McKinsey

The great rebalancing
http://www.mckinseyquarterly.com/The_great_rebalancing_2627

As the center of economic growth shifts from developed to developing countries, global companies should focus on innovation to win in low-cost, high-growth countries. Their survival elsewhere may depend on it.
JUNE 2010 ‡ Peter Bisson, Rik Kirkland, and Elizabeth Stephenson

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Exhibit: Executives weigh in on the major developments that will be important for business over the next five years. Comments (3)

The vibrancy of emerging-market growth will not be the only major disruption reshaping the global economy in the next ten years, but it may prove the most profound. This decade will mark the tipping point in a fundamental long-term economic rebalancing that will likely leave traditional Western economies with a lower share of global GDP in 2050 than they had in 1700. Two socioeconomic movements are under way.
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Declining dependency ratios. Virtually all major emerging markets are undergoing demographic shifts that historically have unleashed dynamic economic change: simultaneous labor force growth and rapidly declining birthrates. Simply put, there will be more workers, with fewer mouths to feed, leaving more disposable income. The largest urban migration in history. Each week, nearly one-and-a-half-million people move to cities, almost all in developing markets. The economic impact: dramatic gains in output per worker as people move off subsistence farms and into urban jobs. China and India are seeing labor productivity grow at more than five times the rate of most Western countries as traditionally agrarian economies become manufacturing and service powerhouses. These same factors powered Western economic growth for the better part of two centuries. (And they should last well into the next decade²at least until China¶s population, finally seeing the full effects of the one-child policy, begins to go gray.) In the next decade, emerging-market economies will rapidly evolve from being peripheral players, largely reacting to events set in motion by wealthy Western nations, into powerful economic actors in their own right. They will shed their role as suppliers of low-cost goods and services²the world¶s factory²to become large-scale providers of capital, talent, and innovation. (One hint of what¶s to come: the number of BRIC1 companies on the Fortune 500 has more than doubled in the past four years alone.) </P...< p...>

The productivity imperative
To sustain wealth creation, developed nations must find ways to boost productivity; product and process innovation will be key.
JUNE 2010 ‡ Peter Bisson, Elizabeth Stephenson, and S. Patrick Viguerie

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Exhibit: Executives weigh in on the major developments that will be important for business over the next five years. About the authors Comments (4)

Emerging markets are riding a virtuous growth cycle, propelled by larger and younger working populations. In the wealthy nations of the developed world, by contrast, low birthrates and graying workforces will make it enormously difficult to maintain what economist Adam Smith called ³the natural progress of opulence.´ These countries¶ best hope for keeping the wealth creation engine stoked is improved productivity²producing more with fewer workers. Paradoxically, doing that well across an economy is also the only way to generate lasting employment gains. In the United States, for example, every point of productivity-led GDP growth has historically generated an incremental 750,000 follow-on jobs. The great tension here arises at the level of politics. Over time, the world¶s rebalancing demands greater consumption and lower savings among the large developing countries, even as developed ones, the United States foremost among them, save, invest, and export more. Fostering policies that raise productivity, and avoiding or altering polices that impede it, will help ensure a smooth transition. Getting this wrong²failing to generate at least modest and broad-based continued income and employment gains in developed countries²raises the odds of a political backlash that will hurt the citizens of wealthy nations and of those moving up the wealth curve alike. We call the productivity challenge an imperative because the need is so compelling. But to eke out even modest GDP increases, OECD1 nations must achieve nothing short of Herculean gains in productivity. In the 1970s, the United States could rely on a growing labor force to generate roughly 80 cents of every $1 gain in GDP. During the coming decade, assuming no dramatic increase in hours worked, that ratio will roughly invert: labor force gains will contribute less than 30 cents to each additional dollar of economic growth. To maintain a GDP growth rate of 2 to 3 percent a year, productivity gains will have to make up the other 70 percent. The challenge is even greater in Western Europe, where no growth in the workforce is expected. Here, in other words, 100 percent of GDP growth must come from productivity gains. And in Japan, the hurdle is higher still: because of a shrinking labor force, each worker will have to increase output by 160 yen to generate an additional 100 yen of growth. To complicate things further, we are seeing a growing talent mismatch. The Western economies have built a workforce optimized for mid-20th-century national industries, yet the jobs now being created are for 21st-century global ones²we need knowledge workers, not factory workers. And there just aren¶t enough of the former. Anywhere. Companies across the globe consistently cite talent as their top constraint to growth. In the United States, for example, 85 percent of the new jobs created in the past decade required complex knowledge skills: analyzing information, problem solving, rendering judgment, and thinking creatively. And with good reason: by a number of estimates, intellectual property, brand value, process know-how, and other manifestations of brain power generated more than 70 percent of all US market value created over the past three decades. Western economies can do many things to change the equation. Deregulation has often raised productivity in the past and can continue to do so. Changing the boundaries around the work±life balance²encouraging people to stay in the workforce longer or increasing the numbers of hours worked each week²could add a few points of absolute growth too. Improving education is a no-brainer. Businesses can and should advocate these and other policy changes that could have a long-term impact, such as easing immigration restrictions. But in the end, the real game changers will be breakthrough innovations created by companies: history shows that a majority of productivity growth²more than two-thirds²comes from product and process innovation.

The productivity economy will reward µdo it smarter¶ companies that build a better business model
Besides providing powerful incentives for companies to deliver their traditional products and services more efficiently, the new environment may make selling productivity²finding marketable ways to ³do it smarter´²the most transformative business model of the next decade.

