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2012 Number 1

A resource revolution
Why the world needs oneand how your business could shape it

2012 Number 1

This Quarter

The world we grew up in was shaped by the Industrial Revolution in Europe and North America in the 18th and 19th centuries. Now many emerging markets are going through their own industrial revolutions, but at a vastly different pace and scale. India and China, for example, are experiencing industrial transitions that are around 10 times faster and, together, 200 times larger than the British industrial revolution. Over the next two decades, the world will witness the emergence of an additional three billion middle-class consumers. In this issue of McKinsey Quarterly, we look at how those consumers will influence the worlds naturalresource landscape.
Demand for resources is already surging, and prices for most have risen since the turn of the century. In an article we coauthored with our colleague Fraser Thompson, we explore how demand can be met through higher resource productivity and expanded supply, what that means for business strategy in the years ahead, and how policy makers can boost the odds that business and society will deliver the necessary resource revolution. Then a diverse trio of experts

Harvard historian Niall Ferguson, the Americas CEO of Veolia Water (a leader in water-related environmental services), and the environmental chief of aviation giant Boeingshare their perspectives on the challenges and opportunities ahead. Innovation, and the scaling up of new technologies across resource systems, have important roles to playas youll hear from McKinseys Matt Rogers, who describes five potentially game-changing technologies that leaders should have on their radar screens. The emerging markets industrial revolution also is spurring innovation, which is the focus of another special report in this issue. Our colleagues Gordon Orr and Erik Roth describe the state of innovation in China today and the contrasting capabilities that local champions and multinationals bring to the competition ahead. In addition, the leaders of General Motors and AstraZenecas Chinese businesses, along with McKinsey experts, provide snapshots of innovation in the Chinese automotive, pharmaceutical, and semiconductor industries. Even as emerging markets surge, many developed economies are continuing to labor under the weight of an overhang of debt. An article by our McKinsey Global Institute colleagues Charles Roxburgh, Susan Lund, and Karen Croxson takes stock of where we are in the deleveraging process that began with the financial crisis of 2008. Harvard University economist Kenneth Rogoff also weighs in on what he calls the Second Great Contraction. These three themesthe resource revolution thats under way, the dynamism of emerging markets, and the deleveraging of developed ones are tightly interrelated. Growth in emerging markets neednt just strain resources; it can create ideas and solutions too. Meanwhile, as developed markets slowly shed the yoke of excess debt, their renewed growth may exacerbate rising demand for raw materialswhile stimulating the resource innovation that the world sorely needs.

Richard Dobbs

Jeremy Oppenheim

Director, Seoul office

Director, London office

On the cover A resource revolution Why the world needs oneand how your business could shape it
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Mobilizing for a resource revolution


Richard Dobbs, Jeremy Oppenheim, and Fraser Thompson
Over the next quarter century, the rise of three billion more middle-class consumers will strain natural resources. The race is on to boost resource supplies, overhaul their management, and change the game with new technologies.

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Five technologies to watch


Matt Rogers
Innovation in energy technology is taking place rapidly. Five technologies you may not have heard of could be ready to change the energy landscape by 2020.

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Voices on the resource revolution


Three expertshistorian Niall Ferguson, the CEO of a water services company, and Boeings lead environmental executivereflect on the resource transition under way, where it could be headed, and what it means for leaders now.

Competing for the home of the future


Giorgio Busnelli, Venkie Shantaram, and Alice Vatta
Companies from a wide range of sectors are preparing for a time when the real money lies in helping households save energy rather than consume it.

Special report How China is innovating


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A CEOs guide to innovation in China


Gordon Orr and Erik Roth
Dynamic domestic players and focused multinationals are helping China churn out a growing number of innovative products and services. Intensifying competition lies ahead; heres a road map for navigating it.

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Chinese innovation: Three snapshots


The automotive, pharmaceutical, and semiconductor industries provide front-row seats on the evolution of Chinese innovation. Learn more about each from the president of General Motors China operation, AstraZenecas head of R&D for Asia and emerging markets, and McKinsey semiconductor experts.

Features

Leading Edge

63

Inside P&Gs digital transformation


CEO Robert McDonald wants to make the consumer goods giant the worlds most technologically enabled company.

