Strategic business risk 2008 — The top 10 risks for business 10 One analyst noted, “The revenue generated from the US pharma market, the largest in the world, enables pharma companies to remain protable [despite] strict price controls in other major markets and the inability of [customers] in developing markets to pay full prices for their products. If imposed in the United States, price controls could transform the global pharma market, including business models and the development of new drugs in the future.” The compliance challenges are particularly strong in highly regulated industries such as banking, insurance, pharma, and biotech, where the regulatory burden is increasing fast, and where rms are feeling pressure to demonstrate a return on investment for long-term risk management initiatives. One banking panelist noted, “Banks are experiencing signicant fatigue around managing the myriad of often redundant compliance and regulatory reporting activities, the cost of which is massive and burdensome.” Similarly, a biotech analyst wrote, “A mounting regulatory compliance burden in areas such as privacy, post- marketing monitoring of drug safety and sales force compliance… poses a management and internal controls challenge to biotech companies.” Increasingly, companies may seek risk convergence initiatives which allow them to coordinate the various risk and control processes, reduce redundancy, which drives down costs, and, perhaps most importantly, more comprehensive enterprise- wide risk reporting to senior management and the board. As companies become more and more global, compliance becomes a greater challenge, forcing them to manage diverse regulations in different markets. A specialist in business strategy noted, “Managing regulations in 10 jurisdictions is one thing. What happens when a rm has signicant markets in 30-40 countries at varying levels of development and with very different regulatory traditions? This is not to say that global regulatory [diversity] is necessarily increasing; but rather, that corporate exposure to existing [diversity] is increasing.” The importance of understanding local regulations, as well as major global industry regulations is crucial to those companies expanding their global reach. “Thefailureofoneormoremajornancialinstitutions remains a real worry and could turn the crisis into systemic failure in the year ahead.” Jens Tholstrup, Oxford Analytica Our analysts acknowledged that few sectors would escape the impact of major global nancial shocks. Biotech and utilities rms, for example, would have trouble raising capital; banking, asset management, and insurance companies would be likely to suffer direct losses from market movements; and after making high-cost exploration investments — oil and gas companies might suddenly nd themselves facing low prices if the global economy moves into sudden recession. Since our research began in April 2007, the August credit crunch, forced by the US sub-prime mortgage crisis has provided a real-life demonstration of how highly contagious such shocks can be across sectors — and indeed — globally. Rory MacLeod, the former Head of Global Fixed Income at Baring Asset Management, somewhat predicted in April 2007 that if there was a “worldwide credit crunch — spread widening would not lead to bank collapses, as in the past, but would be spread throughout the nancial system. There will be unexpected pockets of vulnerability. Disintermediation has replaced international banking as a nance source with a range of specialized credit instruments held widely, with risk exposures that regulators nd it difcult to assess. A credit shock could lead to a temporary closing of the market for new credits, while traditional lenders such as banks have moved away from the area.” A crisis could spread from alternative investment vehicles such as hedge funds or private equity. One analyst wrote, “Financial innovation and structural changes have contributed to the success of private equity, but cyclical factors have also played an important part in their over-expansion… High-prole failures of some investee companies could lead to a loss of condence among investors and lenders.” Another remarked, “A crisis in CDO/structured nance markets could lead to potential systemic problems. Sustainability of nancial sector growth is more fragile than markets realize. There is the potential for dramatic fallout from excessive leverage. Carry trades are cited as a risk area, but other hedge fund strategies are exposed to a change in the macroeconomic environment. There are potential systemic issues in the nancial sector.” In the future, continued nancial innovation — which tends to disperse risks and, as a consequence, makes the detection of potential shocks more difcult — is likely to increase the potential for nancial shocks. 