The Profitable Shift to Green Energy
Global consumer goods companies following today's energy trends are finding that greening their energy supplies with renewable energy initiatives is good—not only for the world but also for their profits.
Before his death last year, Ray Anderson was anointed by The New York Times as America's greenest businessman. When Anderson, CEO of the Atlanta-based global carpet firm Interface, first decided to move manufacturing and operations toward full sustainability in the mid-1990s, he had trouble convincing his colleagues that such a move was in the company's best interest. Barely a decade later, however, it was clear that Anderson was ahead of his time. By 2005, Interface was saving $400 million a year by reducing waste, decreasing absolute greenhouse gas emissions by 92 percent, cutting water use by 75 percent, and sending fewer materials to landfills. Profits doubled in the same time period. Anderson clearly understood the impact a green strategy could have on the bottom line.
Today, retailers and consumer packaged goods (CPG) companies are following in Interface's footsteps, strategically making their operations more environmentally sustainable. Wal-Mart, IKEA, Tesco, and Target have set sustainability goals at varying degrees and are pursuing ways to meet them (see figure 1). Major producers and suppliers have followed suit. Nestle, Procter & Gamble, Coca-Cola, PepsiCo, Kraft, Johnson & Johnson, and Unilever have all made public commitments and are developing energy programs to achieve their green goals.
Although corporate motives for going green are often similar, the approaches can be quite different. For example, Tesco is primarily carbon-focused and deals primarily with managing, reducing, and offsetting carbon or greenhouse gas (GHG) emissions. The company, the world's third-largest retailer, has pledged to halve emissions by 2020. Other companies are focusing on water, reducing freshwater use, or landfill diversion, such as Coca-Cola's water-stewardship and sustainable-packaging initiatives. Some go even further: Nike, for example, launched responsibility programs that address its social and economic impact on the communities in which it operates.
Green energy is at the heart of all ecological strategies because it affects companies in three vital areas: environmental, economic, and social (see figure 2).
Environmentally, a company's core activities will determine the size of its energy footprint, but reducing greenhouse gas emissions, which have a sizable environmental impact, is an essential element for any sustainability pledge.
Economically, conserving energy can have a huge impact and mitigates risk around fossil fuel costs. After a company has picked the low-hanging fruit—the well-known, no-cost energy-conservation measures—the question becomes how to further reduce energy consumption, especially in an environment of volatile commodity prices and supply. Green energy practices can also improve revenues, thanks to many of today's shoppers who are especially loyal to environment-friendly brands. The United Kingdom's Carbon Trust initiative, for example, has prompted companies such as Walkers Crisps, Levi Strauss, and PepsiCo to add a carbon reduction label to packaging that states the amount of GHG emissions associated with manufacturing and distributing.
On the social front, the sustainability argument focuses on community impacts, such as how open-pit mining or hydroelectric dam construction can affect life in a small town or how energy projects can create jobs.
With this trifecta of factors in mind, many firms recognize the value of going green and want to build renewable-energy initiatives into their corporate goals without negatively affecting the bottom line. Yet, going green can positively affect a company's bottom line through energy efficiency and financially feasible renewable projects.
Saving Energy: The Greenest and Usually the Most Profitable Strategy
Becoming more energy efficient is the first step toward reaching sustainability goals. Energy efficiency projects can vary in terms of capital investment and complexity, ranging from simple changes in lighting policies or production processes to investing in more efficient heating systems. Most initiatives yield attractive returns and relatively short payback periods. For example, AT&T is saving $86 million a year in energy costs from roughly 8,700 energy projects launched within the past two years, and Tesco estimates that energy efficiency projects dating back to 2006 are now saving the company $320 million a year.
Energy-efficiency measures also help achieve sustainability goals that are expressed as a percentage of overall consumption. If total energy consumption is reduced, less renewable energy is needed to reach those targets. Thus, assessing current energy consumption and right-sizing potential is directly related to the type of renewable-energy technology that best suits a company's needs.