10 A bias against investment


Tim Koller, Dan Lovallo, and Zane Williams
Companies should be investing to improve their performance and set the stage for growth. Theyre not. A survey of executives suggests that decisionmaking biases are a culprit.

96

Working out of debt


Karen Croxson, Susan Lund, and Charles Roxburgh
An update of our research on the efforts of developed countries to work out from under a massive overhang of debt shows how uneven progress has been. US households have made the greatest gains so far.

14 What really drives value in

corporate responsibility?
CB Bhattacharya, Daniel Korschun, and Sankar Sen
Few companies are clear about how investing in social initiatives will change stakeholder behavior or the harm a bad strategy can cause.

108

Understanding the Second Great Contraction:


An interview with Kenneth Rogoff
The economist and coauthor of This Time Is Different explains what history can teach us about the global downturn and why climbing out of it is still rife with risks.

Spotlight on open innovation


17 Managing the business

risks of open innovation


Oliver Alexy and Markus Reitzig
Focus on the factors that could redefine intellectual-property competition in your industry.

22 Wiring the open-source

enterprise
Jacques Bughin
Social technologies lie at the core of a new model that spurs user participation and speeds up product innovation.

Applied Insight

Departments

115 Beware the inside view


Daniel Kahneman
The Nobel laureate recalls how an inwardly focused forecasting approach once led him astray, and explains why an external perspective can help executives do better.

7 McKinsey on

the Web
Highlights from our digital offerings

8 Idea Exchange
Readers mix it up with authors of articles from McKinsey Quarterly 2011 Nu mber 4

118 The human factor in

service design
John DeVine, Shyam Lal, and Michael Zea
Focus on the human side of customer service to make it psychologically savvy, economically sound, and easier to scale.

132 Extra Point


Deleveraging: Where are we now?

124 How leaders kill meaning

at work
Teresa Amabile and Steven Kramer
Senior executives routinely undermine creativity, productivity, and commitment by damaging the inner work lives of their employees in four avoidable ways.

Editorial
Board of Editors Allan R. Gold Bill Javetski Allen P. Webb, Editor-in-Chief Senior Editors Luke Collins Frank Comes Thomas Fleming Lars Fyen Josselyn Simpson Dennis Swinford Editorial and Design Production Veronica Belsuzarri, Senior Designer Kelsey Bjelland, Editorial Assistant Andrew Cha, Web Production Assistant Elliot Cravitz, Design Director Roger Draper, Copy Chief Jake Godziejewicz, Design Intern Daniella Grossman, Assistant Editor Drew Holzfeind, Assistant Managing Editor Mary Reddy, Data Visualization Editor Delilah Zak, Associate Design Director McKinsey Quarterly China Glenn Leibowitz, Editor Lin Lin, Managing Editor Rebecca Zhang, Assistant Managing Editor

Business
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McKinsey on the Web


Highlights from our digital offerings

Now available on mckinseyquarterly.com

A wake-up call for Big Pharma


Lower profit margins suggest a need for new business models.

Other features:
Audio and video podcasts on iTunes audio: http://bit.ly/mckinseyitunesaudio video: http://bit.ly/mckinseyitunesvideo How the role of equities may shrink

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Our fifth annual survey on the way organizations use social tools and technologies finds that they continue to seep into many organizations, transforming business processes and raising performance.
What Matters on social innovation

Change makers share stories on innovative ways to solve the worlds toughest problems. Also, dont miss the results of our social innovation video contest.
Fishing for sustainability

Fisheries create work for 180 million people and $500 billion a year in economic activity. They are under pressure.

Idea Exchange
Readers mix it up with authors of articles from McKinsey Quarterly 2011 Number 4

The second economy


In our previous issue, economist and technology thinker W. Brian Arthur described the digitized, invisible, and autonomous second economy that drives much of the worlds economic activity and affects jobs, productivity, and the distribution of wealth. A robust conversation continued on mckinseyquarterly.com; here, Arthur responds to readers comments.