2 Global nancial shocks Continued from page 8 11 Strategic business risk 2008 — The top 10 risks for business Jens Tholstrup Oxford Analytica The credit crunch and its implications for the availability of capital For the time being the world’s major central banks have eased the credit crunch that manifested itself in the beginning of August, but the risks to the nancial system remain very real. The origin of this nancial crisis has been well documented: the inability of large numbers of less creditworthy borrowers in the United States to service the debt on their home mortgages. What has made this development so contagious are certain innovations in the global nancial system. The securitization of nancial risks has resulted in a wide disbursement of such risk throughout the nancial system. In theory the dispersion of risk should reduce the risks of systemic failure but, in fact, the very opposite has been the case. The negative effects of disbursement are exacerbated by lack of transparency. In theory, all nancial assets have been, or are capable of being securitized and traded. However, at the present moment, no regulator or market participant can be totally clear where the risks lie. The use of off-balance sheet vehicles to hold sub-prime and other risk assets, has further reduced transparency. A related issue that has made the sub-prime crisis more contagious is the use of pooling of nancial assets. Any investment vehicle which has some exposure to sub-prime mortgages will be regarded as contaminated. In this market environment, nancial institutions become very wary of lending to other nancial market players since they will be concerned that others will be holding impaired assets. Credit for all but the largest and most secure borrowers will seize up. This is precisely what has happened in recent events, where central banks have had to intervene and act as lenders of last resort. Any institution that is holding high-risk assets, particularly asset-backed or pooled vehicles, is facing substantial losses. In addition, the market for many securitized assets has dried up leaving the holder unable to sell the assets. The commercial paper market for asset-backed securities has all but dried up with the consequence that borrowers nancing such assets will need to draw on standby lines of credit provided by banks. Contingent risks become real risks, underwriting positions become stuck and credit becomes severely restricted. The failure of one or more major nancial institutions remains a real worry and could turn the crisis into systemic failure in the year ahead. The central banks and regulators have already shown their disposition to take the steps which they feel are necessary to maintain the stability of the nancial system and in particular to minimize the likelihood of economic contagion. The implications are: Even in the event of central bank rate • cutting, the cost and availability of credit for most borrowers will be negatively impacted for the year ahead. Banks will be forced to ration their lending and lower-rated borrowers will nd access to capital difcult and expensive. The capital markets may well provide • better fund-raising opportunities especially if investors believe that the anticipated rate rises will be reversed. However, access is likely to be restricted to better credits for some time at least. The funding of off-balance sheet assets • and other structured nance products will become severely restricted. • Jens Tholstrup is an Executive Director and Director of Consulting at Oxford Analytica. Prior to joining Oxford Analytica in 2000, Jens had an extensive career in investment banking. Strategic business risk 2008 — The top 10 risks for business 12 An increasing strategic risk for the majority of industries is the threat posed by workforce and consumer aging. Sectors such as asset management and insurance are experiencing dramatic shifts in demand and competitive battles are being fought for savings products that will appeal to the growing group of older consumers. Other rms, for example, those in the auto sector, are facing severe competitive challenges as a result of their aging workforces. A number of industries are experiencing dramatic shifts in demand — often dramatic growth — as a result of the rising average age in, for example, Europe, North America, and Japan. Sectors most affected by these shifts include pharma, biotech, consumer products, insurance, and asset management companies, which could lose their competitive edge if they cannot effectively respond to these new opportunities. One insurance panelist noted, “People reaching retirement age have very different nancial needs.” As a result, a struggle is now emerging between insurance and asset management rms to deliver the innovative products that will meet these needs, such as income maintenance and health care spending. To be competitive, companies will need to gain an understanding of the specic needs of these new consumers, and many will need to have an aggressive approach to key competitors that may increasingly come from outside their sector. The other strategic challenge posed by an aging population is workforce aging, a risk issue that gures highly in oil and gas and is perceived to be a ‘next ve risk’ for sectors such as banking. These sectors are already experiencing a signicant human resource challenge. Perhaps the most extensive example of this threat can be seen in the US auto industry, which is particularly weighed down by pensions and health care costs. “There remains a possibility of insolvency in the US auto industry, and a long line of dependent component companies have yet to construct a path to safety.” The ndings of our survey Risk Management in Emerging Markets 2007 reveal that, while many companies have been in these markets for some time, emerging markets remain dynamic for developed market (DM) companies. Over 60% of DM companies have been in