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Security and predictability

Security and predictability

The figure shows and example of what economists call a "utility curve". It shows the mean response that people can be expected to have to risk. Where the environment is predictable, they are usually prepared to take larger risks than in a choppy, uncertain world. Such curves have been shown to be valid for organisms as diverse as honey bees, pigeons and, of course, humans. Increased risk - or increased perception of risk - lead to sharply more "aversive" behaviour. We rein in our aspirations, moderate our goals and wait out the storm.

This tells us two very important things about an uncertain environment. First, it lessens the strength with which we pursue are prepared to follow our goals. Attractive things become less attractive when levels of uncertainty rise. Second, it is the general level of risk - rather than issues specific to the project in question - which may be crippling to projects that are innately risky. This notion is considerably at odds with the receive approach to risk assessment in financial circles. It has the intuitively-satisfying implication that, for example, countries which have high levels of general uncertainty, crime or political turmoil are likely to be risk-averse, even though the strictly financial criteria are favourable to ssuch projects.

Formal risk assessment.

The word "risk" has many connotations. To a sportsman, "risk" means the likelihood that he or she will break their back. It has entirely negative connotations. To those handling portfolios of traded assets, however, "risk" is equivalent to volatility. The aim of portfolio management - reinforced by a vast literature and all manner of mathematical tools - is to get the best relationship between its overall rate of return and the volatility of the portfolio's component parts. Partly through an innate relationship and partly through the workings of these instruments, virtually all traded stock lie on a line which relates their relative volatility to their overall earnings for an investor. Vast sums are managed on the basis of this model land of its elaborations.

To someone with a set of operational projects to consider, however, risk is concerned with the uncertainty in the earnings which is likely from any one of these projects. The size of the initial investment, the size and timing of the return, the uncertainties inherent in the scale and timing of both of these have much to say to such an assessment. Such a manager is usually trying both to mitigate such risks and to choose between rival claimants for scarce resources. These are different tasks which use some similar concepts, only some of which have much to do with what is commonly meant by "risk". However, there are real issues which have practical policy implications. Let us begin by considering issues of mitigation, and then turn to the means of project screening and ranking. The section which follows will consider what we have learned in the light of adaptive policy measures.

Project risk has two fundamental components to it. There are uncertainties which are endogenous to the activity: a new technology may simply fail to work, for example, or may be more expensive or time consuming to deliver than had been thought. Second, risk comes from factors with are exogenous to the project. The economy may plunge, for example, or the customers may change their interests.

There are actions which can be taken to mitigate these risks, by staging a project, for example, by diversifying supply or outlets and by using financial instruments such as options. Most of these measures have costs and other overheads that are associated with them, and the massive activity to mitigate quantifiable risks that took place in the 1985-'95 period have driven most of these measures to their economic limits. Indeed, there is a whole technology that allows one to shift the quality of risk around in a project - for human resource shortfalls, for example, to the possibility of being late. It is possible to price a particular moiety of risk. Indeed, if "risk" consists largely of what we do not know (because otherwise we would be able to avoid the risk!) then it is also possible to set a value on gaining information of this sort, as it is easy to set a cost on the reality of the risk. An exploratory drill into an area where a company is about to construct a large building will, for example, provide information on the potential for subsidence, and will tell the civil engineers whether they need expensive foundations or not. As such, the item of knowledge can be directly valued.

Comparing dissimilar projects uses different, but related techniques. Most projects consist of a phase of investment, followed at least in aspiration by a phase in which the reward is reaped. The capital and other resources which are invested has a direct or opportunity cost to it, and as a result, the future cash streams have to be discounted over cash which is in hand today. There are various formalisms, such as discounted cash flow, assessing the internal rate of return of the project and the like. All of these rely on a mathematical technique which discounts earnings and expenditure in proportion to their remoteness in the future.

The most standard technique for project ranking is the internal rate of return, or IRR. This is the numerical discount rate which means that the overall earnings from a project are exactly zero. That is, if I spend $100 this year to earn $110 next year, then discounting future earnings at ten percent will make the project worth exactly zero. Typically, attractive business options have IRR values between 10 and 15% real, meaning after inflation has been taken into account. Equivalent figures for the public sector are usually 6-8%.

