The Need for ERM is Crystal Clear

Unlike the waters of the Gulf of Mexico, the need for companies to have robust enterprise risk management (“ERM”) programs became crystal clear during an interview of former BP CEO Tony Hayward aired this week by the BBC. Here’s some of the highlights from the interview.

Former BP PLC chief Tony Hayward has acknowledged that the company was unprepared for the disastrous Gulf of Mexico oil spill and the media frenzy it spawned, and said the firm came close to financial disaster as its credit sources evaporated.

In an interview with the BBC to be broadcast Tuesday, Hayward said company’s contingency plans were inadequate and “we were making it up day to day.”

Hayward said BP had found itself unable to borrow from international investors during the spill crisis, threatening its finances. He said that before a meeting with President Barack Obama at the White House in June, “the capital markets were effectively closed to BP.” “We were not able to borrow in the capital markets, either short or medium term debt at all, ” he said. “It was a classic financial crisis issue.”

Hayward’s successor, Bob Dudley, told the program that “these were frightening days” for BP. “With a company the size of BP, its reputation, what it does — you almost can’t quite believe how close you are” to financial disaster, he said.

This interview demonstrates the catastrophic impacts of a risk event not only to the environment at large, but also to every corner of the company responsible for the event occurring. BP obviously did not have a comprehensive ERM program at the ready that resulted in improvisation and ultimately a full-blown crisis. Only a company of BP’s size and resources could weather this type of event. So, how effective is your ERM program?

Risk Blindness at BP

In the pursuit of profit, sometimes a company becomes blind to risk.  This is most evident in the latest debacle of British Petroleum (“BP”) with the oil spill in the Gulf of Mexico. While their recent offshore deepwater drilling posed great environmental risk, BP experienced the results of poor risk management onshore as well.  According to the New York Times, BP’s current CEO faced similar challenges in 2007.  Here is what happened back then:

In 2007, when Mr. Hayward first took over as chief executive, BP settled a series of criminal charges, including some related to the explosion of BP’s Texas City, Tex., refinery, and agreed to pay $370 million in fines. Admitting that the company’s operations had failed to meet its own safety standards and requirements of the law, Mr. Hayward pledged to improve BP’s risk management. Following the Deepwater Horizon explosion, Mr. Hayward conceded that the company had problems when he took over in 2007. But he said he had instituted broad changes to improve safety, including setting up a common management system with precise safety rules and training for all facilities.

Some analysts say the safety problems indicate that BP has not yet reined in the culture of risk that prevailed under Mr. Hayward’s predecessor, who transformed BP from a sleepy British oil producer into one of the world’s top explorers through the acquisitions of Amoco and Atlantic Richfield.

A strong culture dedicated to risk management is essential for companies who are looking to succeed in the long run. BP’s current crisis is a prime example of the perils of ignoring the importance of strong risk management practices.

Growing Web of Risks in Today’s Business World

As many companies look to better understand the complex risks within their organization, recent events are pointing to the increasing need to understand the even more complex risks posed by partner organizations. Richard Thaler, professor of economics and behavioral science at the University of Chicago, provided his view in the New York Times this week.

AS the oil spill in the Gulf of Mexico follows on the heels of the financial crisis, we can discern a toxic recipe for catastrophe. The ingredients include risks that are erroneously thought to be vanishingly small, complex technology that isn’t fully grasped by either top management or regulators, and tricky relationships among companies that are not sure how much they can count on their partners.

For the financial crisis, it has become clear that many chief executives and corporate directors were not aware of the risks taken by their trading desks and partners. Recent accusations against Goldman Sachs suggest the potential for conflicts of interest among banks, investors, hedge funds and rating agencies. And it is clear that regulators like the Securities and Exchange Commission, an agency staffed primarily with lawyers, are not well positioned to monitor the arcane trading strategies that helped produce the crisis.

The story of the oil crisis is still being written, but it seems clear that BP underestimated the risk of an accident. Tony Hayward, its C.E.O., called this kind of event a “one-in-a-million chance.” And while there is no way to know for sure, of course, whether BP was just extraordinarily unlucky, there is much evidence that people in general are not good at estimating the true chances of rare events, especially when human error may be involved. There was another major blow-out in the gulf 31 years ago by the Mexican rig Ixtoc I. So was this really a one-in-a-million risk?

In the current spill, the problems of assessing risk were complicated by the teamwork required among BP; Transocean, which owned the rig; and Halliburton, which had provided services like concrete work. “Of the 126 people present on the day of the explosion, only eight were employees of BP,”reported Ian Urbina in The New York Times. “The interests of the workers did not always align.”

Certainly, before a company can fully understand the growing web of internal and external risks inherent in their business activities, the company must have a disciplined approach to risk management. A strong enterprise risk management program can help in this regard. If your company is looking to implement or improve its enterprise risk management program, Wheelhouse Advisors can help. Visit www.WheelhouseAdvisors.com to learn more.

ERM Helps Avoid Risk Miscalculations

A recent article in the New York Times discusses the inherent failings in estimating risks in our society today.  As our environment becomes more complex, people are faced with ever-increasing amounts of risk that are difficult to quantify until it is too late.  Here is an excerpt from the article that explains the challenge very well.

But there also appears to have been another factor, one more universally human, at work. The people running BP did a dreadful job of estimating the true chances of events that seemed unlikely — and may even have been unlikely — but that would bring enormous costs. Perhaps the easiest way to see this is to consider what BP executives must be thinking today. Surely, given the expense of the clean-up and the hit to BP’s reputation, the executives wish they could go back and spend the extra money to make Deepwater Horizon safer. That they did not suggests that they figured the rig would be fine as it was. For all the criticism BP executives may deserve, they are far from the only people to struggle with such low-probability, high-cost events. Nearly everyone does. “These are precisely the kinds of events that are hard for us as humans to get our hands around and react to rationally,” Robert N. Stavins, an environmental economist at Harvard, says. We make two basic — and opposite — types of mistakes. When an event is difficult to imagine, we tend to underestimate its likelihood. This is the proverbial black swan. Most of the people running Deepwater Horizon probably never had a rig explode on them. So they assumed it would not happen, at least not to them. Similarly, Ben Bernanke and Alan Greenspan liked to argue, not so long ago, that the national real estate market was not in a bubble because it had never been in one before. Wall Street traders took the same view and built mathematical models that did not allow for the possibility that house prices would decline. And many home buyers signed up for unaffordable mortgages, believing they could refinance or sell the house once its price rose. That’s what house prices did, it seemed. On the other hand, when an unlikely event is all too easy to imagine, we often go in the opposite direction and overestimate the odds. After the 9/11 attacks, Americans canceled plane trips and took to the road. There were no terrorist attacks in this country in 2002, yet the additional driving apparently led to an increase in traffic fatalities.

The best way to avoid miscalculating risks is to develop a disciplined enterprise risk management program with a solid framework to help quantify the level of risk.  Wheelhouse Advisors can help.  To learn more, visit www.WheelhouseAdvisors.com.

Follow

Get every new post delivered to your Inbox.

Join 46 other followers