supplier

Process

Location

Customer

Base

Employee

Industry

Product or

Service

Enterprise

Risk

Sources

the product is found. Companies in othersectors are often not so limited.Companieshaving or choosing to operate in higher riskenvironments must identify these risks as afirst step in evaluating and managing them.DeBeers,which operates in regions where theincidence of HIV/AIDS is the highest in theworld, calculates that 10% of its employeeswere likely infected with HIV and that aprogram to treat its infected employees wouldcost the company US$1,200-US$3,500 perworker annually for 10-14 years.DeBeersconsidered this a cost-effective approachcompared to its other two choices: (a) thecost of losing HIV-infected workers to AIDS-related illness and death requiring the hiringand training of new workers, or (b) the costand inefficiency of hiring and training threeworkers for each job, to prepare for AIDS-related losses. DeBeers is currentlyimplementing an HIV/AIDS employeeeducation and treatment program.8

• Footwear and clothing production have beenassociated with low wages, child labor, andunfair working conditions. Companies withmanufacturing operations in developingcountries, and thus faced with non-Westernlabor practices in areas such as wages,overtime, and child labor, find that thesepractices are often scrutinized by the media orthe companies’ customers both of whom aresensitive to these practices.

■ Nike was accused of employing children asyoung as ten years old in Cambodia andPakistan to produce sneakers, clothing, andfootballs, leading to consumer boycotts.These consumers did not differentiatebetween the company and its subcontractors.

■ In 1997,Kathy Lee Gifford’s clothing linecame under attack when the news mediabroke a story alleging that the televisionstar’s clothing line was being manufacturedby Honduran women and girls as young as12,who were working in dreadful conditions.

■ In September 2005, a class action lawsuit wasfiled against Wal-Mart on behalf of workersin Bangladesh, Swaziland, Indonesia,China,

and Nicaragua. The lawsuit alleged that theworld’s largest retailer had failed to monitorworking conditions in its supply chain, andthat its demand for low prices forcessuppliers to enforce sweatshop conditions.

• A computer chip manufacturer might strugglewith stakeholder reactions to chemical use andits impacts on the local environment. Thesebusiness-to-business industries are oftenaffected less by damage to reputation relatedto social and political issues than arecompanies in other sectors.

• Telecommunications firms may face negativereactions by its customers over use of theirpersonal information and records of their useof the telephone or Internet. Refusing toshare such information, however,may presentother risks. Recently, news has emerged thatthe U.S.National Security Agency (NSA) hasbeen secretly collecting the telephone recordsof millions of Americans by agreement withAT&T,Verizon, and BellSouth. When QWEST, afourth company, declined to participate, theNSA threatened negative consequence ingovernment dealings for failure to cooperate.9

• Prescription drugs and their producers havebeen linked to developing countries’ lack ofaccess to essential medicines.HIV/AIDS drugproducers were boycotted because they wouldnot lower product prices in South Africa.

• Food and beverage companies have beenassociated with the obesity epidemic;McDonald’s has been accused of encouragingobesity through marketing its products.

The obesity-related lawsuit against McDonald’swas revived in January 2005, and has led to moregeneral changes in both production andmarketing practices of the food industry.McDonald’s began to offer salads and fruits inaddition to the traditional hamburgers andFrench fries, and PepsiCo’s Frito-Lay snack unitreplaced trans-fats with corn oil in its products ata cost of $57 million, and began producingreduced-fat Lay’s potato chips and Cheetos.10 Thethreat of legal liability could reach as far as localsupermarkets and convenience stores, sincerecent studies have found that products in stores


17

8.Global Business Coalition on HIV/AIDS <www.businessfightsaids.org>

9.Cauley, Lesley.“NSA has massive database of Americans’ phone calls.” USA Today May 11, 2006.

10.“Food Giants Scramble to Avoid Lawsuits.” The Agribusiness Examiner, August 30, 2004.http://www.organicconsumers.org/school/obesitylawsuits083004.cfm

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located in the poor neighborhoods of NorthAmerica offer more convenience (junk) foodand few fresh fruits, and hardly any vegetables.11

Some convenience store chains like 7-Eleven areresponding by offering organic and healthiersnacks to consumers.

Companies beginning to identify social andpolitical risks that may affect them or theirproducts must understand the setting for theirbusinesses, and how that setting might generaterisks. This process need not necessarily becostly and time-consuming, though the degree ofinvestment in risk identification would likelydepend on the size and importance of thecompany or project.

Risk may emerge simply from:

• Operating Location: Locating a plant inMyanmar,where a totalitarian militarygovernment is known to encourage the useof forced labor,will likely pose more risksthan doing business in Singapore,where thisis not a common practice. Likewise, opening apub near a school may generate protestsfrom the local community.

• Reaction of society or a group of peopleaffected by,or who believe they will beaffected by, business activities: In Peru’sCajamarca region,Newmont Mining has beengrappling with the local community’sdissatisfaction and its sometimes violentreactions.This is based in part on changes inthe community since the arrival of the mine,such as rising housing prices and inflation. Itis also based on the perception that miningoperations have contaminated and siphonedoff local water supplies, and are negativelyaffecting human health, farming yields, andfishing.The matter is further complicated byinvolvement of activist groups,who are usingthe Internet to spread information, in somecases destabilizing relations between thecompany and the community. Local distrust isat such a high level that when NewmontMining began exploration of a nearbymountain as a potential site for furthermining activities, rioting began and thecompany abandoned its expansion.

• An employee base that is deemedunacceptable to society:Wal-Mart recentlysettled a lawsuit brought by the U.S.Department of Labor for $135,540, for 24

violations of employing teenagers and allowingworkers to operate hazardous equipment.12

Although the amount of the settlement maybe insignificant to the company, the negativeimpact on its reputation is reverberatingthrough the company.

The new power of communications technologyto spread information quickly and efficiently,withlittle oversight,means that companies have to beeven more aware of their social and politicalrisks to avoid targeting by activists.This isdiscussed further in Appendix 1:Real vs.Perceived Risk.

Exhibit 6 outlines some of the social and politicalrisks generated by product, sector, customer,geographic location, employee base, and industrycharacteristics, as well as examples of industriesaffected by these issues. Risk can be divided into:(a) risks to society that could createdissatisfaction, and (b) other issues that couldnegatively affect the company, thereby posingrisk to the company. Analyzing thecharacteristics of these two kinds of risk, aidscompanies in understanding their potentialimpacts on the company or project, a criticalfirst step in developing a risk profile andestimating the effect on profitability.

A comprehensive risk identification process willascertain risk variables that may apply to one’scompany. Additionally, identifying the issues towhich stakeholders may be sensitive (if theywere to discover companies engaged in them) isimportant, since the financial effects ofstakeholder reactions can be significant andeasily spiral out of control.

Element 2: Identify Company- or Project-Relevant Social and Political Risks

Next in critical importance after identifyinggeneral enterprise risk sources and issues(Element 1) is identifying company- or project-relevant social and political risks.These can vary,depending on specifics such as location within acountry, and can be more nuanced than thosepreviously identified.The discussion of riskmanagement often focuses on financial issues, tothe exclusion of other similarly important matters.

Although the CEO and the board are theultimate risk managers in the company,employees in many parts of a company can

11. “Where You Live Affects What You Eat.” NAASO, The Obesity Society. http://www.naaso.org/news/20041118.asp

12.“Wal-Mart settles child labor cases.Company denies charges but agrees to pay penalty.” Associated Press,February 12, 2005.


19

EXHIBIT 6: EXAMPLES OF RISK SOURCES & CORRELATED POTENTIAL RISKS

Source Examples RiskRisk to Society Risk to Companies

Product Diamonds • Diamond trade and • Business disruption, threats to employeesrevenues being siphoned • Reputation: profits from legal diamondoff by corrupt governments mining fueling civil wars in Africa.and rebel groups, thereby • Accusations of profiting from trade offueling civil wars in Africa, “conflict diamonds” may affect sales and e.g.Angola product reputation

• Consumer boycotts/protests and pressurefrom employees (both existing and potential)

Petroleum • Negative environmental • Long-term business sustainability products impact (need to replace reserves, etc.)

• Imposition of legislation to manage emissions, creating a cost to the company and consumers of its products

• Reputation: fossil fuel emissions correlated to climate change

Fast food, • Increased consumption of • Reputation: blaming food and drinksnack foods, unhealthy food and drinks manufacturers, as well as retailers, for soft drink negatively affecting obesity producing and marketing food to consumersmanufacturers, in the developed world who over-consume, thereby suffering from food retailers and potentially the less obesity and related health problems

developed world • Obesity lawsuits that, to date have beenthrown out of court, but may still posesignificant potential liability, as wasexemplified by tobacco lawsuits.These suits,whether or not they lead to payouts, take time and energy from corporate legal teams and executives to address, at considerable cost to the firm.

Prescription • Lack of access to medicines • Reputation: Anger in developed world aboutdrugs in developing countries, lack of access to essential medicines for

e.g. South Africa and the world’s poorest leads to action and/orHIV cocktails public protest in developed countries where

companies are based• Cost to pharmaceutical companies of filing lawsuit to overturn South African law lowering price of HIV medicines

• Cost of withdrawing the suit and public outcry at blocking access to medicine in Africa.Consumer boycotts/protests and pressure from employees (both existing and potential).

• No legal liability but cost of negative public opinion once the issue becomes public.Consumer boycotts/protests and pressure from employees(both existing and potential).

(continued)

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M E A S U R E M E N TSource Examples Risk

Risk to Society Risk to Companies

Shoes, clothing, • Potentially poor working • Reputation: Accusations by consumerstoys conditions, including long of sweatshop conditions leading

hours and little pay to boycotts of products• No legal liability but cost of negative

public opinion once the issue becomes public.Consumer boycotts/protests and pressure from employees (both existing and potential).

Chocolate • Slave labor, child labor • Reputation: boycotts of products and badand people trafficking in publicity connected to use of slave andWest Africa child labor, as well as human trafficking

• Lawsuits under the Torture Victims Protection Act and the Alien Tort Claims Act (U.S. court).