In addition, putting a spotlight on ways to improve energy efficiency can reveal unexpected new ways to improve standard operations (see sidebar: Going Green Can Trigger Innovation).
However, energy efficiency is rarely the silver bullet for achieving ambitious sustainability goals. And it's not a matter of choosing energy efficiency over renewable energy or vice versa—rather, it's combining both to the best possible effect. The multitude of initiatives and strategies it takes to realize this ideal combination can be daunting. The market has recognized this dilemma, and various energy-efficiency and renewable-energy offerings now minimize risk exposure and require minimal internal resources. Essentially, they allow locking in a price for an agreed-upon period of time. Providers of these services usually guarantee certain savings and earn a commission on every reduction target that is met, while taking on the risk for missed targets.
It is possible to blend usually profitable energy-efficiency projects with less attractive renewable-energy investments—in essence, cross-subsidizing the latter with the former. Although it is essential to define an all-inclusive strategy that combines both types of initiatives, renewable-energy projects can be structured as standalones with no subsidies. While sometimes cumbersome at first, such an approach generates higher value.
The Economics of Energy
Financial feasibility is often a challenge when implementing a renewable-energy project. After all, such projects compete with other business investments and have to pass the same return-on-investment tests. The economics of an energy project are determined by five parameters that can differ widely depending on regional or even site-specific factors: energy prices, technological effectiveness, incentives, capital expenditures (capex), and operations and maintenance.
Energy prices. Price defines both the cost of the energy that the project is intended to replace and the key cost components for certain type of energy projects, such as biomass, an option that faces its own inherent hurdles (see sidebar: The Biomass Challenge). Energy prices are determined by regional generation portfolios, the price of competing fuels (particularly natural gas), and a company's demand pattern. The development of shale gas in North America and elsewhere is expected to dramatically reduce the price of gas—and thus electricity—making it even harder for renewable energy projects to compete.
Technological effectiveness. Technology is especially important because renewable-energy sources yield widely varying amounts of energy, differ significantly across regions, and often depend on site-specific parameters. Thus, a one-size-fits-all technology is unlikely to make sense for a global company. The most popular renewable-energy strategies are usually those that implement a portfolio of various technologies—even as they can cause problems with operating competencies and involve high maintenance costs. As an example, biogas installations require permanent care and quality control, but photovoltaic (PV) systems require only a fraction of the manpower to operate.
Most renewable-energy technologies are evolving rapidly, and feasibility studies performed only a few years ago might look entirely different today. The lesson here is that going green with renewable energy is not a one-time decision. Rather, it is a multifaceted, continuous process of building up the right portfolio in the best way (see figure 3).
Incentives. Incentive mechanisms differ from country to country and state to state, but there are two general types: feed-in tariffs and tax credits.
- Feed-in tariffs define a fixed rate per sold kilowatt hour from renewable energy sources. The system is common in most European countries, is used in the Canadian province of Ontario, and is being considered in other regions of North America. The intent of feed-in tariffs is for the electricity seller to benefit from the incentive to stimulate demand for renewable-energy applications. Although CPG firms and retailers tend to consume the generated electricity so they can claim true "green-ness," this system is of little help. Nevertheless, a company might decide to embark on a safe-haven investment under this kind of incentive, if only as a way to gain experience for investing in self-consumption once lower technology costs make such incentives unnecessary.
- Tax credits are common in North America. These credits reduce the burden of the upfront capital investments by granting a tax refund on a share of the investment (investment tax credit) and credits or depreciation allowance for each kilowatt hour produced over a certain period (production tax credit). Because these credits generally do not require selling the energy produced, they are ideal for retailers and CPG companies.
Capital expenditures. Capex is usually the most important—and in the case of solar and wind projects, the only—material cost component and therefore a key driver of project profitability. Capital expenditures are driven not only by technology sourcing, but also by tailoring engineering and project design to specific site conditions.
