Recent price volatility provides a sample of what’s to come, as Western states bring more wind and solar into a hydro-dependent market.
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.
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