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Use and misuse of the three-horizons | The Discipline of Innovation

Use and misuse of the three-horizons

About three years ago, Gerald Marion, a friend from the Brisbane office of Deloitte, introduced me to a book called the Alchemy of Growth. This is an interesting book and one of its main ideas is that there are three horizons for developing new business opportunities. Its a reasonably simple idea with Horizon 1 being the current business, Horizon 2 being a related business and Horizon 3 being a completely new business that could disrupt the existing business.

As an example, we can look at a company like Beach Petroleum. For Beach, Horizon 1 is the core assets of oil and gas production in the Cooper Basin in central Australia and the Gippsland Basin off the south-east coast of Australia. Their Horizon 2 play is primarily the coal-seam methane investment in the Surat Basin in that has grown to a point where it is now a business in its own right. Horizon three plays include exploration of potentially huge oilfields in Tanzania and joint ventures in South Australia in geothermal energy. The model is dynamic in the sense that, over time, Horizon 3 becomes Horizon 2 and Horizon 2 becomes Horizon 1. Because competitive advantage in any business is transient, the core of the business needs to be moving into different spaces. This is logical to me and fits with the classical ideas from Edith Penrose on the growth of firms.

I like the model because it says that competition is restless and staying still and being good at what you do must be counterbalanced by trying new businesses out in Horizons 2 and 3. Connecting to some of Tim’s thinking on this blog, it means that you need to be climbing your current Horizon 1 peak but you also need to be thinking about jumps onto the slopes of H2 or H3 peaks. It’s a portfolio management tool like the BCG matrix without the assumptions that make the BCG matrix so risky to use. However, like the BCG matrix it means that firms need to actively manage their portfolio of businesses with the use of organic growth, acquisitions and divestments.

So far so good….. so where does the misuse of the three horizons happen? I think that the problem becomes when the three horizons is used as a conventional planning tool. Going back to the Beach Petroleum example, we could use the three horizons to say that Horizon 1 will last 1-2 years while core business in being driven by the declining Australian oil and gas fields and then Beach will move to Horizon 2 where international oil and gas ventures will be the main earner for the business and then there will be a move into Horizon 3. When Tim and I talk to firms who are using the three-horizons, this is a typical interpretation. The biggest risk is that using the model this way eliminates any consideration of uncertainty. Firms move from H1 to H3 as part of a long term plan. Now, what we know about this type of planning is that it suffers from optimistic assumptions and bounded rationality. Long-term planning fails because of uncertainty. Who could have predicted world events from the past two years? To borrow a phrase, prediction is very difficult, especially when it concerns the future. A 3 horizons model that describes in detail what horizon 3 will look like is deeply flawed. Uncertainty is real and the further we go into the future the more uncertain the world becomes. Uncertainty can come from within the firm in terms of innovations and also beyond the firm from new competitors and operating environments.

I think there is a role for conventional planning processes in horizon one. We can set targets, estimate demand and manage progress. Horizon 3 is not just along the time dimension, it is also along the uncertainty dimension and when there is time and uncertainty together, the best way to approach a business opportunty is like an financial option (or in correct terms, a real option). Taking a stake in a new business and trying something out buys an option in horizon three. If the idea pays off then the option can be “exercised” by moving into horizon two as a fully operating business. If the idea doesn’t pay off then the option can be abandoned. The trouble is that we don’t know in advance what will eventually pay off and what won’t. Taking a conventional analysis and planning approach to horizon 3 will prevent innovation because innovations, by definition, involve taking measured risks to do something that hasn’t been done before.

Going back to the Beach example, geothermal energy is an uncertain and lengthy investment in energy innovation. Beach is reserving the right to play but they certainly don’t see it as a foregone conclusion that they will turn into a geothermal company. If the investment is unsuccessful then that is just another opportunity that can be crossed of the list.

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