What is Political Risk?
Protestors in Aden, Yemen, a constant source of political risk for the past decade
When I first got a job at a political risk firm, my parents said, “That sounds great. What is it?”
One of the main problems with practicing political risk is that it can be easily defined too narrowly or too broadly. When the former, huge disruptions can happen without being foreseen. When the latter, the analysis starts to resemble general punditry and organization fail to see the value.
To correct this, let’s start with some basic definitions that show how we look at the best way to confront the field.
Finance first
Investopedia defines political risk as “the risk an investment's returns could suffer as a result of political changes or instability in a country.”
This is the most basic conception. Political risk is a risk that comes from politics. If you could add the political risk to an investment’s discount rate, under this definition, you would have completed the task. End of story.
Caldara and Iacoviello, economists at the Federal Reserve who created the Geopolitical Risk Index, classify geopolitical risk as “the risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations.”
This also fits what I would consider a standard approach based on traditional metrics. While they do not focus on investments alone, and focus on international relations and other measures of “high politics,” they are looking at some of the biggest risks that could be recorded in the headlines of newspapers (which is how they build their index).
These definitions emerge naturally from the earliest ideas of political risk. A dictator nationalizing the oil sector, a civil war choking off commodities trade, or a terrorist attack targeting a hotel for ex-pats - all of these check the boxes of what people for decades saw as the archetypes political risk.
However, they are not the totality of it.
Broadening the public sphere
Condoleeza Rice and Amy Zegart, in their book Political Risk, take a broader view. They write: “For companies, 21st-century political risk is essentially the probability that a political action will significantly affect their business—whether positively or negatively. This definition is more radical than it sounds. We chose the phrase “political action,” not “government action,” to highlight the growing role of risk generators outside the usual places like capitals, army barracks, and party headquarters. These days, political activities that affect business are happening almost everywhere—inside homes, on the streets, and in the cloud; in chat rooms, dorm rooms, and boardrooms; in neighborhood bars and summit sidebars. Companies that want a competitive edge need to manage the potential impact of this widening array of global political actors.”
This is a crucial step forward in the field. Rather than simply the risk to an investment, or only relating to international relations, Rice and Zegart’s approach includes any political actor, from activists to armies.
This definition also calls to our attention that these disruptions could be positive or negative. If a government banned the consumption of meat, it would be a major blow to ranchers - but a boon to vegan chefs. The same event is a risk to one and an opportunity to the other.
However, there is one problem.
Rice and Zegart write about political risk exclusively in terms of business. If Russia, for example, were to seize control of all McDonald’s, it would certainly cause chaos at the Golden Arches’ headquarters. But it would also get people running at the State Department, the UN, and a number of other non-business organizations.
To focus just on business is to miss a large part of who consumes political risk advice.
The Two Lanterns approach
While the industry’s founders may have started selling to banks and multinationals, they soon found out that their analysis was needed in the governmental, IGO, and NGO sectors.
That is why our definition of political risk is: The probability of a significant change in the operating environment of an organization due to political factors.
There are key components to this definition.
Probabilistic and predictive
Focus on the overall environment rather than a specific risk
“Significant” means that we must be able to assess the impact
Could be positive or negative
Can be from domestic or international political means
Organizations can be corporate, governmental, or institutional.
Perhaps the most important implication of this definition is that it stresses that political risks only matter to the extent that they matter to you.
For example, is the election of the Governor of California a political risk?
If you are the Minister of the Interior in Kazakhstan, no.
If you are a solar company with a focus on photovoltaic panel installations in the San Francisco metropolitan area, probably.
Experience has taught us that there is no absolute set of political risks that can be externally classified and measured. You could track catastrophic weather events- another low frequency / high impact threat to organization - and in fact there are Wikipedia pages that do that.
But how can we establish some canonical set of political risk events when the Department of Defense may be most concerned with Chinese military capabilities in 2040 and Ford wants to know about tariffs right now?
Even the country risk ratings that many firms generate (like the one above) are to some extent the result of averaging lots of risks together. An accountancy in Kinshasa faces a very different risk profile than a copper mine in rural Katanga, but both would see the same country risk for operating in the DRC - and require a more bespoke approach to know about what specifically matters to them.
What does this mean for the political risk industry?
What we refer to as the political risk industry - a disparate collection of consultancies, experts, and think tanks - focuses on the biggest risks that affect the most people.
One reason why US and Chinese tariffs attract so much new attention is not just because they had high economic costs, but also because the audience for analysis on them was so wide.
Imagine, for example, that you’re a biotech company. The biggest political concerns for your business may be whether a zoning board in North Carolina approves your plans for a new research facility, or whether public transit in Boston is fixed so your employees can get to work on time, or whether San Francisco addresses the housing crunch that requires you to pay your staff much higher than elsewhere.
The idea of Sino-American decoupling certainly matters to you, but the challenge is not as immediate as what may come out of a few municipal conference rooms across the country.
However, there is not a clear global market for Research Triangle land use analysis. A political risk firm can’t pay the bills by focusing on that, but they can by addressing tariffs, or the US presidential election, or EU competition policy, or Indian economic growth rates. There are enough clients worldwide who will pay for that. Therefore, that’s what they do.
This is not to criticize my colleagues in the rest of the industry. Informational services is a tough business, and forecasting uncertain politics is one of the hardest parts of it. They are able to generate valuable insights and we are happy to recommend some of them for daily subscription or data purchases.
It does mean, though, that there is a lot of political risk that the industry can’t address.
Perhaps the question a client wants to know is so narrow (like when the Red Line gets fixed) that it can’t be part of a sustainable consultancy business model. Perhaps the question depends on so much proprietary knowledge (like whether a new molecule is likely to be approved by a regulator) that the client doesn’t trust it to be addressed externally.
Either way, if it can’t be answered by an external consultant or subscription, organizations must ask it internally. Even if the analyst has no experience in political risk, they are left to manage as best they can.
Dealing with what the others can’t
By all means, subscribe to political risk services. If you’d like to commission a traditional risk report, we’re happy to help.
But Two Lanterns was created to addressed this particular problem - political risk that, for one reason or another, has to be dealt with in-house.
There are a number of techniques for doing so well.
Long-term planning should be accompanied by a scenario planning report. A strategic juncture should be preceded by a matrix game. A set of threats should be tracked in a risk monitor. A team that covers these issues should receive training in this topic.
There is no one-size-fits-all solution for every organization. But there are some best practices.
Get in touch to learn more about how we can improve your political risk capabilities so that you are best equipped to avoid the threats and seize the opportunities that your environment throws at you.