Risk Management

How to Bungle Political Risks

A survey finds that most senior executives consider overseas perils a low priority, even when they have investments and operations abroad.
Helen ShawMay 24, 2006

AES Corporation’s 1998 purchase of Telasi, the nation of Georgia’s electricity-distribution company, entailed the myriad of political risks that most international businesses deals do. But the venture resulted in one catastrophe that could not have been anticipated: the murder of AES-Telasi’s CFO, Niko Lominadze, in 2002.

Why the finance chief had been shot dead in his Tbilisi apartment by a policeman’s gun remains murky nearly four years after the crime. Although the police officer whose gun was identified as the murder weapon was arrested shortly after the killing, he was released a few months later. Recently, however, five people, including a local gas industry executive, were arrested in connection with the murder, according to a Caucasus Press story cited by the EurasiaNet website. Georgia’s Interior Minister said in March that the goal of the person who hired Lominadze’s killer was to prevent the discovery of an embezzlement scam within AES-Telasi, according to EurasiaNet.

Indeed, AES’s handling of its political risks in the country in the years leading up to the crime appears to have been an object lesson in how to make a hash of them. The company’s foray into Georgia “was just like Vietnam,” an AES manager told Witold Henisz, a professor at the University of Pennsylvania’s Wharton School. “We were the big, bad Americans—completely naïve, did not understand consumers or the government, and thought we could come in and everything would work,” he said. Henisz, who is also a principal in PRIMA LLC, a political risk management consulting firm, declined to name the manager. AES Corporation did not respond to a request for comment.

The electrical-power giant’s experience in forming AES-Telasi in Georgia, however, went through fluctuations in the company’s attempts to manage its reputation and address concerns of government officials, consumers, and other groups, according to a case study co-written by Henisz and Bennet Zelner, a visiting assistant professor at the University of California at Berkeley’s Haas School of Business. To start with, AES encountered a poor, widely corrupt country with little energy infrastructure and a population that was unfamiliar with paying for electricity, the professors report.

Still, things began fairly well. Until 2001, Mike Scholey, head of AES-Telasi, initiated significant investment in the company, battled against corruption, and launched a high-profile public relations campaign. The approach resulted in higher bill collections and an improving public opinion of the company.

After the fall of 2001, however, the company fared much worse under its new leader, Ignacio Iribarren. His hand forced by headquarters’ pressures and the post-Enron environment, Iribarren focused heavily on improving the company’s financial results, targeted non-paying industrial consumers, and suspended new investments and public relations activities, according to the case study.

The ensuing problems that resulted from this approach included a Parliament investigation into AES-Telasi, lawsuit threats, and the cutoff of power to government organizations — in short, a loss of public and government support for the company, the authors say. The company ultimately sold its operations in Georgia, resulting in a $300 million loss to AES shareholders.

AES’s management of its political risks in Georgia followed a common trajectory, according to Henisz. Often, companies make foreign investments during boom times, sign contracts they assume will protect them, and expect to be greeted with open arms, he said. When a recession, a chemical spill, or other possible negative events occurs, the host nation can view the foreign company as an outside enemy.

With oil prices soaring in recent weeks, many foreign companies involved in the energy industry have found themselves in hot water in host countries. Bolivia has decided to nationalize its gas industry, for example, and Venezuela changed contracts with international oil companies to garner a greater share of revenue. “The level of petro arrogance developing on the back of $65 oil and the willingness of government officials to squeeze more cash and preferable deals out of contracts with multinationals has been heightened,” observes Ian Bremmer, president of Eurasia Group, a New York-based political risk consultancy.

At the same time, political risk includes many other hazards, including political violence, expropriation, the inability to repatriate profits, and terrorism. The stumbling block for most multinational companies is setting priorities for managing potential problems, according to Bremmer, whose firm has linked up with PricewaterhouseCoopers to offer a political-risk-assessment service.

In fact, companies grant political risk low importance, even when they have investments and operations abroad. A September 2005 Protiviti survey of 76 senior executives at Fortune 1000 companies revealed that they ranked the importance of political risks in highly imperiled countries as “not significant, but monitoring for change.” The executives were more fearful of the risks involved in competition, regulation, the environment, technology innovation, and the financial markets.

To be sure, a PwC-Eurasia Group survey of 106 companies between December 2005 and February 2006 found that although 69 percent of companies gauge political risk as part of their financial projections for new investments. But once operations are established, only 27 percent create formal reports on those risks at least twice a year.

Companies also err by regarding the management of political risk as merely a matter of purchasing coverage for it. At Engelhard Corporation, however, managing these perils does not just revolve around buying insurance, according to Rich Sarnie, director of risk management. “You should be looking at loss prevention, have an awareness of what is going on in the country,” he notes, “all those are factors that need to be monitored on a daily basis.”

Every six weeks, Engelhard’s CFO gathers all business unit controllers to make sure the departments are aware of one another’s endeavors, the risk manager says. During those meetings, the risk management department shares political-event reports it subscribes to and examines investment opportunities, said Sarnie. The finance chief isn’t alone in his involvement: at 34 percent of the companies responding to the PwC-Eurasia Group survey, the chief financial officer pilots political risk management efforts.