Climate change will alter the economics of demand. As consumer sentiment evolves so too will the value equation at the heart of commerce. Introducing the Net Customer Value lens.
While we often focus on the physical impacts of climate change, what is less well understood is how climate change will alter the economics of demand. Rising input prices and falling incomes potentially create a long-run perfect storm of dwindling consumption if businesses don’t act to safeguard demand now.
A precursor for the change needed could be the concept of Net Customer Value (NCV). For decades brands have passed hugely costly externalities onto customers while banking big premiums. This is increasingly incompatible with business purpose in the 21st Century. Accounting for or avoiding externalities will be fundamental to delivering customer value – and preserving business value – in the future.
Value matters
Customer value is a poorly understood area of management. In many ways the history of commerce is defined by supply-side product innovation. Thinking about what customers want is relatively new territory. The gap is bridged by marketing campaigns driving us to consume what brands want us to consume. Digital disruptors have challenged this orthodoxy to an extent, highlighting the power of taking a demand-side approach.
Price and value are often confused but they are not the same thing. There are numerous pricing models yet all are essentially rooted in determining commercial viability. The link to revenue is direct. Value on the other hand is about utility, helping customers achieve a desired outcome. The link to revenue more complex.
It’s no surprise that business leaders are more comfortable in the tangible world of price, and traditionally brands have grown demand through price, not value. Customer value is considered a psychological construct that is hard to quantify. Attempts to do so (Net Promotor Score, Total Lifetime Value, etc) are incomplete measures at best. However, it’s worth remembering customer value is no more ethereal than business value. Today only an estimated 20% of a company’s value is captured on its balance sheet, the rest is a complex mix of intangibles that ultimately determine demand for a stock.
By extension, customer value – of which price is but one component – similarly plays a key role in determining demand for a commercial proposition. While the metrics might not be as mature, few debate that customer value exists – and if it can be created, then it can be destroyed.
Customer tipping point
At its core NCV addresses a growing disconnect between a company’s value chain and its value proposition. As climate awareness grows, customers will begin to reassess the value exchange equation at the heart of commerce.
In theory if you sell me a product that creates as much harm as benefit for me, the net value to me is zero. What use is a car if the running costs are prohibitive and the asset uninsurable? What good is cheap clothing if fast fashion supply-chains indirectly cause the cost of my groceries to double? Why invest in the financial security of a pension if the fund managing it is investing in equities that harm my daughter’s earning potential? These contradictions are very real. Climate change will lead to spikes in energy and insurance costs, soaring food prices, lower wages and much else.
The 2019 UK general election saw virtually all parties making climate change a central component of their manifestos in response to electorate sentiment. As far back as 2014 a survey showed that some 10% of UK adults are signed up members of an environmental organisation. More recent surveys have tracked sustainability rising up the purchase criteria ladder.
However, so far ethical consumerism has been niche. While environmental concerns rank high among mass market audiences, this simply has not translated into behaviour change at the transactional level. Research conducted across 25 countries and involving 25,000 consumers, released last year by GlobalScan and GreenBiz, shows that by far the biggest barrier to wider adoption is affordability. People believe that it’s far more expensive to shop ethically. The economics of externalities pose a genuine challenge to that supposition. The rise of low-cost consumerism is directly linked to the worst elements of unsustainable global supply. If customers begin to connect the dots, the illusion of cheap materialism will be harder to sustain.
As Covid-19 demonstrates the power of shocks in accelerating trends and exposing fragilities, the sense of an advancing tipping point on this issue is palpable. The game-changer is that climate economics are becoming increasingly tangible. In theory if it’s possible to create a science-based target, it’s equally conceivable to create a science-based liability.
NCV is essentially a risk-adjusted value calculation and there’s every reason to believe that NCV will play a growing role in the purchase calculus of the future. After all, the stakeholders who know the brands best – investors – are already factoring this into their own value equation.
Follow the money
Climate risks have not escaped the attention of alert investors and Value-at-Risk is a common way to assess portfolio ESG risks. One way of accounting for externalities is carbon pricing. Applying a realistic carbon price (one that alters the climate pathway) to the earnings of large publicly traded businesses makes for sobering reading. One study shows a carbon price of $100/tonne would wipe 10% off corporate profits, as demand slumps. Another shows how applying a carbon price of $120/tonne would reduce operating profits of S&P500 firms by up to 12%.