• Consumer boycotts/protests and pressure from employees (both existing and potential)

Chemical • Negative environmental • Fines by governmentimpact • Lawsuits

• Employee health • Remediation• Community safety • Consumer boycotts• Risk perception • Inability to recruit talent• Long-term hazards that may • Reputation risk

not be currently understoodbut may take years to emerge

Sector Retail • Companies that sell products such as diamonds, fast foods, snack foods, soft drinks, chocolates, shoes, clothing, toys,furs, etc. could be faced with the same risks as the producers and may be met with lawsuits and/or boycotts

Customer Socially • Reputation issuesresponsible • Consumer boycottsconsumers • Inability to recruit talent(particular correlation with products produced in developing markets)

Geographic Stable • Locating certain businesses • Limits ability to open in certain locationslocation13 developed near particular areas • Consumer reputation risk

country (taverns, liquor stores near schools).

EXHIBIT 6: EXAMPLES OF RISK SOURCES & CORRELATED POTENTIAL RISKS (continued)

13.The distinction between developed and developing countries is often based on levels of economicdevelopment,which are usually closely associated with social development, in terms of education, health care,and life expectancy.The United Nations’ Human Development Index (HDI) serves as a measure ofdevelopment, as does the World Bank’s Country Classification Database,which uses gross national income (GNI)to classify economies and their level of development.


21

Source Examples RiskRisk to Society Risk to Companies

Unstable • Government is supportive • Potential for corruption creating difficultdeveloping of company but local situations when trying to uphold homecountry population could be country law [such as Foreign Corrupt

dissatisfied Practices Act (U.S.)]• Legal framework where contracts cannot

be enforced creating an uneven playing field• Targeting by predatory government with

potential for nationalization of assets [Bolivia LNG,Venezuela general corporate challenge]

• Targeting by insurgents or other non-government actors [i.e., insurgents if company seen as colluding with government (Colombia)]

Employees Children • Working at young ages • Reputation issues: Anger in consumer[This may not be as much markets about use of child laborof an issue for local • Violation of child labor lawspopulation when the alternative to child labor can be a worse option,such as child prostitution or homelessness]

Adults • Female employees’ • Loss of skilled employeesexposure to hazardous • Health problems among employeesmaterials that cause • Potential that consumers will reactbirth defects negatively to poor working conditions

• Social issues with • Lawsuitswomen working • Increased absenteeism due to illness,

• Discrimination higher turnover of workers due to• (Men) Working, particularly HIV-related deaths

in extractive and transport • Increased instance of industrial accidentsindustries, away from their because of intoxication by drugs or alcoholfamilies and communities,risk exposure to sexually transmitted diseases (STDs) and increased drug and alcohol use. The STD is often transmitted to others,including women along the trucking route or wives.

Non-diverse • Lawsuits filed under laws such as theworkforce in Racial Discrimination Act, the Sex North America, Discrimination ActEurope • Reputation loss that affects ability to hire

talented workers• Legal fees• Inability to recruit• Potential obstruction in capturing growing

minority markets

EXHIBIT 6: EXAMPLES OF RISK SOURCES & CORRELATED POTENTIAL RISKS (continued)

22

M A N A G E M E N T

S T R A T E G Y


integrate risk management into their jobs.Financial risk is usually managed in a specific andestablished manner.On the other hand, theintensification of social and political risks oftenrequires an integrated risk management processacross a firm, to adequately identify emergingissues. Personnel who can become aware of riskat an early stage include a line manager at a plantin a developing country. That manager may beaware of negative community reactions to thecorporation through discussions amongworkers, or from personnel in public affairs wholearn of negative government attitudes to thefirm while lobbying. These first signals can heraldmuch larger issues if left ignored.

To anticipate social and political risks, personnelmust be aware of what constitutes risk to thefirm, and understand how to identify these risks.Identification is a two-step scanning process:

1) Generate a risk profile for the corporation(Element 1) that can include some of theissues illustrated in Exhibit 4. A variety ofrisks can materialize from factors such assector, industry characteristics, product,customers, geographic location, andemployment. A risk profile is simply a list ofrisks generated from these contextual issues.

2) Generate a risk catalogue for thecorporation (Element 2): risks can be specificto a particular project or location. Forexample, a new shoe manufacturing plant inBolivia will face different risks than an existingrefining facility in Oman. A risk catalogue issimply a more specific list of ‘red flag’ issues,developed from the general risk profile, thatare connected to a certain project or location.

Existing Operations vs. New Investments

Evaluating and responding to risks is significantlydifferent for existing operations than for newinvestments. Ongoing operations are oftendifficult or costly to uproot if a major riskmaterializes. In some cases, such as extractive orother materials-based operations that bring acompany to a particular location and require largeinitial investment, the risk would have to beimminent, or have the potential to exactenormous consequences, to warrant movingoperations or withdrawing.When ongoingoperations face social and political risks, they mustfind ways of minimizing their impact,whilemaximizing their potential for continuingoperations.The same applies to changes tooperations that generate risk. However,when

new investments are considered, companies canevaluate a variety of locations and compare theirrisk impacts. In addition, evaluating risk for newoperations can present opportunities for pre-emptive mitigation and management of unavoidablerisks. That is not possible in ongoing operations.Risk mitigation is discussed in a later section.

Reputation Risk

For most firms, reputation is a large issue, andintangible assets such as brand can account forover 60% of a company’s market value.Reputation damage from issues such as negativepublicity and costly litigation can create a loss ofrevenue, a decline in customers, or the exit of keyemployees. (Argenti; 2005) Negative perceptionsabout a corporation can emerge from the socialand political issues it deals with, and put thecompany’s reputation at risk. Although a goodreputation can have potentially positive outcomes,such as (a) enhanced access to capital markets,and (b) the ability to attract investors and betteremployees, and charge premium prices, theconverse can also be true. Reputation issuesarising from social and political risk can negativelyaffect the organization as much as the risksthemselves, and can account for some of thelargest costs—lost sales and profits. As acomponent of social and political risks a companyfaces, reputation risk also needs to be managed.

Increased consumer interest, instantaneouscommunication via the Internet, and professionalactivist organizations have generated newchallenges for companies trying to managereputation risk. They must identify thestakeholders that may be affected by, or mayhave an impact on, a particular issue. Exhibit 7illustrates stakeholders that may be involved.

Evaluating a firm’s stakeholders and thereputation risks they may generate is animportant part of creating the corporate riskprofile. Identifying these reputation risks followsthe same steps used in identifying political andsocial risk. Identifying the stakeholder group thatis the source of this reputation risk is also criticalto creating mitigation strategies. Riskidentification does not have to be a long andcostly process—even a few people spending afew hours discussing and identifying risks, andassigning probability values to them, can producehelpful, if not precise, results.This is better thanno risk deliberation at all.More thoroughdeliberations can be expected when moremoney is at stake.

Embedding Risk Identification into Corporate Activities

Identifying a company or project’s social andpolitical risks, and their associated reputation risks,should generate a company- or project-specificrisk catalogue that includes all relevant risks andtheir sources. Internal company expertise andexternal advisors together can perform theidentification.

• Internal analysis: Either (a) employeesspecifically hired for the purpose, or (b)personnel located in key locations whointerface with local and national social andpolitical entities such as local leaders,politicians,NGOs and communities, can gatherthis risk information.They would know thebusiness and therefore understand howparticular social and political issues may affectthe company. They will need a means of

reporting on risks they identify. Coming fromwithin the company, these personnel may,however, have a narrower view of the industryas a whole and be less sensitive to ‘red flags’generated outside the company. Therefore,other sources of risk data can be used for amore inclusive set of risk indicators.

• External analysis: Boutique political riskanalysis firms (such as those listed in Appendix2) are another source of risk data. Theseorganizations supply country-specific reports.In some cases, they also calculate nationalratings based on issues such as: risk fromgovernment, society, security, and economicfactors.The benefit of information from thissource is that (a) they give a broadunderstanding of a country’s current situation,(b) they update the information regularly, and(c) those generating the data are deeply


23

Exhibit 7: Potential Stakeholders

Employees

Business

Decisions

&

Issues

Stockholders

Lenders

Suppliers

Customers

Distributors

Local

Communities

Home

Country

Local, State,

Federal

Governments

& R l t

Social

Activist

Groups

Host Country

Local &

National

Governments

& Regulators

Media

General

Public

24

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knowledgeable about the regions they cover.In addition, the country risk ratings simplifythe process of comparing countries. This isparticularly useful when beginning newoperations and trying to decide where tolocate them.One limitation of the productsthese firms generate is that they are usuallyneither industry- nor region- specific. This issignificant, since what could be lethal to oneindustry located in one part of a certaincountry could pose no threat whatsoever toanother. In addition, these firms’ products arenot monetized so as to be useful ininvestment decision-making.

• Stakeholder scanning: Stakeholders such assuppliers, consumers, and surroundingcommunities are sources of data on social and political risk. Information can be gathered from surveys, interviews, communitymeetings, and market perception studies, aswell as hiring local advisors. The drawback of these methods, particularly in countrieswhere new operations are being established,is that undertaking the study could reinforceexisting expectations of stakeholders that the company will find hard to meet. Inaddition, engaging stakeholders can sometimesembroil the company in local politics inunanticipated ways. For these reasons, acompany wanting this information would bewise to seek assistance from a third party, orhire personnel trained in conducting social impact assessments.

It is possible, and likely most useful, to combineelements of all of the above methods. Forinstance, a company could assign general riskoversight to several people within thecompany,while also enlisting personnel in thefield and training them to be aware of ‘red flags’indicating potential problems. Boutiquepolitical risk firms could supplement thiscountry information at various stages ofoperations, and a social impact assessmentcould be undertaken periodically within theproject life-cycle by a lending agency, a thirdparty, or specifically hired personnel.Thisprocess should not, however, become all-consuming. Instead, companies should adopt amethodology for gathering and reportinginformation that is appropriate to the companyand the project. Section IV further discussesreporting and decision-making.

