Why scenario analysis matters and how to make it work for you

With the recent slump in the price of crude oil jeopardizing the financial viability of some of their current production sites and future tar oil extraction initiatives, I imagine energy giant Royal Dutch Shell has its strategic planners pouring over scenario models to give executives guidance on how to realign strategy with the new reality.

When I arrived at business school in the early 1980’s, the company was already lauded for their use of scenario modeling which had started a decade earlier. So after 50 years of refining (no pun intended) a methodology they pioneered in-house, their prowess in scenario planning ought to be reflected in the value they have created for their investors.

In recent months the downturn in the price of oil has resulted in Shell’s stock price, along with those if its peers, taking a hit. Such short term fluctuations are hardly the basis for assessing the benefits of scenario planning though. More meaningful measures of that would be that the company has been consistently listed as one of the world’s most valuable companies. And that it has had the confidence to invest more than its peers in building up its oil reserves and growing its downstream distribution business across all parts of the globe.

Investing when others are hesitant takes confidence, and some of that confidence is undoubtedly rooted in their grasp of the future. Clearly, Shell is a sustainable business looking to the future. Only 55 (11%) of the companies listed alongside Shell in the 1955 Fortune 500 made it through to the 2014 listing; the majority having been acquired, merged, or broken up. And before you remind me that oil is a steady business, let me point out that the oil giant Amoco disappeared off the list in 1999, closely followed by Texaco in 2001. Meanwhile, Shell has ridden through the last 50 years, including the major oil embargo of October 1973, and currently looks to be in a stronger position than its peers; in part due to the insights that scenario planning brings.

Real scenario analysis is more than short-term what-if? analysis

The type of scenario analysis that Shell practices so well goes way beyond short-term “what-if?” analysis. As frequently happens in business, I would suggest that we use the word “scenario” far too loosely. We might say that assessing what incremental revenue can be generated by adding a couple of additional sales people is scenario analysis, but as we have hard historical data to work with, to me that is more akin to forecasting. Real scenario analysis involves a group of subject matter experts coming together to consider a whole range of economic, geopolitical and technological issues, and how they might evolve to create a number of plausible futures. Scenario planning enables planners and strategists to avoid becoming too narrowly focused by the false certainty of a single forecast or overcome by the confused paralysis that often strikes when unexpected events which have never previously been explored or planned for occur. But when well executed, scenarios boast a range of advantages. Here are just a few:

Scenario planning expands our horizons.

If we think about a range of possible futures and the sequence of events that might lead to them, we can monitor how things unfold and prepare contingency plans in readiness. We are not necessarily talking about looking into the distant blue yonder either. In rapidly changing markets such as technology, consumer electrics, and retailing, the outlook for scenarios need only be a few years ahead. For example, if the UK grocery retailers had paid more attention to how family incomes were impacted by the 2008 downturn, they could have had time to realign their offerings, rather than lose newly prudent customers to the discount stores.

Scenario planning rapidly uncovers the inevitable.

In my experience you do not have to do too much scenario planning before you realize there are already changes happening that will have inevitable consequences. Many of these will be demographic trends, such the steady increase in longevity, which seems to have remained beyond the typical planning horizon of most western governments until it is now crippling health services.

Scenario planning protects against consensual thinking.

If companies involve the right experts and prevent senior people forcing their views on others, scenario planning gives people the opportunity to question conventional wisdom and the assumptions that underpin current strategy. If Kodak, a company that was founded a decade before Shell, had allowed more internal dissent, could they have embraced digital imaging more readily and avoided having to file for Chapter 11 bankruptcy protection? Who knows?

Picking the most likely from a range of plausible futures should result in a more considered strategy and more focused annual planning. However, contingencies always need to be made should other scenarios begin to emerge instead. Having no Plan B, or even Plan C, is heroic–and most likely foolish. That said, once a strategy is developed to exploit the most likely scenario, business leaders should always communicate a single vision, putting those alternate scenarios aside.

The uncertainty that prevails in many markets today has resulted in the demise of the type of long range planning that was popular a few decades back. However I am not suggesting that happened because it is now impossible to understand the future; it was just that rigid, deterministic, long range planning is incompatible with today’s turbulent world. No matter how complex the future may seem we always need to plan and, if anything, scenario planning is even more of an imperative.

Best practices for making the most of scenario planning

The points above contain some general principles–look for trends that are certain to continue; cover a broad range of outcomes and consider extremes. But here some actionable best practices that I’ve picked up while scanning through recent writing on the topic:

• Never develop an odd number of scenarios as people will always choose the middle one
• Try to distil uncertainties into a two-by-two matrix wherever possible
• Always identify the scenario that has the highest probability and use it as the base case
• Give each scenario a memorable name so it can be easily discussed by the business. Shell’s scenarios for 2050 are called “Dynamics as Usual” and “The Spirit of the Coming Age.”

That even some of the world’s most respected companies occasionally experience a hiatus, suggests scenario planning is not as pervasive as it ought to be. That is because conceptualizing the future and building a robust set of scenarios and contingency plans takes time and requires an investment in time and resource. The Shell website currently lists six people in their Global Business Environment team and one suspects there is another tier below those named. However, the company clearly believes that this level of investment, (approximately 1 scenario planner to every 8,000 employees), is commensurate with the benefits it delivers for the business.

Scenario planning cannot be expected to provide all of the answers, but it does help a company to ask better questions and prepare for the unexpected. In my book, that makes it worth doing.