Are today’s industrial companies up to meeting the “Schumpeter challenge”? — Hard lessons from 40 years of “creative destruction” within the chemical industry
“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”
― John Maynard Keynes
Back in the 1980s, the Austrian political economist Joseph Schumpeter suddenly came back into fashion. As neoliberal reforms were introduced under the Carter and Reagan Administrations to “unleash the dynamism” of markets and private enterprise, journalists and trained economists grew fond of quoting Schumpeter’s mantra about the need for “creative destruction” to push the engine of economic growth forward. Schumpeter’s ideas were used to justify scaling back the scope of antitrust enforcement so that innovation could be encouraged among the “winners” in a competitive economy. His ideas were also used to justify the growth of the debt-fueled “market for corporate control” as a way of brushing out the cobwebs that had kept “stodgy” big corporations from exiting unprofitable sectors and redeploying capital in ways that made investors more money and grew the economy.
Nearly 40 years after neo-liberalism ushered in a new era of creative destruction, it is high time for an evaluation. The round of earnings releases and investor calls by US-based global chemical companies give us a chance to begin to assess the legacy of this “Schumpeteran moment.”
The Case of the Chemical Sector.
Chemical companies largely inhabit a world of imperfect or oligopolistic competition that Schumpeter saw as necessary for capitalist innovation and growth. Moreover, these firms have merged, divested, reorganized in every possible way, leaving a path of closed plants, abandoned communities and environmental liabilities. Nevertheless, the industry has survived. Now important global constituencies like the UN, environmental NGOs and the European Union are looking to industrial companies to embark on a new program of innovation, in the hope of reducing carbon emissions and moving towards a zero-waste future. Most of the largest chemical companies have signed up, on paper, to promote UN Development Goals, to meet goals for carbon emission reductions, to work towards a “circular economy” where all used materials become the inputs for new products, and waste is either reduced drastically or eliminated entirely.
I argue that any fair assessment of the state of industry will reveal that, as currently organized and financed, the chemical industry will fall far short of its goals — both on measures that activists will place on it and those that the industry itself has established in various “sustainability reports” its members release. This likely failure will have a lot to do with the fact that the mechanisms of “creative destruction” unleashed in the post-1973 period have not delivered as advertised.
What did Schumpeter say about the future of capitalism?
Joseph Schumpeter arrived in the United States during the Great Depression and while the storm clouds of a second world war were gathering. Schumpeter came bearing a message of hope for capitalism at a time when traditional faith in markets and private ownership were being challenged by Communism and Fascism as well as more moderate democratic reform programs such as the US New Deal and Scandinavian social democracy. Yet Schumpeter was no classical liberal either. In fact, his dynamic theory of capitalist development challenged the British and Austrian “laissez-faire” schools of economics at the same time as it challenged (and some say refuted) the scientific socialism of Karl Marx. Schumpeter’s radical proposition was that there was nothing stopping material progress from continuing within capitalism, at least on the grounds of pure economic forces. The real threat to the continued “triumphant march” of industrial capitalism — in raising popular living standards and spreading general happiness — were contained within the larger society in which capitalism lived. Capitalism, according to Schumpeter relied on the audacious creativity of individuals outside of the class system — industrial entrepreneurs — without whom the system would have failed to grow. Industrial entrepreneurs offered the element of “creative destruction” which was necessary to drive growth as growth was impossible without technological innovation.
The problem was that industrial entrepreneurs everywhere and at all times are too weak politically to run society according to their own needs. Industrial entrepreneurs need to rely on the traditional upper classes (those who have inherited privileges tied up with paper wealth and access to elite education and political power). These classes are made nervous by creative destruction and will seek to allay public hostility by doing things that smooth out the negative side of growth, but in ways that also replace the disruptive entrepreneur with administrative bureaucracy. Schumpeter identified the bureaucratizing trend both with the demands of the state and the demands of industrial enterprises themselves. He believed that Democracy would naturally lead to Socialism and that was not necessarily a bad thing (at least for political stability and elite rule), but it would tend to slow the dynamic growth of production that had characterized capitalism up to Schumpeter’s time of writing (1943). Traditional elites he believed often favored coupon-clipping and financial manipulation to the hard stuff of industrial entrepreneurship.