these countries for less than 10 years, and almost 20% less than two years. In most cases, global rms are competing with other global players for opportunities in these markets, although in several sectors, emerging markets rms are themselves entering the global stage. Often companies are being driven to these markets by the saturation of existing markets. An analyst in consumer products commented, “Over the next few years nearly all of the increase in world population will take place in the developing countries. In the meantime, other established markets will reach maturity.” Similarly, in real estate, “Intense competition for a limited pool of desirable assets, combined with yield compression in most global markets, has resulted in real estate funds needing to broaden their geographic search for opportunities. This has created an increased number of competitive variables in real estate markets.” For other sectors, such as biotech and consumer products, emerging markets offer supply chain advantages. One biotech analyst remarked, “The sources of biomedical innovation will become more diverse in a globalized marketplace. The implication is that while, in the past, the main source of competitive advantage for rms throughout the industry has been technology, in the future the supply chain will be important as well. Global companies will need to partner/form networks with rms in many markets.” In many sectors, the value chain will increasingly extend well beyond the developed markets and the BRICs, and the volume of business conducted in these markets will be signicant. On the downside, global expansion into foreign and/or emerging markets has always carried with it traditional threats such as: currency, operational, regulatory, language, and cultural risk. Increasingly, a signicant challenge lies in rms effectively managing outsourced business and supply chains in these markets. Recent events in the consumer products sector, for example, have demonstrated the specic need to focus on quality control standards and compliance testing when sourcing from relatively unknown suppliers in emerging economies. 3 Aging consumers and workforce 4 Emerging markets “Only 41% of developed market companies have a risk strategy for emerging markets, with more than half (56%) saying that no strategy is in place.” Ernst & Young, Risk Management in Emerging Markets study, October 2007 13 Strategic business risk 2008 — The top 10 risks for business Chris Raham Ernst & Young Winning the battle for the savings market Changing nancial needs The baby boomer generation is retiring just as employers and governments are progressively disengaging from pension provision. As a result, the nancial needs of individuals are changing dramatically. The central nancial challenge for these retiring baby boomers is how to transform the wealth they have accumulated in their pension accounts into a steady income stream. To a large extent this is a decision that they will have to face alone. The vast majority of baby boomers have only three assets: house, occupational plans and social security. With the exception of the high net-worth segment, the value of additional savings is minimal. These trends will transform the savings- products industry, which so far, has been accumulation-oriented. The business challenge over next 15-20 years will be to create products for the pay-out phase. The strategic risk for insurers is their inability to adjust, develop products for new needs, and compete against other sectors of the nancial services industry. How can insurers capitalize on new opportunities? Occupational pension/cash-balance • plans, and individuals in the mass market offer the most signicant opportunities. Successful ventures here will benet the largest segment of the population — those without sufcient wealth to attract the assistance of wire houses, retail advisors or independent nancial planners. Only a handful of competitors are offering well-planned, valuable services to these segments, although most major nancial institutions are circling the opportunity. In the dened contribution market, • insurers should offer employers products that combine the accumulation and payout phase. These products transfer most of the risk from the individual to the insurance company. Combining the two phases can represent a competitive advantage. At present, the asset management industry has the capability to offer only investment products. To sell against investment-only • solutions, insurers must have the ability to provide key constituents with clear information about product benets and competitive advantages from the employee’s perspective. Such assessments will help employers and their benet consultants understand the value of the product. Insurers may also support the plan sponsor by providing nancial advice to employees. In the retail market, insurers must take • steps to leverage their ability to write contracts that will provide more dollars of lifetime income per dollar of investment. A retirement program that combines decisions around the timing of social security elections, the use of home equity, and the disposition of cash balance plans into an easy-to-use, cost-efcient menu approach will be effective in the mass market. Barriers to success — the threat of competition To be successful, insurers must change their approach to the competition and take a