Can the ‘risk’ equation convince companies to work with communities?

Community risk is the one area of risk that can destroy 100% of Net Present Value. So why doesn’t the finance industry agree on how to factor in that risk?    This blog originally appeared in the Cornerstone Capital Journal for Sustainable Finance and Banking here: http://cornerstonecapinc.com/CornerstoneJSFB_Dec_2013.pdf

iStock_000008519628Medium-1024x682Here is a challenge of the investment industry: When valuing assets for prospective investment, are funds managers properly measuring community risk? If a company has a good community relationship that is not being valued properly then Net Present Value of company assets (NPV) will be underestimated and a good investment opportunity may be missed.

On the other hand, if a poor community relationship is not being measured then the NPV may be artificially inflated and an investor may be buying into a dud.

When looked at this way community development programs are more than just green-washing, they are value creating.

Some in the left wing find it hard to accept that there is a growing role of the private sector in playing a genuine and real role in community development. They are sceptical and think such programs are only window dressing.

Equally some hard-nosed business leaders think such programs are done to protect the corporate reputation but provide little measurable benefit to the bottom line.

Both these views are be wrong.

While many companies have ‘Corporate Social Responsibility’ (CSR) programs, leading companies have moved beyond CSR to ‘Shared Value’. Leading companies do this not because they have taken a ‘be nice’ pill, but rather because leading companies now understand truly effective and non ‘green-washing’ community programs reduce community risk and thereby increase net present value (NPV) of their assets in non OECD economies.

In the resource sector for example, the value of a mine, ore body or natural resource is often expressed in terms of NPV. Put simply, NPV of the asset is calculated by subtracting Net Present Cost from the Net Present Revenue.

Net Present Revenue, in simple terms, is calculated by estimating future revenue over the life of an asset and subtracting from that figure a discount for things such as cost of holding money, sovereign risk and community risk.

Net Present Cost is calculated in a similar way for costs looking at the best estimates of asset construction and running costs over life of mine.

Genuinely reducing community risk can increase the value of assets as measured in today’s balance sheets. Let me take you through a hypothetical and simplified example.

Let’s say a mining company is looking to develop a new copper mine in a remote region with an estimated life of mine of 100 years. The Rio Tinto operated Oyu Tolgoi mine in Mongolia would be such a mine.

Let’s hypothetically say the future costs of construction and operating the mine expressed in today’s terms is $100 billion over the live of the mine.

Let’s now say that estimated future revenue is $150 billion. Let’s now discount that amount by 10% for the cost of holding money, 10% for community risk and 10% for sovereign risk factors. This would give a total discount on future revenue of $45 billion leaving Net Present Revenue of $105 billion. Taking from this the $100 billion in Net Present Cost leaves a NPV of $5 billion.

If the company were to implement a genuine community risk reduction process, and genuinely involve the community in discussions around issues of concern such that the community risk rating could be reduced from say 10% to 5%, lets see what happens to NPV.

NPR of $150b discounted by 10% for cost of holding money, 10% for sovereign risk and only 5% for community risk gives a 25% discount of $37.5b instead of $45b. NPV rises from $5b to $12.5b, more than doubling the value in today’s balance sheet.

BHP Billiton and Rio Tinto, the two largest global mining companies, are well known for their risk reduction approach. They see this as a critical element of maintaining their positions among the lowest quartile cost producers in the commodities of their choice. A focus on cost reduction and risk reduction is the reason that commodity prices tend to stabilise above their cost of production ensuring long term profitability.

Let’s examine another example.

Recently I was approached by a Chilean mining company and asked to advise on the transport of sulphuric acid from port to mine. The company had the choice between road and rail freight, with the rail option being slightly more expensive than road. Management were leaning towards the road option because of the lower freight rate.

But how does risk factor into the overall value?

The lower freight rate of road will reduce the Net Present Cost of the operation and thereby increase NPV. But road transport has three significant risk factors that rail does not: Catastrophic spill, community dissatisfaction of road congestion and community dissatisfaction on particulate pollution.

The road option is likely to have a higher risk rating than rail, hence there should be a higher discount rate applied to future revenue and therefore reduce Net Present revenue. Hence the road option will both reduce net present cost and net present revenue.

The question is what happens to NPV? Does risk impact on value more than freight rate? Would rail, on balance be a better option? This is a question management often avoid answering because the calculation involves some degree of artistry rather than science. Good management must tackle this question though.

Here is another example. BHP Billiton, the world’s largest mining company runs one of the world’s most effective anti-malaria programs in Mozal Mozambique, not because it is nice, but because it increases value.

The company’s program has reduced adult malaria infection from above 90% of the adult population to below 10%. The improved community health has lowered absenteeism in the work force and that has increased the productivity of their operation by a measurable amount higher than the cost of the program itself. When measured well, one can demonstrate that the anti-malaria program is directly, measurably profitable.

Additionally the company can lower the risk rating as the community genuinely values the mining company impact hence increasing NPV still further.

How much does this really matter? Well ask yourself this: Rio Tinto wrote off $3b in value from their Mozambique Coal assets recently. The asset was purchased for $4b, less than half a decade ago. That is ¾ of the value lost. How much of that write down was caused by the lack of gaining permits to use the Zambezi River as route to port for the coal? According to the company, a lot. And how much was community dissatisfaction involved in not gaining the permits?

Andrew Macleod is a Board member of Cornerstone Capital Inc (New York), advisor to Gane Energy (Australia), Critical Resource (UK) a former General Manager at global giant Rio Tinto and a former senior official of both the United Nations and the International Committee of the Red Cross. He is the author of ‘A Life Half Lived’ by New Holland Press.

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