Risky matters, such as venture capital, the bonds of uncertain states and organisations need to offer discount rates that are higher, or much higher, than these. Consequently, investment is expensive for these entities and there are projects which are therefore denied to them by both by capital markets and - if they are sensible - by their own good sense. However, it should be noted that these screening rates are either set by markets, by track record where this exists or, quite as frequently, by arbitrary convention. There are technologies - such as assessing the uncertainty in each contributory element of a project, as described above - and using this to create a range of uncertainty in the consequent earnings. Such a range is exactly equivalent to the portfolio volatility which we have already met, so it is theoretically possible to match the earnings of the project (its screening rate) against the rates of return on securities which show equivalent earnings. This is done, but is a black box too far for most pragmatic investors.

IRR can also be used as a universal figure of merit: for example, investment in science earns an IRR or around 25-50% for firms, and in the order of an extraordinary 70% or so for the society at large. Primary school education (and female adult education in third world countries) also earn about 70%. This makes them exceptionally attractive investments for far-sighted policy makers.

The implications of risk assessment and ranking tools.

Projects which are susceptible to formal assessment in this manner are those which are tradable, or which have outcomes which are tradable - which have a price. However, a large number of public sector investments (and private sector expenditure on issues such as brand, reputation, human resource development, knowledge management and the like) do not directly generate deliverables which can be traded. It is hard to set a price on a life saved by traffic scheme improvements, or a cleaner world. Assorted techniques exists - ranging from calculating the full social cost of a road accident, but ignoring the value of the victim as a being - to approached which ask the public to trade one sort of benefit for another. This asks a panel: would you rather have ten less road accidents or 10ppm less sulphur in the city's air? Most panels are nonplussed by this and there is no satisfactory mechanisms that we have yet found by which to handle these issues that advances much beyond intuition and political skill. That said, this is not how we actually behave, and there is a strong bias in favour of things which can be measured and quantified. This is particularly true in the public sector of the industrial nations, where the cynical might say that quasi-objectivity offers some protection to the initiators of a scheme when it is challenged, or when it fails.

Risk assessment has a profound affect on which areas of the world get access to resource. As we have already noted, projects have two kinds of risk built into them. Endogenous risk is native to the project, exogenous risk is native to the operating environment. Where projects are mobile, then these will tend to settle where exogenous risk is low, or they will demand higher returns - tax breaks, lower regulatory burdens - where exogenous risk is high. Instability, the threat of inflation, simple uncertainty about future prospects are, therefore, potent deterrents of investment. Where the investment is speculative, as it is in blue sky research when compared to 'continual improvement'-driven renewal, then even mild insecurity will prevent action from being taken.

The public have a very different model of what constitutes a risk, as we have already noted. Many people and organisations make their choices with little formal analysis, and it is the tone of the times which tends to set our perceptions of risk. The people of Northern Ireland, for example, have been conditioned by years of exposure to terrorism to see their society as crime ridden and innately dangerous. In fact, measured objectively, it is one of the safest places in which to live in Europe. Switzerland, by contrast, is viewed as being extremely safe, despite its having amongst the highest levels of street crime, drug addiction and HIV of its peer nations. We are all of us directly threatened with mutilation and death by motor vehicles, by accidents in the home (and particularly by perils in the bathroom!) yet we tend to worry about the rare or tenuous hazards of nuclear power, genetically-modified foodstuffs and violent crime. We seek out 'natural' foods, despite toxicological evidence that these are laden with natural toxins which were evolved to kill insect pests, and we happily ingest known carcinogens such as coffee, herbs, barbequed meat or chilli peppers, whilst worrying about trace quantities of synthetic compounds in our food which have been shown objectively to be safe.