broader view of the market. For years, they have been focusing on competition among themselves. In the US, for example, insurance companies have only a small share of the US savings market. Their true competition is represented by other providers of savings products, in particular, mutual fund entities. Insurers must become as aggressive as other institutions competing for the same dollar. As the only writers of payout annuity products, insurers should be well positioned to take advantage of the shift from accumulation to payout. However, they face three signicant obstacles. Most of the retirement wallet is now • in the hands of other asset managers, who are in a strong position to retain customers. Even though pay-out annuities • provide the most income for a given investment, individuals dislike the idea of suddenly transferring all of their assets to the insurance company. They feel that they are losing control over the wealth and they would prefer to keep the money with the insurance industry’s competitors. Some sales practices related to • deferred annuities, have created negative sentiments that have been actively expressed in popular media and by regulators. Twenty ve years ago, insurance companies were strongly positioned against asset managers to dominate the savings industry. Mutual funds were vulnerable and their market share was relatively small. However, insurers were complacent and lost the battle for individual retirement assets. The demographic shift is creating new demands that insurers are well-placed to satisfy. It would be a shame for insurers to repeat the same mistake and squander their opportunity to recapture lost territory. • Chris Raham is a Senior Advisor in Ernst & Young’s Insurance and Actuarial Advisory Services. Strategic business risk 2008 — The top 10 risks for business 14 Farokh T. Balsara Ernst & Young From emerging markets to surging markets — The future of global media growth Emerging markets are attracting signicant attention because of a surge in demand for content. With China and India accounting for one-third of humanity, these markets are the future for global media growth. Currently, some of the largest global media and entertainment companies are making less than 5% of their global sales from emerging markets, but the management within these companies are spending a disproportionate amount of their time dealing with these markets. It is partly a lack of both content and a handle on distribution in Europe and North America that is preventing emerging market companies from moving into developed markets. More signicantly, however, the growth in their home markets is so fast that they don’t have the bandwidth to think about it. Another important growth factor in these markets is technology. Broadband connectivity in South Korea is 98%, enabling the push-through of huge amounts of content. In India, a global multinational company has recently conducted the world’s biggest rollout of digital cinema through satellite. This means that these companies can control exactly where movies are showing and how many times they are shown. It also means they can control piracy. And it allows them to release not just in Delhi or Mumbai, but in the smallest towns, simultaneously. This is a paradigm shift in how lms are released, and it is happening in India. At a time when technology is reshaping the global industry, emerging markets are the fastest adopters of technology. They provide an ideal test-bed where global rms can trial new technologies, before bringing them out in their home markets. Winning in emerging markets To win in these markets, companies need to localize content and be sensitive to local culture, rather than automatically dubbing and repurposing. It is possible to sell from media libraries, but this will not make you a winner in these markets. One major global media player had been in India for seven or eight years, with a mostly English offering. In 2000, they invested in 24-hour Hindi programming with local productions and quickly became the largest and most protable channel. Firms that don’t localize their content can also run higher risks. One foreign broadcaster that was in the Indian market showed too much adult-oriented content in its programming before 11pm and the government took the channel off the air. However, growth in demand for local content by these global players and by local companies funded by private equity rms could soon outpace the growth in supply of local production talent. This could lead to super-ination which should be factored into business plans. It is important to understand that even a single emerging market country has multiple markets within. Southern India is completely different from the North. To win in a national market, investors may need a very different strategy in each region. There will be differences in where the demand is, the type of content, the distribution of content, and how to take out earned revenues. The price points in emerging markets are also often a fraction of what consumers would be charged for similar content in developed markets, often due to regulations, competition or extensive piracy. However, the huge and fast growing volumes more than make up for the low charges. As a result, a thorough assessment of the market and distribution channels is needed to appropriately price the content. A nal critical