II. ASSESSING & MEASURINGSOCIAL AND POLITICAL RISK

Business resource allocations are primarily basedon ROI calculations. For a more completeanalysis and improved operational and capitalinvestment planning, ROI calculations mustinclude political and social risks, to make themmore explicit and relevant.

After identifying the social and political issuesthat could affect the company, and compilingthose issues into a comprehensive risk profile,metrics must be developed for each issue toassess their relative potential impact.One of themain aims of quantifying social and political risksis to integrate them into a financial model,thereby incorporating social and political issuesinto traditional risk analysis. We recommendincluding social and political risk in the financialequation through an ROI model, describedbelow.Measurement of social and political riskthrough the following eight-stage process isillustrated in Exhibit 8:

1. Calculate the benefit associated with each issuethat may generate risk:For instance, shiftingoperations to Bangladesh could savesignificant money to a company’s payroll byemploying personnel earning less than homeoffice personnel.

2. Calculate the potential costs associated with each political or social risk, including reputation costs.

3. Estimate the probability that each risk willmaterialize.

4. Multiply the potential cost of each risk by itsexpected probability of materializing to calculatethe expected value of each risk.


Manage & Monitor Ris k C


Communicate RisksD



Risk Identification


A

B

5. Estimate when, over time, the risk may emerge.Calculate the net present value (NPV) of the risk.

6. Aggregate the NPVs of all social risks. Insertas a line item in ROI calculations.

7. Aggregate the NPVs of all political risks.Insert as a line item in ROI calculations.

8. Calculate the expected value of the ROI.

Social and political issues pose risks to companiesthat can be quantified and monetized, even if only bya rudimentary estimate. In fact, risks should bemonetized for inclusion in ROI calculations, and toimprove resource allocation and investmentdecisions. Product take-back and producerresponsibility (requirements that companies acceptresponsibility for final disposal of their products likecomputer goods, cartridges, appliances, etc.) isincreasingly common throughout the world.Similarly, site cleanup has become mandated in manylocations, and companies are now recognizing thatthey did not consider these social and political riskswhen making costing decisions.This has led tounderestimating total product cost. Betterforecasting of potential changes in the social andpolitical environment can lead to improved decision-making on process, product, and capital investment.

Like other estimates used in financial analysis, theseestimates are often imprecise.However, through properestimating and disclosure, they certainly aid decision-making and are relevant in management discussions.Often, decision-makers will estimate ranges of costsand choose a point estimate for use in the analysis. Theranges, along with the measurement techniques used inthe ROI analysis,would then be included as a footnoteor appendix to the ROI calculation. Discussion of theseranges, and decisions on a certain point estimate,assists personnel in thinking about and communicatingthese often-neglected risks. Although the output ofthis practice is important, just as critical, ultimately, isthe process for deciding on the appropriate issues, theirassociated costs, and the probabilities of occurrence.Ultimately, it is the board, the CEO,or the CFO,who mustchoose the appropriate metric. The quantitative analysis,ranges, point estimates, and ensuing discussion are criticalelements in decision-making.The assumptions, decisions,and measurement techniques that lead to quantificationof social and political risks must therefore be includedas a footnote or appendix to the ROI analysis.

Although calculations of the expected values ofindividual risks may be imprecise, the totalestimate will likely move towards the mean. Thisgreater precision occurs in a manner similar to theportfolio effect,where the propensity of risk on awell-diversified set of investments tends to fallbelow the risk of each individual component.

Measuring the Cost of Risks

Step 1—Calculate Issue Benefit

Measuring the cost of social and political risksinvolves monetizing the savings and costsassociated with each issue that could generate risk.


25

Exhibit 8: Stages to Measuring Social and Political Risk

1. CALCULATE

BENEFIT OF EACH

RISK ISSUE

2. CALCULATE POTENTIAL

COSTS, INCLUDING

REPUTATION

3. ESTIMATE

PROBABILITY

4. CALCULATE EXPECTED

VALUE OF EACH RISK

5. CALCULATE NPV OF EACH

RISK

6. AGGREGATE NPVS OF SOCIAL

RISKS.

7. AGGREGATE NPVS OF

POLITICAL RISKS.

8. CALCULATE EXPECTED VALUE

OF ROI

1. CALCULATE

ISSUE BENEFIT

2. CALCULATE POTENTIAL

COSTS, ALSO REPUTATION

3. ESTIMATE PROBABILITY


OF EACH RISK


RISK

6. AGGREGATE NPVS OF SOCIAL RISKS.

INSERT TO LINE ITEM

7. AGGREGATE NPVS OF POLITICAL

RISKS. INSERT TO LINE ITEM

8. CALCULATE EXPECTED VALUE OF

ROI

26

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For example,when corporations are consideringoperating in a region where child labor is thenorm, they may contemplate following this norm.In considering this option, the savings from usingchildren would be calculated by measuring thedifference in the wage rates between paying anadult and a child.The savings of using child laborwould represent the issue benefit,which isgenerally assigned a positive value.

Although some industries like clothing and shoemanufacturing have been seriously damaged by theuse of child labor, and have therefore attempted tostop the practice, others like the chocolateindustry did not consider this a risk.Childrenworking as cocoa bean pickers were employed inthe supply chain. Chocolate and candymanufacturers largely ignored the issue, untilnewspapers began publishing stories of kidnappingsand forced child labor on cocoa plantations inWest Africa. If the company considered thisoutcome, it should calculate each potential costassociated with employing this labor force, and thepublic discovering it.These costs could include:

• Lost sales and other reputation impacts(measuring reputation is addressed in a later section);

• Managing a consumer boycott by hiring apublic relations firm, creating a newadvertising campaign, hiring a stakeholderrelations manager, communicating internallywith employees, and senior management’stime devoted to dealing with the issues;

• Diminished brand value; and

• Negative impact on recruiting potential hires.

Step 2—Calculate Risk Costs, Also Reputation

Each of these costs is assigned a value to get therisk costs of employing child labor.

Measuring Reputation Risk

Reputation risk is considered a cost resultingfrom, and therefore a secondary effect of, socialand political risk.These include all of the real andperceived risks discussed in Appendix 1.Theprocess of identifying and measuring reputationrisk is the same as for political and social risk.

Polling firms, a public relations team, andinformation from other companies, can identifywhich stakeholders may view certain social andpolitical issues negatively, thereby generatingreputation risk. Exhibit 8 lists a number ofstakeholders that should be considered.

• Third-party polling:Polling by opinionresearch firms can provide a sense of howimportant these issues are to the company’sstakeholders, and how they might react. Acompany’s public relations team can calculatethe impact of reactions like opting for anotherbrand, boycotting, or a negative media campaign,based on numbers provided by polls and usingmethods similar to measuring brand value.

• Surveys:Surveys can give some insight intothe intensity of stakeholder reaction tocertain issues.These “intensity of feeling” pollscan be translated into monetary terms byasking questions about the impact of certainissues on buying products.The resultingnumbers can then be calculated as lost sales.

• Other companies:Researching the impactson other companies that have experienced asimilar issue can give insight into themonetary impact they experienced.

The biggest cost of social and political risk isusually a reputation cost, typically as a result of lostsales due to consumer boycotts or protests. Thiscan be measured through lost sales minus the costof producing those goods, or the lost net profit.

Share price and market share decline are two otherpotential issues to consider. Perrier was once theleading sparkling water brand in the U.S., holding80% of the U.S. imported bottled water marketand close to 6% of the total bottled water market.In 1990, benzene was found in the bottled watersold in South Carolina and the company recalled70 million bottles in the U.S. and Canada,whileclaiming that it was an isolated incident.Whensimilar contamination was discovered by Danishand Dutch officials, the company did a worldwiderecall and claimed that benzene naturally occurred

1. CALCULATE

ISSUE BENEFIT

2. CALCULATE RISK COSTS ,

ALSO REPUTATION



OF EACH RISK


RISK


INSERT TO LINE ITEM




ROI

in the carbon dioxide that makes its water“sparkling”, and was usually filtered out.They lostsubstantial market share. Six years later, Perrier’ssales was still at only one-half of its 1989 peak, andPerrier had to spend large amounts of money onincreased advertising, free samples, and make othermarketing and promotional expenditures in anattempt to recover its market share.14

Where possible, the impacts of share price andmarket share decline should be included incalculations as potential long-term losses. Thecosts of managing stakeholders in the medium tolong-term, either through additional personnel orother strategies, should also be included.

The professional services and insurance firm,Marsh & McLennan Companies, Inc., experienced a40 percent drop in its stock price whenaccusations of bid-rigging activity made the newsin November, 2004. In addition to a downgrade ofits debt by credit rating agencies due to itsdeteriorating reputation,Marsh & McLennan cut5% of its workforce on predictions of a 94%decline in its 3rd quarter profits.15

Step 3—Estimate Probability

After calculating the potential costs of each risk tothe company, the potential likelihood, in percent,that each risk would occur and cause damage tothe company, is approximated.This number is theestimated probability. (Later we calculate theimpact on the company in expected value.)

However, a footnote can be included in the ROIanalysis that indicates that these numbers aremidpoints (which would most likely settle within arange). An estimated probability should beassigned to each identified risk. For example, theestimated probability of the emergence of socialand political risks for a fictitious coffee processingplant in Colombia could include:

• Workers being kidnapped by the local militia:60%;

• Being “taxed” by local militias or cartels: 25%;

• Being found guilty and paying fines under theU.S. Foreign Corrupt Practices Act or otherhome country laws that regulate bribery andpayoffs: 6%;

• Supplier’s coffee plantation destroyed by crop dusters as part of local government-led cocaine eradication scheme creating asupply gap: 27%.

