Risk: Seeing around the corners
Risk-assessment processes typically expose
only the most direct threats facing a company and neglect indirect ones that
can have an equal or greater impact.
The financial crisis has reminded us of the valuable lesson that risks gone bad in one part of the
economy can set off chain reactions in areas that may seem completely
unrelated. In fact, risk managers and other executives fail to anticipate the
effects, both negative and positive, of events that occur routinely throughout
the business cycle. Their impact can be substantial—often, much more
substantial than it seems initially.
At first glance, for instance, a
thunderstorm in a distant place wouldn’t seem like cause for alarm. Yet in
2000, when a lightning strike from such a storm set off a fire at a microchip
plant in New Mexico, it damaged millions of chips slated for use in mobile
phones from a number of manufacturers. Some of them quickly shifted their
sourcing to different US and Japanese suppliers, but others couldn’t and lost
hundreds of millions of dollars in sales. More recently, though few companies
felt threatened by severe acute respiratory syndrome (SARS), its combined
effects are reported to have decreased the GDPs of East Asian nations by 2
percent in the second quarter of 2003. And in early 2009, the expansion of a
European public-transport system temporarily ground to a halt when crucial
component providers faced unexpected difficulties as a result of credit
exposure to ailing North American automotive OEMs.
What can companies do to prepare
themselves? True, there’s no easy formula for anticipating the way risk
cascades through a company or an economy. But we’ve found that executives who
systematically examine the way risks propagate across the whole value
chain—including competitors, suppliers, distribution channels, and
customers—can foresee and prepare for second-order effects more successfully.
Risk along the
value chain
Most companies have some sort of process
to identify and rank risks, often as part of an enterprise risk-management
program. While such processes can be helpful, our experience suggests that they
often examine only the most direct risks facing a company and typically neglect
indirect ones that can have an equal or even greater impact.
Consider, for example, the effect on
manufacturers in Canada of a 30 percent appreciation in the value of that
country’s dollar versus the US dollar in 2007–08. These companies did
understand the impact of the currency change on their products’ cost
competitiveness in the US market. Yet few if any had thought through how it
would influence the buying behavior of Canadians, 75 percent of whom live
within 100 miles of the US border. As they started purchasing big-ticket items
(such as cars, motorcycles, and snowmobiles) in the United States, Canadian
OEMs had to lower prices in the domestic market. The combined effect of the
profit compression in both the United States and Canada did much greater damage
to these manufacturers than they had initially anticipated. Hedging programs
designed to cover their exposure to the loss of cost competitiveness in the
United States utterly failed to protect them from the consumer-driven price
squeeze at home.
Clearly, companies must look beyond
immediate, obvious risks and learn to evaluate aftereffects that could
destabilize whole value chains, including all direct and indirect business
relationships with stakeholders. A thorough analysis of direct threats is
always necessary—but never sufficient .
Competitors
Often the most important area to
investigate is the way risks might change a company’s cost position versus its
competitors or substitute products. Companies are particularly vulnerable to
this type of risk cascade when their currency exposures, supply bases, or cost
structures differ from those of their rivals. In fact, all differences in
business models create the potential for a competitive risk exposure, favorable
or unfavorable. The point isn’t that a company should imitate its competitors
but rather that it should think about the risks it implicitly assumes when its
strategy departs from theirs.
Consider the impact of fuel price hedging
on fares in the highly competitive airline industry. If the airlines covering a
certain route don’t hedge, changes in fuel costs tend to percolate quickly
through to customers—either directly, as higher fares, or indirectly, as fuel
surcharges. If all major companies covering that route are fully hedged,
however, that would offset changes in fuel prices, so fares probably wouldn’t
move. But if some players hedge and others don’t, fuel price increases force
the nonhedgers to take a significant hit in margins or market share while the
hedgers make windfall profits.
Companies must often extend the
competitive analysis to substitute products or services, since a change in the
market environment can make them either more or less attractive. In our airline
example, high fuel prices indirectly heighten the appeal of video-conferencing
technologies, which would drive down demand for business travel.
Supply chains
Classic cascading effects linked to supply
chains include disruptions in the availability of parts or raw materials,
changes in the cost structures of suppliers, and shifts in logistics costs.
When the price of oil reached $150 a barrel in 2008, for example, many offshore
suppliers became substantially less cost competitive in the US market. Consider
the case of steel. Since Chinese imports were the marginal price setters in the
United States, prices for steel rose 20 percent there as the cost of shipping it
from China rose by nearly $100 a ton. The fact that logistics costs depend
significantly on oil prices is hardly surprising, but few companies that buy
substantial amounts of steel considered their second-order oil price exposure
through the supply chain. Risk analysis far too frequently focused only on
direct threats—in this case, the price of steel itself—and oil prices didn’t
seem significant, even to companies for which fluctuating costs may well have
been one of the biggest risk factors.