Operations and maintenance (O&M). While operations and maintenance comprise a relatively small cost component, they are essential to plant functionality and, thus, yield. O&M costs are often based on the level of variation. Different versions of technologies at various locations are incredibly cost-intensive, while larger numbers of identical technology allow for better conditions in O&M service contracts.
Clearing Capital Hurdles
Energy projects, whether conventional or renewable, are generally capital intensive and require large initial investments. Because such projects are low risk and have a long life span, typically 20 to 30 years, payback periods tend to be lengthy. How does this jibe with retailers and CPGs that typically target 10-year payback periods at 12 to 18 percent? Our experience is that it doesn't. Instead, a third-party contractor can take on the capital burden and deliver energy savings through up-front pricing agreements. While high-return projects are common in product development, they are less so in renewable energy, without putting the project at risk.
Adding to the challenge is the convergence of aggressive sustainability targets, a fragmented operations footprint, and varying energy needs. In most cases, targets cannot be met by silver-bullet projects but by tailored, multisite projects. This requires significant incremental resources to manage development, construction, and operations. Companies want projects that need limited capital investment and minimal internal resources. Therefore, they need to identify the best capital and internal resources that will deliver the most profitable project, especially when going green with a renewable technology. Figure 4 shows renewable energy projects and varying degrees of commitment.
Ownership. Obviously, full—and even partial—ownership requires significant capital investment. What might not be as apparent is that ownership requires significant internal resources to develop and operate a plant. These kinds of investments typically generate 8 to 10 percent return rates over a 20-year project lifetime, certainly not very desirable returns for the typical retailer or CPG company. The advantage of ownership is in gaining internal expertise, having more control over production and future development, and being independent from conventional energy sources or green-energy providers that might not be qualified.
Contracting. A contract structure eliminates the main disadvantages of ownership. For example, the developer handles project design, financing, construction, and operation. Contracting also allows energy purchases at or below market prices.
For some renewable-energy sources—wind, for example—production needs to be shaped to demand. This can be accomplished either through the developer or contracted out to the incumbent utility company—a scenario that can put significant strain on project profits.
The downside of using a developer is that it is harder for the contracting firm to gain green expertise, but this can be resolved by hiring some of the developer's engineers or flipping ownership after 15 or 20 years.
Power purchase agreements (PPA). A PPA is a long-term agreement—typically 10 to 20 years— with a developer or utility to purchase a certain volume of green power at a fixed price. For wind and solar projects that generate intermittent power, the purchase can be for demand-specific volumes from either the utility or a third party. As with a contract strategy, a PPA requires no capital and no owned resources. On the other hand, as with contracting, a PPA does not allow for developing internal green-energy expertise and requires a long-term commitment. Although attractively priced, tailored PPAs are not available everywhere.
Certification. Companies that acquire renewable energy certificates go green without actually changing their energy consumption portfolio. They claim green status by buying a commitment incremental to the company's current energy costs. The strategy is neither cost-neutral nor profitable and may well be of little value in terms of public perception.
The Path to Green
As major retailers, manufacturers, and utilities pursue the value of going green, three lessons can be used as guidelines to a stronger bottom line:
Don't sacrifice profits. Companies can make good on sustainability pledges and still create value. Remember, however, that returns are typically below industry norms, especially for CPG companies. We have helped clients find partners along the energy supply chain that have lower thresholds or longer investment horizons to overcome this obstacle.
Consider the entire spectrum of solutions. While overall complexity needs to be managed, our experience is that an all-inclusive approach is most effective, such as improving energy efficiency while scouting for renewable-energy options. This is the best way to evaluate the full spectrum of solutions and potential partnerships. Rather than cross-subsidizing renewable energy with energy-efficiency gains, we look at a portfolio of options and then pick the combination with the best outcomes.
Focus on partnerships. Finding the right development or financing partner can make all the difference. Seek out relationships with reputable technology suppliers and service providers to help ease the learning curve. This will require a significant amount of strategic consideration and mid- to long-term vision. The "lowest bidder no matter what" approach is not the way to go.