CHAPTER 19 STRATEGIC RISK MANAGEMENT IN PORTS S.N. Srikanth Senior Partner, Hauers Associates, India Ramesh Venkataraman CEO-Asia, CurAlea Management Consultants, India Abstract Risk management has evolved from risk transfer or risk avoidance to one of pro-actively managing risk to create higher value. This approach sees risks as opportunities rather than threats. Good risk management is about enabling organisations take more and better informed risks. The emphasis today is shifting from management of financial and operational risks to management of strategic and reputation risks. The latter have much greater impact on the success or failure of an enterprise and the value that can be created for the stakeholders. Yet, the concept of risk management in ports continues to be overwhelmingly associated with operational risks such as security. This paper makes the case for due consideration to be given to major strategic risks that ports face, including those linked to global economic trends, political instability, change in vessel sizes and competition from existing and new ports. This would involve drawing up of a risk portfolio, with clear actions to build adequate safeguards that will help in bringing the risks to acceptable levels. The paper also refers to the clear linkage that needs to be established between the safeguard actions identified and the business planning process to ensure that the safeguard actions get the priority they deserve. 1 STRATEGIC RISK MANAGEMENT 1.1 Risk and Profit The word risk is often associated by the layman with luck or fate. Modern risk management however defines risk very differently, as something that can be influenced, something that we can profit from. The emphasis today is on proactively seeking out ways of taking acceptable risks. Profits are seen largely as a reward for successful and informed risk taking. This is a paradigm shift from the thinking that risks are associated only with losses. 335
336 Strategic Risk Management in Ports 1.2 Strategic and Other Risks There is significant importance attached to risk management in ports today, but not quite enough to the management of what we may call strategic risks. Strategic risks can be defined as the array of external events and trends that can significantly impact an organization s growth trajectory and shareholder value (Adrian Slywotsky and John Drzik, Harvard Business Review, April 2005). An analysis 1 of companies across 43 industries by the authors indicates that only around 30% of the shareholder value created by the corporation, and a port must be viewed as a corporation even if it may happen to be a department of the government, is constituted by its net asset value as appearing on its balance sheet while the remaining 70% is represented by the corporation s intangible assets like business strategy, brands and goodwill. Risks related to the net asset value are unlikely to have a major impact on growth or shareholder value as the underlying assets can be secured through a variety of hedging techniques and in case the risks materialize these assets can also be reinstated. To the contrary, risks related to the intangible assets have the potential of impacting the growth prospects of the firm significantly. Other noteworthy features of risks facing intangible shareholder value are that they are often inter-linked, complex and difficult to manage. Strategic risks, therefore, are largely related to the intangible assets of a firm. The focus of this paper is on these risks. 1.3 Risk Management as an Opportunity Traditional responses to risk consist of avoidance, transfer and control. For example, a port management company may opt not to venture into geographies with high security risks. A State-run port that mandates a minimum throughput guarantee when privatizing a terminal would be transferring the risk of volume fluctuations to the private operator. And a code such as the ISPS is essentially an attempt to control security risks. Modern corporations have progressed beyond these traditional risk responses to the proactive management of risks. The management of risks in general and strategic risks in particular, while embracing the components of avoidance, transfer and control, also sees risk as an opportunity. Corporate Social Responsibility for example, commitment to sustainable development or preservation of the environment could be seen as a threat that erodes the bottom-line. Progressive corporations, however, view such commitments as opportunities to enhance shareholder value. Recyclable packaging, eco-friendly hotels and energy saving computers are some examples of the resultant response. Of course, this is not an easy task as one cannot take risks blindly. One has to take better informed risks, risks that are acceptable and within the risk appetite of 1. Analysis of companies listed on the NYSE across 43 industries comparing the market capitalization with the Book Value of the shares.
