the “risk-optimised” structure has been found, there is still generally residual risk; some risks will not be economically effective to eliminate, even where doing so would be possible. One is still exposed to potentially adverse outcomes, so that the ultimate outcome may not be satisfactory (of course, the chance of a satisfactory outcome should increase as a result of the risk assessment activities).
Nevertheless, it is still of fundamental relevance to understand the extent of residual (or non-controllable) risk that remains after all worthwhile measures (or decisions) have been implemented: the range of possible outcomes will help to establish whether to proceed or not with a particular decision, or to inform the process of modifying targets and setting contingencies. For example, before a decision is made, one may typically wish to know the average outcome, as well as the best or worst 10 % of cases for key metrics (such as sales, cost, cash flow). Risk tolerances therefore come into play when the final decision is being made: one person may reject a decision that has a 10 % chance of a significantly bad outcome (even if all other outcomes would be highly favourable), whereas another person may choose to proceed, in order to generally benefit from the mostly positive outcomes.
Risk assessment also has a key role to play in project management and execution. For example, one may wish to analyse potential risks relating to the schedule, potential delays, specific cost items or on-specification delivery. To some extent, such activities are a continuation of those that may have been initiated at project design and conception: risk considerations relating to project execution should ideally be reflected in the earlier stages of conception and basic design; projects that are expected to be more complex to execute than others should be evaluated less favourably.
However, in practice it is not possible to fully take into account all project execution risks at the earlier stages of project conception:
• Very often, following authorisation, a much more detailed planning procedure is undertaken prior to (or as part of) the implementation: items such as detailed technical planning, obtaining quotes from several suppliers for all outsourced items, conducting contractor negotiations, planning internal resources and making resource trade-off decisions can really only be conducted once decisions to proceed have been finally made.
• In the time period between the authorisation and the implementation of a decision, the external environment may have altered (such as a change in regulations issued by the government, or other risk events materialize, which alter the best possible future course of action). There may often be some change to the scope, or other changes that may have occurred.
• The project may inherently contain phases (or decision gates), where future activities within the project may need to be adapted as the project proceeds; examples include exploration, appraisal and development projects in the oil, gas and resource sectors, as well as in pharmaceutical development.
Most businesses are portfolios of activities or other elements in some way. For example, sales revenues are the sum of those of different product lines, regions, business units, customers, geographies, projects or assets. In general, the constituent components typically have different characteristics in terms of their implications for key business metrics, such as growth rates, capital investment requirements, project delivery timeframe, cost, cash flow, return on capital, etc. (as well as for their associated risks):
• Mature projects (or products that may be generating a fairly dependable stream of revenues or cash flow) may require little ongoing investment or development activity.
• Projects currently in the implementation phase may require significant amounts of cash investment: whilst not yet producing revenues, these may nevertheless be of medium risk, in the sense that future revenues and cash flow may be uncertain, subject to uncontrollable factors, or to overruns in capital expenditure, or to implementation delays.
• Projects in research or early-stage development may currently require fairly small investments, but their success or failure (and associated timeframe) may be crucial to the medium-term performance or to the long-term survival of the business; in that sense, these projects may be considered highly risky.
• There may also be existing joint ventures, potential acquisition possibilities, and so on; each will have its own specific risk profile for key metrics.
In addition, there will be some issues that are important at a corporate (or aggregate) level, even though such issues may be less relevant at the level of individual projects. For example:
• Generally, issues concerning corporate cash flow, financing, debt and equity structures, treasury and tax have to be dealt with at the corporate level, even though the aggregate corporate position is driven by individual projects.
• Although individual projects within a set of investment projects may appear to make sense on a stand-alone basis (for example, each may have a highly positive net present value, resulting from some initial investment and then a series of positive cash flows), in aggregate, the investment requirements for the full set of projects may be too high to allow them all to be implemented simultaneously. There could also be non-financial constraints to their simultaneous implementation, such as technical expertise or material resources.
• Holding a portfolio of “high risk/high return” projects may be acceptable, even if – when viewed in isolation – each individual project would likely be judged as too risky. For example, a project with a 30 % chance of success (creating a net gain of $100m), and a 70 % chance of failure (creating a net loss of $10m), will have a positive (weighted) average net gain of $23m (i.e. 0.3 × 100–0.7 × 10). On a stand-alone basis, one may wish to avoid the possibility of a $10m loss; however, as part of a portfolio, the project may be acceptable:
• As part of a mixed portfolio of stable cash-generative projects (whose cash flow could be used to cover the investment of the newer projects, or of any additional costs resulting from unexpected events), the single project may also be acceptable.
• If the project were shared with partners, in order to reduce the effective investment and exposure to losses, one could still partly benefit from the average positive nature of the project whilst reducing the downside losses proportionally.
• A large portfolio of similar but independent projects would be profitable not only on average, but also in almost all cases. For example, given 100 such projects, it is very likely that outcomes close to the average would be observed in most cases, i.e. close to 30 successes and 70 failures. Since the benefits of success easily outweigh the cost of failure, such a portfolio would be attractive in general, as success at the portfolio level is almost guaranteed (providing that there is financing available to cover early failures). Figure 1.1 shows the distribution of the number of successful projects, such as that in 77 % of cases the number of successes is between 25 and 35 inclusive (the details of such analyses are discussed later in the text).
Figure 1.1 Number of Successful Projects out of 100, Each with Probability of Success Equal to 30%
Risk assessment (and uncertainty analysis) can have a number of applications in the construction, adaptation and optimisation of project portfolios, to help to ensure that business growth or other objectives are met:
• Identify, for any assumed portfolio, how likely it is that corporate objectives and targets would be achieved with that portfolio:
• Identify whether new projects or different activities are required; this is related to the development of strategic options, which is covered separately below.
• Understand the
