Why are we still surprised by industrial catastrophes?

woodhouse
Posted: 08/15/2017

In the fourth part of John Woodhouse’s assessment of asset management, he explores why the inevitability of major disasters still leaves companies shocked and in economic turmoil

Chernobyl, Three Mile Island, Bhopal, Texas City, Piper Alpha, Macondo.

After traumatic and tragic events, people often ask “How could this have happened?” and exclaim that “It must never be allowed to happen again!”

Tragedies and catastrophes like these come with direct, indirect and societal consequences that cannot be accounted for in any conventional system. They cannot be prepared for in a human sense, and no amount of preparation can help us recover from them easily.

Nonetheless, we must do the best we can to preconsider and prepare for such events, in the rigor of our preventive efforts and in contingency plans or emergence response. It is part of responsible asset management to think about the “unthinkable”.


The zero risk fallacy

Risk management is a core part of asset management, and a professional, disciplined consideration of rare, catastrophic events is part of this responsibility.

As much as we would like to, we can’t eliminate risk: there’s no such thing as “zero risk” in operating and managing complex systems.

Unpleasant as it is to consider and discuss such possibilities, we have to include low probability, catastrophic consequence events in our risk management strategies.

Remote probability events are hard to envisage, and even harder to quantify. Similarly, the scale of consequences of major incidents is difficult to consider, and many people simply choose not to think about it.

But there is a way of dealing with the subject: of considering the scales of risk and the appropriate asset management implications.


COMAH and the rarity scale

probability-impact

In the UK, the Control of Major Accidents and Hazards (COMAH) legislation includes a requirement for “disproportionality” in risk management.

This forces the extra degree of conservatism needed when assessing and managing rare event risks. Let me explain what I mean.

If we estimate an incident as having a 1 in 10 chance of occurring, and the event consequences as $100,000, then the level of risk is 1/10 x 100,000 = $10,000 and a preventive action (or insurance policy) costing less than this would be justifiable.

If, however, the event were rarer, say a 1 in 10,000 chance, with consequences that could be as high as $10 million in impact, a “proportionate” risk assessment would say the risk was the same (1/100,000 x 10 million also equals $10,000).

However, the rarity of the very rare event means that the quality of our knowledge or estimate is much poorer, and so is our ability to predict potentially massive consequences.

To reflect this weaker information, we have to inflate the fear in case we are wrong. This is “disproportionality” and it requires a deliberate non-linearity in probability scales and in consequence scales.


Towards a proactively conservative approach

Rare, catastrophic events must be assessed as if they were less rare, and have even greater catastrophic consequence than we would directly estimate.

Asset managers must show that this conservatism is built into their risk management processes in determining how to control such risks, and to what degree.

We will never eliminate all risk but we can manage it to the best of our ability. And a head-in-the-sand reliance on simply complying with rules and procedures is not an adequate or acceptable practice.

woodhouse
Posted: 08/15/2017

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