This is subtle stuff. Subtlety that was lost on the neo-liberal policy entrepreneurs who sought to justify their “de-regulatory” reforms sold on the strength of Schumpeter’s memorable phrase (“creative destruction”). The Schumpeteran moment of the 1980s had two notable results:
- The relaxation of antitrust enforcements by the courts in the United States in the name of “dynamism.” This did not affect the chemical industry directly, but it did serve to increase returns in certain sectors like pharmaceuticals, electronics and IT as it allowed entrepreneurs to defend monopoly positions as “hard earned” and not likely to last forever, as the forces of “creative destruction” would hollow out the temporary advantages of one company in favor of a new disruptor. Think of Microsoft’s battle against the Netscape browser being made irrelevant by the shift of gravity towards in IT search engines like Google and social media companies like Facebook. A monopoly in 1995 is irrelevant by 2005. For chemical companies, this meant that there were other lucrative opportunities for capital, meaning many industrial activities that generated less than stellar returns, increasingly needed to be jettisoned (i.e. closed, slimmed down or sold to new owners able to use leverage to boost returns).
- The removal of institutional barriers to well-heeled outsiders influencing the management of large-scale public companies. When the Great Depression and New Deal reforms spelled the end to the previous era of finance capital (and the investment bank led cartels like J.P. Morgan and Co. that had tried to instill “rationality” (and bureaucratic methods) on industrial capitalism), the large corporation came to be seen as self-sufficient and essentially run by a top rung of credentialed managers. This “managerial revolution” came to an end in the 1980s as junk bond innovators like Michael Milken provided a way for a new class of speculators like Ivan Boesky and Henry Kravis to raise large amounts of capital in the bond market and put pressure on Boards of Directors to approve sales to new owners willing to pay more with other people’s money. Later a new crop of investors, operating under the “capitalist cool” label “private equity,” raised large pools of capital and used it to entice corporate managers into making divestments to new owners in the private market as an alternative to running businesses that were non-strategic. This appeal proved almost impossible to resist in an environment where activists had the power to pressure management to adapt strategies that boosted returns. In the end, many large chemical companies successfully fought off corporate raiders only to learn to play in an environment where mergers and acquisitions and divestitures (often also through the mechanism of a public spin-off) were pursued as alternatives to organic growth and the appeal of shareholder activists was in theory thwarted by adopting strategies for raising stock price through use of a significant proportion of cash flow to buy back stock from public shareholders. This use of cash had large opportunity costs: R&D pipelines abandoned, capital investments delayed, talented people pushed into early retirement etc.
The recent earnings cycle in Chemicals: what can we learn?
We are now emerging from a period of unprecedented dynamism within the chemical sector, at least if dynamism can be measured in terms of merger and acquisition activity and shuffling and reshuffling of company portfolios and strategies more generally. Earlier this year, DuPont and Dow completed their complicated merger and de-merger into three separate units made up of businesses combined from each of the two predecessors. This process has resulted immediately in the creation of two very large companies: DuPont de Nemours, Inc. (specialty products focussed on faster growing sectors like food, electronics and automobiles); and Dow Chemical (plastics and their feedstocks and materials for construction and inputs into other industrial processes); and a third which is smaller called Corteva Agroscience (crop protection products and seeds for agriculture). Each piece is reporting lower (often significantly lower) revenue, earnings and cash flow as compared with the prior year quarter. Moreover, management in each case is describing the operating environment globally as “challenging” and emphasizing metrics of management performance that focus on managing those “things within the company’s control” which presumably means not macro-economic trends or even overall industry pricing and demand environment. In each case, management is pledging to investors that they will keep a tight reign on capital spending, achieve promised “synergies” from the mergers and de-mergers and fork over a large share of cash flow to investors through buy-backs and dividends. Other large companies with large production footprints in the US include LyondellBasell, PPG Industries and Eastman Chemical. All to one extent or another report being challenged by a “difficult operating environment.” Management of this class of company typically reminds investors about “the inherent strength of our businesses” but counsels patience until conditions improve and “value” can be “unlocked.” R&D capabilities have been maintained, but are under constant pressure of cost-cutting.