Economy or infrastructure?
Brett Champlin Management consultant, Allstate; Northbrook, Illinois; United States It seems youre describing an infrastructurealbeit one that operates differently and even intelligentlyand not an economy. But it enables, not replaces, economic activity. If I buy music through iTunes and not a store, the artist still creates it; I just access it through a different channel, supported by digital infrastructure. The economic activity isnt the infrastructure but the making and selling of the music itself.
W. Brian Arthur responds: Sorry, but I dont buy it. Certainly, if you are pushed, you could say that anything that supports human activity is infrastructure. But that misses the point. The second economy is an autonomous neural system where business processes are querying each other constantly and making decisions as a result. Water supplies and steam tunnels and railroads dont do that. The autopilot system of a Boeing 787 isnt infrastructure; its a second neural system that operates automatically in parallel to (and answering to) the human one. So it is with this new, automatic second economy.

Productivity creates jobs


John Baranowski General manager of accounting and operations, Greyhound Lines; Dallas, Texas; United States Wealth will be created but also spent in some form we cannot imagine. Past productivity eliminated millions of jobs and created millions more and while it is highly disruptive, there is no precedent for a long-term negative impact on total jobs and no reason to expect that the future (and the second economys impact) will be different.
W. Brian Arthur responds: I only hope you are right that the new prosperity will create new jobs. The idea that this always happens is called Says law in economics, and its now held by economists to be a tenet of faith, not true in reality. Since the second economy began, in the early and mid-1990s, weve had wave after wave of downsizing and layoffs, and now we have ongoing structural joblessness. I hope jobs will be created, and maybe they will. More likely, the system, as so many times before in history, will have to readjust radically. It needs to find new ways to distribute the new wealth.

Changing companies minds about women


Responding to stalled progress in the number of women in senior roles, McKinseys Joanna Barsh and Lareina Yee argued in our previous issue that new mind-setsabout womens ambitions, reliance on data, and the role sponsors playare needed to effect change. Here, Barsh and a reader from mckinseyquarterly.com continue the conversation about gender diversity.

Are men satised with the status quo?


Nick Smith Strategy manager, Tesco; London; United Kingdom The article loses some impact by saying, Mind-sets like this one inadvertently treat men as individuals and women as representative of their whole gender, then noting the role women play in this vicious cycle. The challenge is creating sensible solutions that dont treat all women the same and all men as individuals. I imagine many men dont react well to push-to-the-breaking-point coaching, where any failure to progress reects their ability, not the possibility that the sponsorship style may have been alienating. More work needs to be done to open opportunities for women, although within the context that men and women are different and there may be a natural imbalance within certain industries.

Joanna Barsh responds: Based on our 2011 research, we would challenge your first point: we found that over 90 percent of women aged 25 to 34 do start out as ambitious (defined by a desire to reach the next level). But when looking at ambition over time, we saw a steeper decline in women than in men, for two possible reasons. First, older women in middle management had less ambition than those at higher levels didworking at the same level for a long time correlates with lower ambition. We also found a correlation with motherhood, though it was not as strong as you might think. Your point that men, too, suffer from poor chemistry with certain sponsor archetypes is a great one. We believe that helping senior executives build their sponsorship skills, along with more thoughtful evaluations and talent discussions, benefits men and women alike; great sponsors shift styles to match the needs of individuals, regardless of gender. Interestingly, even in male-dominated industries (such as heavy construction), women are making their markthough fewer women graduate with engineering, computer science, and mathematics degrees. We challenge you to consider your own mind-set here; perhaps women would naturally advance at higher rates than men on the basis of self-selection.

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2012 Number 1

Research, trends, and emerging thinking

10 A bias against investment

14 What really drives value in corporate responsibility?

Spotlight on open innovation


17 Managing the business risks of open innovation 22 Wiring the open-source enterprise

A bias against investment


Tim Koller, Dan Lovallo, and Zane Williams Companies should be investing to improve their performance and set the stage for growth. Theyre not. A survey of executives suggests that decision-making biases are a culprit.

One of the puzzles of the sluggish global economy today is why companies arent investing more. They certainly seem to have good reasons to: corporate coffers are full, interest rates are low, and a slack economy inevitably offers bargains. Yet many companies seem to be holding back. A number of factors are doubtless involved, ranging from market volatility to fears of a double-dip recession to uncertainty about economic policy. And a McKinsey survey points to another, perhaps more intractable, factor: the surprisingly strong role

cognitive biases play in the investment decision-making process.1 Conservatism . . . Most executives we surveyed believe that their companies are too cautiousparticularly when it comes to investments expensed immediately on income statements and not capitalized on the balance sheet. Two-thirds of the respondents said that their companies underinvest in product development and more than half that they underinvest in sales and marketing, as well as in start-up financing for new products or new markets.

