Monte Carlo method application for environmental risks impact assessment in investment projects

Abstract

The paper highlights some of the results of the feasibility study of an investment project in an energy company in Romania. One of the objectives of this study was to determine in which extent the technical and economic objectives of the investment can be attained in a context heavily influenced by various risks, including environmental risks. The results of this study showed that the integration of a multi-iterative analysis based on Monte Carlo method allowed the determination of the degree of uncertainty in achieving the proposed safety performance indicators, which has had a positive impact on project objectives.

1. Introduction

In the current economic context, marked by globalization and by the growing interdependences between environment and development, it has become largely accepted that the environmental risks management is both an economic and a social priority. The globalization of environmental issues leads to growing concerns, especially for companies aiming at obtaining ecological performances, having the purpose to keep under control the impact on the environment of their activities, products and services (Udrea, 2011; Olaru, et al., 2011; Dobler, et al., 2012). New responsibilities and obligations for the companies involved in the implementation of investment projects arise from the environmental regulations and occupational safety requirements. Customers and other stakeholders have growing expectations and most importantly, do not accept uncertainties regarding the expected results. In these conditions it is considered that ensuring long-term economic performance, meeting the needs and expectations of stakeholders, ensuring development sustainability requires an integrated approach of potential risks (Springett, D., 2003; Olaru, t al., 2009).

According to the international standard ISO/IEC 31010:2009, a risk is an effect of uncertainty over the objectives, the possibility for some events to occur with a negative impact on certain objectives.

This paper illustrates some of the results of the “Engineering, Procurement, Construction and Commissioning the gas desulphuration system of a Romanian energy company” investment project, an EPCC project co-financed with European funds. One of the objectives of this project was to establish the extent to which reaching the technical-economic targets of the investment is attainable, considering an environment which is strongly influenced by different risks, including environmental risks. Such risks may be emphasized, measured and diminished by implementing certain programs for risk mitigation, based on adequate methods, Monte Carlo method being one of them.

The Monte Carlo method is a multi-iterative statistical method, which is based on various repetitive scenarios. It assesses the impact on the project from financial standpoint, but especially in terms of framing established for contractual objectives (Kwak & Ingall, 2007). As a result of the Monte Carlo method, it was possible to assess the impact of different types of risks, including the environmental risks for the abovementioned investment project and, starting from this, defining adequate programmes for risk mitigation, ensuring the prioritisation of the measures to be taken.

2. Current approaches to risk management process in developing energetic investment projects

Risk assessment, as an integrated part of risk management activities, is a structured process to identify the risks and their effects on attaining the company’s targets. Under this process, risks are analysed from the point of view of their effects, but also in relation with their occurrence probability, so that the organization may take subsequent adequate decisions to diminish or eliminate the negative consequences of such risks. A largely used approach framework for risk management is the “7Cs Framework”.

According to some authors, the risk management process is iterative, repetition can be done in case of the introduction of any modified or additional criteria for risk assessment, resulting a continuous improvement process, similar to the one generated by using the Kaizen continuous improvement strategy (Băbuţ & Moraru, 2006).

The same authors define the following stages of the risk management process:

• establishing the strategic, organisational and risk management context, as well as establishing the criteria based on which risks will be assessed;

• identification of risks, including hazards and related consequences;

• risk analysis, taking into account their occurrence probability and severity;

• risk assessment and hierarchy, in order to identify priorities.

• risk mitigation, by developing and implementing an adequate management plan;

• sharing the established measures with regard to approaching the identified risks;

• risk monitoring and revision of the measures to reduce/eliminate them.

After going through the stages of risk identification, risk classification, drafting the risk register and the risk matrix, under the risk analysis carried out by means of different methods, among which the Monte Carlo simulation method, the necessary IT support may be provided to ensure a correct risk reaction. The determining factors of the reaction to risk are thus considered to be: the possible effect of the risk, the incidence, i.e. the risk occurrence probability and the cost of the measures for risk mitigation.

The risk reaction is also influenced by the sensitivity to risk of decision makers. High risk sensitivity provides the framework for a slower development, but a lower uncertainty level, whereas on the contrary, low risk sensitivity offers a chance for a more rapid development by not engaging in the risk minimisation effort, but with a significantly higher uncertainty level.