In sectors of the chemical industry that are less tied to high-growth sectors or whose fundamental market structure makes their results more cyclical, the enterprises are much smaller than the majors (in any case smaller than $5 billion annual revenue versus DuPont’s approximately $20 billion and Dow’s approximately $30 billion) even if there owners are publicly owned (as most are). Typically, these companies are highly leveraged (meaning their debt to earnings ratios are greater than 2.0x) and some fail to report positive earnings (at least expressed in terms of generally accepted accounting principles or GAAP). Innovation strategies for these companies tend to be closely focussed on lowering manufacturing costs and keeping overall supply balanced with demand and their proprietary technology relate to manufacturing processes and to a lesser extent how their products work in customer applications. A good example of a market that is dominated by companies in this category is Titanium Dioxide (TiO2). This source of most white pigment used in paints, plastics, cosmetics and food report challenging conditions globally and have struggled to minimize losses in volume and erosion in market price. Each of the publicly traded US-based firms that operates in this space is the result of a corporate spin-off, Tronox from Kerr-McGee, Chemours from DuPont (prior to the Dow merger and the subsequent three-way split) and Venator from Huntsman Chemical or is owned by a family who acquired it by leveraged buy-out (Kronos Worldwide). In these cases, “de-leveraging” (i.e. reducing debt levels) must command a large share of cash flow, followed by the obligatory stock buy backs and dividends, leaving only a portion of free cash flow for re-investment in plant and equipment and R&D. This is not the industry tier where one should expect much disruptive innovation, as management is too focussed on executing quarter-to-quarter to invest in R&D on long time-horizons.
There are chemical companies who are trying to carve out distinct niches. FMC Corporation is now a “pure-play” agricultural chemicals company after selling its industrial chemicals businesses in private transactions, buying a Europe-based rival and swapping its food and pharmaceutical business for the piece of DuPont’s agrosciences business that Europe’s regulators would not let it combine with Dow. FMC is reporting much stronger revenue and earnings on strong sales in Latin America and pockets of product strength in Europe. Agricultural chemicals as a sector is showing more growth than others, with BASF and Bayer AG both reporting stronger year-over-year sales and earnings in their agro-sciences businesses, while Syngenta and Corteva report flat to weaker results. This is a sub-sector of the chemical industry that benefits from highly regulated product markets (insecticides and herbicides), successful patent protection of original molecules and crop applications, and that managers have sensibly protected from some of the cash-generation-above-all strategies pursued in markets with less favorable fundamentals.
FMC’s lithium chemicals spin-off, Livent is busy fighting off short-term headwinds and defending its plans to expand capacity to meet the anticipated demands of the battery market, especially for electric vehicles. As reported, regulatory requirements are expected to push electric vehicle sales dramatically higher in China and Europe, and auto manufacturers are aligning with battery companies, who in turn are seeking reliable long-term sources of supply of lithium hydroxide and lithium carbonate. Livent has paid some short-term costs for its commitment to a robust capital spending, but appears positioned adequately to weather the current supply and demand crunch. But like comparable firms in the broader category of inorganic materials like TiO2 or soda ash, Livent’s technology is focussed on chemical processing and to a lesser-extent particular applications of its chemistries to its customer’s processes. In these markets, no one has a composition of matter patent on their product. Supply chains in this space are highly vertical with much of the innovation, and thus much of the potential value creation, happening at the automotive original equipment manufacturers (OEMs) and at the battery-design and manufacturing levels. Fundamentally, companies like Livent and its competitor Albemarle must compete by having low-cost production capabilities at the ready to produce products of consistent quality that are demanded by the end-customers farther up the supply chain. Meanwhile, Albermarle reported higher sales and profits year-over-year based on strong end-market demand and also is investing heavily in capacity expansions to meet anticipated demand.
