10 minute read 29 Oct 2020
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How political risk affects five areas at the top of the C-suite agenda

By Courtney Rickert McCaffrey

EY Global Geostrategic Business Group Insights Leader

Geopolitical analyst and strategist. Creative methodologist. Proud feminist. Passionate about generating insights to help executives make better-informed decisions.

Contributors
10 minute read 29 Oct 2020

Recent research reveals five key areas in which political risk is having a material impact on companies.

In brief
  • Multinational firms from countries with greater political affinity to the US experience significantly stronger post-acquisition performance.
  • Corporate responsibility initiatives and a greater focus on environmental, social and governance outcomes may help reduce a company’s political risk.
  • Our review found that the majority of political risk impacts that companies report are firm specific, rather than shocks that occur at sector or market level.

Political risks are in the headlines every day, from elections and regulatory changes to social protests and trade wars. Not surprisingly then, more than half of global executives we surveyed in 2019 said that the effect of political risk is higher on their company than it was two years ago. They pointed to strategy and mergers and acquisitions as the business functions most significantly impacted by political risk. But it can be difficult to identify how material these impacts are for company performance. Recent academic studies point to some answers.

Through the EY Geostrategic Business Group’s collaboration with The Wharton Political Risk Lab, each year we examine new studies about the impact of political risk on companies. Our goal is to provide a bridge between the latest academic research and business practices for executives navigating a volatile political risk environment. This year we highlight 5 key areas:

  1. Cost of capital
  2. Cross-border flows
  3. Market entry and global footprint
  4. Corporate responsibility
  5. Innovation

These findings build on our 2019 literature review, which assessed more than 300 academic articles published over the last 2 decades.

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Chapter 1

Cost of capital

Economic policy uncertainty increases the average weighted cost of capital at the macro level.

The uncertainty typically associated with elections often has a broad impact on business. As such, one of the biggest political risk events of 2020 will be the US election in November. For example, one study found uncertainty caused by the US election cycle negatively affects equity returns in foreign countries, with stronger effects when a country has larger equity market exposure to foreign investors. And while the reaction of non-US market indices was approximately -1% in the 6-month period prior to an election, it was even greater (-2.4%) when there was more uncertainty in political power such as a possible swing of control in either chamber of Congress (as is the case this year).1 And even beyond elections, increases in global economic policy uncertainty have been shown to increase the average weighted cost of capital at the macro level as well.2

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Chapter 2

Cross-border flows: Human resources and supply chains

Geopolitical tensions impact the flow of goods and labor, posing a direct threat to cross-border trade.

Recent studies highlight the effect of government policies on the flow of goods and labor. In one, completed before the start of the pandemic, visa-free travel was shown to have a large positive impact on trade—as much as 27% for small and medium size businesses. Such impacts are particularly relevant during the pandemic, as policy shifts on cross-border mobility are happening on an outsized scale during the COVID-19 pandemic. Border closures have had widely reported material impacts on airlines, hotels and other travel-related industries. More broadly, migration policy is being politicized to protect local labor forces during the COVID-19 crisis. If these restrictions are not temporary, they may slow or derail the recovery of companies reliant on international mobility.

Political risks also pose a more direct threat to cross-border trade. Supply bottlenecks and, in some cases, export restrictions – especially for newly strategic items such as ventilators and personal protective equipment – have exacerbated supply chain pressures on companies that operate across borders. In extreme cases, countries may even erect physical barriers to trade. One study found such barriers are, on average, are associated with a 31% reduction in bilateral trade.3 Such dramatic policy-induced trade reductions could affect the viability of many companies’ cross-border supply chains.

Rising geopolitical tensions are more likely to affect some companies more than others though. A study on the bilateral trade patterns of China and India found that political tensions impacted the imports of state-owned enterprise (SOE) more than those of private companies.4

Policy restrictions on cross border trade and investment are rising
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Chapter 3

Market entry and global footprint

Political risks cause companies to rethink their global portfolios.

The dramatic disruption of the COVID-19 pandemic and shifting government policies such as trade restrictions and industrial policies are prompting many companies to reevaluate their global footprints. In fact, the EY Global Capital Confidence Barometer found that the majority of global companies (72%) will be conducting more regular strategy and portfolio reviews.

One consideration in market entry and global footprint decisions should be a country’s regulatory environment. A study examining the locations of almost 7,000 US multinational subsidiaries indicated that a one standard deviation decrease in the quality of a country’s property rights decreased the incidence of entry by 1.8%.5 In addition, conflict in a market leads to less investment there. A study of more than 4,000 mining firms in 177 countries found that firms reduce investment by 8% in sites that have recently experienced a fatal armed conflict.6

Regulatory quality is gradually improving worldwide

Political risks can also affect the performance of cross-border mergers and acquisitions (M&A). A study of M&A targets in the US revealed that multinational firms from countries with greater political affinity to the US experience significantly stronger post-acquisition performance – up to 35% higher firm value three years after the acquisition.7 This finding was further validated by a study of cross-border M&A transactions led by Chinese companies, in which cultural distance exerted a negative influence on value creation of acquirers in both the short and long term.8

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Chapter 4

Corporate responsibility

The relationship between social responsibility, political risk and corporate performance strengthens.

