Risk is a key area of responsibility for directors, but for those involved in large-scale infrastructure projects, balancing that risk with the company’s appetite for growth is paramount.
Graham Burdis: Following the decline in Australia of infrastructure projects by the private sector, the government sector is now returning to the area.
However, the recent global experience of such projects has not been an altogether happy one. It is recognised that often, large infrastructure projects suffer from significant under-management of risk throughout every stage. These projects are usually very complex and combined with their long-term nature, the management of risk is equally difficult, with failures at any stage having impacts for the long term.
According to a research report by Infrastructure Australia, 48 per cent of these major projects fail. In addition, 70 per cent of the people polled believe the project teams are held responsible for the failure currently, but that 60 per cent believe the government should be held responsible. Do you think this is a fair reading?
Paul Forward: I think it really depends on what you mean by failure. It might be failure from one side but not the other. In New South Wales there are two motorways considered to be great failures from the funders’ point of view, but from the government’s point of view, they were huge successes. The Cross City Tunnel and the Lane Cove Tunnel are two classic cases where both proponents really had to sell the assets off because they weren’t making enough money to cover their debt, but the community got two strong assets out of it.
I think the key to these things is good relationships between both sides, and realistic relationships and views about what those assets are going to produce.
Peter Coates: I agree with your analysis that these large infrastructure projects have a history of over running and cost much more than anticipated, but I think the problem starts with management and you’ve got to go back to management and recognise what drives management.
Management is driven to grow the business either by committing to expansionary projects or by acquisitions. There are incentives for management to grow the business which may mean a bigger market cap and more financial rewards for management. The management team may well be focused on having the board approve a project which satisfies management’s desire for growth rather than the shareholders’ desire for returns.
It’s no good going into a major project with a rate of return that’s just above your cost of capital. Based on history, there is a very high chance that, for one reason or another the project will overrun and the returns will evaporate. The answer of course is to ensure that projects are sufficiently robust to cater for the risk that should be identified right at the start.
Paul Forward: Your point is well documented. A vast majority of projects have optimism bias at the start. Ben Flyberg from Oxford University has documented a whole stack of projects, which he has demonstrated, start out at X and end up at X plus.
Ian Watt: I think you made a very good point, Paul, when you said that there are two different perspectives with regard to success and failure, one from the owner perspective and one from the contractor perspective. Both sides are driven by shareholder value. Shareholder value is perceived on the owner’s side – the owners are the taxpayers essentially, and from a contractor’s side, the owners are the shareholders driving shareholder value from both perspectives. It is divergent.
The contractor is trying to drive shareholder value by building their forward book and delivering on their financial outcomes as they promised the previous year, which drives the share price up and attracts buyers and so on. On the owner’s side, they are trying to get the best product for the cheapest price in the cheapest time. The two things don’t typically marry.
Graham Burdis: How does a board cope with those things?
Peter Coates: That’s where you come to the board’s responsibility for fully identifying project risk. I’ve been caught out on this a number of times and I’m talking from the bitter experience of living with projects where the risk was not properly identified – whether that risk was a commodity price, whether that risk was foreign exchange movements, or whether that risk was simply not accounting for the pressures on contractors and construction costs. My experience says you’ve really got to put the effort into identifying these risks and try to cater for them within the economics of the project.
The pipeline business is a different sort of infrastructure project with a different risk profile. There are generally less variables and you would normally only commit to a pipeline project with a locked in usage contract so you know what your returns are going to be.
Steve Crane: The distinction I would draw is that there’s stuff that you do which I would call your normal business, such as pipelines: you’ve built lots of them, you know everything about them, you know the types of issues that come up like putting the pipe in the ground or running it above the ground or over water. You’ve got those contexts and you’ve got lots of experience and have been doing it for a long time. That is one type of project. For me that’s a lot lower risk.
Then there’s the size of the project. If the size of the project is very big it is usually very high risk, although small projects can also come with risk. Therefore, you’ve got those different quadrants of risk and that is a challenge for a board.
Kelvin McGrath: So you put all those together and ask “what’s the portfolio risk and what’s our risk appetite?”
Peter Coates: The difference here is you’re talking about your base business, which is building, owning and operating pipelines. Or if you’re a general contractor, its design, contract and construct. I come from an industry where construction is not our base business and so companies are often caught out because they often don’t have the necessary contracting or contract management skills. That’s the difference.
Graham Burdis: Boards are fixated on strategy at the moment. Do these things still fit within a strategy remit?
Peter Coates: From a board’s viewpoint, risk can be reduced by hedging foreign currency and commodity prices and taking on a fixed price contract.
Ian Watt: Lump sum is the predominant contract method in this area and it’s going to be more so over time. The dilemma is do you really know what you’re signing up for? You’re happy to accept a reasonable number and they’re going to come back to you with all sorts of ridiculous variations and scope changes, which are going to extend that number.
Kelvin McGrath: It is about the right party assuming the risk. You may be in a better place to assume the risk rather than take a fixed-price contract.
Graham Burdis: This also comes back to the risk team. Often the project managers are part of the risk team, but they’ve also got that conflict as they’re running the project but they’re also part of the risk. There was some talk about having independent risk management, is that possible?
Steve Crane: I think companies have tried. You have separate risk functions, but the people running the project have got to own the risk and the project.
Graham Burdis: What about the governance of risk? If you’re a project manager and you can see it’s going to head off the rails, you can be conflicted about reporting that up to the board can’t you? You can delay the issue until the worst possible scenario.
Peter Coates: That will always happen. The optimistic project manager thinks he can work his way out of the problem until it is too late to ask for help.
Graham Burdis: One of the things that came out in this report was 71 per cent of people reported that the risk managed by a contingency budget was flawed. Eighty per cent believe that governance teams don’t understand the best practice risk management. The other thing that came out of the study is that risk managers are not being measured. They don’t have key performance indicators for risk management.
