A political risk revolution: Social & regime risk

A political risk revolution: Social & regime risk

In an ever evolving risk environment subject to global trends and local incidents, risk management firms and corporate boards should re-adjust their risk management mitigation procedures to have policies in line both with regime and social risks. A guest post by ENODO Global, Inc.

Corporate executives and boards struggle to maximize risk-adjusted returns because they are unable to consistently evaluate, forecast and mitigate political risk. Contemporary political risk manifests in increasingly diverse ways: Iceland’s Prime Minister was forced to step down amid protests over the Panama Papers scandal, Ukraine’s Prime Minister was forced to resign due to public pressure over economic reforms,  and  French  strikes and protests  have  turned  violent  over  labor  law reforms. Today’s dynamic social environments render traditional political analysis ineffective and require new strategies to measure risk.

Traditional analysis has historically failed to accurately forecast political risk because it (1) is not repeatable across diverse geopolitical conditions, (2) overlooks industry-specific data, (3) requires local knowledge of individual leaders’ personalities and behaviors, and (4) remains incompatible with typical investment time horizons. Moreover, yielding a positive return on investment from political risk analysis becomes nearly impossible when social risk variables that impact national policies like globalization, climate change, pandemics, and migration are factored into this complex equation.

Reactive mitigation policies

Traditional political risk mitigation strategies are inherently reactive. Approaches include: cultivating long-term relationships with senior political officials or deal brokers, engaging regional and industry subject matter experts to navigate investors through unfamiliar environments, employing analysts to conduct regression analysis to predict future events, or using valuable internal resources that lack experience integrating political risk into financial analysis. While the typical mitigation strategy often comes in form of business interruption insurance, such policies have proven unreliable given the often costly litigation associated with making a claim. Meanwhile, avoiding risk altogether results in a lost opportunity to make an otherwise attractive investment. In today’s geopolitical landscape, these strategies are increasingly ineffective as they fail to incorporate social risk variables.

Geopolitical landscapes are rapidly evolving. The proliferation of communication technologies and social media create platforms that strip away barriers to transparency and allow individuals, communities, and even terrorist groups to advance their agendas. The challenge is to understand what event(s) will lead to political or policy changes: the 2013 bus fare protests in Brazil were the first indicators of President Rousseff’s political demise. In this new geopolitical environment, business leaders must shed the traditional lens through which they view political risk in order to fulfill their fiduciary responsibility to maximize shareholder value. A paradigm shift that incorporates social risk analysis provides business leaders with additional lead-time to understand, quantify, and proactively manage contemporary political risk.

Regime risks and social risks

Contemporary threats require political risk to be re-categorized into: (1) regime risks, which emanate from the government and are problems typically associated with political risk such as elections, coup d’états, and policy changes, and (2) social risks,  which originate  from the  general population and result in events such as protests, strikes, litigation, looting, and violence. Although regime risk shares many of the same challenges as political risk, applying social risk analysis informs regime risk and enables firms to create proactive mitigation strategies. For example, Goldman Sachs realized a $200 million loss in Colombia after they removed locals from the vicinity of their  coal mines. If Goldman Sachs had incorporated social risk analysis into their risk portfolio and valuation process, they could have forecasted the lack of support from the Colombian government (regime risk) as well as the local protests, strikes, and work stoppages (social risk).

Social risk analysis focuses on understanding the populations where firms operate and invest. It begins with a population-centric approach that integrates a region’s unique social factors to create baseline assessments. Assessments are then actively monitored for anomalies and deviations within a specific geographic location or business sector. It employs a repeatable, comparable process across varying geopolitical landscapes throughout the entire investment timeline. This allows firms to leverage common platforms used by individuals and groups to measure, quantify, and compare the drivers of social risk. A population-centric approach also integrates unique social  factors that guide the design of tailored engagement strategies to proactively  forecast and mitigate risk. Unlike traditional political risk analysis, which has limited access to specific information, there is ample social data (e.g., human networks, news outlets, print media, academic reports, blogs, and social media) to inform decisions and opportunities to engage society.

Social  risk  analysis enables firms to quantify and identify mispriced investment opportunities, mitigate risk through comprehensive engagement strategies to increase risk-adjusted returns, and forecast events to avoid extreme  downside losses previously labeled as black and gray swan events. This approach is in stark contrast to traditional political risk that relies on external power brokers, insurance policies, or regressive analysis, which assume past experience is a key indicator for the future investment environment.

Firms that successfully incorporate social risk analysis into their business models have a distinct competitive advantage. The inability to accurately forecast political risk and its historic unpredictability accentuate reputational, technical, market, environmental and legal risks. Social risk analysis actually reduces these risks by uncovering the social tensions that drive instability. By engaging society to shape the political landscape, firms can buttress their investments from other risks in their portfolio. This enables firms to identify projects, acquisition targets, or other investments mispriced by competitors that rely only on traditional risk analysis.

By re-categorizing political risk into regime and social risk, firms reap additional benefits beyond enhancing their investment decision-making processes. They are able to demonstrate their commitment to Environmental, Social, and Governance (ESG) issues—an increasingly important factor for institutional investment. They improve  governance  by internalizing risk mitigation strategies previously outsourced to intermediaries. They can streamline public relations and corporate social responsibility operations to enhance community engagement, decrease the occurrence of protests and strikes, and lessen costs for expensive hard security (e.g. gates, guards, and guns). Moreover, a firm’s brand benefits from positive public opinion that is reflected in stock price or inclusion in socially responsible investing (SRI) or ESG screens. By simply changing the way risk is categorized, firms can identify new opportunities for growth in an increasingly dynamic, complex, and competitive environment.

James R. Sisco is the founder and President of ENODO Global, Inc. a risk advisory firm that conducts population-centric analysis to solve complex social problems in dynamic cultural environments. Jim draws upon a distinguished 23-year military career in Marine Corps Special Forces and Naval Intelligence to lead ENODO Global. 

Bryan Bloom is the Chief Financial Officer of ENODO Global Inc. He leads ENODO’s finance practice to pinpoint, forecast, and mitigate social risk for financial firms to take advantage of mis-priced investments. He earned a B.A. from Colgate University with a double major in Economics and Political Science and an MBA from The Wharton School with concentrations in Finance and Management.

Categories: Economics, Finance

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Guest Post

This article was published as part of the GRI Guest Post Series. GRI guest posts come from leading experts in business, government, and academia. The series strives to bring a diverse range of perspectives on the critical issues of our time. The views expressed in this article are solely that of the author and do not necessarily represent the views or opinions of GRI.