Managing Complexity in Alternative Energy Fuels Value Chains

This is the second article we're publishing
by Al Naqvi, president of Restructuring, Inc. As is the case with the first, this is one of the most valuable analyses of our business we've seen.

A new value chain is being architected. This value chain promises better national security, a cleaner environment, more jobs and greater economic prosperity. Despite the much anticipated rewards – the challenge of successfully establishing the alternative fuels value chain is not a simple undertaking. The task is extraordinarily complex and requires a new way of thinking. This article identifies the risks and complexity of building the alternative fuels value chain. It also highlights the factors driving the complexity and shows how to strategically manage these factors. A contrast with recent making of the computer industry value chain is used to demonstrate the complexity involved.

The task of building a new value chain is never an easy undertaking. It involves creativity, design, planning and luck. Take the example of computer industry – a value chain that was recently established in the last three decades. The sector observed unprecedented advances in a short duration of three decades but it also experienced a major bubble burst. Many companies were launched, many ideas were explored, and many investments were made – but only a few companies survived. And all of this happened in a sector that didn’t have nearly as many challenges as faced by the alternative energy sector. There are many lessons that can be learnt from the information technology revolution and applied in designing the alternative fuels value chain but it is important to understand the remarkable contrast between the two. Only by recognizing the differences between the two can we truly appreciate the challenge that lies ahead.

WHAT MAKES ALTERNATIVE ENERGY VALUE CHAIN COMPLEX AND RISKY?

Unlike computer industry, which was a fresh idea, alternative fuels industry comes with a baggage. A series of past disappointments haunt the present. Whenever oil prices rose beyond our wallet capacity – innovators and investors were drawn to explore the alternatives. When oil prices declined to a comfortable level, we rushed back to traditional oil. The innovation fervor was betrayed before even it got a chance to make its case. What is different this time? Some analysts believe that the actual relationship between supply and demand conditions has been altered. The emergence of China and India has increased the total global demand and has constrained the oil supply. The result is the possibility of a sustainable higher price for oil. Combine that with national security and environmental concerns and we have a viable investment opportunity without the stigma of yet another betrayal. Since Alternative Energy value chain complexity and risk can be driven by several factors, identifiable supply and demand conditions are only a small part of the total picture. The following factors should be considered to develop a comprehensive view of the market:

The Enemy Within

Unlike other newly emerging value chains the alternative energy value chain is threatened by its most fierce enemy – oil. Alternative Fuels can be viewed as options. When oil prices are high, alternative fuels option goes “in the money”. When oil prices fall, alternative fuels option becomes “out of money”. The problem is that traditional oil industry has an established and well capitalized infrastructure. The huge investments made in that infrastructure offer a compelling reason to resist alternatives. Compound that with the fact that the infamous international big oil club has a history of engaging in predatory pricing practices – the return of oil as the preferred fuel is a serious risk. It shouldn’t be a surprise that investment in new oil exploration is continuing and in fact the recent oil find by Chevron in the Gulf of Mexico reminds us of the risk of return to oil.

Traditional oil can easily continue to be the fuel of choice. The debate on environmental impact can be temporarily suspended by achieving significant transportation efficiencies. Other concerns can be addressed by pointing to a blooming economy whose thirst for oil can only be satisfied by pumping and importing even more oil. The combined effect of all of these factors can rapidly tumble oil prices – once again leaving alternative fuels option “out of money”.

Network not really a chain

Value chains are interdependent sets of multidimensional networks and not really a single linear chain. The number of dimensions and the inherent complexity in each one of those dimensions determines the overall topology of the value chain. Furthermore, for optimal growth and performance, the innovative capacity of all interdependent dimensions must be nurtured and fostered simultaneously. For example Information technology value chain is composed of hardware, software and service providers. In the IT world the innovations made on the software side needed to keep up with the hardware side and vice versa. Interdependence and mutual reliance on innovations in multiple parts of the value chain forces all parties to stay competitive and an innovation accomplished in one part typically opens up a series of opportunities in other parts. Sector wide collaboration and collective vision fuels simultaneous innovation across multiple dimensions. Such collaboration becomes extremely difficult when:

a) innovation has to take place across multiple disconnected sectors
b) each component sector is independently established with its own processes, ways of doing things, culture, terminology, and profit maps
c) each component sector has an independent value proposition that serves other stakeholders besides the one needed to launch a new value chain

It is clear that in the Information Technology revolution, competitive forces lined up within a single sector with very little overlap with other sectors. Suppliers were heavily dependent upon customer facing companies and the industry’s setup and design fostered rapid innovation across all dimensions of the value chain. For example Dell Inc. led by Michael Dell introduced powerful supply innovation in computer assembly. Product modularization helped to cut costs; it brought wider product variety for customers, increased production efficiency and cemented powerful relationships with suppliers. Although Dell was able to become one of the most powerful companies, its supply chain was designed to support Dell’s customers. The dilemma faced in the alternative fuels industry is that each participant sector (e.g. agricultural, coal, industrial biotech, and mining) has its own currently established business models, processes, cultures and profit maps. Their profit incentives are not solely dependent upon a single industry. Establishing standardized processes, developing shared visions, integrating and instituting simultaneous innovation requires returns that can at least match the next best opportunity to invest shareholder’s money.