Western economies can boost productivity not only through deregulation but also by adjusting the work±life balance²keeping flexible hours and staying in the workforce longer, as 95-year-old Sydney Prior of Britain has.

This push is bound to have a ³no pain, no gain´ dynamic. Innovation, by definition, is a disruptive process. Think about the book-publishing industry. Only two years after the release of the Kindle, Amazon.com now sells half of its books electronically for the titles it offers customers in both bound and digital formats. The Kindle is short-circuiting the entire physical supply chain, and Apple¶s new iPad is sure to accelerate that process. Something similar is shaking up the world of computing. It¶s considered the poster child of productivity²and for good reason. But probe further and it¶s not hard to find evidence of waste. Companies spend, on average, 5 to 10 percent of their total revenues on IT. Yet reliable estimates suggest that upward of 70 percent of server capacity goes unused²even more at midsize and small companies, since they can¶t achieve scale. Advances in ³cloud computing´ (sharing computer resources remotely rather than storing software or data on a local server or PC) have vast potential to raise utilization rates and simultaneously help companies to increase their computing capacity, while slashing IT costs by 20 percent or more. Little wonder tech giants as divergent as Google, IBM, and India¶s Wipro Technologies are investing furiously to win the battle for the cloud.

Companies that can master productivity techniques, such as robotics, and sell that expertise may capture the coming decade¶s most transformative business model.

Health care is another arena where do-it-smarter businesses will thrive. On average, health care spending in OECD countries has outpaced GDP growth by nearly two percentage points a year, and even more in the United States. Still, in most countries, increased health care spending actually creates a productivity drag on the economy overall, because the sector has lagged behind in adopting productivity measures. (To take just one indicator, health care organizations spend, on average, only 20 percent of what financial-services companies do on IT.) But multiple innovations promise to improve outcomes significantly while reducing costs. For example, some 75 percent of health care spending in many OECD countries pays for chronic-disease management. France Telecom¶s Orange is partnering with health care providers to offer services that constantly monitor diabetics and cardiac patients remotely. Low-cost mobile-monitoring devices ensure better compliance with treatments and reduce the number of high-cost, life-threatening events. Germany¶s T-Systems has linked up with the health insurance provider Barmer to provide mobile systems that track and monitor exercise patterns, so patients²and doctors²can monitor progress and reduce risk more effectively. A raft of industries and services are poised to benefit from productivity improvements. Huge gains could be extracted just by applying the insights learned over the past 15 years in the most productive sectors, such as telecoms and financial services, to less productive ones, such as health care, education, and government.

The best companies will learn how to maximize returns from people who think for a living

Just as the early 20th century saw the development of management theory for improving the productivity of factory workers, the 21st century will see the evolution of myriad better techniques for managing people who think for a living. The potential stakes are enormous. Companies that have higher concentrations of knowledge workers (above 35 percent of the workforce) create, on average, returns per employee three times higher than those of companies with fewer knowledge workers (20 percent or less of the workforce). Yet companies with more knowledge workers also show more variable returns: differences between competitors in the same industry with fewer knowledge workers. Turning this gap into a key source of competitive advantage requires much more than reverting to the well-worn ³attract, deploy, develop, and retain´ talent wheel found in HR manuals everywhere. Yes, the road to success still starts with capturing more of the right talent. But to increase productivity dramatically, companies will then need to think aggressively about how to increase the pace of talent development, to deploy the best talent against the highest-value opportunities, and to improve the way such workers engage with their peers. Our analysis suggests that at many large multinationals, nearly half of all interactions between knowledge workers do not create the intended value²because people have to hunt for information, do not know where to find what they need, or get caught in the maws of inefficient bureaucracies.

Companies will need to reinvent work²what, where, when, how, who, and why
Companies such as Best Buy have increasingly recognized that work is not a place where you go but rather something you do. To get the most out of its corporate workforce, the company has adopted a ³results-only work environment,´ which gives workers big targets but lets them meet these goals any way they see fit. This approach has improved worker productivity by as much as 35 percent in departments that have deployed it. Transforming process flows will also unlock new kinds of productivity. Companies such as Cisco and IBM are aggressively developing approaches²from social networks to videoconferencing²that tear down silos and reinvent how far-flung employees collaborate and exchange knowledge. What¶s more, these approaches work: UK grocer Tesco, for example, saved up to 45 percent of the travel budgets of key departments by substituting videoconferencing for long-haul travel. The Hong Kong apparel supplier Li & Fung now uses videoconferencing to connect clothing designers with fabric and notions suppliers around the world, dramatically speeding the design process. That¶s no mean feat for a company known for its ability to turn around ³fast fashion´ in weeks, not months. Although the demand for knowledge workers is sure to grow, the supply will not. Governments aren¶t moving fast enough to educate workers with the skills needed to meet the productivity imperative, and businesses can¶t afford to wait. That means companies must get much more innovative at sourcing talent, whether by tapping global labor markets, building part-time workforces, or making better use of older workers. Firms also will need to rethink work progressions in a world with much flatter age pyramids²young workers no longer outnumber old ones, which has been the premise for role advancement in most companies for decades. BMW has experimented with auto production lines geared for older workers. Retailers such as CVS and Home Depot are pioneering ³snowbird´ programs, which let retirees go to warm climates in the winter and to work in stores there, returning to their original stores in the summer.

