ESG-driven innovation in the chemical industry

The world is decarbonizing. Plans to cut carbon emissions to meet commitments to the Paris Agreement on climate change and those made at COP26 are producing a flurry of corporate, national, and international initiatives aimed at eliminating net greenhouse gas emissions by mid-century. The EU projects that it will reach net zero by 2050 and aims to cut its emissions by half over the next decade.

This powerful trend places a particularly stringent set of demands on the chemical industry because it accounts for a large share of global emissions. It is an energy-intensive industry that relies on hydrocarbons for raw materials. And about 50% of its total emissions are Scope Three, i.e., the results of all activities of the organization or its assets along the value chain. Reducing these emissions will require huge investment. To further aggravate matters, as the International Energy Agency (IEA) points out, the technologies for achieving 75% of the required emissions cuts by 2050 are not commercially available today.

But these challenges also present the chemical industry with a particularly powerful set of opportunities to position itself as a key partner in the sustainability-driven transformations of its customers’ industries. Because they are essential participants in the manufacturing value chain, chemical companies that prepare early to comply with more rigorous environmental, social, and governance (ESG) standards will build an advantage. And their response to address ESG pain points will spur important innovation.

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Six distinct trends

However, few of these firms are taking advantage of the full suite of strategies available to them. And that’s vital, because reaching net zero will require a root-and-branch transformation. Many businesses appreciate that they must innovate and change but are unsure where to begin. In our daily work with clients and through interviews we conducted with key stakeholders, we have observed six distinct trends common to the most innovative companies in the chemical sector. Increasingly, ESG is central to all of them.

1. Innovating beyond regulatory requirements

As key players in the manufacturing value chain, chemical companies stand to gain an advantage through early preparation to comply with more stringent ESG standards.

2. Aligning ESG-driven innovation with the authentic identity of the business

To deliver the appropriate value to stakeholders, chemical companies should align their innovation strategies with their authentic identity or “true north.”

3. Adopting a hybrid corporate-business unit operating model for innovation

Though hybrid operating models for innovation already exist in the chemical sector, they will need to be adjusted to deal with new ESG challenges.

4. Building an innovation ecosystem with external partners

Historically, chemical enterprises have conducted most of their research in-house, collaborating within innovation ecosystems only when there was a need to share risk or access new markets.

5. Leveraging external funding opportunities for innovation

Though technologically feasible, full ESG compliance in all dimensions will come at a cost. Across the globe, governments are providing strong financial support at national and multinational levels to assist industry in its ESG transformations.

6. Adopting innovation impact metrics that include new concepts

The new world in which we operate calls for a new set of metrics. It is common for large chemical companies to report the results of operations with a triple bottom line, using three distinct frameworks to assess performance.

Innovating beyond regulatory requirements

As key players in the manufacturing value chain, chemical companies stand to gain an advantage through early preparation to comply with more stringent ESG standards. Innovation that addresses ESG pain points is an important aspect of these efforts, and leading companies report that ESG-related ratings and frameworks increasingly play a role in shaping their innovation portfolios.

An ESG-driven approach to innovation should involve assessment of a company’s entire value chain and ecosystem. Due to the central position they occupy, chemical companies have an opportunity to influence ESG innovation across entire value chains. Potential interventions include innovations to reduce emissions and waste, the replacement of inputs with lower-carbon alternatives, and the recovery and recycling of materials and products at end-of-use or end-of-life. Innovation in products, processes, and business models can help value-chain players to comply with and, in some instances, even shape regulation.

Aligning ESG-driven innovation with the authentic identity, or "true north," of the business

To deliver the appropriate value to stakeholders, chemical companies should align their innovation strategies with their authentic identity or “true north.” Important elements to include in the framing of this authentic identity include a clear ESG ambition, a thorough understanding of the existing ESG profile, and a plan of action.

