“Governance: the return to scenario planning” by Christian G. Lauron (January 16, 2012)

(Second of two parts)

SUITS THE C-SUITE By Christian G. Lauron

First Published in Business World 1/16/2012)

Last week, we discussed the evolution of scenario planning and why it had failed its purpose in mitigating the impact of recent global crises. Moving forward, we believe that it becomes even more critical for today’s organizations to integrate scenario planning and stress testing into their core strategies, and suggest a structured method for making stress testing integral to one’s corporate culture and business dynamics.

Operationalizing Scenario Planning: Think-Calculate-Embed

We propose a three-point framework to “operationalize” scenario planning (customized from base material of Broetzmann and Goetz), viz:.

• THINK: Scenario Identification without Prejudice

The three main activities in THINK are to:

• Elaborate and discuss scenarios;
• Identify and cluster major future drivers (certain and uncertain); and,
• Reflect existing business models and discuss current strategic options.

In identifying and developing scenarios, organizations select the uncertainties that are critical to their success and viability. The realm of uncertainties could range from the extreme “unknowns” and “unknowables” to known and basic yet disregarded (e.g., ‘in-between the cracks’ lapse). Instead of attempting to “de-bias” the process, organizations can direct their efforts to drawing fresh perspectives on uncertainties and gaining a working appreciation of their drivers and interconnectedness.

The following steps — taken either alone or in combinations — can help develop relevant and coherent scenarios:

• Reflect on current and emerging developments and trends and their drivers. The Ernst & Young 2011 report Tracking Global Trends identifies six global trends reshaping our world, namely:
• Emerging markets increase their global power;
• Cleantech becomes a competitive advantage;
• Global banking seeks recovery through transformation;
• Governments enhance ties with the private sector;
• Rapid technology innovation creates a smart, mobile world; and
• Demographic shifts transform the global work force;
• Distinguish between certain and uncertain trends. “Predetermined” elements are future elements which occur with an extremely high probability (e.g., an aging population based on birth rates); and,
• Analyzing alternative developments of uncertain trends.

2. CALCULATE: Link Scenarios to Financial and Capital Planning Models

The three main activities in CALCULATE are to:

• Test business model and strategic options against scenarios;
• Show financial and capital impact of business model and strategic options; and,
• Further develop and elaborate strategic options and potential adjustments of the business model.

This is where scenarios developed from THINK are interfaced with financial and capital planning models through the use of well-defined assumptions. Assumptions — external and internal — allow organizations to systematically quantify the financial and capital impact of scenarios and give feedback to the organization’s business models.

External assumptions correspond to the characteristics of the defined scenarios, such as economic, technological and socio-political characteristics. Internal assumptions correspond to the elements of the business model, which include:

• Objective;
• Markets and products;
• Value-adding processes;
• Resources (people, working capital and capital employed); and,
• Organization and structure.

Under CALCULATE, organizations perform (1) the systematic translation of scenarios into assumptions and; (2) the disciplined quantification of the assumptions in terms of financial (EBIT, EVA, FCF) and capital planning (CAR or Capital Adequacy Ratio, EC or Economic Capital, RAPM or Risk-Adjusted Performance Measures) impact, enabling the true testing of the business models and strategic options.

This testing process and its results can be summarized in a strategic scenario matrix: the vertical axis plots the strategies (each strategy reflects the business model and the measures), the horizontal axis plots the scenarios, and each cell shows an assessment of the financial performance (very successful, successful, unsuccessful based on EBIT, EVA and FCF measures) and capital planning implication — showing both the amount of impact and the range of impact based on an analysis of variance-based assessment of the assumptions.

This process requires “decision-support” personnel or professionals whose integrated “hard” competencies include accounting, risk, finance, operations and strategy, and “soft” competencies such as human and group behavioral dynamics, history and uncertainty distillation.

This risk-performance measurement approach bridges the two schools of thought in scenario planning (Wack, Mason) — risk reduction (which aims to act swiftly in tumultuous times) and revolutionary (which strives to set up a vision that not only the organization, but also an entire industry can aspire to as being best among competing visions).

This approach provides a strategic, top-down direction for capital planning, thus managing the ex-nihilo, ex-cathedra issues on capital allocation — nonfinancial organizations may find it instructive to understand risk-based or economic capital planning developments in the financial services sector.

It will also provide both the calculation base and the calculation framework, making scenario planning the encompassing umbrella for disparate measures being developed by firms, which range from VaR-based to spectral/distorted risk measures and full simulation (e.g., econometric modeling).

3. EMBED: Embedding in Performance and Develop Early-Warning Monitoring Systems

The three main activities in EMBED are to:

• Decide on relevant strategic options and potential adjustments of the business model;
• Translate new insights into action plans; and,
• Incorporate into long-term strategic planning and the organization’s culture.

Through the interaction of participants and the process of iterations, embedding of scenario planning has actually taken place during the THINK and CALCULATE phase. However, to ensure proper closure of the exercise, a plenary is convened to communicate the decisions made on the strategic options and business model adjustments. This plenary is often accompanied by a separate communication management initiative designed for cascading and synchronicity.

Conducting scenario planning as an annual exercise requires sensing the organization’s circadian rhythm. As an example, a calendar-year bank that undertakes its corporate planning exercise from September (preparatory) to November (consolidation, plenary and cascade) may conduct its integrated stress testing in August, followed by the corporate planning that now fully integrates scenario planning as a way of thinking.

Concluding Thoughts

Through the ‘Think-Calculate-Embed’ framework, we covered the linear aspects of implementing scenario planning. But the effectiveness of scenario planning rests on something non-linear: depth of shared vision. It takes the form of awareness, reinvigoration, or deepening of the organization’s sense of purpose. Perhaps uncertainty is our collective metaphor for our fear of the unknown, of the collapse of mental models and our familiar ways of thinking. As we embark on scenario planning, may the organizational sense of purpose and individual equanimity guide us to the ultimate insight that scenario planning is both a verb and a noun, and that it is our tool for seeing through and navigating complexity.

Christian G. Lauron is a Partner of SGV & Co.

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.