Bachelor Thesis

Quantification of risks in project management as a way towards elimination

of subjective assessment. The case of a German wind farm portfolio.

Submitted by:
Marina Zaitseva
Submission date: 07.08.2015
Berlin

Study Programme: B.A. International Business Management

Student ID: 299345

1st Supervisor: M.A., Dipl.-Kfm. Alexander Boensch

2nd Supervisor: Prof. Dr. Hansjrg Herr

Words: 15,020

Abstract
The aim of this thesis is to investigate and identify the present status of a quantitative approach
to risk analysis and to make recommendations for any interested parties who are required to
assess risks based on quantitative and qualitative criteria. A wind farm portfolio has been successfully used to test several quantitative risk methods, with the aim of describing each
methods suitability for the reduction of subjective estimation.
This thesis first examines the theoretical aspects of risk management and the applied approaches
to risk assessment and analysis. These show that widely used in risk estimation qualitative risk
assessments highly depend on cognitive factors. The thesis identifies the use of quantitative risk
assessments to promote less subjective results and undertakes sensitivity analysis, scenario
analysis and Monte Carlo simulation to a wind farm portfolio for the testing of rationality. In a
detailed empirical section, the thesis provides the reader with the practical application of quantitative risk methods, including their advantages and disadvantages.
Finally, on the basis of the results of this research, it can be concluded that Monte Carlo simulation is well suited to decreasing the presence of subjectiveness, but is unable to fully address
subjective judgements about the risk. The thesis hopes to offer the reader some useful tools and
techniques on quantifying risks, and thus make a small contribution to the improvement of risk
analysis when applied to wind power industry in general.

II

Table of Contents
Abstract ...................................................................................................................................... II
Table of Contents ......................................................................................................................III
List of Abbreviations ................................................................................................................. V
List of Figures ......................................................................................................................... VII
List of Tables ........................................................................................................................... IX
1

Introduction .......................................................................................................................10

Theoretical aspects of risk assessment and analysis .........................................................13

2.1

The importance of quantitative assessment applied to wind farm portfolio ..............13

2.2

Development and scope of the risk assessment applied to wind farms .....................14

2.2.1

Overview of the project risk management ..........................................................14

2.2.2

Integrated risk assessment model into onshore wind farm projects ...................16

2.2.3

Some risk assessment considerations: the role of emotions in judgements about

risk

24

Applied approaches to risk assessment and analysis ........................................................27

3.1

3.1.1

Scoring model as an example of the qualitative assessment tool .......................27

3.1.2

Limitations of the scoring model and need for quantitative enhancement .........28

3.2

Qualitative risk modelling ..........................................................................................27

Quantitative risk modelling ........................................................................................30

3.2.1

Non-probabilistic based risk techniques .............................................................30

3.2.2

Probabilistic based risk techniques .....................................................................34

Empirical studies of the wind farm portfolio in Germany ................................................36

III

4.1

Research design and methodology .............................................................................36

4.2

Preparation of quantitative modeling procedure ........................................................37

4.3

Results of the empirical analysis ................................................................................38

4.3.1

Application of the sensitivity analysis ................................................................38

4.3.2

Application of the scenario analysis ...................................................................50

4.3.3

Application of Monte Carlo simulation ..............................................................59

4.4
5

Evaluation of the quality of disclosed quantitative risk analysis ...............................64

Conclusion ........................................................................................................................67

Bibliography .............................................................................................................................69
Appendices................................................................................................................................77
Affidavit ....................................................................................................................................88

IV

List of Abbreviations
ABC

Activity-Based-Cost

AEP

Annual Energy Production

AS/NZS

The Australian and New Zealand Standard on Risk management

AWEA

European Wind Energy Association

BCG

Boston Consulting Group

BWE

Bundesverband und Windenergie

CAPEX

Capital Expenditure

DCF

Discounted Cash Flow

DoD

Department of Defense

DSCR

Debt Service Coverage Ratio

ETCs

Exchange Traded Commodities

EBITDA

Earnings before Interest, Taxes, Depreciation and Amortization

ETCs

Exchange Traded Commodities

G.E.

General Electrics

IEA-RETD

Environment Impact Assessment-Renewable Energy Technology

Deployment

IRENA

International Renewable Energy Agency

IRR

Internal Rate of Return

kWh

Kilowatt-hours

M_o_R

Management of Risk guideline

MW

Megawatt
V

MWh

Megawatt hour

NPV

Net Present Value

O&M

Operation and Maintenance

OPEX

Operational Expenditure

PMBOK

Project Management Body of Knowledge

PRAM

Project Risk Analysis Management

VaR

Value-at-Risk

VDMA

Verband Deutscher Maschinen- und Anlagenbau

WT / WTG

Wind Turbine / Wind Turbine Generator

VI

List of Figures
Figure 1: Benchmark of risk management standards................................................................15
Figure 2: Risk assessment stages within the risk management process ...................................17
Figure 3: Classification of risks in the real estate sector ..........................................................19
Figure 4: Overview of wind energy project life cycle ..............................................................21
Figure 5: ABC matrix ...............................................................................................................22
Figure 6: Example of the sensitivity analysis within the theoretical aspect .............................32
Figure 7: Survey evidence on the popularity of different capital budgeting methods ..............39
Figure 8: IRR sensitivity analysis. Treuen-Pfaffengrn (T-P) ................................................41
Figure 9: IRR sensitivity analysis. Mncheberg (M) ..............................................................41
Figure 10: IRR sensitivity analysis. Holel (H) .......................................................................42
Figure 11: IRR sensitivity analysis under Annual Energy Production (AEP). TreuenPfaffengrn (T-P) ......................................................................................................................45
Figure 12: DSCR sensitivity analysis under Annual Energy Production (AEP).

Treuen-

Pfaffengrn ...............................................................................................................................47
Figure 13: DSCR sensitivity analysis under total operating costs. Treuen-Pfaffengrn .........48
Figure 14: DSCR sensitivity analysis under total losses. Treuen-Pfaffengrn........................49
Figure 15: DSCR sensitivity analysis under interest rate. Treuen-Pfaffengrn ......................50
Figure 16: Scenario analysis. Treuen-Pfaffengrn ...................................................................51
Figure 17: Scenario analysis. Mncheberg ...............................................................................52
Figure 18: Scenario analysis. Holel ........................................................................................52
Figure 19: Summarized scenario analysis for IRR ...................................................................53

VII

Figure 20: Summarized scenario analysis for the cumulative cash flow ..................................55
Figure 21: Risk assessment using probability density function. Treuen-Pfaffengrn ..............57
Figure 22: Risk assessment using cumulative distribution function. Treuen-Pfaffengrn .......58
Figure 23: Monte Carlo application. IRR distributions. Treuen-Pfaffengrn .........................61
Figure 24: Monte Carlo application. IRR distributions. Mncheberg ......................................62
Figure 25: Monte Carlo application. IRR distributions. Holel ..............................................63

VIII

List of Tables
Table 1: Main project characteristics of an onshore wind farm ...............................................18
Table 2: Location-specific key wind farm considerations ........................................................20
Table 3: Two modes of thinking: comparison of experiential and analytic systems ................26
Table 4: Break Even Point (years) of cumulative cash flow under different scenarios ............54
Table 5: Annual energy output under exceedance probability and overall uncertainty level.
Treuen-Pfaffengrn ...................................................................................................................59
Table 6: Monte Carlo application. IRR statistics. Treuen-Pfaffengrn ....................................61
Table 7: Monte Carlo application. IRR statistics. Mncheberg ..............................................62
Table 8: Monte Carlo application. IRR statistics. Holel ........................................................63

IX

Introduction

Derived from natural processes, wind became potentially one of the largest sources of renewable energy in countries which are focusing on transmitting energy using alternative sources.
Based on official guidelines from the European Wind Energy Association (Corbetta, Pineda, &
Wilkes, 2014, p. 3), two countries - Germany and the UK keep driving the European market,
reaching 59.5% of all total new wind power installations in 2014.
In terms of annual installations, Germany alone accounts for 44.8% of all EU wind power turbines (Corbetta, Pineda, & Wilkes, 2014, p. 5). Increased wind power capacity, rising number
of jobs and cost efficiency in the last years have determined trends and potential opportunities
for the wind energy market in Germany. The research conducted by Bundesverband und Windenergie1 (BWE) (2014b, p. 2) confirms the current trend in the growth of wind power capacity. For the year of 2015 manufactures and energy experts expect inflows of 3,500 to 4,000
megawatts (MW) from onshore (BWE, 2015c) wind turbines (WT). By 2030 the amount of
jobs attributable to renewable sector in Germany can be expected to rise up to 500,000
600,000 (Krewitt, Nitsch, & Nienhaus, 2009, p. 6). Finally, the BWE projects that the price for
wind turbines will gradually decline in the future due to the shift towards larger turbine sizes
with taller towers, which makes it possible to achieve higher energy outputs (Deutsche
WindGuard GmbH, 2014, p. 6).
In Germany, there are numerous locations where wind conditions enable to be utilized economically, hence this the most important pillar for investments in wind turbine generation (WTG).
Investments in wind energy have a long-term character2, which place a capital at risk. According to the PMI (2013, p. 559) a risk is An uncertain event or condition that, if it occurs, has a
positive or negative effect on one or more project objectives. Risk has always been an integral
part of the investing decision, therefore banks and equity investors are continuously executing
risk management. There are various risk management practices applied in business, but all of
them have in common to determine the risk level and, in consequent, to evaluate an investment
decision.

1
2

Federal Association of (the) Wind Energy Industry in Germany (BWE)

A wind farm typically operates around 20 years.

10

The importance of this thesis originates from the debate concerning the two approaches to risk
analysis: qualitative and quantitative. Qualitative risk analysis is mainly based on personal experience such as expert judgments or interviews collected in workshops. Even though tools like
the Delphi method are used to have a more objective assessment, qualitative analysis always
has a tendency to be biased, because people make decisions based on their emotions and, as a
result, qualitative approach have subjective evaluations (PMI, 2013, pp. 333-335).
The Bachelor thesis of Hoffmann (2010) Entwicklung eines Scoring-Modells fr Windparkportfolios auf Basis von Empirischen Analysen deals with the qualitative methods to asses
wind power plants, this thesis is focusing on the quantitative methods in particular. The accurate
objective performance of risk analysis is of particular interest not only to investors and banks,
but also to wind farm developers. The findings of the thesis aim to provide the reader with the
comprehensive information about the importance of the risk quantification process as a way
towards reduction of subjective assessment. To achieve representative results, this thesis will
conduct:
1. sensitivity analysis,
2. scenario analysis and
3. Monte Carlo simulation,
as well as, their practical application for the selected wind farm portfolio, of which three casestudies are described in this paper.
The first two parts of this thesis cover the theoretical discussion of the quantitative risk analysis
under risk assessment. It introduces the scope of risk assessment under different risk management standards, and proposes a unique risk assessment model for the wind power industry. The
theoretical research focuses on the risk analysis which involves qualitative and quantitative
methods. The study uses a scoring model as an example to discuss the subjective nature of
qualitative analysis and creates the preconditions for the reasoning of risk analysts to apply
quantitative analysis. At the same time, the research provides an overview of the quantitative
approaches to risk.
The fourth part demonstrates an empirical study by applying quantitative methods to three wind
farms in Germany. Based on the financial modelling provided by Mr. Boensch3, this thesis

M.A. Dipl.-Kfm. Alexander Boensch is a lecturer at Berlin School of Economics and Law. Please refer to Mr.
Boensch to obtain the financial modelling.

11

provides several tools to reduce biased judgments about potential risks in the wind farm portfolio and assist risk analysts with the application of quantitative techniques. Additionally, the
results obtained from the quantitative analysis evaluates the most feasible quantitative method,
which serves as an alternative to the purely subjective probability estimation. Finally, empirical
research critically screens the viability and reliability of quantitative results.

