Scenario planning and stress testing provide a structured approach for board and management to deal with strategic opportunities and threats in 2022 and beyond, writes Peter Deans GAICD.
Business decisions made today will reverberate for many years. Investment decisions, new business partnerships and strategic initiatives will all impact the future shape and direction of a company or organisation. In the short term, there is arguably more certainty. During this time horizon, decision- making should be easier. However, the pandemic has probably shaken some confidence in this proposition.
Medium- and longer-term uncertainty in the future political, socioeconomic and technology landscapes presents boards and management teams with serious challenges to the decision- making process. A failure to act today may result in the stranded business assets of tomorrow. To make well-considered and informed decisions, a structured approach to dealing with these issues is needed.
Scenario planning and stress testing are two tools that directors and executives should be regularly using to support and guide their decision- making process.
Shell Scenarios, The Shell Group
Living in the Futures by Angela Wilkinson & Roland Kupers, Harvard Business Review (2013)
Setting the scene
Scenario planning is a way to describe numerous possible futures. These futures — or scenarios — inform leaders on the implications of the events described, advance thinking on how their businesses could respond to the possible changes and facilitate the development of business ideas and options under these scenarios.
Scenario planning gathers data, information and views on the future and transforms these inputs into plausible, realistic story lines to stimulate a strategic discussion. It provides fresh perspectives on longer-term issues that often fail to be adequately discussed at board level.
In a crowded board agenda and with scarce financial resources, it can be difficult to get into a regular rhythm to undertake both strategic planning and scenario analysis. Scenario planning takes a significant commitment and may require the engagement of external consultants, facilitators, and researchers. Scenario planning was made famous in the early 1970s, when Royal Dutch Shell’s financial modelling capabilities evolved into a formal process of developing and documenting future industry scenarios. Royal Dutch Shell (now the Shell Group) continues to use scenario planning and it publishes its outputs — Shell Scenarios — on its website. The Shell Group states that it has “been developing possible visions of the future since the 1970s, helping generations of Shell leaders explore ways forward and make better decisions“. Shell scenarios today explore and analyse issues across the broader environment and energy spectrum.
Shell’s adoption of scenario planning and success in identifying its industry challenges, encouraged many corporations across the world to undertake similar exercises. It is now considered a mainstream, strategic planning management tool. Many listed Australian companies have invested in scenario planning capability and publish their scenarios. This includes the major banks, BHP, Lendlease Corporation, Macquarie Group, Transurban and Wesfarmers. The need for climate change scenario work has been the driver of much of this investment in recent years.
But scenario planning and stress testing don’t require big budgets to achieve. At a high level, scenario planning involves four main steps:
1. Identify trends and driving forces
The first step in the scenario planning process is to identify the key trends and driving forces within the industry and other external factors. Preparation and research at this stage are critical to ensure the development of relevant scenarios. This will entail drawing on the expertise and insights within the organisation. However, this may need to be supplemented with external research. This can be from academic institutions, government agencies, industry bodies or private research firms.
In its 2021 annual report, Transurban outlined the global trends influencing its strategy, pointing to research it had commissioned to understand changes in mobility and other trends that may impact the usage of toll roads. Transurban highlights that “identifying and positioning for trends and advancements within the infrastructure space enables us to pursue opportunities while mitigating risks such as potential disruptions”.
External perspectives can also contribute to building scenarios that may challenge the status quo and counter potential bias inherent in current business strategies.
2. Focus on critical uncertainties
In the research undertaken to identify the trends and driving forces in the business, industry and/ or society, critical uncertainties will be uncovered. One or two of these will usually be the subject of the story lines.
These critical uncertainties will also shape the scenarios — the uncertainties need to be identified, researched and documented to assist the development of the story line. For example, in the airline industry, the focus may be on the likelihood of and impact of affordable subsonic travel. Alternatively, it may be on the impact of climate change on the viability of air travel and the industry response to climate change-driven outcomes.
The time frames selected for the scenarios will in part be driven by the nature of the critical uncertainties. Wesfarmers disclosed in its 2021 annual report that it had split its climate change scenario planning into three distinct time horizons — one to five years, five to 15 years and 15-plus years.
Each business area has considered the uncertainties and climate change-related issues across each of the time horizons and categorised them according to physical risks, transition risks and opportunities.
3. Develop the scenarios
Developing the scenarios requires a focus on building out several alternative scenarios to present and debate. How many? It depends on the core issues being considered. One or two scenarios may be seen as presenting too polarised or binary potential futures. However, preparing five or six scenarios will be time-consuming and may also result in several being too similar. In addition, scenarios need to be built out, documented in detail and modelled. All of this will consume valuable management time and resources.
