CFO Leaders: Mapping And Pricing Risk

“We got into thermal power at a time when it looked very promising. Every Tom, Dick and Harry had plans to put up thermal plants. So as an EPC (engineering, procurement and construction) contractor we thought that there is a huge opportunity available. We didn’t realise the nuances around making a thermal plant work efficiently. We didn’t bargain for fuel shortage, disputes around the PPA (power purchase agreement) that promoters will have. We definitely didn’t bargain for the financial collapse around thermal power plant projects. So, today we are fully geared and invested in the thermal power plant business but we don’t see the environment supporting that investment today. When we look back, I didn’t anticipate this environment.”

‘Risk’ is a four letter word that makes the best CFOs sweat. It is shape-shifting—policy risk to financial risk, M&A risk to compliance risk, and more common nowadays, technology risk to cybersecurity risk. Each has to be mapped, measured and priced. And mitigated.

Mapping Risk

At Mahindra & Mahindra Ltd., Group Chief Financial Officer VS Parthasarathy outlines how his team and he map risk. It’s an almost mathematical model, he says. First they create a budget with clear assumptions. Then they create a risk matrix for both inherent risks and residual risks. So whether it’s volume/sales risk, margin risk, cost risk—each is mapped in a 2/2 matrix of impact and probability. High probability and high impact would amount to extreme risk, as would medium probability and high impact. And for each, there is a risk-mitigation plan.

“It is not rocket science and it is not just at the top. It is for each line item and for division level and at the smallest unit level, plant level, sales operation level and it is built up to each business unit and built up to a company. Then it rises. All high risk and extreme risk items come to a central risk committee to look at and extreme risks go to the board.”

This mostly applies to operational risks. For other kinds of risk, say technology risk or even environmental risk, the mapping is more qualitative.

Pricing Risk

L&T follows a similar process - a risk dashboard where key risks as perceived are put in project and bid wise. And mapped based on probability and severity. The difference lies in the nature of the business—the engineering giant works on projects that often take years to complete. So depending on the severity of the risk, a risk owner is appointed.

“Unless the project has risk owners defined, we don’t get into the project and we don’t allow the bidding to be done,” says Shankar Raman.

This helps in pricing the risk as well, a critical factor for the company to get bid pricing right. Overpricing risk can make for uncompetitive bids.

“When we try to price risk, once we know there is a certain owner at seniority and there are certain mitigants possible, we try to put (ascertain) probability and price that. We add all of it and see in our judgment, given the competition, whether it is good enough to win the bid. Then the chiseling starts, of what risk you can manage or ignore. Is there something that we are being conservative about? And then that chiseling happens. But it comes to a point where there is a cut off beyond which no more. Via trial and error we try to find the ideal price and go in. The fact that we win one out of four projects...shows that we are reasonably there.”

But...

For instance...what happened in Oman...

“We had a four-year project. Midway in the project, may be 1.5-2 years in, the laws of the land changed. They said that minimum 30 percent should be Omanis, in terms of engaging resources. They realised quickly that there is no skilled labor which will account for 30 percent. How many car drivers and office assistants can you hire? You need people to work on a project live. They gave concessions saying that you can engage local subcontractors. At a point in time when there are so many foreign companies who are doing it (taking on projects) on assumption that they will move their resources and their machinery in, when you have this kind of change of law, everybody scampers to the few available subcontractors and the demand of supply changes. Then the cost becomes prohibitively high. What looked profitable, the labour arbitrage, in one instance became a disadvantage. This kind of risk is very difficult to price or even anticipate.”

Watch VS Parthasarathy and R Shankar Raman discuss risk with other finance leaders.

Opportunity Risk

What about the risk of missing out? That’s an unquantifiable risk, isn’t it?

Parthsarathy puts it in the context of the reward. “For example, Uber in cars has already happened. Can I get an equivalent of that shared mobility in tractors? Should I wait or do it now? So, we created a platform called Trringo and we have put it outside (the company) to compete. Maybe it will not come out to be same. Maybe it will be very different in tractors as compared to auto. This is the balance between risk and reward.”