12

Theoretical aspects of risk assessment and analysis

2.1 The importance of quantitative assessment applied to wind farm portfolio

According to the Global Wind Energy Council (BWE, 2014a, p. 12) the accumulated installed
capacity of wind power worldwide at the end of 2013 reached 318,000 MW. This number has
almost doubled since 2009 with 160,000MW (BWE, 2014a, p. 12), proving the fact that a lot
of countries realize their potential in wind industry. Regardless of ones current position,
whether it is a leader or new to the market, one should recognize that wind farms are extremely
intensive asset-investments (Hulsch & Strack, 2006, p. 1). Thus, to keep the expansion curve
upwards (Chaves-Schwinteck, 2011, pp. 1-3), one must continuously explore any risks and/or
uncertainties towards financing wind farm projects.
In this sense, Lidia Hoffmann (2010) in her Bachelor thesis Entwicklung eines Scoring-Modells fr Windparkportfolios auf Basis von Empirischen Analysen4 has developed a comprehensive scoring-model as an integral part of portfolio analysis. The scoring-model based on a
questionnaire reflects the risk perception of industry actors, such as wind farm investors, financiers, developers, retailers, manufacturers and consultancy companies. It also takes into account
a wide range of factors that influence both business attractiveness and industry attractiveness,
and provides the respective weightings to each factor on the basis of expert assessments. Questionnaires, like checklists or templates provides a starting point for evaluating the presence of
some risks (Conrow, 2000, p. 115), and serve as a first step in carrying out a risk assessment.
However, in weighing potential hazards questionnaire should never be used as the sole method
of assessment, due to some risk evaluations always being left out. The fact alone that wind
farm projects are growing in size, number and volume, thereby increasing their absolute risk
exposure in terms of millions of Euros at risk (Hulsch & Strack, 2006, p. 2) demonstrates the
necessity of risk management using strategic and less biased methods.
Brnger (2009) suggested several general analyses and methods for the quantitative risk analysis, which are based on either probability or non-probability techniques. Non-probability techniques generally involve a certain level of heuristics and biases. Roeser (2010) examines how
emotions could be both favorable and destructive in the decision-making process. A study by
Khindanova (2013) implements a Monte Carlo analysis to a wind power generation investment.

Development of a scoring model for wind farm portfolios based on empirical analyzes

13

This paper contributes to decrease subjective estimation by implementing non-probabilistic and

probabilistic (Monte Carlo simulation) analysis of wind farm portfolio.
As already mentioned, the scoring model serves as an integral part of the portfolio analysis and
bundling wind farms into such portfolios allow for a greater handling of risks and uncertainties
(Hulsch & Strack, 2006, p. 1). It would be a mistake to presume that quantification leads to
unflawed risk assessment, however quantitative approaches brings additional advantages to the
portfolio analysis. Normally, major financial, technical and economic risks can be quantified
using financial and statistical methods, because most of these risks are known in advance, hence
they could be avoided if managed in time (Deloitte, 2014, p. 19). For examples, quantitative
approaches provide insights into investment decisions, based on probabilities (expected returns)
and risk (standard deviation) (Hulsch & Strack, 2006, p. 1). Also simulation-based techniques
help one to better to understand investment cases and to make the right investment decision
(Deloitte, 2014, p. 21).
Overall, wind farm portfolio can be significantly improved by assessing technical risks using
quantitative approaches, which allow the reduction of uncertainty around the energy production
(Chaves-Schwinteck, 2011, pp. 1-2). For this reason, the portfolio analysis enhanced by quantitative approach (as well as by other instruments) serves as a promising model to provide appropriate strategic decisions on investments and disinvestments.

2.2 Development and scope of the risk assessment applied to wind farms
This part of the thesis introduces and compares the most common risk management standards.
It then employs a mixture of the described standards to the onshore wind power generation and
provides some risk assessment considerations with regard to emotions in risk regulation.
2.2.1

Overview of the project risk management

While wind project costs billions of euros, risk management is needed to take an unbiased look
at the project management, otherwise an improper risk management may lead to significant
financial losses.
Several business books adopt the following risk management definition: Risk management is
the act or practice of dealing with risk (Kerzner, 2009, p. 746; Conrow, 2000, p. 20). A similar
definition is also given by Bridget M. Hutter (2010, p. 3): Certainly, anticipating risks and
organizing for their control is an integral part of risk regulation regimes which have long been
14

associated as much with their proactive as their reactive activities. It is to be inferred that any
formulation of risk management always involves two issues: risk identification and subsequent
risk response actions. Although, historically risk management was perceived as something good
to have, today it has become crucial for both government and commercial programs (Conrow,
2000, p. vii). In this respect, a risk management framework would assist in ensuring a consistent
project from the initiation until the final phase. Figure 1: Benchmark of risk management standardsFigure 1 below gives an overall picture of several risk management standards.
Figure 1: Benchmark of risk management standards

Source: Michelez, et al., 2011, p. 26

The Management of Risk guideline (M_o_R) focuses on the private sector. It explains how risk
management exercises strategic, project and operational objectives and highlights the process
from the strategic aspects to the operative context (Michelez, et al., 2011, p. 26).
The Australian and New Zealand Standard on Risk management (AS/NZS 4360)5 is an approach for risk management process applied mostly in public and private sectors (Cooper, 2004,
p. 1). The AS/NZS 4360 advises to adapt the risk management elements into its existing management system (Knight, 2010, p. 9). Due to its simplicity many organizations follow this standard.

The AS7NZS 4360 is one of the most popular standard in publication. Internationally adopted ISO 31000:2009
standard (Risk Management - Practices and Guidelines) based primarily on AS/NZS 4360 (Crickette, et al., 2011,
p. 3)

15

The Project Risk Analysis Management (PRAM) Guide describes which methods should be
used at which stage throughout the entire project lifecycle, stressing clear linkage to the management (Yusuff & IntSecMgmt, 2006, p. 8).
The risk management process presented in Chapter 11 of PMBOK is a precise and cost-effective technique. It sees risk management as an essential part of the overall project management
process (PMI, 2013, p. 309).
As can be seen from the Figure 1, the risk management process can follow different numbers
of steps according to different standards. However, based on this short review, it can be concluded that:
1. different risk management standards share similar workflow,
2. components within standards are adaptable for specific organizations and projects,
3. frameworks are continuously developed and changed within standards.
Frequently risk identification and risk analysis are considered as one process, called risk assessment (Duncan, 1996, p. 111). Also risk evaluation (see AS/NZS 4360 model) and a definition
of the acceptable risk level (see M_o_R) fall into the category of risk assessment. Based on the
findings, one can generate a unique risk assessment model for a particular project. Recognizing
risk assessment as the most time-consuming part of the risk management process (Conrow,
2000, p. 25), this thesis develops in the next part a risk assessment model which can be applied
for wind farms.
2.2.2

Integrated risk assessment model into onshore wind farm projects

This section aims to demonstrate how risk assessment can be applied to an onshore wind
project. The analysis is based mainly on results from an offshore wind case study conducted by
Environment Impact Assessment-Renewable Energy Technology Deployment (IEA-RETD). It
is then finally adjusted with respect to onshore wind farms, including a number of
recommendations given by external specialists and lessons learned from a real estate portfolio.
Based on four risk management guidelines displayed in Figure 1, a pattern for the unique risk
management process has been developed. Figure 2 illustrates the unique risk management process, where the grey shaded areas represent risk assessment stages.

16

Figure 2: Risk assessment stages within the risk management process

START

Establishment

of the risk
context

Risk
identification

Project
definition,
requirement

Life-cycle
approach

Risk analysis
Qualitative
analysis

Quantitative
analysis
Monitor
and Review

Probability
of occurance

END

Impact of
consequences

Addressed
risk
Unaddressed
risk
Risk Treatment
Preventive
actions
Corrective
actions

Risk evaluation

Acceptable
risk

Acceptable risk
level
ABC method

Unacceptable risk

Source: Based on Hammadi, L., Ouhman, A. A., & Ibourk, A., 2014, p. 1566

The displayed risk assessment consists of the following steps: risk identification, risk analysis
and risk evaluation (including risk prioritizing). In order to integrate such risk assessment model
to wind farm projects, it is important to consider the particular features of wind energy and their
implications for managing risks.
Before going into details with the risk assessment methodology, some necessary information
about the project should be provided to the reader in order to know the objective, goal, technique
and communication needs (PMI, 2013, pp. 110-117). This starts with the definition and
17

requirements of the project (Michelez, et al., 2011, p. 51), which as an example can be
summarized in Table 1 below.
Table 1: Main project characteristics of an onshore wind farm

Source: Based on (Michelez, et al., 2011, p. 131)

Risk Identification
Risk identification aims to analyze critical risk issues which may have an impact on the project
(Conrow, 2000, p. 24). Usually, this begins with the classification of the project risks with regard to its source: objective (e.g., lessons learned files) or subjective (e.g., interviews)
(PMBOK, as cited in Kerzner, 2009, p. 775). Among many tools to identify risks, Grey &
Walker (2005, p. 16) recommended techniques used in renewable sector projects are brainstorming6 and the Delphi method7. Another practical way of addressing potential risks is to
6
Brainstorming (also called nominal group technique) is a direct communication between stakeholders: ideas are
listed on a board and being discussed for potential risks [PMBOK, as cited in (Kerzner, 2009, p. 757)]
7
Delphi Method is a way of aggregating experts ideas on particular subject anonymously. Feedbacks are collected
and then revised again based on received feedbacks anonymously. The process is repeated when necessary
(PMBOK, as cited in Kerzner, 2009, p. 757).

18

perform a life-cycle analysis (PMBOK, as cited in Kerzner, 2009, p. 756). In Figure 3 below,
Kristin Wellner (2003, pp. 21-22) demonstrates risk classification. Five types of the risks lay
within different layers. The deeper the layer, the more intensive the risks become when influencing a project. Risks that directly affect real estate are, according to Wellner (2003, pp. 2122), object risks, followed by external risks, such as: environmental, economic, industry and
location-specific risks.
Figure 3: Classification of risks in the real estate sector

Environ mental
risks
Economic
risks
Idustryspecific
risks

Object
risks

location-specific risks (micro-/macro-)

the economic strength of the regions
(communities)
supply- and demand behavior at the
location
vacancy risk
the neighbouring construction/development
the infrastructure at the site

Source: Based on Wellner, 2003, pp. 21-22

Based on the real estate example, a good practice for the onshore wind farm project could be to
pay attention to the classification of location-specific risks. This will better help understand the
needs of the project against the merits of its location and play an important role in the planning
process. Because wind turbines are placed on land, some key considerations should be taken
into account (see Table 2 below).

19

Table 2: Location-specific key wind farm considerations

Source: Based on A good practice during windfarm construction, 2010, pp. 5-55

Wellners risk classification serves however as an overview of external potential risks during
the overall process, but it lacks the ability to identify risk issues for each life-cycle phase separately. This can be improved with a life-cycle risk analysis. For example, IEA-RETD via the
Delphi method arrives to the PEST8 risk classification, spread throughout five project phases:
conception, procurement, construction, operation, and abandonment (Michelez, et al., 2011, p.
133). Deloitte (2014, p. 5) also suggests a similar project lifecycle but for the onshore wind
farms; this includes project planning, construction, operational and decommissioning phases.
Such life-cycle risk analysis is a good practice to identify risks as early as possible and address
(likely to decrease) critical costs and uncertainties (Conrow, 2000, pp. 50-51).
Summarizing the data from two reports and adjusting it to onshore, Figure 4 reports risk identification based on the project life cycle.

P=Political, E=Economic, S=Social, T=Technical

20

Figure 4: Overview of wind energy project life cycle

Source: Based on Deloitte, 2014; Michelez, et al., 2011

Risk Analysis
Risk Analysis evaluates probability and consequence of occurrence and the impact of risks on
the project (Conrow, 2000, p. 25). PMBOK (2013, p. 309) identifies two types of assessing
risks: qualitative and quantitative techniques. Qualitative approach involves probability and
consequence of occurrence scales, which along with risk mapping matrix turn values into risk
level. The quantitative techniques show how different risks communicated with each other.
Among techniques available are quantitative approaches such as probabilistic techniques
and non-probabilistic techniques (Steinberg, 2011, p. 90). In the case of a single risk issue,
qualitative approach is preferred, whereas quantitative approach analyzes all risks combined
into portfolio (Michelez, et al., 2011, p. 53).
Risk evaluation and definition of acceptable risk level
According to ISO 31000, risk evaluation is a process that is used to compare risk analysis
results with risk criteria in order to determine whether or not a specified level of risk is acceptable or tolerable (ISO 31000, 2009). How to define an acceptable level of the risk if risk means
different things to different persons?
To tackle this problem, scientists developed technical and system theoretical approaches, which
contributed to the issue of risk perception and acceptance. (Bell, R., Glade, T., & Danscheid,
M., 2006, pp. 77-78). Natural scientists state that tolerable and acceptable risk are two different
phenomena. Tolerable risks are such risks, which are accepted by managers until they can be
monitored and reduced, whereas acceptable risks are taken without any further risk management actions. Although managers can define the acceptable risk levels, taking into account the
risk perception of the threatened individuals, no single acceptable risk level is possible. Up to
now regulators apply a technical approach (Bell, R., Glade, T., & Danscheid, M., 2006, p. 82)
to determine the acceptable level.