In its Climate Change Report 2020, BHP outlined four climate-change scenarios it had developed to assist it to understand the impact of climate change and inform its future business strategies. The scenarios — the 1.5°C Scenario, the Central Energy View, the Lower Carbon View, and the Climate Crisis Scenario — are used to develop forecasts for its key commodities and, in turn, shape long- term investment decisions. The conclusion from its analysis is that “demand for renewable energy technologies is likely to grow at unprecedented rates as the power sector decarbonises and electrification trends accelerate in coming decades”.
The depth of analysis required depends on the industry, the nature of the businesses and the issues being addressed in the building of the scenarios. Expertise and insights within the organisation will assist to develop the scenarios. The analysis completed by BHP and Wesfarmers highlights the importance of also looking for opportunities — not just the threats and downside.
4. Connect today to the future
Connecting the current business to the possible futures involves discussing the scenarios, drawing out key possibilities and outcomes, and considering what action is to be taken. It may not be possible to find definitive answers on the future, nor the strategies to be developed immediately. The scenarios may simply open the eyes of the board and management team to issues that need to be considered in the coming years when business investment decisions are made.
However, the scenarios developed and stress testing undertaken for one or more of the scenarios might alert the organisation to emerging risks. These risks may not have previously been identified, or perhaps their impact has not been fully appreciated. The scenarios can then be used to inform future strategic planning as well as further research and investigation.
Lendlease demonstrated in its 2021 annual report how it connects today to the future. From the three climate scenarios it developed, it has identified 10 climate-related impacts (CIRs). Lendlease uses these CIRs to assess the likely positive/negative impacts on its businesses. It states that the “integration of climate risk assessments into our investment decision-making processes has seen reduced residual sensitivities to climate impacts”.
Taking this a step further, scenario planning practices and outputs can be formally embedded into regular decision-making. Scenario planning can be used as a key input into the strategic planning cycle. In addition, management teams can also undertake bespoke scenario planning exercises on specific issues identified during any group-wide scenario-planning exercise.
The range of possible scenarios developed to be discussed may need to have their financial outcomes modelled, at a high level. Scenario planning cannot be undertaken without the ability to financially model the various scenarios.
Stress testing — or downside scenario modelling — is a well-known technique in the financial services sector. Banks and other regulated financial institutions are required to undertake frequent stress testing of aspects of their business such their loan credit portfolios and liquidity. Commodity- linked businesses such as oil and gas companies also stress test for scenarios that forecast extended periods of lower prices. This analysis is used on an ongoing basis to assist with capital management activities and investment decisions.
Stress testing will usually involve single- or multiple-variable scenarios. A single-variable scenario will focus on one key variable and assess the impact of a change in it alone. This could be, for example, the imposition of additional environmental taxes on the company’s products. The impact of this tax on the demand for the product can then be modelled. The stress testing can show the impact before any actions are taken by management.
Multiple-variable scenarios are employed to model the real world as much as possible by developing modelled outcomes of multiple variables at the same time.
Stress testing can stretch over any time horizon. For more dynamic industries and markets, the stress testing may only be over a one- or two- year period. In technology-driven sectors, the profitability of individual products or business lines can be disrupted almost overnight. As noted earlier, Wesfarmers has investigated the impact of climate change over three different time periods.
Businesses with the finance function focused on financial and management reporting will need to build out capability or source it externally. However, all businesses should have access to sophisticated financial modelling capability. This can enable the running of various scenarios promptly to support board and management decision-making.
Embracing the outputs
The magic scenario planning delivers comes when leaders embrace the outputs and use lessons from the scenario development and workshop debates to assist in decision-making and strategic planning.
Scenarios that are developed, but then left on the shelf, are a waste of time and effort. Directors must stare into the difficult challenges that potentially lie ahead, even if those scenarios are unpalatable. Executives and managers alike may find the possible outcomes confronting. The scenarios may necessitate the eventual closure of a line of business, or perhaps the diversion of investment to new and risky business initiatives.
Scenario planning and stress testing are valuable additions to any organisation’s planning and management toolkit. Those facing ongoing disruption from new technologies, new competitors, climate change or government policy changes must act urgently, armed with detailed insights into the possible futures they face. Leaders who fail to understand this risk their businesses becoming stranded assets.
Peter Deans GAICD is a non-executive director, risk adviser, former chief risk officer and founder of the 52 Risks management framework.
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