From scenario planning to stress testing: The next step for energy
companies
Utilities
and oil and gas firms have long used scenario analysis, but extraordinary times
call for new measures.
Strategic and financial
scenario analysis has a long,
venerable history at energy companies. Shell Oil popularized the technique in
the 1970s, and almost all of them have adopted it as a vital part of their
decision-making processes. But as executives know well, scenario planning has
its pitfalls; 40 percent of the leaders we surveyed in 2013 said that it didn’t
meet their expectations. Often, companies fall prey to one of several tendencies, such as availability or stability
bias, that hinder the exercise and produce unusable results.
Energy companies are
finding that in today’s volatile world, one flaw of scenario planning is
particularly acute: when business leaders consider a range of scenarios, they
tend to “chop the tails off the distribution” and zero in on those that most resemble their current
experience. Extreme scenarios are deemed a waste of time because “they won’t
happen” or, if they do, “all bets are off.” But this approach leaves companies
dangerously exposed to dramatic changes.
Consider the shocks and
disruptions of recent years. The 2010 Deepwater Horizon disaster had
far-reaching effects on the oil companies involved, and many others. The 2011
Fukushima earthquake and tsunami upended nuclear policy in Japan and elsewhere,
changing the industry’s structure. Geopolitical shocks have upset the plans of
energy companies in too many countries to name. Most recently, the rise of
antiglobalization sentiment has thrown a new wrench into energy planning.
It’s hard to overstate
the consequences of events like these. Take the German experience of Energiewende, the
nation’s transition to sustainable energy. To predict the effects on
electricity prices, most energy companies relied on the classic scenarios—a
base case, with best and worst cases that skewed slightly to either side.
However, the Fukushima disaster vastly accelerated the switch to renewables.
The price of power tanked by more than 50 percent—far worse than the gloomiest
projections. The effect has been devastating: power producers had to write off
tens of billions of euros.
Enter stress testing
At most companies,
scenario analysis looks for the likely development of core risk factors over
time. That approach can work well in an era of gradual change. But at times
like the present, it is extreme risks, not the everyday ones, that should most
concern energy companies. Likewise, it is the prospect of chaotic overnight
change, not gradual shifts, that should keep energy executives awake at night.
Enter stress testing, a
form of scenario planning focused on the tails of the distribution. Scenario
planning and stress testing are methodologically identical; they differ only in
the likelihood of the scenarios they consider. Stress testing therefore
requires a shift in mind-sets. In today’s environment, the sum of low-probability
events quickly adds up to a high probability that one of them will actually
happen. The banking industry offers an example: the financial system has become
so volatile, and subject to so many unexpected disruptions, that regulators now
require banks to conduct comprehensive stress tests.
Let’s be clear: stress
testing will not prevent stress. Nor can it identify, with total confidence,
precisely which stressful scenarios might play out in the future—especially
those that feature “unknown unknowns.” But it can help senior executives to
consider some previously overlooked sources of stress, the potential magnitude
of their impact, and the adequacy of the company’s risk-bearing capacity to
absorb them. Stress testing should be only one element of a risk-management
system, but done well, it can be a tool to build the resilience that today’s
environment requires.
What ‘extreme’ means
Companies need to be
bold as they imagine extreme scenarios; almost nothing is too strange or
ridiculous to consider. To show the range of ideas that energy firms might
contemplate, we offer five extreme scenarios covering several kinds of risk,
from compliance and legal risk to business-model disruption to full-bore
crisis.
Energy for free
Real-time
energy-consumption data are increasingly seen as crucial for a knowledge of
customers and their behavior patterns. Smart meters can identify the appliances
in operation. Combining data sets on electricity use, heating use, and mobility
could provide even more detailed insights. Data-driven companies such as Amazon
might challenge incumbent utilities by offering “energy for free” in exchange
for personal data. In this scenario, utilities lose the customer relationship
and are reduced to mere suppliers of commoditized power. Given the negotiating
power, agility, and customer-centricity of digital giants, margins erode
significantly.
A decentralized energy landscape
New entrants focus on
serving customers in a completely decentralized energy regime, bundling solar
photovoltaic rooftop systems with power-to-heat technologies, powerful
batteries, and electric cars. An integrated solution and a strong, emotionally
compelling brand (such as Tesla’s) help these attackers to reduce residual
demand for grid-based power substantially and to capture the customer
relationship. As in the first scenario, utilities are reduced to suppliers of
commodity power, infrastructure operators, and backup providers. Volumes and
margins shrink quickly in the wholesale and retail businesses, and generation
assets lose value rapidly.
An emissions fraud
A data leak reveals
that a power company has manipulated processes affecting human health—say,
flue-gas purification at a coal plant or the handling and disposal of waste—and
has thus emitted substantially more pollution than allowed. Subsequent
investigation shows that the manipulation was deeply anchored within the
organization: top leaders knew that analyses and impact assessments had
intentionally been skewed. As a result, all energy companies suffer a loss of
public and political trust. They are then subjected to intense scrutiny of
their assets and processes, and this leads to increased regulation, massive
penalties, and personal liability in the form of substantial fines and imprisonment.