Step 4—Calculate Expected Value of Each Risk

After approximating the estimated probability, theexpected value for each risk is calculated, bymultiplying the estimated cost of the risk by thepercent estimated probability of itsoccurrence. For example, if the costs of a reactionto use of child labor are estimated to be $100,000,and the likelihood that this risk would materializeis estimated 10%, then:


27

14.“Perrier,Nestlé, And The Agnellis,” Thunderbird Business School Case Study

15. “Marsh & McLennan to cut 3,000 jobs,” The Business Journal of Milwaukee,November 9, 2004, and “Cherkasky says Marsh maysettle Spitzer's lawsuit within a month:CEO is seeking to fix 40% drop in share price,” The Boston Globe,November 23, 2004.

1. CALCULATE

ISSUE BENEFIT


ALSO REPUTATION



OF EACH RISK


RISK


INSERT TO LINE ITEM




ROI

1. CALCULATE

ISSUE BENEFIT


ALSO REPUTATION



OF EACH RISK


RISK


INSERT TO LINE ITEM




ROI

Child Labor Risk Expected Value = ($100,000) x (10%) = $10,000

28

M A N A G E M E N T

S T R A T E G Y


After steps 1-4 have been completed, the netpresent value (NPV) of each issue is calculated.Note that each issue has risks that emerge atdifferent times.NPV is calculated on the outcome of:

Step 5—Calculate NPV of Each Risk

NPV calculations for social and political risk arecompleted in the same way as traditional NPVcalculations.Therefore, companies can use a tablelike that in Exhibit 9 to input the cost that therisk will incur, and the year that it will occur.Discounting back, using a set discount rate, isdone in the traditional manner. These calculationsare carried out for each identified social andpolitical risk. For the purposes of these exhibits,we assume that project revenues and costs areconverted to cash in each current year.Thefollowing example of a coffee plantation inColombia illustrates this methodology.

Calculating NPV for Social & Political Risk:An Example16

In this example, a corporation already in thecoffee-growing business is developing a coffeeplantation in Colombia. Risks related to thecoffee market, the corporation as a whole, andso on, need not be considered since thecompany is already in that business. The risks

that do need to be considered are thosepertaining to this particular project. Earlier in thisManagement Accounting Guideline (MAG),weidentified a number of typical social and politicalrisks/business decisions that any project wouldface; in Exhibit 9,we include those that couldapply to this project.

For the purposes of the example,we haveselected the business decision on possible use ofchild labor to reduce project costs and thusincrease profitability and/or reduce the productcost to consumers. Since this is an opportunity(rather than a risk), the first step is to quantifythe gross benefit, say $8 million/year, an amountpartially offset by $300,000 in up-front trainingand related costs (year1only).

The second step is to quantify the risks bydetermining the probability of each risk occurring,and its financial impact.This is shown in Part 1 ofthe table in Exhibit 9.The direct net benefit of theopportunity is therefore expected to be:

• Year 1: $8,000,000 – 300,000 – 1,530,000 =$6,170,000

• Year 2: $8,000,000 – 2,880,000 = $5,120,000

• Year 3: $8,000,000 – 5,580,000 = $2,420,000

• Year 4: $8,000,000 – $1,380,000 = $6,620,000

Assuming a 10% discount rate, the Net PresentValue of this opportunity (assuming that thebenefits and costs are incurred in the middle ofeach year) is calculated as (all figures rounded tonearest ‘000):

• $6,170,000 discounted 6 months = $5,876,000




• NPV = $16,951,000

However, this analysis does not yet reflect theimpact on the company’s reputation and resultinglost sales, nor the efforts required to recoupthose losses.Here are some common examplesof elements of reputation risk:

1. Employee relations and attitudes

2. Product quality, reliability, safety

3. Customer relations

4. Presence in foreign markets (i.e. not is it inmarket x but how does it act, how is itperceived?)

1. CALCULATE

ISSUE BENEFIT


ALSO REPUTATION



OF EACH RISK


RISK


INSERT TO LINE ITEM




ROI

16.We thank Robert Torok for this example.

net

PV benefits – PV[(cost1) x (% likelihood1) + [(cost2) x (% likelihood2)...RiskN] = cost of risk

expected value

calculate NPV of issue

5. Supply chain partners and practices

6. Community relations

7. Fiduciary responsibility

8. Behavioral standards, code of ethics, etc.(loosely called business practices)

9. Quality of management

For purposes of the example, the company considerselements 1, 3, 6, and 8 to be relevant.The approachthen follows the same steps as were taken earlier forthe quantitative aspects, that is, estimate theprobability of the impact being felt, its timing, and theresulting costs.The principal differences when dealingwith reputation risk are that second-order effects,including the costs of mitigating the initial loss and alonger period, are involved.

This is shown in Part 2 of the table in Exhibit 9,which calculates reputation risks totaling$2,675,000 in year 1, $5,350,000 in year 2, and soon through year 6.The NPV of these risks can alsobe calculated. Again assuming a 10% discount rateand that all costs are incurred mid-year; the NPVof the risks would be approximately $38.5 million.

In total, therefore, the NPV of the opportunity =$16,951,000 - $38,500,000 = ($21,549,000) - arather poor choice!

Steps 6 and 7—Aggregate NPVs of Social Risk;Aggregate NPVs of Political Risk

Once all NPVs for social and political risks havebeen calculated, the social risk NPVs should beadded together, as should the political riskNPVs.The aggregate social risk NPV and theaggregate political risk NPV should then beinserted as line items in the normal ROI

calculation. Schedules should be provided thatshow the calculations of benefit, expected value,likelihood, and cost of social and political risk, asillustrated in Exhibit 10. It is critical that seniormanagement see both the process and theoutput of doing these calculations.

Schedules A and schedule B in this exhibit listexamples of mock social and political risks.Schedule A lists risks that could emerge for acompany, for instance in the extractive industry,that operates in an unstable region. Although someissues that emerge, such as civil unrest near thesite,would likely not present any benefits, others,such as establishing operations on indigenouslands, can produce short-term savings because oflow land prices. However, costs associated withthese social risks are incurred that include:

• Remuneration for indigenous land;

• Hiring someone to negotiate with protestersor assigning some of current employees’ timeto those negotiations;

• The cost of extra security to protect the site;

• Hiring a community relations manager;

• Executive time spend strategizing on managingNGO relations;

• Work stoppages due to community protests;

• Reputation damage; and

• The potential for litigation fees and fines if theissue goes to court.

Unlike some social risks,most underlying causes ofpolitical risks do not present any savings to acompany. Although entering a country with politicalinstability can bring both benefits and costs, anti-business legislative changes, policy changes orcontract re-negotiation that would be consideredrisks offer a company little or no benefit. Favorablepolicy or legislation changes, however,would not beconsidered political risk as defined here. Schedule Blists various costs the company would incur if therisks mentioned were to materialize. For instance, ifthere is an armed insurrection targeting thecompany site, costs could include:

• Hiring private security to protect executivesand their homes;

• Training personnel in self-defense (defensivedriving, home invasion protection, etc.); and

• Extra training of local police who protect thecompany site on the level of force companystandards allow (where they go beyond locallaws), to protect the company from litigationfor human rights abuses.


29

1. CALCULATE

ISSUE BENEFIT

2. CALCULATE RISK COSTS,

ALSO REPUTATION



OF EACH RISK


RISK


INSERT TO LINE ITEM




ROI

30

M A N A G E M E N T

S T R A T E G Y


Par

t 1—

Dir

ect

Fina

ncia

l / B

usin

ess

Ris

ksR

isk

Prob

abili

ty o

f Risk

#

Pote

ntia

l Risk

Bein

g R

ealiz

ed in

:$

Impa

ct$

Impa

ct in

the Y

ear

if R

isk is

Rea

lized

:Ye

ar 1

Year

2Ye

ar 3

Year

1Ye

ar 2

Year

3Ye

ar 4

(Not

e 4)

1C

hild

ren

are

less

pr

oduc

tive

than

ad

ults

20%

20%

20%

$900

,000

$180

,000

$180

,000

$180

,000

$180

,000

Use

of c

hild

labo

r be

com

es p

ublic

kn

owle

dge

25%

50%

100%

2.1

Valu

e of

m

anag

emen

t tim

e to

deal

with

the

issue

$1,0

00,0

00$2

50,0

00$5

00,0

00$1

,000

,000

$500

,000

2.2

Cos

t of c

omba

ting

dom

estic

lega

l ch

alle

nges

$1,0

00,0

00$2

50,0

00$5

00,0

00$1

,000

,000

$400

,000

2.3

Cos

t of c

onvi

ctio

n un

der

rele

vant

st

atut

es (p

roba

bilit

y of

con

vict

ion

= 30

%)

$10,

000,

000

$750

,000

$1,5

00,0

00$3

,000

,000

$02.

4A

dditi

onal

site

sec

urity

$400

,000

$100

,000

$200

,000

$400

,000

$300

,000

Tota

l Dir

ect

Ris

k C

osts

:$1

,530

,000

$2,8

80,0

00$5

,580

,000

$1,3

80,0

00

Par

t 2—

Rep

utat

ion

Ris

ksR

isk

Prob

abili

ty o

f Risk

#

Pote

ntia

l Risk

Bein

g R

ealiz

ed in

:$

Impa

ct$

Impa

ct in

the Y

ear

if R

isk is

Rea

lized

:Ye

ar 1

Year

2Ye

ar 3

Year

1Ye

ar 2

Year

3Ye

ar 4

Year

5Ye

ar 6

Use

of c

hild

labo

r be

com

es p

ublic

kn

owle

dge

25%

50%

100%

3.1

Cos

t of r

educ

tion

in e

mpl

oyee

mor

ale

& p

rodu

ctiv

ity;

Exh

ibit

9:E

xam

ple

of N

PV

Cal

cula

tion

for

Chi

ld L

abor

Ris

k


31

grea

ter

turn

over

,re

crui

ting

chal

leng

es$3

,000

,000

$750

,000

$1,5

00,0

00$3

,000

,000

$1,0

00,0

00$5

00,0

00$0

3.2

Loss

of m

argi

n du

e to

wea

ker

cust

omer

loya

lty

lead

ing

to

redu

ced

sale

s$6

,000

,000

$1,5

00,0

00$3

,000

,000

$6,0

00,0

00$5

,000

,000

$3,0

00,0

00$1

,000

,000

3.3

Loss

of m

argi

n du

e to

poo

rer

com

mun

ity im

age

lead

ing

to

redu

ced

sale

s$4

,000

,000

$300

,000

$600

,000

$1,2

00,0

00$8

00,0

00$4

,000

,000

$03.