What does all this mean for innovation?
The global agenda on climate change and Europe’s commitment to a waste-free “circular economy” by 2050, will necessarily tap the creative talent of scientists to develop new ways of turning raw materials into finished products and turning discarded products back into raw materials for manufacture of new products. The industry functionally best placed to drive this innovation is the chemical industry. However the forces of “creative-destruction” have left a fragmented landscape, where big companies are pursuing their dreams in niche sectors like “agro-science” and “life sciences” and large legacy companies, like DuPont and Dow and LyondelBassel are left mired in slower growing markets highly dependent on petrochemical-based supply chains. So it is difficult to see the sources of renewal coming primarily from within the existing industry players, and it is difficult to picture what a new crop of activists might be able to achieve short of taking large companies private and bankrolling large innovation and capital spending programs. The debt markets would have a lot to absorb and the payback prospects would likely drive leverage ratios and interest rates to levels that would put the companies at some risk of default.
Could a new crop of start-ups challenge the majors in their markets, offering innovative products that get the job done and meet regulatory targets for de-carbonization and waste reduction? Certainly, anything is possible, but it is unlikely. Chemical manufacture is highly capital intensive and it is highly asset-specific, meaning where you build the plant and how you source energy, water and other raw materials is highly sensitive to politics and to location. New entry is expensive and difficult to pull-off. Outside of China, there are very, very few “greenfield” chemical investments, and it would take an ultra-risk-tolerant Elon Musk figure to figure out how to make this work on a large scale. What is much more likely is that innovation will happen at the OEM level and chemical industry will do its best to invest in capacity to meet these new requirements for materials for the batteries and the building materials of the future. But this likely will not be enough.
The possible role of industrial policy
As currently constituted, the chemical industry is not institutionalized in a way that it is likely to meet the expectations of the next 30 years. Schumpeteran “disruptive entrepreneurs” are not in evidence and it is unlikely that capital markets or product markets would support entrepreneurial strategies unless other institutional structures were built up to increase certainty and absorb some of the risk of failure. This debate has not been initiated, although there are bright people in companies and on the staffs of industry associations such as the American Chemistry Council (ACC) and Cefic (the European Chemical Industry Council) who have the skills, background and idealism to start the debate. Especially in the context of the newly fluid global environment where the future of the liberal international order (upon which the global supply chains of today’s chemical giants depend) will only be assured if the aspirations of those who today who believe that global capitalism (or global elites, if you are a populist but hostile to the “left”) has performed badly can be addressed. The concept of the “Green Deal for Europe” (as announced as a priority by incoming European Commission President Ursula van der Leyen) as well as the more controversial “Green New Deal” proposed by progressive activists and politicians in the US proved a starting point (if flawed by a one-sided hostility to energy-intensive solutions like nuclear and a transition role for natural gas) for creative engagement. While it is unlikely that the huge investments called for by these plans will occur as budgetary appropriations by legislatures financed by taxpayers, it is not impossible that national and multi-lateral development banks could be organized to raise capital and spread risk widely enough to permit the scale of investment that is required. And the chemical industry is an important home to the knowledge, skill and experience necessary to make any such program a success.
Industrial policy has been debated in the United States, but insufficient consensus has emerged on what to do and how to do it effectively. The worry about inefficiencies arising from the government “picking winners and losers” has persisted and received additional support by the less than transformative results of many of the grant programs organized by the US Department of Energy during the Obama Administration. The evidence against these grant programs remains anecdotal as there appears to be no systematic study although there is some evidence of the positive effects of grants in formation of biotechnology start-ups.
Any effective policy and institutional design in the chemical sector would be wise to give adequate space for individual creativity and a diversity of approaches and programs. A one-size-fits-all approach based on a consensus view (how ever well informed) about the shape of the future cannot help but be less potentially fruitful than organizing institutions capable of making multiple competing investments where failure of any one project is not a valid criterion for judging the political wisdom of the entire program. I will write more on the design of this type of program in the future.