Risk management is thus understood as an extremely important tool, a decision-making support of the management team making attainable the project objectives. A poor risk management may lead to negative effects with significant impact, some of the even irretrievable.

3. The results of the application of the Monte Carlo method to assess the impact of environmental risks on energy investment projects

3.1. Identification of environmental risks and their occurrence probability

The first stage in risk management is risk identification, the assessment of potential hazards, their effects and the risk occurrence probability. At the same time, this stage eliminates those risks, which are inconsistent with the aimed objectives, risks with insignificant effects or with a very low occurrence probability. Risk identification was carried out taking into consideration both the internal and the external risks. Internal risks, unlike the external ones, are those risks that the company’s management keep under control or may significantly influence them.

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For this purpose, a “risk register” was developed, which included all potential risk sources for the energy investment project taken into account, per types and categories, also making a first assessment of the effects these risks may cause. The personnel responsible for risk tracking filled in this register. Next, comparative analysis was carried out to show risks and their impact, based on available statistical data.

Under this analysis, the identified risks were taken into account, making their in-depth analysis by using the Monte Carlo simulation method. It was opted for this method by consideration the analysis objectives and the accuracy of available data.

3.2. Defining the environmental risk matrix

According to the impact of risks and their occurrence probability, a scoring formula was used to make a hierarchy of risks (Table 1).

The way to assign the scoring risk according to the occurrence probability and impact is done based on the risk matrix analysis (Table 2).

The risk register, their scoring and the risk matrix have ensured the primary data to identify and asses the risks, by means of the Monte Carlo simulation method.

3.3. The results of using the Monte Carlo method to assess the impact of environmental risks

According to risk typology, for investment projects, there are various methods and frameworks to assess and mitigate the effects of such risks. The environmental risks do not generally represent risks with an impact on the deadlines for implementing investment projects, but they have a significant financial impact, as a result of the measures necessary to diminish the effects. Such risks may however affect the implementation programme of the investment projects, considering the efforts to remediate the environment, which requires the use of the Monte Carlo simulation method to assess the risk effects.

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In order to use the Monte Carlo method, a special IT software was used, i.e. Pert master which allowed to carry out multi-iterative analysis to emphasise from a statistical point of view the risk effects, based on their scoring, for the considered energy investment project deadlines and budget.

The multi-iterative analysis is carried out with an impact on different activities of the project works with related risks (Figure 3), the impact is variable and is included in the calculation framework according to the risk matrix and assigned scoring. As a result of the Monte Carlo analysis, various reports are obtained showing the estimated effects from the temporal and financial points of view following the impact probability of different risks. The most suggestive reports resulted from the Monte Carlo analysis address the effects on the deadlines and specific milestones, as well as other key-performance indicators.

Moreover, percentages are shown as to the chances to observe the deadlines both at the level of the entire project under the project works, and at a detailed level, per different work breakdown structures.

This analysis may be carried out at different stages of the investment projects, to establish the actions for risk prevention and diminishing their effects on the project performance deadlines and budget.

4. Conclusions

The use of the Monte Carlo simulation method to assess the risk impact in general and for the environmental risks in particular, taking as an example a Romanian energy investment project allowed to establish the uncertainty level in attaining the planned key-performance indicators for the respective project. The result was an increase of the chances to meet such indicators with optimal effort, adjusted on the basis of the multi-iterative analysis carried out using the Monte Carlo method. The use of this method allowed establishing the risks and the impact of such risks, especially with regard to: the environmental impact of the processes of the project, the impact of various stress factors on the technical economic processes of the project, especially the processes that ensure the health and occupational safety of the project teams.

The results of the study have highlighted the fact that the integration of a multi-iterative analysis based on the Monte Carlo simulation method, allowed the determination of the uncertainty degree in attaining the planned performance and safety indicators. It has also showed that the implementation of a risk management system based on the use of adequate risk impact analysis methods may become a highly important tool to rely upon when making decisions for the development and implementation of investment projects, ensuring the reach of planned objectives at the established deadlines and with the assigned resources.

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