Large infrastructure projects come with an array of challenges. Projects are getting more complex, remote building locations are more common, budgets are larger than ever, and schedules can extend for multiple years. The COVID-19 pandemic has also wreaked havoc on supply chains and increased the need to free up cash. Against this backdrop, it is hardly surprising that project owners often struggle to estimate costs.
Due to market uncertainty and ongoing questions about the global economic outlook, many companies are freeing up cash by deferring capital expenditure. McKinsey’s data indicate capital expenditure was cut by 25 to 30 percent in 2020, with cuts of 60 to 80 percent in sectors such as transportation, pipelines, and oil and gas. Nevertheless, companies still have to manage their current projects, and future revenue generation will require continued and significant investment. What is needed is a shift in capital-outlay approach from “survival minimum” to “strategic optimum.”
A major driver of capital efficiency is the extent to which capital becomes “trapped” within project portfolios. Businesses have traditionally taken a bottom-up estimating approach to developing and setting the budget for investment projects. While project-level development and accountability are crucial, a lack of clear direction on risk analysis and budget development can lead to an inefficient use of capital. A portfolio-level perspective can help to optimize capital expenditure and ensure consistency at both the business-unit and individual project levels. This approach should involve a better understanding of risk management, alignment on acceptable levels of risk tolerance, and the elimination of systemic biases—in either direction—in the construction of initial cost estimates.
Implementing new processes for project approval and risk management requires a strong commitment from leadership and a sustained change-management effort. However, businesses that rethink the way they manage capital-investment risk will be well positioned to thrive in the next normal.
Why companies struggle with trapped capital
For many companies, there is limited integration and communication between leadership at the project and portfolio levels regarding risk management. In addition, the project funding process often does not require that risks and their potential impact be properly identified and understood.
We commonly see the onus for risk assessment and accountability falling on the project leaders and teams, with insufficient executive guidance to ensure a robust process or consistency between projects. Many decisions are therefore made, and many risks are managed, beyond the view of executives. This tendency means that most risks—including those that might be better managed at the portfolio level—become de facto project risks. This can lead to capital becoming trapped in two different ways.
- Overcommitting capital can trap unnecessary capital in contingency funds. Projects in the typical capital-expenditure portfolio tend to be only partially correlated, and some project risks (such as foreign-exchange fluctuations) may be offsetting. This means that the appropriate level-of-risk coverage for these types of risk may be lower at the portfolio level than the sum of risk-funding requirements at the project level. Companies that account for these sorts of risks at the project level may therefore be holding a substantial amount of excess capital, which could be employed more profitably elsewhere.
- Undercommitting capital can lead to cost overruns. Risk assessments that are overly optimistic, often driven by the intense competition for capital-expenditure funding, may underestimate the amount of money likely to be required during the development process. This can lead businesses to tie up more capital than intended in centralized funds for allocation to the many projects experiencing unforeseen cost overruns—including capital that they might have preferred to deploy elsewhere. In extreme cases, these understated risks may lead to the approval of projects that would not otherwise have been given the green light. Project leaders and teams also tend to systematically overlook some risk categories, including geopolitical and macroeconomic risks. For example, project teams may ignore the risk of tariffs stemming from regulatory changes, which can have a significant effect on the pricing of raw materials or vital equipment.
An approach to unlocking trapped capital
Our experience suggests trapped capital can be unlocked by ensuring that capital budgets are set consistently across the portfolio, all risks are recognized, adequate funding is secured, and outcomes are more predictable. This approach has four key principles:
- resolving ambiguity in how risks are defined and managed
- reducing financial risk by managing shared risks across the portfolio
- replacing systemic bias with consistent cost estimates set at an appropriate confidence level
- reinforcing the relationship between risk and resilience
1. Resolving ambiguity in how risks are defined and managed
A high level of ambiguity around risk can make it difficult to locate—and unlock—trapped capital. This lack of transparency can flow from a punitive culture around cost overruns, but it can also be the result of insufficient portfolio-level direction on how to define both the level of confidence in base estimates and the appropriate level of contingency funding.
In our experience, it is vital to define carefully which risks ought to be managed at the project level and which would be better managed at the portfolio level. We have seen examples of contingency duplication at project and portfolio levels due to this lack of clear definition and examples of contingency omission from risks not covered at either level. We recommend the following definitions, which should be applied consistently across the project portfolio (Exhibit 1).
- Project-level risks: Risks that project managers have the expertise and authority to assess and control should be funded and managed at the project level. These include design changes, execution variations (such as weather delays or craft shortages), and estimation variations (such as higher craft per diems). These project-level risks should be funded by the contingency fund that is allocated to each project.
- Portfolio-level risks: Risks that project managers and teams do not have the expertise or authority to assess and control should be funded and managed at the portfolio level. This type of risk is usually associated with the environment in which the project will be executed, including geopolitical risks (which may result in changes to regulations, unanticipated imposition of tariffs, or difficulties in obtaining government approvals); macroeconomic risks (including extraordinary changes in global supply, demand for key materials and services, or both); and the actions of nonfinancial stakeholders. These portfolio-level risks should be financed through a centralized management reserve, which is a preauthorized allocation that is held across the portfolio and that may be released to individual projects by the executive team.
2. Reducing financial risk by managing shared risks across the portfolio
We have already noted that the level of management reserve required at the portfolio level will be less than the sum of the reserves required for each project, but risk mitigation may also be more cost effective at the portfolio level. An oil and gas operator with multiple projects across regions, for example, reviewed material and equipment supply contracts, as well as exchange-rate risk across its portfolio, to understand the cumulative impact. Managing this risk centrally took advantage of natural hedging between regions and released management capital. Part of the savings came from capital that had been trapped at the project level, and part came from the assessment that the preexisting central reserve, which had previously been calculated using a less sophisticated approach, was unnecessarily large.
