Strategic risk management and scenario planning help a firm gain competitive advantage. Such planning helps leaders distinguish the firm’s real vulnerabilities from those that are imagined or marginal. It also helps identify those opportunities that are worth the risk, and helps plan contingencies for dealing with disruptions, whether inevitable or almost inconceivable.
Every opportunity and every decision involve some risk and uncertainty. Successful firms realize the dramatic difference between taking active risks and sitting passively at risk. Transnational operations encounter many potential dangers, yet remaining close to home courts the hazards of inaction and the harm of lost opportunities, particularly against competitors that are more bold and agile. But while reward requires risk, successful business leaders must distinguish smart risks from dangerous gambles. The question is, how can their firms grasp opportunities without endangering themselves in markets that seem ever-changing and ever-threatening?
Approaches to risk management have changed radically from the centralized, top-down model in vogue two decades ago to the broad, multidimensional model that has begun to emerge in recent years. Firms are adapting because now, more than ever, they must assess and manage risk strategically — to explore dangers and vulnerabilities in the context of corporate goals and market opportunities. Strategic risk management does not eliminate uncertainty, hazard, harm, loss, or tumult. Rather, it helps companies develop resilient operations, foster quick recovery, and plan measures to work around disruptions.
The most successful transnational firms manage risks and build value. These firms plan for success by assessing the strategic context, monitoring the global environment, preparing for future conditions, and weighing potential dangers. The best firms take smart risks that help them add to top-line growth while protecting against risks to the bottom line. They thoughtfully pursue opportunities by vigorous geographic expansion and by the development of innovative products derived from the existing business. These firms build muscle as they trim fat, so they are lean, fit, and ready to quickly seize opportunities. In short, by integrating risk management into their strategic planning processes, firms can take the smart risks that allow them to gain competitive advantages.
Managing risks and taking smart risks involves internal and external monitoring. Internally, managers need to identify the core activities that drive their company’s earnings, isolate the most critical infrastructure and related vulnerabilities, and then devise contingency plans. Externally, they must monitor the environment for dangers that threaten those vulnerabilities and for opportunities that may build value and corporate muscle.
This article illustrates and applies strategic risk management principles and provides a regimen for developing a resilient, adaptable, profitable firm: the imperatives of that regimen are to chart current conditions, anticipate future conditions, and plan accordingly. Section 1 describes six characteristics rapidly reshaping the global environment. These “drivers” create opportunities and represent potential threats. Section 2 traces and entwines those characteristics to depict three possible future global scenarios. The scenarios describe broadly systemic conditions arranged from least likely to most likely to occur in the foreseeable future. These scenarios depict wildly different futures. Imagine Ebenezer Scrooge receiving visits from three different Ghosts of Conditions Future. Like Scrooge, you too can adjust or dramatically alter your present behavior to prepare for or preclude future conditions. Although Scrooge knew his heart and happiness were endangered, can you as readily identify what potential jeopardy might threaten your firm? Section 3 identifies how to develop risk profiles unique to your business and situation.
With a solid grasp of these risk management principles, business leaders will be well positioned to comprehend the drivers of change that reshape global markets and environments, to manage the corollary risks, and to take advantage of ripe and abundant business opportunities.
1. Drivers, Fuel, and Changing Landscapes
Rapid and large-scale change often disorients, disrupts, and disturbs. Yet strategic risk management offers a framework that clarifies the world and its changes. Ours is built around five current drivers that propel future changes in social and economic conditions, each “turbocharged” by the power of technological innovations.
Information technologies embody the process of technological connectivity that has lowered the costs and heightened the accessibility of information, spurring much of the economic and political globalization over the last 20 years. We witness economic globalization in deeply integrated financial markets and liberal trade arrangements. Political globalization is evident in international institutions designed to manage and regulate affairs between countries by minimizing conflict, fostering stability, promoting liquidity, and liberalizing trade and investment. Social globalization — contact between people from different places, reflecting diverse conditions and divergent ideas — arises from the technological, economic, and political traits. As a whole, globalization has produced unprecedented wealth and inequalities, but it has also produced a quandary: Can the beneficiaries of new opportunities create conditions that spread benefits more broadly and protect those harmed, frightened, distressed, or made insecure by global integration?