4In

crea

sed

cost

du

e to

pre

ssur

e to

st

reng

then

cod

esof

con

duct

/beh

avio

r$5

00,0

00$1

25,0

00$2

50,0

00$5

00,0

00$1

00,0

00$0

$0To

tal 1

st O

rder

R

eput

atio

n R

isk

Cos

ts:

$2,6

75,0

00$5

,350

,000

$10,

700,

000

$6,9

00,0

00$7

,500

,000

$1,0

00,0

00

4.1

Cos

t of i

ncre

ased

ad

vert

ising

to d

rive

sale

s to

pre

viou

s le

vels

(see

Not

e 3)

$3,5

00,0

00$2

,500

,000

$1,0

00,0

00$5

00,0

004.

2Lo

st m

argi

n du

e to

lo

wer

pri

ces

to d

rive

sa

les

to p

revi

ous

leve

ls (s

ee N

ote

3)$4

,200

,000

$3,1

00,0

00$1

,800

,000

$500

,000

Add

itio

nal 2

nd

Ord

er R

eput

atio

n R

isk

Cos

ts:

$7,7

00,0

00$5

,600

,000

$2,8

00,0

00$1

,000

,000

Tota

l Rep

utat

ion

Ris

k C

osts

:$2

,675

,000

$5,3

50,0

00$1

8,40

0,00

0$1

2,50

0,00

0$1

0,30

0,00

0 $2

,000

,000

NP

V$3

8,48

9,10

9$2

,547

,619

$4,6

32,0

35$1

4,48

2,48

7$8

,944

,224

$6,7

00,0

37$1

,182

,707

NO

TES

:1)

If th

e kn

owle

dge

beco

mes

pub

lic in

yea

r 1,

one-

time

cost

s ar

e re

aliz

ed th

en,b

ut n

ot th

erea

fter.

For

simpl

icity

,thi

s sit

uatio

n is

not s

how

n.2)

In th

is sit

uatio

n,th

e pr

obab

ility

incr

ease

s fr

om y

ear

1 to

yea

r 2.

But i

f the

kno

wle

dge

beco

mes

pub

lic in

yea

r 1,

then

the

year

2 p

roba

bilit

y be

com

es 1

00%

;how

ever

,to

simpl

ify th

e ex

ampl

e,th

is sit

uatio

n is

not s

how

n.3)

To k

eep

the

exam

ple

even

mor

e sim

ple,

it w

ill b

e as

sum

ed th

at th

ese

cost

s ar

e in

curr

ed s

tart

ing

in y

ear

3 an

d co

ntin

ue a

t low

er r

ates

thro

ugh

year

6,a

fter

whi

ch th

ey s

top.

The

lost

sal

es o

rm

argi

ns b

egin

to r

ecov

er b

ut ta

ke th

roug

h ye

ar 6

to fu

lly r

etur

n to

pre

viou

s le

vels.

4) S

ome

cost

s w

ill ‘w

ither

aw

ay’ i

n ye

ars

4 an

d on

as

the

issue

fade

s fr

om th

e pu

blic

eye

;one

can

ass

ume

zero

afte

r ye

ar 4

.

32

M A N A G E M E N T

S T R A T E G Y


If the company overseas faces endemiccorruption, costs associated with this risk could include:

• Dollars (or equivalent) paid directly in bribes,or other methods of payment to facilitatetransactions;

• Legal fees and fines if found guilty of briberypractices in a lawsuit filed under the ForeignCorrupt Practices Act or similar legislation;and

• Reputation damage sustained by the company for being associated with a corrupt regime.

Reputation costs have been included as aseparate line item in each schedule becausethey represent a large component of social and political risk. In addition to how reputation costs were treated in the previousreputation risk section, they can be listed as lost sales and profits.

Step 8—Calculate Expected Value of ROI

Once Schedules A and B have been calculated,their results can be integrated into traditionalROI calculations, as illustrated in Exhibit 10.

Integrating political and social risks into ROIcalculations enables managers to betterunderstand (a) the full range of risks theiroperations face, and (b) their costs. Although theoutput of the analysis is useful, the analyzing processitself also provides the opportunity to strategizefor risk management—either to develop ways toavoid the risk, or to create risk mitigation plans.

III. MANAGE & MONITORPOLITICAL AND SOCIAL RISK

• RESPONDING TO RISK: INSURANCE,AVOIDANCE,MITIGATION

Taking these steps to identify social and politicalrisks and to measure their potential costs beginsa process of integrated risk management that (a)allows for a new understanding of the full scopeof operating risks, and (b) provides thegroundwork for managing these risks. Unlikefinancial risk,which can usually be shared ortransferred, this is often not possible with socialand political risks in an environment where firmsare often held liable for their suppliers’misdemeanors, either in the court of law orpublic opinion. In the early 1990s,when Nike’sglobal labor practices were being criticized,protesters did not typically differentiatebetween the company’s 20,000 employees andthe half million indirect contractors working in565 contract factories in 46 countries, aboutwhose working conditions they were protesting.Photos of children in Pakistan sewing soccerballs in dismal conditions peppered the news, asdid stories of paying women 14 cents per hourto sew shoes in Indonesia, and workers’exposure to toxic chemicals in Vietnam.Nike didnot have the option to buy risk insurance tomitigate the losses incurred from these anti-Nike campaigns. Nor could the companydistance itself from the subcontractors who ranthe contract factories and set the rules—thishad been Nike’s initial response, but it failed tostem the tide of criticism.

Managing political, social, and reputation riskincludes devising policies and programs to

1. CALCULATE

ISSUE BENEFIT

2. CALCULATE RISK COSTS,

ALSO REPUTATION



OF EACH RISK


RISK


INSERT TO LINE ITEM




ROI


Manage & Monitor Risk C


Communicate RisksD


The Role of Senior Managemen t

Risk Identification


A

B


33

EXHIBIT 10: Integrating Social and Political Risk Costs in ROI Calculations

1

2

3

CALCULATE THE MONETARY BENEFITS OFTHE PROJECT

CALCULATE THE TOTAL COSTS OFTHE PROJECT

CALCULATE THE PROJECT ROI

OUTPUT REVENUES NPV

New product Added revenue stream $.....................................

Labor cost savings $.....................................

New customer base $.....................................

Total Benefits $....................................

COSTS NPV

Shipping Transport rates, import duty,transporting goods from port to factory $.....................................

Raw materials $.....................................

Labor $.....................................

Total Social Risk costs See schedule A $.....................................

Total Political Risk costs See schedule B $.....................................

Total Costs $.....................................

Total Benefits —Total Costs

ROI = ---------------------------------------- * 100

Capital Costs (Investment)

34

M A N A G E M E N T

S T R A T E G Y


Risk Benefit Cost types Costs Likelihood Expected Value

Civil unrest surrounding site

$......... � Costs of engaging employees skilled in negotiating with protesters � Cost of engaging extra

security personnel Reputation-Related: � Cost of hiring community

relations manager � Cost of managing activist

NGO relations

$.........

$.........

$.........

$.........

$.........

$.........

......... % $...................

Prostitution near site

$......... � Costs of implementing health education for workers to teach about sexually transmitted diseases (to avoid costs related to HIV infection)

$......... $......... $......... $.........

......... % $...................

Child Labor $......... Reputation Related: � Costs of reputation damage � Cost of managing boycotts

when information reaches activist consumers � Cost of NGO-relations

manager

$......... $......... $......... $......... $.........

......... % $...................

Infringement of indigenous lands

$......... � Costs if litigation in international courts � Cost of remunerating

population � Cost of work stoppages due

to local strike, reputation damage, community protests, work stoppages

Reputation-Related: � Cost of hiring community

relations manager

� Cost of managing activist NGO relations

$......... $......... $......... $......... $......... $......... $......... $......... $......... $......... $.........

......... % $...................

Reputation Costs, including lost sales and profits $...................

NPV $..................

SCHEDULE A

COSTS OF SOCIAL RISKS


35

Risk Benefit Cost types Costs Likelihood Expected Value

Changes in legislation that change the rules of the game

$......... � Lost revenues

� Increased taxes and tariffs $......... $......... $.........

......... % ......... %

Forced contract renegotiation with host government

$......... � Lost profits � Lost investment

$......... $......... $.........

......... % ......... %

Armed Insurrection

$......... � Cost of hiring private security

� Cost of training local

police/military to prevent

human rights abuses (if

required to use these forces by contract)

$......... $......... $.........

......... % $...................

Associated Reputation Risk � Cost of incentive packages to

attract workers to location

� Cost of protests, etc. due to

potential linkages with

human rights abuses

$......... $......... $.........

......... % $...................

Endemic corruption

$......... � Costs of payoffs and bribes � Costs of potential lawsuits

for that activity

� Cost of lost contracts for

refusing to engage in that

activity

$......... $......... $.........

......... % $...................

Targeted criminal activity

$......... � Costs of protecting personnel, including extra security, reinforcing security at private

homes, providing security

training to employees and

families

� Costs of attracting workers, including increased pay, time off and hardship bonuses

� Costs of increased security to

protect facility

� Costs of potential work

stoppages

$......... $......... $.........

......... % $...................

Terrorism $......... � Costs of reinforcing infrastructure � Cost of hiring additional

security personnel � Cost of rebuilding

$......... $......... $.........

......... % $...................

Reputation Costs, including lost sales and profits $................... NPV $...................

SCHEDULE B

COSTS OF POLITICAL R ISKS

36

M A N A G E M E N T

S T R A T E G Y


identify,measure,monitor, respond to, and reporton risk, as well as formulating methods to avoidor mitigate identified risk. As outlined in theidentification section, risk identification occursthrough internal analysis, evaluation ofinformation from risk firms, and stakeholderanalysis. Effective management calls both formonitoring of political and social risks, andcommunication to management of changes intheir levels.Monitoring does not have to beexhaustive—it can involve selecting certainindicators, such as advertising campaigns aboutchild labor, for observation.

