Risk Management

The Difficulties of Thinking Ahead

Doing scenario planning requires some scenario planning of its own.
Kris FrieswickFebruary 5, 2002

It’s June 1999. You are the CFO of a successful telecom-products supplier. Your vice president of strategy has just completed an exhaustive scenario-planning exercise. Of the several scenarios he presents, one says that in less than three years there will be an excess of telecom bandwidth that will drive your industry into a tailspin. You wonder how much money the scenario-planning exercise cost. Then you file it on your shelf and forget about it.

Such has been the fate of most scenario plans. As companies scramble for ways to predict an increasingly volatile future, many view scenario planning as a crystal ball–but then do nothing with the elaborate scenarios that result from most planning exercises. This is backwards. Scenario planning is useful not for predicting the future (which can’t be done) but for helping companies become more aware of possible outcomes. And just as awareness means nothing unless it is acted upon, even the best scenario planning is worthless unless companies use the scenarios to construct strategies that can succeed in those possible futures.

One critic of current scenario-planning exercises is Peter Schwartz, chairman of the Emeryville, California, consulting firm Global Business Network, and formerly head of scenario planning at Royal Dutch/Shell. During the 1970s, that company created one of the first scenario-planning protocols, now known as the Shell method. This protocol helped Shell predict and successfully prepare for the rise of OPEC pricing power. “Many more people are interested in scenario planning now, because the magnitude of the risks is rising,” says Schwartz. But, citing a recent study by The Corporate Strategy Board that reports that one-third of major American companies now engage in scenario planning, he warns that only one-third of them do it right. By “right,” he means testing the robustness of a company’s strategies under each scenario and updating the scenarios frequently as conditions shift. This is how such companies as American Century, UPS, and Cargill plan for problems and opportunities that their competitors never see coming.

Scenarios, says Schwartz, can be as narrowly or broadly focused as a company wants, and are best done in companies that have long product-cycle times, are capital intensive, or keep high levels of inventory. “They’re not good for fashion-focused or short-cycle companies, where there are infinite possible scenarios,” he says. “In those cases, the risks are not analyzable. What is the hot new toy going to be this year? No one can predict that. But if your company is looking at overall risks, that’s different.”

Scenario planning is an especially important tool for CFOs, who can use it as an early-warning system to reduce resources in anticipation of tough times or to staff up to take advantage of pending opportunities. “It allows you to understand potential risks, such as discontinuities that could dramatically affect earnings,” says Rick Eno, vice president in the global management consulting practice at Arthur D. Little in Cambridge, Massachusetts. The key, he says, is to identify “signposts” for each scenario: events or metrics that signal when a scenario is unfolding, such as a drop in the rate of adoption of a new technology or numerous debt defaults within a specific industry. When linked to a scenario, they serve as clues that allow companies to “move very quickly if you see things veering away from or toward your assumptions.”

Act On Warnings

That’s how Bob Jackson, CFO of American Century Cos., an investment managing firm based in Kansas City, Missouri, has used scenarios since 1998. In 1999, scenarios the company built for 2001, and the signposts around them, indicated that the bull market would soon end. Heeding the signs, the company did not staff up as much as some of its competitors did; as a result, it has weathered the recent downturn without layoffs. “We were maybe too conservative in 1999, but in the long run, it really helped us plan our people side,” says Jackson.

American Century also used scenario planning to determine whether to get into new markets and to roll out new products and distribution channels. Today, signposts indicate that conditions are improving, so the company is positioning itself to gain market share. “It has accelerated our decision-making process,” says David Klinginsmith, vice president of strategic planning. “We’ve made investments in parts of our business that we would not have made without this thinking.”

American Century starts its scenario-planning process by deciding on a central question around which the exercise will focus; for example, what the degree of acceptance for new mutual fund packages and services will be. The company then identifies no more than 20 factors that could affect the outcome, says Klinginsmith. (Such factors could include new laws affecting 401(k)s or the rate of Internet adoption for financial services.) Next, it groups these factors into four levels by their degree of uncertainty and likely impact on outcome. Group one factors are certainties. Group two factors are critical uncertainties, meaning most uncertain yet likely to have a big impact on the future. Group three consists of wild cards, which have a low probability of occurring but a high impact on the future. Finally, group four are factors that people agree are likely to happen.

Klinginsmith organizes workshops and “learning journeys” during which key executives visit companies, places, and people from which they hope to gain insights into how the identified uncertainties might play out. For instance, in 1999, when the company was investigating how the Internet would affect customer needs and distribution channels, executives, including CEO Bill Lyons, spent two-and-a-half days visiting businesses in Silicon Valley, interviewing leaders in the field of E-commerce and learning about cutting-edge technology, marketing, and consumer trends. Executive commitment to these trips and to scenario planning is high, because they are crucial parts of corporate planning, which includes a balanced scorecard approach. “It’s about getting everyone on the same page,” says Jackson. “This work even precedes our budgeting efforts.”

Prepare For New Futures

Since the events of September 11 made it plain that the unthinkable can happen, the range of scenarios now on the table is broader than ever. Still, both Ged Davis, vice president of global business environment at Shell International in London, and Klinginsmith say that the basics of their scenario planning haven’t changed substantially as a result. Klinginsmith believes that creating scenarios around such dramatic events lowers the effectiveness of the process. “We view these events as a wild-card concept,” he says. “They don’t happen very often. To spend significant resources to deal with them is to move into a state of paranoia.”

Davis says Shell already factors in such extreme actions because it does business in the Middle East, where terrorism has been an issue for decades. “We need to assess our strategies against [terrorist] scenarios. That’s what scenarios are about. They allow you to benchmark your visions against the assumptions.”

Whatever you assume could be a factor in your company’s future–from terrorism to the price of tea in China–scenario planning offers a structure with which to envision and prepare for new futures. “You can describe what a winning company looks like in various scenarios,” says Arthur D. Little’s Eno, “and with that information, almost every time, it will stretch your thinking about what your company can be.”

Sidebar: The Shell Method Today

The Shell method helped make that company an oil giant. Ged Davis, vice president of global business environment at Shell International in London, took over the division in 1999. One of Davis’s most recent efforts charts energy markets out to 2050, and features two distinct scenarios: one in which renewable energy sources gain popularity very slowly over time and another in which new fuel technologies, such as hydrogen fuel cells, quickly rise to acceptance.

“Scenario planning is our way of handling risk,” says Davis. “There are some things you can forecast and there are some things you can’t. You distinguish the things that you can’t, and that’s what you build the scenarios around.”

For the 20-year-scenario plans, which are updated every 3 years, Davis conducts a long process (up to nine months) to define the problematique, the question the company wants to focus on, and the factors that influence it. He and his team, which includes economists, sociologists, energy experts, and other specialists who add new perspectives, interview key executives to find out “what is on their minds and what they think the main challenges are.” The analysis phase includes workshops at Shell locations around the world. “You can’t get hung up on the focus of a specific discipline,” says Davis. “You have to get out, see things, talk to lots of people who have strong views.”

Once the analysis portion is complete, Davis determines the scope of the problematique and seeks approval from the board of directors. If the board agrees with the scope, the research phase proceeds. The process, which can take up to a year, goes into great detail on a variety of scenarios and involves 30 to 40 people. Once the scenarios have been crafted, Davis goes back to the board for approval on two of them. Once they have been approved, says Davis, the most crucial step begins: wind tunneling.

“This is when you test the company’s strategies against these focused scenarios,” he says. “We use the scenario as a global backdrop.” The real value is gained when the scenarios are tested against country and local strategies. “When you do this more-focused work, people can see much more clearly the sorts of risks they’re facing.”