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. . . is amplified by cognitive biases M  ore than four-fifths of the executives reported that their organizations suffer from at least one well-known bias; more than twofifths, three or more. And executives who believe that their companies underinvest are much more likely to have observed a number of common biases in the way those companies make investment decisions. Such biases, generally linked to the past experiences of the people who make or support investment proposals, included the following:
 Loss aversion, a major reason

The bias against loss apparently extends to much smaller deals: respondents were just as loss averse when the size of an investment was $10 million and the potential gain $40 million.
 Most respondents also cited the

confirmation bias, which manifests itself when decision makers focus their analysis of investment opportunities on reasons to support a proposal, not to reject it. Depending on the proposal, this bias can result in decisions to underinvest or not to invest at all just as easily as it can in decisions to overinvest.
 Also common was a bias toward

for underinvesting, plagues the decision making of many executives.2 When asked to assess a hypothetical investment scenario with a possible loss of $100 million and a possible gain of $400 million, for example, most respondents were willing to accept a risk of loss of only 1 to 20 percent, although the net present value would be positive up to a 75 percent risk of loss.

using inappropriate analogies based on prior investment experiences that werent applicable to the decision at hand.
 A final issue was the cham-

pion bias, evident when managers unjustifiably defer to the person making or supporting an investment proposal, rather than considering the merits of the proposal itself.

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Taken together, these behavioral twists seem to have a substantial effect on how well investments perform. Respondents observing the fewest biases were also much more likely to report that their companies major investments since the onset of the global financial crisis had performed better than expected. By contrast, those who reported observing the most biases were more likely to report that their companies investments had performed worse than expected (Exhibit 1).

beneficial investments (Exhibit 2). This reluctance to spend, of course, has spillover effects, sapping economic growth and job creation. Confronting bias Prior research suggests ways for leaders to dampen the impact of decision biases.3 Organizations can counter loss aversion, for example, by pushing accountability upward so that each individual investment is just a small part of the full range of results for which a senior executive is responsible. This is the obvious approach in industries such as oil and gas or pharmaceuticals, where executives are usually evaluated on the performance of a portfolio, not of individual wells or drugs. The same

Q1 2012 of investment as well. In fact, Decision biases respondents reporting fewer biases Exhibit 1 of 2 were significantly less likely than

Biases appear to constrain the level

those reporting more of them to say that their companies had forgone

Exhibit 1

The more biases reported, the lower the perceived returns The more biases reported, the lower the perceived on a companys investments. returns on a companys investments.
How would you characterize the returns on your companys major investments since the global nancial crisis started?
% of respondents n = 211 202 397 640

Higher than forecast

54

50

47

37

24 About the same as forecast Lower than forecast 28 18 0 24 25 1 28 39

25 2

3+

Number of biases observed by respondents within their companies1

Figures may not sum to 100%, because of rounding. Source: Feb 2011 McKinsey survey of >1,500 executives from 90 countries

Q1 20112 Leading Edge Decision Biases Exhibit 2 of 2

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Exhibit 2

Companies exhibiting a greater number of biases are more Companies exhibiting a greater number of biases likely to pass upto worthwhile investments. are more likely pass up worthwhile investments.
Have you forgone investments that, in retrospect, would have helped?
% of respondents who answered yes, n = 1,586 51 52 58

44

3+

Number of biases observed by respondents within their companies

Source: Feb 2011 McKinsey survey of >1,500 executives from 90 countries

underlying dynamicsin particular, senior executives responsible for the collective performance of many small investment betsare evident, though less obviously, in fastmoving consumer goods. Executives will never eliminate loss aversion or other cognitive biases that influence investment decision making but can put in place processes to reduce their impact. That could encourage the pursuit of value-creating opportunities and improve the performance of corporate-investment portfolios.
1 From a February 2011 survey of more than

2 In loss aversion, decision makers weight

potential losses signicantly higher than equivalent gains, even when the value they expect from an investment appears strongly positive. 3 See Dan Lovallo and Olivier Sibony, The case for behavioral strategy, mckinseyquarterly.com, March 2010.

