AD ALTA
JOURNAL OF INTERDISCIPLINARY RESEARCH
ASSESSMENT OF RELATION BETWEEN LEGISLATIVE RISK AND EXPECTED PROFITABILITY
OF A SUBSIDIZED PROJECT
a
SIMONA HAŠKOVÁ,
b
PAVEL ROUSEK,
c
JAKUB HORÁK
Institute of Technology and Business, School of Expertness and
Valuation,
Okružní 517/10, 37001 České Budějovice, Czech
Republic
email:
a
haskova@mail.vstecb.cz,
b
rousek@mail.vstecb.cz
,
c
horak@mail.vstecb.cz
Abstract: The paper analyses relationship between the risk of a legislative change and
expected profitability of subsidized projects. Introduction in risks is given in terms of
their internal and external origin with focus on legislative risk within projects
subsidized from public resources. This risk is covered by some specialized ratings.
The aim is to measure the legislative risk of subsidized projects. To do it, we lean on
data of the rating agency Euromoney Country Risk for the selected EU countries. The
input ratings are processed to capture certainty degree of legislation stability. The
certainty degree induces the possible threat of subsidy cuts of the purchase price for
subsidized production here expressed as indicator of market risk. Based on this, we
build and apply a statistical model for estimating expected profitability of an average
subsidized project of a biofuel plant measured by E[NPV]. The E[NPV] results reflect
differences depending on the certainty degree according to the country the subsidized
production is realized. Possible reasons for neglecting legislative risk within cash flow
budgeting and profitability calculation in subsidized projects is discussed. Here
performed approach to express and incorporate legislative stability by means of
certainty degree and market risk is an original contribution of the paper.
Keywords: legislative risk, expected profitability, biofuel plant, financial management,
project management
1 Introduction
Risks associated with business projects are generally structured
in terms of their internal and external origin. The basic division
of internal and external risks and their analysis is expanded by
several authors into more detailed categories (see
e.g., Kaplan and Mikes, 2012, pp. 2-5): „Category I: Preventable
risks. These are internal risks, arising from within the
organization that are controllable and ought to be eliminated or
avoided; Category II: Strategy risks. A company voluntarily
accepts some risk in order to generate superior returns from its
strategy, which could companies further redistribute (Klieštik et
al., 2020); Category III: External risks. Some risks arise from
events outside the company and are beyond its influence or
control.“
The distribution allows us to perceive internal risks arising
within a company or a project as a more easily influenced by the
enterprise. Acceptance of financial indicators is a partial help to
eliminate risk (Klieštik et al., 2020; Machová and Horák, 2019).
The general concept and tools of the control of internal risks for
different options of risk existence enable the company to
optimize risks in the case of distribution control of scarce
resources (Vasilkov and Gushina, 2015). External risks are of
course broader and can be broken down into the risks of the
microenvironment (e.g., supplier, customer, and competitor risk)
and macro-environment (e.g., legislative, tax, and economic
risk). It is the competitive market environment and the
environment of more concentrated markets that influence the
perception of market risk (Dvorský et al., 2020). The predictive
potential of bankruptcy models can be used to determine the
risks arising from the companies micro and macro environment
(Klieštik et al., 2018). Special attention will be further paid to
the legislative risk in connection with projects subsidized from
public resources.
We consider the legislative risk as the possibility of a significant
change in legislation. Such a change may subsequently adversely
affect investments and their returns. The unforeseen change in
legislation may cause attenuation of the subsidy supply e.g., to
renewable energy projects by means of economic barriers such
as subsidy cuts for renewable energy, the introduction of
additional tax, etc. (Pimonenko et al., 2020). The literature
works with the theoretical concept of legislative risk, including
its assessment and evaluation. Some authors examine the
qualitative and quantitative risk assessment methodologies (Di
Nicola and McCallister, 2006). General risk management
guidelines can be applied to quantify legislative risk (Jeynes,
2012).
On the practical level, the legislative risk is included in subject
rating (Vinš and Liška, 2005), which is widely utilized despite
legitimate criticisms, which makes it an imperfect valuation tool
(Hill, 2002). In accordance with (Oetzel et al., 2001) the risk
associated with the possible undesirable changes affecting the
projects´ profitability can be estimated from the ratings of the
services to which belong the Bank of America World
Information Services, Euromoney, Standard and Poor's Rating
Group, Moody's Investor Services, Transparency International
and others.
It is considered that investing financial resources in the
subsidized projects involves risks that may prove to be greater or
at least more complex than generally considered within the
capital budgeting (Busse and Hefeker, 2007). The threat of any
undesirable legislative change could substantially alter the
prospects of the project’s cash flow prognoses thus affecting the
economic results of the company (De Haan and Siermann,
1996). Political and economic risks influencing subsidy policy
may arise in many forms such as: a new president or prime
minister coming to power, a change in the country’s ruling party,
the power of lobbyists, high budget deficit, corruption, etc.
(Wallace and Latcheva, 2006).
The aim of the paper is to assess the risk of legislative change on
the profitability of a subsidized project of renewable energy. We
particularly take into account the threat of the subsidy cuts of the
purchase price (feed-in tariff) for the energy produced. To
measure it we derive from the data of the rating agency
Euromoney Country Risk for the selected EU countries
promoting production of subsidized renewable energy and
therefore acting in the line with commitments of the Kyoto
Protocol, which aims to combat global warming
(Kyoto protocol, 1997). Based on this, we build a statistical
model for estimating the expected profitability of the subsidized
average project measured by E[NPV] for the given group of
selected countries. In this context, the theoretical approach will
be justified in the methodology and applied in the case of the
project of a biofuel energy plant evaluation under consideration
of legislative risk. The conclusive part summarizes procedures
and states the original findings.
2 Materials and methods
The stochastic uncertainty of the business environment affects
the reliability of the outcomes of managerial calculations with
the subsidized projects being no exception.
The methodological approach to the profitability assessment of
subsidized
projects leans to the value concept
(Froot and Stein, 1998) that takes into account explicit and
implicit payments so that the result is a complete objective part
of the economic assessment. The key decision-making criterion
is presented by net present value (NPV) of the cash flow
generated by the project during its life expectancy n (see e.g.,
Sayadi et al., 2014):
NPV=�
R
−C
(1+)
=0
(1)
In relation (1), the variables R
t
and C
t
represent the revenues
and costs at time t. In the case of a subsidized project, the
discount rate i stands for the internal yield on investment – IRR
(Horowitz, 1996). Investors, who use public sources to
implement their projects, calculate with this annual yield; its size
depends on the type of grant, subsidy and incentive policy.
Ideally, it is equal to the alternative costs of the capital
(Wiesemann et al., 2010). In the field of renewable energy
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