Chaotic Development
Markets develop haphazardly; periods of stagnation are sometimes followed by sparks of rapid innovation. Chaotic development is a standard feature of emerging technologies and markets but what makes it incredibly challenging in alternative fuels markets is its capital intensive nature. Many different types of fuels will be created. Innovation would drive costs down. Powerful innovations in feedstock choices, biotech and process technologies would transform the industry. New processes would replace the old ways of doing things. But sometimes rapid innovation can be its own worst enemy. Investment risk is often increased when an industry goes through major bursts of innovation in a short period of time.

A stable and preferred technology platform doesn’t exist at early stages of development. Since significant investment is often needed to build upstream and downstream capabilities, the influx of newer, better and cheaper ways to manufacture fuels can rapidly drive capital intensive plants out of business. The direction taken by a specific market can expose older technologies to lethal risks. Take the example of gas turbine power plants that began losing money as soon as gas prices rose while power generation broke away from traditional contracts and found itself at the mercy of merchant market mechanism. The prevailing overcapacity in the industry, unmanageable debt tied to initial investments, and the perils of newly created markets forced the plant owners to shutdown or mothball their plants. While power sector was able to absorb that shock – alternative energy sector may not have similar tolerance capacity.

Conversely, even if the field develops without any hiccups, the typical problems associated with high promising newly emerging field would still be there. Speculative attitude would give rise to gold rush mentality, product proliferation and opportunistic behavior.

Volatility and Tradability
Unlike the IT value chain, several dimensions of the Alternative Energy value chain are composed of exchange traded commodities. The impact of futures strategy, analysis, and derivative trading are all important parts of Alternative Energy value chain. For example agricultural commodities are traded, so are emission credits, oil, coal and power – all important components of the total alternative fuel value chain. In the absence of well define analytical models, managing a value chain with several “market traded” nodes becomes immensely difficult. Since the overall profitability is derived from the interaction of these various market based forces – protecting margins and guarding against unforeseeable risks becomes immensely difficult. Various types of hedging strategies need to be applied to make sure that companies can deliver against their promised returns. Since, the drivers of volatility may be different for each component of the alternative fuels value chain, many diverse and disconnected forces can cause major unforeseeable profit gaps. Volatility can also lead to inconsistent demand. With a complex value chain spanning over multiple sectors and consisting of several interdependent nodes – demand fluctuation can paralyze the industry. Small changes in demand can create major changes on the backend of the supply chain.

Support Infrastructure
Support infrastructure includes logistics, storage and distribution networks. The current infrastructure is designed to support traditional oil industry. As previously mentioned, the newly emerging alternative fuels industry would require its own support infrastructure. But having a supporting infrastructure is not enough if it is not designed to be efficient and competitive. Its design should take into account the overall costs including the cost of capital. This is an area where productivity can be achieved through design excellence and collaboration. A high cost infrastructure that is not designed to support the unique needs of alternative fuels would increase the total cost and make alternative fuels less competitive.

Public Opinion and Regulatory Forces
Unlike other sectors, the energy sector is particularly sensitive to regulatory forces, public opinion, governmental policies, investment environment, and geopolitical factors. The good news is that this sector also receives a lot of helpful attention from government agencies. For example, in the US – Department of Energy’s Biomass Program offers tremendously valuable and strategic information for the industry. In the energy sector, failure to build, develop, and nurture relationships typically carries a heavy price.

HOW TO MANAGE RISK AND COMPLEXITY?

The above discussion identified significant risks and issues with the new alternative energy value chain. The inherent complexity may appear discouragingly unmanageable but the good news is that through careful planning and design, investors and companies can maximize their upside in this field. The most fundamental point to remember is that success belongs to superior designs. In other words, future of too many investments is sometimes left to chance, speculation, and wishful thinking – but true investment excellence can be achieved by having superior strategies to manage growth, returns and risk (the key drivers of value). Underdeveloped plans or half-baked business models can launch a company but they don’t allow one to successfully tread through the complexities of launching a successful startup or jumpstarting a new industry. Companies and industries can maximize their chances of success by leading through a superior strategic design. Winning by Design implies developing a holistic and most comprehensive picture of the business dynamics of an industry and then architecting a superior business model that can survive the systemic changes in a system. In building the value chain of alternative fuels, winning by design involves the following:

1- Create a real value proposition and make alternative fuel competitive: While in its initial stages the alternative fuels market can be helped through government subsidies, tax policies, and insurance programs – it is not a long term solution. In the long run a value chain should determine its own profitability and chart its own progress path. It should be competitive enough to stand on its own and without any support from government. Achieving such a competitive position requires extremely low cost structure, high margins, and enough profitability for all participants in a value chain. It requires a powerful focus on productivity and performance improvement.

