Scenario Planning for Supply Chain Risk Management—Part One

This is the first our in a two-part series on Scenario Planning for Supply Chain Risk Management.

Global Supply Chain Uncertainty … in Spades

Last year we introduced our Framework for Mitigating Risk in High-Uncertainty Scenarios. Since then, Russia invaded Ukraine, resulting in the ongoing Russo-Ukraine war, causing spikes in energy, fertilizer, and food prices. This fed into inflation, peaking at over 9% in the U.S., driving the Fed and other central banks to raise interest rates substantially. High-interest rates dramatically reduced the value of long-term bonds, into which some banks had much of their assets locked. This has caused turmoil and panic/bank runs in the banking sector, resulting in several major bank failures, bailouts, and an ongoing financial crisis that is still brewing as of this publication date. Additionally, the past year has seen many extreme weather events, major earthquakes, and ongoing tectonic east-west geopolitical realignments, with the threat of a China-Taiwan war ever looming.

Thus, companies continue to face a diverse set of high-uncertainty supply chain disruptions and risks. Many different functions within an enterprise get involved in managing these supply chain risks, deploying a wide range of tools and tactics to identify, reduce, monitor, and mitigate these risks (see sidebar, ‘Examples of Diverse Supply Chain Risk Management Functions and Approaches’). In this article, we examine the potential conflict between China and Taiwan, the U.S., and allies to illustrate some of the scenario planning and monitoring strategies advocated in our framework. We discuss the required coordination of functions and leveraging of expertise within and outside the enterprise. We touch on a few other examples of risk as well, to broaden the perspective. 

The Taiwan Strait^[1] has the potential to precipitate the most destructive conflict since WWII. China’s president Xi Jinping has repeatedly vowed to ‘reunify’ Taiwan with the PRC, saying China will never renounce the right to use force, and is striving to develop the military capability to overrun Taiwan by 2027. Xi may lead China for the rest of his life^[2], and retaking Taiwan is seen as the most critical part of his legacy^[3] and essential to his continued grip on power. Xi has displayed increasingly aggressive rhetoric and actions aimed at reunifying/annexing Taiwan.

Taiwan produces 92% of the world’s advanced semiconductors^[4] (used in cell phones, networking equipment, and many other electronics) and over a third of all logic chips. It is highly unlikely that the U.S. would stand by idly and let China simply take the island, given the strategic importance of that supply of semiconductors. In the event of an invasion, the U.S. would be drawn into a devastating war, now between two superpowers. This is not an inevitability. There is enormous uncertainty regarding whether, when, and how this conflict might unfold. 

President Xi is aggressive in asserting Chinese power. But he’s not necessarily foolhardy. The outcome of the Russo-Ukraine war will likely weigh heavily on Chinese calculations on Taiwan. If the West continues vigorous support for Ukraine and Russia ends up being driven out of Ukraine and outright losing the war (in an extreme scenario resulting in a regime change in Moscow), it will certainly give pause to China to reconsider any thoughts about attacking Taiwan. On the other hand, if the West falters, eventually losing its resolve, enabling Russia to take over the areas it has illegally annexed and sustain a frozen conflict in Ukraine, China would take a vastly different lesson.

Another unknown is the rate and extent to which the U.S. and Europe will build up their advanced chipmaking capabilities, as incentivized by the US CHIPS act and similar EU investments. This may not prevent a war, but could provide alternate sources of supply to partially sustain businesses reliant on these chips. However, it will in any case take a decade or more to build up meaningful capacity. If Taiwan chip production were to be disrupted due to a war, much of that capacity may be coopted by the U.S. government to ensure continued supply to the military, national security infrastructure, aerospace, and other critical infrastructure needs.

A Chinese invasion of Taiwan would have profound consequences for the entire world economy, not just for companies directly dependent on advanced semiconductors. It is highly likely that the U.S. and China would impose sanctions on each other. The U.S. would likely try to blockade fuel shipments to China. Financial flows, investments, and trade flows could be severely curtailed. Some have predicted a crash worse than the Great Depression of the 1930s.

For example, consider a company that incorporates advanced semiconductors in its products, all of them sourced from Taiwan. They would be highly exposed in the case of a conflict. They may bring together a team consisting of engineering, marketing, supply chain, sourcing and procurement, finance, an economist, and others. They might brainstorm various risk mitigation options such as:

• Product redesign—Explore possible redesign so that products can work with reduced functionality without the advanced semiconductor they currently use. This might involve designing an alternate module that uses earlier-generation chips that are readily available from non-Taiwanese sources. Engineers can explore what alternative designs are feasible. Sourcing can find out what chips are available from non-Taiwan suppliers, at what prices and quantities. Marketing can weigh in on the salability impact of various compromises in the alternate designs proposed. Prototypes of the alternate design could be built and tested without actually mass-producing it until needed. As events unfold, it could trigger the acquisition of chips and a manufacturing rollout, as described below in Monitoring and Triggering. A real world example (this one involving magnets rather than semiconductors), Tesla recently announced plans to redesign their motors to use magnets that do not require rare earth metals, presumably due to the risk posed by China’s complete dominance of supply (China processes about 90% of the world’s rare earth magnets).
• Stockpiling—Another option to consider is doing forward buys, stockpiling advanced chips ahead of demand. This is normally a very unattractive option, the opposite of a just-in-time approach. Over long-time horizons, the cost of semiconductors falls at an average rate of about 30%-40% per year^[7], so it makes no sense to buy them before you need them. However, if things are looking dire in Taiwan, then panic buying may ensue. It is a good idea to be ahead of the pack in that situation, especially considering the long lead time involved in acquiring advanced semiconductors.
• Dual-sourcing/Geographic Diversification—This is a classic strategy, but currently is really not available (except potentially from a limited set of alternate Korean suppliers).^[8] In the future, this may become more viable if the CHIPS and Science Act achieves some of its goal.
• Product Portfolio Diversification—It may not be feasible to redesign products that can’t exist without advanced semiconductors, such as smartphones. A company should consider how they could survive, if they had to abandon products that can only be made with advanced chips. If that would cause an existential crisis, they may consider a push to diversify their product portfolio to include products not requiring those chips, thereby providing ‘life support’ to survive the crisis and live to see another day. Such a major decision, redefining what the company is and what they make, would necessarily involve the senior executive team, with input from major functions across the enterprise.
• Balance Sheet Strength and Financing Diversification—Considering the threat of bank failures, credit freeze, and global depression, a company may want to invest in strengthening their balance sheet and diversifying their financial relationships, especially if they are overly dependent on banks in China or Taiwan, or that have exposure to those countries. Other hedging strategies may be considered.
• Strategic Supplier Stress Testing—Conduct an exercise to consider the impact of a conflict on strategic suppliers. Based on the results, work to help those suppliers improve their resilience in the case of a conflict and/or diversify to other suppliers in a better position.

This is by no means a complete list … and admittedly not a very creative list. It is only intended to give an idea of potential mitigation strategies. The right people in the room, doing the right kind of brainstorming, would likely come up with much better ideas.

In Part Two of this series, we look at how to brainstorm and prioritize mitigation options, monitor risk, define preplanned triggers and actions, other examples of high uncertainty risks, and finding mitigation strategies that serve a wide range of purposes.