Corporate responsibility (CR) has increasingly come into the spotlight in recent years – even more so now amid the COVID-19 pandemic and social justice protests. We expect the relationship between CR, political risk and corporate performance to grow further in the coming years. One pressure driving this shift is societal political risk from increasing NGO activism and legitimacy.9 Yet, this pressure, according to one forthcoming study, differs across countries based on the political strength of civil society.10

Another source of pressure on companies is investors. According to the 2020 EY Climate Change and Sustainability Services (CCaSS) Institutional Investor survey, 67% of investors surveyed now make “significant use” of ESG disclosures that are shaped by the Task Force on Climate-related Financial Disclosures (TCFD). Investors know ESG risks can have significant material impact on companies because this is increasingly borne out in the research. For instance, one study found companies facing social boycotts experience 30% higher board turnover.11 And another recent study on the global mining industry found that equity markets apply a discount to announcements that indicate a company’s mines are close to environmentally sensitive water resources.12

CR initiatives and greater focus on ESG outcomes may help reduce the political risks that companies face. However, investments in CR can also create risks, particularly when companies fail to live up to their reputation. One recent finding is that firms with stronger reputations for CR incur greater valuation losses from environmental lawsuits.13

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Chapter 5

Innovation

The impact of political risk on innovation is growing in importance, as new technologies increasingly drive the global economy.

Political risk can affect innovation, research and development (R&D) and intellectual property rights in a variety of ways. Such effects are growing in importance, as fourth industrial revolution technologies such as 5G wireless networks – and the data that they generate and use – increasingly drive the global economy. Several recent academic studies explore one aspect of how political risk affects innovation: the degree to which companies establish and maintain relationships with politicians and policymakers. Interestingly, the conclusions are inconsistent.

Asian companies lead 5g wireless innovation

There is some evidence that political relationships support company innovation – likely due to reduced political uncertainty fostering greater investment in innovation. An analysis of patents and political contribution data of more than 6,500 American companies found that those that support more politicians, winning politicians, politicians with jurisdiction over their industry, and those who join congressional committees innovate more.14 A similar result was found with relation to high-tech firms’ affiliation with higher levels of government in China.15

But there is countervailing evidence as well. A study focused on transition economies found that managerial time invested in political ties can weaken the relationship between organizational innovation and productivity.16 One study found a potential solution for companies with less international experience is to co-locate R&D activities with production activities, which can substitute for the ability to coordinate complex and dispersed organizational structures.17

Incorporate political risk analysis into business decisions

With material impacts from political risk on a wide array of business activities, the case for incorporating political risk analysis into C-suite decisions is clear. This is especially important for maintaining competitiveness because researchers have found that the vast majority of political risk impacts that companies report are firm specific (91.7%), rather than shocks that occur at the sector (7.5%) or market (0.8%) level.18

There are several specific actions executives can take to reduce their company’s political risk exposure and more effectively manage the political risks they still face. They should use scenario planning or other strategic foresight tools to assess how political risks may affect their workforce mobility and cross-border supply chains in the coming years. They should also incorporate political risk analysis into market entry and global footprint decisions. And as CR and ESG continue to rise up the C-suite agenda, executives should determine how stakeholder relationships could improve the effectiveness of their political risk management. Finally, companies should consider how their political risk management and innovation decisions may be intertwined – and make any adjustments necessary to foster greater innovation in the future.

These political risk management actions are especially important in the midst of the COVID-19 crisis, as governments play a more active role in managing their economies. Companies need to ensure that they have the necessary governance frameworks to integrate political risk analysis into their strategic planning and broader risk management processes in order to mitigate the potential negative impacts of political risk and also seize any opportunities that the shifting political environment may generate.

  • Show article references#Hide article references

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    2. Xu, Z. (2020). Economic policy uncertainty, cost of capital, and corporate innovation. Journal of Banking & Finance, 111, 105698.
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Summary

More than half of global executives we surveyed in 2019 said that the effect of political risk is higher on their company than it was two years ago. Political risk continues to materially impact a wide array of business activities. The case for building political risk analysis into the core of C-suite decision-making is more important now than ever and will become increasingly critical in the years to come.

About this article

By Courtney Rickert McCaffrey

EY Global Geostrategic Business Group Insights Leader

Geopolitical analyst and strategist. Creative methodologist. Proud feminist. Passionate about generating insights to help executives make better-informed decisions.

Contributors