Tim Koller is a principal in McKinseys New York office, where Zane Williams is a consultant; Dan Lovallo is a professor at the University of Sydney Business School and an adviser to McKinsey.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

1,500 executives from 90 countries. The participants held a wide range of positions in public and private companies, and all had exposure to investment decision making in their organizations. Two-thirds of the companies had annual revenues of more than $1 billion.

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What really drives value in corporate responsibility?


CB Bhattacharya, Daniel Korschun, and Sankar Sen Few companies are clear about how investing in social initiatives will change stakeholder behavior or the harm a bad strategy can cause.

Now that stakeholdersincluding consumers, investors, and employeespay increasing attention to the social and environmental footprints of business, corporateresponsibility efforts have moved into uncharted management territory. We see companies reengineering supply chains to make them greener, supporting social causes through volunteer programs for employees, or lobbying for human rights in far-flung corners of the globe. As this tide swells, many executives are left with the nagging sense that such investments rest on a shaky understanding of how corporate responsibility creates value, both for their companies and for society. Some investments, of course, produce immediate and quantifiable gains, such as those from recycling or from manufacturing processes that save energy. But often, social investments are expected to yield longer-term benefits as engaged consumers step up their purchases, a broader investor base develops,

or new talent flocks to a companys recruiters. In these more ambiguous cases, how is a manager to know whether stakeholders will indeed respond positively? Our research, described in greater detail in our recent book, Leveraging Corporate Responsibility: The Stakeholder Route to Maximizing Business and Social Value,1 suggests that while stakeholders interpretations of corporate responsibility are multifaceted and far from uniform, it is vital that managers avoid creating an impression that such activities are crowding out core business priorities. In fact, some well-meaning corporate-responsibility activities can actually harm a companys competitiveness. Consider an experiment. We had consumers rate their own purchase intentions for computer accessories after learning about a companys product quality and corporateresponsibility activities. Descriptions of the company as having high product quality had a modest posi-

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tive effect, but for a company with low product quality, the consumers willingness to make a purchase actually decreased when it engaged in otherwise positive corporateresponsibility activities (exhibit). In this second case, consumers were wary of these activities, thinking that the company ought to give precedence to product quality. Related research shows a similar dynamic at work with investors: highly innovative Fortune 1000 companies derive greater financial returns from their corporateresponsibility activities than their less innovative counterparts do. By following a few basic principles,

that stakeholders will interpret corporate-responsibility initiatives more accurately and thus more positively. Dont hide market motives. Stakeholders are remarkably open to the business case for corporate responsibility, as long as initiatives are appropriate given what stakeholders know about the business, and as long as companies genuinely pursue and achieve the accompanying social value. Companies should understand that they can pursue profitable core business and corporate-responsibility objectives in tandem, without trade-offs.

Q1 2011 leaders can increase the likelihood Corp responsibility Exhibit 1 of 1 Exhibit

Companies with low-quality products may reap negative Companies with low product quality could reap negative returns returns from their corporate-responsibility activities. from their corporate-responsibility activities.
Example of computer accessories purchase decision; on a scale of 1 to 7, where 1 = not at all likely to buy, and 7 = very likely to buy High 6 5.4 5 Consumer purchase intentions

5.5

Company with high product quality

4 3.4 3 2.5

Company with low product quality

Low 2 Negative Positive

Record of corporate-responsibility activities


Source: CB Bhattacharya, Daniel Korschun, and Sankar Sen, Leveraging Corporate Responsibility: The Stakeholder Route to Maximizing Business and Social Value, New York: Cambridge University Press, November 2011

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Serve stakeholders true needs. Consumers are drawn to products that satisfy their needs. Likewise, stakeholders are drawn to companies whose corporate-responsibility activities produce solid benefits, which can be tangible (such as improved health in local communities) or psychological (for instance, volunteer programs that help employees better integrate their work and home lives). Before investing in corporate responsibility, however, managers need to set clear objectives that companies can meet and then, ideally, create programs together with key stakeholder groups. Test your progress. Corporate responsibility acts as a conduit through which companies can demonstrate that they care about their stakeholders. A company should assess its initiatives regularly to ensure that they foster the desired unity between its own goals and those of stakeholders. Calibrating strategy frequently improves the odds that corporate responsibility will create value for all parties.