Information streams are the infinite by-product of a knowledge economy²the best companies will turn this free good into gold
A final productivity driver will be something businesses are creating in digital bucket loads: information. Although the volume of data created is expected to increase fivefold over the next five years, best-guess estimates suggest that

less than 10 percent of the information created is meaningfully organized or deployed. That number will only shrink as the rate of information production goes up. Enter business analytics software, which increasingly allows companies to make sense of data ³noise´²helping them ³de-average´ data to eliminate waste, more closely target customers, and identify new opportunities. In general, companies that are aggressive adopters of business analytics are proving twice as good at predicting outcomes and three times as good at predicting risk as those that aren¶t. The Swiss telecom operator Cablecom, for example, reduced customer churn nearly tenfold through the better use of customer information. Both Amazon and Google have developed predictive models that use enormous amounts of data to figure out what products customers might like, based on past searches and clicks. IBM, Microsoft, Oracle, and SAP have spent a combined $15 billion in the past several years snapping up companies that develop software for advanced data analytics. Expect a host of new offerings that help turn information into gold. Soon, Web 3.0 technologies²which create ³smart´ data, or data that can be combined intelligently with other data, mostly without direct human involvement²should extend the power of information even further. We fully expect Web 3.0 to begin disrupting information networks within the decade. In short, companies that deploy technology more successfully to get more from the higher-quality knowledge employees they attract will gain large business model advantages²and drive substantial growth and productivity gains.

The global grid
The global economy is becoming increasingly interconnected, and innovative businesses are harnessing the power of this network.
JUNE 2010 ‡ Peter Bisson, Elizabeth Stephenson and S. Patrick Viguerie

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Exhibit: Executives weigh in on the major developments that will be important for business over the next five years. About the authors Comments (1)

Over the past two decades, globalization and digital technology have combined to create vast, complex networks that weave themselves through every economic and social activity. Money, goods, data, and people now cross borders in huge volumes and at unprecedented speed. Since 1990, trade flows have grown 1.5 times faster than global GDP. Cross-border capital flows have expanded at three times the rate of GDP growth. Information flows have increased exponentially. These networks form a global communications and information grid that enables large-scale interactions in an instant. Within this digital fabric, old boundaries begin to blur; cross-border capital flows also become information flows; and just-in-time supply chains also serve as just-in-time information chains. Case in point: only one in ten US dollars in circulation today is a physical note²the kind you can hold in your hand or put in your wallet. The other nine are virtual. On this grid, trillions of large and small transactions synchronize instantly. The striking thing about the recent economic downturn wasn¶t just the rapidity of the decline but the fact that so many seemingly diverse markets

plunged at once. By the end of 2008, the volume of trade had fallen by more than 10 percent in more than 90 percent of OECD1 economies. Why? Trade declined everywhere because, increasingly, products are made everywhere. These days, a typical manufacturing company relies on more than 35 different contract manufacturers around the world to provide the necessary parts for its goods, which for some companies, such as auto and airplane manufacturers, can range in the tens of thousands. No wonder that over the past 40 years, trade in intermediate goods as a percentage of total trade has doubled. These interconnections are even more pronounced in capital markets. Who would have imagined that Iceland¶s financial system might collapse when mortgages in Las Vegas went belly up? Such complex adaptive systems create their own organizing dynamic. In the absence of direction from a single center, they grow, evolve, interconnect, disrupt, and²quite important²heal themselves. Even as capital flows temporarily shut down during the crisis¶s darkest days in the winter of 2008±09, for example, the global information grid kept growing. Estimates by Cisco Systems suggest that in 2009, global data flows expanded by nearly 50 percent. In China alone, more than 150 million new people connected to the Internet last year, giving that country a digital population almost as large as the world¶s biggest social-networking site, Facebook. And last year, Facebook¶s user base more than tripled, to upward of 400 million members²a population that would make it the world¶s third-largest country. Alongside this relentless advance in digital connectivity, the financial crisis has underscored the commitment by most countries to maintain market-based economies and free flows of capital and trade²though the precise shape of new regulations remains to be determined. On average, governments across the globe have passed three protectionist measures a day since the advent of the crisis, but they haven¶t added up to much: less than 1 percent of global trade has been affected by these rulings. Meanwhile, links form in new directions. Trade flows between China and Africa, for example, have been growing by 30 percent annually, creating robust commercial networks that barely existed a few years ago. Similarly, Asia has supplanted North America and Europe as the Middle East¶s largest trading partner. Transactions between emerging markets are on the rise. The Indian wireless operator Bharti¶s recent bid to acquire Kuwait-based Zain¶s African assets could create a global wireless giant that would reach across more than 20 countries in South Asia and Africa.

Every company is now a global company²and the most innovative ones are building the global grid into their DNA
Innovative businesses will grow by harnessing the interlocking power of these new grids. Some will be disruptive newcomers like Skype. Formed less than seven years ago, and lacking any network infrastructure, Skype nonetheless ranks as the world¶s largest carrier of transnational telephone calls. Even if companies eschew such radical business models, they need to think strategically about how to use these new networks to advance their existing business models. Techniques such as ³near-shoring,´ ³crowd sourcing,´ and sophisticated labor arbitrage help companies efficiently build products, source ideas, find employees, deliver services, and reach customers efficiently.

As an English nurse orders medicine on a wireless electronic tablet, she links her hospital up to the global information grid, which will help innovative businesses grow and become increasingly international.

