When developing a strategy or making investment decisions, there will be many uncertainties that need assessment. These can range from cost and timing issues to broader questions at the macro level, for example political, regulatory or social developments. A way to get to grips with the latter category is by using ‘scenario analysis’, sometimes called ‘scenario thinking’ or ‘scenario planning’.
A scenario in this context is an alternative future: a coherent narrative of a set of developments, trends and events that could unfold within some defined environment space. Examples of such spaces are: a country, a group of countries, a sector, a city, the world. This is the environment space within which an entity (company, organization) anticipates operating over a predefined time frame, usually somewhere between 10 and 40 years. By articulating multiple such scenarios, each internally consistent but distinctly different, the entity is able to fathom various significant external (contextual) uncertainties that might have an impact on its future well-being or existence.
The purposes of scenarios can be multiple. They are a framework for discussion and strategy development. The entity can use them to engage with external parties. They can be a means to bridge gaps between different interests. A famous example of that are the Mont Fleur scenarios in South Africa, composed in 1991. In this article I however focus on the use of scenarios for decisions.
The question is how, once the scenarios are available and digested, the entity can use these in decision making. The common basis for investment or strategic decisions is some quantification of opportunity attractiveness coupled to various forms of risk analysis. Descriptions of alternative futures, however interesting they may be, do not easily find a place within the decision processes. For example, in most cases it is not (credibly) possible to assign probabilities to scenarios to sharpen the outlook (in another article I will discuss situations when this may nevertheless be an option). There is not a most likely future that can be used as a basis for landing the decision. The fuzziness around the scenario concept makes it difficult to appreciate its use for concrete decisions. This is the reason for the skepticism that the scenario approach encounters in many organizations. It should, however, be accepted that scenario analysis, like any quantitative modelling for that matter, does not eliminate the uncertainties. It justs helps to map them out, frame them, categorize them, discuss them. But we will see that meaningful operationalization of scenarios is certainly possible.
I distinguish three ways of incorporating scenario analysis in the decision making process.
Firstly there is the pervasive impact of the influence on senior leaders and decision makers within the organization of the insights that are brought about by the scenario analysis process. When a significant decision is taken, the underpinning data and analysis, of course, play a crucial role. However, the experience, background and intuition of decision makers is also important. In decision boards they will bring their own perceptions and judgements to the table, calibrating these against the analysis results and information presented to them. The insights from scenarios will assist shaping the perceptions of decision makers of the future contextual environment. At that level, they will have clear views of their own about themes such as the market, (geo)politics, technology and societal developments. Scenarios will enrich these perspectives and allow decision makers to adapt and adjust their thinking as appropriate. A well known characterization is that scenarios act like ‘memories of the future’. Of course it is then a great benefit if senior leaders within an organization are involved themselves in devising the scenarios to the extent practical.
Secondly there is the option of qualitatively stress testing investment decisions, but in particular strategies, against the different scenarios developed. This is what Kees van der Heijden, in his book Scenarios, The art of strategic conversation, called ‘wind tunneling’. This is about creating a matrix with the scenarios on one axis and the various strategy options on the other axis. Each box triggers a discussion of how attractive a specific strategy option will be under a particular scenario. This could result in qualitative attractiveness scoring in some form. Also here, the discussion associated with this process is more important than the resulting overview.
Thirdly, a quantitative approach is possible. The starting point is the key decision variable, for example the (aggregate) NPV of the investment or strategy. This variable is decomposed in its components (revenues, costs, tax) and the chain of influences on these components is mapped out. This is best done with an influence diagram so as to also visualize the interrelationships. In the contexts of the various scenarios, reasonings and quantitative assumptions are developed for the key influences. This is worked through to the level of the NPV: different NPVs under different scenarios (even better: NPV ranges under different scenarios). For the quantitative analysis techniques from the econometrics discipline can be useful (e.g. regressions). Sometimes a system dynamics model can be of assistance. But it does not need to be very complicated. Developing rounded estimates of some key external drivers whilst considering the interrelationships can be good enough. This is in fact what oil companies do (to some extent) when they annually consider a scenario based outlook for the oil price, link this to an assumption about cost escalation, exchange rates and a future price for carbon emissions.
There is no scheme that will allow collapsing all considerations into one number of attractiveness of an investment opportunity or strategy for the benefit of decision makers (except perhaps by judgementally assigning a ‘score’). But the earth is not flat and projecting its surface on a plane leads to substantial geometric distortions. Likewise, the richness of a scenario based analysis should not be kept away from decision makers, be it that the insights need to be adequately presented. Vice versa, decision makers should be prepared to digest the perspectives offered by the scenario approach and contrast that with their own perceptions, even though in the end the decision itself may be quantifiable by a single bit: 0 or 1.