The global population grows exponentially. In Europe and North America people live longer, swelling the ranks of retirees who demand and require ever-larger outlays for social and health services. These costs consume increasing shares of the developed world’s economic output, yet also represent opportunities for firms serving the health, travel, and leisure needs of retirees. In parts of the developing world, the number of children continues to grow, while swelling ranks of young adults – age 15-29 — press for more jobs and better opportunities. Some want goods, services, and lifestyles that resemble those in the Western world, while others simply want to leave. Either way, their frustrated efforts to work, travel, emigrate, and consume may lead to pent-up anger and in some places, tilt toward radical violence.
The sweeping demographic changes noted above will dramatically alter future consumer spending. By 2015, many of today’s middle class consumers will graduate to higher levels of consumption, while an aspiring middle class, made up mostly of young people in emerging markets, will have a prodigious appetite for physical, status-oriented goods that promise empowerment, individuality, and sex appeal. “Grey populations” will spend on health care, comfort, convenience goods, and vacations. Consumers in advanced markets will look for sensory experiences, whether from leisure, entertainment, and travel, or from luxury products that promise to extend youth and soothe minds and bodies, especially of overworked middle-aged consumers.
Natural resources and the environment
Massive industrialization in Asia and the continued high industrial output of advanced economies pose environmental concerns. Energy demands will skyrocket as populations and industrial outputs grow. Proven oil reserves will likely satisfy demand for several decades, yet the largest reserves are in the Middle East and Central Asia, where chronic political instability will continually threaten supply. Europe and the United States consume so much natural gas that domestic reserves are dwindling and utility prices are rising. Together, China and India will account for two-thirds of global demand for coal through 2030. And China alone is already the world’s second largest oil importer. As some key resources dwindle, prices rise, and supply shrinks, competition for these resources may grow intense. Conflicts over water and oil are perhaps the most likely. However, as energy costs and environmental concerns grow, alternative sources will also become price competitive, as solar power is on Long Island and wind power is in Minnesota and elsewhere.
Regulation and activism
Security fears, corporate scandals, and disillusionment with deregulation provoke citizens to press governments for regulation and reprieve. Yet national governments are ill-positioned to respond ably. With slashed budgets and smaller staffs, governments face limited options. Simultaneously, complex issues requiring regulation abound: biotechnology, stem cell research, cloning, ecommerce, information technology, hacking, privacy, intellectual property, and taxation. Contradictory local, national, regional, and global standards on these matters thwart operations, markets, and profitability. Activist groups become regulatory bodies as they monitor and report on firms’ practices.
2. Three Scenarios
These drivers shape the environment, but not definitively. Likely, you foresee pessimistic, neutral, and optimistic prospects. For example, ever-deepening global integration may continue, as witnessed in the 1990s (optimistic); could become more incremental, with an emphasis on bilateral arrangements instead of comprehensive global arrangements (neutral); or recede amid a backlash sparked by security threats, corporate malfeasance, and economic uncertainty (pessimistic). By overlaying the drivers and braiding their mutually dependent trajectories, we project three broad, system-wide scenarios as visions of a future that could emerge ten years down the road (see figure 1). These scenarios help business leaders identify threats and opportunities and establish contingency plans.
Castles and Moats
In this darkly pessimistic scenario a sharp economic downturn and violent outbursts spark defensive policies that drive people, firms, and nations into barricaded feudal enclaves. A stagnant and recession-plagued global economy inflames fears, threatens instability, and derails globalization as national security trumps all other concerns. Insecure citizens feel themselves besieged by forces beyond their control, so batten the hatches, circle the wagons, and rally ’round the flag. Most global inhabitants become inward-looking and nationalistic because they no longer believe in the efficacy of multilateral arrangements. Instead, citizens prefer alliances with small groups of likeminded people and countries. A world of insular, defensive castles and moats emerges.
