The WEF Global Risks 2015 identifies ‘interstate conflict’ as the top catastrophe threat of concern, in a new ranking order of business risks for the next decade. Managing the business risk posed by political instability and other threats is a research theme of the Cambridge Centre for Risk Studies.
Ahead of its yearly meeting in Davos in January 2015, the World Economic Forum (WEF) published Global Risks 2015, its annual survey of catastrophe threats of concern to world leaders and captains of industry. The headline is that interstate conflict is now the highest concern, together with infectious diseases, water crises, extreme weather events, cyber attacks, ‘profound social instability’ and failures of national governments as a cluster of top worries.
It is not entirely coincidental that these threats of global crises are those that the Cambridge Centre for Risk Studies focuses on – our supporters are part of the same concerned business community. At the same time, we believe that a consistent methodology for calibrating the severity and frequency of a wide range of threats – in our case the Cambridge Risk Framework – is the most fruitful way to move beyond perception of threats to policy and management actions.
From a wide range of crisis causes identified in our threat taxonomy of 2011, the Centre has analyzed example scenarios recently published in a suite of reports.
The Centre’s studies provide a detailed exploration of potential scenarios so that companies and policy-makers can develop contingency plans to deal such crises as:
Our reports illustrate 1-in-100 year catastrophes in each of these categories, starting with a scenario narrative and modelling that through to estimate direct damage bills, macroeconomic losses across the globe and related financial market shock.
Our selection of these scenarios has been influenced by their current salience and, just as importantly, their severity and impact profiles which can be drawn from the historical record and/or inferred from scientific and commercial sources. Our research proposes that a 1-in-100 year event in any of these categories has the potential to cause huge systemic losses, in the ballpark of the five years of cumulative GDP losses that can be attributed to the global financial meltdown beginning in 2008.
Global Risks Perception Survey
The WEF report summarizes feedback from its Global Risks Perception Survey: a polling of 896 respondents between mid-July and the end of September 2014. The report is an impressive compilation of the concerns of the risk management community. The surveyed sample has a high representation from business (42%) and those with expertise in economics (41%). The respondents provide their opinion of their highest concern risks for an outlook of 10 years and 18 months. Events are rated qualitatively by how likely the respondents perceive the crises to be, and on a relative impact scale.
The report profiles the zeitgeist and documents how this has changed over the 10 years that the survey has been running.
Reflecting events of 2014
It is not surprising that geopolitical threats and pandemics are the highest concerns for respondents polled in the summer of 2014. The crisis in Ukraine brought Russia and the West to the brink of military confrontation, and the Ebola outbreak in West Africa threatened to spread worldwide. Other recent events such as the Islamic State take-over in Syria are reflected in ‘state collapse or crisis’ becoming the 4th most likely concern.
It may not be surprising to see ‘water crises’ rated as one of the highest impact risks after the worst drought in California for a century, and ‘extreme weather events’ move towards the top of the likelihood scale in this year’s survey after one of the most severe winters in North America.
Over the past 10 years, the Global Risks studies have mirrored the recent events of that time in the concerns of the business community. ‘Asset price collapse’ was the top concern for three years after the Great Financial Crisis of 2008, but started slipping down the rankings from 2011. Bad years of natural catastrophes are followed by boosts in the rankings of environmental hazards, and geopolitical and technological events drive up the concerns of those categories of risks for a period afterwards.
Planning for the next 10 years
The Global Risk Report is intended to provide indicators of what risks businesses should incorporate into their planning for the next business cycle. Recent events and perception levels by the professional community provide a pointer to these, but not the whole picture. Business preparedness should be forward-looking, not retrospective. Risk managers need to keep their view on the road ahead, not drive by looking in the rear-view mirror.
The Cambridge Centre for Risk Studies endorses the Global Risk Report series for raising these threats as issues. Our research builds on this type of work and aims to provide a systematic framework – the Cambridge Risk Framework – for evaluating and managing risks of these types (and others that have not occurred recently) to prepare for shocks that might happen in the future. This requires threat identification, consequence analysis and likelihood assessment.
Frequency and severity for a risk
The risks are important in two dimensions – the severity of their impact and the likelihood of their occurrence. The Global Risk Perception Survey rates these on a qualitative scale 1 to 7, to assess opinions about the relativities between different threats.