21

In order to assess the level of risks, it is recommended to classify risks into groups (Hammadi,
L., Ouhman, A. A., & Ibourk, A., 2014, p. 1571). Risk classification aims to increase transparency and track the project risk situation (Schieg, n.d.). The most frequently used method for
risk classification is the Activity Based Costing (ABC) method (Schieg, n.d., p. 3).
The ABC matrix describes how likely a risk happens (the probability of occurrence) and what
are the consequences of the risk (the magnitude of the consequences). The ABC analysis states
that a small number of factors make up the larger proportion of an entity (Schieg, n.d., p. 3).
The aim of ABC analysis therefore is to find out the factors which have the highest impact on
the project. The ABC matrix in Figure 5 depicts A, B, C classes of frequencies of risks and A',
B', C' of the gravity (magnitude) of risks accordingly.
Figure 5: ABC matrix

Source: Based on Hammadi, L., Ouhman, A. A., & Ibourk, A., 2014, p. 157

The bottom line - criticality (L) completes the ABC matrix. It should be noted that both danger
and frequent threats should be reduced, because the impact of risks in the high risk area can
cause serious damage to a project. Normally, risks are classified by the extent of their probability value (Schieg, n.d., p. 3) , where

A - major risks

B - medium risks

C - minor risks

22

All other risks should be analyzed separately to prevent potential harm and ensure compliance
with resources if needed (Hammadi, L., Ouhman, A. A., & Ibourk, A., 2014, p. 1571). Once
frequencies and gravity of risks are classified and calculated, the criticality of risks (L) can be
defined via the intersection of the classes (Hammadi, L., Ouhman, A. A., & Ibourk, A., 2014,
p. 1571), where:
Criticality (L) = Frequency Gravity
Establishing the criticality enables one to monitor any potential error stacks which are ranked
according to gravity and frequency of risks, thus preventing failures rather than getting better
at emergency responses. The criticality is used to assess critical risks which should be treated
specifically. The application of the ABC matrix is subject by the principle of Pareto (Hammadi,
L., Ouhman, A. A., & Ibourk, A., 2014, p. 1571), which says:

A group gathers 80% of the observed effect.

B group items after gathering 15%.

C group collects items remaining 5%.

In order to reflect the risk profile of the project, the risk roadmap or risk matrix can be used
(Schieg, n.d., p. 3). For the application of this in the wind energy industry, Lidia Hoffman has
introduced a risk matrix of the McKinsey and General Electrics (G.E.), which measures market
attractiveness on one side and industry attractiveness on the other side9. Such risk matrices
define the risk factors and discloses which risks are critical in the risk management. Additionally, a borderline should be defined to assess which risks should be accepted and which should
not. (Schieg, n.d., pp. 3-4). The borderline requires diverse steps, such as the establishment for
the maximum acceptable probability value of the risks costs or relevance of a risk10 (Schieg,
n.d., p. 3). If risks can be accepted, then no specific risk management options are needed. In
case the risks cannot be accepted, they should be managed. This includes different techniques
and methods, such as avoid, transfer, mitigation for negative risks or exploit, enhance, share for
positive risks also called (PMI, 2013, pp. 344-346).
Finally, risk evaluation enables effective and efficient management of the measures for the risk
assessment (Schieg, n.d., p. 3). However, the risk amount and the probability of occurrence of
9
For further reading, please refer to Hoffmann, L. (2010). Entwicklung eines Scoring-Modells fr Windpark-Portfolios auf Basis von empirischen Analysen, (Unpublished Bachelor's thesis), Berlin School of Economics and Law,
Germany.
10
Quite often the probability of occurrence is low, but risks are viewed as unacceptable

23

risks are defined usually via checklists, interviews or similar qualitative methods, which have
certain limitations in overall judgements about risks. The next section aims to highlight such
limitations, which should be considered in the risk assessment.
2.2.3

Some risk assessment considerations: the role of emotions in judgements about risk

Today, managers and executives have become aware how subjective assessments affect decisions in business. Confirmation bias, for example, causes stereotyped notions, anchoring
favors one information over the other in decision-making process, whereas risk-aversion
makes individuals very prudent with respect to gains (Kahneman, Lovallo, & Sibony, 2011, pp.
50-60).
Indeed, any decisions taken at a personal or organizational level directly or not directly involve
emotions. The problem is therefore not whether decisions are emotional by nature, rather what
role should emotions play in our judgements (Roeser, 2010, p. viii), how to apply emotional
response to risk assessment and should managers perceive emotions seriously or not in the decision making process.
It was found, that one group of researchers considers emotions essential for making a rational
decision, whereas the other group views emotions as something akin to sand in machinery
(Roeser, 2010, p. vii). Roeser (2010, pp. xxiv-xxx) refers to the contributions of numerous
scholars who write about risks and emotions; she splits authors in two camps: those who believe
that emotions are barriers to risk perception and those who argue that emotions are needed to
assess risk issues.
According to Roeser (2010, p. viii), risk assessment is a matter of emotion, rationality and responsibility. Usually, emotions have been perceived to be opposed to rationality. However,
Roeser (2010, p. ix) argues that emotions are functional, rational and are actually often in conjunction with rationality, because emotions are the product of a life experience. Yet, Jean-Paul
Sartre (1948, p. 58) adds that emotions are a set of strategies, which people use to control their
thoughts and actions to achieve a goal. Responsibility is another essential emotion involved in
risk assessment, enhanced by such feelings as remorse, shame, guilt, and pride (Roeser, 2010,
p. xi). These moral emotions certainly could play a role in risk assessment. For example, if
certain emotion deeply affects a manager, his or her judgment would be very subjective. Mark
Coeckelbergh (as cited in Roeser, 2010, p. xxx) recommends to take emotions into account,
especially for the risk analysis, because emotions strengthen the quality of judgement and that
24

the rejection of laypeoples emotions can itself be characterized as a bias (Roeser, 2010, p.
xxx).
However, empirical psychologists argue that emotions are heuristic11 and cause biases, which
can degrade judgements and thus should be rectified by rational approaches (2010, p. xxi).
Daniel Kahneman and Amos Tversky (as cited in Levy, 1992, p. 171) developed a prospect
theory, according to which people do apply heuristics in judgement and decision-making under
conditions of risk (Levy, 1992, p. 171). Using heuristics, people think in terms of possible values of gains and losses rather than a possible final outcome, thus overweighting small probabilities and underweighting high probabilities; people are also more sensitive to potential losses
than to potential gains and as a result are risk-averse toward gains and risk-acceptant toward
losses (1992, p. 171). An important indication of the prospect theory is the framing effect,
which implies that a decision makers risk tolerance (as implied by their choices) is dependent
upon how a set of options is described (Gonzalez, Dana, Koshino, & Just, 2005, p. 2). When
statistical information is not available, people make mistakes because they are likely to rely on
heuristic methods, such as simple rules of thumb, illustrations or resemblance. Such practice
can lead to the distortion of facts: fear of small risks and extreme disregard of the larger ones
(Roeser, 2010, p. 4).
In addition, Ronald de Sousa (2010, p. 17) adds: Objectivityremains an ideal worth striving
for in the perception of risks posed by technology in particular. Therefore when conducting
a risk analysis, managers should regard emotions with a great deal of caution in order to avoid
biased decisions. This, however does not mean to diminish the role of emotions. Emotions are
an essential part of both intuitive and analytic modes of thinking (Slovic, 2010, p. 41). Seymour
Epstein (as cited in Slovic, 2010, p.41) referred to intuitive modes of thinking to as automatic,
natural, non-verbal, narrative, and experiential and the analytic modes as deliberative, verbal,
and rational. Adapted from Epstein, Table 3 below illustrates the characteristics of both systems.

11

A heuristic is a strategy that ignores part of the information, with the goal of making decisions quickly, frugally,
and/or accurately than more complex methods (Gigerenzer & Gaissmaier, 2011, p. 454).

25

Table 3: Two modes of thinking: comparison of experiential and analytic systems

Source: Epstein, as cited in Slovic, 2010, p. 41

According to Slovic (as cited in Dring & Feger, 2010, p. 100), an experiential system can be
described as intuitive, fast, and mostly automatic model, whereas an analytic system is slow,
effortful, and requires conscious control. Slovic (2010, pp. 41-42) emphasizes that the affect12
plays an important role in the experiential model. Any response based on the affect is a quick
reaction to the problem, and as a result, people make instinctive judgments and fail to provide
a credible reason for them. For example, when a manager strongly believes in profits, he or she
tends to assume that the project is not very risky, but when the manager feels insecure about
the project, he or she might disregards profits as well. Although managers are aware of rational
and logical analysis, dependence on emotions takes place, because it requires less time and
efforts to reach a decision.
Finally, de Sousa (2010, p. 32) argues that emotions are crucial in discovery and motivation
stages, but shall not play a role in phase justification. He explains that justification should be
supported by good statistics, measurements of probabilities and outcome values, stripped of
the power of rituals or immediate emotional response (de Sousa, 2010, p. 32). Taking this
consideration into account, this thesis offers quantitative measurements in the next chapter,
which could be a good remedy to emotions.

12

Affect is the experience of feeling or emotion (Hogg, Abrams, & Martin, 2010, p. 646).

26

Applied approaches to risk assessment and analysis

3.1 Qualitative risk modelling

According to Grey (1995, p. 4), methods of assessing risks fall into three groups: issue-based,
scoring and quantitative techniques. This thesis shortly introduces the application of scoring
model mentioned in research by Hoffmann (2010). The study also critically evaluates the limitations of the scoring model and builds the need for the quantitative risk modelling enhancement.
3.1.1

Scoring model as an example of the qualitative assessment tool

Hoffmann (2010, p. 11) in her thesis works with qualitative risk assessment and introduces
scoring techniques. Back to Grey (1995, pp. 4-6): Scoring techniques are a natural extension
of checklists which are derived from questionnaires. The questionnaire developed by Hoffmann for wind farm industry asks whether something affects the project and by how much. In
a questionnaire, respondents usually evaluate criteria and assign weight to the certain applicable
factors, which are then added together to measure the entire level of risk of the project (Grey S.
, 1995, pp. 4-7). This is followed by preparation of the multistage rating system.
In most cases, the scoring model is used to consider risks which are difficult to quantify. Such
assessment techniques usually include different types of scales13. Hoffmann (2010, p. 20) uses
13

Various scales from statistics are applied for the risk estimation (Brnger, 2009, p. 124) but only several of them
are used in risk management (Conrow, 2000, p. 144). Besides subjective estimates of probability for probability
statements, this includes nominal, ordinal, calibrated ordinal, ratio and interval scales (2000, p. 144).
Nominal scale requires the assignment of special identifiers (such as letters or colors) rather than the assignment
of numbers. These values have no mathematical meaning and thus any mathematical operations are worthless. For
this reason, this scale is not applied in risk analyses (2000, p. 144).
Ordinal scale indicates only that one value is bigger or smaller than another value (Conrow, 2000, p. 144). These
are levels, which are rank-ordered. However, ranks alone are meaningless because they do not convey the difference of interval values. (Privitera, 2014, p. 13).
As for calibrated ordinal scale, these are ordinal scales whose scale-level factors are computed by evaluating an
additional utility function (Conrow, 2000, p. 148). The idea is that ordinal values should be replaced by cardinal
values. Then again, values and zero point are usually relative rather than absolute. (Kerzner, 2009, p. 766). Therefore, calibrated ordinal scales are rarely used in risk analyses, particularly because of the complex calibrating
process.
Conrow (2000, p. 149) emphasizes that ratio scales have cardinal coefficients, zero point is definite and intervals
between scales are comparable. With this in mind, mathematical operations based on ratio analysis provide meaningful and credible results. Ratios have been perceived as ideal scales for estimating risks, however they are seldom
found in practice (2000, p. 149).
Privitera (2014) gives the following definition of interval scales: Interval scales are measurements where the
values have no true zero and the distance between each value is equidistant (p. 15). The definition already indicates on the limited mathematical operations. Conrow (2000, p. 148) explains the nature and limitation of interval
scales, citing the example of the Celsius and Fahrenheit temperature scales. Here is the example: if given that
C1=100C and C2=50C and if given that D= C1/ C2, then D must be equal to 2.00. However, the correct answer,