Peter Coates: It’s particularly hard for boards to manage projects because of how the reporting is done. If it’s a January report, it is completed by mid-February and then goes through a couple of reviews. By the time the board gets it, it is March and you’re a month behind anyway. This means you generally can’t rely on reports to warn you in sufficient time to instigate corrective action.
One of the projects I am involved with has introduced a process to overcome the shortcomings associated with the timing of monthly reports. We make sure that at every board meeting the board personally interfaces with the appropriate project manager. We directly interrogate him on the status of the project and he is required to identify his three major risks and identify the steps he is taking to mitigate those risks. If the next month he comes back with a different risk and it’s out of control, then he’s either not across the project and is being blindsided by unidentified risk or alternatively, he has not been transparent in his discussions with the board the previous month.We are trying to push the responsibility back on the project managers to be transparent and to share their problems at an early stage.
Steve Crane: The other thing is sometimes even the information the board gets is not accurate, not because someone has purposely misled you, but if you don’t have the right systems in place, then you don’t get the information you need.
Paul Forward: It is really important for boards to actually eyeball the project as you go through.
Ian Watt: You’re absolutely right, the timeliness and the accuracy of the information that’s being fed back is critical. Directors getting information with a significant lag is almost useless; it’s historical. This plays towards this whole concept of risk and risk is based on uncertainty. Risk is what eventuates when you don’t really know what’s going on. You have got to go out and eyeball it to either have visibility or have confidence in the trustworthy nature of the data.
Kelvin McGrath: I think that’s important but you need to think about whether you have got the foundations in place. It’s part of the board’s responsibility to ensure that wherever we are in the project, all the processes are in place. We understand that we’ve got internal audit in there making sure that all those things are working properly.
Peter Coates: Value reporting is particularly important I think. If you can get that started right at the beginning of the project, I think you’ve got a great monitor.
Ian Watt: Just this morning I read a survey analysing 160 major projects between $1 million and $5 billion or over around the world. It identified that only 45 per cent of those projects were run using systems that linked their financial systems to their project systems, which is diabolical because you have no actuals in your performance.
Graham Burdis: From your experience are risk registers used by the boards?
Steve Crane: I think so. The trouble is they can be in use but the board has got to rely on that information flow. The register is fine, but at some level the board is going to have to trust management.
Peter Coates: As a principal it is important to be watching what’s going on in the contract and making sure that issues don’t develop which have knock-on effect.
The ability of boards to be on top of these things, is in many cases quite limited unless contracting is your base business and you are watching it every day. Boards are particularly inept at managing a whole variety of issues because they operate at quite a high level, as they should, and you don’t want to be doing management’s job. You’ve got to find a way of being able to “read the tea leaves”, being able to sense that something is amiss. That can only be achieved by directly communicating with the people involved in the project. This is often quite difficult for a board to achieve.
Kelvin McGrath: Maybe the converse may be true as well. Are the best and brightest in the company actually being poured into a project which is in a bit of trouble at the expense of the rest of the portfolio or in operations? That’s really difficult to pick.
Ian Watt: What is the attitude of a board if a contractor actually proactively came to you and said we have this real big problem at the earliest opportunity?
Peter Coates: The board would welcome that because it’s only going to get worse. If the contractor is losing money because he has underestimated some aspect of the job, then you’ve got to sort that out as quickly as possible. The option of showing no flexibility can often lead to the worst possible result for both parties.
Steve Crane: When there’s been a problem from the contractor’s point of view, the best thing they have ever done is go to the client and say we’ve got a problem. This isn’t working, it’s not going to work for us, therefore it’s not going to work for you. It’s not pleasant but we’re going to have to sit down and work out how we are going to solve this problem. If you do that sometimes you can find your relationship gets enhanced by that whole process.
Graham Burdis: Can you share an example of projects you were involved in that went off-track but came back and you successfully managed to save it or to mitigate the liability?
Paul Forward: I was chair of Agri Buyer, which is an agricultural bio-science research centre at La Trobe University. I was involved from concept to operations on the project. This was a state of the art research centre and it’s a public-private partnership. Scientists are in the research centre doing experiments and clearly the experiments are key to the whole atmosphere and temperatures they are conducted in have to be in a very stable environment.
In January 2013 in Melbourne the temperature exceeded 46 degrees and the cooling systems broke down and some scientists lost over 12 months worth of experiments. So the issue there was one of trust and faith in the management and the board that the experiments were going to be safe going forward.
Peter Coates: It’s difficult because you’re building a commercially viable project and the project cost or time blows out to the point that there is no rate of return and all the value may have gone. There’s no return and you are forced to just write off the whole cost of the capital and move forward and run the business on the basis that it is cash positive. I can name many projects which are now operating and making cash but where the original shareholder value was all lost because of project over runs.
Graham Burdis: What do you think are the key factors for board members to consider when managing big infrastructure projects?
Peter Coates: Know your management team. Know their weaknesses and their strengths. Identify the risks early and make sure that you keep close to the project and keep communicating.
Paul Forward: The board can’t be at arms length from big projects.
Peter Coates: It also works for the CEO. If the guys managing your big projects come and report to the board and the board interrogates them aggressively, it’s good for the CEO to see them put under a bit of pressure.
Ian Watt: A level of focus, governance, visibility and insight into their behaviour and activity is going to keep them on the ball.
Steve Crane: A healthy level of challenge is really important. It’s also important management doesn’t feel like you are just there to be against them. I think it’s got to be constructive otherwise you get a breakdown.
Kelvin McGrath: The board has got to make sure that it has got a risk appetite which management knows about. It has got to then decide what it is going to do with those risks.
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