Our approach to risk is probably conditioned by our evolutionary environment. That is, we learned to accept the familiar if it did not lead to clear and devastating consequences, but we were conditioned to fear the new, the subtly pervasive, the potentially catastrophic. We seem to be particularly sensitive to weak signals in respect of the pervasive threat - the first hint of the new disease, the source of social disruption, the contamination of the waterhole - and these were, no doubt, of great importance in our early experience as a species. However persuasive or otherwise the reader may find this model, the fact remains that we are easily 'spooked', and that the things which most alarm us are those which we do not understand, over which we have no control, and which seem most likely to have sweeping negative consequences.

Industries and policies which operate in these fields are those in which alarm is most easily raised. It is, therefore, exactly these areas which have a potent disjoint between "real" risk and perceived risk. This is likely to be the case for nations in which the regulatory hand is lax or misplaced, where public awareness has been shaped by crisis or adversarial lobby groups, or where other forces of history accentuate certain classes of risk. These nations may find that uncertainty and political pressure directly increases exogenous risk and, as a result, that they are driving away whole classes of industry. Germany, for example, has almost lost its pharmaceutical industry as a result of public alarm about biotechnology, and has certainly completely lost its once-obvious supremacy in the field. Alarm about genetic and stem cell technology, artificial cognition and technologies which allow direct action on the human brain may well characterise other societies. The largely unanticipated British panic about genetically-modified agricultural organisms (GMOs), and the consequent move to the US of many related projects, sources of capital and expertise is an example of what happens when debate passes into a few hands.

This may prove to be a fact of life about which no policy steps can be taken. However, an aware, consulted, debating public is more likely to accept new risks than one which finds that such risks have been nurtured at its ignorant heart. British concerns over GMOs grew from experience with the consequences of decades of intensive farming - such as BSE, food poisoning and the increasing homogenisation of the countryside - and a language of discussion had set itself into place that was unfriendly to technified agriculture. Policy spokespeople had completely failed to talk to the community at large in ways which generated confidence. The activists, the media and increasingly the buying public had developed their own discourse which distrusted the regulatory voice, let alone the producer companies. It is expensive to create such dialogue, but potentially far more expensive not to have it.

Clarity as an object of policy.

High levels of uncertainty, of perceived risk and of actual volatility prevent renewal. Nations which are simply erratic or badly governed deter saving, inward investment, forward-looking activities. Nations which are otherwise placid, but which present exogenous risk on the regulatory or consumer front may also find that options are closed to them. Firms which are undertaking projects will find capital markets and regulators more prepared to underwrite and otherwise permit their plans to go ahead if they have shown a track records of stability. Their cost of capital is lower than that of their more erratic peers. These hurdles fall still further if they can show how their proposals actively advance the interests of their stakeholders. Projects which fall cleanly within their domain of expertise are less risky than step-outs; and projects that are taken in milieux - clusters, partnerships - in which collective understand can be brought to bear are less risky still. Broadly, if a new project has to get five things right, and has a 50% chance that any one of these will fail, then the overall chance that there will be a failure somewhere in the chain is an alarming 97%. In a cluster of related activities - or in a large firm - most of these steps have been perfected elsewhere, and the risk reduces to that of getting the one critical step to work.

The prescription for a nation, region, company or partnership that wishes to promote new potential, or invest in uncertain but promising options is thus relatively clear. First and foremost, macroeconomic and political stability has to set the ground for low exogenous risk. Second, as much of the commercial uncertainty which is innate to long term projects is connected to regulatory issues and questions of law and liability, forward-looking debate amongst the parties is needed to lessen this. (Firms need to know what emission regulations will be in place during the lifetime of a plant, for example, and discussion will help to illuminate this.) Third, those who want to use other peoples' money to undertake risky activities must be able explain themselves, doing so with due regard to full range of the issues which they have to address in order to manage exogenous risk - as, for example, the regulatory uncertainties just discussed. Fourth, of great relevance at the local level, risk is lessened by an appropriate local framework of partnership and specialisation. (And, of course, fifth but less relevant to this section, the engagement of the knowledge and capabilities of such networks inside and beyond the organisation is central to success in the knowledge economy.)

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