27

in her study an interval rating scale. For the portfolio analysis, the G.E. matrix14 is applied. The
G.E. model places the market attractiveness on the Y-axis and industry attractiveness on the Xaxis. The underlying variables are then analyzed as a high, medium, and low risk factors.
(Hoffmann L. , 2010, p. 24). For the wind farm industry, this model15 is approved to be applicable (2010, pp. 23-25) and the following challenges have been addressed: identification factors
which influence market attractiveness and industry attractiveness and assignment the weights
to those factors (2010, pp. 25-26). In order to develop an exhaustive picture of the risk factors,
Fishbein model and factor analysis have been applied for risk assessment (2010, p. 73). The
Fishbein method allows one to classify influencing factors and assign weights correspondingly,
whereas factor analysis defines correlation between the factors (2010, p. 73). These underlying
conditions promise a scoring model to be complete and objective as much as possible.
Although scoring model is widely used among risk assessment techniques and thus is considered by users to have value, in most cases it however leads to misleading results (Hubbard &
Evans, 2010, p. 1). The next section explains the limitations of applying the scoring model for
risk assessment and argue for introducing quantitative techniques instead.
3.1.2

Limitations of the scoring model and need for quantitative enhancement

Weighted scoring methods, such as one developed by Hoffmann, have been promoted in many
companies for assessing the value and risk of investments, especially for ranking infrequent
events (2010, p. 2). The widespread use of scoring model is flawed for many reasons, hence
limitations of the scoring model must be addressed.
First problem is a heuristic phenomenon. Like any qualitative risk assessment, scoring model
assumes heuristics in judgement and decision-making. Generally, people estimate risk based
on their memories or experience; assume that previous events influences the current one; over/underestimate the probability or frequency of occurrence; anchor on specific information when

is D=1.15. This is due to the fact that Celsius values have no true zero point and thus must be firstly converted to
Kelvin (2000, p. 148). If so, C1=100C=373.15K and C2=50C=323.5K, then D=373.15K/323.5K=1.15. Celsius temperature scale is like a rating scale, where a zero point is not an absolute value, but a result of the researchers level of agreement or opinion (Privitera, 2014, p. 15). On the contrary, Kelvin temperature scale is an
absolute (ratio) scale and mathematical operations yield meaningful results (Conrow, 2000, p. 148).
14
G.E. multi factorial analysis is also known as McKinsey-Portfolio.
15
For further reading, please refer to Hoffmann, L. (2010). Entwicklung eines Scoring-Modells fr WindparkPortfolios auf Basis von empirischen Analysen, (Unpublished Bachelor's thesis), Berlin School of Economics and
Law, Germany

28

making decisions. Psychologists have diagnosed many other cognitive biases16. Lidia Hoffman
in her research (2010, pp. 48-49) has requested additional information from the survey respondents, such as a statement about the company group and the field of activity. This helps to calculate how many experts out of the total respondents have been involved in defining risk
influencing factors. However, the problem is not so much in bias, but in the human inconsistency (Hubbard & Evans, 2010, p. 3). The respondents being asked to weigh the same factors
on different occasion can provide different results. On the contrary, mathematical probabilities
remove human inconsistency and leads to reduction of subjective risk assessment results.
Second problem is the interpretation of likelihood categories: for example, three categories
high, medium and low or put into seven categories, such as certain, very likely,
likely, medium likelihood, very unlikely, and exceptional unlikely. It is believed that
the labels should be simple and that detailed likelihood categories undermine reliable results
(Hubbard & Evans, 2010, p. 4) . In reality, this is not the case. For example, 90% could mean
for one person certain, whereas for the other person very likely meaning. This again proves,
that respondents tend to interpret same labels very individually, attaching different probability
intervals to the same categories of likelihood.
Next flaw is the interpretation of scales as if they are ratios. In the study by Hoffmann (2010,
p. 33), relevance factor is originally assessed on five-point verbal scale converted then into
numbers. If very high is converted to 3, then high is converted to 2.25. Hence, the medium is treated exactly as 0.75 likelihood of the latter range (or half of the highest value). Such
assumption can be misleading. Moreover, sometimes in practice five-point verbal scales are
reduced further to three-point verbal scale, thus rounding results and increasing errors.
The last problem is the invisible correlation between variables. This flaw is addressed by Hoffmann (2010, pp. 40-41) and in order to enhance the data reliability, correlation coefficient and
statistical significance are introduced. This however results in subsequent elimination of some
variables in the factor analysis, thereby making scoring model less complete. Moreover, scoring
system does not model cascade failures single failures that simultaneously cause several
other failures and failures that cause a chain reaction sequence of other failures, respectively
(Hubbard & Evans, 2010, p. 6). Leaving cascade failures causes underestimation of risks.

16

For further reading, please refer to Baron, J. (2000). Thinking and deciding. Cambridge University Press.

29

The practice when different events scored into medium or low risks produces one high
risks if events correlated and treated as entirely independent (2010, p. 6). Scoring methods assume that the factors being aggregated are entirely independent, although such an assumption is
hardly tested. On the contrary, quantitative risk techniques consider to exclude high correlations
from a well-diversified portfolio and generally accounts for potential cascade failures.
In order to prevent or mitigate the problems associated with scoring model, risk assessment
could be improved by introducing quantitative probability techniques, which define probabilities and consequence of losses expressed by numbers rather than by scales. For instance, it is
highly suggested to apply Monte Carlo simulation for risk assessment to frame the relationship
and correlation of variables in the system (2010, p. 7).

3.2 Quantitative risk modelling

Quantitative approaches to risk aim to overcome the disadvantages of the qualitative risk methods. Rather than just classify risks under headings (e.g. checklist approach) or say that a high
risk is worth 5 points (e.g. scoring model), quantitative techniques reveal what causes risks and
by how much. This section of the thesis presents several techniques which have been developed
around quantitative risk analysis, including non-probabilistic and probabilistic based methods
(Brnger, 2009, p. 131).
3.2.1

Non-probabilistic based risk techniques

Non-probabilistic based techniques are used to assess the consequence of occurrence of risky
events with the probability of occurrence being not determined (Brnger, 2009, p. 131). This
includes, but are not limited, sensitivity analysis, scenario analysis, and stress test.
Stress test is usually used in combination with scenario analysis (Laycock & Reuters, 2014, p.
4) and other tools applied in the business to assess the changes in a companys risk profile (e.g.
forecasting) (Blunden & Thirlwell, 2013, pp. 195-196). According to Laycok and Reuters
(2014, p. 4): Stress tests, as a process, are intended to identify and quantify risks to business
portfolios and implies only the move of one risk variable (Blunden & Thirlwell, 2013, p. 197).
Running stress test through a model allows one to analyze extreme operational risk event and
their effect on the project (Brnger, 2009, p. 134), as well get some insights to the sensitivities
of a company (Blunden & Thirlwell, 2013, pp. 195-196). After all, experts claim that stress

30

tests demand imagination and a great understanding of scenarios interactions (Laycock &
Reuters, 2014, p. 9). For this reason, stress tests will not be analyzed in details in this study.17
Sensitivity analysis
Sensitivity analysis is the calculating process used to analyze the effect of changes of input data
on the final outcome of the project (Jovanovi, 1999, p. 218), for example how a sale decrease/increase by 10% affects profit. In the sensitivity analysis only the change in one variable
is considered (Brnger, 2009, p. 131). Nonetheless, all variables that can potentially affect the
project results, should be included for the risk assessment. The simple way to conduct, sensitivity analysis is to start with the series of What if questions (2009, p. 131):

What if the quantity of the product is 5% higher/smaller as expected?

What if the selling price 10% higher/smaller than expected?

According to Brnger (2009, p. 131), the sensitivity analysis should give a better feeling for
the consequences of forecast errors have on the project. Again, this method does not account
for probability of occurrence and is never applied to more than one variable changes at the same
time. The simple example for the application of the sensitivity analysis is performed in Figure
6 below.

17

For further reading about stress test approach, please refer to Rippel M., & Teply, P. (2010). Stress testing and
scenario analysis: The key challenges of operational risk, VDM Verlag Dr. Mller.

31

Figure 6: Example of the sensitivity analysis within the theoretical aspect

Source: Based on Brnger, 2009, p. 132

The example assesses the consequence of occurrence of two different types of risks. In the first
case, the expected volume of a product decreases by 15% compared to the planning data. This
results in profit of 7,200,000 (-40%). In the second case the selling price drops by 35%. This
leads to loss of 4,000,000 (-100%). The findings show not only the change in profit but also
the sensitivity of underlying input variable.

32

Although sensitivity analysis does not assume the interrelationship between the variables, it
defines the most critical risk factors for which further actions might be needed. Risk analysts,
for example, could apply sensitivity analysis to identify factors which affect the future movements of cash in and out of the business. This information helps risk experts to understand and
evaluate investments project (Jovanovi, 1999, p. 218).
Scenario analysis
Scenario analysis has been recognized for its usefulness in managing risk and developing strategic plans under uncertainty (Maack, 2001, p. 62). Scenario analysis does not focus on one
certain future solution, it rather presents several alternative future paths. According to Brnger
(2009, p. 133), scenario analysis estimates the impact of environmental conditions on the
achievement of the objective. Usually in practice, experts distinguish three major scenarios:
optimistic, pessimistic and the most likely18 (Brnger, 2009, p. 133). A big number of scenarios
do not usually represent reality. The values across different scenarios are contrasted with the
expected value. This provides a picture of the riskiness of the asset; the asset is riskier if the
values change more across scenarios and safer if the values change less (Damodaran, 2007a, p.
7).
Mathematical operations of scenario analysis are similar to the sensitivity. However, in contrast
to the sensitivity analysis, scenario analysis allows a simultaneous move of operational risk
parameters, both macro-economic and asset-specific (Damodaran, 2007a, p. 3). This makes the
process of risk assessment more transparent (Brnger, 2009, p. 133). In addition, scenarios are
often based on both quantitative and qualitative data (Kosow & Ganer, 2008, p. 33), thus attempting to minimize biased judgements.
However, scenario analysis has been criticized that it does not consider probability of occurrence for different development stages. (Brnger, 2009, p. 134). Very often scenario analysis
considers a limited number of scenarios, leaving potential development processes out (2009, p.
134). Overall, scenario analysis is used to shows what to do in order to decrease the effect of
downside potential and increase the effect of the upside potential on the value (Damodaran,
2007a, p. 13).

18

Optimistic scenario is also known as the best-case scenario and pessimistic as the worst-case scenario accordingly (Damodaran, 2007a, p. 1).

33

3.2.2

Probabilistic based risk techniques

Probabilistic based risk assessment is a comprehensive methodology which characterizes risks

by the probability of occurrence (frequencies) and consequence of occurrence (Brnger, 2009,
p. 136). The multiplication of probabilities by consequences results in the expected loss, in
other words total risk. Considering the complexity of big projects, risk management process
always contains a certain level of uncertainty that should be addressed. There are different factors that create uncertainty and affect risk management process including world economy, technology innovations and development of business processes. Addressing uncertainty in risk
management can be best achieved by applying at-Risk methodology including Value-at-Risk
(VaR), Cash-flow-at-Risk, and Earnings-at-Risk (Brnger, 2009, p. 136).
The mentioned models varies only in the input variables, whereas the process for measuring
risks stays the same (2009, p. 136). Value-at-Risk is the expected loss from an adverse market
movement with a specified probability over a period time (Tapiero, 2012, p. 17). In other
words, VaR measures the market risk of a portfolio. Value-at-Risk is a potential maximum loss
a company is likely to experience given a certain level of probability (for example 95%) with a
certain time period (Brnger, 2009, p. 137).
The most commonly used in the VaR approaches are the variance-covariance method, Monte
Carlo simulation and historical simulation (Brnger, 2009, p. 138). All three approaches used
to find out how much the market could possibly move against the company, so to know how
much capital is needed to support the companys position. Historical simulation is a simple and
intuitive estimation, which does not involve probability distribution. Based on past data, historical simulation does not consider unique risk events and their impact on the companys portfolio (2009, p. 138). This simulation needs lots of historical data for things for which there is
little history. The variance-covariance approach is more suitable for computing VaR for portfolios over short time periods, whereas assessing VaR over longer time period Monte Carlo
simulations do a better job. (Damodaran, Value at risk (VaR), 2007c, p. 21). On that basis, the
focus of the thesis is on the Monte Carlo simulation only.
Monte Carlo Simulation
According to Grey (1995, p. 21): Producing a random sample of all the outcomes of a project
and using them to assess the entire project is known as Monte Carlo simulation. Monte Carlo
simulation is similar to historical simulation tool (orkalo, 2011, p. 84). The difference is only
34