The developed world experiences a strong resurgence of xenophobia, populism, nationalism, and nativism, in part as reactions against seemingly uncontainable terrorism. The United States is the foremost target, primarily from those in the Middle East and elsewhere who resent the consumerist values of the West and the striking global inequalities in wealth and lifestyles. Citizens in affluent countries willingly trade certain civil liberties and privacy in exchange for broad defensive measures against the vicious cycles of war, crime, resource competition, disease, and terrorism that embroil the world.
Worsening standards of living in the Middle East galvanize a new generation of Islamic militants and local freedom fighters. Other disenfranchised extremists violently pursue their own causes in Latin America, Africa, and Central and Southeast Asia. The new security regulations affecting the movement of people, cargo, and money severely put the brake on international trade and investment. Also, consumers swept up by nationalist fervor prefer goods and services made at home, so multinational corporations scale back operations by limiting business to specific locations with low risks and favorable local trade agreements. Corporate power dwindles relative to the authority of security oriented national governments. Price hikes, arising from higher tariffs and high domestic production costs, slow consumption among almost all consumers.
The environment decays and demographic change marches on, but concerns remain localized absent a multilateral framework to address such problems. Activists demand relief for the most needy, but in this bunkered environment, their cries influence few.
The chaotic and turbulent world of 2015 shreds the fabric of globalized norms, institutions, and markets woven over the last several decades into an irregular patchwork of contrasting regional and bilateral agreements. In this most likely scenario, international consensus on liberal trade and investment arrangements erodes and key institutions, such as the World Trade Organization, become paralyzed. Bilateral and regional arrangements supplant multilateral agreements. As the global economy stagnates, poverty and violence become increasingly widespread, but largely outside of North America and Europe. Few government officials demonstrate leadership or have the resources and talent to address problems, so officials recycle familiar, increasingly parochial and protectionist measures to shield industries and jobs.
Within this stagnant environment, the vast internal demand and relative self-sufficiency make the United States and the European Union the most resilient economies. In Japan, China, and Southeast Asia, on the other hand, trade barriers severely damage industrial growth and economic performance. “Privatization” becomes a policy mantra borne of fiscal necessity and partisan appeal. Corporations begin to handle many formerly public services, including law enforcement, health care, and education as governments confront tight budgets and growing obligations to care for their aging populations. Corporations become the most significant and powerful players in domestic and international markets.
The developing world is left to fend for itself amid rapidly worsening economic, political, social, and environmental conditions. High birth rates further bury development prospects and persistent turmoil plagues Africa, Central Asia, and the Middle East. Although violence is largely contained in these regions, failed states pose a continuing threat to regional and global stability as they “specialize” in terror, black marketeering, money laundering, arms deals, and narcotics trafficking.
Rapid population growth continues unabated. Wealthy elites and groups of middle-income consumers in emerging markets drive global consumption. Global and local environmental conditions worsen demonstrably, but governments manage problems well enough that economic growth is not threatened. As government regulation weakens, activist groups seek to enforce standards of corporate behavior.
Open Borders, Lingering Fears
Amid these lingering fears, inequalities, and backlash, the United States and China dominate a stable, bipolar world marked by intense business activity, technological innovation, and increased flows of trade, investment, and services. Globalization grows, although the pace slows somewhat from the heady integration of the 1990s as border controls and security measures take their toll. Governments counterbalance the increased risk that globalization poses by intervening in markets to promote security and maintain social safety nets for those alienated “victims” of globalization.
Barriers to trade and investment that were lowered in previous years continue to propel international commerce, and per capita income levels rise throughout the industrialized and developing world. Yet further liberalization is hampered by impasses over trade, services, and investment. Firms in advanced economies relocate most manufacturing and many services to emerging markets, even as citizens in the developed world protest. Developed economies focus ever more on information and services, though increasingly secure IT fosters far-flung, truly global production and distribution in which service providers outsource relatively easily.