The Cambridge Risk Framework tries to assess these objectively with meaningful metrics. We measure ‘impact’ in terms of ‘GDP@Risk’ – the global economic output that would be lost if the event happened. ‘Likelihood’ is assessed by the annual probability of an event of that severity or worse occurring somewhere in the world. Risk is the product of likelihood and impact.
Each risk is not a single number or point on a scale. The Global Risk Report 2015 places the average impact score of ‘interstate conflict’ at 5.2 out of 7, and its likelihood score at 5.7 out of 7. A more thoughtful assessment of the threat of interstate conflict, however, would consider that there is a range of scenarios of interstate conflict, ranging from a minor war through to a major global conflagration, and that moderate impact events would be more likely than severe impact ones.
What does history tell us about the likelihood of a future war?
If we consider the likelihood of ‘interstate conflict’ as an example and think about business planning over the next 10 years, what kinds of crises and conflicts should we expect? History is probably a better guide to the occurrence of wars than perception surveys of current opinion, for a number of reasons.
It would certainly be remarkable – unprecedented – if the next decade saw no conflicts. Even the most peaceful decades in history have seen minor conflicts every few years. Most decades since the mid-19th century have seen an average of two conflicts involving at least medium-ranked powers. At least one decade in five could be expected to see a regional war involving a G20 nation, most typically a proxy war between superpowers.
It might be considered very unlikely – possibly unthinkable – that superpowers would go to war with each other in this post-nuclear age, but history shows that unthinkable wars have had a nasty habit of surprising people – even the war leaders who instigate them.
For business managers it is prudent to have contingency plans, and risk management strategies, that incorporate the possibility of geopolitical conflicts occurring somewhere in their international operations, and to consider a range of possible scenarios and severities that could occur.
Scenarios for future conflicts
Analysis for the Cambridge Centre for Risk Studies by Cytora Ltd., a research partner specializing in geopolitical risk, identifies over 100 scenarios for two nation states that could spark off a military conflict in the next decade, gauged from recent antagonistic statements towards each other, antithetical values and historical enmity. The risk map of future conflicts identifies a number of regional hot-spots, including the obvious Middle East, Central and Eastern Africa; the Eastern European margins; the Indian subcontinent, parts of Latin America and the emerging Southeast Asian powers.
The scenario selected by the Centre for detailed presentation as a ‘what-if’ stress test entails China and Japan engaged in a ‘magnitude 3’ military conflict. The two countries have fought two wars against each other historically, and their enmity levels are currently running high as China tries to impose military influence in the Pacific Ocean, and sovereignty disputes over remote island clusters threaten to become flashpoints.
The scenario is based on Pentagon war game plans and the Centre’s published report contains several variants of duration and severity. These two economies are the world’s second and third largest, so the impacts on the global economy would be very significant. The worst economic damage is caused by the disruption to international trade. In total, the scenario envisages the world’s GDP output to be between $17 trillion and $32 trillion less than currently expected over the next five years. The capital markets would be badly hit and investment portfolio returns could be reduced by 20-50%.
Other threats in the Cambridge Risk Framework
The Cambridge Risk Framework considers each threat category as a continuum of frequency and severity – an exceedance probability distribution, or EP curve for short. Defining the EP curve for each threat in a wide range of threat types is challenging, and requires a lot of detailed research and subject matter expertise.
By assessing the range of threats using objective metrics, we can estimate the relative expected losses that these threats would cause to the global economy. Our assessments suggest that the range of risks identified in the Global Risk Survey would collectively cause at least $5.5 trillion of lost GDP output from the world’s economy over the next ten years.
Our assessment of the ranking of the world’s risks
And would ‘interstate conflict’ be the worst risk to the world’s economy? Actually no. Not in the assessment using the Cambridge Risk Framework. In this assessment, financial crises destroy more economic value worldwide than wars do. Financial market crises occur more often, they are more systemic and affect many markets at once, and they are very destructive of capital value. We estimate that endogenous financial crises are the biggest destroyers of capital, followed closely by interstate conflicts, then pandemics, natural disasters, and then cyber catastrophes.
The Centre’s research programme is continuing to try to provide objective metrics for the risks that businesses and our society faces. This will complement the work being carried out by the Global Risk Survey and provide detailed guidance to help businesses manage these risks.
The Global Risk Survey provides an excellent annual reminder of the importance of preparedness and the changing perception of risks in the business community.