that a risk manager works with probability distributions rather than with historical changes
(2011, p. 84).
During the simulation, computer chooses random values for every input in accordance with the
probability distribution and measures the output (Liberman, 2003, p. 22). Usually 300 to 1,000
samples will be generated. (Grey S. , 1995, p. 22). After a repeated series of runs, the range of
outcomes values for each output variable produces a frequency distribution (Ball, 2000, pp. 5859), which tells how likely the resulting outcomes are. Every recurrence of the Monte Carlo
cycle represents a realistic potential outcome of the whole project, which does not only simply
show the maximum and minimum potential outcomes, but also casts a shadow on how the risk
weakens between these two extremes (Grey S. , 1995, p. 23). The fall off is usually represented
by a nonlinear curve, where risk changes slowly at the top minimum and maximum points, but
falls off quickly in the area between the two extremes (1995, p. 25).
Monte Carlo techniques are widely used in all kinds of optimization processes, and can also be
applied to the wind energy industry: A limited number of wind turbine studies have applied
Monte Carlo techniques to account for the variability of the wind resource and uncertainty associated with system reliability and energy conversion efficiency (Liberman, 2003, p. 26). For
example, Monte Carlo method can be used to simulate hourly operations of wind energy system
(Desrochers, et al., as cited in Liberman, 2003, p. 26) or to randomly choose turbine design
variables (Crosby, as cited in Liberman, 2003, p. 26).
Researchers use Monte Carlo simulation to enhance the design of wind turbines and their
placement in wind farms (Liberman, 2003, p. 38). Like any forecasting model, Monte Carlo
simulation is used for better strategic decision making: the wind energy results obtained from
the simulation can then be compared to the traditional sources of electricity. Moreover, the
simulation model can be easily extended when any further developments are required (SaRS,
2011, pp. 3-4), especially when a project becomes complex. In order to run simulation easier
and faster, it is suggested to apply different techniques, such as scenario analysis or variancecovariance, along with the Monte Carlo method (Damodaran, 2007c, p. 18).

35

Empirical studies of the wind farm portfolio in Germany

The theoretical study of risk assessment and comparison of the quantitative approaches form
the background for the actual empirical study. The empirical study conducts a quantitative risk
analysis for the portfolio of wind farms in Germany with the objective to answer the questions
defined in the thesis. Therefore, the first research questions this study is going to answer is: why
quantification of risks is needed and how quantification of risks can be applied to wind farm
portfolio?
The findings of the theoretical analysis suggested to opt for both probabilistic and non-probabilistic risk approaches. These results would prepare a background for answering the next research question: which quantitative method better serves towards the elimination of subjective
judgements about risks? Because risks can vary over time, wind farm managers would prefer
the most favorable techniques under certain conditions. Therefore, the undertaken research
analysis selected wind farms to identify ongoing challenges and learn about practices of quantitative risk methods.
The empirical analysis also critically assesses the quality of the results obtained from the quantitative risk analysis and gives the answer to the last research question of the thesis: how reliable
are the results obtained from quantitative risk methods?

4.1 Research design and methodology

The empirical study provides an application of quantitative risk methods for three wind farms
in a portfolio. Together with research questions, the study is also expected to:

Define the most sensitive risk factors across the wind farm portfolio.

Analyze the importance of the applied quantitative methods for different industry
actors, such as equity investors and banks.

Assess the worst, best and most likely scenarios for the selected wind farms.

Evaluate the consistency of Monte Carlo simulation results.

The corporate data of the wind farm portfolio is provided by Alexander Boensch, which consists
of three wind parks located in Germany. These are Treuen-Pfaffengrn in Sachsen, Holel in
Niedersachsen and Mncheberg in Brandenburg (see Appendix 1). Financial modelling of wind
farms serves as the secondary data source for the data collection. The point of the interest is
36

that wind farms have a different lifecycle period. The empirical study refers however to the first
twenty years of operation when comparing various wind farms.
The quantitative data analysis involves elements of capital budgeting methods as well as the
statistical analysis of numerical data from Monte Carlo simulation. In this manner, the study is
supposed to provide the reader with consistent and objective results.

4.2 Preparation of quantitative modeling procedure

As already mentioned, the decision to introduce quantitative risk analysis was driven by the
need to define major key risk factors by using mathematical operations rather than purely relying on the data from the questionnaires converted then to numerical values.
At the time of the beginning of the research, the catalogue of risk factors were available for one
of the wind farms provided by Mr. Boensch. This catalogue of risk factors served as a starting
point for analyzing which risk factors could possibly quantified. The rating catalogue presents
9 types of risk factors influencing the relative competitive advantage and 6 types of risk factors
influencing the market attractiveness. The actual sample was developed to target economic and
investment-related risk factors, as well as an annual energy yield risk factor. The other groups
of risk factors were excluded from the study as they do not provide enough data (e.g. social
demographic risk factors) or might require specific technical knowledge (e.g. wind turbine infrastructure).
The modelling procedure starts with (i) sensitivity analysis, (ii) scenario analysis, (iii) Monte
Carlo simulation and ends up with visualization of risks and a collection of information.
The actual paper assesses 10 risk factors during sensitivity analysis, where the input variables
are arbitrarily selected from the portfolio. After assessing risk factors from the equity investors
perspective and applying the inductive reasoning, it was decided to analyze the risks factors
from the creditors perspective for one wind farm in the portfolio. Based on the results from the
sensitivity analysis, the study determined most sensitive risk factors to apply in the scenario
analysis. A point of particular interest is the integration of Monte Carlo simulation, which offers
deeper risk analysis by recognizing multiple sources of uncertainties. The inductive reasoning
allows for assuming generic results between wind farms in the portfolio and for that reason
Monte Carlo simulation was applied only for one wind farm.

37

A better understanding of the quantitative analysis is expected to be achieved, and the described
modelling procedure can be applied for both stand-alone wind farms and wind farm portfolios;
for both wind and other renewable energy technologies.

4.3 Results of the empirical analysis

Proposed by Hoffmann (Hoffmann L. , 2010, p. 20) a multi-attribute model of Fishbein is a
common qualitative risk analysis model used for weighting risk factors. Based on the cognitive
process underlying human beliefs and attitudes, the Fishbein model has not been mathematically derived and therefore the accrued result generally involves subjective estimation.
Quantitative risk analysis on the other hand strives to assign numeric values to risks. Understanding the need in risk quantification, the following chapters present the results of an empirical study of the financial modelling of the wind farm portfolio. The research is limited to a
twenty-year period due to the scope of this thesis. Nevertheless, this period should emphasize
the wind farms exposure to risks through a variety of quantitative risk management techniques
as well as succeed in providing representative comparison of results between the three wind
farms.
4.3.1

Application of the sensitivity analysis

To define project evaluation techniques, Graham and Harvey (2002) conducted a comprehensive survey with the focus on capital budgeting methods. The results of the survey showed that
the majority of companies use Net Present Value (NPV) and Discounted Cash Flow (DCF)
approaches to assess new projects (2002, pp. 9-10). As shown in Figure 7, the most popular
capital budgeting techniques for evaluating investment projects are NPV and Internal Rate of
Return (IRR).

38

Figure 7: Survey evidence on the popularity of different capital budgeting methods

Source: Graham & Harvey, 2002, p. 11

Additionally, it was discovered that highly leveraged companies are more likely to use sensitivity and simulation analysis to estimate the probability of a financial downturn (Graham &
Harvey, 2002, p. 11). This chapter demonstrates the sensitivity analysis based on modelling
input variables and simulating the IRR output for the equity investors and Debt-Service Coverage Ratio (DSCR) output for creditors. As it was determined earlier, sensitivity analysis is when
one changes an input variable and evaluates its impact on the output variable (2005, p. 267). In
other words, sensitivity analysis defines what is driving the risk estimates (USEPA, 2001, pp.
A-1). Thereby, sensitivity analysis should make it possible to evaluate the impact of underlying
variables on the performance of wind farms in the portfolio.
Equity investors perspective
When investing in any project, equity investors seek to maximize the return on their investment
and to minimize any risks. To minimize the risks in a wind project, this study suggests following
steps for carrying out the IRR sensitivity analysis:
1. In the developed financial model of a project set the IRR at a base rate for each wind
farm. The expected IRR was set at 7% for each wind farm19 according to Deloitte report

19

Note, that IRR for onshore wind farm at the pre-operation stage varies between 7.0% 9.5%, whereas at operation stage IRR varies between 5.5% 7.0%. For further reading, please refer to Deloitte.(2014). Establishing the
investment case Wind power. Deloitte Statsautoriseret Revisionspartnerselskab.

39

(2014, p. 22). In addition, one should set the exceedance probability at P75 level20. Because equity investors typically apply P75 or P50, both scenarios are possible. Investors
that base their decisions on the P50 will expect an IRR between 8-10%21.
2. Perform sensitivity analysis by changing the values of the input variable of the project.
The input variables here are specific to the project22. Holding the other variables value
constant, change the base-value of the input variables by 30%23. Afterwards, reord the
percentage change in the IRR. The obtained results measure the degree of sensitivity of
each input variable on the project outcome while holding other variables constant.
The IRR was set at 7% using the Excel function What-If analysis (Goal Seek) in the financial
model developed by Mr. Boensch. It should be noted that the Goal Seek function derives the
IRR close to the level of 7%: Treuen-Pfaffengrn was set at 7% of the IRR, Mncheberg at
7.01% of the IRR and Holel wind farm has the IRR of 6.95%. This, however should not be
viewed as a limitation of the analysis.
The actual paper considers in total 11 variable inputs to define the most influential parameters.
Holding everything constant, 10 variable inputs are changed 30% up and 30% down from the
base case levels. These are interest rate (DSRA), availability losses, electrical losses, other
losses, merchant price from year 18 and inflation on the merchant price, trade tax, interest rate
for the first 10 years and later, Operation and Maintenance (O&M) price for the output higher
than 5,750 MWh. Annual energy production level is the eleventh variable input and it is analyzed separately using financial modelling.
The Figure 8, Figure 9 and Figure 10 below illustrate the results of the sensitivity analysis for
the first 10 variable inputs. The percentage amounts are newly generated IRR values, which are
obtained from the changes in the abovementioned variable inputs (blue for decrease in input
variables and orange for increase). The input base parameters of each wind farm can be found
in the Appendix 2, Appendix 3, and Appendix 4.

20

A level of P50, P75 and P90 describes an annual power production with a probability of 50%, 75% and
90% correspondingly; with a chance of 50%, 25% and 10% that the respective level will not be reached.
21
Provided by Alexander Boensch a graph of return requirements of different investors under different P-Scenarios
22
Note, that in other projects variables inputs can also be macroeconomics input.
23
The study by Salvadore & Keppler (2010) estimate sensitivity using input changes of 50%, whereas Roques,
Nuttall, and Newbery (2006) apply changes of 10%. This paper apply 30% as the average of the ranges, which
should well represent the IRR sensitivity.

40

Figure 8: IRR sensitivity analysis.

Treuen-Pfaffengrn (T-P)

Source: Based on the financial modelling

Figure 9: IRR sensitivity analysis.

Mncheberg (M)

Source: Based on the financial modelling

41

Figure 10: IRR sensitivity analysis.

Holel (H)

Source: Based on the financial modelling

Interest rate (DSRA)

The findings shows that any change in the interest rate on the Debt Service Reserve Account
(DSRA) in all three cases impacts the IRR value. The DSRA interest rate can be seen as the
interest on the savings, which has an impact on the interest income and total income. The higher
the interest rate on DSRA, the higher the total income and the more desirable the expected IRR
and vice versa. The conducted analysis reveals very little impact on the interest rate of the IRR
of wind farms.
Availability, electrical and other losses
Losses have a certain impact on the course of the project. Availability losses can be caused by
maintenance works. For example, a contract with the producer of the wind farm guarantees the
investors that the wind farm can be used 98% of the year. The gap of 2% is saved for maintenance, for example to change the oil, change a gear-box, fix blades etc. Other losses24 can occur
for example in certain areas, where the wind farm has to be run in an acoustically mode during
24

Other losses have zero values in the wind farm portfolio. Hence, the sensitivity analysis takes into account only
increase by 30%.