Demographic changes create a vast “middle class” of consumers in emerging markets and compel industrialized countries to accept large numbers of immigrants to provide necessary labor and to moderate wage pressures at the lower end of the income scale. The natural environment suffers, but firms advantageously offer to regulate themselves. Indeed, acting on the belief that social responsibility helps to differentiate their brands, firms increasingly rely on self-regulation to guarantee the highest labor and environmental standards. Firms seek out respected international nongovernmental organizations (NGOs) to earn their seal of approval.
These scenarios depict wildly different futures. Depending upon the scenario, what feature, relationship, physical plant, personnel, or ideas in your firm are in jeopardy? Which are advantageously positioned to seize emerging opportunities?
3. Mapping Risk Profiles
Each company has a unique risk profile. Take the following five steps to develop yours. The goal is to evaluate risk in a series of escalating “stages of excellence” at the level of business units, corporate officers, and boards of directors (see figure 2).
Prioritize earnings drivers
What factors, if disrupted, would most significantly harm a firm’s earnings or endanger the business? For example, ten minutes of IT downtime impair a financial services firm. A tarnished reputation profoundly injures a consumer products company.
Identify critical infrastructure
What infrastructure — including equipment, plant, processes, personnel, proprietary information, relationships, and regulations — supports the firm’s ability to generate earnings? What elements, if disrupted, would most seriously harm earnings? Brand reputation may depend on quality control. Research and development may depend on specific laboratories, critical personnel, and patent protection. Identify the features most essential to the fundamental activity that generates earnings.
What is your Achilles heel? Upon what crucial factors do other factors and abilities depend? It could be a single supplier for a critical component, a border that 80 percent of your products cross to reach key markets, a single employee who knows how to restore data if the IT system fails, or a regulation that makes it possible for you to stay in business. It may be a bottleneck, a process with no alternatives, or insecure access points to important infrastructure. It may be an association with dangerous geographic areas (war zones, hurricane paths), jeopardized industries (airlines, nuclear energy), or hazardous products (toxic waste, explosives). You don’t care whether your vulnerability is stricken by earthquake, terrorist attack, economic crisis, or contaminated product. You care only about responding to the disruption.
With knowledge of operational vulnerabilities, how can a firm plan to mitigate risk flexibly and redundantly? Flexible responses generally require advance planning but little upfront investment. Flexibility involves identifying alternate suppliers, modes of transport, and additional production capacity. Flexibility also entails cross-training employees, designing and using products and processes compatible with rapid switching of components, and (potentially) performing tasks in multiple locations. Redundant responses, on the other hand, require maintaining a surplus and investing in excess stock, capacity and relationships. Examples of redundant responses include holding increased inventory, cultivating alternate suppliers, and building backup IT and telecom systems.
Monitor the environment
What is the likelihood of potential risks occurring and threats materializing? Determining which responses to disruption are most apt depends upon your assessment of the external environment. Gauging the likelihood of various events – pandemic or global depression versus labor strike or power blackout – helps a firm determine how much to invest for the each of the firm’s vulnerabilities. As economic and market conditions, consumer tastes, the regulatory environment, and products and processes change, so hazards and uncertainties constantly change. A firm’s risk profile must change at the same time. A risk profile helps to identify the necessary contingency plans that decision makers can quickly implement when dangers appear.
Many global issues appear challenging. Executives preoccupied by their overwhelming commitment of time and energy to their firms have little opportunity or expertise for dissecting, unraveling, and projecting global conditions. Most firms lack the means to identify and manage external hazards and uncertainties. These firms are at risk because they cannot identify risk. Yet these issues, singly or in combination, can be managed — and managed effectively — by strategic risk management and scenario planning. Such planning helps firms to understand the external world in order to engage it ably. Strategic risk management helps decision makers distinguish the unnecessary from the essential vulnerabilities. It helps identify those opportunities that merit taking risk and flirting with uncertainty. It also helps plan flexible and redundant contingencies for dealing with disruptions, whether inevitable or almost inconceivable. The resulting agility helps corporations maintain their equilibrium, build muscle, act swiftly and decisively — and gain competitive advantages.