Risk, Uncertainty and Creating Possibilities

Quick Summary

With risk, there are probabilities. With uncertainty, there are no probabilities and no knowledge of what will happen. We must build capabilities before knowing when they will be needed. Before giving up a capability, we must also examine what we will lose.

Risk management is essential.

But under uncertainty, it is not enough.

Uncertainty requires us to look beyond a list of risks.

To create courses of action and preserve essential capabilities.

Plasan shows how connecting capabilities opened a possibility for growth without forecasting what demand would emerge.

Germany illustrates the danger of giving up a capability that is difficult to rebuild, while remaining heavily dependent on an external supplier.

Creating possibilities and preserving essential capabilities are strategic obligations. We know what we are giving up today. We do not know when we will need it tomorrow.

Why, then, do companies underinvest in this work?

I argue that a central barrier is accounting thinking combined with incentives that favor current profit. The cost of building the future is visible today. The value of the possibilities being created is not always visible in the financial statements.

We will begin with the distinction between risk and uncertainty.

From there, we will turn to building possibilities and preserving capabilities. Finally, we will examine what prevents companies from investing in their future.

When a list of risks is not enough

Risk management begins by identifying events in which things could go wrong. Their likelihood and impact are estimated. Action is then taken to prevent them and reduce the damage.

This approach rests on the ability to identify the events and assess them reasonably.

Under uncertainty, there are no probabilities. We have no knowledge whatsoever of what will happen.

With risk, we know what could happen. There are probabilities. We can estimate the likelihood and the damage, even when we do not know which event will actually occur.

Under uncertainty, there is no basis for such a calculation. A number we choose must not be presented as a known probability. Sometimes, even the events themselves lie outside our picture of what could happen.

Uncertainty has always existed. As technology, markets and the political environment change, a plan based on the continuation of familiar conditions may lose its foundation. Adding detail to a plan does not provide knowledge of the future.

This does not mean that we should stop planning or managing risks.

We must recognize the limitations of planning.

Alongside preparing for events we can assess, we must build the capacity to act in situations we do not know how to describe in advance.

Some of these possibilities are not needed today. Their value may become clear only when reality changes.

A company needs to build courses of action before it knows which it will need. A technological capability, a partnership, access to a new market or a different use of existing knowledge can open such possibilities.

An idea alone is not a possibility for action.

Experiments, learning and staged investment turn it into a capability that can be put to use.

Plasan and the creation of possibilities for growth

In the Plasan story as I describe it, the motive was an aspiration to grow.

The question was how to enter a field in which the company did not yet operate and create a solution offering new value.

Developing passive armor raised a complementary question: how could the vehicle carry the weight of the armor while maintaining mobility and stability? Good armor is not enough if the vehicle carrying it cannot perform its mission.

The response required a connection between several fields: armor, weight distribution, center of gravity, chassis and suspension. Building a complementary capability in vehicle engineering increased the value of the armor capability. The engineering capabilities Plasan describes today combine protection, weight and vehicle performance. [1]

Each capability increased the value of the other. Connecting them broadened the kinds of problems the company could solve and the kinds of solutions it could offer.

Significant demand later emerged for solutions combining protection and mobility in Iraq and Afghanistan. In 2009, Oshkosh documented the use of Plasan armor on a vehicle designed for combat requirements in Afghanistan, building on protection systems already used in Iraq. [2]

The demand illustrates the value of the capabilities that had been built. The strategic lesson does not depend on predicting the wars.

It lies in building capabilities that allowed the company to act when the opportunity appeared.

Creating possibilities does not require knowing in advance who the next customer will be or what event will generate demand.

It requires understanding which new combination of capabilities might expand the value we can offer.

The strategic question is: which complementary capability will turn what we already know how to do into the basis for a new possibility?

Germany and the cost of narrowing possibilities

After the Fukushima disaster in Japan, Angela Merkel’s government decided in 2011 to accelerate the phaseout of nuclear power. Developing, building and operating the infrastructure had required enormous resources. In my view, abandoning such a capability without an available alternative is a serious strategic failure.

The last three reactors were consequently shut down on 15 April 2023, under a different government. [3]

Alongside its promotion of renewable energy, Germany remained heavily dependent on Russian gas. According to Germany’s Federal Network Agency, Russia supplied 52 percent of German gas imports in 2021. In 2022, gas supplies through Nord Stream declined until they stopped in early September. [4]

Gas was also used for heating and industry. Nuclear electricity could therefore not have replaced all of it. Dependence on Russia did not arise solely from closing the reactors, and keeping them running alone would not have resolved the gas crisis.

Even so, in my view, the combination illustrates a strategic failure: reducing an existing capability that is difficult to rebuild while relying heavily on a party whose decisions you cannot control.

Safety, cost and the environment must also be considered when examining the decision. Alongside them, we must examine the possibilities that are lost.