42

the nighttime (or completely stopped during the nighttime) because people are nearby. Electrical losses are caused by transforming the produced energy to another level or by cable failures
to the grid connection. The higher the losses, the lower the total income. Changes in income
affect flow to equity and therefore lead to changes in the IRR. Based on the sensitivity results,
an increase or decrease in losses by 30% will change the IRR by approximately 1%, therefore
such minor changes in IRR will hardly make equity investors review their decisions and approaches25.
Trade tax
Trade tax also has little influence on the IRR, because the tax base rate is fixed at 3.5% and the
multiplier is imposed individually by every municipality (Germany Trade and Invest, n.d.).
Changes in the multiplier by 30% are realistic and shall be considered for the project development. In the actual analysis, trade tax does not exhibit high deviations in IRR values.
Operation and maintenance price
Careful attention should be paid to Operation and Maintenance (O&M) contracts. Choosing
between short-term warranties and long term-warranties can decrease financial risks. When the
O&M costs are fixed (Holel), then further sensitivity analysis is not required. However, in the
case of Treuen-Pfaffegrn and Mncheberg, O&M costs are both fixed and variable.
This study assumes a change in the variable O&M price by 30% when the energy output exceeds 5,750MWh. The calculations for variable O&M costs were performed for TreuenPfaffegrn and Mncheberg by adjusting O&M variable prices for the whole project life-cycle.
For example, a rise in the O&M price (Treuen-Pfaffengrn) from 0.008 per KWh to 0.0104
KWh in first two years and a rise from 0.011 Kwh to 0.0143 KWh in the subsequent years result
in higher O&M costs and total operating costs26. These changes decrease cash flow and flow to
equity and result in lower IRR values. It shall be noted that the O&M price in the case of Holel
is fixed. Therefore, if the investors of Holel prefer to see the results in nominal terms, the
O&M price has to be indexed by the projected rate of inflation.
Merchant price of electricity
25
According to the interest rate table provided by Mr. Boensch, the interest rate of the equity investor falls between
5%-7% for P75.
26
The variable O&M price for the first 15 years is based on the Nordex maintenance options provided by Mr.
Boensch (Nordex Wartungsangebot). Starting from year 16, O&M variable price equals the price from the previous
year times inflation.

43

As Figure 8 and Figure 9 show, the prices of electricity inversely affect the IRR. Particular
notice ought to be made to the project life of the wind farms. As mentioned earlier, this study
takes into consideration only the first 20 years of each wind farm. This decision has been taken
based on selected IRR values for 20 years. On that account, Figure 10 (Holel) demonstrates
no correlation between the market price and the IRR, because the wind farm introduces market
price from the year 21. This, however, shall not put the impact of the merchant price on the
project under the question. According to the results achieved from the sensitivity analysis, it
can be stated that the correlation between the market price of electricity and the returns is positive: if one variable increases, the other also increases and vice versa. Inflation on the market
price was applied at 3.32%27 according to the highest average harmonized inflation rate in Europe in the last 18 years.
Interest rate
Besides the electricity market price, changes in returns are dependent on the changes in the
interest rate. Interest rate determines a payment amount, which has an effect on the cash to
cover its debt. The higher the interest rate the lower the DSCR ratio. As a result, flow to equity
goes down and investors get less returns on their investments. Conversely, when interest rate
decreases, the return on investments increases and investors are more inclined to undertake
project.
Annual energy production
Figure 11 uses the Treuen-Pfaffengrn wind farm as an example to demonstrate the fact that
when the exceedance probabilities increase (Pxx28 values), then the yield expectations of the
investors decreases dramatically29.

27

For more statistic of the average harmonized inflation rate in Europe, refer to http://www.inflation.eu/inflationrates/europe/historic-inflation/hicp-inflation-europe.aspx
28
A "Pxx" stands for the annual energy production level that is achieved with a probability of xx%. For example,
P75 means that there is a chance of 15% that the P75 case will not be reached.
29
The negative correlation between exceedance probabilities and IRR is relevant for the whole wind farm portfolio.

44

Figure 11: IRR sensitivity analysis under Annual Energy Production (AEP).
Treuen-Pfaffengrn (T-P)

Source: Based on the financial modelling

While a bank (creditor) may offer a loan based on a P95 level at 2.17%, an equity investor will
expect 11.28% or higher on the P50 level. With more uncertainty, less annual energy production
is achieved. This results in a higher cost of capital and makes equity investors account for more
risk. Thus, it is important to emphasize that the most sensitive risk factor is always the annual
energy production level.
Based on the sensitivity analysis results, it can be concluded that the most critical risk factors
for the selected wind farms are the market price and the interest rate. This observation, however,
does not consider complex design characteristics (wind speed, turbine design, electrical requirements etc.), nor does it consider any changes in uncertainty. The analysis assumes that the overall uncertainty stays unchanged.
Creditors perspective
Exceedance probability values are used highly by equity investors and banks as a base in their
financing decisions. Apart from this, financiers (banks) want to be sure that a wind farm project
promises to produce sufficient cash to pay interest and principal on the debt. Thus, to protect
themselves against loan defaults and approve the amount of debt a wind farm can receive, banks
will check debt service coverage ratios (DSCR). For the banks, a good DSCR ratio is around
1.25 (Leybovich, 2014). The DSCR ratio can be calculated using the following equation:
DSCR = Net Operating Income / Total Debt Service Costs

45

Lenders may also conduct sensitivity analysis at different exceedance probability levels to assess the results of DSCR ratios in case a wind farm is underperforming. These are the steps of
the DSCR sensitivity analysis:
1. In the financial modelling set the IRR at a predetermined rate. The expected IRR was
set at 4%30 based on the P90 level. Potential creditors usually apply a conservative level
of P90 and higher to define an adequate interest cover and estimate the risk associated
with the ability of a wind farm to meet its debt obligations.
2. The P90 level increases the value of the selected input variables by 30% while holding
the other variables constant.
Similar to the IRR sensitivity analysis, the What-If analysis function in Excel (Goal Seek) sets
the IRR at 4% and new values are generated in the financial modelling. The sensitivity analysis
suggests one consider such input variables that might influence net operating income and/or
debt service. Net operating income is quite sensitive to the changes in the annual energy production, losses, and operating costs, whereas debt service depends on the deviations in the interest rate (see Appendix 5).
Annual energy production level
DSCR sensitivity analysis analyzes, first and foremost, the change in the annual energy production level input. Figure 12 takes again the Treuen-Pfaffengrn as an example to demonstrate
that a high DSCR ratio is achieved at higher wind farm output potential.

30

According to the return requirements of different investors under different P-scenarios provided by Mr. Boensch.
The expected return at P90 level for banks varies between 2% and 4%.

46

Figure 12: DSCR sensitivity analysis under Annual Energy Production (AEP).
Treuen-Pfaffengrn

Source: Based on the financial modelling

Holding everything constant this could be explained by the fact that as exceedance probabilities
go lower, the annual energy output goes up (Pxx value and DSCR are inversely related). High
energy output promises higher total income and an increase in EBITDA. Also holding debt
service constant, while increasing the EBITDA result in the positive cash inflows and thus
DSCR ratio is higher than 1. In the Figure 12, at P50 (the most likely scenario) an average
DSCR ratio of 1.49 means that the wind farm makes enough income to cover the loan (including
principal payments) and operating expenses; in addition, the farm makes almost fifty percent
more income than it needs to pay for liabilities. An average DSCR of 1.18 for P90 means that
banks expect a project to cover debt obligations in the worst case scenario. The minimum DSCR
ratio here is simply the minimum DSCR value throughout the life of the project. It might differ
from the minimum loan condition of the bank. However, both values are widely used by banks
when analyzing the financial condition of a wind farm.
Total operating cost
A DSCR ratio can also fall below 1 (see Figure 13 below) and thus represent a negative cash
flow. Holding everything constant, shall increase the total operating costs by 30%31, EBITDA
will reach a critical level and result in the drop of the DSCR below breakeven point. Changes
in EBITDA helps managers understand the critical value of EBITDA, which can cover only
principal payments, interest, tax and other expenses (e.g. dividends).
31

Given the fact that some operating costs are fixed, the paper assumes an average increase of total operating costs
by 30%.

47

Figure 13: DSCR sensitivity analysis under total operating costs.

Treuen-Pfaffengrn

Source: Based on the financial modelling

Availability, electrical and other losses

A low DSCR ratio can be also a result of increased losses. It is known that any potential losses
(electrical, availability, other) have a high impact on the economic performance of the wind
farms. High losses lead to reduction in net output and total income, thereby lowering DSCR
ratio. The total losses before analysis amount for 6%. The sensitivity analysis has increased the
total losses by 30% under a P90 level and lead to the new result of 9% (see Figure 14 below).

48

Figure 14: DSCR sensitivity analysis under total losses.

Treuen-Pfaffengrn

Source: Based on the financial modelling

When a wind farm has a DSCR ratio of 0.98, its net operating income can cover only 98% of its
annual debt obligations. In this case, the project will experience difficulties in obtaining approval

for new loans. The creditworthiness of the borrower goes down and the borrower has to rely on
their own personal funds to keep the project afloat. However, banks may allocate DSCRs to the
various energy production levels, and later define the amount of debt a certain wind farm can
best fit the corresponding levels of forecasted production.
Interest rate
The interest rate on a loan also affects wind farm DSCRs ratio. As soon as the interest rate
starts to grow, the value of the interest payment increases proportionally, thereby increasing the
total amount of debt service. Increase in debt service weakens DSCR index. Hence the higher
the interest rate, the the lower DSCR ratio (see Figure 15 below).

49

Figure 15: DSCR sensitivity analysis under interest rate.

Treuen-Pfaffengrn

Source: Based on the financial modelling

Although the analysis does not consider uncertainty (which is very important for the creditors,
because more loan is secured under lower uncertainty), altogether the sensitivity analysis underlines that creditors expect positive cash flows to meet the minimum required DSCR in order
to approve a loan for a project.
Sensitivity analysis allows managers first of all to identify the likely major course of the uncertainty in the portfolio. Decisions to accept or reject a project shall not be based on the sensitivity
analysis alone, because a risk analyst makes subjective judgements in deciding which variables
inputs to test in the sensitivity analysis. In addition to the sensitivity analysis, the analyst might
apply scenario analysis as a natural extension of the sensitivity analysis.

4.3.2

Application of the scenario analysis

Risk analysis under the market price of electricity and interest rate
Scenario analysis goes through the consequences of an output under several sets of variable
parameters. Due to the volume restrictions of the thesis, this paper conducts scenario analysis
from the equity investors perspective only. The analysis begins with scenarios. A scenario is
set of paths generated by selected risk factors. Based on the results obtained from the IRR

50

sensitivity analysis, the actual study considers a market price of electricity and an interest rate32
as risk factors. Given the fundamental principle that rates and prices generally move in opposite
directions, the paper generates at P75 level with a combination of a base, worst and best case
scenarios, where:
1. The base case scenario assumes no additional changes in the input variables33.
2. The best case assumes a scenario when interest rate goes down and price goes up.
3. The worst case assumes the increase in the interest rate and decrease in the market price.
Once the scenarios have been specified, the next step is to analyze the expected value of the
cash flow to equity after 20 years under each of the scenarios. Below, Figure 16, Figure 17 and
Figure 18 illustrate three scenarios for each wind farm, applying the logic of the above described
sensitivity analysis, namely a change of 30% in the electricity market price and interest rate.
Appendix 6, Appendix 7 and Appendix 8 provide the input data information.
Figure 16: Scenario analysis.
Treuen-Pfaffengrn

Source: Based on the financial modelling

32
33

Interest rate for the first 10 years only.

The original set of data was provided by Mr. Boensch.

51

Figure 17: Scenario analysis.

Mncheberg

Source: Based on the financial modelling

Figure 18: Scenario analysis.

Holel

Source: Based on the financial modelling

52

Assume that interest rate goes down by 30% and market price for electricity goes up by 30%
and stay at that level for the duration of the scenario. This direction is marked with a dotted line
which appears in all wind farms. The dotted lines represent the best case scenario with the
highest cash flow to equity over time. The dashed lines, conversely, specify the level of cash
flow to equity when the market price of electricity falls by 30% and the interest rate increases
by 30% up. This is the worst case scenario with the lowest cash flows. The base case scenario
(shown as a solid line) is placed in-between best and worst case scenarios, involving no changes
in the risk factors.
Because interest rate changes all the time, it affects the value of the company and the value of
shares. The value of shares is the future cash flow discounted to the present value using the
required rate of return. When interest rate is too high, the value of shares decreases. This results
in lower profits, lower cash inflows and also lower internal rates of return (shown in the Figure
19 below, where T-P stands for Treun-Pfaffengrn wind farm, M for Mncheberg and H
for Holel).
Figure 19: Summarized scenario analysis for IRR

Source: Based on the financial modelling

The Figure 19 reflects the exposure of wind farms to the changes in interest rates. Therefore,
interest rate is an important risk factor to company cash flow evaluation.

