As part of Gowling WLG's Special Projects Series, Paul Murphy, Managing Director of Gowling WLG's Energy Group, recently sat down with Michael Samis, Associate partner at Ernst & Young, and John Seddon, Principal at Canada Control Risks, for a discussion on country risk analysis for investment decisions and corporate strategy.

Country Risk - Part 1



Paul Murphy: My name is Paul Murphy, managing director at Gowling WLG and today we're here with Michael Samis, Associate Partner at Ernst & Young and John Seddon, Principle at Control Risk, and today we're talking about the issue of country risk.

All of us in our respective businesses deal with this issue on a variety of projects, and the world continues to remind us time and again that it's a very complicated place.You know, we've seen just within the last week with the US withdrawing from the JCPOA, the impact on Boeing's potential deal for airplanes.We see Total saying that they'll probably have to withdraw from their major project that was scheduled for Iran, and so when we deal with major projects — particularly infrastructure projects — we learn time and again that all countries aren't created equal and that when you put a project in a particular place, where you're putting it starts to matter very much.So what we've intended to do is in this two-part series is talk about the topic of country risk, first at a high conceptual level, and then really in the second session, get into some of the analytical tools.

So in starting with first principles on country risks, John — what do we really mean when we're talking about country risk and what are the biggest risk categories and considerations when we talk about the subject?

John Seddon: A  part of the real challenge in all of this is that there's not really any single universally accepted definition of what country risk is and different companies who look at it in different ways, but broadly speaking, the sorts of things that are typically considered are economic factors, political factors, operational factors, and then crucially, some social factors — and in particular, how some of that can sort of manifested some of this.Those social factors and social risks can manifest themselves in operational challenge and even sometimes security challenges.Now, what I'd say is perhaps most interesting when considering country risk is that, whereas in the past you know it was quite clear when there was an event, you know you that you would have perhaps nationalization or expropriation, and always quite clear when that event occurred and it was quite dramatic.More recently, things have shifted quite significantly with those sorts of events that are comparatively rare, and we have many more cases where companies are impacted by point.In particular, say we think of the resources sector with issues around permitting, for instance, and this can have quite a significant impact on projects and then obviously for share prices as well; and some of the other impacts we see are, you know, quite local levels I mentioned before — some of the social risk issues, but also things like actions of local security forces and how companies and projects engage with them and manage them in support of their operations.

Paul Murphy: So why the companies want to assess country risk early on, what are the benefits and what are some of the shortcomings if they're failing to look at the actual location of where this project is going to be and just seeing it like a project like any other project.

John Seddon: Well it's crucial to look at it from a very early stage given that really assessment of a country which should form part of strategy formulation and ultimately how a project is structured and doing it in an energy iterative way what allows acompany or a project to carefully understand the context in which it's operating both its sort of national level sub-national level and then consider that the local dynamics around a project and also from an early stage consider perhaps what sort of controls would be appropriate be that in the way the financing is set perhaps some of the sort of more operational controls go through the design construction and ultimately operation of a project.

Paul Murphy: You mentioned in your answer just now the financing aspect do you find that this is something that project developers need to aggressively manage and their dialogue with the bank's in terms of the diligence process so that it's both something that they're doing internally and assessing their decision to go forward and how they manage the project, but also if they're going out for project financing is one technique that's a dialogue not just for themselves, but with their lenders as well.

John Seddon: It's quite often that it's a high priority item that is carefully considered, so it's what we'd say though and what we find is that some of the some of the ways in which these issues are considered and then ultimately integrate into the decision-making process perhaps could benefit from greater rigor in terms of how things are modeled.

Paul Murphy: Let's talk about a particular sector and sort of assessing the problem a little bit more.We thought about natural resources and that's one, Mike, how in that sector this country risk play may be a unique role even differently maybe than other types of infrastructure investments? What do you see in that sector specifically?

Michael Samis: Yeah so obviously mining being and oil and gas being a you know global business, country risk has a big impact on Global Investments and obviously a big concern for a lot of the mining and oil and gas companies. The issue for them there's a number of special I'd say special characteristics in these investments that make country risk a sort of a larger concern you know particularly around the fact that you're investing in a movable asset so it's not like you can take your mine or your gas field or oil field and move it if you know a country becomes unstable.There's also issues around, you know, large upfront capital investments; so you're investing a lot of money over a long period to get your project or investment up and running and the issue will be that once you're in there, you're very exposed to possibly losing that capital or not making the returns that you were expecting.

