Is your board doing enough to oversee the risks involved with capital projects?
A PwC analysis of 52 capital project missteps at public companies has revealed that after a public announcement of a capital project delay or shutdown, a majority of companies experience a steady decline in share price. By the three-month mark following the announcement, the decline in share price averages 15 percent. In the most severe case of the companies analyzed, one experienced an almost 90 percent decline in share price.
Large capital projects — with their multi-year timelines, changing requirements, and complex procurement issues — are inherently risky. They require diligent oversight from management and the board, given the common occurrence of budget overruns and their impact on the company’s financial health.
Lack of board oversight can result in severe consequences. For example, in the power sector, regulators have rejected substantial portions of capital funding requests in situations where they believe management and the board could have exercised better oversight of costs, schedules, and risks.
Corporate boards have the responsibility to oversee a company’s strategy and key risks. Capital projects fall squarely in this realm in light of their significant costs and the business implications of delayed or over-budget projects.
“Large capital projects, by their nature, tend to be long-term,” Craig G. Matthews, a director on the boards of Hess and Natural Fuel Gas, said. “Factors beyond your control can impact them. For example, look at the financial crisis and the dramatic change in interest rates since then.”
How a board and its company’s management handle such factors when carrying out a capital project goes a long way toward determining the success of that project.
“A capital project is rarely derailed by a single problem,” says Daryl Walcroft, a PwC Capital Projects & Infrastructure principal. “It usually takes a series of failed steps along the way to put a project in jeopardy.”
PwC’s analysis shows key failure points leading to overruns on large capital projects. The primary contributor to project failure is lack of early planning, according to Insights and Trends: Current Portfolio, Program, and Project Management Practices, a 2012 PwC survey of more than 1,524 respondents in 34 industries in 38 countries.
For capital projects, deficiencies in early planning generally result from the following:
Setbacks also result when project governance teams lack essential experience. At companies that invest infrequently in large capital projects, project teams sometimes rely too heavily on contracts (sticking to the letter of the agreement without building in flexibility), independent engineers, or construction managers.
When issues snowball without adequate reporting to the C-Suite and board, even companies with experience in capital projects can be caught off-guard. Issues that impede a capital project, despite strong upfront planning, include project complexity, scale, geographic location, and the role of new technology.
Matthews recalls a situation where several companies placed huge bets on investing in projects to import liquefied natural gas to the United States. However, the long delays in government approvals and the simultaneous development of natural gas fracking led to an enormous increase in the US production of natural gas. As such, exports, rather than imports of liquefied natural gas, became more practical, which had huge implications for the investment in these facilities.
“There are many other external factors that can impact a large capital investment,” Matthews said. “Many of them are beyond a board's control, but they should at least assess the risks involved and mitigate them where they can. For example, hedging against interest rates or energy cost fluctuations.”
Cost overruns and delays can alter the fundamental economics of a project, ceding an advantage to competitors while saddling a company with added debt and a late or underperforming asset. In most cases, improved reporting can help address issues before they become major problems.
The degree of the board’s involvement in a capital project will depend on a variety of factors including the magnitude of the investment (boards typically identify a minimum hurdle rate for their approval), its strategic importance, the proven track record of management to handle complex projects, and the project’s susceptibility to identified risks. A good risk manager can help identify these issues and lay out a strategy to minimize and remedy them.
Matthews added he would be surprised if there were companies that had not experienced cost overruns, extended completion dates, and added complexities in large projects. “It's the nature of the beast,” he said. “Given that, I would recommend boards ensure there is a healthy contingency added to the budget, that the minimal hurdles on profitability reflect the risks in a project, and that the board assures a postmortem be done to assess if and why there were cost overruns or delays to be a learning experience for the next project.”
For example, directors can ask questions of management to evaluate the desired strategic and tactical business objectives (lower production costs or increased outputs) as well as project performance (measured by key performance indicators) against actual progress. Some of those questions and other considerations include:
Capital projects require careful forethought, comprehensive planning, and vigilant monitoring. Responsibility for day-to-day decisions lies with the project management team. The board of directors, however, should ask the right questions of management – questions that ensure project performance meets strategic goals while conforming to the company’s overall tolerance for risk.