53

As for changes in the market price of electricity, for many equity investors a fall of the market
price is not a desirable outcome. Price is a key driver of investment decision, because it promises potential gains to investors. Investors want their invested money to increase in value rather
than decrease. Even when the electricity is sold under a fixed tariff, the market price serves as
a base for the electricity pricing. There are different reasons why market price may fluctuates
over time, such as supply-demand mechanisms, energy efficiency, adverse weather conditions,
government intervention etc. Although investors will benefit if the prices go up, they shall be
cautious about the movements of electricity price. According to Yearsley, Exchange Traded
Commodities (ETCs) of energy are usually placed on derivatives, and the prices of these are
subject to further volatility compared to investments such as shares or bonds. Because the cost
of electricity changes regularly from one contract to another, investors shall be ready to bear
possible losses as well (Can investors benefit from rising energy prices?, 2013).
As for the wind farms that can potentially see increased gains from the increase in the electricity
price, the investors may consider the yield of energy provider to hedge against heavy bills.
There is, however, no warranted yield which can satisfy all kind of risks. Therefore, investors
also will have to distinguish whether the profit is a result of the electrical power efficiency or
the result of its sale to consumers and individual businesses. Finally, when the price of electricity remains volatile over time, investors might also prefer to put their money in the diversified portfolio in order to minimize the price risk.
For the illustration purpose, all three wind farm are presented under three scenarios in Figure
20 below. According to the findings, typically the higher the initial equity investment, the faster
a wind farm reaches a breakeven point and the higher the cash flows to equity (see Table 4).
Table 4: Break Even Point (years) of cumulative cash flow under different scenarios

Source: Based on the findings from the scenario analysis

It shall be reminded that Holel wind farm is not exposed to the uncertain market prices of
electricity, because it operates the first 20 years under fixed-tariff price. In addition, Holel
54

starts its operational activities from the year 2. These limitations shall be considered for the
sake of clarity and comparison purposes.
Figure 20: Summarized scenario analysis for the cumulative cash flow

Source: Based on the financial modelling

As can been seen from the Figure 20, each wind farm in the portfolio generates a higher cash
flow in the best case scenario and a lower cash flow in the worst case scenario. This accounts
for the sensitivity to overall risk factors. Hence, the presented scenario analysis shall be interpreted as a mix of sensitivity and scenario operations. Sensitivity analysis looks at the changes
in risk factors and their influence on the outcome, whereas scenario analysis examines particular cases in which a project might be executed.
Risk analysis under exceedance probabilities
Scenario analysis can also be performed at a different level of the overall uncertainty. Overall
uncertainty is an important factor related to the prediction of the wind energy yield on site.
Based on wind turbines information (e.g. turbine design, turbine height etc.) and site meteorological reports (e.g. spread of wind speeds, wind direction etc.) wind developers define an average energy yield possible to obtain from a particular site. Uncertainties are always included
55

in the energy yield calculations and account for the probability of reaching the average energy
yield forecast. According to Wind Prospect (Wind Prospect Group Ltd, 2011, p. 1) the uncertainties might result from reading anemometers34 (ca 2%), turbine performance (ca 5%), measurements obtained from removed mast35 (ca 5-15%), wind variations. The wind assessment
team sum up all uncertainty values and apply a single overall uncertainty level.
The actual study undertakes an overall uncertainty level of =16.90%36 for Treuen-Pfaffengrn
wind farm and treats it as a current (base) overall uncertainty level. Now the focus is to take a
more in-depth look into the changes of the uncertainty and define using related distributions
how changes in the standard deviation impact the probability of reaching average energy yield.
Before turning to the distribution function analysis, two additional scenarios of overall uncertainties shall be introduced:
1. Worst case scenario: overall uncertainty level of =25.35%, which corresponds to increase of 50% of the current overall uncertainty level.
2. Best case scenario: overall uncertainty level of =8.45%, which corresponds to decrease
of 50% of the current overall uncertainty level.
The paper assumes a normal distribution for the values of the annual energy production. This
means that the normal distribution is centered around the base case, thus the shape of the curve
will be symmetrical about the center (mean). Normal distribution has the following logic in
Excel spreadsheet = NORM.DIST(x, mean, standard_dev, cumulative)37. The Figure 21 below
illustrates normal probability distribution at different uncertainty levels.

34

Anemometer is a device to measure wind speed.

A mast is a temporary measurement tower which is built before wind farm construction to determine wind
resources.
36
The overall uncertainty expressed by sigma sign. The overall uncertainty of =6.90% for Treuen- Pfaffenrgn
was specified by Mr. Boensch. The study does not aim to identify the sources of uncertainty.
37
The components of the normal distribution are described below:
X: distribution value. The Excel function =RANBETWEEN randomly returns numbers (amount of energy output)
between top value and bottom values. Because the mean is equal to 7,501 MWh, the paper assumes the following
range for =RANBETWEEN function: the top value of 14,000 MWh and bottom value of 2,500 MWh.
Mean: mean is defined in the financial modelling and fixed at 7,501 MWh.
Standard_dev: the current standard deviation is 1,267 Applying the financial modelling, get following results:
1. Standard deviation equals 1,901 when overall uncertainty level set at =25.35%
2. Standard deviation equals 633 when at overall uncertainty level set at =8.45%
Cumulative:
set
at
FALSE
logical
parameter
for
the
specified
arguments.
The Figure 22 below illustrates normal probability distribution for different values of the abovementioned parameters.
35

56

Figure 21: Risk assessment using probability density function.

Treuen-Pfaffengrn

Source: Based on the financial modelling

The findings show that the distribution is symmetric about the mean value and width of the
distribution increases together with the increase in the uncertainty level. This means that the
higher the overall uncertainty level, the wider the shape of the curve and the more alteration
from the mean value will occur. Alternatively, the lower the uncertainty value, the steeper the
curve and the closer the results to the average (mean) energy yield forecast. In summing up, the
interpretation of the probability distribution function is the likelihood that a random variable
(AEP) lies in a probability range from zero (impossible to happen) and one (certain to happen).
In order to reduce risks, wind power developers should apply best practices to minimize and
quantify the uncertainties.
Another way to illustrate risks under uncertainty is to apply cumulative distribution for three
different exceedance probability levels. The normal distribution provides a cumulative distribution function which describes how likely a random variable has a value less than or equal to
x (Sullivan & Verhoosel, 2007, p. 387). The central value of the annual energy production is
P50, which means that the probability to reach a lower value of higher annual energy production
is 50:50, which in the best scenario. Similarly, the risk that the annual energy production will
not be reached of P75 is 15% (most likely scenario) and of P90 is 10% (worst scenario) (Klug,
2006, p. 38). The financial modelling generated a set of N values of the annual exceedance
probability of the target P75 and P90 considering every change in the overall uncertainty. It
57

shall be noted that wind farms are not likely to operate below P50, because such scenarios are
too optimistic. Operating under P30, for example, would mean that wind developers calculate data with values that are in 70% of the cases lower and just 30 % of the cases higher than
the target value. That means that the 30% of that higher value would have to equalize the 70%
of the lower values for a working financing model. No banks, no investors, nobody would likely
accept such data.
The sketch presented in the Figure 22 below is built with a cumulative distribution function for
the same set of parameters used in probability density function38.
Figure 22: Risk assessment using cumulative distribution function.
Treuen-Pfaffengrn

Source:Based on the financial modelling

At the overall uncertainty =16.90%, the annual energy output reaches 7,500 MWh at P50 and
6,646 MWh at P75, while 5,877 MWh at P90. Based on the obtained results, it is observed that
as uncertainties increase, the values of wind farm capacity decreases. Table 5 below provides
the results of annual energy output at three different overall uncertainty levels and exceedance
probability levels.

38

For cumulative probability function, set cumulative parameter to TRUE.

58

Table 5: Annual energy output under exceedance probability and overall uncertainty level.
Treuen-Pfaffengrn

Source: Based on the financial modelling

The findings prove that less uncertainty results in higher Pxx levels and lower risk, whereas
high uncertainty results in lower Pxx values and higher risk. Uncertainties are a major components of risk and they cannot be avoided. Being too optimistic, people tend to underestimate
uncertainties. Therefore, uncertainties and their effect must be assessed objectively, excluding
human biases and introducing quantitative techniques. Scenario analysis proves to be a better
method for analyzing uncertainties when compared to the sensitivity analysis.
The study concludes that scenario analysis attempts to reduce uncertainties by recognizing possible disruptive activities, which are considered valuable in future strategic planning. Scenario
analysis however does not predict the future, it rather determines multiple potential future outcomes. To a certain extent, both the development and the interpretation of scenarios are based
on assumptions, and thus also involve subjective judgement. Yet, in the absence of information
about the probability of occurrence, scenario analysis would present a reasonable alternative to
assess the future performance of a wind farm.
For robustness risk assessment, scenario analysis can be further enhanced by Monte Carlo simulation, where numerous scenarios are randomly created and the output comes out with the
frequency distributions, rather than with the testing of each scenario.
4.3.3

Application of Monte Carlo simulation

Monte Carlo simulation is one of the most comprehensive risk modelling techniques, which
allows variations of multiple risk factors at the same time. This study conducts a Monte Carlo
simulation using SimVoi39. The analysis is based on modelling input variables and simulating

39

SimVoi is a Monte Carlo simulation add-in for Microsoft Excel. Trial version of SimVoi can be uploaded from
the official web site: http://simvoi.com/trial/

59

the IRR of the project. Generated distribution results should demonstrate a much deeper risk
assessment comparing to a single point estimate or a collection of output scenarios. It also enables risk analysts to define some additional risk measures: standard deviation, skewness, minimum and maximum values and their probability level.
This research applies the SimVoi add-in to run Monte Carlo simulation and repetitively solve
the model 10,000 times. This amount of iterations should provide representative results. After
every iteration the project variables are generated and the simulation derives a probability distribution for the wind farm IRR.
The IRR simulations are performed at three different interest rates: i) the rates given in the
financial modelling (base rates), ii) interest rate of 4.5% for the first 10 years, as in Fraunhofer,
I. S. E (2013) and interest of 6.5% for the next 10 years based on the assumption, iii) interest
rate of 6% for the first 10 years and 8% for the last 10 years based again on the assumption.
The simulated IRR distributions for three interest rates are shown in Figure 23, Figure 24, Figure 25 and the statistics are provided in the Table 6, Table 7 and Table 8. The findings show
that the IRR simulations of three wind farms for all three interest rates are close to normal
distributions. Their kurtoses40 are close to 0 and skewnesses41 are close to 0.
Table 6 and Figure 23 show that the mean IRR value (10.35%) of Treuen-Pfaffengrn wind
farm is within the expected return on investment42 at 2.95% and 5% interest rates. For the interest rates of 4.5% and 6.5%, the IRR mean value (8.21%) decreases but still within the range
of the expected return. At the 6% and 8% interest rates, the wind farm IRR is below the anticipated return. The standard deviation is higher at the lower interest rate. The probability the IRR
is greater or equal to 8% is 66% at an interest rate of 2.95% and 5% and the probability the IRR
is greater or equal to 8% is 52% at interest rate of 4.5% and 6.5%, whereas at an interest rate of
6% and 8% the probability the IRR is greater or equal to 8% is 39%. The mean IRR value falls
within the certain IRR brackets (bins) a category in the generated histogram via Monte Carlo
simulation. For the better illustration, the IRR brackets are colored in the histograms.

40

Kurtosis measures whether the data sets peaked or flat in terms of normal distribution. Positive kurtosis stands
for the peaked distribution. Negative kurtosis means a flat distribution.
41
Skewness is a sign of symmetry. At normal distribution skewness equals zero. Negative skewness indicates that
the left tail is longer that the right tail. Positive skewness means that the right tail is longer than the left tail.
42
Expected return on investment varies between 8% and 10% at P50 level according to the expected returns provided by Mr. Boensch.

60

Table 6: Monte Carlo application. IRR statistics.

Treuen-Pfaffengrn

Source: Based on Monte Carlo simulation

Figure 23: Monte Carlo application. IRR distributions.