We do have issues around commodity price cycles where, when money prices are high, these assets will make what seems like excessive profits; and so that makes it a target for government actions, particularly around when there's revenue shortfalls — and then the other aspect also is that you may find in country that there's a bias against foreign ownership that can come out in various government actions; and also you may be finding you're competing against other country or other countries for, you know, very good assets.It's not like there's a lot of great assets around the world, so you may find you're dealing with other country champions and businessesthat may try to take your asset away; so these sort of perspectives, they can cause outside country risk effect.

We see that quite recently in the mining industry, last year,Acacia mining out in Tanzania was unable to export concentrates and that caused, over a month, a decline in share price of 20%.More recently with Kinross, they weren't given an expand permit to expand one of their mines, and within a day, there was a 20% drop in their shirt price.So, I mean, these are big issues and companies need to consider them when they're making their investments and have a plan for them.

Paul Murphy: Is it fair to say that that when we're looking at country risk, it's not just a moment in time?Things like natural resourcesare making a long-term play; you're having to project out over long periods of time which complicates the analysis at a lot of different levels because now you're having to factor in political cycles and changes in market conditions. I mean, how does that complicate the analysis?

Michael Samis: Well it definitely does. You know you're investing for over a longer period; you knowyour exploration and development period; you know maybe anywhere from five to ten years and then you're operating the project from ten years up to sixty or seventy; and so, you do have these... you know you have to consider that in the way you look at your investments.So you're looking at the investment over its entire cycle. So that creates an issue about the types of projects you might want to get into, you know.Investing a large amount of capital for a very long time in a moderate risk country can actually be more risky than investing a smaller amount of capital and a high risk jurisdiction where your project life is shorter; and so you have to start thinking carefully about what type of projects that I want to invest in, and where in the world, how do we share the risk, and all these sorts of issues.

Paul Murphy: How do companies generally approach country risk in your experiences? I mean what general policies do they have?Where do they evaluate it, in your experience?

John Seddon: Well there's quite a bit of variation between companies' floors, so some companies have very large in-house teams, government affairs, government relations teams who have this as part of their team.Since comms teams will also play a role as well as legal teams, in gathering raw information from media, from third parties, and so on with qualitative analysis, quantitative analysis and synthetic houses, as well in order to sort of provide a picture of what is going on in a specific jurisdiction or region or what have you — what we often find though, is that analysis is not necessarily translated as effectively as it could be into investment decisions and into how portfolios are managed; and I think that's where there's significant opportunity to better manage country risk in in a way that is more aligned to how organizations manage other types of risk across their wholeness.

Paul Murphy: I mean given that answer, what do you think are some of the elements that are missing?Do you see that it's an issue of lack of appreciation of the country and its history and internal dynamics, and they just see it from afar?Or is it market conditions or not having good intel on the ground and maintaining that? What are some of the shortfalls that you're seeing that either companies aren't doing or they think they've maybe done an adequate job of, but in fact they're missing key elements?

John Seddon: It's of course tough to make generalizations; but one issue that companies seem to be challenged by in many instances is that because there isn't necessarily the means to translate solid analysis into how strategic decisions are made in terms of capital locations, there's not the — I would say — adequate imperative to get that pro analysis right and to ensure that there is great sort of combination of national level factors combined with issues that may have more to do with some of the partners that one organization is working with or maybe some of the local government dynamics or a whole host of other issues.And so it's that, with a more nuanced approach, to translating those inputs into decision-making then that would create a greater imperative to do a sort of more detailed analysis in the first place.

Paul Murphy: It seems that a lot of this could be very subjective but then there's probably an opportunity for analytics as well.In terms of data-driven analysis, how would both of you assess the balance between the subjective things like projecting the stability of a particular government versus other types of things that could be more data-driven?And, how should companies maybe combine the two to get a more robust result?