Strategic Risk Management Process 337 the corporation. The challenge of strategic risk management is thus to empower businesses to take more and better informed risks and to successfully manage them to maximize shareholder value. 1.4 Types of Strategic Risks The different kinds of strategic risks are discussed below with examples. No attempt has been made by the authors to make the list comprehensive. Risk type Macro-economic risks Political risks Industry risks Competition risks Technology risks Customer risks Environmental risks Examples of risk Economic instability, slow down in GDP growth, hyperinflation War, political instability Excess capacity creation, tariff control by the state New ports likely to open in the vicinity, expansion of existing nearby ports, price wars Obsolete technology leading to competitive disadvantage, technology mismatch with emerging vessel and cargo traffic mix High concentration of business with a few shipping lines or a few large cargo interests, inadequate understanding of customer priorities Natural disasters, adverse change in land use pattern surrounding the port, action from NGOs against a new port project Table 1: Risk type and attributes 2 STRATEGIC RISK MANAGEMENT PROCESS The process of managing strategic risks involves a series of key activities. 2.1 Risk Identification This involves the identification of the key risks that could impact the organization in the near to medium term. This is normally achieved through brainstorming sessions among senior managers that are organized by the Risk Management Co-ordinator, who presents an initial risk universe drawn from
338 Strategic Risk Management in Ports diverse sources of information as well as from interviews with Board members. The brainstorming results in a short list of risks for further evaluation. 2.2 Assessment of Impact and Probability This step involves the assessment of the possible impact and the probability or likelihood of occurrence of the risks identified. The objective here is to arrive at a robust judgement on the materiality of the risk rather than to achieve an accurate quantification. A reasonably accurate evaluation of the financial impact of the risk will however help in prioritizing the risk management plan. 2.3 Evaluation of existing safeguards This is a key activity that involves the evaluation or assessment of the safeguards that are currently in place to manage the risks identified. 2.4 Net Risk Assessment The next step is to assess the net risk level after taking into account the existing safeguards. This helps in determining whether the net risk level is acceptable or not in relation to the risk appetite of the corporation. The risk appetite varies between organizations and also between geographies. For instance, high employee turnover may be an acceptable risk in the IT industry in India where demand vastly outstrips supply. Even within the same industry, the risk appetite may vary between enterprises based on factors like the management philosophy, ownership structure, stage in the life cycle of the firm, etc. 2.5 Development of the Risk Management Action Plan Where the net risk level is found to be unacceptable, further safeguards need to be planned to bring the risk to an acceptable level. This step is at the heart of strategic risk management. Even where the risk is at an acceptable level, further safeguards might be planned to strengthen its management. 2.6 Integration into the Business Planning Process The risk management action plan, to be effective, needs to be integrated with the business planning process. This will require the key safeguard actions planned to be incorporated in the business targets, budgets and score cards. The strategic risk management exercise would normally result in a risk grid or portfolio matrix that depicts the risk profile of the corporation in a summarized form. The grid would include all risks that merit monitoring by the Board at least twice a year to ensure that changes in the portfolio are reflected on a timely basis.
3 CASE STUDY: PORT X Case Study: Port X 339 We would like to walk you through the construction of a risk portfolio for a port we had occasion to study. Let s call it Port X for this exercise, as we are unable to reveal the name of the port for reasons of confidentiality. Certain specifics have also been altered for the same reason. 3.1 Background Information Located in a developing country, this port handles somewhat less than 100 million tonnes of cargo a year. Of the three most important customers of Port X, two are importers of coal and together they account for 25% of the traffic through the port. The third and the largest a government owned refinery that receives crude oil through the port accounts for another 25%. Port X is government owned and operated. The workforce is excessive and the wage bill exorbitant. Militant labour unions force frequent work stoppages. The government has a significant say in labour management at the state-run ports in view of the strong political affiliations of the trade unions, making retrenchment plans difficult to implement. The current wage agreement with the workers will expire in a year s time and the unions are expected to demand a steep increase in wages. It is feared that labour unrest will grow as the time for the new wage agreement draws closer. Port X is in a cyclone prone area and faces the constant threat of a natural disaster. However, it has reasonably good crisis management systems and a trained team to tackle such emergencies. The Port has inadequate draught and ageing equipment, and the assets are largely depreciated. Equipment productivity is poor. The port currently handles small container feeder