Scenario planning techniques can significantly reduce risks in the innovation chain Page 1 of 5

The new New Economy Analyst Report – Sept 08, 2001

Juergen Daum’s new New Economy Best Practice service
©2001 Juergen Daum. All rights reserved.

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How scenario planning can significantly reduce strategic risks and boost
value in the innovation chain
News categories: the New Economy Economics, strategic enterprise management and business performance management, value based management

Industrial value chain processes no longer dominate value creation in the developed economies. Today it is
innovation, it is seeking new ways of meeting market demands, that is yielding the highest return on
investment - much more than improving incrementally a company’s existing production line. And that means
that companies in nearly all industries have to invest into systematic innovation and related intangible
assets like R&D. The problem with these investments is, that they generate a financial return only after a
considerable amount of time has passed and that they are often much more subject to external influences,
such as changes in the market or customer preferences, than investments in tangible assets. And these
influences can have a dramatic impact on the value of these investments. Innovation investments are
therefore usually associated with large inherent risks. When a pharmaceutical company starts to develop a
new compound, it does not know, if these typically very large investments will generate any benefit in the
future. Success often is dependent on many factors – internal factors such as the skills and knowledge of
researchers and developers, and external influences such as technology trends, demand and price
developments etc..

From stock options valuation we know, that the higher the risk, the higher the possible return. And the value
of a stock option can be exponentially increased, if you are able to limit the downside, the inherent risk.
There exists also a second value lever, which is the identification and leverage of sudden opportunities. And
one very powerful technique to limit risks from external influences and to identify future opportunities is
scenario planning.

What is scenario planning ?

Scenario planning is a discipline for rediscovering

the original entrepreneurial power of creative foresight
in contexts of accelerated change, greater
complexity, and genuine uncertainty.
—Pierre Wack, Royal Dutch/Shell, 1984

To manage risks related to innovation investments that extend long into the future, managers must be
willing to look ahead and consider uncertainties. But rather than doing that, many people react to
uncertainty with denial. They take an unconsciously deterministic view of events. They take it for granted,
that some things will or will not happen. Not having tried to foresee surprising events, they are at a loss for
ways to act when upheaval takes place. Scenario planning is a tool for helping managers to take a view into
the future in a world of great uncertainty. It is a tool to manage strategic risks and opportunities.

Scenario planning is the process in which managers invent and then consider, in depth, several varied
scenarios of equally plausible futures with the objective to bring forward surprises and unexpected leaps of
understanding. These scenarios represent a tool for ordering the perceptions of a management team. The
point is not to select one preferred future and hope for it to become true. Nor is the point to fund the most
probable future and adapt to it. Rather, the point is to make strategic decisions that will be sound for all
plausible futures. No matter what future takes place, a company and its management team is much more
likely to be ready for it and influential in it, if it has seriously thought about scenarios. Scenario planning is
about making choices today with an understanding of how they might turn out.

The history of scenario planning

The scenario planning concept first emerged following World War II, as a method for military planning. The
U.S. Air Force tried to imagine what its opponents might do, and to prepare alternative strategies. In the
1960s, Herman Kahn, who had been part of the Air Force effort, refined scenarios as a tool for business
prognostication. He became one of America’s top futurist. Then scenarios reached a new dimension in the

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early 1970s, with the work of Pierre Wack, who was a planner in the London offices of Royal Dutch/Shell in
a newly formed department called Group Planning. Pierre Wack and other planners were looking for events
that might affect the price of oil. And they found several significant events that have been in the air. One
was, that the United States was beginning to exhaust its oil reserves. At the same time American demand
for oil was steadily rising. And the emerging Organization of Petroleum Exporting Countries (OPEC) was
showing signs of flexing its political muscle. Most of these countries were Islamic, and they bitterly resented
Western support of Israel after the 1967 six-day Arab-Israeli war. Looking at this situation, the planning
team realized that Arabs could demand much higher prices for their oil and there was every reason that
they would. The only uncertainty was when. It seemed likely to happen before 1975 when old oil price
agreements were due to be renegotiated. So Pierre Wack and his team wrote up two scenarios – each a
complete set of stories about the future, with tables of projected price figures.

The first story presented the usual opinion at Shell: that the oil price would stay somehow stable. But in
order for that to happen, a miracle would have to occur. New oil fields, for example, might have to appear
in non-Arab countries. The second scenario looked at the more plausible future – an oil price crisis sparked
by OPEC. But after they have presented these scenarios to Shell’s management, there was no change in
behavior happening. The managers understood the implications, but no change in behavior came. So
Pierre Wack went one step further and described for the scenarios the full ramifications of possible oil price
shocks and he tried to make people feel those shocks through the scenario. He warned management, that
the oil industry might become a low growth industry, that OPEC countries would take over Shell’s oil fields.
They described the forces in the world, and what sorts of influences those forces had to have. This was
when scenario planning for businesses was born. It helped Shell’s managers to imagine the decisions they
might have to make as a result. And it was just right in time. In October 1973, after the Yom Kippur war in
the Middle East, there was an oil price shock and of the major oil companies, only Shell was prepared for
the change. The company’s management responded quickly and in the following years, Shell moved from
one of the weaker of the seven large oil companies that existed at that time to the second in size and the
number one in profitability.

