Most companies remain as vulnerable as ever to risks that may initially appear unrelated until an unanticipated event occurs. Emerging risks are risks triggered by unexpected events, such as the volcanic eruption in Iceland, and familiar risks in unfamiliar conditions, such as the souring mortgages that triggered the financial crisis. While many senior executives prepare for obvious business threats such as a prolonged global recession, only 10 percent incorporate potential threats related to environmental issues, societal risks and technological concerns into their risk indicators, according to a survey conducted by Oliver Wyman in collaboration with the Financial Times.
Emerging risks are increasingly introducing volatility into companies’ earnings. Across industries and geographies, these risks are jeopardizing companies’ supply chains, impacting raw material prices and threatening the security of critical industrial information. In effect, they are transforming the very nature of many companies’ business models, while receiving little to no attention in the boardroom or the executive suite.
Companies need to prepare for a new reality in which emerging risks increasingly impact their earnings and long-term strategy. Those that develop the ability to manage emerging risks will gain a significant competitive advantage over rivals who lack this level of sophistication.
Emerging Risks Explained
The inherent unexpectedness of emerging risks is the fundamental reason companies still struggle to identify and assess them. A survey of 650 senior executives we recently conducted with the Financial Times revealed that 90 percent of respondents’ organizations have made efforts to increase their capacity to identify emerging risks. Nevertheless, 62 percent of senior managers still consider their firms to be “ineffective” or only “moderately effective” at incorporating these risks into their business decisions.
Companies need to develop the ability to integrate emerging risks into their decision making. Volatile commodity prices are becoming some of the largest and most unpredictable costs for organizations ranging from consumer products manufacturers to transportation companies to food processors. In November of 2010, German auto parts supplier Continental AG announced weaker-than-expected quarterly earnings because of rising raw material prices. Food distributor Sysco Corp. missed its earnings estimates because of surges in the prices of dairy, meat and produce. And Archer Daniels Midland Co., the world’s largest grain processor, had weaker earnings because of rising commodity prices.
The Need to Redefine Business Models
Weaker-than-expected quarterly results are only a small portion of the much larger dilemmas that emerging risks create. In many ways, these risks are altering the essence of many companies’ business models.
Highly volatile raw material prices, for example, are rewriting the rules for how companies must conduct business. For much of the second half of the 20th century, agricultural prices declined fairly steadily. In more recent years, many crop prices have tripled and remained at a high level over several seasons. In the last year, sugar prices have ranged from 13 to 30 cents per pound, while wheat prices have surged by more than 100 percent.
Sudden shifts in agricultural prices will continue for several reasons. First, the global demand for food is increasing, straining agricultural supply. Also, as populations grow and become more affluent, people are consuming more protein and processed food, which requires additional agricultural inputs to produce. Second, the number of extreme weather events is rising, causing more frequent disruptions of supply and introducing volatility into increasingly tight agricultural markets. Finally, fluctuating agricultural prices are attracting financial trading participants who are exacerbating already unpredictable price movements.
Taken together, these developments are creating billions of dollars in potential new costs that will be difficult for the food industry to pass on to consumers, especially as the global economic recovery remains sluggish. That means food companies, ranging from processors to manufacturers to restaurants, could feel significant strains on working capital and pressure on margins.
The same is true for airlines. Crude oil prices spiked, tumbled, and then doubled back to $70 a barrel in 2009: we estimate that jet fuel became more than half of top airlines’ total losses that year. CEOs of a number of airlines have expressed concerns about rising fuel bills in 2011 and the resultant impact on profitability. If airlines do not adjust their business models to account for these conditions, they will continue to remain vulnerable to jet fuel price swings.
When Non-Core Becomes Core
Another way that emerging risks are redefining organizations is by introducing uncertainty in earnings through non-core activities. Many companies are discovering that the commodities they use have more of an impact on their earnings than their ability to increase efficiencies or to boost the sales of their core products or services. CEOs of heavy industrial companies, consumer products companies and even restaurant chains are increasingly attributing missing earnings estimates to vacillating prices for electricity, diesel fuel and natural gas.
In some cases, emerging risks are prompting companies to embark on ancillary activities that are morphing into businesses that account for a significant percentage of their earnings. Often these activities are highly profitable, but they require a different skill set from senior executives and introduce a much higher level of volatility into a company’s overall business.
As a result, senior executives are being forced to make tough decisions about whether they want to be in businesses they never anticipated entering—like trading commodities and generating power—or to spin off these operations. For example, after commodity trading and merchandising operations started to account for a large percentage of the profits of ConAgra Food Inc., the food maker sold the operations to the hedge fund Ospraie Management for $2.8 billion. According to a Wall Street Journal report, ConAgra did this in order to remove volatility from its earnings and to focus on its consumer brands like Chef Boyardee pasta.
A Three-Dimensional Approach
Given the quandaries that emerging risks are creating for companies, senior executives cannot afford to ignore them. Instead, they must take a three-dimensional approach to tackling emerging risks.
The first dimension involves a reverse stress test of the financial resiliency of a company’s operations. In addition to spending time identifying what highly improbable event could impair their companies, senior executives should pay increased attention to assessing the size of a financial shock that could destabilize their business. For example, they should determine the amount of financial deterioration that would need to occur before it would trigger a potentially debilitating downgrade of the company’s credit rating.
Designing a framework to achieve this is not easy. Companies that operate in the same industry and even geography can have very different exposures to emerging risks, depending on their financial structure, the nature of their supply chain, their exposure to raw materials and other inputs, and their contractual relationships with customers and suppliers.
After determining how large a financial shock a company can endure regardless of its source, senior executives should examine the potential impact of emerging risks from a second dimension: risk-adjusted scenario planning. By doing so, they not only gain insight into specific situations or a series of events that can result in a loss, but also understand how the range of potential outcomes will impact their company’s portfolio of businesses. These include both those events that are internally driven, such as a disruption in operations, as well as those tied to the external business environment, such as credit tightening. Such planning exercises can reveal not only how potential risks can impair a business, but also how risks can enable a company to gain a competitive edge.
The third dimension that senior executives have to consider is the impact of macroeconomic shifts outside of their control such as commodity prices, consumer demand, currency values and interest rates. While many companies may consider how one of these factors could impact the performance of the organization or the earnings of a business unit, it is important to examine the net effect of multiple macroeconomic shifts across the entire portfolio.
For this type of scenario testing to be effective, executives must also determine the impact of a wide variety of correlated macroeconomic shifts – both those that occur on an ongoing basis and as potential single events. For example, they must understand the combined implications of slowed Chinese GDP growth, interest rate increases and volatile crude oil prices.
A Competitive Advantage
By designing such frameworks, companies can anticipate outcomes and quickly respond when an event strikes. They will be able to pinpoint areas of vulnerability under different market conditions and the net impact on the overall organization. These insights allow senior executives to focus on initiatives to mitigate emerging risks and to capitalize on the resultant market conditions.
Sometimes senior executives who succeed in identifying which emerging risks could cripple their companies are challenged to do anything about it. Some rationalize inaction by assuming that their competitors will suffer the same consequences. Others feel overwhelmed by the prospect of addressing events that are difficult to conceive of and complex.
Business models are being transformed by emerging risks in powerful ways, whether companies choose to acknowledge this fact or not.
These changes have potentially severe consequences for those senior executives who are unprepared for them. But they also present a significant opportunity: Business leaders who address these risks with a sophisticated, multidimensional approach will gain a significant competitive advantage over rivals who don’t.