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

Deck: 

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

Fortnightly Magazine - February 2007

The consequences of a flawed strategic choice unfold slowly, but they carry great weight. Consider IBM, which in 1980 chose to outsource to Intel the 16-bit processor needed for its entry into the personal computer market. The Intel chip, however, could not use the operating system that IBM had designed for its older 8-bit processors. And so the company had to outsource the operating system as well as the chip—to a startup company called Microsoft.

The decision made strategic sense at the time. IBM had entered the personal computer (PC) race late, and needed to establish a market position quickly. The company achieved that goal, introducing the IBM PC in August of 1981 and rapidly gaining over 40 percent of the market. That success, however, contained the seeds of strategic failure, because IBM had outsourced the crown jewels of the business. The “Wintel” duopoly soon captured the value-added from IBM and its fellow PC-makers, who were left competing on price at the commodity end of the business. In 2005, IBM sold its PC business and left that market entirely.

Utility companies, however, face an even more challenging strategic environment because of the asymmetric nature of risk in a regulated business. In this second of two articles on strategic risk (see part 1, “Future Imperfect: Managing Strategic Risk In the Age of Uncertainty”), we will examine this basic asymmetry and consider two practices that can provide utility leaders with early warning and a hedge—scenario planning and real-options analysis. When these management tools operate within a culture of open inquiry and communication, they can make a material difference in responding to the hazards of the strategic environment.

Strategic Foresight and Asymmetric Risk

Utility companies often accomplish their business planning and capital budgeting through an approach that we might term “strategic foresight.” Planning staffs and strategic leadership work together to set goals, prepare forecasts, and design an operational pathway to achieve these goals. Discounted cash flow (DCF) methods are applied to individual projects, the sum of which yields a “strategic” budget, the agenda for capital expenditures for the next 5 or so years.

But this approach also has inherent limitations that could sow the seeds of later trouble if it consumes the entire strategic process for a utility company. First, the planning horizon for detailed analysis customarily does not reach beyond 5 years, even though the assets in question might have assumed lives of 30 to 40 years. To be sure, forecasts extend to the life of the strategic asset, but they carry the assumption, often-implicit, that the long-term future will turn out to be an extrapolation of the near future. In effect, strategic expectations concentrate on a single scenario that stretches well beyond the limits of reasonable forecasting. Perhaps this scenario will prove accurate—but 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 future. They ask: How could the future diverge from the present? What are the fundamental forces driving change in the business environment and how can these forces affect the success of the business? Understanding the range of these forces and their consequences for the business leads to the central strategic question: If the future unfolds as described in the scenarios, what would we do about it?

One must begin with a strategic choice. Otherwise, the scenario process can become irrelevant to the management of strategic risk. This choice should be framed as a closed question rather than an open-ended question. For example, an open-ended question like, “How will we make money?” does not lend itself to the scenario process. In contrast, closed-end questions like those below focus the scenario process on the strategic risk being managed:

• Should we invest in developing a coal-to-liquids capability (coal company)?
• Should our next investment in base-load generation be coal fueled (electric utility)?
• Should our next commercial aircraft aim for the long-haul, large-capacity market or for the short-haul, medium capacity market (aerospace company)?

Note especially two characteristics of these questions: (a) They are framed as a strategic choice; and (b) the outcome of the decision depends on events largely outside the direct control of the company.

Identifying the Relevant Uncertainties

Next we identify the unknowns in the business environment that will exert the strongest influence on the outcome of this strategic choice over a planning horizon of about 10 years. (This period is long enough to reach comfortably beyond mere extrapolation from the present, yet not so far as to become fanciful.) These unknowns are then grouped into two principal axes of uncertainty to create a matrix for scenario building like the one illustrated in Figure 2 (see p. 32). In this example, the Electric Power Research Institute (EPRI) has identified two key uncertainties that it believes will influence the choice of generating technology: (a) the cost of venting carbon dioxide; and (b) the cost of natural gas. These can be arrayed as axes in a matrix shown in Figure 2. The horizontal axis measures the cost of carbon venting, with severe constraints on the left-hand side, and ease of emission on the right. The vertical axis measures the cost of natural gas, high at the top and low at the bottom. Each quadrant should be given a name that captures the essence of the business environment that would obtain there. This name provides a convenient shorthand for communicating the scenarios throughout the utility organization.

Writing the Scenarios

Though outside facilitators can help, each utility management must take on the task of identifying and writing its own scenarios. A high level of engagement ensures capture of the tacit knowledge in the heads of the senior leaders. In most cases, a writing team would be chosen to develop each of the four and any additional “wild-card” scenarios. In each case, the scenario should begin with a logical pathway from the current business environment to that in the scenario. In “Solid Black Gold,” for example, the scenario might cite the inability of the industrial nations to persuade the developing world to participate in effective carbon constraints, and so no controls are established anywhere. The high cost of natural gas could arise from two possibilities: (a) terrorist threats that render LNG terminals unlicensable in the United States; and (b) high demand for natural gas used to produce liquid fuels from low-quality crude oils or solid hydrocarbons. In that world, coal would become the low-cost alternative, the solid form of “black gold.”

Moreover, some strategically important scenarios might not fall directly from the systematic process sketched out above. Utility planners should be alert to these, as they might offer essential clues to unsuspected risks or opportunities.

