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Future Imperfect II: Managing Strategic Risk In the Age of Uncertainty

Part two of our series shows how utility companies can manage, but never eliminate, strategic risk.

Fortnightly Magazine - February 2007

perhaps not.

Second, the DCF-based approach fails to recognize the value of strategic flexibility. Hence, it militates against investments that could provide future managers with the ability to respond to events outside the baseline scenario.

Finally, the mainstream capital budgeting and planning process can build in subtle rigidities. Leaders and planners alike become committed to a course of action, and tend to favor data that confirm the current program over data that do not. Internal constituencies grow with a vested interest in the familiar routines of the actions currently under way. Thus strategic leadership can become blind to the possibility that unfolding events are rendering their strategic foresight irrelevant. In sum, relying on strategic foresight alone leaves a company vulnerable to strategic myopia—as shown by the problem of the fat tail.

Fortune and the Fat Tail

No, this is not about too many second-helpings of french fries, but rather about the unfairness of life. In an uncertain but fair world, the outcomes of risky decisions would be distributed evenly around some rational expectation, as shown in the upper right portion of Figure 1. But down here on Earth, uncertain events enjoy a limited upside, the limitations often imposed by the counter-moves of competitors (in fast-moving technology or fashion markets, for example) or by regulators for the utility company.

This asymmetric risk is shown in Figure 1. In most cases, the outcome of an uncertain event will fall within the range of expectation—imagine an airline flight, for example, that gets you to your destination close enough to on time and with minimal hassles from surly employees and overly zealous security people. This forms the expected range of most customer experiences. In a few cases, the customer receives a “wow” experience, though the possibilities for that are limited.

But on the other tail of the probability distribution, the experience can include canceled flights and extensive delays—and in some cases outright human tragedy. These prospects for disaster form the “fat tail” of the distribution in Figure 1. The banking industry, for example, explicitly plans for fat-tail outcomes with a loss contingency 10 times greater than the upper end of the expectation range. Many utility companies also have experienced these fat-tail effects—in the 1980s, for example, when unanticipated difficulties in nuclear power plant construction and licensing led to massive cost overruns and financial loss. The companies that did well received a normal rate of return.

To be sure, the fat tail sometimes reflects the risks in executing a strategy, but most successful companies have become skilled in managing execution risk. Here, we concern ourselves with strategic risk—the possibility that events beyond the planning horizon and unknowable at the time a decision must be made arise to upset an otherwise well-conceived strategy. The best laid plans of mice and men are really about equal.

To Manage Asymmetric Risk: A Scenario Approach

A management technique known as scenario planning enables strategic management to think outside the customary risk box—to include in their thinking discontinuous events that cannot be discerned by extrapolating present trends.

Scenarios are stories about the