The World is Changing…
By Dave Cooley, GHPB
The world is changing! As change occurs, risk also increases because change continuously challenges the status quo. What can be done? How do we survive? One significant step on the roadmap to survival is identifying and understanding risk, how it is addressed, and then selecting the appropriate risk management technique; for if not proactively addressed and managed, rapidly changing events will manage you.
Risk is everywhere and affects everyone. To assess the risk environment, risk can be classified into two basic sets. One set includes the risks we know. These risks are generally straightforward and as a result, a firm usually understands these risks and has the ability to determine a value. In addition, these risks are usually endogenous to a firm and are suitable to being proactively managed. The other set are those risks of which we are unsure and therefore the risk exposure may or may not be generally understood. In addition, we may have concerns as to how to properly determine a value. These risks are generally more complicated, usually exogenous to the firm, and are risks more suitable to transfer or mitigation as opposed to management.
Furthermore, whether a firm is addressing the risks we know or the risks for which we are unsure, the magnitude and composition of the types of risk within each portfolio can vary. For example, a firm’s risk profile may include multiple risks, but the magnitude of one risk type far outweighs all the others and therefore requires a special focus. Conversely, a firm’s risk profile may include a large number of risk types that individually do not present a concern, but when aggregated, the total creates a significant risk exposure that requires attention across all types of risk. Generally, a firm will concurrently experience elements from both sets of risk classifications, but with varying degrees of magnitude and composition.
Figure 1 shows two distinct risk profiles, each of which depict the extremes of each risk class based on magnitude and composition of the risk portfolio. Panel A reflects the risk we know as being dominant while Panel B reflects the opposite, where the risk for which we are unsure is dominant.
What is Risk?
Risk is uncertainty. What will happen in the next minute, or the rest of the day, or tomorrow, or next week, or at any time in the future is uncertain. Since firms are viewed as “ongoing concerns,” there is a high probability that a firm’s existence will continue during the near term. However, when viewed through a longer lens, risk increases with time simply because, over time, the number of possible factors or events not only increases, but also becomes more variable and uncertain. Furthermore, as each firm has a unique risk profile, different firms will create quite distinct evaluations of the same risk.
A. What are the Types of Risk, and Where Does Risk Come From?
All business firms are exposed to risk. Understanding the various types of risk that are possible and where each type of risk originates is the first step. Examples of various types of possible risks and how they might arise might include:
Market Risk – the change in the free market-determined price for a product, an asset, an interest rate, or an index
Consumer Preference Risk – unaware changes in preferences to brand selection, product quality, and service
Credit Risk – the deterioration in the financial worth of the firm or the non-performance under a contractual arrangement
Liquidity Risk – Funding Liquidity Risk arises when the current cash inflows and the existing cash balance are insufficient to meet current cash outflow requirements. Market Liquidity Risk arises when market behavior inhibits either liquidating a current position or establishing a new transaction that would mitigate the risk of an existing position.
Operation Risk – operational inefficiency causing loss of productivity; congestion created from a sub-optimum processes or procedures; a loss of production that arises as a result of either mechanical or human failure
Organizational Risk – poor productivity caused by a misaligned organizational structure
Intellectual Risk – the loss of, or the inability to hire, specially trained personnel
Technological Risk – technological innovation outpaces the firm’s ability to assimilate change
Catastrophic Risk – major decimation of facilities due to a natural disaster, explosion, or fire
Legal Risk – arises when your lawyer is smarter than our lawyer
Government Risk – regulations that hamper output or delay the efficient use of capital, devaluation of the currency, loss of purchasing power evolving from inappropriate monetary, or fiscal management; and the unilateral exercise of various sovereign powers
Systemic Risk – the fall of “dominos” affecting a large swath of the economy
B. What to do With the Risk While You Own It?
The second step is to understand what to do with the risk while you “own” it. To address this aspect of the risk process, a standardized sequential procedure is proposed in order to develop a comprehensive assessment of the risk exposure. The key four steps in developing this aspect of the process are:
Risk arises in the normal course of everyday life. Since risk affects everyone, it is essential to determine the types of risk to which a firm may be exposed. This is accomplished by creating a list of possible risks (a risk profile) and determining which of those risks can affect business outcomes, such as the risk types that could impair revenue, create a cost over-run, or be the impetus of a rare exogenous event.
Risk is generally quantified as the deviation from a predesignated norm against which the results of current activities are compared. The norm can be an average of activities expressed in monetary terms, or as operating results expressed as either volume or weight of the units produced or handled, or as a defined number of occurrences of a target event. Examples could include a multi-period running average of annual financial results, or the units of production, or the number of days without an accident.
Risk Accepted and Managed
Risk acceptance can be managed through vertical integration, risk matching, or designing and implementing the appropriate administrative controls. In each case, the risk is proactively addressed.
Vertical integration internalizes some of the risk of the firm as the raw material is transformed into the finished product. For example, in a vertically integrated firm, the revenue of production is the cost sales to either manufacturing or processing and the revenue of manufacturing or processing is the cost of sales to marketing. As a result, these risks are matched and offset as the product moves along the production chain.
Risk matching also balances risk by matching the inflow/outflow of risk with an equal but opposite outflow/inflow of the same risk. For example, revenue generated in a foreign currency can be balanced by incurring equal value of cost or payment obligations in that same currency.
Managing risk can be accomplished by implementing administrative controls. These are specifically designed procedures established to address each risk by formulating specific actions that describe the proper methodology to perform each task that would avoid or minimize each specified risk.