Distribution
channels
Indirect risks can also lurk in
distribution channels: typical cascading effects may include an inability to
reach end customers, changed distribution costs, or even radically redefined
business models, such as those recently engendered in the music-recording
industry by the rise of broadband Internet access. Likewise, the bankruptcy and
liquidation of the major US big-box consumer electronics retailer Circuit City,
in 2008, had a cascading impact on the industry. Most directly, electronics
manufacturers held some $600 million in unpaid receivables that were suddenly
at risk. The bankruptcy also created important indirect risks for these
companies, in the form of price pressures and bargain-hunting behavior as
liquidators sold off discounted merchandise right in the middle of the peak
Christmas buying season.
Customer
response
Often, the most complex knock-on effects
are the responses from customers, because those responses may be so diverse and
so many factors are involved. One typical cascading effect is a shift in buying
patterns, as in the case of the Canadians who went shopping in the United
States with their stronger currency. Another is changed demand levels, such as
the impact of higher fuel prices on the auto market: as the price of gasoline
increased in recent years, there was a clear shift from large sport utility
vehicles to compact cars, with hybrids rapidly becoming serious contenders.
Consider too how the current recession has shrunk the available customer pool
in many product categories: demand for durable goods plummeted among consumers
holding subprime mortgages as their access to credit shrank, and demand for
certain luxury goods fell as even financially stable consumers turned away from
conspicuous consumption.
Effects on a
company’s risk profile
Risk cascades are particularly useful to
help assess the full impact of a major risk on a company’s economics. Exploring
how that risk propagates through the value chain can help management think
through—imperfectly, of course—what might change fundamentally when some
element in the business environment does.
To illustrate, let’s examine how the risk
posed by new carbon regulations might affect the aluminum industry. Aluminum
producers would be directly exposed to such regulations because the
electrolysis used to extract aluminum from ore generates carbon. They're also
indirectly exposed to risk from carbon because the suppliers of the electrical
power needed for electrolysis generate it too. The carbon footprint can be
calculated easily and its economic cost penalty determined by extrapolation
from different regulatory scenarios and the underlying carbon price
assumptions. This cost penalty would of course depend on the carbon efficiency
of the production process and the fuel used to generate power (hydropower, for
instance, is more carbon efficient than power from coal).
In general, large industrial companies
believe they are “carbon short” in the financial sense—their profits get
squeezed when carbon prices increase. Is that always true? A different story
emerges from a closer look at the supply chain, which stiffer carbon
regulations would change in many different ways. The cost of key raw materials,
such as calcined petroleum coke and caustic soda, would increase, along with
logistics costs and therefore geographic premiums. The US Midwest market
premium, for example, reflects the cost of delivering a ton of aluminum to the
region, where demand vastly exceeds local supply. Not all competitors in the
industry would be affected alike: this effect favors smelters located close to
the US Midwest, because they could then pocket the higher premium. Some
suppliers might even benefit from their geographic position.
Moreover, in a carbon-constrained, tightly
regulated world, aluminum becomes a material of choice to build lighter, more
fuel-efficient cars. Since automobile manufacturing is one of the largest end
markets for aluminum, carbon regulation could substantially accelerate demand,
thus helping to support healthy margins and attractive new development
projects. Clearly, a high carbon price would enhance aluminum’s value
proposition—positive news for the industry.
Finally, carbon regulations would affect
not only a particular company but also its competitors, changing the economics
of the business. For commodity industries, the cash cost of marginal producers
sets a floor price. In a world where carbon output has a price, the cost
structure of different smelters would depend on their carbon intensity (such as
the amount of carbon emitted per ton of aluminum produced) and local carbon
regulations. It’s possible to show how any regulatory scenario could influence
the aluminum cost curve. In nearly all the plausible scenarios, the curve
steepens and the floor price of aluminum therefore increases. For most industry
participants, especially very carbon-efficient ones (such as those producing
aluminum with hydropower), a meaningful margin expansion could be expected.
A simple risk analysis suggested that one
of our clients would be carbon short and that its profits would therefore
decrease under new carbon regulations. But a more extensive view of the way
carbon risk cascades through the industry value chain shows that this company
would actually be carbon long: as carbon prices increase, the company benefits
economically thanks to its high carbon efficiency, its desirable geographic
location (proximity to the US Midwest), and the potential added demand for
aluminum.
Unknown and unforeseeable risks will
always be with us, and not even the best risk-assessment approach can identify
all of them. Even so, greater insight into the way they might play out can
provide a more comprehensive picture of an industry’s competitive dynamics and
help shape a better corporate strategy. Thinking about your risk cascades is a
concrete approach to gaining that insight.
By Eric Lamarre and Martin Pergler
http://www.mckinsey.com/business-functions/risk/our-insights/risk-seeing-around-the-corners?cid=other-eml-cls-mkq-mck-oth-1611
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