success factor is exibility. These markets can see growth of 40 to 50% per annum. In such an environment, local entrepreneurs have an big advantage, and right now, a lot of local media companies are beating the global players in China and India. Multinationals will need to have exible business plans which do not always need to be approved by the regional ofce and the head ofce. • Farokh T. Balsara is the National Sector Leader for Media and Entertainment and the Markets Leader for Advisory Services at Ernst & Young, India. “ These [emerging] markets can see growth of up to 40 to 50% per annum. In such an environment, local entrepreneurs have an advantage, and right now, a lot of local media companies are beating the global players in China and India.” Farokh T. Balsara, Ernst & Young 15 Strategic business risk 2008 — The top 10 risks for business Part of the consolidation phenomenon has been driven by the global M&A boom, which several analysts believe may slow in years ahead. However the majority of sector analysts we polled believed that industry transition would continue to pose a key strategic challenge in 2008. This continued transition will be driven, in most sectors, by underlying structural trends. One analyst, commenting on the auto sector noted, “Population growth and GDP growth are highest outside of the US, EU, and Japan, resulting in a global misalignment in the location of industry capacity and the location of demand. The industry, especially in the US market, is in transition including consolidation, restructurings and spin-offs.” Another analyst highlighted that, in asset management, transition entails the migration of the industry’s leading rms towards one of two opposing business models, “On the one hand, massive asset gathering [companies] that drive down costs and provide cheap access to markets and market risk and, on the other, those companies that… (as a business proposition) offer better-than-market returns.” In the media and entertainment sector, M&A is a central feature of many companies’ attempts to respond to the internet’s impact on the sector, for example, via the acquisition of ‘new media’ rms. Companies in other sectors may continue to merge, driven by competitive pressure. In banking, “Many of the deals are of sizes never-before experienced. The trend to become bigger and more dominant by acquiring existing franchises is an ongoing driver for growth.” And in telecoms, “Accelerated M&A trends in the telecoms industry will lead a transition to three to four players per country.” In utilities, one analyst commented, “Size is vital when negotiating with the owners of major primary resources; size is vital as some protection against hostile acquisition. Hence, the impact of failing to grow can be a loss of competitive supplies or even loss of the business.” There is a growth imperative in many sectors, and if it cannot be met by organic growth, then it may need to be met by acquisitions. Fluctuations in energy prices and access to supplies pose a clear challenge to the energy sector, including utilities and oil and gas. In utilities, for example, loss of access to competitively priced long-term fuel supplies is the top strategic risk. One analyst noted, “The impact on the business is the need to acquire short-term supplies to meet demand obligations and can lead to a huge loss of protability, hence the need for skilled hedging of sources, types and timing of fuel supplies.” However, beyond the energy industry, a large swing in prices could also trigger economic shocks that could impact sectors such as insurance, consumer products and real estate. Few leading global companies are immune to this risk. One telecoms analyst remarked, “As more and more equipment is racked up in data centers, more and more power is needed to run and cool down the servers that are at the heart of the web infrastructure.” Even the virtual world needs ‘real’ world energy. Various potential causes of such energy shocks were noted, including a US strike on Iran, a breakdown in relations with Russia, contests for control of ‘strategic’ energy supplies, or an action to disrupt shipping through one of several key maritime choke points. The risks of a shock are also dramatically heightened in today’s environment of increasing energy nationalism. One analyst noted that on the supply side, “The development of the world’s oil and gas supplies over the past 40 years, with concomitant advances in extractive technologies, has been undertaken largely by private sector enterprises. Now, however, the global supply of prime energy fuels has become dependent on a few national, state- owned suppliers.” In the future, the risks associated with the continued and sustained supply of such fuels to the developed world may rise signicantly. On the demand side, the risks from rising energy nationalism may be even greater, “Governments are increasingly convinced that energy security needs to be pursued actively. The reality may be quite different, but the perception could trigger a crisis [caused by] desperate efforts that countries may make to secure their supplies (paying above market rates, long-term deals, etc.). If markets then panic, this would cause governments to respond with even more uncoordinated, unilateral steps, making the situation innitely worse.” 