2- Modularize Operations and apply a Platform Growth Strategy: Microsoft revolutionized the software market by rapidly expanding its footprint. However, Microsoft’s footprint expansion was not haphazard. The company applied a product platform strategy where it was able to grow into several new areas while maintaining a single integrated platform. Similarly alternative energy companies should pay special attention to designing a modular strategy for building plants and developing infrastructure. The platform strategy should take into account potential innovations in process and feedstock technologies. A modular platform oriented design facilitates adaptation to newer methods of production without abandoning older technologies or incurring significant incremental adjustment costs. The plants, infrastructure, and manufacturing technologies evolve with advances brought out by newer technologies. Operational best practices related to lean manufacturing, standardized processes and information content management must be applied right from the inception of launching a new company or developing a new value chain link.

3- Prepare for Growth: Alternative Energy companies must prepare for rapid growth. Growth should be viewed as an absolute necessity. Rapid growth can enable a company to use its scale to affect both demand and supply economics. Growth implies aggressively seeking and closing opportunities to launch new plants, expand into new fuel types to build portfolio diversity, and to grow in either direction of the value chain. Aggressive growth doesn’t imply haphazard growth. On the contrary, it implies disciplined growth strategy but with an uncompromising commitment to constantly explore growth options. It also implies that a company should refrain from drawing artificial boundaries for its growth and be open to global growth opportunities.

4- Develop an Investment Roadmap: Prepare an investment roadmap to guide growth strategy. Such a roadmap should be based upon portfolio management best practices. Investment management implies making disciplined and selective investments in the value chain. Gaining or taking control of various dimensions of the value chain at an early stage of market evolution helps strengthen the growth strategy. It removes dependence upon decisions and actions of other parties. Instead of being dependent upon other sectors, global cartels and predatory forces – companies can take charge by acquiring certain key elements of the value chain. For example an ethanol manufacturer can acquire farmland, logistics, storage infrastructure and distribution network to control maximum parts of a supply chain. Such a growth strategy is architected by carefully analyzing those topological nodes and constructs that can be devised through reliable contractual relationships and derivative trading and hence may not require capital intensive acquisitions. The investment strategy treats every company as a portfolio of real assets and portfolio theory is used to make asset acquisition decisions to broaden the footprint.

5- Institute Risk Management: Since several parts of the value chain are actively traded, building risk management capability can make the difference between success and failure. From managing the price risk of feedstock to understanding best practices in emissions trading – risk management plays a critical role in improving the chances of success. Absence of risk management implies that not only a company remains unaware of its perils and risks but can also face a sudden fatal end. A properly designed risk management function looks at the total value chain, prepares a comprehensive value map, builds solid understanding of risks and develops strategies for managing those risks.

6- Develop and Manage Channel Relationships: Oil industry has well developed channels. Alternative energy participants can build upon existing networks, channels, and relationships. In the early stages, developing and managing channel relationships would require creative planning. A channel relationship plan is based upon three core principles: a) It doesn’t impose significant cost burden for partners b) It doesn’t increase risks beyond a partner’s tolerance level and c) It provides an excellent incentive system for channel partners. Building new channels requires creativity and a determined effort to explore various contractual relationships. For example, short to medium term risk adjusted contracting, outsourcing, or even joint ventures can be a source of tremendous competitive advantage.

7- Build Awareness: Public opinion, regulatory forces and other multilateral/bilateral agencies matter. Creating awareness at consumer level will be the key to drive end user demand. For consumers, nothing speaks louder than cost. While chances are that consumers would favor cheaper fuels – they can be educated that the total cost of using traditional oil is much higher than what they pay at the pump. There are hidden costs of importing a gallon from abroad – particularly when it involves importing oil form conflict ridden nations. Costs related to national security risks, cost of conflicts in the oil rich Middle East region, and environmental costs – when all added together can make alternative fuels look much cheaper than imported oil. Awareness building requires a fully developed marketing and communications plan.

In summary, success of alternative fuels depends upon successful sector integration by building solid value proposition for all participants in the value chain. It also depends upon architecting a winning game plan that can bridge the gap between operational excellence and investment astuteness. Be alert, be opportunistic and design to succeed.

Al Naqvi is a seasoned business executive with a strong track record of creating business value for energy companies. With visionary and transformational leadership experience in energy sector, and a career focus in supply chain, finance, planning and business development – Al Naqvi offers state of the art knowledge and uniquely modern understanding of strategies and solutions fit for the sector. He has built and led high-performance teams at multi-billion dollar organizations as well as small and startup enterprises and has a track record of leveraging his entrepreneurial leadership style and broad business background to deliver strong results. His specialization is in strategy and leadership for startups and turnarounds. He has extensive experience in managing global enterprises and building organizations in 35 countries. He assists companies in situations where margin of error is extremely limited, and surgical precision and speed of execution are of paramount importance. His approach is comprehensive and is based upon a powerful focus on shareholder value creation. Al Naqvi has pioneered the concept of Management by Valuation: a disciplined approach to manage a business entity with a strict focus on shareholder value creation. He is the President of Restructuring Inc. He can be reached at 571 426 9016 or [email protected] Fuel Chain is a Restructuring Inc. offering.