Yes, this level of carbon pricing is a long way from today’s reality (outside of Sweden). However, that is the point. If corporate profits only exist because consumers subsidise the true cost of commerce, they why shouldn’t we discount value destroyed against value created? After all, investors essentially make an analogous assessment when looking at business value through an ESG lens.
Brands will argue this leaves them in an impossible position. If they internalise externalities, profit is all but wiped out. If they don’t, climate change will wreck the economy and crash demand. The answer is of course not just accounting for externalities but avoiding externalities.
The NCV equation effectively means that full customer value can only be delivered from a fully regenerative value chain. Any deviation from this represents a depreciation in value, as impacts offset utility.
This is the theory behind corporate net zero targets. However, in practice strategies focus predominantly on operational emissions. This does little to protect a business’ commercial engine from the threat climate change poses. A broader demand-side strategy is needed, but first it’s worth examining why viewing performance through an NCV lens is as much in business’ interest as it is in customers’.
Join the resilience
Climate change dominated the World Economic Forum’s Global Risk Report 2020 and the issue is widely recognised as the greatest threat business has ever faced, a direct result of a finite economic model that has run its course. The landmark Stern Report on climate economics warns of a 20% contraction in global GDP each year if we don’t act. More recent analyses show that these are not far off events, the damage is unfolding before our eyes.
The beauty of NCV is that it aligns customer interests and business interest. Just as customer value cannot be created with one hand and destroyed with the other, business value cannot be generated short term while the means upon which value depend are eradicated long term. In practice NCV involves modelling the effects of climate impacts on demand and conceiving strategies to reduce exposure by reducing impact.
Business reform, far from being a threat, is critical to long-term viability and resilience. Yet if business departs from its neo-classical anchorage, it needs a destination, a new model for success. NCV offers an organising idea for just such a system change.
Describing that system design in detail is a separate topic altogether. However, NCV will inevitably result in a number of significant reforms in the way businesses operate. Purpose will revolve around solving customer problems, not maximising profit. Performance will be measured on a long-term value basis, bridging the gap between financial reporting and ESG reporting. Shareholder primacy will be supplanted by a stakeholder focus. Ultimately NCV is designed to create a positive, regenerative cycle between business value, customer value and ESG value.
Crucially, NCV gives business a credible, attractive pathway for reform. Putting customers at the heart of a company is hardly controversial. Peter Drucker, the Godfather of modern management theory, said “the purpose of business is to create a customer”. Returning to an updated version of this foundational logic can only strengthen business.
Enter the value-sphere
Protecting your business' revenue engine from climate change means expanding ESG into the value-sphere of core business. NCV can help brands make this crucial transition, moving sustainability from a limiting factor to a value driver. This switch, more than any other, will be critical to preserving demand in the long run.
Rethinking products and propositions through an NCV lens is not just about minimising where value is destroyed, but augmenting where value is created. This is because in the short term, NCV will need to be delivered more by rethinking business models than reformulating products.
For millions of products, sustainable inputs simply do not exist. The science and technology are not there yet. In the near term, we should look at what can be achieved with how we commercialise propositions and this is where a profound understanding of customer value is immensely important.
We need to think far more expansively, challenging the traditional mechanics of value exchange as we actively conceive concepts that decouple consumerism from materialism. Models based on rental, asset sharing, usage-based pricing, and so on, are already redefining many markets and represent early incarnations of what is possible. Uniting unmet customer needs with science-based regenerative business models could unlock new categories of commerce altogether, such as time-limited ownership.
Brands need to be on the same side as their customers. NCV gives them a means to operationalise traditionally fluid concepts like “business purpose” and “licence to operate”. In essence, NCV tries to reconnect a company’s value chain with its value proposition on the basis of sustainability, a critical bridge for companies to forge if they hope to transcend into tomorrow’s regenerative economy. Ultimately, to achieve this we need a new form of demand-side innovation – value innovation – to reconceptualise value exchange in a time of climate change.
Comments