What goes up may come down…

The rebound in the mining and metals sector has outpaced the recovery of other industries from the recent global financial crisis. The level of interest in mining can be attributed to a number of factors, including the domino effect of a flight to safety from uncertainty in financial markets fuelling voracious demand, coupled with the long lead times required to bring new operations on stream.

Companies around the world have invested in and reactivated capital projects and exploration activities in frontier regions. Large amounts of money are being spent in these new regions and with controls streamlined during the financial crisis. The result is a heightened risk of fraud and corruption.

Company management and boards of directors have an interest in understanding and mitigating the risks that may negatively impact stock price. The mining and metals sector is more vulnerable than many other industries to fraud and corruption. Experience shows that stock prices are sensitive to fraud risk: an association with fraud can have a disproportionate effect on stock prices because investors worry about the consequences beyond the disclosed misrepresentation. Investors begin to focus on critical questions such as, what else remains to be discovered? And this in turn leads to questions about what the impact will be on the organization’s ability to operate — not just its profitability, but also its social licence to operate, its ability to access new projects, and its relationships with stakeholders, including local regulators.

There are several characteristics that are unique to the mining and metals sector that provide specific risk exposures for consideration.

Operational risks in remote locations

The risk of operating in remote locations can lead to a heightened risk of fraud and corruption. As the global appetite for commodities grows and known reserves are depleted, there is an increased willingness by companies to explore, develop and operate further afield in remote geographies that previously were unexplored or deemed too risky. The economic cost-benefit analysis, which previously may have restricted entry to particular countries and regions, has been tipped in favour of rapid development in order to access deposits.

New remote locations pose unique challenges. For example, the segregation of duties can be significantly less effective when relationships with the local team are close knit and may be stronger than relationships with a distant head office. Internal controls and systems may be new or evolving, rather than “tried and tested,” and policies and procedures may not adequately deal with local business customs and practices, or even be communicated in the local language.

The mining and metals sector is one of the most highly regulated sectors because of the health, safety and environmental impacts, as well as the relative importance of the sector to many emerging market economies. Licences, permits and approvals require frequent interactions with government officials. Similarly, government officials may also control access to the utilities and infrastructure, such as the ports and railways systems that are integral to establishing and maintaining the lifeblood of an operation.

High levels of government regulation

The compensation of these government officials may be low relative to the economic consequence of their decisions. The combination of many opportunities, pressure to complete and rationalizations make for a significant exposure to corruption or extortion.

Many countries have refreshed their anti-corruption regulations and renewed their enforcement commitments. The new UK Bribery Act includes a failure to prevent bribes as a criminal offence. The US Dodd-Frank Act includes potentially significant financial incentives to whistleblowers. Both of these statutes can affect transactions outside of the UK and US.

The large capital expenditures required represent a significant opportunity for some individuals in a position of power and influence. Despite the efforts of the majority of governments to tackle the issues of corruption head on, exceptions still exist and some individual government officials may abuse their powers to delay and stall attempted development, until they can extort personal financial benefits. Their ability to extort the corrupt payments remains high, as the mining industry is constrained by the location of the resource and companies do not have the option of readily moving away from a particular geographic location.

This ability to control the operating capacity of the project heightens the risk that mining companies are exposed to various levels of government officials that may have the power to block, delay or frustrate a project.

Expenditures in remote locations

Operating in remote locations can result in environments where communication and physical access remain a challenge, banking systems are poor and antiquated, supply routes remain insecure and business is conducted in a primarily cash-based economy. CMJ