Responding to social and political risk canhappen in four ways:

• Insuring against risk when possible;

• Avoiding risk;

• Mitigating risk; or

• Some combination of these.

◆◆ Political risk insurance

Both public sector bodies and private firms offerpolitical risk insurance, in use since the 1970s.Public sector insurers such as the World Bankand government-backed plans seem to haveproven a useful deterrent to host governmentsinterfering with investments—the World Bank’sMultilateral Investment Guarantee Agency(MIGA) has paid out a political risk claim onlythree times in its eighteen year history.17 This low rate of payout is due to a number of factors:

• MIGA does significant due diligence oninsurable projects and the politicalenvironment before offering a guarantee.Presumably, it has identified and mitigated

many potential risks before underwriting;

• Countries are members of MIGA, and theorganization always requests governmentapproval before issuing a guarantee for aproject in their country. Presumably, thegovernment’s approval indicates that it isfundamentally happy that the investment ismeeting some part of its development agenda,hence making the investment “safer” fromadverse government attention in the future;

• MIGA has some influence with governments,by virtue of its membership in the WorldBank Group, and so is able to work withclients and governments if a potential claimssituation emerges, to try to reach an amicablesolution for all parties, to avoid a claim.

Political risk insurance plans usually insureagainst: (a) confiscation, expropriation ornaturalization; (b) currency inconvertibility;(c) property destruction; (d) businessinterruption and other disruptions associatedwith war, terrorism, and other civil disturbances;(e) contract frustration. Likewise, ExportDevelopment Canada (EDC), a crowncorporation of the Canadian government andthe Overseas Private Investment Corporation(OPIC), a U.S. government agency, offer politicalrisk insurance to Canadian and Americancompanies, respectively. Private firms like Marsh& McLennan and Aon also offer protections forpotential losses due to expropriation, currencyinconvertibility, and war. Exhibit 11 illustrates therisks covered by Aon political risk insurance.

Political risk insurance is, however, of limited use.Sometimes the market cannot or will not coverthe investment because it is simply too large, asin the case of some major infrastructure

Exhibit 11: Risks Covered by Aon Political Risk Insurance18

17. Judith Pearce, Lead Operations Officer,MIGA.Discussion with author, April 2006.

18.Aon political risk insurance for investment. <http://www.aon.com <accessed January 2006>

• Confiscation, expropriation / nationalization of holdings / fixed or current assets, including "creeping expropriation" and selective discrimination;

• Cancellation, suspension or withdrawal of concession permits, exploration licenses or operating licenses;

• Deprivation of rights to own and use an asset, including cancellation of re-export licenses;• Deprivation of collateral held as security for loans;• Forced abandonment or forced divestiture;• War, terrorism, sabotage and other forms of political violence;• Foreign exchange restrictions;• Breach of government undertakings on which the investment was predicated.

projects. Even when coverage can be obtained,however, it is usually limited to risks that are“quantifiable and provable,” and presumablyinsurers have a way to limit claims so defined.

◆◆ Avoid Political & Social Risk

Another method of dealing with political andsocial risk is to avoid it, either by making pre-emptive risk mitigation plans, or by deciding notto undertake a project whose risk-return ratiois too low.When Shell and Mobil Oil wereconsidering a liquefied natural gas concession inPeru’s Lower Urubamba Valley, one of theworld’s most biologically diverse regions, theyengaged in extensive discussions with thegovernment, local indigenous tribes, localenvironmental groups, and internationaladvisors. As a result, the companies developedplans adapted to local conditions, butnonetheless decided to withdraw because ofcombined local and international opposition tothe project and disputes with the government.19

◆◆ Mitigate Social & Political Risk

Another option is mitigation. In this alternative tomanaging social and political risk, creative solutionsare devised to lessen the cost of a risk’s impactand/or to diminish the likelihood of the riskemerging. While designing solutions to diminishrisk, it is useful to refer back to the potentialsources of risk outlined in Exhibit 7. Understandingthese sources and what motivates them will allowmanagers to devise targeted solutions.

For example, a firm with operations in South Africais faced with a growing number of employees whoare becoming symptomatic and dying of AIDS.Thecompany has decided that the prospect of moving itsoperations to another location is unattractive forbusiness reasons. It is therefore forced to bear alarge overhead cost due to absenteeism, highturnover, and the need to consistently train newskilled personnel for jobs left open because of AIDS-related deaths. In the long-term, the companyprojects that this problem will only get worse—asthe AIDS-related mortality rate in South Africa growsexponentially, the company assumes that the rateswithin the company will too. Understanding that therisk is a social one, generated by lack of awareness,education, and perhaps social stigma associated with the illness,may allow the company to deviselocation-specific solutions to address the risk.

When strategizing how to mitigate the risk fromHIV/AIDS, a business can consider a variety ofalternatives.One option is to do nothing, leavingthe risk unmitigated. Another is to try to mitigatethe risk once it has materialized, by establishing avariety of programs such as workplace education,condom distribution at work sites, voluntary HIVtesting at facilities, and medical treatment forworkers and families. A firm contemplatingentering the South African market could alsoentertain a third choice, pre-emptive mitigation. Inthis case, the company would undertake risk-reducing programs mentioned previously as partof the market entry strategy, instead of waiting forthe risk to emerge and affect its business.

Exhibit 12 illustrates these three approaches, firstone that calculates the estimated value of theproject with no mitigation (the base case), thenpre-emptive mitigation, and finally mitigation whenthe risk has materialized:

• No risk mitigation:This base case optionanalyzes the impact of not taking any action toaddress or mitigate risk. Calculations includethe operation’s value and the impact of risk onthe operation:

• Pre-emptive mitigation: This option analyzesthe impact on the operation if the risk were tobe mitigated before it emerges. Calculationsinclude: the operation’s value, the expected costof implementing mitigation programs, projectedlong-term savings from those mitigationprograms, and any reputation value theyproduce. Note that some risk still exists, evenwith pre-emptive mitigation, but this will likelyresult in a lower cost than if no mitigation wereundertaken, because programs are commencedbefore the risk emerges.This does not implythat there will be zero risk-related cost; ratherthat both the likelihood of risk emergence andthe associated cost will likely be lower:


37

19. James Grimaldi.“Texas Firms Line Up U.S.Aid in Peru:Gas Project's Damage to Rain Forest Assailed,” WashingtonPost.November 20, 2002.

Operation Value Unmitigated Risk =

(Operation Value) + / – [(Political/Social Riskcosts) x (%likelihood)]

Operation Value Preemptively Mitigated Risk =

(Operation Value) + / – [(Lowered Political/SocialRisk costs) x (lowered % likelihood)]– [Mitigation Program (Savings – Costs)] + (NetChange in Reputation Value)

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M E A S U R E M E N TEXHIBIT 12: Calculating Mitigation Strategies for Social and Political Risk

A

B

C

UNMITIGATED RISK FOR ONGOING OPERATION

PRE-EMPTIVE RISK MITIGATION FOR ONGOING ORNEW OPERATIONS

MITIGATED RISK FOR ONGOING OPERATION

Project Value $...........................

RISK COSTS LIKELIHOOD (-) EXPECTED COST

HIV increasing among • Cost to replace personnel ......... % $...................

personnel resulting in employee • Cost to re-train personnel $...................

illness and death • Personnel turnover $...................

inefficiencies $...................

Reputation Value (-) $...................

Risk Reduced Total Operation Value $...................

Project Value $...........................

LOWERED RISK COSTS LIKELIHOOD (-) EXPECTED COST





MITIGATION PROGRAMS COSTS (+) SAVINGS (=) EXPECTED VALUE• condom distribution at $......... $.........

work sites

• HIV testing at facilities $......... $.........

• medical treatment for

workers & families $......... $........... $...................

Mitigation-Gained Reputation Value (+/-) $...................

Mitigated Risk Operation Value $....................

Project Value $...........................

RISK COSTS LIKELIHOOD (-) EXPECTED COST





MITIGATION PROGRAMS (-) COSTS (+) LT SAVINGS (-) EXPECTED VALUE

• condom distribution at $......... $......... $...................

work sites

• HIV testing at facilities $......... $.........

• medical treatment for

workers & families $......... $...........

• Move families together so

men not separated $......... $.........

Mitigation-Gained Reputation Value (+/-) $...................

Preemptive Mitigation Operation Value $....................


39

Changes in the likelihood and the costsassociated with the risk can occur duringmitigation, requiring additional calculation.

• Mitigating risk when it has materialized:This option analyzes the impact on theoperation if a mitigation strategy is undertakenafter the risk has presented itself and had animpact. Calculations include the operation’svalue, the impact of risk on the operation, thecost of undertaking one, several or all of themitigation programs, and the long-term savingsthese would generate. Another impact thatshould be included is any positive impact onreputation from a mitigation strategy:

These also can create changes in costs andlikelihood, again requiring further calculation.Theresults of these calculations can then be comparedfor cost efficiency on a net present value basis.Pre-emptive mitigation strategies, often the sameactions as post-emergence mitigation activities,willfrequently lower the likelihoods and costs beyondthose that could be realized from undertakingmitigation after a risk has emerged. Exhibit 12illustrates these three approaches.

Day-to-Day Operations versus CapitalInvestment Planning

In addition to the process outlined in Exhibit 12for ongoing operations, considering the threeoptions can be helpful when evaluating capitalinvestment decisions and comparing variouspossible locations. In these cases, it is useful togather risk data on all of the most likelyoperational locations, and determine the likelihoodthat risks will emerge for each.Doing this allowsmanagers to compare various locations,understand the most relevant and dangerous risksin each location, and include them in decision-making to determine the best alternative. Inaddition, by thinking through the costs of the risksand generating pre-emptive mitigation strategies,decision-makers can determine whether it is intheir best interest to wait for the risk to emerge,or to incorporate programs into the projectdesign that would mitigate risk at the outset.

