Escalation (market) Risk

A principle of recommended QRA methods, and integration, is that they include all the risk types (i.e., systemic, project-specific, and escalation) and quantify all the outcomes (i.e., cost and schedule). Escalation risks, sometimes called external market risks, are driven by economic conditions. It should be noted that escalation is not inflation which is monetary in nature. Escalation includes inflation. Escalation is also specific to regions and markets whereas inflation, as the purchasing power of money, is general.

Escalation risk is somewhat manageable (e.g., change timing of purchases, contract clauses, etc.), but is largely out of the business’s and project team’s control. A common escalation risk is a hot capex market (supply/demand imbalance) that results in shortages of skilled labor, high prices for labor services and materials, and sometimes supply chain delays. On the other hand, a cold market can result in better prices. Another driver of escalation is schedule delay. Escalation compounds over time, so delay risks that push spending to later dates, adds escalation.

Being driven by economic conditions and the timing of spending, escalation risk is best quantified in an escalation tool. Escalation estimating starts with documenting the base cash flow by cost item by period. The cost items are those with unique pricing behavior; e.g., labor is separated from steel materials, etc. Next, forecasts of price levels by period are obtained from econometric consultants or other reliable sources. A deterministic escalation estimate simply multiplies the spending by period for an item times the compound price increases up to that period. The escalation by item and period are summed.

ValidEsc quantifies escalation probabilistically. To address escalation probabilistically, uncertain elements of the deterministic model are replaced by distributions and Monte Carlo simulation is applied. The primary uncertainties are the price level (i.e., price indices) and the cash flow (i.e. schedule). Note that cost contingency must also be escalated, and contingency itself is a distribution. The base cost and schedule risk are quantified by ValidRisk and imported to ValidEsc. Therefore, the ValidEsc tool’s heuristics quantify all the cost and schedule risk on a project (except exchange rate). It provides not just a probabilistic escalation output, but also a universal capital cost risk profile, incorporating cost contingency, schedule contingency, and price uncertainty.