Similarly, companies that can figure out how to capture winning positions in the global supply chain will thrive. Japanese companies have mastered that strategy as no others have. In 30 different technology sectors with revenues of more than $1 billion, Japanese companies control 70 percent or more of global market share. They have done so by creating an array of ³choke point´ technologies on which much larger industries depend. Mabuchi Motor, for

instance, makes 90 percent of the micromotors used to adjust car mirrors worldwide. Nidec makes 75 percent of the world¶s hard-disk drives. Japanese companies own nearly 100 percent of the global market for the substrates and bonding chemicals used in microprocessors and other integrated circuits. The information grid makes every company, no matter how small, a global company. Even individual proprietors now sell to customers around the world via sales platforms such as eBay or Alibaba. Snaproducts, a US-based product-development company with fewer than 40 employees worldwide, uses virtual sourcing to supply US retailers with an array of low-cost seasonal and basic products: summer flip-flops, Christmas decorations, beauty products, socks²more than 50 million pairs in the past three years. The company marries a high-touch, customercentric design process with low-cost production; it collaborates with retailers to predict fickle consumer trends and then designs and sources products in collaboration with a range of low-cost manufacturers across Southeast Asia. This approach provides retailers with rapid sales on high-margin products and allows Snaproducts to deliver yearover-year growth rates as high as 400 percent, without ever taking ownership of inventory.

Your customer is tweeting²how will you answer?
The global grid¶s most important impact on business over the next decade may come from the disruptive changes in consumer behavior that it will spur. These changes may well overshadow the radical pricing transparency, ubiquitous information availability, and massive new networks of engaged consumers that we have already witnessed. Recall that 15 years ago, less than 3 percent of the world¶s population had a cell phone and less than 1 percent was online. Today, those numbers are 50 percent and 25 percent, respectively. These technological changes are altering behavior that was once thought impossible to shift. For example, Americans now spend 30 percent more time reading than they did a decade ago, thanks to the explosion of text messaging, e-mail, and social networking.

The complex digital networks that form the current global communications and information grid have brought mobile phones and Internet access to nearly every corner of the world.

What¶s more, these readers also write. More than 15 million Americans (or 10 percent of the US workforce) now post online product reviews every week. Aside from recommendations by friends, US buyers now rate online user reviews as the top influencer of their buying decisions²nearly twice as influential as old-style advertising. Traditional media companies know just how large a hole this behavioral shift has blown in their bottom lines. But it¶s not just Big Media¶s problem. Companies everywhere are struggling both to capture the benefits of this always-on, user-driven world²and to contain the damage it can cause. Product problems can become global issues overnight, putting a premium on constant monitoring. Viral networks also help inflame nationalist passions around formerly isolated incidents. (Carrefour learned that lesson when negative remarks made by French politicians promoted an overnight boycott of its Chinese stores in the run-up to the 2008 Beijing Olympics.) In such situations, speed and agility in crafting a response can make the difference between successful crisis control and enormous economic harm.

Imagine the power of four billion connected minds²are you prepared for the innovation about to be unleashed?
The spread of mobile broadband will multiply these challenges and opportunities. Users of the iPhone surf the Internet 75 percent more than do users of regular cell phones, and more than half use their phones to watch video. In just three years since the iPhone¶s launch, developers have created more than 200,000 applications, and this is only the beginning: nearly 50 percent of all new mobile phones purchased in developed markets are now Web-

enabled smartphones. That rush of new Net surfers includes a growing number of emerging-market users too: in China last year, more than 100 million people logged on using the country¶s new 3G network, which is why global mobile data usage rose 2.5 times in 2009.

The global grid¶s interconnectedness can bring volatility as well as stability to the marketplace. Stock traders in São Paulo were no more immune to the financial crisis than their counterparts in New York were.

Emerging markets are where the information grid¶s influence may be most profound. The explosion of mobile networks is giving billions of people their first real entry point into the global economy, helping them become more informed consumers, connecting them with jobs, and providing much better access to credit and finance. The economic impact is tangible: every 10 percent increase in cell phone penetration in India corresponds to a nearly 0.6 percent rise in national GDP. Kenya shows how the future might unfold: just four in ten Kenyans have cell phones, yet half of all users²or one in five Kenyans²now make purchases via mobile-payment systems. Kenya¶s largest employer is txteagle, an SMSmessaging company, which provides jobs to more than 10,000 Kenyan citizens by doling out ³microwork´: small tasks that can be accomplished over mobile networks.

A world where not just everyone but also everything is connected opens up radically new possibilities
Increasingly, people plugging into the planet¶s digital nervous system will be joined by inanimate objects in a phenomenon we call ³the Internet of Things.´ At present, more than 35 billion ³things´ are connected to the Internet²sensors, routers, cameras, and the like²but this phenomenon is just getting started. More than two-thirds of new products feature some form of smart technology. For example, John Deere tractors now deploy GPS guidance systems to apply fertilizers to cropland precisely, reducing farmers¶ costs and increasing annual yields. The Dutch start-up TomTom has created systems of ³smart´ traffic lights that improve traffic flows. Nortura, Norway¶s largest food supplier, uses radio-frequency identification (RFID) technology to trace chickens from the farm to the store shelf, helping to monitor optimal refrigeration temperatures throughout the supply chain. Kraft and Samsung have partnered to develop the Diji-Touch, a Webenabled vending machine that allows real-time updates of rich-media images of products for sale. The stakes are high: as objects and devices connect online, some estimates suggest that at least $3 trillion of current spending could be disrupted.

Expect a bumpy ride²a connected world will be a volatile world
A profound tension remains at the core of this expanding global grid. In theory, all this interconnectedness is supposed to increase stability by helping to diversify risk. But while the ability to diversify risk has risen, so has the ability to identify and channel resources instantaneously toward or away from opportunities. The global financial crisis painfully underscored how interconnectedness can actually amplify the impact of a particular shock, so the key will be to focus on building in greater redundancy and resilience. In the meantime, we should not be surprised if the years ahead bring long stretches of stability²the payoff from a larger and more resilient system that is still subject to bubbles and powerful shocks. The next few years in particular may well be bumpy as a massive deleveraging process rolls through many Western economies. The eurozone will prove especially tumultuous as structural imbalances get worked out between savers, such as Germany, and debt-laden countries, such as Greece, Ireland, Portugal, and Spain. It¶s important to note that these bumps will occur across all markets²capital and currency markets, trade markets, and labor markets.