A company’s "true north” must always be considered in the development and execution of an innovation strategy, especially when considering the innovation operating model and key performance indicators (KPIs). Decision committees should focus on selecting innovation projects that target the ESG topics identified as most critical. The targeted outcome of an innovation strategy should also be as ambitious as the company’s overall “true north.”

Adopting a hybrid corporate-business unit operating model for innovation

Though hybrid operating models for innovation already exist in the chemical sector, they will need to be adjusted to deal with new ESG challenges. On the one hand, companies need to continue to develop incremental innovations, which deliver fast returns. On the other hand, companies need to think ahead to longer-term challenges, such as meeting net-zero targets. This will require setting aside research time and budgets to develop disruptive innovations that will likely be more costly, but that are crucial for achieving longer-term goals.

As a result, chemical players need to split their teams. Regional business unit–based teams should continue to focus on the incremental innovations that best fulfill customer needs, while corporate innovation teams can engage with research into disruptive technologies. This research is usually driven by a senior group that also steers the strategic direction of R&D.

Building an innovation ecosystem with external partners

Historically, chemical enterprises have conducted most of their research in-house, collaborating within innovation ecosystems only when there was a need to share risk or access new markets. However, the approach to innovation is changing in response to the complexity of ESG challenges. It is becoming more open, and innovation ecosystems are growing larger and more versatile. Such an approach is important for ESG innovations that require significant investment, but for which returns are uncertain and may lie well in the future.

This is particularly true when specific capabilities cannot already be found within a company and are difficult to acquire in a timely and affordable manner. The challenges that come with some ESG requirements, such as cross-enterprise circularity or traceable supply chain monitoring, can be much better addressed when working in a diverse ecosystem. Success is sometimes predicated on venturing outside the company, and often outside the industry.

Leveraging external funding opportunities for innovation

Though technologically feasible, full ESG compliance in all dimensions will come at a cost. Across the globe, governments are providing strong financial support at national and multinational levels to assist industry in its ESG transformations. Given the longer time horizons required for ESG investments to deliver sustainable returns, companies should increase their leverage in these external funding opportunities. This would help to lower costs and improve the chances of long-term innovation success. Leading companies lobby for new funding opportunities and are skilled at accessing public funding for their research projects. Public grants must then be managed and audited for compliance purposes, which is best done by dedicated teams to lighten managerial demands on core innovation units.

Adopting innovation impact metrics that include new concepts such as value to society and the environment

The new world in which we operate calls for a new set of metrics. It is common for large chemical companies to report the results of operations with a triple bottom line, using three distinct frameworks to assess performance. The chemical industry needs to adopt a similar approach when reporting on investment in ESG-driven innovation. Companies should be valued for their broader contribution to the three Ps - people, profit, and the planet - and given longer horizons for delivering returns.

Undoubtedly, an ESG transformation has costs, particularly in the short term. However, if negative externalities arising from unsustainable legacy technologies are appropriately accounted for, the case for investing in sustainable technologies becomes much stronger.

Conclusion

To reach net zero within the next 30 years, the chemical industry will need to innovate across all value-chain segments. This means companies must think of reducing their own emissions (Scope One) by developing new processes. They need to reduce their Scope Two emissions by leveraging more sustainable energy sources. But most important, they need to reduce their Scope Three emissions, which means they should consider the upstream value chain segments by sourcing more sustainable raw materials.

This will need an ESG-driven innovation approach that is aligned with a company’s authentic identity. Such an approach sets aside specific funding for disruptive technologies and is smart about leveraging public funding to lower R&D costs. Lastly, it thrives in an innovation ecosystem that includes its supply chain and other external partners. Throughout this transformation, companies should embrace new concepts to measure the broader impact of investment in innovation on people, profits, and the planet.

Looking forward, companies from the chemical industry should change their mindset and rethink their time horizons. They need to focus on engaging with their ecosystems and being open to new ways of collaboration. Chemical companies need to follow an innovation-push strategy to comply with increased environmental, social, and governmental pressures, if they want to stay ahead of their competitors and attract new customers who are focused on ESG concerns.