Risk and risk management

It is obvious that if you want to make returns (that is, to create value for your shareholders), you have to accept risk. In Rio Tinto, we say that the key to valuation is understanding risk and ensuring that it is reflected in the returns you require. We like to think we are risk-aware rather than risk-adverse.

Mining has more than its fair share of risks, starting with the most fundamental one — you have to spend considerable capital as a rule before you can even see your product.

In the mining industry, project returns depend on the quality of the initial investment decisions. The greatest opportunity to influence the final value of the project occurs at this early stage. The ability to add value diminishes as plants are built and business commences. During the early phases, the aim is to get a thorough understanding of where the value in a project lies, and how that value is geared to the relevant risks. The aim is to identify what events could lead to a project’s failing to create value, and to decide how best to reduce these risks. We continue to study the risk-value relationship throughout the life of a project — from the feasibility study right through to eventual closure. Always the focus is on increasing value.

Rio Tinto is clear in thinking about how to assess risk in this process. We demand a rigorous and disciplined approach to risk management on all our projects. Yet, at the same time, we recognize that it is not possible to address this with a step-by-step instruction book.

We expect and depend on intelligent thinking about the difficulties facing a project and the opportunities it presents. No amount of procedure can make up for the absence of such thinking. Likewise, computer simulations, excellent in their way, are only as good as the assumptions on which they are based.

Although we do not have a step-by-step instruction manual, we do have clear definitions of what we are trying to achieve at each stage — order of magnitude, prefeasibility and feasibility — to ensure that we proceed in a disciplined way.

An important factor in project appraisal is that the process and the key financial assumptions, such as prices, exchange rates, inflation and discount rates, are not the responsibility of the sponsor of a proposal. They are determined centrally.

Each project is subject to independent commercial and technical review, and the reviewers are not part of the technical team. Their role is to test the resilience of a project to the full range of risks which it faces. The independence of the review team from those sponsoring the project is vital.

It is the review team that ultimately brings the project before the corporate investment committee for a final decision. The investment committee’s decision becomes one of whether the returns warrant the risks. There is a broader point: by focusing on mining and smelting, we enhance our ability to identify and manage risks. We know what to look for.

Another risk Rio Tinto faces is country risk. This appears to have increased in several parts of the world, which is a disappointment. In the 1990s, it looked as though country risk was a diminishing issue for the industry. It is a difficult risk to evaluate and can take many forms — for example, expropriation or higher tax rates. Many of today’s risks seem to be associated with governance problems in the host country. The more difficult the environment, the more prospective returns must compensate for the risks.

In talking about risk, sooner or later, someone always asks why Rio Tinto does not hedge currencies in order to reduce financial risk. Our response is that we are a U.S. dollar company, as most of the products we sell are priced in U.S. dollars. We have a natural hedge in the U.S. dollar in that most of Rio Tinto’s debt is raised in that currency. Our main exposure on the cost side is to the Australian dollar. We have found we cannot do better than the market, so we choose not to hedge this currency against the U.S. dollar.

I might add that nearly twenty years ago, Rio Tinto commissioned a major study into the pluses and minuses of hedging. That study concluded that hedging strategies got it right about half of the time. As the financial institutions take a commission for conducting your hedging strategy, you are unlikely to end up in front.

— The author is the managing director of Rio Tinto Australia. The preceding is an excerpt from a speech he presented to Resources Convention 2003 in Perth, Western Australia.