The Costs Of Ecoflation

The Costs of Ecoflation Preparing business for a changing environment

Soaring prices for commodities from 2006 to 2008 brought renewed attention to the scarcity of natural resources and the economic impact of these shortages. In “Rattling Supply Chains,” a new study from A.T. Kearney and the World Resources Institute that examines the effects of environmental change on business, research indicates that failure to adjust to changing conditions could cost companies up to 47 percent in earnings over the next 10 years. Companies must adapt to this changing environment—which we call Ecoflation—and make it an integral part of their business.

The world’s natural resources are under pressure. Human consumption has compromised, diminished or destroyed ecosystems, rising temperatures are threatening plant and animal species, and freshwater use in many areas far exceeds the long-term supply. Climate change and growing populations are leading to roiled markets and new government regulations. Global businesses are already dealing with the consequences. A new study by A.T. Kearney and the World Resources Institute (WRI) indicates that these environmental trends and their consequences could have even wider ramifications for businesses in the coming years. According to the study, “Rattling Supply Chains: The Effect of Environmental Trends on the Fast Moving Consumer Goods Industry,” businesses in the fast-moving consumer goods (FMCG) industry could see earnings fall by 13 to 31 percent by 2013 and 19 percent to 47 percent in

earnings in 2018 if they do not implement sustainable strategies throughout their supply chains. Sustainability initiatives will cost more in the near term, as businesses transform their processes to meet new requirements, but in the long run the investment will be worth it — potentially even crucial to survival. Technological advances, increased efficiency and better-allocated resources will not only allow companies to protect the environment but will also help them reduce costs and limit their exposure to increasingly scarce natural resources. These trends present an unprecedented challenge for businesses, which must remain profitable while also protecting the fragile environment upon which they depend. Our findings suggest that the winners in this new world order will be those firms that understand the consequences and transform their business models to meet environmental needs.

New government policies and growing constraints on natural resources will force companies to acknowledge the environment as one of the core costs of doing business.

FMCGs and Ecoflation In “Rattling Supply Chains,” WRI and A.T. Kearney investigate the impact of “Ecoflation.” Ecoflation is a future scenario that combines existing economic forecasts—government estimates on population, consumption and gross domestic product, which we call the “base case”—and adds in projected environmental trends and potential public policy responses. It then measures their combined effects on the FMCG industry, including producers of food, beverages and various household items. Ecoflation describes how four major policy and environmental issues play out over the next 10 years in a hypothetical, yet distinctly possible future. • Climate change policy. The United States implements a comprehensive climate-change policy, which spurs international cooperation and results in a global price for greenhousegas emissions. • Water scarcity. Climate change causes more drought and water scarcity throughout major agricultural regions and leads to increased production costs and declining yields. • Deforestation. Consumer products companies in the United States and the European Union voluntarily agree to source all wood and fiber from sustainability-certified forests, and to increase the use of recycled fiber for all paper packaging and products. • Biofuels. Major biofuel-producing countries retreat from existing mandates and apply sustainability requirements to all relevant government policies.

We applied these scenarios to the price implications for eight important commodities—oil, natural gas, electricity, cereals and grains, soy, sugar, palm oil and timber. We selected these resources because they represent large expenses for FMCG firms, are used

Leaders in this new landscape will be companies that make environmental sustainability one of their core business principles.

throughout the supply chain, are at risk for price volatility, are influenced by policy changes, and are vulnerable to water scarcity and other environmental factors. We then examined the effects these commodity prices have on the earnings of a set of FMCG companies. This industry was selected because of its size ($1 trillion), susceptibility to environmental pressures, exposure to a wide range of commodities and familiarity to a wide audience.

The Findings Based on our findings, we estimate a sharp reduction in earnings for

FMCG companies that do not develop strategies to mitigate the risks posed by environmental pressures — 13 to 31 percent decreases in earnings before interest and taxes (EBIT) by 2013, and 19 to 47 percent EBIT decreases by 2018 if costs cannot be passed on to consumers. The study broke down the Ecoflation price forecasts for the eight commodities. Following are the findings. Energy (oil, natural gas and electricity). If the United States and other major economies implement new public policies, including caps and taxes on carbon emissions and mandates on efficiency, infrastructure and alternative fuels, it will lead to increased prices for energy compared with the base case projections. Climate change will cause increasing shortterm disruptions and price spikes, and water scarcity will affect existing hydroelectric power plants. Biofuel policies could drive prices either positively or negatively: Increased biofuel consumption would lower the demand and price for oil and gas, but a rollback of biofuel mandates would bring prices back up. In all, by 2018, Ecoflation is expected to bring sharply higher energy costs compared with the base case: increases of 22 percent for oil, 40 percent for natural gas and 45 percent for electricity. Cereals, grains and soy. Rising oil prices from government-enforced carbon fees would increase transport costs and drive the demand for biofuels, raising these crops’ prices in comparison with the base case. At the same time, a discontinuation of existing biofuel policies would lower demand and prices. Climate change and water