So to operate in an uncertain world, managers need to be able to question their assumptions about the way
the world works, so that they could see the world more clearly. The purpose of scenario planning therefore
is, to help managers to change their view of reality, to match it up more closely with reality as it is, and
reality as it is going to be. The end result, however, is not an accurate picture of tomorrow, but better
decisions about the future.

How the does the scenario planning process work ?

Peter Schwartz, an expert in scenario planning, described this scenario planning technique in his book: The
Art of the Long View (New York: Currency Doubleday, 1996). The book is an excellent description of the
scenario planning concept including many case studies and examples. The rough concepts goes like this:

Step1: Uncovering the decision

Management has to understand its choices. For this it has to know, what will be “on the agenda”. For each
company decisions loom in the near or immediate future. Management’s responses to them will determine
much of its future performance and survival. So in the first step these strategic decisions that might have to
be made in the future have to be uncovered. This is done by asking the right questions related to the
mission and business purpose of a company such as: where is our industry going? What is the path of
development of our industry ? What events might influence it and will force us to change ? Under which
circumstances might we become incredible successful, under which circumstances will the company be at
risk ? It takes persistent work to penetrate the internal mental defenses of human beings. Therefore this
task includes examination of existing mind-sets of managers, so that prejudices and assumptions become
obvious, and careful thinking whether those mind-sets would keep these managers from seeing the right
future. The best way is to begin with important decisions that have to be made anyway and then built out to
the environment. This step also should include an identification of the key factors of the business system
influencing the success or failure of the decision.

Step2: Information-hunting and –gathering

To create scenarios, stories, that resonate in some ways with what people already know and leads them
from that to question their assumption of how they see the world, observations from the real world must be
built into the story. The scenario process thus involves research – skilled hunting and gathering of
information. This is practiced both narrowly – to pursue facts needed for a specific scenario – and broadly –
to educate the scenario planner, so that he is able to pose more significant questions. Flexibility of
perspective is critical in doing it. The scenario planner has to simultaneously focus on what matters in a
given decision situation, but keep awareness open for the unexpected. Because some research subjects

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emerge again and again in the work of a scenario planner, some planners recommend to move along these
typical topics during research before looking for others. Such typical topics are: science and technology
developments; perception-shaping events, that shape or change the perception of the public; new ideas
that emerge in the “fringes” (that means not in the mainstream) and are spreading further.

Step3: Identifying the driving forces of a scenario

The first task in building the scenario itself is to look for driving forces, the driving forces of the macro-
environment that influence the key factors identified earlier. For example government regulations might
influence them. But beside government regulations, there are many less obvious external factors as well.
Identifying and assessing these fundamental factors is both the starting point and one of the objectives of
the scenario method. Driving forces are the elements that move the plot of a scenario, that determines the
story’s outcome. Driving forces often seem obvious to one person and hidden to another. Therefore the
identification of driving forces should be done in a team, by brainstorming together. By looking on such
driving forces, it is helpful to run through this common list of categories of driving forces: social
forces/demographic developments, technological developments, economic developments and events,
political developments and events, environmental developments. Normally, companies have little control
over driving forces. Their leverage for dealing with them comes from recognizing them, and understanding
their effect.

Step4: Uncover the predetermined elements

Predetermined elements are developments and logics that work in scenarios without being dependent on
any particular chain of events. That means, a predetermined elements is something, that seems certain, no
matter which scenario come to pass. For example the most commonly recognized predetermined element
is demographics, because it is changing so slowly. For example the Soviet Union experienced a sharp
decline in births during and immediately after World War II. One generation later, in the 1960s and 1970s,
that original “baby bust” was echoed by an even greater decline than we saw for example in the U.S.. In the
mid-eighties therefore the U.S.S.R. experienced a decline in its labor force as fewer and fewer young
people came of age. This might have induced its economic breakdown which has lead to its political
breakdown. Since the 1960s and 1970s, the decline in labor force in the U.S.S.R. in the mid eighties was a
predetermined element. Identifying such elements is a tremendous confidence builder in strategic decision
making. Managers can commit to some policies and feel sure about them. There are several useful
strategies for looking for predetermined elements. For example you could look for slow-changing
phenomena like the growth of populations or the building of physical infrastructure. You could look for
constrained situation, where companies, nations or even individuals have, at least for a certain time, no
choices. Look for “in the pipeline” effects. Today we already know what the teenage population in Germany
in the 2000s will be. All of them are born already and are already “in the pipeline ”.

