Risk identification and management

Spreadsheet analysis of investment opportunities prior to commitment is an obvious way to identify and eliminate risk. The strictest interpretation could be that if the proposed investment is not risk free, do not invest. The practical use of sensitivity analysis is to identify which parameters are sensitive and then responding to limit risk. Where a parameter is identified as being sensitive, in that a small change in it will materially adversely affect the project outcome, the risk should be eliminated or at least 'tied down'. If it cannot be satisfactorily dealt with, the project should be indeed be abandoned.

It is obviously very sensible to carry out extensive and detailed sensitivity analyses. However, there is a danger that either too much analysis is done or too pessimistic a view is taken. Is it really likely that all parameters go wrong at the same time? Another potential problem with sensitivity analyses is that they may be comprehensible to the preparer of the model, but may not really make clear to others the risks involved in the investment and sanctioning process.

Need for a defined model

There is the need for a well-defined clear base, a 'most likely case' model where the sensitivities of the parameters can be demonstrated in as clear and simple a manner as possible. The emphasis of the sensitivity analysis should be to identify sensitive parameters, quantify just how sensitive they are, and then identify how the risk of the parameter 'going wrong' can be averted. Sensitivity analysis should lead to real risk management.

The risks, technical, commercial and otherwise, inherent in any project should be identified by structured, thoughtful review of the project. Having made this very important point, the use of structured sensitivity analyses of projects is of the greatest support in identifying, and thus being in a position to overcome, risk.

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