5 Industry consolidation/transition 6 Energy shocks Strategic business risk 2008 — The top 10 risks for business 16 Tony Ward Ernst & Young A loss of access to fuel supplies — mitigating the risk Whilst global primary energy prices remain volatile, power utilities remain generally high-volume, lower-margin operations. The primary risk for utilities is to balance relatively short-term customer contracts with the longer-term nature of fuel supply and, in doing so, deliver access to economically attractive, secure and reliable contracts, whether for their primary fuel needs, or eventual customer off-take. In part, this is a matter of trading strategy, procurement and hedging, but the choice of technology to convert fuel to power, is also a key issue. Decisions made today to embed fuel needs, emissions proles and cost drivers may have long-term implications. These assets can have economic lives of up to 50 years, and investment lead times of over ve years, as is the case with some coal and all nuclear assets. The interaction of these two short and long-term pressures is mirrored in the convergence of the respective interests of the private sector utilities and national governments — the former managing their discrete businesses for protable growth on behalf of their shareholders, and in competition with others, and the latter focusing on the aggregated concerns of diversity and supply-security of fuels, minimal environmental impact and overall national economic competitiveness. Managing the risks for contracts and fuel supplies Securing access to fuels and supply contracts for a utility carries with it substantial risks and uncertainties. This is true both in mature markets with an aging infrastructure and greater competitive pressures, and in developing countries that may struggle to match generation capacity to rapidly growing demand. In committing to asset construction programs, companies face signicant regulatory, market, nancial, and public relations risks. Access to adequate amounts of capital at reasonable rates may also be a factor as the industry enters a period of escalating infrastructure investment. The effective management of the risks associated with pursuing organic growth will enable utilities to deliver predictable value to shareholders. Being exible is the key to success for both governments and companies. At a national level, certain countries are responding by moving towards greater self-reliance, focusing on making use of local resources and markets, and looking for diversity of fuel technology and fuel type. Companies are building up their portfolio of relationships and supply sources with crossholdings and minority interests in assets. Key strategies to reduce the risk of supply shortages include scale, collaboration, supply chain shortening, infrastructure investments, new technologies and ‘convoy’ procurement of scarce resources. By ‘racing for scale’, companies, and increasingly, countries and regions (for example, the EU), are pursuing joint efforts to create larger entities which automatically create larger off-takes for suppliers. Scale mitigates risk through spreading the portfolio of contract timescales, geographies, and fuel types, reducing reliance on vulnerable areas. Joint operations, asset swaps and other alliances may provide an alternative to a single company striving for scale. Collective weight can help in negotiations and the mitigation of risk. Shorter supply chains can also help to reduce the risk arising from intermediaries. This is especially true from a security of supply perspective, but can also limit overall losses. The use of local resources, an approach increasingly taken by companies, can also reduce the supply chain. Infrastructure and technology investment Infrastructure investments are needed to reduce supply shortages, especially in developing economies, and also to restore aging assets elsewhere. Investors are aware of the degree to which national politics can destroy their contractual positions. Given the long-term nature of these investments, investors require a clear understanding of the political environment and the risks. A national framework on security of supply is crucial in order to achieve investors’ condence. New technologies will change the market. The successful utilities of the future will be those who make the bold decisions to ex their assets, supply chains, and operating models. Governments, and corporates, should consider a diversied fuel mix as an important means of mitigating the risk of loss of access to competitively priced long-term fuel supplies. • Tony Ward is a Director within the Transaction Advisory Services Team at Ernst & Young. “ New technologies will change the market. The successful utilities of the future will be those who make the bold decisionstoextheirassets,supplychains,and operating models.” Tony Ward, Ernst & Young 17 Strategic business risk 2008 — The top 10 risks for business Strategic risks often result from an attempt to take advantage of major opportunities. Nowhere is this more evident than in the area of transactions. Too often a move that seeks to quickly and signicantly respond to an opportunity, becomes an expensive and long-term risk in its own right. There is a major risk that transactions undertaken in response to industry consolidation may fail to deliver, not because they are poorly conceived, but because of a failure to meet operational challenges. This was perceived