How to use Scenario analysis in the context of the Covid-19 crisis ?
What is scenario planning ?
Although scenario planning has been in use since the 1970’s, it is still a great tool to brainstorm and plan what would be the impact on the business but above all how the company could adapt to these different scenarios. Paul Schoemaker[1] considers that it is recommended when “uncertainty is high relative to the manager’s ability to predict or adjust”. Scenario planning is different from sensitivity analysis which focus only on one or two factors. Scenario analysis aims to consider several complete sets of factors, how they would impact the business and what would be the appropriate measures to be taken to adapt to the change in assumptions.
Today we are in the midst of the crisis related to the coronavirus, it is no more time to design scenarios taking into account such a black swan but it is urgent to envisage the different scenarios which can occur to exit the crisis. Economist views are diverging whether we can have a sharp V scenario (that is to say coming back to business as usual almost as soon as the lockdown ends), a smooth recovery or a long-term recession. It is thus necessary for management teams to design the impact of such scenarios on their business and how the company would react and anticipate these impacts.
How to define the different scenarios ?
The Note[2] from Bruno Tertrais of the Fondation pour la Recherche Stratégique highlight some possible trends like « towards an age of digital individualism” or “the retreat of globalization”. Although it gives a starting point for discussion about the macro environment, we must make sure not to focus on one scenario only but to address the different possibilities that will raise for these factors.
Macro-economic impacts of this crisis should be considered as they will have effect on the financing of the company particularly if governments let inflation rise in order to repay for the measures they are taking to support the economy.
Behaviour trends shall also be examined in particular the accelerated digitalization. Customers of e-commerce have increased their volume of purchases made online and employees have get used to home office. Theses trends will probably be leave strong marks on the habits of many stakeholders however as people lack the social link they may value more the interpersonal contact hence there could be some positive side effects for the local stores and restaurants after the lockdown period. It is too early to have any certainty on the long time effect of these trends hence it would be advisable to design at least three scenarios : a base scenario where we would come back to the same habits as before the crisis, a scenario with strong focus on the online activity and a scenario with a increase request for interpersonal interaction.
A key checkpoint of the scenarios that we shall select will be the consistency check between all the assumptions. For example, strong support from the governments through special measures might not be compatible with long term very low inflation.
Financial modelling of the chosen scenarios
Once the scenarios have been defined comes the time of financial modelling of these scenarios. Since we are discussing of recovery scenarios of the current crisis, I believe the time horizon of the model should limit to the next 24 months with a monthly or quarterly view depending of the cycles of the business. Even when dealing with very short cycle, it would be wise not to go below monthly modelling in order to keep the strategic vision of the exercise.
The number of factors that will be incorporated in the model will make it as accurate as possible without overcharging the model. Bear in mind we want to keep it manageable and assess significant impact. Make sure not to incorporate variables which have low impact. Obviously, the model must be the same across the different scenarios to get comparable results. Only the assumptions values should change. A nice visual dashboard will be a first step for interpretation and analysis in order to compare the results and challenge the actions which can be taken.
The benefits of scenario planning
Thinking through scenarios will allow also to shift from a reactive management to a proactive approach looking for the opportunities to develop business by proposing new services adapted to specific scenarios or to anticipate what a new trend could bring.
The advantage of scenario planning is that, although it puts the finance community under pression through various financial model analysis, it requires the active participation of all the management levels of the company, from the top management who shall define the scenarios to the operational managers that will estimate the consequences of each scenario and the response they could bring.
[1] Paul J.H. Schoemaker, “Scenario planning : a tool for strategic thinking” Sloan Management Review Fall 1995
[2] Bruno Tertrai, “Year of the Rat. The Strategic Consequences of the Coronavirus Crisis” Fondation pour la Recherche Stratégique April 6th 2020, https://www.frstrategie.org/en/publications/notes/year-rat-strategic-consequences-coronavirus-crisis-2020