Step5: Identify critical uncertainties

In every plan critical uncertainties exist. Scenario planners seek them to prepare for them. Critical
uncertainties are often related to predetermined elements. You find them by questioning your assumptions
about predetermines elements and chains of predetermined elements. For example consider the publishing
industry of a specific country. The readership population is mostly predetermined – it depends on
demographics. Literacy is also a crucial element to estimate demand, but it is far from predetermined. It
depends on decisions made by government, on its education policy in the next years. Thus, the quality of
education now will influence the print media market in the next twenty years. So critical uncertainties are the
variables in scenario planning and are the basis to create different scenarios in parallel. One method to
identify the most important critical uncertainties is, to rank key factors and driving forces on the basis of two
criteria: first, the degree of importance for the success of the focal issue or decision identified in step one;
second, the degree of uncertainty surrounding those factors and trends. The point is to identify the two or
three factors that are most important and most uncertain. These factors are forming then the basis for the
different scenarios, because the goal is to end up with just a few scenarios whose difference make a
difference to decision-makers.

Step6: Composing scenarios

To explain the future, scenarios describe how the driving forces might plausibly behave, based on
assumption of predetermined elements and critical uncertainties. To describe the different scenarios, their
plots, you use the uncertainties that have seemed so important. For example for the publishing industry,
scenarios may be created, depending on the degree of literacy. In scenario one, a large number of literate
people spend some of their time reading. Scenario two is the opposite: people become more oriented to
television and radio because reading is unable to hold their attention. But there is also a third possible
scenario – even faster growth for print media, because more people spend their time with a variety of
media, including the Internet, which mutually reinforce each other. So driving forces, predetermined
elements, and critical uncertainties give structure to the exploration of the future. To create the scenario
stories, the plot lines, the recommendation is, to bring a team together that is aware of the decision that is

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considered. Each member of the scenario planning team has done his or her research. Then they sit
together talking and developing ideas in response to the questions: What are the driving forces ? What we
feel is uncertain ? What is inevitable ? How about this or that scenario ? The goal is to select plot lines that
lead to different choices for the original decision. The challenge is to identify the plots that best captures the
dynamics of the situation and communicates the point effectively. The scenario writer’s task is then, to
define the forces inside and outside the company, and analyze which plots they fit. Having gathered the
variations that are possible, the scenario writer would tease out five or six variations that fit the case.
Eventually he or she narrow and combine those into two or three fully detailed descriptions of what might
happen – the scenarios.

Step7: Analysis of implications of the decisions according to scenarios

Once the scenarios have been developed in some detail, then it is time to return to the decision identified in
step one. How does the decision look in each scenario ? What vulnerabilities have been revealed ? Is the
decision or strategy robust across all scenarios, or does it look good in only one or two of the scenarios ? If
a decision looks good in only one of several scenarios, then it qualifies as a high-risk gamble, especially if
the company has little control over the likelihood of the required scenario coming to pass. The question
what should be discussed then by management is, how the strategy should be adapted to make it more
robust if the desired scenario shows signs of not happening.

Step8: Selection of leading indicators and signposts

It is important to know as soon as possible which of several scenarios is closest to the course of history as it
actually unfolds. For that, as soon as the different scenarios have been finished and their implication for the
decision determined, then a few indicators should be selected, to monitor the strategy or decision in an
ongoing way. Monitoring these indicators will allow a company to know what the future holds for a given
industry and how that future is likely to affect strategies and decisions in the industry. If the scenarios have
been carefully developed, then the scenarios will be able to translate movements of few key indicators into
an orderly set of industry -specific implications. The logical coherence that was built into the scenario will
allow logical implications of leading indicators to be drawn out of the scenarios.

Summary

Risks associated with investments into intangibles, especially of investments into the strategy and in the
product innovation chain of a company, is much higher than in traditional industrial physical asset type of
investments. But on the other hand the upside is often unlimited. So businesses which are engaged in R&D
and continuous product and market innovations must find ways to limit the downside, the risks, and to boost
the upside in order to fully leverage their investments and to generate value for investors and other
stakeholders. In order to do that, they have to tap into tacit information that is already available within or
outside the company and to convert it into knowledge about possible future scenarios and options the
company has, to react before unfavourable events take place. And scenario planning is a very good
to do that and to limit especially large strategic risks.

Additional resources:

More information about scenario planning can be found at the website of GBN Global Business Network .

How to incorporate more predictive information into the business performance management process of a
company (scenario planning is a technique to support the strategy management process) and how to get
of the traditional performance management process that limits managers thinking to the past and present,
described in the new New Economy Analyst Report about the Beyond Budgeting concept from May 22,
2001.

I will continue in future reports to present some other methods, which complement scenario planning, such
as real options valuation (to manage risks) and systems thinking (to identify limits to growth). To subscribe
for my free-of-charge e-mail newsletter click here.

A comprehensive concept for a new management system for knowledge and intangible assets based
businesses, that integrates strategy management (strategic innovation) and product and market
development (product and market innovation) with operations management (supply chain management,
customer relationship management) and resource management (finance, hr, alliances, IT) is described in
detail in my forthcoming book "Intangible Assets oder die Kunst, Mehrwert zu schaffen: Erfolgreiche
Unternehmensführung im Zeitalter des Intellectual Capital" ("Intangible Assets or the Art to Create Value:

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Successfull Enterprise Management in the Era of Intellectual Capitalism").

Additional books about scenario planning and more forward looking management techniques can be found
in Juergen Daum’s book store, section “The learning and adaptive organization”.

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