scarcity could have an impact on production of crops, although soy, wheat and corn are not heavily irrigated and need less water than other crops. Soybean fields have proliferated in Brazil, and a strengthening of deforestation policies there would raise prices for soy. Grains and cereals are expected to be 13 percent higher than existing 2018 price forecasts, while soy is expected to be 3 percent more expensive. Sugar. Like other crops, new carbon policies would have an effect on transport costs and the demand for ethanol, and hence, sugarcane prices would go up. Water scarcity issues are not expected to affect sugar prices, as Brazil is not at high risk for water shortages. Sugar production may be less exposed to climate change, because sugar beets, grown in northern countries, can be substituted for sugarcane. Palm oil. Palm oil is widely used in food and personal care products and, increasingly, as biodiesel, which would mean a rise in demand (and prices) if carbon policies are implemented. Because it is grown almost exclusively in Malaysia and Indonesia, palm oil prices would be susceptible to localized floods, droughts and fires caused by climate change, as well as to any local changes in deforestation policy. Its use as a biofuel is increasing, but that demand may go down because of concerns about deforestation. Timber. The production of packaging material is heavily dependent on energy prices, and would be vulnerable to policy changes that affect the price. In fact, while deforestation policies could become of increasing importance as more pulp is imported in coming years, fees on carbon are

expected to have the greatest impact on timber prices. Climate change also has a price impact, as it has led to more forest fires, pests and viruses, threatening the timber supply in many parts of the world. Wood and paper products are expected to have 13 percent higher prices during Ecoflation than in the base case.

Although the earnings risk from Ecoflation is serious, it is also avoidable.

Four Steps to Environmental Awareness Although the earnings risk is serious, it is also avoidable. Companies have the ability to find solutions independently and collaboratively, and to transform their operations to mitigate this risk and take advantage of growth opportunities. The following are steps to take immediately to address the emerging environmental risks: Understand environmental impact and dependencies by examining how environmental trends drive costs and, when possible, seeking more sustainable substitutes. For example, it takes more than 200 liters of water to

grow the sugarcane to make one liter of soda. This is significantly more than the 2.5 liters of water required to produce a bottle of soda in a bottling plant. Companies that want to reduce their impact on the environment must first understand the depth of their dependencies. Take inventory of current environmental initiatives throughout the value chain to see what your company, suppliers and partners are already doing. Previous A.T. Kearney surveys indicate that many companies do not have a central group to coordinate sustainability initiatives. Strong, companywide communication is needed to assess needs, discover gaps in the value chain and reduce the time it takes to better meet changing requirements. Prioritize environmental issues and opportunities according to their potential impact on costs, revenues and reputation. This is where sustainability initiatives can offer cost-saving opportunities. For example, General Mills reduced its Hamburger Helper packaging by 20 percent, lowering the cost for materials and eliminating the need for 500 distribution trucks per year. ConAgra Foods incorporated recycled plastic in its frozen meal trays, removing 8 million pounds of plastic from landfills. Chart a new course by incorporating sustainability principles into an action plan. Whether it’s a factory retrofit to increase energy efficiency, a packaging redesign to reduce costs or a product reformulation to decrease dependency on commodities, smart companies will incorporate sustainability as part of a clearly defined plan

founded on sound principles. The portfolio should include short- and long-term strategies that can have a lasting impact.

Winning in a Changing Landscape The world’s dependence on natural resources is fragile. As the economies of developing countries grow, worldwide consumption will increase

and place greater demands on finite resources. Leaders in this new landscape will be companies that make environmental sustainability one of their core business principles. These companies will not only be able to anticipate the changes, but also to collaborate with suppliers and other stakeholders to address them.

A.T. Kearney is a global strategic management consulting firm known for helping clients gain lasting results through a unique combination of strategic insight and collaborative working style. The firm was established in 1926 to provide management advice concerning issues on the CEO’s agenda. Today, we serve the largest global clients in all major industries. A.T. Kearney’s offices are located in major business centers in 35 countries.

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