A detailed understanding of the portfolio, including project size, location, and the commodities involved, is required to ensure portfolio-level exposures are quantified and the appropriate level of reserve is identified. A megaproject, for example, can have a disproportionate impact on a portfolio of smaller projects. The size and visibility of the megaproject can generate market, political, and location risks that are very different from those in the remainder of the portfolio; these risks, if they eventuate, may not be offset by movements in other portfolio projects.
3. Replacing systemic bias with consistent cost estimates set at an appropriate confidence level
Cost estimates for both public and private projects are often—intentionally or otherwise—both overly optimistic and unreasonably precise. This systemic bias toward overconfidence is often due to rational economic behavior from the project sponsors, contractors, and other financial stakeholders, who expect to benefit if the project goes ahead. Executives often encourage this bias by rewarding those who both showcase attractive project economics and display a can-do attitude.
An accurate most likely cost estimate can help to avoid trapping capital. An overly optimistic approach can have serious consequences; it can mean that companies fail to recognize the full scope of risks, which increases the likelihood that risk management will be ineffective and understates the required level of funding. In one recent case, for example, a company was looking to fast-track a project and therefore simply added a 10 percent contingency, even though the project scope remained largely undefined. The final cost was significantly over budget.
Leaders can take several mutually reinforcing steps to change these mindsets and behaviors and to avoid trapping capital. First, they can ensure project documentation is developed to the level of maturity required to support the desired accuracy of an estimate. Second, they can increase the use of independent estimate validation, which may be provided by internal assurance teams or external independent experts. Third, they can expand project-performance metrics to include internal- and external-cost benchmarks. These actions will improve the likelihood that the base estimate, excluding contingency, is a most likely cost.
A probabilistic cost-risk analysis can lead to more accurate funding at the start. The most likely cost provides the basis for probabilistic cost-risk analysis, which should take place within a culture of open, frank discussions of project risks. The resulting curve, which shows cost versus cumulative probability, enables decision makers to quantify the costs associated with higher levels of confidence that an overrun will not occur. This is often expressed as a P-value. A P30 estimate, for example, is the cost for which there is a 30 percent probability the final cost will be lower than or equal to the estimate and a 70 percent chance the final cost will be higher. A P50 estimate—for which there is a 50 percent probability that the final cost will be less than or equal to the estimate—may be the appropriate value to use in a multiproject portfolio.
An important benefit of probabilistic cost-risk analysis in the cash-constrained COVID-19 environment is that it enables decision makers to recognize the probable range of outcomes. For example, an informed decision-making process might use the P90 estimate (that is, a pessimistic cost assessment) to confirm economic viability under a worst-case scenario, the P50 estimate to set contingency, and the P30 estimate to set a target for outstanding cost performance. Regardless of approach, a detailed understanding of different cost scenarios—and their impact on the project—is critical when establishing the funding based on project risk.
This approach will also enable risk recognition and funding to be tied to accountability in a more consistent way. When projects are overfunded, teams may lack an incentive to keep costs down. On the other hand, a culture that punishes cost overruns, regardless of the cause, can delay conversations about possible overruns until it is too late to do anything about them. Up-front agreement on the possible range of outcomes enables a uniform understanding of management expectations and a performance-management system to match.
4. Reinforcing the relationship between risk and resilience
Large-scale investors can sometimes find themselves trapped in projects for which the economics are no longer attractive, that are too far progressed to change or cancel, or where there are no viable options to stop or exit.
This can be avoided using an enhanced understanding of risk to build resilience. Resilience in a capital investment requires a robust business case, commercial optionality, strategic off-ramps, and an agile execution plan (Exhibit 2).
To achieve capital resilience, the economics of each potential project should be rigorously stress tested. Executive and project teams need to be sure that the expected return justifies the inherent risks, with adjustments then made—or cancellations ordered—as necessary. Different project scenarios should be used in this pressure testing to understand the implications of project decisions, to inform the project scope and strategy, and to identify where strategic off-ramps are required. Without a scenario analysis, the executive and project teams risk pursuing project development with insufficient resilience, off-ramps, or commercial optionality to respond to challenges and avoid trapping capital.
Building this sort of economic resilience may require rethinking conventional project-approval processes, which discourage deviations from the original plan. The current approval process typically involves a rigid set of stages that are separated by decision gates, which means that changes become more expensive and less desirable as the project progresses. This reluctance to respond to changes in the business case can be a major cause of future cost overruns.
One way to correct this is to expand the discussion at each decision gate to include explicit analyses of resilience. While project sponsors will inevitably express confidence that the proposed plans will meet investment goals, that confidence is enhanced when the plan explicitly identifies both key inflection points and alternative strategies that could be deployed to adjust to changing circumstances. For example, the final investment decision for a global megaproject considered the potentially serious impact of certain geopolitical risks. It was difficult to predict the timing of these risks or how they would manifest, so—to increase resilience and, therefore, investor confidence—a variety of alternative strategies were defined, each with clear trigger events. The necessary resources were earmarked upfront.
Leadership drives the change
Among the many lasting changes from the COVID-19 pandemic is an increased focus on the importance of preserving capital while meeting short- and long-term investment needs. As part of this, leaders will need to rethink where and how capital-expenditure risks are managed. Progress will require an in-depth reassessment of organizational culture, as well as key project approval and risk-management processes. This is not easy, but the rewards are significant; trapped capital can be unlocked, short-term capital expenditure can be reduced, and systematic improvements in cost-risk performance can be realized. These changes will position companies to optimize portfolio performance once capital expenditure begins to ramp up again in the postpandemic world.