Consider, for example, a technology arising from outside the customary sphere of utility cognizance to threaten the well-ordered marketplace—distributed telecommunication and computing technologies, which are enabling intelligent micro-grids to enter unexpected markets like autos. The advances pioneered in autos could diffuse quickly to stationary electrical grids, especially those operating on the customers’ side of the meter. If that happens, then both mobile and stationary applications would converge in performance, scale, and technological configuration— leading to sharply discontinuous change in both autos and utilities.

The pace and direction of these changes will be driven by the auto industry, which must reform its product in response to public concerns with energy security and global warming, private concerns with fuel prices, and opportunities for dramatically improved performance of motor vehicles. In such a market, entrepreneurs and innovators might find opportunities in the automobiles and electric energy for new offerings and innovative business models. If one finds credibility in this line of reasoning, then a wild-card scenario might usefully supplement the more formal methods sketched out previously.

Once in place, thoughtful scenarios can help to manage strategic risk in several ways. First, they provide a platform for focused organizational learning about the key forces influencing corporate strategy. Second, they offer insight into the ways the world might unfold. These enable the utility to construct “signposts,” early warnings of the way important but uncertain events are turning out. Third, the scenarios serve as a communication device within the utility company, a commonly understood rationale for the strategic actions being taken. Fourth, scenarios provide a “virtual wind tunnel” to test the implications of strategic commitments under a variety of circumstances.

But fifth, and certainly most important, scenarios enable strategic-level managers to ask the all-important question, “What would we do if this came to pass?” The answer to that question takes the utility from the realm of thought to the realm of action, enabling the company not only to “take up arms against a sea of troubles,” but also to define and shape what those arms will be. And for this latter, we must turn to a complimentary planning tool—real-options analysis.

To Manage Asymmetric Risk: Real Options

An option offers the opportunity to make a decision after time reveals the future rather than before. For example, purchasing a call option gives the holder the right, but not the obligation, to acquire an asset or a capability at a prespecified price. A put option works in the opposite direction, giving the holder the right, but not the obligation, to sell at a prespecified price. Such options are commonly used to trade passively managed assets—financial instruments, such as stocks, and standard commodities, such as wheat and oil. But options thinking also can apply to strategic choice, serving to improve the upside and limit the downside consequences. There is, of course, a price for this—the general prohibition on free lunches applies here—and real options typically require present investment to secure the flexibility needed to defer risk or capture opportunity.

Utilities are not strangers to real-option thinking—consider, for example, the decision to acquire more land than a new power plant will need to provide the flexibility to construct a second one in the future. What is needed now is the inclusion of options thinking in the strategic-planning process. Scenario planning can mesh with and assist an options-based strategy in two ways. First, the scenarios themselves suggest options that would be valuable in the event that the scenario is realized. And second, scenarios offer the virtual wind tunnel, which can be used to estimate the value of the option should that scenario come to pass.

For example, a future in which carbon dioxide venting becomes costly would reward an option to build coal-fired power plants that capture the carbon and sequester it from the environment. A utility could build that capability by investing in technology development projects now—recognizing, of course, the risk that carbon capture and sequestration might never prove practical. In that case, the development of another kind of option, that of constructing nuclear power plants, might be warranted. The point here is not to recommend one option over another, but rather to recommend that the strategic conversation among a utility’s leaders include the value of real options in providing flexibility into an unknowable future.

Marrying Strategy and Culture

Finally, developing a capacity for wise strategic choice and effective response to the unfolding future runs deeper than merely adopting certain management tools. More fundamentally, it concerns the ability of a company to learn from events that are not a part of its historical experience, to distill from the cacophony of signals that clutter the business environment, the few that must command attention. And that is less a matter of tools than of organizational culture—the web of unwritten customs, habits, rewards, and punishments that shape the behavior of any corporation.

In the short term, an inflexible culture might serve a company well by providing a highly focused impedance match with its surrounding business environment. Consider Dell, which achieved strategic surprise when it introduced its novel Dell Direct business model in 1984. The power of the model lay in three realizations: (1) standard processors and a standard operating system would allow consumers to switch easily among PC brands; (2) these standard components could be procured and combined with extraordinary efficiency in a distributed logistics system; and (3) a direct sales model, based on the then-emerging Internet, offered better service and lower cost than the factory-to-dealer-to-customer channels then in practice. But a killer business model kills no one unless it can be implemented, and Dell’s highly focused culture of execution enabled this relatively complex strategy to provide a wide moat against competitors.

But the moat proved transient. The business environment was changing, and Dell was slow to recognize the emerging differences. First, rivals finally succeeded in duplicating Dell’s supply chain efficiency, which became merely the entry ticket to the industry and not a source of distinct advantage. Second, sales growth increasingly came from consumers and from developing countries, while Dell had focused on industrial sales. And third, rival chip makers began to duplicate the quality of Intel, used exclusively by Dell, at a lower cost. Thus, a culture based chiefly on execution became a liability as the future unfolded in ways unexpected by Dell. And in the third quarter of 2006, Hewlett-Packard reclaimed from Dell leadership in worldwide computer shipments.

And so a culture based on learning and open inquiry eventually will prove superior to one rigidly tuned to the needs of the moment. Consider Western Union once again, the story in last month’s Public Utilities Fortnightly with which we began our exploration of strategic risk. Did some unappreciated technologist deep within the organization come to understand the long-term potential of telephone technology? Did that person attempt to convey that idea to strategic management? Was anybody listening? Of course, we have no way of knowing. But we can say with certainty that an open culture that rewards initiative, inquiry, and learning is more likely to benefit from such a person than a culture without these attributes. Whatever management tools a company employs to guide the bets it must place on an unknowable future, an effective culture provides the foundation for wise strategic choice.