Rattling Supply Chains: The Effect of Environmental Trends on Input Costs for the Fast-Moving Consumer Goods Industry

In recent years, the world has experienced a remarkable rise in the prices of vital commodities, including energy and agricultural products. For example, between 2006 and 2008, the average world price for oil rose by 110 percent, rice by 217 percent, wheat by 136 percent, maize by 125 percent, and soybeans by 107 percent. The resulting economic impact on firms, households, and entire economies has renewed attention to the scarcity of natural resources and the best way of managing them in the twenty-first century.

The world’s natural resources are under pressure, as approximately 60 percent of the benefits provided by natural ecosystems are being degraded or used unsustainably. As much as 20 percent of freshwater use exceeds the long-term sustainable supply, and between 15 and 35 percent of the withdrawal of water for irrigation is unsustainable, raising concerns about agricultural yields and costs. The current patterns of resource consumption are exemplified by the case of oil. North America and Europe consume more than 50 percent of this resource yet account for only 20 percent of the global population. At the same time, the growing populations of developing countries are realizing their desire for a better quality of life, which has led to increased consumption and thus greater demands on finite resources.

As global forces like changing demographics, growing environmental pressures, environmental regulation, and climate change interact to alter the future landscape of markets and industries, business leaders have recognized the need to understand their nature and magnitude. For large companies with global dimensions, this need for understanding is not limited to their direct operations but instead may rest primarily in their supply chains.

To illustrate the financial relevance of environmental issues, WRI and A.T. Kearney, Inc., collaborated to develop a future scenario of major environmental trends, including the physical impacts on the environment and the public policy response. We then determined the potential implications for a basket of commodity prices for energy and agricultural commodities, as well as the effects of those prices on the earnings of a representative set of companies in the fast-moving consumer goods (FMCG) sector.

Our scenario, which we named Ecoflation, shows a future in which policies and constraints on natural resources force firms to add to the cost of doing business the environmental costs previously borne by society. While this concept will inevitably increase costs in the near term, technological advances, efficiency gains, and reallocation of resources should ultimately lower costs to firms while reducing natural resource–related risks over the longer term.

Based on our scenario of more stringent climate change regulations, enhanced and enforceable forest policies, growing water scarcity in key agricultural regions, informed biofuel policies, and a greater consumer demand for green products, we estimated a reduction of 13 to 31 percent in earnings before interest and taxes (EBIT) by 2013 and 19 to 47 percent in 2018 for FMCG companies that do not develop strategies to mitigate the risks posed by environmental pressures. While we do not claim to be able to predict the future, and indeed our methodology has inherent limitations, our scenario is based on scientific knowledge and a sound understanding of policymaking. We believe that the magnitude of our estimated impact on earnings is not unrealistic for companies that do not act. Please see the accompanying technical document for further information about data sources and underlying assumptions of our methodology.

Even though the earnings at risk for our selected sample are significant, we believe that companies have the ability to independently and collaboratively find solutions and transform their operations to mitigate this risk and also to take advantage of growth opportunities. We suggest the following actions for companies in the FMCG and other industries to address the emerging environmental risks to their supply chains:

• First, understand environmental impacts and dependencies by examining how cost drivers are exposed to emerging environmental trends and, when possible, seek substitutes with lower environmental impacts.
• Take inventory of current environmental initiatives through the value chain to see what the company, its suppliers, and its partners already are doing.
• Rank environmental issues and opportunities according to their current and future potential impact on costs, revenues, and reputation.
• Chart a new course by embedding sustainability principles into an action plan, by including externalities in the decision-making process and establishing the principal performance indicators.

Winners will generally be those companies that anticipate the implications of a changing landscape, collaborate with suppliers and other stakeholders, and make environmental sustainability one of their business principles. Hedging strategies or shifting suppliers will not be enough. We believe that in order to adapt to these challenges, companies will need to implement real structural changes, such as product innovation and restructured value chains, which will affect both the companies and millions of existing and new consumers.