In response, businesses should strive to improve their peripheral vision by gaining a better understanding of the full range of areas where disruptions could emerge and by scanning the horizon for potential shocks. Volatility is here to stay. Learn to recognize it, prepare for it, adapt to it, manage it, and profit from it. But don¶t ignore it.

Pricing the planet
Understanding a company¶s full exposure to energy and environmental risks will in many cases be a²if not the²decisive factor determining its long-term viability.
JUNE 2010 ‡ Peter Bisson, Elizabeth Stephenson, and S. Patrick Viguerie

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Exhibit: Executives weigh in on the major developments that will be important for business over the next five years. About the authors Comments (1)

The tension between rapidly rising resource consumption and environmental sustainability is sure to prove to be one of the next decade¶s critical pressure points. Natural resources and commodities account for roughly 10 percent of global GDP and underpin every single sector in the economy. No one will sit on the sidelines in this debate. The interplay of three powerful forces will determine what resources we use, how we use them, and what we pay for them:
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Growing demand. Even the most conservative projections for global economic growth over the next decade suggest that demand for oil, coal, iron ore, and other natural resources will rise by at least a third. About 90 percent of that increase will come from growth in emerging markets. Constrained supply. As easy-to-tap and high-quality reserves are depleted, supply will come from harder-toaccess, more costly, and more politically unstable environments. Increased regulatory and social scrutiny. Around the world, political leaders, regulators, scientific experts, and consumers are gravitating to a new consensus that is based on fostering environmental sustainability. Climate change may be the most highly charged and visible battleground, but other issues loom: water scarcity, pollution, food safety, and the depletion of global fishing stocks, among other things. For businesses, this new sensibility will present itself in two ways: stricter environmental regulations and increasing demands from consumers²and employees²that companies demonstrate greater environmental responsibility. To understand how the world is likely to change as these forces collide, start by distinguishing between resource stocks, which are not likely to change much over the next decade, and resource flows, which will change enormously.

The fossil fuel consumption infrastructure is so large that, despite recent clean-energy investments, the ratio of fossil fuel to renewable and nuclear power use in 2020 will still be 80 percent, as it is today.

Despite huge investments in clean energy, in 2020 the ratio of fossil fuel consumption to renewable and nuclear power will remain largely as it is today²roughly 80 percent. No realistic scenario will move the needle: the embedded resource infrastructure is so large that any transition away from fossil fuels will take decades. But the view changes dramatically when you look beneath the supply stock to the flows of new investment. Suddenly, clean tech emerges as one of the next decade¶s biggest growth industries. Upward of $2 trillion will probably be invested in building clean-energy capacity globally over the next ten years. In the United States, 90 percent of this

expanded capacity will be in renewable or nuclear energy²66 percent in the European Union and China. Before 2020, this investment will probably create a clean-tech industry generating well over $1 trillion a year in sales. No country better epitomizes this contradictory dynamic than China, which in recent years has emerged as both the world¶s biggest carbon emitter and²if future actions speak louder than words²arguably its leading clean-energy champion. Buoyed by strong economic tailwinds, Chinese electricity demand is growing by 15 percent a year, creating the world¶s largest market for power generation equipment. To date, China has kept pace by adding a slew of coal-burning power plants that emit a lot of carbon. But motivated both by the huge costs of environmental degradation and by fears of overdependence on Middle Eastern oil, Beijing has moved decisively to support the development of clean-energy technologies. China may be the world¶s number-one polluter, but it is also the world¶s largest consumer²and manufacturer²of wind turbines and solar panels. And it will soon take a commanding lead in the use of clean-coal and nuclear technology. In fact, China is building the clean-energy businesses of the 21st century²not just locally but globally too. Suntech Power, China¶s largest manufacturer of solar panels, now commands 12 percent of the US solar market. The company, which will soon open its first factory in the United States, hopes to capture 20 percent of the US solarpanel market over the next two years. As a result of this enormous shift in flows, some business models will be obliterated, others will thrive, and yet others, especially outside the resource sector, may barely change. For CEOs, understanding their true exposure to energy and environmental risk will require more sophistication than ever and will emerge for many as a²if not the² decisive factor determining the long-term viability of their companies.

Commodity prices will rise higher²and fall harder
For most resource commodities, the question is not whether supply will be sufficient but rather what will happen to the price. And that depends in part on what it takes to gain access to resources.

With 12 percent of the US solar market, China¶s Suntech Power leads the country in solar-panel manufacturing and in building the 21st century¶s clean-energy businesses, both at home and abroad.