The decision was intended to reduce nuclear risk. But readiness for a disruption in external supplies also needed to be examined. A decision that reduces one kind of risk can increase exposure to another.

An existing capability has value as a reserve. Knowledge, people and infrastructure make it possible to respond to surprises. Eliminating them may weaken preparedness even if it appears justified under current conditions.

Not every capability needs to be preserved forever. But before giving one up, we must understand which possibilities it preserves, what alternatives are available and how long it would take to rebuild. We must distinguish an alternative planned for the future from one that can already operate.

Plasan illustrates how connecting capabilities expands the scope for action.

Germany illustrates how giving up a capability can narrow it.

In both cases, the question is not only what makes sense under current conditions, but what we will be able to do if conditions change.

What prevents companies from building possibilities

The two examples sharpen the importance of having scope for action.

Why, then, do companies invest too little in building it?

I argue that one central barrier is a managerial mindset that reduces the company’s success to its current accounting results.

Accounting rules do not treat all research and development expenditure alike. Under international accounting standards, research expenditure is recognized as an expense when incurred. Development expenditure that meets defined criteria is recognized as an asset. [5]

But the managerial gap remains: the cost of building the future is visible today.

The value of the possibilities being created is not always visible in the financial statements.

Even when an investment is recognized as an asset, its strategic value is not necessarily reflected in its carrying amount.

Investment in research, experimentation or a new capability may reduce current profit. The benefit may arrive later, perhaps during another CEO’s term.

The cost is immediate and tangible.

The benefit is distant and depends on things that are not yet known.

When rewards, market recognition and peer assessment depend mainly on current profit, there is an incentive to postpone the investment. A cut can improve the reported result immediately.

The loss of capability may become apparent only in the future.

The CEO can succeed on current measures while the company loses possibilities for the future.

Behavior that looks sensible under the CEO’s incentive system may damage the company that the CEO is supposed to prepare for the years ahead.

This is not an inevitable consequence of accounting rules. It is a danger that arises when the Board makes the financial statements an almost exclusive measure of success. Accounting plays an important role in measurement and control. The problem begins when it replaces strategic judgment.

In that situation, the CEO manages today’s company well but may neglect tomorrow’s company. The company may report higher profit while its ability to innovate, adapt and open new sources of growth weakens.

The solution requires an economic measurement system that gives managers better tools for making decisions.

Alongside current results, it must examine the investments that build the company’s future.

In Chapter 5, we will examine how economic measurement can support investments that build the company’s future scope for action.

The aim is to connect measurement and incentives with responsibility for the company’s future.

A test can show whether a technology works today or whether a particular customer is willing to pay under the conditions tested. It does not reveal what will happen in the future or generate probabilities for an unknown world. Its role is to build a basis for the next action. Managing in an age of uncertainty requires us to keep creating possibilities.

Responsibility for the company’s future

Risk management helps us deal with what we can assess.

Under uncertainty, it is not enough.

Managing under uncertainty requires creating possibilities whose future value is not yet clear, and preserving essential capabilities even when they are not needed today.

Rebuilding them may be expensive, slow and sometimes impossible within the time available to us.

A company that wants to prepare for uncertainty must therefore work systematically to create possibilities.

Choosing not to invest is also a decision with a cost, even if that cost does not appear in the current financial statements.

We do not know what the next surprise will be. We can build capabilities for action before it arrives.

In the following chapters, we will examine how possibilities are created, how they are tested and how they become real courses of action.

A question for the reader

What capability are you about to give up today, and which possibilities will that decision close off for the company?

One Step into Practice

Choose one capability that is about to be cut back or discontinued. Bring into the discussion what it makes possible and what rebuilding it would require. Examine whether this information changes the investment decision.

Sources

[1] Plasan, Survivability Technologies and Armored Vehicle Engineering. https://plasan.com/engineering/

[2] Oshkosh Defense, Mission Proven Vehicle Components and Technologies Featured in Oshkosh M ATV Vehicle Design, 26 February 2009. https://oshkoshdefense.com/mission-proven-vehicle-components-and-technologies-featured-in-oshkosh-m-atv-vehicle-design/

[3] German Federal Government, Compensation for the Phaseout of Nuclear Power, 24 March 2021. https://www.bundesregierung.de/breg-en/service/archive/compensation-for-nuclear-phaseout-1881422 ; BMWE, 13 April 2023. https://www.bundeswirtschaftsministerium.de/Redaktion/DE/Pressemitteilungen/2023/04/20230413-deutschland-beendet-das-zeitalter-der-atomkraft.html

[4] Bundesnetzagentur, Gas Supply Figures for 2022, 5 January 2023. https://www.bundesnetzagentur.de/SharedDocs/Pressemitteilungen/EN/2023/20230105_RueckblickGas2022.html

[5] IFRS Foundation, IAS 38 Intangible Assets. https://www.ifrs.org/issued-standards/list-of-standards/ias-38-intangible-assets/