The beginning of each new year is high season for listing the risks that are most likely to keep executives and board directors up at night. But like streamers on the floor, empty champagne bottles, and dried-out holiday greenery, most are quickly cast aside and all but forgotten.
That is a pity, because these lists can be a helpful exercise when used properly. Regularly taking stock of the probable risks facing your organization helps to keep from getting trampled by “gray rhinos,” which may be charging right at you or grazing on the horizon. A “gray rhino” is a highly probable, high impact, yet surprisingly often neglected threat. Unlike the unforeseeable, even unimaginable black swan, gray rhinos are not random surprises but rather obvious, clear and present dangers. They are the subject of headlines and many discussions, and even some actions, but too often are not dealt with in time or effectively.
We ignore these dangers at our own peril. Yet we humans often fail to manage the things we know will become problems. The more complex a risk is, or the more difficult the solution, the less likely we are to handle it promptly and effectively. Misplaced incentives to focus relentlessly on the short term can blind us to the greater cost of ignoring dangers and opportunities farther down the road.
It is not enough to enumerate dangers and opportunities just for the sake of making a list. Once you have identified the gray rhinos facing your organization, it is time to do a much deeper scenario analysis: a range of ways they might affect your business and your competitors, how well prepared you and others are to respond effectively and how these risks affect each other.
A Crash of Gray Rhinos for 2023
The zoological term for a group of rhinos is, appropriately enough, a “crash.” Here, then, is a crash of three global, stampeding gray rhinos with summaries of some of their consequences and how they relate to each other: financial fragilities, global tectonic shifts and climate change.
Financial fragilities. Several threats loom over the global economy, creating challenges for companies. Supply-chain bottlenecks, trade wars and loose monetary policies have fed inflation and price instability, especially around food, energy and real estate, and, in turn, have dampened consumer and business confidence. Responding with higher interest rates, central banks have created knock-on effects on financial markets, access to credit and flagging economic growth. Rising rates already are causing troubles in highly speculative markets, among “zombie” companies whose revenues cannot keep up with interest payments and emerging-market economies.
Global tectonic shifts. Political instability in the United States has led Russia, China and other nations to surmise that it is a declining power. Russia's invasion of Ukraine and territorial ambitions has unnerved Europe and its allies. The United States and China are caught in a vicious circle of economic and political tensions. Great-power rivalries have fed inflation by adding to supply chain and energy market shocks. Tensions also have heightened worries over cross-border cyberattacks on key infrastructure, the economic costs of tech decoupling and failure to collaborate on digital standards, and obstacles to climate cooperation. They interfere with the flow of information and skills across borders and add to an “uncertainty tax” on the global economy.
Climate crisis. Extreme weather feeds food-price inflation and threatens financial stability though its impact on insurance, real estate, municipal finance and more. Businesses need to pay attention to what facilities and markets are most vulnerable and how they can reduce their emissions. Geopolitical conflict threatens to make the net-zero transition choppier by hurting clean tech trade and access to key minerals. As regulators require increased reporting on climate risk and impact, U.S. political theater threatens asset managers and companies employing ESG screens and policies while complicating efforts to harmonize standards.
Note how each of these gray rhinos connects with the others. A more stable U.S. political environment could lead to progress in calming geopolitical tensions and, in turn, improve the prospects of brighter financial and climate outcomes. By contrast, worsening tensions could have catastrophic domino effects.
Most top-risk lists emphasize potential threats. In reality, each scenario can bring both dangers and opportunities, depending on how your organization is positioned. If you are cash-rich, for example, a recession may be an opportunity to snap up assets at a discount. If you're a clean-tech firm, the urgency of a zero-carbon transition to slow the climate crisis is an opportunity. If you're an oil company, the energy transition may give you the opportunity to sell lower volumes at higher margins — or it may leave you with stranded assets.
That is why scenario analysis — including the specific impact of these gray rhinos on your organization given your strategic and operational strengths and weaknesses — is essential.
Futureproofing for Global Gray Rhinos
How should corporate executives and directors manage gray rhinos and other disruptive risks facing their organizations? Scenario analysis is a valuable, time-tested tool for assessing the potential negative and positive impacts of critical events. This technique is especially important when little or no historical data or experiences are available to help guide your responses.
Scenario analysis works best when organizations draw on the diverse backgrounds, experiences and skills of their boards. Board and executive management collaboration generates strategic insights involving key performance and risk drivers and helps establish a set of early-warning indicators to flag developments requiring swift action.
A Seven-Step Methodology
The seven-step scenario analysis methodology developed by one of the authors can help make sense of how the gray rhinos of 2023 may affect your organization, particularly involving financial fragilities. Dislocations in financial markets impact not only financial institutions, but also the business, investment and funding activities of all organizations.
Source: James Lam & Associates, Inc.
The seven steps are as follows:
- Industry-competitive analysis
- Enterprise risk analysis
- Scenario development and analysis
- Board/management workshops(s)
- Early-warning indicators
- Action triggers and decisions
- Monitoring and reporting
Industry-competitive analysis. In this foundational step, management assesses key external performance drivers including industry, regulatory, technology, social, macroeconomic and geopolitical trends. In other words, this provides an “outside-in” strategic analysis of the company's competitive positioning.
Enterprise risk analysis. Turning to a quantitative, “inside-out” analysis, management develops short- and long-term financial projections, performs sensitivity analyses using earnings-at-risk and value-at-risk models, identifies key performance and risk drivers, and measures risk-adjusted profitability by business segment.
Scenario development and analysis. Using the baseline model developed in the first two steps, management develops a range of positive and negative scenarios and their potential impacts on the company. Scenarios may include competitive shocks, breakout product successes, disruptive technologies, geopolitical risks, large-scale cyberattacks, regulatory changes and financial markets dislocations. Best-case scenarios may increase the company's value by, say, five to 10 times in a few years. Worst-case outcomes may severely hurt business performance or even lead to bankruptcy. The scenarios you develop provide a range of possible future states for the company to consider.
Board/management workshop. Management organizes a workshop to obtain valuable input from the board. Participants review the scenarios, discuss strategic and risk implications, and challenge and fine-tune key assumptions, leading to a few, more deeply developed scenarios. Directors and executives may also agree on the key internal and external trends that need to be monitored, changes to the risk appetite statement and board reporting, and executive and board responsibilities to develop and approve key decisions.
Early-warning indicators. For each scenario, the company develops a set of early-warning indicators to signal that a specific outcome may be materializing. With respect to financial fragility, key external indicators may include yield-curve inversion, increases in actual and implied price volatility, increases in cash and derivative credit spreads or breakdowns in historical price correlations. Key internal indicators may include sharp changes in revenue, cash reserves or refinancing costs.
Action triggers and decisions. For each indicator, management establishes specific “trigger points” to indicate whether to continue to monitor (green), review and investigate (yellow) or consider taking action (red). Strategic actions to protect from financial fragility may include cutting expenses, raising liquidity and capital reserves, and reducing the company's overall risk profile.
Monitoring and reporting. To support oversight and effective execution, management incorporates the output from the scenario analysis into its ongoing monitoring and reports to the board, including industry intelligence, enterprise risk analyses, early-warning indicators, and action plans. This additional content adds externally focused, forward-looking and actionable information.
Pulling It All Together
Together, gray rhino identification and scenario analysis are crucial for improving organizations' ability to stay on top of major business trends, analyze the potential impact on their performance and risk profile, and make more timely strategic decisions.
These abilities to respond are what distinguish the organizations that get trampled by obvious, probable gray rhino risks from the ones that turn the power of those gray rhinos to their advantage.