Just four countries²Iran, Iraq, Saudi Arabia, and Venezuela²hold some 50 percent of known oil and gas reserves. Nationally owned oil companies now control over 85 percent of them. Many of the key providers are highly exposed to broader geopolitical instability, which makes security of supply a major risk. Meanwhile, new supply is proving harder to find. Most new sources, such as deep-sea reserves or oil sands, require high-priced, environmentally controversial approaches to extraction. These factors all suggest that oil prices will be both higher and more volatile. Adding to the complexity is the fickle nature of global commodities markets. The number of ³virtual´ barrels of oil, in the form of futures and derivatives, traded on global exchanges each day exceeds the number of real barrels by an estimated ratio of 30 to 1. This ³market effect,´ enabled by the global grid, amplifies any market tremor²a key reason oil prices collapsed to just 20 percent of pre-crisis levels in the immediate wake of the financial crisis, falling from above $150 to roughly $30 a barrel. Few other industries could experience such pricing changes in just six months. Yet oil isn¶t the only commodity susceptible to wild price swings. For example, more than half of the world¶s copper production is concentrated in a handful of countries with limited infrastructure and high extraction costs. Producers know that over the long term, demand for copper can only grow. At the same time, they¶re wary of investing in infrastructure ahead of the demand cycle²a strategy that practically guarantees future pricing volatility.

In uncertain times, the need to plan for widely different outcomes is the one clear certainty
Regulation will prove another wild card. Virtually every major economy in the world is contemplating stricter rules, but there¶s little consensus over which regulatory schemes will be adopted, much less how they will be enforced. Some could dramatically transform business models. How, and if, carbon is priced, for example, could fundamentally alter many industries. The same is true with water. Large regulatory changes are sure to disrupt entire value chains. Agriculture, for example, is one of the world¶s leading carbon emitters. If it becomes regulated under a carbon regime, that will affect not just farmers but also their suppliers²for example, equipment manufacturers, seed producers, and fertilizer providers²as farmers scramble to adopt emission-reducing agronomic techniques, such as no-till planting. Consumer behavior may prove the great unknown. Although consumers are becoming much more environmentally aware, to date they have not shown much proclivity either to reduce their resource consumption or to pay for environmentally friendly products²and certainly not if such products cost more. (There are some notable exceptions, such as the Toyota Prius, which captured more than 2 percent of the US market, despite being 20 percent more expensive than a similar vehicle powered only by gasoline.) That resistance could change dramatically as we have seen before: recall the backlash against chemical companies in the 1960s, following the publication of Rachel Carson¶s Silent Spring. The implication: companies can no longer rely on business-as-usual scenarios when it comes to resources; they must factor in higher base-level prices and increased volatility. They also need to weigh any number of factors that are not yet²but may become²priced in the future, such as carbon and water. And they need to understand how customers might respond. Since these are huge uncertainties, companies will have to consider their options and outcomes under multiple scenarios.

Business models that drive resource productivity will be just as important as those that drive labor productivity
Despite the hype over clean energy, the biggest impact from rising pressure to price the planet may well come from something much more mundane: conservation. Boosting resource productivity²like labor productivity²will become an increasingly important way for businesses to reduce both their costs and their pricing exposure. Many of these gains require low capital investments and are comparatively easy to adopt. Advances in fields such as environmental product design and ³green software´ (which helps optimize resource usage) will become important ways for companies to reduce resource consumption. UPS, for example, has saved 2 percent on fuel costs by using software that helps plan delivery routes with fewer left turns (which use more fuel than right turns). Similarly, Apple has created approaches to reduce waste in its products: since it launched the iMac, it has reduced raw-material content by 50 percent and energy consumption by 40 percent. Boeing designed its new Dreamliner with both the environment and costs in mind: by using lightweight composite materials, the company improved fuel efficiency by more than 20 percent, reducing both a customer¶s lifetime ownership costs and potential future environmental exposures. Regulatory decisions will foster clean-energy innovation as well. Long-term Spanish subsidies of wind power are major reasons for the rise of two Spanish companies, Iberdrola Renewables and Gamesa, as global leaders in wind energy. Customers, too, are pushing companies to become more environmentally friendly²and helping to spawn some great new businesses. Clorox, for example, captured 40 percent of the US natural-cleaning-products market within the

first quarter of launching its GreenWorks line, increasing the size of the overall category substantially. Moreover, it did so by offering a suite of products that were up to 25 percent cheaper than other natural products. That made customers happy, and GreenWorks pleased shareholders as well by generating margins 20 to 25 percent higher than the company¶s average. Of course, not every green investment is a good investment, so companies need to assess the puts and takes on their options carefully. The future of some green businesses, such as carbon trading, depends hugely on still-murky regulatory environments. Other opportunities, particularly in clean energy, will take years to scale. Still others, such as ³smart´ building technologies, may have an immediate payoff today, both for customers adopting them and businesses selling them.

Plan for regulatory change²but don¶t count on global consensus
Governments everywhere hear the clamor for sustainability, but most also know they will retain power only if they keep delivering economic growth. Couple that imperative with the high coordination costs and fundamental resource usage inequities that persist across countries²China, for example, emits less than a fifth of the carbon dioxide per capita that the United States does²and it¶s hard not to conclude that while broad agreements may be possible, they will more likely prove elusive, as first Kyoto and now Copenhagen have demonstrated.

Future natural disasters seem inevitable, and so does the rise of ³adaptation´ businesses and offerings²for instance, new insurance and building products that respond to environmental challenges.

Nonetheless, we should fully expect a flurry of environmental regulations at the regional and local level. Local environmental problems, especially those (such as water safety) with immediate health consequences, will be solved more easily than global ones. Companies should identify where regulation is most likely to occur and get ahead of potential challenges²not always by taking action but, at least as a first step, by having a plan for what to do if laws change. Without coordination, this likely future patchwork of varied global regulatory standards may create unexpected opportunities. The model example is hybrid-electric-motor technology. First commercialized in Japan in response to stricter emission guidelines there, it later proved a commercial hit with US consumers, even though US regulations did not require the same standards. Expect more such arbitrage plays in the years ahead. Finally²and sadly for regions especially exposed to climate change and other forms of environmental degradation² we should prepare for the strong likelihood that an effective global regulatory regime will not appear in time. Look for the emergence of ³adaptation´ businesses, which develop in response to environmental disasters or challenges. New kinds of insurance products, building products, commercial fisheries, and other businesses designed to respond to tomorrow¶s environmental realities may well grow and thrive.