as a high risk by analysts in a number of sectors including auto, asset management, media and telecoms. A banking panelist wrote, “Stakeholders expect M&A to very quickly have a positive effect on the bottom line and create synergies between the acquirer and the target. Required integration may challenge the people, process, and technology of the combined entity. Stakeholder expectations may not be met or the deal may ultimately need to be unwound.” New types of strategic transactions, including divestitures in real estate, spin-offs in auto, and separation of telecom companies into utilities and service providers are driving further risk. While it is the big mergers that dominate the headlines, in some sectors, excellent execution of small and highly strategic transactions may have as great a competitive impact. Consumer products companies are, for example, using transactions more strategically to acquire innovation. Similarly, in asset management, rms are employing M&A in the hope of “acquiring… talent that cannot be home-grown.” We have been operating in a low ination global economy for some time. Our analysts believe that the return of high ination is a major risk. Cost ination, though the result of various drivers, is a signicant operational threat for all sectors. In oil and gas, for example, the problem extends from exploration all the way through the value chain, impacting everything from renery build costs to pipeline construction costs. One sector analyst commented, “The impact on oil and gas companies is increased pressure on operating margins, higher risk investment prole, increased asset portfolio optimization, consolidation, and risk sharing arrangements. Companies with high cost reserves could be at risk of failure.” In many cases, these cost pressures are driven by changes to the fundamental structure of an industry. Demographic changes and the rising costs of health care are creating a serious challenge for US auto manufacturers. One analyst noted, “American automobile companies labor under the weight of health care costs eroding their international competitiveness.” Another predicted, “The aging workforce at established Western producers leads to costly buy-outs, benets, and so on. There will be an ongoing decline in employment in the sector in the Western World, with large impacts for affected economies.” In biotech, cost ination is driven by regulation, as well as the increasing focus on drugs targeting chronic diseases, which means that “clinical trials are increasingly expensive, and higher costs to develop drugs put pressure on raising capital and drug pricing.” In consumer products, by contrast, the structural shifts that make cost control such a strategic challenge are related to consolidation in retail. Consumer products are being squeezed between, on the one hand, a “consolidating base of retailers that has resulted in greater control over pricing through strong buying power and hard discounters” and, on the other, “volatility of raw materials prices,” making management of input prices a crucial challenge. In other industries, radically changing business models are making cost a centerpiece of competitive strategy. One notable example is asset management, where the best performing companies are often those that control costs through overall scale, or product specialization. 7 Execution of strategic transactions 8 Cost ination Strategic business risk 2008 — The top 10 risks for business 18 We use the term radical greening to apply to the increasing environmental concerns which could be the result of a wide range of pressures — from the voluntary world of corporate social responsibility — to hard regulatory and economic necessity. Radical greening is a strategic risk, partly driven by the consumer and regulatory responses to climate change, and also by the weather events resulting from climate change. A specialist in science and international affairs wrote, “Current climate predictions are based on models and, naturally, the scenarios communicated to the policy world are the scientically conservative scenarios (i.e., those which most scientists agree are likely). Yet scientically conservative scenarios are not necessarily what will happen; it is possible that the hazard is actually more imminent than is commonly understood. In this case, we may see physical climate surprises as well as an increased policy response that is more abrupt than most rms are currently planning for.” In the short term, barring such unexpected developments, the strategic challenge centers on how much ‘radical greening’ rms should undertake. Going green is expensive, but could pay dividends if consumer tastes and regulation shift quickly. For example, in real estate ownership, some analysts favored rms with ‘green’ portfolios. One analyst noted, “As ‘green’ becomes law it could result in forced obsolescence and write-downs for non-green real estate assets along with substantial capital expenditure obligations to meet the new standards.” In a similar vein, in utilities, “Carbon trading is a reality in Europe and will almost certainly happen in the US. The caps that are set directly inuence the cost of generation with different fuels and hence can make a nonsense of the wrong fuel generation mix strategy. Fixed ages for renewable generation are also likely to come. The imposition of xed percentages of renewable