Risk Not Accepted and Managed
Risks that are determined as being unacceptable can be either transferred or mitigated by entering into various contractual arrangements. When transferring risk, the responsibility for managing those risks is moved to another entity and usually involves the firm making one or more cash payments, similar to those when purchasing an insurance contract. Risk transfer actions are generally utilized to address various risk types, such as fire, natural disasters, and other catastrophic events that have a very small probability of occurring, but should they occur, a very large cost would result. Conversely, if mitigating risk is preferred, the responsibility for managing these risks remains with the firm. Risk mitigating activities would include either buying or selling various derivative contracts (forwards, futures, swaps, or options) that are designed to offset various existing risk exposures, such as adverse price move or a potential credit default. Success in this area requires a well disciplined and closely monitored program to ensure the actions employed are achieving the desired objective.
C. What Happens to Risk?
The third and final step in this process is to understand what happens to risk. The key thought is that risk never goes away. Over time, the exposure to various individual risks may rise or fall and various types of risk may disappear while other types of risk may emerge. It is essential to maintain an ever-vigilant process that continually identifies change and determines how that change will affect the firm’s exposure to risk. As events, both internal and external to a firm, continually evolve, a firm that proactively addresses change by periodically repeating the risk assessment and evaluation process could be well positioned to capture a competitive advantage as change takes place.
With the largest number of ship arrivals as well as handling the most foreign waterborne tonnage (both imports and exports) compared to any other port in the country, Houston is a very vibrant and productive port that offers the maritime community many opportunities for continued growth. However, the port and the maritime community are not without issues and having issues creates risk.
This overview of the current issues and the associated risks related to the Houston maritime community is presented from a hypothetical viewpoint of the total port in general, as opposed to aggregating of all the issues and risks emanating from each of the individual firms and organizations along the waterway. Table 1 offers a broad outline of these possible maritime issues.
In these examples, the primary risk category associated with all of these issues would be Government Risk, including federal, state, and local entities, since all of which focus on maritime policies, regulations, and funding. A discussion of both the issues and the associated risk are presented starting below.
Waterways Issues and Risk
Today, one of the primary waterways issues facing the maritime community is ensuring adequate and consistent funding for maintaining the depth of the Houston Ship Channel (HSC) at 45’. Similarly, a possible future waterways issue could be developing an inclusive port-wide economic evaluation (currently underway) to support further deepening and widening of the HSC to maintain a competitive position with other ports dredged to a channel depth that currently can, or will in the near future, accommodate post-Panamax ships.
In this regard, the largest and most prevalent risk is the consistent and adequate congressional appropriation and funding of monies collected under the Harbor Maintenance Tax (HMT). This process was designed in 1986 to fund the operation and maintenance of federal ports and harbors and, the tax is charged against the value of foreign waterborne imports as well as waterborne movement of domestic cargo along the coasts between two or more U.S. ports. While appropriations from the HMT are primarily used for maintenance dredging, including the development of any associated dredged material placement areas. However, the HSC region is historicaly under-allocated for maintenance, despite contributing significantly more monies to the HMT than it needs to adequately maintain the channel. Also, in the context of dredging, current legislation requires a 50/50 cost sharing for dredging channel depths greater than 45’, which is 25% above the sharing level required for dredging to depths of 45’ and below.
To deepen and widen the HSC any further would require developing an agreeable financial program to aggregate the port’s 50% share from a loosely knit maritime community, which may be a challenge. If Houston desires a deeper and wider channel, perhaps seeking state sponsorship with funding recovered through a tariff could be a viable alternative for advocating an increase in the current depth limit from 45’ to 50’.
Shoreside Development Issues and Risk
Issues related to shoreside development respond to the needs of the market. However, given the current political climate not only in the U.S., but also in many other countries, various issues could impact Houston’s waterborne trade activity, such as rising anti-globalism; the effect of increasing protectionism; or the potential trade benefit that could arise should any broad program of domestically sponsored infrastructure projects be implemented.
Since shoreside development is generally accomplished by private firms as opposed to government, the risk of government policies and regulations (federal, state, and local) remains a paramount concern. When developing either a greenfield or a brownfield project, or responding to change emanating from anti-globalism, rising protectionism, or national infrastructure projects, risk exposures emerge from following time-consuming regulations that range from completing a Federal Environmental Impact Statement to following state or local construction codes and regulations governing the hiring of labor. Funding would usually be privately sourced or in special cases, funding assistance could be obtained from federal or state grants. Any of these risks could create unexpected exposures.
Supporting Infrastructure and Risk
The efficiency and productivity of the Houston maritime community includes assets and activities far beyond those located on the waterfront and include all aspects of the landside logistics spectrum. Any inefficiency or low productivity inland of the water’s edge will eventually be reflected by a lesser number of ship arrivals and the resulting consequence of handling a lower quantity of foreign waterborne tonnage; both imports and exports. Creating unimpeded access and egress for both rail and truck from the port and to outer boundaries of the city limits and beyond would be a definite competitive advantage.
Supporting infrastructure is also generally accomplished by private firms as opposed to government and likewise, government risk (federal, state, and local) again remain a paramount concern. Improving transport infrastructure, such as removing “at grade” rail crossings or providing dedicated truck lanes and rail corridors could involve intensive efforts to acquire right-of-way, extensive efforts to obtain land-use variances, and very significant capital investment. Some of these efforts could benefit by being state sponsored and recover funding through a tariff.
Change is in the air. At some time in the future, some or all of these inspired changes will be eliminated, become better defined, or become manifest; each with an associated economic impact. Determining what could be the range of possible outcomes for any of these potential events and how each of the possible outcomes could effect the risks stated herein is the challenge. Regardless what happens in the future, the interim provides a great opportunity to recalibrate risk and re-calculate its exposure. The world is changing . . .
- Date April 18, 2017
- Tags April 2017