The market state
Governments around the world are facing complex, difficult decisions. Business leaders would do well to work with them to develop solutions.
JUNE 2010 ‡ Peter Bisson, Rik Kirkland, and Elizabeth Stephenson

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Exhibit: Executives weigh in on the major developments that will be important for business over the next five years. About the authors Comments

While we expect the steady advance of market capitalism to continue, the state²far from withering away²is likely to play an ever-larger role over the next decade, for three reasons. First, even before the financial crisis hit, governments everywhere found themselves increasingly called upon to mitigate the sometimes negative impact of globalization on individual citizens. Second, the crisis itself has prompted large-scale direct government intervention, both through fiscal stimulus and calls for increased regulation. That tilt in the power balance has been reinforced in much of the world by the perceived failings of the US-led free-market model and the success so far of a Chinese model that, while marketoriented, assumes that the state¶s guiding hand will stay firmly clasped around many levers of power. Third, the spread and dispersal of economic power around the world is making it harder to reach consensus on multilateral approaches to setting the rules of the global game. Bilateral and regional deal making is increasingly common, and these more local arrangements will remain largely market-based. Yet for business, this continuing shift away from a single set of rules will inevitably make it more challenging to seize opportunities globally. It will also require companies to engage across many fronts with many critical regional and national government actors.

A standoff between police and demonstrators in Greece: rising debt-to-GDP ratios and expanded demands for government services will raise political tensions in the developed and developing worlds alike.

Business executives, of course, face no shortage of challenges. But the tensions confronting policy makers in the coming years are truly daunting. On the one hand, states have been charged with driving prosperity by fostering economic growth and job creation. Most of them understand that this goal requires a strong role for the market rather than a reverse march toward command economies (hence our term, ³market states´). On the other, governments must also ensure social stability and maintain social-safety nets. What¶s more, they must accomplish these ends for citizens who continue to live within distinct national borders, even though those citizens¶ ultimate fortunes will be hugely influenced by transformative shifts in flows of capital, goods, labor, and information that recognize no borders. How governments respond to these pressures, both individually and collectively, will do more to shape outcomes over the next decade than the actions of any other single kind of economic actor. Let¶s drill into the complications. In the developed world, virtually all major economies are struggling with expanded claims for government services, rising debt-to-GDP ratios, and looming entitlement time bombs. Debt levels in OECD1 countries will, on average, likely rise to 120 percent by 2014²up from less than 80 percent today. In emerging economies, governments may enjoy better demographics, but their aspiring citizens and growing economies demand huge investments in physical and social infrastructure²from roads to education to health care² if they are to avoid social disruptions and build thriving 21st-century economies. Then there¶s this consideration: over the past 100 years, an income inequality gap split the world into two large camps²Western economies buoyed by an increasingly prosperous middle class, and other nations caught in a seemingly endless cycle of poverty. Now, while inequality among nations (and across this former divide) is thankfully shrinking, the gaps between rich and poor within individual nations are widening. While overall standards of living have risen across the globe, the gap between rich and poor has grown in almost three-quarters of OECD countries over the past two decades. Inequality is rising even faster in emerging markets: in China, it is increasing more quickly than in any Western economy.

This shift is partly structural. As economies develop, overall living standards tend to rise but so does income inequality. Manufacturing economies tend to be less equal than agrarian ones, service-based economies less equal than manufacturing ones. (The Gini coefficient²the measure of the difference between top and bottom earners²is two-thirds higher for service sectors than manufacturing sectors, and 150 percent higher for service sectors than agrarian sectors.) Globalization further compounds the problem²and not in ways that are intuitive. Trade, though often blamed for aggravating income inequality, is not the key culprit. Instead, the rate of technology adoption is by far the biggest driver, accounting for more than three-quarters of the impact, mainly by automating away many low-skill jobs. The shortage of knowledge workers and capital deepening (which increases the productivity of top talent, hence raising its earning potential) accentuate the problem by causing salaries for top earners to soar. The effect can be eye-popping. While a US unemployment rate topping 10 percent has drawn headlines in the current recession, the reality is starker. The unemployment rate in the top income decile of the population is barely 3 percent, but in the bottom decile, it¶s ten times higher²more than 30 percent. Upward of a third of the US unemployed are now considered to be long-term (or structurally) unemployed and thus unlikely to rejoin the workforce any time soon. While the gaps in Europe and Japan are generally smaller²Spain is a notable exception, with unemployment now approaching 20 percent²these nations pay a price. Estimates suggest that Germany and Japan, for example, have given up over a point of GDP growth a year for at least the past decade as a result of labor and taxation structures designed to produce a more robust safety net. In other words, to ensure a more equal society, they give up a third of the potential growth they could achieve each year. Income volatility is another key issue. Despite the ³great moderation´²the decline in overall economic volatility in the years preceding the recent downturn²the volatility of individual incomes has actually been increasing. In the United States, from the 1970s to 2008, it rose by as much as one-third. On average, 15 percent of US households can now expect their incomes to fall by as much as 50 percent each year. This isn¶t just a US issue: more than 50 percent of middle-class Brazilians worry that they are at risk of losing their jobs or otherwise seeing their incomes plummet. The bottom line: risk is shifting to individuals in a market-driven global economy²and governments are increasingly responsible to help pick up the pieces.