vessels. With vessel sizes increasing the mainline vessels of today may become the feeders of tomorrow with draughts too deep for Port X and requiring advanced facilities for loading, discharge and evacuation. If Port X does not upgrade it may lose the container trade if current trends in vessel size continue. Importantly, a new private port Y is under construction barely 150 kms to the south. The new port will have deeper draught than Port X and will be capable of handling larger vessels. Mechanised handling systems are also being proposed. Being a private operation, the port is expected to be run more effectively, with higher productivity levels than in Port X. The management of the private port will have greater flexibility in regard to tariffs and should be able to respond swiftly to attract and retain users, unlike the management of Port X. The private port management has been aggressively wooing the two large coal importers, currently users of Port X, with low tariffs, modern infrastructure, preferential berthing facilities and other incentives. The government refinery, the largest customer of Port X today, is toying with the idea of building a captive port closer to the refinery and with a Single Point Mooring (SPM). Needless to say, this would mean a huge loss of business to
340 Strategic Risk Management in Ports Port X. The economy is growing briskly in the hinterland of Port X and an economic slowdown seems unlikely in the immediate future. However, if this happens Port X will be affected. 3.2 Port X: Strategic Risk Grid The strategic risks faced by Port X are represented in the grid below. Each risk is assessed in terms of likelihood and impact and categorised by type of risk. The safeguards that the port presently has against each of the risks in the grid and the resultant profile of the risk are given below. Exposures to the risks are classified as unacceptable with urgent action required, acceptable but requiring further action and acceptable with periodic monitoring required. Port X is now ready to meet the challenge of strategic risk management, of converting strategic risks into opportunities. If existing safeguards are inadequate and render a risk unacceptable, additional safeguards are proposed to make it acceptable within a specified time frame. Taking such informed risks is expected to translate into opportunities for Port X to enhance shareholder value. Figure 1: Strategic risks Existing safeguards and risk profile
Case Study: Port X 341 Risk Existing safeguards Profile of risk Entry of new privately run port nearby None Exposure unacceptable, urgent action required Excessive dependence on a few large customers Government refinery s plans to set up captive port with SPM Two-year contract with largest customer expiring 14 months from now Long term contract with refinery valid for another two years Discussions between oil and shipping ministries with the latter arguing for the continued use of port X Exposure unacceptable, urgent action required Exposure unacceptable, urgent action required Stoppage/loss of business due to labour unrest Volume drop due to GDP slowdown Detailed negotiation strategy in place None Exposure acceptable, but needs further action Exposure acceptable, but needs further action Increasing container vessel sizes None Exposure unacceptable, urgent action required Business discontinuity due to severe cyclones Detailed crisis management plans in place Regular monitoring of weather forecasts and trends through the Met department Exposure acceptable, monitor periodically Table 2: Converting strategic risks into opportunities
342 Strategic Risk Management in Ports Risk Entry of new privately run port nearby Excessive dependence on a few large customers Government refinery setting up own port with SPM Stoppage/loss of business due to labour unrest Volume drop due to GDP slowdown Proposed safeguards Privatize coal terminal to achieve higher efficiencies and competitiveness. Private operator to modernize terminal and take over existing labour on present scales. Minimum throughput to be guaranteed by private operator Apply to government for budgetary support for deepening draught to handle larger vessels Negotiate three to five year contracts with the two coal customers with volume based discounts Institute competitor tracking mechanism Short term: Offer contracts with volume based tariffs for the top six customers other than coal Medium term: Broaden customer and cargo base and reduce dependence on the coal customers to 15% of total volumes Lobby with government to retain refinery business Offer to construct SPM at port X or enter into joint venture with the refinery for the proposed captive port Institute voluntary retirement scheme ahead of settlement Outsource activities such as pilotage and dredging to reduce fixed costs and lower the break-even level Increasing vessel sizes container deepen draught at container berths to 12.5 metres invest in modern handling equipment explore other ways of increasing productivity build additional container stations off-dock monitor new building sizes regularly Business discontinuity due to severe cyclones Institute early warning systems Test crisis management plan twice a year Table 3: Strategic risk management action plan The strategic risk management action plan for Port X describes each risk in detail, lists the current and proposed safeguards and provides a detailed action plan, indicating the individuals vested with the responsibility for carrying out the actions. It also specifies time deadlines for each action and sets a target date for the level of risk to become acceptable. An example of the Risk Management action plan for one of the risks is given below.