IV. COMMUNICATING SOCIAL ANDPOLITICAL RISK

REPORTING AND DECISION-MAKING

Successful corporate management of social andpolitical risks is predicated on integrating suchrisks into management systems, and on effectivecommunication both within the firm and withexternal stakeholders. Employees at all levels mustbe apprised of senior management’s commitment,for better inclusion of social and political risk intodecision-making. In addition,management shouldcommunicate (a) information about the company’sapproach to risk, (b) how it defines social andpolitical risk, (c) the potential consequences ofrisks if they are left unmitigated, and (d) means ofreporting on potential hazards. Internalcommunication can be undertaken duringtrainings, via the company’s intranet, in companymanuals, and through focused bulletins.

It is also critical to establish appropriate companyand project internal reporting mechanisms foremployees to report on risk. An internalreporting system is particularly useful forcollecting data on risk in the “identification” stageoutlined in this paper.However, to avoid relying onemployees to contribute risk-related information,specific risk management personnel should beidentified to be alert for risks, so as not to side-line the risk issue. Personnel can either be hiredspecifically for a risk management function, orcross-functional teams can undertake the work,staffed with individuals from various departmentstasked with this responsibility.

As outlined in Epstein and Rejc (Reporting ofOrganizational Risks, 2005), organizations are


Manage & Monitor Risk C


Communicate Risks D



Risk Identification


A

B

Operation Value Post-Materialized Mitigated Risk =

(Operation Value) + / – [(lowered Political/SocialRisk costs) x (lowered % likelihood)]– [Mitigation Program (Savings – Costs)] + (NetChange in Reputation Value)

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recognizing the need for broader internal andexternal risk reporting—for enlightened internaldecisions and for improved analysis and betterdecisions of external stakeholders.However,standardized general templates for broad riskreporting do not exist.

Reporting social and political risks in monetaryterms is, however, an important part ofintegrating these issues into financial planning. Inso doing, these risks climb from their currentposition as a mere footnote to the financialcalculation, to a position that accurately reflectsthe devastating impact they can have.Transforming the discussion of political andsocial risks from a largely qualitative to aquantitative one emphasizes their relevance.Although quantifying social and political risks isoften imprecise, it is the first step to integrating awider set of risks into calculations that will moreaccurately reflect the true nature of risk in anincreasingly interconnected world.

Internal Reporting

Internal reporting on social and political risks iscritical to sound decision-making and riskmanagement. Boards of directors, riskmanagement committees, and senior managersneed timely information about the effectivenessof internal controls, as well as risks, includingsocial and political ones.

• Boards of directors have responsibility foroverseeing the development andimplementation of the company’s mission,values, and strategy.This includes carefulreview of processes of risk identification,monitoring, and management (Epstein andRoy, 2002).

• Risk management committees’ oversightrequires a substantive understanding ofcorporate risks and internal controls.Theirduty is to review and evaluate theeffectiveness of the company’s process forassessing risks, and the steps thatmanagement is taking to monitor and controlthose risks. Doing so requires the committeeto receive, review, and consider both broadrisk reports as well as issue- or project-specific ones (Epstein and Roy, 2002).

• Senior management’s need for informationregarding organizational risks is of particularimportance. Senior management needsrelevant, accurate, and reliable real-time riskreports for effective decision-making andcontrol.Without proper internal reporting on

organizational risks—strategic andoperational ones, in particular—senior andother managers cannot make the beststrategic and tactical decisions.Only bygenerating both a broad understanding andanalysis, supported by targeted, specific anddetailed schedules of risk-related information,can organizations inform senior managers andother decision-makers with facts, notintuition. They can then appropriatelyintegrate those risks into more effectivemanagement decisions that advance theorganization’s strategy and goals.

• Employees want safe and secure workingconditions, as well as corporate financialstability, and are interested in what mayjeopardize both. In addition, as members ofthe community-at-large, they are ofteninterested in the company’s impact beyondthe workplace.

Reporting on social and political risks should beintegrated with communication on other risks,including the compliance, reporting, strategic,and operational risks outlined in Exhibit 1.Particularly when reporting is aimed at (a) riskmanagers, (b) the risk management committee,(c) the CFO, and (d) if the results are seriousenough, the CEO and the board, discussion ofsocial and political risk should include:

• An outline of current risks faced by the firm,the projected likelihood of occurrence andtheir potential costs;

• The source of these risks; and

• Mitigation strategies, their potential costs,and the management plan if that strategy is undertaken.

However, internal risk reporting that leads todysfunctional behavior of different internalaudiences, such as a reduction in appropriate risk-taking of managers that is necessary for businesssuccess, can impose costs on the organization.

External Reporting

Increasingly, shareholders and other stakeholdersare aware that disclosing only current financialrisks—market and credit risks—does notprovide sufficient information aboutorganizational and financial performance, becausethese are also affected by other risks, includingsocial and political ones. Although externalreporting is not mandatory, some parties thatmay be interested in a deeper knowledge of acompany’s risks include: auditors, regulators,

shareholders, creditors, financial analysts,customers, suppliers, consumers, and the media.After identifying, assessing, and possibly respondingto social and political risks, companies must decidewhether they should be reported externally and, ifso, to whom and at what level of detail. Reportcontent will vary with the user.

When contemplating external risk reporting,however, potential costs must be weighed.Voluntary disclosures should therefore be subjectto careful cost-benefit analysis. The primarypotential costs of external risk reporting arebelieved to be: (a) competitive disadvantage frominformative disclosure, (b) bargaining disadvantagefrom the disclosure to suppliers, customers, andemployees, and (c) unmerited lawsuits attributableto disclosures.The greater the level of detail abouta specific risk, the greater the likelihood ofcompetitive disadvantage. Thus, some enterprisesmay wish to undertake a cost-benefit analysisregarding how much information on social andpolitical risk to report externally. The timing of adisclosure also affects its potential for competitivedisadvantage, because at some stage disclosureloses its capacity to create competitive advantage.(Epstein and Rejc, 2005). In their ManagementAccounting Guideline, The Reporting ofOrganizational Risks for Internal and ExternalDecision-Making,Epstein and Rejc outline a method for a cost-benefit analysis for reporting,as well as modes of data presentation, so that risks can receive proper consideration while notcausing undue alarm.

THE ROLE OF SENIOR MANAGERS

Senior financial managers play a critical role inmeasuring,managing, and reporting social andpolitical risks. In addition to signaling theimportance of the issue to all levels of thecompany, senior management, boards of directors(and audit committees), and various otherfinancial stakeholders need the informationgenerated by quantified social and political riskanalysis to better understand and manage therisks facing the company.

Inclusion of social and political risks plays a criticalrole in due diligence regarding both internal andexternal decisions.Understanding the potentialthreats from political and social issues in ongoingoperations can mean the difference between being pre-emptive and resilient when faced withcatastrophe, or being caught unaware,with

potentially tremendous negative effect onrevenues or costs. Likewise, appreciating thatsocial and political risk may materialize, andunderstanding the resulting hidden costs to thecompany is critical in due diligence for majorinvestment decisions.When undertakingacquisitions and mergers, these risks are also afactor that should not be ignored.

That said, a financial professional must provide acomplete and fair presentation of organizationalrisks without being seen as alarmist, and therebycausing a reduction in appropriate risk-takingthat is necessary for business success. To thisend, integrating social and political risk intofinancial calculations allows for comparison withother risks, putting them in a context so thatthey can be understood along with otherchallenges.Measuring a project’s attractivenessby including social and political risks into itseconomics is not the intended end point of themethodology outlined in this MAG.Rather,measurement is only one important componentin a project review that must include dialogueabout the levels of risk and the likelihood of itsemergence. The project analysis must beshaped to provide background and generatediscussion on ways to manage risks, as well asalternatives that could shift the trade-offbetween risk and return.

CONCLUSION

In an increasingly globalized world, integratingsocial and political risks is critical to effectivemanagement of a company’s real risks, and toimproved resource allocation. This demands thequantification of social and political risks in anatypical manner. To account for these risks, theymust be identified,measured,monetized, andincluded in ROI calculations. Social and politicalrisks that can devastate a company’s operationscan be adequately accounted for, rather than beingrelegated to a footnote to financial calculations inthe hopes that the risks will not emerge.Measurement of social and political risks alsoenables decision-makers to devise mitigationstrategies, sometimes pre-emptively, that canproduce significant cost savings. This ManagementAccounting Guideline provides a method toinclude social and political risks in financialcalculations, and to integrate them into overall riskmanagement for improved decision-making.


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APPENDIX 1: REAL ANDPERCEIVED RISK

Factoring in the stakeholder perspective allowssocial and political risks that companies face tobe separated into real and perceived risks.Stakeholder reactions to an issue can transformtheir perceptions of a company’s involvementwith a matter of concern (perceived risk) into areal risk for the company, and increasing acompany’s costs. Real risk includes all social andpolitical issues that (a) result from businessactivities, and (b) external actions (likenationalization of industries) imposed on thecompany that affect its business. Perceived riskincludes all issues that stakeholders, includingconsumers, employees, and communities hold acompany responsible for,whether or notevidence supports the perception.

It is important to identify real and perceivedrisks, and their sources, to better manage them.Both real and perceived risks carry financialcosts to the company and can cause significantreputation risk. Real and perceived risk can becombined in three ways:

• Real and perceived: risks created by acompany’s actions that lead to a reactionfrom affected constituent, or risks generatedby a social or political issue that directlyaffects a company’s profits.

