Corporate exposure: time for political risk standards

Our Deputy Director of Advisory argues that investors should be raising more questions about the link between political risk exposure and valuation, and Boards should be in a better position to answer.

Executive summary

  • Investors will begin to ask more about the link between geopolitical exposure and valuation
  • Board and CEO disclosure is inadequate, and the political risk function underpowered
  • Management teams are overvaluing the cost of political risk and avoiding net positive investments
  • In time, enhanced disclosure norms will enable investors to benchmark MNCs against their peers
  • Forward-thinking management teams are acting now

Analysis

The inversion of global economic and geopolitical risk – along with expectations that political risk levels and volatility will remain unusually high – should be raising more questions about the link between geopolitical exposure and valuation. A particular concern is the inadequate reporting standards for risk exposure that ally to public companies. 

Exposure to geopolitical risk can have a direct impact on a company’s top- and bottom- lines

Following a series of interviews with risk professionals at some of the world’s leading companies during 2017, it became clear that the current areas of concern include regulatory risk, security and violence, royalty changes, change in government and cyber terrorism. A surprising number of the companies we talked to admitted recent risk-related losses throughout the world. 

Figure 1
Countries where panelists had experienced a political risk loss (mentions)

Source: Oxford Analytica and Willis Towers Watson

Exposure to geopolitical risk – including tax or royalty changes, confiscation of assets and security concerns – can have a direct impact on a company’s top- and bottom-line. For public companies, these impacts flow through to a company’s market valuation. While the significance of the link between geopolitical risk and valuation will vary between companies, political risk generally equals complexity, which drives up costs and/or – depending on market segment – positively or negatively impacts revenues. Sector and business model determine whether such costs can be passed on.

Recognition that there is a link is prompting institutional investors – including pension funds and investment managers – to ask more questions of the board of public companies. Crucial questions include:

  • What is the company’s exposure to geopolitical risk?
  • How is it being captured and monitored?
  • Is the company’s capital allocation and investment strategy appropriate given current and emerging geopolitical dynamics?

Our research indicates that board responses to these questions are often inadequate. In some cases, this can result from the style and composition of the board itself, but often the problem lies in ineffectual organisational design still evident at many leading companies.

When asking how leading companies are managing today’s geopolitical risks, we found that the political risk function is often isolated and underpowered. Typically, it is only engaged with when a risk is realised or sought out at an advanced stage of a transaction. In other words, unlike horizontally integrated risk functions such as compliance, legal and enterprise-risk-management, political risk is regarded as a cost of doing business but not seen as a requirement for conducting business. 

The political risk function [at leading companies] is often isolated and underpowered

For investors, this should raise an alarm because it suggests that many companies up to now have succeeded in spite of the geopolitical environment. This made sense because economic risk dominated the macro environment for decades and, therefore, most OCED companies have been structured to cope with economic rather than political risk – including, for example, adjusting workforce to meet demand and launching products targeted at price sensitive consumers during periods of economic recession.

However, in a risk inverted environment – one where political actions or consequences pose more concerns than economic trends – it implies that insufficient consideration of political risk is likely leading to suboptimal decision making. This is not to suggest there is only downside risk. In fact, the political risk function’s limited involvement in supporting business decisions is likely leading many management teams without sufficient political risk support to overstate – particularly over the medium and long-term – the cost of political risk and, in turn, avoid net positive investments. In other words, the inclusion of political risk in business decision-making could increase returns (or financial performance) without increasing internal risk thresholds.

For example, without adjusting risk tolerance, we calculate that FDI inflows into emerging markets could have been 3.6 billion dollars greater in 2016 had political risk been measured more accurately.

Figure 2

What next

Forward-thinking management teams recognise the opportunities in the link between geopolitical exposure and valuation. Coca-Cola is one such company. It frequently turns risk into opportunity by getting out in front of its competitors to set industry standards through identifying and acting on public rhetoric with potential for policy implications. Its latest PR coup related to recycling all of its packaging by 2030 is one such example. Amazon’s very public consultation period for the building of HQ2 – a process that normally takes place behind closed doors – is another. Amazon is using the process to highlight significant job creation and create goodwill at a time of growing concern about consumer privacy and the replacement of jobs by artificial intelligence, a technology on which Amazon’s current and future growth depends.

 

Few CEOs can answer questions about geopolitical risk mitigation

Yet too few CEOs would be prepared to publicly discuss – or even know the answer to – questions about geopolitical risk mitigation strategies, ROI of government affairs and public relations, and effective stakeholder management practices. From a disclosure perspective, for example, few companies provide a detailed breakdown in annual reports of geographic financial performance and exposure. This is usually aggregated at a firm-defined ‘regional’ level, making accurate geographic benchmarking across companies almost impossible for investors.

Political risk is set to become a fiduciary responsibility

In an inverted risk environment, this lack of information quickly moves from being undesirable to unacceptable. Inadequate political risk disclosure norms and limited levels of board competency indicate that a tidal change is imminent, if not already upon us: Political risk is set to become a fiduciary responsibility, for which investors will increasingly hold senior management and the board accountable for losses – and lost opportunities – related to political risk.

To meet such requirements, the corporate approach to transparency on exposure to geopolitical risk will require a significant overhaul. Our current assessment is that many companies – particularly non-extractive sectors – would struggle to:

  • shift to a model of active risk management; and then
  • meet external stakeholders’ transparency requirements.

Over time, increased disclosure norms and requirements will enable investors to benchmark public company geopolitical exposure and capabilities against their peers.

The question is: what will this risk matrix and comparative framework capture and reveal?