By Vlad Antikarov, Verea Group LLC
This is a reprint of the original article, the was initially featured in the March 2022 AFERM newsletter
Over the last few years, it has become clear that the federal agencies are and will continue to operate in a more turbulent and unpredictable environment. The COVID pandemic, the internal and international political tensions, and climate change are only some of the risk factors that are likely to sustain this turbulence. In this new environment, investing in organizational resilience where the agencies can meet their objectives under a wide range of risk scenarios should become a key priority for their budgeting processes.
It has been a long-stated maturity objective of the ERM function to embed risk management principles in key decision processes. The growing resilience-building requirements for the federal agencies will provide the challenge and the opportunity for the ERM professionals to engage with their finance colleagues and respective agency’s leadership to improve the current capital budgeting decision processes and enable the more rigorous assessment and approval of resilience-building projects.
Reactive Resilience vs. Proactive Resilience
Every organization has some level of resilience where it responds to a particular risk by absorbing and overcoming its negative impacts. The unfolding of the COVID pandemic underscored the difference between:
- Reactive Resilience where the organization starts to develop a response, mobilize resources, and deploy required capabilities only when the threat emerges.
- Proactive Resilience where through pre-planning responses and pre-positioning contingent capabilities the organization can take prompt, effective, and efficient actions to mitigate the threat.
Only through building up proactive resilience, the federal agencies will be able to sustain mission-critical operations while coping with a range of possible risk impacts.
Optimizing and Justifying Investments in Contingent Capabilities
Federal agencies through the capital budgeting process build up and maintain a wide range of operational capabilities enabling them to meet their objectives under the regular course of business conditions. However, under certain risk scenarios they need additional contingent capabilities to enable their effective response and resilient operations. The pre-investing and pre-positioning of the necessary contingent capabilities is a critical element of building and maintaining proactive resilience.
At federal agencies, investments are assessed with Benefit-Cost Analysis comparing their long-term benefits with incremental costs1. Projects with a positive benefit-cost ratio are approved for financing and implementation. The challenge of investing in contingent capabilities is that while their up-front costs are predictable, their long-term benefits are uncertain. A good example is the requirement for federal agencies to invest in climate change resilience and adaptation capabilities2. Because the climate in the short-term is highly uncertain, the timing and the size of the expected benefits from climate risk mitigation investments are uncertain as well and hard to assess with traditional benefit-cost analysis.
In recent years, there have been some innovations based on the insight that contingent capabilities provide organizations with different “options” to respond to risks if they occur. These options can be properly valued by option pricing methodologies used in financial markets. This area of finance is called Real Options Analysis (ROA)3 and is a well-established field of research and practice. Foreign governments, particularly the UK Government, have been using Real Options Analysis in multiple areas such as energy investments and climate adaptation4. U.S. federal agencies also can benefit from the application of this innovative best practice to their budgeting decision processes.
Net Present Value (NPV) vs Agility Adjusted Net Present Value (AANPV)
Under normal circumstances, a project would require certain investments and provide certain benefits all reflected in a base case scenario. If risk events are to occur the performance of the project would deteriorate and it could require extra costs or deliver lower benefits. This possibility can be described with a stress test risk scenario.
An additional resilience-building mitigation project would require additional funding but would improve the stress test scenario by reducing the likely losses. For example, building and maintaining a storage facility with emergency supplies for a hospital would require an initial investment and ongoing costs but would provide great benefits under emergency shortages scenarios.
Current Net Present Value-based cost-benefit methodologies like the Benefit-Cost Analysis mentioned above, evaluate only the base scenario and do not incorporate the potential improvements in the stress test scenario of a project.
Agility Adjusted Net Present Value is an improved cost-benefit methodology that enables the correct valuation of resilience-building projects. In addition to the base case scenario, it incorporates the stress test scenario and an upside potential scenario. The total Agility Adjusted Net Present Value of the project is equal to the value of its baseline performance minus the value of downside risk plus the value of upside potential5.
An additional resilience-building project, while reducing the baseline value with the extra cost requirements would also reduce the negative value of the downside risk scenarios. As a result, the total AANPV of the resilience-building project could be positive and its funding could be justified.
Quantifying the Strengths and Weaknesses, Opportunities and Threats (SWOT) Analysis with AANPV
The SWOT analysis has been the standard approach for assessing operations and projects. The Strengths and Weaknesses of a project determine its projected future results reflected in the base case scenario and plans. The uncertainty around the actual results of the project is reflected in the Opportunities and Threats analysis. Opportunities represent likely positive developments that would enable the achievement of results higher than the base case projections. Analogously, the threats analysis captures the likelihood and negative potential impact of future risks on the base case expected results. Currently, the Opportunities and Threats analysis is part of a project’s assessment, but their specific valuation impacts are not incorporated into the Benefit-Cost Analysis. With the use of AANPV the whole SWOT analysis can be quantified and included in the final benefit-cost ratio.
Key Benefits of Incorporating the AANPV into the Federal Benefit-Cost Analysis
By correctly evaluating resilience-building projects, AANPV can become a critical tool in achieving the following key objectives:
- Motivate and empower agency leaders to develop and implement resilience and adaptation projects consistent with their fiduciary duties.
- Optimize project design to achieve long-term proactive resilience and adaptability at minimum cost to the taxpayer.
- Achieve additional benefits to the consumers of government services by increasing their availability and reliability at critical moments of unfolding risks.
By strengthening their proactive resilience, federal agencies will successfully overcome their present and forthcoming challenges and meet their objectives in serving the American people.
1 Circular A-4, Office of Management and Budget 2003
2 Executive Order on Tackling the Climate Crisis at Home and Abroad, White House, January 2021
3 Real Options: A Practitioner’s Guide, Tom Copeland and Vladimir Antikarov, 2003
4 Real Options and Investment Decision Making, The Office of Gas and Electricity Markets (Ofgem), UK 2012.
Accounting for the Effects of Climate Change, Department for Environment Food and Rural Affairs (Defra), UK 2009
5 Both the values of the downside risk and upside potential scenarios of the project are correctly valued using
Real Options Analysis. (Real Options: A Practitioner’s Guide – Tom Copeland and Vladimir Antikarov, 2003)