• Real and not yet perceived: risks createdby a company’s actions that affect someconstituents, but who are not yet aware of itand therefore have not yet reacted. Some ofthese may not be perceived by the companyor society at large for some time. In theshort-term the risk is real, but may have noimmediate effect or cost.Once stakeholderperceptions change, however, either throughgreater information or shifting sensitivities,the risk to society manifests, and the reactionto it can lead to significant costs for thecompany. Sometimes the stakeholdersidentify the risk before the company does,and the company is taken by surprise,withvery negative consequences.Coca-Colaworked in Kerala, India for years. Its water usewas not recognized as an issue by thecompany, by its stakeholders, or by the publicat large. Then, in the mid-1990s,members offifty villages surrounding Coca Cola’s bottlingplant claimed that the company was siphoningoff drinking water and depositing waste withhigh cadmium and nickel content in thesurrounding areas. Soon international

activists joined in. Although the outcome ofthe legal battle was settled in Coca Cola’sfavor, information about the issue has spreadquickly to both North America and Europe,sparking anti-Coke protests. As a result ofthe ongoing lawsuits, trouble with the localcommunity, and worldwide protests,Coca-Cola weighed the revenues produced bydoing business in Kerala against the cost to itsreputation worldwide, and decided the priceit was paying was too high. As a result itdecided to leave Kerala.Coke’s experience illustrates that in an age of24-hour news, the Internet, and textmessaging, information can spread across theglobe,mobilizing people and leading tonegative impacts on reputation. Activiststoday can use the Internet to spreadinformation,whether it is factual or not,within seconds.Twenty years ago, informationwas passed by mail or by telephone from oneperson to another person. Today, activists’global reach and connection to one anotheracross vast distances, coupled with high publictrust in the non-governmental organization(NGO) sector,make it much easier foractivists to attack companies and put them onthe defensive. This makes it more difficult forcompanies to deal with and react to risksituations, particularly ones generated byperception. Some risks, like Coca-Cola’swater use in India, are, in the short-term, notrisks at all, because they are not presentlynoticeable to stakeholders. However, theseissues have the potential for long-termdamage to reputation when the riskmaterializes or perceptions change.

• Perceived and not real: the company isperceived, because of its business practices,location, reputation, or targeting by activists,to have caused damage or created a risk tosociety, even though it has not.The companyis held to account because variousstakeholders react through, for example,customer boycotts, strikes by workers, etc.These reactions in turn create a risk and acost to the company. Shell’s 1995 Brent Sparexperience is a case in point.The companydecided to dispose of its decommissioned oilplatform by sinking it in the North Atlantic. Inresponse,Greenpeace activists carried outintensive campaigning in Northern Europe,claiming that Shell was being environmentallyirresponsible, and that sinking the Brent Sparwould dump 5500 tons of oil in the sea,wreaking havoc with the environment. In

addition, 25 activists occupied the platform andthe organization encouraged boycotts of Shellstations that resulted in some violent attacksand threats to Shell workers. In the face offalling sales and a drop in share price, thecompany commissioned a third party toinvestigate Greenpeace’s allegations,whichwere later acknowledged to be inaccurate,leading to an apology by the activists to Shell.Shell suffered substantial losses from the BrentSpar incident, because of lost sales, reputationdamage, time by management dedicated tomanaging the incident, other internal companyresources applied to the issue, and the cost ofthe diversion from ongoing operations.Reputation risk is further discussed in a latersection.The costs resulting from the Brent Sparincident occurred as a result of perceived risksto the community, rather than actual ones. It isimportant that companies effectively manageboth the perception that their activities pose arisk to society, and any actual or real risks theiroperations may create. Both of these cancreate costs for the company.

Company-generated risk to society, or society’sperception that a company is causing a negativeimpact, can create a feedback loop. In such afeedback loop, illustrated in Exhibit Appendix 1, the

company’s activities create a risk to society [1] (orsociety believes that business operations are havinga negative impact);members of society, thecompany’s stakeholders, become aware of this riskthrough various means including the Internet [2];these stakeholders react to the identified risk byprotests, strikes, boycotts, adverse legal verdicts, orfines [3]; and these stakeholder reactions create realrisks to the company’s ability to do business [4].

Risk generated from perception, here calledperceived risk, can represent an equal or greaterthreat to the company than risk generated by realsocial and political issues, since the consequencescan be as dire and the costs as high. Althoughliability for real risk may be expressed throughfines and the cost for tasks like environmentalcleanup, accountability for perceived risk can beexpressed through lawsuits and boycotts, both ofwhich have real costs.

Differentiating between real and perceived risks is,therefore, critical to identifying potential hazards,thinking through their prospective impacts, anddesigning mitigation techniques. A managerweighing the consequences of the various optionsmust factor public opinion, even if it is based onerroneous information, into decisions about thebest course of action.The potential costs of bothreal and perceived risks are very high.


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Exhibit Appendix 1: The Real and Perceived Risk Feedback Loop

RIS

K P

ER

CE

IVE

D

Stakeholder Reaction

REAL

RISK

REAL

RISK

REAL

RISK

REAL

RISK

REAL

RISK

COMPANY

GENERATED

RISK

Internet

SOCIETY COMPANY

ACTIVISTS

WORKERS

SUPPLIERS

CONSUMERS

Internet

PROTEST

STRIKE

BOYCOTT

COURTS VERDICT

REGULATOR FINE

Stakeholders

Convergence of Real & Perceived

1

2

3 4

46

M A N A G E M E N T

S T R A T E G Y


CONSULTING FIRM SCOPE SERVICES OFFERED PRODUCT

Control Global • Political and security • Impact-likelihood matrix toRisks Group risk analysis measure 8 aspects of risk

• Security consultancy • 120 Country Risk Forecast:• Crisis management and response analysis of political, security• On-line risk assessment service and travel risks, ranked• Country Risk Forecast extreme, high,medium,

measuring the impact of low or insignificant political and security developments on businesses and business activities

The Economist Global • Country analysis • ReportsIntelligence Unit • Forecasts • Market Indicators and

• Risk assessment forecasts• Economic and market data• Industry trends

Eurasia Group Asia, Latin • Country analysis • Political stability index,America, • Forecasts produced with Deutsche Europe, • Risk assessment BankEurasia, • Economic and market data • PublicationsMiddle East, • Trends in global energy, • ConsultingAfrica homeland security, bio-security

Kissinger Global • High-level intervention regarding • Strategic advisory servicesMcLarty special projects, assist clients to • Advocacy servicesAssociates identify strategic partners and

investment opportunities, and advise clients on government relations

Political Risk Global • International Country Risk Guide • Assess 12 components ofServices Country provides assessments of political, political risk (military in Forecasts economic, and financial risk based politics, democratic

on analysis of worldwide experts, accountability, internal conflict,subject to a peer review process government stability,

bureaucratic quality,investment profile, law and order, corruption etc.),

• 5 components of economic risk

APPENDIX 2: POLITICAL RISKCONSULTING FIRMS AND THEIR OFFERINGS20

20. Adapted from:Campbell, A and David Carmet.“The Private Sector and Conflict Prevention Mainstreaming:Risk Analysis and Conflict Impact Assessment Tools for Multinational Corporations.” Carleton University,May 2002.

THE AUTHORS:

Marc J. Epstein is Distinguished Research Professorof Management at Jones Graduate School ofManagement at Rice University in Houston,Texas.He recently was Visiting Professor and WyssVisiting Scholar at Harvard Business School. Priorto joining Rice,Dr. Epstein was a professor atStanford Business School,Harvard Business School,and INSEAD (European Institute of BusinessAdministration).Dr. Epstein has written previousMAGS for the AICPA and CMA Canada includingco-authoring “Applying the Balanced Scorecard”and “Measuring and Improving the Performance ofCorporate Boards Using the Balanced Scorecard”,“Evaluating Performance in InformationTechnology” and “Identifying,Measuring, andManaging Organizational Risk for ImprovedPerformance”.He has also written other articleson strategic management systems andperformance measurement, and over 100 articlesand 15 books. In 1999, he wrote the award-winning“Counting What Counts:Turning CorporateAccountability to Competitive Advantage”.

Tamara Bekefi is the Manager of Business andInternational Development Research and aResearch Fellow at the Center for Business andGovernment at Harvard University’s KennedySchool of Government.Ms. Bekefi analyzes theintersection of business and internationaldevelopment including risk management, small andmedium enterprise development andcompetitiveness, and multi-sector partnerships.Previously,Ms. Bekefi worked for the oil industrygroup IPIECA, ExxonMobil, Phillips-Van Heusen,and KLD, a social investment research and analysisfirm.Her work related to the implementation ofhuman rights policy, public-private partnerships,social risk, and fair labor issues for eight years. Shereceived her M.A. from the Fletcher School of Lawand Diplomacy with a concentration ininternational business and political risk and herB.A. summa cum laude from McGill University.


47

Barry Baptie,MBA,CMA,FCMABoard of DirectorsVCom Inc

Richard Benn,MBA,CMA,FCMAVice President Knowledge and ProgramDevelopmentCMA Canada

Ken Biggs,CMA,FCMA,FCABoard Director and Business Consultant

Dennis C.Daly,CMAProfessor of Accounting Metropolitan State University

Michael Fortini,CPADirector of CompliancePearson plc

William Langdon,MBA,CMA,FCMAKnowledge Management Consultant

Melanie Woodard McGee,MS,CPA,CFEDirector of MBA ProgramsThe University of Texas at Arlington

Robert Torok,MBA,CAExecutive ConsultantIBM Global Business Services

Kenneth W.Witt,CPATechnical Manager,The New Finance American Institute of Certified Public Accountants

This Management Accounting Guideline was prepared with the advice and counsel of:

For additional copies or for more information on other products available contact:

In the U.S.A.: American Institute of Certified Public Accountants1211 Avenue of the AmericasNew York,NY 10036-8775 USATel (888) 777-7077, FAX (800) 362-5066www.aicpa.orgVisit the AICPA store at www.cpa2biz.com

In Canada and elsewhere: The Society of Management Accountants of CanadaMississauga Executive CentreOne Robert Speck Parkway, Suite 1400Mississauga,ON L4Z 3M3 CanadaTel (905) 949-4200FAX (905) 949-0888www.cma-canada.org

The views expressed in this Management Accounting Guideline do not necessarily reflect those of theindividuals listed above or the organizations with which they are affiliated.

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AICPA Member andPublic Information:www.aicpa.org

AICPA Online Store:www.cpa2biz.com

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