The following is an excerpt from a keynote presentation delivered at Project Evaluation 2016 Adelaide. The full paper is available in the conference proceedings, which can be purchased via the AusIMM shop.
Projects are approved for development by a company’s board of directors. Generally speaking, boards compriseboth executives and non-executives, led by a non-executive chair. Projects are promoted and championed by the executive directors, led by the CEO. The non-executives are independent of the executive and their function is to adopt a position of constructive but sceptical detachment with respect to all matters relating to the running of the business, not least in relation to major new investments.
Non-executive directors carry a material burden of personal responsibility for a company’s decisions but are almost entirely dependent on the executive for the information upon which those decisions are based. Much therefore depends on mutual trust and respect. Both are intangibles that require careful nurturing over time, and they are fragile and easily damaged.
One should also remember that few non-executives have a detailed technical knowledge of the company’s business as director selection is usually based on financial and governance skills combined with a deep general knowledge of the commercial world. Forensic skills, applied to interrogation and assessment (including the assessment of people), are an important part of a non-executive director’s survival pack.
It should be remembered that most directors are capable interrogators and experienced in assessing the competence of those presenting to them. It should also not be forgotten that the non-executive directors are the elected representatives of the owners – the shareholders – and, as such, are accountable for the overall success of the company.
All of this is an essential introduction to understanding the perspective of a non-executive director when confronted with a decision to approve, or not, a major new investment. Boards of directors know through their own past experience that few investments pan out as promoted and that a high proportion fail for one reason or another to varying degrees.
Partial success is no substitute for meeting the goals spelled out in the feasibility study upon which basis the project was approved.
Given this background, how does a non-executive director penetrate the executive veil to assess the likely real value of an investment and the likelihood of successful delivery on time, on budget and to specification? Conversely, how does an executive team convince a wary board that the project they are presenting is a good strategic fit, has significant and deliverable value and has a manageable risk profile?
What follows derives substantially from my own career experience, both as an executive and a non-executive director – a necessarily personal journey. That journey has not been without blemish, but it has also witnessed some very satisfying successes.
Project evaluation practices applied to mining investments have evolved considerably over time, particularly since the 1960s. This first occurred with the general acceptance and application of discounted cash flow as the principal financial evaluation tool then, thanks to the advent of computers and their ability to process vastly increased amounts of data at high speed, much more sophisticated technical and financial modelling than could previously be contemplated. Prior to these developments, project evaluation was invariably the preserve of those who had a proven track record in project execution and operations. The conventional wisdom of the time was that with experience came knowledge and good judgement, and that those ingredients were in turn the proper foundation for a trusting relationship with a board of directors. Results showed that this was a viable arrangement, suited to the needs of the times.
Projects are now generally larger and certainly more capital intensive. Modern information technology and data processing supports more formal processes and more complex evaluation methodologies, but it is perhaps debatable whether the results are markedly better overall. The traditional human values of experience and judgement, good communication and good management remain supreme. When all is said and done, technology is still no more than a very useful tool.
From the creation of small teams of very experienced people, supported by a modest technical staff, and largely internal company studies with carefully managed input from trusted contractors, we have seen the establishment of what might well be called a project evaluation industry centred on the provision of turnkey services by professional engineering firms and individual specialist consultants.
Projects have tended to become larger and the scope of feasibility studies much broader than used to be the case, so the trend towards complexity and rapidly escalating costs is hardly surprising.
However, what has not changed significantly is the proportion of flawed studies and poorly executed projects. Few companies will object to paying for success, but it seems that failure has also become more expensive.
The growth in the scale and complexity of projects, combined with the escalation in the real cost of projects that is in part due to the social and environmental responsibilities that mining companies must now bear, has increased and diversified project risk. Commitment to higher standards of risk management has addressed this trend to an extent but has arguably not turned the tide. While directors continue to value the skills and experience of their management teams, the burden of proof is higher than ever before.
The goals of project evaluation
Before elaborating on the project evaluation process, it is necessary to set out its fundamental goals.
The first is clearly to demonstrate the financial and strategic value of the project both on a standalone basis and, more broadly, as a value-adding increment to the business of the owner (the shareholders). Financial value is a function not only of the characteristics of the project itself, as designed, but most particularly of the assumptions made for external inputs such as commodity price and foreign exchange (FX) rate. Indeed, these are commonly the principal variables and the ones that are most difficult to predict with confidence.
The second goal of the project evaluation process must therefore be to define and describe as closely as practicable the overall commercial environment within which the project must prosper. Given the uncertainties inherent in forecasting, project design must also be flexible and robust and able to respond to both unforeseen and sometimes unforeseeable internal and external events. These are conditions that make a degree of redundancy in design prudent.
Project evaluations commonly devote more effort to matters of technical detail that have less impact on the economics of the project than to the factors that have the greatest impact. It is not that the technical detail is unimportant – it is important because it has a direct influence on what is designed, costed and built – but more a case that often not enough attention is given to the most significant variables, generally because they are difficult to forecast with any confidence.
The technical components of a design lend themselves to estimation, and levels of confidence can reasonably be assigned to such estimates. The commercial factors that determine the environment within which a project must prosper can only be forecast, and forecasts have limited integrity at best. The fact that non-technical factors are difficult to forecast does not excuse superficial analysis. For example, even though price and price volatility cannot be forecast with confidence, assessment of future supply and demand, including competition and the specific requirements of prospective customers and intermediaries is a worthwhile discipline, and market intelligence has great value overall. Adding to this, rigorous and realistic stress testing of the project based on what is known or can be deduced with some confidence will inform the development of a thorough risk management plan and, by this means, will assist with the mitigation of risks that are fundamentally unquantifiable.