power can expose severe strategic errors of corporate judgment.” The pace and extent of this new ‘green revolution’ is hard to predict — but what is almost certain is that some rms will get the right fuel mix, real estate portfolio, or carbon footprint, while others will go either too radically green or, more likely, not green enough. Our nal strategic risk for business in 2008 is the failure to anticipate and respond to consumer demand shifts. There are a number of examples of such shifts, perhaps the most obvious being the demand for ‘green’ products or services. Other trends have already been mentioned, including those driven by demographic shifts, such as growing consumer aging. It is the task of business to identify and respond to changes in demand. Such a challenge moves to be a strategic risk when the changes are signicant, fast or unexpected. A general theme across the sectors was the challenge posed by consumer empowerment making this an area of strategic risk. In media and entertainment, for example, one Ernst & Young panelist highlighted that, “Consumers today have more power than they did 10 years ago. Consumers are controlling the decisions about the content they receive and how they receive it. Consumers today are driving the content and distribution channels.” In auto, “Increased interest in customization of products requires a shift away from mass- production philosophies.” Or, as another consumer products panelist noted, “Factors such as the web, deregulation of markets and globalization will continue to lead to a rise in customer expectations and basic customer segmentation strategies are already becoming less and less effective, as customers look for individualized and customized purchase experiences.” As technology continues to expand consumer power, this challenge may well rise higher on the radar in the years ahead. 9 Radical greening 10 Consumer demand shifts “ This issue of climate change extends beyond just managing regulatory risk. Climate change and the regulatory and consumer response must be seen as a fundamental strategic challenge. We can expect a future of carbon labeling on products, carbon trading worldwide, and tight regulation and heavy taxes on carbon.” Jonathan Johns, Ernst & Young 19 Strategic business risk 2008 — The top 10 risks for business Jonathan Johns Ernst & Young How to deal with climate change regulation The climate change debate has made the environment the biggest single issue in the public’s mind. We are moving closer to a world of zero tolerance for environmental accidents and we have started to see this in recent incidents involving oil and gas rms. Many oil and gas rms are already demonstrating leading practice in environmental compliance, but in a zero tolerance environment mistakes will occur. New roles, such as an environmental ofcer, will begin to emerge at the corporate level. There may also be regular, independent audits of procedures and we could even see the emergence of environmental stakeholders on an independent board. This issue of climate change extends beyond just managing regulatory risk. Climate change and the regulatory and consumer response must be seen as a fundamental strategic challenge. We can expect a future of carbon labeling on products, carbon trading worldwide, and tight regulation and heavy taxes on carbon. Companies must make a fundamental decision about where they want to be in the new carbon economy. For many companies, the decision is whether to adopt a minimal response and simply follow regulation or to make an active decision to reduce their carbon intensity, which could be achieved by offering blended products, a strategy of acquisitions or by mitigating through carbon sequestration and storage. Others may decide to go one step further and offer services that help their customers to manage their carbon footprint. The climate change agenda also presents opportunities for skills transfer, for example, many of the capabilities that make a rm a leader in offshore oil also apply to offshore wind. Moving into renewable energy is not a ‘one size ts all’ solution. The fossil fuel era is not over yet. For reasons of security of supply and economic growth, petroleum will be used for some time yet. The degree of repositioning will vary and will depend on the character of the company, but many rms are nding renewables and clean energy a protable activity. Measures such as green-friendly tax regimes, carbon trading and carbon labeling on consumer products are, however, accelerating the movement. Those companies that are carbon-friendly will have a competitive advantage and also be able to better attract the young talent they need for the future. • Jonathan Johns is a Partner in the Infrastructure Advisory — Renewables, Waste & Clean Energy Group at Ernst & Young LLP, UK. . Strategic business risk 20 08 — The top 10 risks for business 10 One analyst noted, The revenue generated from the US pharma market, the largest in the world, enables pharma. increase the potential for nancial shocks. 2 Global nancial shocks Continued from page 8 11 Strategic business risk 20 08 — The top 10 risks for business Jens Tholstrup Oxford Analytica The credit. study, October 20 07 13 Strategic business risk 20 08 — The top 10 risks for business Chris Raham Ernst & Young Winning the battle for the savings market Changing nancial needs The baby boomer