While Japan and most European countries don¶t share Spain¶s punishing 20 percent unemployment rate, they have sacrificed GDP growth to support a robust social-safety net.

Businesses need to recognize that governments bear the burden of legitimate challenges² and work in partnership to help solve them
In such a world, companies can no longer shrug off policy makers and legislators as interfering meddlers to be managed. Governments are facing legitimate and difficult decisions and will be forced to make trade-offs. Business leaders would do well to acknowledge these problems and to work with governments to help solve them. The risk of a populist antibusiness backlash is high²and companies will need to continue to earn ³the right to operate´ in relatively unconstrained, probusiness environments. Successful business leaders already recognize this reality. Wal-Mart Stores, for example, has worked alongside national and local governments, as well as other stakeholders, to help reshape US health policy. Innovative approaches born of the effort, such as the company¶s $4 prescription plans and in-store clinics, are helping to reduce

the cost of health care delivery in the United States, while also helping Wal-Mart¶s customers and employees to pay less for care.

Helping governments to improve the public sector¶s productivity will not only save them money but can also generate profits for the providers
Some of the most agile businesses will turn the ability to help solve the state¶s challenge into an opportunity. As the tax base for many governments shrinks and burdens grow, states too face a productivity imperative: how to increase services and decrease costs. Governments have been notoriously bad at adopting the lean processes and IT improvements that have driven years of productivity gains in the private sector. Creative approaches by businesses to help solve the public sector¶s problems will be part of the solution. In Spain, the health insurance provider Adeslas is partnering with the provincial government of Valencia to run hospitals and clinics more efficiently. In the United Kingdom, when the British Airport Authority built Terminal 5 at Heathrow Airport, it created an incentive plan to get private suppliers to finish the project faster and under budget. (And that example showed both how these new approaches can be successes and also hit bumps along the way²more than 50,000 pieces of luggage got hung up when the terminal opened, as baggage systems worked out kinks.)

States will be competing for jobs and growth, and selecting the right nations to partner with can be a competitive advantage for companies
While politicians will continue to be pressured by²and may sometimes pander to²the antibusiness backlash, most governments will continue to see working well with business as the best way to resolve their biggest dilemmas. Just as businesses need to recognize the legitimate challenges facing governments, governments must recognize the legitimate role businesses must play in contributing to the solution. After all, only a strong, expanding private sector can provide the revenue required to meet the state¶s burgeoning needs. More and more, countries will be competing for investment and wooing enterprises to generate jobs and growth. Two cases in point: Poland has recently created special tax breaks for companies relocating operations there, and both HP and IBM have put centers in Wroclaw to take advantage of these provisions. Similarly, Singapore¶s government has invested heavily in education and training in an effort to attract investment by leading multinational firms and also offers subsidies to companies locating there. As corporations think about where to invest, build factories, locate offices, and source talent, they should explore such opportunities actively. In an interesting twist, governments sometimes turn to private-sector businesses to enhance their prospects of attracting more private-sector business. For example, the city of Shanghai enlisted the employment-services firm Manpower to help it qualify entrepreneurs for government subsidies.

Global companies need to learn to work within and across multiple²and often divergent² regulatory environments
As companies expand globally, they will need to become even more sophisticated about navigating an increasingly complex regulatory landscape. Take financial services as an example. In Europe and the United States, banks have traditionally been managed as a profit-maximizing industry²an approach that has generated no end of secondguessing given the tumultuous outcomes of the past two years. By contrast, banks in Asia have, in effect, been treated as capital-providing utilities. However these regulatory regimes evolve, they will not soon converge. Google¶s recent challenges show just how hard it can be to drive a global business model while coping with widely different political and social cultures. In China, the company has strongly reasserted its own right to privacy, maintaining that data stored on its servers cannot be probed by the state. Meanwhile, in Italy, Google executives have been convicted for impinging on the privacy rights of others; several executives received suspended jail

sentences for providing a platform, via YouTube, that allowed individuals to post videos with no oversight from the company. Information standards, such as those for safety and labor, will remain fragmented and variable across countries and regions. Continued globalization will not homogenize cultural norms and expectations. Yet, as the global grid expands, the reaction and interaction from a single misstep in one country will ripple at the speed of light to more and more places, in new ways that will make the earlier experiences of companies such as BP and Nike seem relatively simple. Companies will need to become even more proactive and dynamic to cope effectively. Finally, if national governments feel challenged, the multinational institutions established under US leadership after World War II²the traditional enforcers of the ³Washington consensus´²are doubly challenged. With little true authority, they struggle to gain agreement from an expanding group of key global players with divergent interests. That¶s why the Doha Development Round of trade talks has been in limbo since 2001, despite the ongoing struggle to revive it. Efforts at coordinated regulation on issues as diverse as intellectual property, environmental protection, and capital markets may well see important progress on some fronts, but achieving large-scale solutions will continue to be a daunting task.

Business leaders must recognize their vested interest in the success of the state²perhaps the biggest risk of all is its failure to meet its challenges
Business executives should wish the leaders of aspiring market states well, wherever their leaders may fall on the light-versus-heavy-touch spectrum of government intervention. The reason is simple and compelling: no single factor is more likely to reverse the global economic expansion than a widespread failure by these states to meet the challenges that face them. This threat cannot be taken lightly. Suboptimal policy choices will dampen economic growth; bad choices could, in the worst-case scenarios, threaten geopolitical stability and this may well be the biggest macro-risk business faces in the decade ahead.