Thus, given the uncertainties inherent not only in project design and execution but also, and often most particularly, in the commercial environment within which the investment must perform, the third goal of the project evaluation process is the assessment of risk.
Risk assessments, starting with process and rigour and concluding with formal plans for risk mitigation, are now an established part of the project evaluation process and should include competent independent reviews of every significant component of a project and its associated risk profile. As projects have become larger and more complex and the industry as a whole more intense in its use of capital, what was previously left to the judgement and experience of a few old hands has now become a distinct area of specialist expertise.
Risk is a topic that most business people understand and one that receives considerable attention from non-executive directors as part of their project due diligence. Because of their generalist background and experience, they will necessarily focus more on the commercial environment and project risk than on project design.
The final goal of a project evaluation is to demonstrate not only that the project is viable, that it will provide a superior return to shareholders on the basis of reasonable economic assumptions, that it can be permitted and built as specified in the evaluation, and that the latent risks are manageable, but also that management has within its ranks the team, organisation, expertise and commitment to deliver the project as promoted in the evaluation. High-quality studies are one thing; successfully executed projects are quite another matter. Directors look for proof of capability on both counts.
The project evaluation process
On paper at least, the project evaluation process is a series of programs and studies, interspersed with decision points or tollgates, that lead to a point where the project is deemed by management to be viable and worthy of investment or is rejected. The evaluation process may vary in quality and rigour and is ultimately a function of the skills, experience and commitment of the owner’s team and the consultants and contractors that they employ.
The feasibility study is the principal result of the evaluation process and the document upon which investment decisions are made. In mining, the feasibility study is based on an ore reserve and resource statement, the preparation of which has been codified and regulated in most, if not all, jurisdictions.
In Australia, that entails compliance with the Joint Ore Reserves Committee (JORC) Code, regulated by the Australian Securities Exchange (ASX). Compliance with the JORC Code ensures that the calculation of ore reserves and mineral resources has been done by recognised competent people and that the process of calculation has been subject to prescribed standards. The former is at least as important as the latter. While a board of directors may rely on the JORC process, I would argue that it is equally important for them to know and respect the Competent Person(s). Process alone is seldom a guarantee of quality.
Feasibility studies come in myriad forms and, as projects move forward through the evaluation process, are prepared to ever-greater levels of detail and, at least purportedly, greater levels of accuracy. The evaluation process should begin in parallel with exploration. Indeed, a case can sometimes be made for broad-brush economic studies in advance of exploration so that the team in the field has a general appreciation of what constitutes an economic target and what constitutes simply a technical success of no immediate economic interest. Exploration funds are the scarcest of all, and exploration teams often succeed or fail on their track record. Only look for that which is worth finding.
Assuming exploration success, a project moves progressively through conceptual valuation to a prefeasibility study and then to feasibility study, each one more complex and detailed than its predecessor. In the past, the feasibility terminology extended to final feasibility studies and even definitive feasibility studies. The former title implies the end of the process of evaluation, which is dangerous enough, while the latter title is simply unreal and indicates a lack of awareness of the volatile external environment within which all projects must succeed. Mining projects take two and usually three or more years to build and, where practicable, should be subject to continuing evaluation, refinement and optimisation during that time as more information comes to hand.
Feasibility studies are also much more comprehensive in their scope and detail than in times past, and that trend continues. It is no longer prudent, or indeed acceptable, to limit consideration to the technical and commercial issues that arise directly from the extraction of the ore reserves and related resources within the confines of the mining lease. Looking back, the first additions to the scope of traditional feasibility studies related to the provision of the social and logistical infrastructure needed to support an operation in a remote area. Then came considerations of environmental impact, management and remediation, followed closely by the need (followed effectively by the requirement) to take a more open and enlightened view of the interests of other stakeholders: first, employees and their communities, then the heightened interest of governments at all levels, then the legitimate rights of indigenous communities, and so on. Many of these additions to project scope are difficult to evaluate, requiring tools unfamiliar to most mining professionals. Some can only be assessed subjectively, adding significant risk and uncertainty to the time and cost of project execution and casting a long shadow over the supposed rigour and accuracy of the feasibility study result.
Poorly executed feasibility studies that lack genuine insight and commitment sow the seeds of future loss of reputation or worse.
Small wonder that boards of directors today, in this age of social media, intense regulation and class action law, are more wary and perhaps more risk averse than their predecessors. Mining investment was once almost universally accepted as rank speculation and riskier than going to the races. Now, there is an expectation that we will at least live up to our promises, with consequences for those responsible if we do not.
Given this background, securing project approval from the board of directors may seem like mission impossible. It is not. Boards are as focused on the performance and growth of their companies as management; it is simply that their responsibilities are different.
The key to a timely and pain-free investment decision is to understand the information that the board needs to make confident and informed decisions (which will go well beyond the technical and commercial). This information should be provided over a period of time that allows due consideration and digestion and, while respecting the requirement for the board to make its decisions with the proper level of independence, communicating with them progressively as project evaluation advances – there should be no surprises and no need for sudden decisions. Such two-way communication will allow directors’ concerns to be addressed in the feasibility study, rather than as an afterthought, and encourage the growth of trust and respect between the two parties, something that will also bring a broader benefit to the enterprise as a whole.
Feature image: Rich Roberts, CC BY 2.0.
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