Treuen-Pfaffengrn

Source: Generated via Monte Carlo simulation

Similarly to the first series of the IRR simulation, Table 7 and Figure 24 depict distribution and
statistics of IRR for the Mncheberg wind farm. The probability the IRR is greater or equal to
8% is 67% at interest rate of 2.25% and 5% and the probability the IRR is greater or equal to
8% is 39% at interest rate of 4.5% and 6.5%, whereas at interest rate of 6% and 8% the probability the IRR is greater or equal to 8% is 22%.

61

Table 7: Monte Carlo application. IRR statistics.

Mncheberg

Source: Based on Monte Carlo simulation

Figure 24: Monte Carlo application. IRR distributions.

Mncheberg

Source: Generated via Monte Carlo simulation

Finally, the IRR simulations for Holel wind power generation are calculated and displayed in
Table 8 and Figure 25 below. The probability the IRR is greater or equal to 8% is 57% at interest
rate of 3.05% and 5% and the probability the IRR is greater or equal to 8% is 39% at interest
rate of 4.5% and 6.5%, whereas at interest rate of 6% and 8% the probability the IRR is greater
or equal to 8% is 25%.

62

Table 8: Monte Carlo application. IRR statistics.

Holel

Source: Based on Monte Carlo simulation

Figure 25: Monte Carlo application. IRR distributions.

Holel

Source: Generated via Monte Carlo simulation

The Monte Carlo simulation considers three wind power projects with different geographical
locations. This allows one to compare the obtained results between wind farms and to prepare
the reader to further research in risk factors attributable to the particular geographical location43.
The findings prove the fact that for all three wind farms there is less than 50% chance of getting

43

The comparative analysis of wind warms does not fall within the scope of this thesis.

63

an IRR value greater or equal to 8% at interest rate of 6% for the first ten years and at interest
rate of 8% for the next ten years unless the parameters of the each wind project change.
Applied Monte Carlo simulation produced a sample of the IRR outcomes of each wind farm,
which could arise in the project. Each IRR value calculated from the randomly generated components results in many possible outcomes, which are illustrated in histograms above. Histograms are very useful, but risk analysts are usually concerned with the probability of exceeding
(falling) a target. The study mentioned the probability of achieving IRR values equal or higher
than 8% for each wind farm under different interest rates. However, this is better illustrated by
generated cumulative curves in the Appendix 9, Appendix 10 and Appendix 11. The cumulative
curves focuses on the outcomes and their likelihood of occurring between the minimum and
maximum points. An advantage of Monte Carlo simulation is that it defines not only the maximum and minimum value but also how the risk behaves in between these two extremes.

4.4 Evaluation of the quality of disclosed quantitative risk analysis

During the empirical study, the quality of the applied risk methods to all three wind farms could
be observed and critically evaluated. Although the obtained results allow one to improve subjective risk assessment, the consistency of the information still leaves room for improvement.
Sensitivity analysis
During the application of the sensitivity analysis, the study focused on the most critical inputs,
rather than investigating multiple variables. This helps a risk assessor to group the input variables into revenue- and cost-related44 classes and distinguish risk factors that have a potential
impact on the IRR output. Based on random variations, the sensitivity analysis tend to explain
the nature of risks and reduce the level of risk variables complexity when applying Monte Carlo
simulation.
However, sensitivity analysis has a range of limitations. Firstly, the analysis does not consider
the probability and uncertainty, as already mentioned. Therefore, it is impossible to determine
that some sensitive variables are more likely to occur than others and thus results in a biased
judgement. Secondly, sensitivity analysis does not consider the correlation between the different risks and does not attempt to understand the interdependence between input variables. It

44 Revenue-related risk factors include energy sales price (e.g. merchant price) and government (policy) related
risks (e.g. fixed tariff), whereas cost-related cover all OPEX associated risk factors (e.g. inflation, interest rate).

64

simply changes input variables one at a time. Lastly, some input variables could be a large
source of revenue and costs, but are not regarded as risk factors unless they vary extremely. For
example, fixed-tariff is not included in the further sensitivity research. This can be explained
by the fact that the wind farm projects are largely set at a fixed-tariff, which is entitled for a
period of 20 years from the beginning of operation (approx. 80% of the project life)45. The
government can also review the tariff scheme, so things may change46.
Scenario analysis
The difficulties also arise when trying to extend sensitivity analysis by scenario analysis. The
empirical study considered three case scenarios for the event. This causes no problem whether
this event happens or not. However, as uncertainties result in numerous future outcomes, some
scenarios might not fully describe arising problems. At the same time, developing a lot of
scenarios could be very time-consuming and confusing to interpret. For example, if cash flow
to equity stay positive during same years of the project in both best and worst cases, the results
are more difficult to understand. In such case, further analysis is necessary. In addition, scenario analysis does not cover the probabilities associated with scenarios, although it does focus
on the interrelationship between underlying risk factors. Finally, tested wind farms might actually present incorrect sensitivity to the underlying variables, a consequence of which is that the
scenario analysis might contain wrong assumptions and is hence bias.
Monte Carlo simulation
The method commonly used in economics and finance for pricing financial instruments and
risk assessment remains to be Monte Carlo simulation. (Kroese, Brereton, Taimre, & Botev,
2014) . The Monte Carlo method is acknowledged for providing important information to risk
managers: the range exposure and associated probability. Both sensitivity and scenario analysis
do not provide this information. The actual study however recognizes some limitations of the
applied Monte Carlo simulation. Firstly, the model requires more data to calculate the precise
level of the uncertainty. Inaccurate or deficient uncertainty estimation can create serious uncertainties in risk estimation, in other words low quality inputs lead to low quality outputs. In the
45

Treuen-Pfaffengrn: the project operates 21 years and merchant price is introduced from the year 18 (fixedtariff lasts for approx. 86% of the project life). Mncheberg: the project operates 25 years and merchant price is
introduced from the year 18 (fixed-tariff lasts for approx. 72% of the project life). Holel: the project operates 26
years and merchant price is introduced from the year 21 (fixed-tariff lasts for approx. 81% of the project life).
46
In Germany, the fourth amendment declares, that starting 1 January 2016, fixed-tariff will be reduced by 1.2%
quarterly taking into account the newly installed capacity (Krakau-Research, 2014, p. 16). This amendment, as
well as a planned switch from fixed feed-in tariffs to competitive auctions (Fraunhofer ISI et al, 2014, S. 5), will
change the course of setting price for wind energy.

65

real world, gathering detailed data might be costly. Secondly, in order to quantify all potential
risks, risk analysts should investigate the interrelationships of risk variables and run the new
simulations accordingly. The question is how widely a reader would like to work with the simulation.
Taking into account these observations, the next improvement proposal could be made in terms
of the application of quantitative methods to enhance the reliability and the quality of results:

Execute sensitivity and scenario analysis using both quantitative and qualitative analysis. Sensitivity analysis, for examples, includes subjective assessment when selecting
risk factors based purely on the historical data. The critical risk factors obtained from
interviews and checklists should be explained and included in the testing for sensitivity;

Run Monte Carlo simulation of multiple risk factors at the same time. With continuing
investments in wind power industry, different risk factors in combination may affect the
target outcome. In order to decrease a subjective assessment, risk analysts should consider the changes in a relationships amount of input variables.

These suggestions should increase the quality of risk quantification process and should help
investors, banks and wind developers to decrease and subsequently eliminate subjective judgements about risks in their research.

66

Conclusion

Biased judgements about risk are caused primarily by subjective estimates. Subjective assessment is one of the existing techniques to assist management when estimating the probability
and consequence of occurrence risk terms. In the context of risk assessment, estimative scales
must be based on statistical data from a large number of a surveys participants (Conrow, 2000,
p. 149). In a similar manner, Kerzner (2009, p. 767) cautions that estimative scales should be
avoided as a first choice in risk analysis, because people perceive the same values differently.
The research showed that the quantitative methods could decrease subjective estimation and
have a significant impact on the assessment of the investment risks and hence affect investors
and banks in their decisions.
The goal of this thesis is to empirically apply and assess quantitative risk methods and to critically evaluate the obtained results to explain which of the presented methods should be preferred when dealing with subjective assessment.
The empirical study shows that a Monte Carlo simulation is among the only described quantitative methods which considers the uncertainty and the interrelationships of these uncertainties.
This study demonstrated a SimVoi application of a Monte Carlo method for the evaluation of
the IRR of three wind farms. Comparing to sensitivity and scenario analysis, Monte Carlo simulation defines the range of possible IRR values and estimates the probabilities of particular
IRR levels. It also provides risk managers with statistical data useful for risk analysis considerations. A Monte Carlo simulation attempts to overcome subjective estimation by providing a
statistical-based range of values, so that risk analyst can interpret probability statements objectively. Hence, the analyst can be sure that the information is derived from the samples and not
from a guess. Additionally, a Monte Carlo simulation represents probabilities which are directly
associated with the targeted values. The preference of Monte Carlo simulation over the survey
results (e.g. interviews) should be given to the fact that Monte Carlo simulation recognizes a
range of possible values rather than a single point estimate. The results of the study allows for
further research to examine the ways of contributing to objective risk assessment.
Finally, the quality of the disclosed information was evaluated. Speaking generally, each quantitative risk method could fulfill and improve a scoring model based upon subjective probability. However, only Monte Carlo simulation signals for a practical way towards elimination of
subjective assessment. Therefore several proposals have been introduced for the improvement
67

of risk quantification, which give rise to expectations that better practice towards elimination
of subjective assessment can be learnt, applied and shared.

68

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Appendices
Appendix 1: Basic information of the selected wind farms......................................................78
Appendix 2: Sensitivity analysis for Treuen-Pfaffengrn wind farm. Investors perspective .79
Appendix 3: Sensitivity analysis for Mncheberg wind farm. Investors perspective .............80
Appendix 4: Sensitivity analysis for Holel wind farm. Investors perspective ......................81
Appendix 5: Sensitivity Analysis of Treuen-Pfaffengrn. Creditors perspective ...................81
Appendix 6: Scenario Analysis of Treuen-Pfaffengrn. Initial Investment 965,987 ............82
Appendix 7: Scenario Analysis of Mncheberg. Initial Investment 2,526,908 .....................83
Appendix 8: Scenario Analysis of Holel. Initial Investment 1,550,000 ..............................84
Appendix 9: Monte Carlo simulation of Treuen-Pfaffengrn. Cumulative Charts of IRR. .....85
Appendix 10: Monte Carlo simulation of Mncheberg. Cumulative Charts of IRR. ...............86
Appendix 11: Monte Carlo simulation of Holel. Cumulative Charts of IRR. ........................87

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Appendix 1: Basic information of the selected wind farms.

78

Appendix 2: Sensitivity analysis for Treuen-Pfaffengrn wind farm.

Investors perspective

79

Appendix 3: Sensitivity analysis for Mncheberg wind farm.

Investors perspective

80

Appendix 4: Sensitivity analysis for Holel wind farm.

Investors perspective

Appendix 5: Sensitivity Analysis of Treuen-Pfaffengrn.

Creditors perspective

81

Appendix 6: Scenario Analysis of Treuen-Pfaffengrn.

Initial Investment 965,987

82

Appendix 7: Scenario Analysis of Mncheberg.

Initial Investment 2,526,908

83

Appendix 8: Scenario Analysis of Holel.

Initial Investment 1,550,000

84

Appendix 9: Monte Carlo simulation of Treuen-Pfaffengrn. Cumulative Charts of IRR.

85

Appendix 10: Monte Carlo simulation of Mncheberg. Cumulative Charts of IRR.

86

Appendix 11: Monte Carlo simulation of Holel. Cumulative Charts of IRR.

87

Affidavit
I declare that I wrote this thesis independently and on my own. I clearly marked any language
or ideas borrowed from other sources as not my own and documented their sources. The thesis
does not contain any work that I have handed in or have had graded as a Prfungsleistung earlier
on.
I am aware that any failure to do so constitutes plagiarism. Plagiarism is the presentation of
another person's thoughts or words as if they were my own even if I summarize, paraphrase,
condense, cut, rearrange, or otherwise alter them. I am aware of the consequences and sanctions
plagiarism entails. Among others, consequences may include nullification of the thesis, exclusion from the B.A. program without a degree, and legal consequences for lying under oath.
These consequences also apply retrospectively, i.e. if plagiarism is discovered after the thesis
has been accepted and graded.

My name:

Zaitseva Marina

Title of my thesis:

Quantification of risks in project management as a way towards elimination of subjective assessment. The case of a German wind farm portfolio.

Date:

Berlin, August, 7th 2015

Signature:

_________________________________

88