Case Study: Port X 343 Short title. Competitive threat from new privately run port nearby Risk definition: The new private port under construction at Y will be operational in the next 30 months. The port will pose a serious threat of shift of cargo and customers due to: ability to handle larger vessels; better equipment; faster turnaround time; greater flexibility in pricing; potential targeting of our two largest customers with attractive pricing. Our initial estimates show that there could be a potential risk of losing 25% of cargo as well as an overall erosion of operating margins by 35%. Current safeguards: Two-year contract with the largest customer A (coal) that expires in 14 months. New/improved safeguards needed: Negotiate with second coal customer (B) to enter into a five year contract. Extend contract with customer A by another three to four years. Negotiate with the other large customers to enter into three to five year contracts, with volume based discounts to be offset by benefits from higher capacity utilization. Privatize operations of coal terminal on revenue sharing basis. The private operator to modernize equipment, take over coal terminal workers on present pay scales and to provide minimum throughput guarantee Apply to government for budgetary support for deepening draught to facilitate handling of larger vessels. Draw up action plan for broadening customer base in the next 24 months to increase tonnage to 130 million tonnes. Explore potential of tie up with inland dry ports to capture cargo at source. Institute comprehensive competitor tracking mechanism to closely track the cost structure and evolving business model of the new port. Also study impact of other private ports that have commenced in the last two years on the industry dynamics and price structure. Draw up action plan for improving turnaround time by 30% by June 2007. Detailed Action Plan
344 Strategic Risk Management in Ports Action By Deadline Initiate negotiations with large customers and AS Jan 07 submit initial proposal to the Board Finalize contract with customers A and B AS March 07 Finalize contracts with at least five out of 10 top AS June 07 customers Present action plan for throughput improvement to PH Dec 06 Board Draft proposal for tie up with two inland ports KJ Dec 06 Quarterly competitor tracking mechanism to be SK Jan 07 started Technical proposal for improving turnaround with capital cost estimates to be submitted PH June 07 Assessment of risk: Impact? Likelihood? Risk profile Critical Very high Unacceptable and required immediate attention With the implementation of the above actions, when will the level of risk become acceptable? 12 months Figure 2: Integration of strategic risk management plan with budgetary process Finally, the risk management plan is integrated into the planning process of Port X. This is necessary for the plan to be recognized as an essential part of the strategy of Port X and to secure the support of the entire organization. The integration involves the steps described below. u Key actions planned to be reflected in the Annual Plans of the respective functions. u All critical actions to feature in the Balanced Score cards of the organization u Capital and Revenue budgets to include the outlay on the risk management actions. u All critical risk management actions to feature in the group and individual targets and thereby linked to the performance bonuses.
Conclusions 345 4 CONCLUSIONS A successful strategic risk management programme needs some key enablers: u Senior management buy-in and sponsorship of the programme. u Active involvement of line managers in the process. u Rigour in risk identification to ensure that the net is spread wide to capture all relevant risks. u Inculcation of the Risk Management philosophy in the corporation rather than treat this as a one-off exercise, with integration of the initiative with the other business processes. u Effective follow-through and completion of the safeguard actions planned. u Capture and review of learnings, to improve and customize the process according to the needs of the corporation. u Adequate resourcing of the Risk Management activity, with clear ownership and appropriate expertise. References: Adrian J. Slywotsky and John Drzik: Countering the Biggest Risk of All. Harvard Business Review, April 2005. Thomas L. Barton, William G. Shenkir and Paul L. Walker: Making ERM Pay Off: How Leading Companies Implement Risk Management. Financial Times/ Prentice Hall. Protiviti: Guide to Enterprise Risk Management. www.protiviti.com James Lam: ERM: From Incentives to Controls. Wiley Finance Peter C. Young and Steven C. Tippins: Managing Business Risk: An organization-wide approach to Risk Management. American Management Association.