A cyberattack on critical infrastructure
Popular movies have
frequently exploited the idea that the infrastructure of modern life is
vulnerable to well-staged cyberattacks. But the real-world Stuxnet virus
succeeded better than anything out of Hollywood in proving that power plants
and other nuclear assets can indeed be sabotaged. A cyberattack that takes
critical infrastructure offline is more probable than ever now that power and
gas grids, street lighting, and traffic control are more and more connected;
the Internet of Things is beginning to reach into every home and building; and
autonomous, connected vehicles are set to emerge over the next few years. In
such a scenario, terrorists hack into the distribution network and shut down
national power systems or even make key assets malfunction or self-destruct.
Public trust would disappear, and energy companies would be subject to enormous
pressure from regulators. Those deemed vulnerable to further attacks might even
lose their operating licenses.
Radical price transparency
Price-comparison
websites, such as Verivox in Germany, have established a strong position in
several European countries. They greatly increase price transparency in retail
markets for power, gas, mobile telecommunications, banking, auto rentals, and
broadband, so retail customers change suppliers more frequently. In a
transparency scenario, price-comparison portals help customers to change their
electricity and gas providers regularly—for example, by acting as energy agents
or through an automated process that selects the cheapest offer at the end of a
contract. Verivox recently announced the first steps in such a process.
With such rapid churn,
utilities may lose many customers—even some who have never indicated any desire
to change their suppliers. Once again, companies might be reduced to providers
of commoditized electricity. Retail margins would wilt in the face of the
negotiating power, agility, and customer-centricity of energy agents.
Assess the stress
To understand the potential
impact of these five extreme scenarios, we modeled their effects on the profits
and losses, balance sheet, and cash flow of a hypothetical utility for each of
several business segments: generation, renewables, trading, distribution, and
retail. After modeling the effects of a scenario separately for each business,
we combined them to show the effect on the enterprise. To be clear on the
overall effects, you must understand, in detail, that the scenarios have
specific impacts on different business units.
For example, it shows
that the energy-for-free and decentralized-energy-landscape scenarios would of
course have a direct and massive impact on revenues, leading to a substantial
loss of equity and an increase in net debt. On the other hand, an emissions
fraud or cyberattack would have almost no relevance for revenues—but equity
would suffer substantially.
The key drivers of these effects: for example, in the
energy-for-free scenario, B2C volumes and market share would decline sharply,
and retail prices would fall by 5 percent. In an emissions-fraud scenario,
operating and maintenance costs would soar by 50 percent, and utilities would
pay regulatory penalties of up to 5 percent of revenues. If a cyberattack
should take down a national grid, affected utilities would have to write off 5
percent of their physical assets; to replace them, they would boost their
budgets for property, plant, and equipment by 7.5 percent. Earnings would
crash, though the effect would be milder after taxes and depreciation.
The financial
implications would be considerable across the scenarios, though none would
necessarily bankrupt a company. Significant profit and liquidity risks appear,
especially in the generation and retail businesses. In the absence of
successful countermeasures, all five scenarios lead to negative recurring
earnings before interest and taxes, revealing major risks for the
sustainability of the current business portfolio. Furthermore, the scenarios
suggest a 10 to 60 percent drop in equity and a 5 to 40 percent increase in net
debt—which might trigger liquidity concerns.
Get ready to improve resilience
Of course, utilities
can forestall or mitigate many of the effects of stress. Hedging and insurance
offer some protection. Establishing a crisis-response team is a no-regrets move for most companies. Better
preparation, such as stronger analytics and
more transparent reporting, can help identify problems such as legal fraud or
cyber vulnerabilities and help companies negotiate with regulators. The German
government, for example, asked utilities to stress test their balance sheets
and cash flows for a planned change in the disposal and storage of nuclear
waste. As a result of the tests, the government took responsibility for these
activities.
Energy companies should
also monitor external developments closely. Today, many utilities are watching the development of battery costs, since if they fall sharply, as they have in solar photovoltaics, generation and retail businesses would be vulnerable.
Some utilities are partnering with or investing in battery companies. Many
long-term strategic options are available, including nimble resource allocation and the transformation of companies into digital utilities.
All these techniques
for building resilience are well covered elsewhere. Our point is that only by
building a stress-testing capability can a company know where to focus its
efforts for resilience. Leaders need to make stress testing an integral part of
the DNA of decision making. They can start by defining a set of suitable stress
tests in two ways: conducting a thorough review of the business system (to see around corners) and questioning basic assumptions. Then they can quantify the potential impact of any
risks and assess the resilience of the company and its individual business
units.
Adding a stress-testing
capability isn’t onerous. Companies will probably need one or two additional
researchers to complement their current market-intelligence and analytics
teams. In all likelihood, the scenario-planning models currently in use can be repurposed
for stress tests.
The strategy function
is stress testing’s natural owner, as part of the main strategic-planning
process and linked to financial planning. The businesses should offer input
much as they do today. Decision-making groups (such as the executive, strategy,
or investment committees) should use stress-test results in their work,
integrating the new capability into the organization. The traditionally strong
links among strategy, finance, and operations should insure smooth integration
and interaction.
By Sven Heiligtag, Susanne Maurenbrecher, and
Niklas Niemann
http://www.mckinsey.com/business-functions/risk/our-insights/from-scenario-planning-to-stress-testing-the-next-step-for-energy-companies?cid=other-eml-alt-mip-mck-oth-1703
