While the war in Ukraine is possibly one of the biggest humanitarian catastrophes facing Europe since the second World War, for many businesses it’s also proving extremely challenging, whether they are based in the Ukraine, Russia or Belarus, or are doing business with suppliers, clients or customers in these countries.

No matter how much advice there is to help businesses navigate the current, challenging environment and sanctions against Russia, it cannot make up for a lack of preparation for the eventualities that are currently unfolding.

Did your board or business have any contingency plans ready to deal with the Ukrainian crisis? Arguably, companies which were decisive about pulling out of Russia were able to do so because they had most likely modelled this risk and put contingency plans in place to deal with such an eventuality. Those that are still undecided on whether to pull out, or find that they cannot, may not have any contingency plans in place.

So, the question is how do you prepare for what seemed such an unlikely eventuality? Here we look at forecasting and why scenario planning is crucial for boards and businesses.

The problem with forecasting

There are several issues with forecasting when it comes to anything more complex than basic economic variables, such as economic growth or interest rates. Forecasting them does not come without challenges.

Forecasts tend focus on the short term (1-2 years), play it safe and typically chose the middle option. Additionally, group thinking is an occupational hazard for forecasters. For example, if inflation over the next three years is deemed by experts to range between 2-4% it would take a brave forecaster to pick a number that falls outside this range, or even a number that is not the average or mean forecast. 

Single-point forecasts as well as the underlying assumptions become problematic beyond the short-term time horizon, as not only would the forecaster be placing a bet on a specific outcome quite some time into the future, but they would also be placing a bet that all other possible outcomes are not going to arise.

However, banks and many non-financial service organisations do look at models utilising a wider range of key metrics, including modelling outlying numbers as part of their stress testing. The testing of such alternative quantitative models certainly has its place to manage financial risks to your business plans.

ICAEW’s Audit and Assurance Faculty’s guide to reverse stress testing outlines how companies can go about such an exercise.

But this type of modelling will not prepare you for a significant disruptive scenario, such as a war or a game changing innovation that could make your product and, even your business obsolete. To manage these types of strategic risks, companies and boards will need to look elsewhere.

How scenarios can help plan and prepare

The challenge for companies is how to model the many risks and underlying variables that can lead to significant changes to their operating environment, for instance changes in (geo)politics, economic growth, public opinion, energy demand, or scientific discoveries, among others. Each of these drivers is made up of many interconnected variables and diverging trends.

Scenario planning can help with modelling such complex events.

Scenario Planning is not about predicting the future but rather modelling diverging trends and potential changes in the key drivers (such as changes in geopolitics) in a structured way. The result is a small number (typically 2-4) of plausible, believable future scenarios.

These scenarios do not need to accurately predict an outcome to be useful. Scenarios allow the business (and their boards) to identify strategic risks (and opportunities) to the business as well as rehearse and put plans in place if similar events described in the scenarios were to occur.

Short versus long-term scenarios

The more uncertainty a business faces, the more useful scenario planning becomes. This is why the process typically uses a long-term time horizon. After all, every business faces a great deal of uncertainty if you look 10, 20 or more years into the future.

In the current, rapidly changing environment, as a result of the Ukrainian war, companies may also wish to develop short-term scenarios, making use of tools such as Reverse Stress Testing, that model the various possible outcomes and timelines of the war. In 2020, many companies went through a similar planning process to model scenarios for how to cope with the impact of Covid. 

Businesses that operate in highly dynamic, high-risk environments will also benefit from developing regular short-term scenarios to model those risks.

Boards as well as audit and risk committees should insist on having access to these short-term scenarios and their associated plans, to confirm that any risks are adequately quantified and mitigated.

But these short-term scenarios, although useful exercises, won’t help companies rehearse or generate strategic options for disruptive, or game changing scenarios. Only long-term Scenario Planning can generate those insights.

The benefits of long-term Scenario Planning include:

• Ability to model many interrelated variables concurrently.
• Ability to test existing operations and business plans for robustness.
• Possibility to create alternative strategic options. These options can be generic or scenario specific that are triggered when specific events unfold.
• Ability to rehearse what to do and when.
• Creation of common language for management and the board. Each scenario will have its own nomenclature, which can be used as shorthand for emerging situations that are quickly understood by all relevant stakeholders. Consequently, threats can be more easily managed, and opportunities seized.

The importance of rehearsing and involving the board

Scenarios are most effective if key internal stakeholders are involved in the creation of the scenarios, the testing of existing business plans and the development of strategic options. Stakeholders (including boards) also need to be involved with identifying strategic risks and rehearsing how and when to act. A good process will make efficient and effective use of the different stakeholders’ time.

Boards as well as their audit and risk committees should satisfy themselves that the company has a scenario planning process in place to identify strategic risks and opportunities. They should also confirm that the business has a range of contingency plans and strategic options in place.

But rehearsing what to do in a certain scenario is of even more value. Is the company able to quickly change course if its business plans or, worse, its business model are under threat?  Is the board able to quickly agree on what actions to take if early warning signs indicate that the risks outlined in a scenario may be emerging?

The biggest danger of not rehearsing or involving boards in the scenario planning process is that they may not be willing to act until they have hard proof that a significant event is unfolding, and it may be too late by then.

Rehearsing for different scenarios will allow for rapid consensus building and quick action by boards.

Adapt to survive – a case study: Kodak

A board that is unwilling or unable to adapt quickly can have disastrous consequences in other ways too. A famous case study is Kodak. It invented the digital camera in the 1970’s but killed it off, deeming it as a threat to the analogue photographic film business at the time. The board failed to see the potential, or real threat of this new technology. Consequently, it wasn’t able or in a position to adjust their business course when digital cameras became affordable consumer products in the late 1990’s. This resistance to change and the inability to change course cost Kodak dearly, with the company filing for bankruptcy in 2012 - five years after its digital photography patents expired.