The analysis explores the nature of the separate items, discussing in general terms what proxies exist for a quantification of industry risk.
Product nature risks
The first component relates to the nature of the product and the way in which it is consumed, produced or transported. There are hazards which are inherent in the nature of the product. Most products carry an element of danger, but some are very dangerous. For example, the occur- rence of a nuclear accident such as that which occurred at Three Mile Island or Chernobyl, is sufficient to cause a major avoidance response.
Certain stakeholder groups are most affected. The use of the product may damage those in close proximity without key personnel being aware of any danger. In this case the problem is ignorance, which gives rise to what has been called ‘long-tailed risk’. It is long-tailed in two senses, that The Context of Risk 141
Industry risk Product nature risks
For producers – health and safety For transporters – health and safety For consumers – product liability Pollution to nearby residential areas
Quality risks Shifts in market supply Changes in the quantity used by other buyers Changes in consumer tastes Availability of substitute goods Scarcity of complementary goods
Rivalry amongst existing competitors Changes in product differentiation and branding New entrants and movements in the barriers to entry or exit
Product innovations Process innovations
Industry standards Govemment regulations Input market risks (resources, labour, capital or goods)
Product market risks
Competitive risks
Technological risks
Regulatory risks
Figure 8.2 A typology of industry risk
its occurrence is infrequent and also that there is a significant separation in time between the causative exposure and the resulting harm. Workers or the local community may be totally unaware of the hazards involved even if there is a public literature showing that research has identified possible harm. Even with accurate knowledge of the consequences of a failure to mitigate, there may be accidents. It is sometimes too expensive to remove the most dangerous of activities from the dense populations exposed to the associated accidents.
This is a component of industry risk which is rapidly rising in impor- tance. The nature of product or production process may expose the enterprise to product liability actions or to accusations of pollution. In the nineteenth century courts tended to favour the defendant over the plaintiff whereas in the twentieth century there was a change in focus with protection being given to those damaged (Scheiber 1971, 1972–3, 1973, 1980 and 1981). Courts are increasingly willing not only to find the defendants guilty but to impose fines and compensation costs which are large. The oil spill of the Exxon Valdes, the chemical explo- sion at Bhopal or the ravages of asbestos are good examples of the problem. Single accidents of a significant magnitude can seriously jeopardise the financial viability of an airline through the loss of repu- tation. Many smaller accidents can accumulate into a major impact, as with breast implants.
Class actions magnify the impact. The implications of this kind of risk can be either domestic or international. An oil spill threatens a wide area. The dangers of smoking or asbestos are the same all over the world. International cigarette companies or miners are vulnerable to action taken by those harmed anywhere in the world.
There are two kinds of cost – direct costs which result from the need to clean up or to compensate those damaged by an accident and indi- rect costs, which result from a loss of reputation; potential customers are deterred from consuming the product for an unknown period of time by the loss of reputation. In principle, it is possible to insure against the former, but difficult to do so against the latter.
There are two ways of dealing with the problem – a mitigation policy which reduces the possibility of such damage or a manage- ment policy which gives the enterprise cover against the losses arising from the action of individuals damaged by such hazards. The former is preferable to the latter in that it avoids the loss of reputa- tion. Avoiding such costs is closely associated with the notion of cor- porate social responsibility. It is also a matter of considering the enterprise as a network of stakeholder groups who can be damaged in the ways indicated above.
The Context of Risk 143
The next two sub-components relate to the supply side. Both can change in unpredicted ways or at an unanticipated pace, thus creating risk.
Technological risks
These risks result from the impact of unforeseen difficulties in imple- menting the technical change involved in the introduction of a new product or group of products, or the introduction of a new process to produce or deliver an existing product.