John Seddon: You're right — it is a challenge to ensure there's a sufficient amount of data underpinning some of these country risk factors, particularly in some of the more complex jurisdictions in the world.It is tough to get that those quantifiable indicators would say that there is certainly value in using those when they are available, but one can't get away from the value that can be provided by people who have very in-depth knowledge and understanding of the political dynamics — in particular in a country in a specific area — and are able to leverage resources that they may have access to in order to understand how different levels of government interface with one another how maybe a project or a company's operation may adversely or positively affect some of the factors that we've been discussing then. Of course looking ahead there is, we think significant opportunity to use more data and more analytic techniques to bring greater rigor and to formalize the entirety of the process make the other thing.

Michael Samis: You know, I think the interesting thing about looking at country risk and trying to model it, you know, it's not like we're going in and trying to look at commodity price uncertainty where we have you know a large amount of historic price information and financial market information that can help us characterize it; so the issue for us going forward, when we try to actually model this and in some detail, it's going to be taking, you know, the qualitative aspect and the experience of people on the ground understanding you know the company's country structures or the local conditions, the, you know, issues around international organizations and things and trying to translate that into you know a more quantitative assessment.And so there's going to be a certain level of subjectivity I guess you could say, but you know, that's fine because what we're trying uses a more quantitative approach to do is you know provide us a way of you know some rigor to our thinking and to see how things potentially play out in terms of cash flow effects and its impact on the value of your investment and the risk exposure.

Paul Murphy: How do you see this sort of traditionally translated in corporate decisions?Is it more of a risk premium so that it goes into the final economic price, or economic valuation that there's a kicker, if you will, for some additional risk in that country?Or in that particular line of work?Or is it a no-go decision, you know, in terms of we're either gonna do this or not?Or is it adding in some mitigation strategies?How do you see companies generally pursue the analysis once they've taken a look at Country Risk?Is a consideration how historically do they tend to translate that into their behavior going forward?

Michael Samis: Yeah, so I think when you we're thinking about some kind of program to manage country risk, you know what we're suggesting is you're gonna be going into a little bit more detail and bit more depth about, you know, its impact on your investments and so we've been looking at the effective country risk over the life cycle of the project and, you know, there's you know the upfront consideration about whether we should invest and there you'll be thinking about you know how are you an investor our capital you know, how do we share the risk through different forms of financing or joint venturing and those sort of things.Once we are in a country and we have an investment up and running we're obviously going to be monitoring it and trying to you know to track potential risks that could impact the value of your investment for your shareholders and [Music] understand how this you know how your investments are affected and the exposure and then you're gonna bring that up to the corporate level and understand how all your different investments around the world come together and expose your company overall. So, it's, you know processes in more detail more depth where we're trying to understand the cash flow effects of country risk how that creates a risk exposure for you and then how that comes up to the corporate level and it impacts your company overall.

Paul Murphy: So, based on those comments, clearly country risk analysis is not just something that you do as a "check the box" activity before you make your final investment decision; that's sort of an ongoing you know a robust country risk program if you will would not just be at the front end but you would be considering that issue throughout the life of the project and maybe planning at the beginning when you're making that investment decision, how you might have in place mitigation techniques over the life of the project or key stages of the project. Is that a fair comment?

Michael Samis: It is because you know you're really looking for a framework in which to you know first off understand what sort of you know what sort of country risk you're exposed to any other different types you know the different actors that are out there and how they can impact your project. You then also have to be able to perform some analysis around there - under you know to get a sense of you know the importance of the different risks and their potential impacts. You also have to think about you know how potentially you might mitigate what sort of strategies that you might employ, you know initially when you're thinking about how to invest but then once you are in-country. And then lastly you know, over the life of your investment something's gonna happen so you need to be thinking about how you're going to respond and so that this needs to be a formal program people have to get prepared for these things they have to think them through from the start and it's not something that you know you just summarize as a risk premium.It needs to be more detailed it has to be thought through and it has to be treated as an important impact or consideration in your investment.

Paul Murphy: And then presumably if you if you're considering these mitigation strategies or contingency planning you're then pricing that at some level into your modeling to make that that final investment decision at the to the project.

Michael Samis:That's correct.

Paul Murphy: Okay, well that concludes our first discussion on Country Risk our second stage will move into more of the analytics; so thank you both for your time and I look forward to talking to you on the next subject.

Thank you very much.

Michael Samis & John Seddon: Thank you

Stay tuned for Part 2 of this talk which will be available next week!

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