Saturday, 26 September 2009

What about Risk?

One of the hot topics in the Dutch news these weeks is the financial disaster the construction of a metro line in Amsterdam is causing. A quantative based risk assessment would have lead to better estimation of the financial risks upfront and better risk mitigation strategies during the project.

At the start of the project the total investment for the metro line was estimated to be €430 million. Based on this estimation the Amsterdam council decided to go ahead with the plan. Besides the relief the metro would bring to the dense traffic in the centre of the city, making it more healthier to live in, it would also make the centre of the city more appealing. No walls of trams blocking your view of Amsterdam. Constructing the metro would take some time and would cause a lot of inconvenience during that period. By the end of 2011 all work would have been done and everybody, either citizen or tourist, would benefit from fast and comfortable transport under the city. The actual situation is much different. Cost are now estimated to sum up to €3.1 billion (that’s more than 7 times the initial estimate!) and the project will finish no sooner than 2017.

These things can happen of course, but all big infrastructural projects in the Netherlands seem to go this way. To name a few, the construction of a high speed railway track is over budget, delayed and still not operational. A new railway track for freight trains towards Germany is operational, cost more than estimated and has a lower than estimated utilization, making it less profitable. And yesterday the construction of the new campus of the university of Maastricht was stopped, because of excessive cost overruns. What questions me is, didn’t the decision makers in each of these projects ever hear of quantitative risk management?

The project plan for the Amsterdam metro included a risk analysis both financially and technically. The tubes of the metro and the underground stations need to be constructed in very wet grounds. Many of the old houses are build on wooden poles and digging deep holes near them might case damages to the houses. Past experience and even tests had shown the construction workers how to deal with it. The total addition for risk in the budget was set to 4%. This number really makes me laugh. When I compare that risk measure with the risk measure normally taken into account in for example IT developments (10%) that would mean that constructing the new Amsterdam metro is far less risky that making a IT system. Is this really true?

The trouble with risk is than we can perfectly look back and see the cause and effect relationship of every incident, but how to asses or even forecast consequences of risks? As Nassim Taleb already described we (as humans) are not capable of dealing with probability. We tend to underestimate the bad (see the financial crisis) and overestimate the positive risks (we all think we will win the €27.5 million price in next months lottery). So we need some help to deal with it. I don not mean the simple risk mapping tools that were probably used in the assessing risks of the above disasters. These methods are not fit for assigning risks, it is far better to use quantative models. It has been shown (see for example the work of Fiona MacMillan in assessing risks in oil exploration) that companies using quantitative risk methods have a better financial performance, this should also hold for (local) governments.

One of the methods that I use a lot is Monte Carlo simulation. It is flexible, pretty straightforward to program and very easy to use. I used it to asses risks for pension funds and insurers and to identify robust strategies in for example investments. I also used to calculate dredging lanes. In one of the projects for insurers I used is to asses the financial risks involved when a catastrophe, like a hurricane or flood, occurred to oil rigs or refineries. That last example is comparable to the construction projects mentioned above.

How come nobody in government uses these methods? It will probably save us all a lot of money and probably also some careers in politics. I think it should be part of legislation. No new big infrastructural project should be started with a certified and quantative risk assessment, using state of the art models.
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