The speed of technical change reflects the point in the life cycle of the relevant product or industry. If the product or industry is young, it is difficult to predict the direction which technical change might take, or the speed with which the new technology will be taken up. Whether it is taken up quickly depends on whether there are first mover advan- tages which might persuade an enterprise to lead the way and incur the additional development costs which fall on the pioneer. Strategy hinges on whether there are first mover advantages to leading the way in technology or whether it is better to wait and allow others to bear the initial costs of developing and mastering a new technology. There is considerable strategic risk in such situations since it is impossible to know what others will do. To some degree there is an attempt to pre- empt others. Will Boeing follow Airbus’s lead in developing the A380 or other mobile operators Hutchison’s in introducing the third genera- tion mobile technology? There is a degree of path dependence in the choice of attributes of any new product and even in the nature of the technology itself. Small events, or apparently trivial circumstances, can sway a decision in favour of a particular variant of a technology. There is a learning process which implies very different rates of productivity increase implicit in different technological variants. Only the techno- logy actually adopted realises this learning. In some industries, the rate of technical change is high and unpredictable, in others slow and more predictable.
Input costs
Input risk takes the shape of unexpected changes in the availability, quality and price of inputs. This relates to what is required for produc- tion, such as equipment, components or intermediate goods, and to the labour and capital required for operations to commence and continue.
The degree of vertical integration of the relevant economic activities determines how far inputs need to be purchased in the market and how far they are under the control of the relevant enterprise. Difficulties can
arise from unexpected changes in the supply or demand conditions for any given input.
There are two sub-components relating to the demand side.
Product market risks
Product market risks take a number of different forms – the impact of unanticipated changes in consumer taste, changes in the availability of goods which are in some way substitutes for the relevant product, and problems in the supply of a complementary good. Such unexpected changes can reduce the demand for a particular product and, therefore, the price. Some product areas are particularly susceptible to such changes of taste.
An unforeseen intensity of competition
The second demand side factor refers to the level of competition from other enterprises and to the advent of new competitors. In any oligop- olistic or imperfectly competitive market, there is always a degree of indeterminateness in the way in which competitions manifests itself.
The price level or the number of competitors may differ although these two factors are interconnected. The smaller the number of competitors, the higher tends to be the price. Such an outcome may reflect an initial strategy of keeping the price down in order to discourage new entrants.
A tendency to reap the maximum profits from an early monopoly of supply encourages new entry and imitation. Prices fall to a level below what they otherwise would have been. There is considerable path dependence in the evolution of most markets for consumer products.
Michael Porter’s analysis of the forces of competition is relevant in this context, in particular his discussion of the barriers to entry. The higher such barriers, the lower is the likely intensity of competition.
The influence of unpredicted changes in regulations or standards Finally there is any change in the ‘rules of the game’ – a change in gov- ernment regulation, a change in industry standards or the emergence of a dominant standard setter. Some of this is formal, much is infor- mal. The process by which the rules of the game emerge is of particular importance in the early history of a product or an industry. There may be rival technologies and both production and consumption methods are poorly understood. The strategic action of the competitive leaders will be important in determining these. The role of government or quasi-government intervention is often important where the product is potentially dangerous or has a particular significance nationally.
The Context of Risk 145
9
Country Risk
….firms engaging in international production are at a disad- vantage compared with local firms (Buckley 1996: 114). …the great puzzle about FDI remains. Why do it at all?
(Buckley 1996: 110) This chapter examines the nature of country risk as a type of system- atic risk which, like industry risk, extends beyond a single enterprise, in this case to the enterprises which operate within the jurisdiction of a particular country. National frontiers are among the most clearly demarcated boundaries which exist in the economic and political world. No part of the world is outside a national jurisdiction. It is obvious who holds sovereignty and is responsible for the law and poli- cies which operate in a particular country. Risk arises from unanti- cipated change in such policies. The aim of this chapter is to establish a template for a measure of generic country risk.
There are six sections in the chapter:
• The first section considers the nature of country risk.
• In the second section there is an identification of the important ele- ments of country risk.
• Section three identifies how the sub-components might be classified within groups constituting the components making up country risk.
• Section four sets out a comprehensive country risk taxonomy.
• The fifth section looks at the issues of weighting and finding proxies for components in a quantitative country risk index.
• The final section analyses the way in which a quantitative index of country risk might influence the investment decision.
146