1 CB Bhattacharya, Daniel Korschun, and

Sankar Sen, Leveraging Corporate Responsibility: The Stakeholder Route to Maximizing Business and Social Value, New York: Cambridge University Press, November 2011. Our research examines the two most important stakeholder groups consumers and employeesto understand how and why they react to corporateresponsibility initiatives. The insights we gained helped us show how companies can develop, implement, and evaluate socialresponsibility programs that foster stronger relationships with stakeholders and thus create value for them and companies alike.

CB Bhattacharya is the E.ON Chair in Corporate Responsibility and dean of international relations at the European School of Management and Technology (ESMT), in Berlin; Daniel Korschun is an assistant professor at Drexel Universitys LeBow College of Business; and Sankar Sen is a professor of marketing at Baruch Colleges Zicklin School of Business.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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Spotlight on open innovation

Managing the business risks of open innovation


Oliver Alexy and Markus Reitzig Focus on the factors that could redefine intellectual-property competition in your industry.

Several years ago, something interesting happened in the infrastructure software sector: IBM and a number of other companies pledged some of their own patents to the public to create IP-free zones in parts of the value chain. They did so when a 2004 report showed that Linux, the open-source operating system that had emerged as a viable, low-cost alternative to established operating systems, such as Microsoft Windows and Unix, was inadvertently infringing on more than 250 patents.1 By voluntarily pledging not to enforce hundreds of IBMs own patents so long as users of the IP were pursuing only opensource purposes, the company led the creation of an alliance of patent holders dependent on (and willing to defend) open-source software against lawsuits. 2 One result: IBM substantially increased the share of its new products based on Linux. This example seems specialized and unusual; after all, who would give away patents to make more money from innovation? But as opensource innovation, crowd sourcing, and engaging with open communities become increasingly prevalent,

could IP-free zones appear in the competitive landscape of other industries? Having studied the case of infrastructure software closely,3 we believe executives can gain some insight into this possibility by asking three questions that underpin the logic of competing by protecting the open spaceopen competition, as you might call it: 1.  D o specialized firms offer proprietary solutions within certain layers of my industrys value chain? 2. D  o integrated firms seek to cut development costs in my industry by drawing on open technologies to substitute for these proprietary solutions? 3.  A re the underlying technologies complexconsisting of so many bits and pieces that a significant number could inadvertently infringe on proprietary IP held by specialized firms? The more affirmative the answers to these questions may be, the more likely it is that the interests of specialized vendors of proprietary

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solutions will collide with those of firms drawing on open innovation, which could involve any type of open good, from software to the genetic code to crowd-sourced designs for parts or tools. Thats because if the answer to question 1 were yes, specialized firms would stand to lose business if integrated firms (question 2) cut them out of parts of the business. And the more complex the technologies are (question 3), the more likely it is that competitive offerings of specialized and integrated firms will overlap and, in turn, that specialized firms will choose to defend their IP. While some executives will find it easy to answer these questions, others will be in less comfortable terrain. To give the latter food for thought, we assembled publicly available EU and UK data to approximate the likelihood that adopters of open innovation could, at some point, clash with proprietary firms in a given industry unless they took precautions (exhibit). Specifically, we sought proxies for the amount of economic surplus available and the number of private players going after it in different industries, for the viability and attractiveness of alternative open solutions that could redistribute some of that value, and for the technological complexity thats a precondition of the inadvertent overlap of proprietary and open technologies. While the metrics were crude and imperfect, we see glimmers of change along this industry continuum and some examples of the varying ways open platforms could shape innovation and competition. (For more details on the methodology,

see sidebar, Open competition: The data behind the risk profiles.) Consider construction cranes, a subset of the machinery not elsewhere classified sector (at the top of the exhibit). Software runs all the drive, calibration, safety, and security systems on modern cranes, and some crane manufacturers have started to adopt opensource software.4 To what extent has this development created a patentinfringement risk and a need to recalibrate innovation strategies? In the pharmaceutical industry (further down the exhibit), several players have formed consortia to ensure that basic genetic information remains accessible to them all. These same players revert to a proprietary model in downstream drug development. They deploy shared research in highly competitive branded products, thus highlighting the potential for diverse patterns of IP-based competition. Finally, in motor vehicles (near the bottom of the exhibit), barriers to entry are significant because of the minimum efficient scale for factories and steep learning curves. Interestingly, even in this sector, the OScar Project has developed an open-source car design (which anyone can download), and Fiat has developed, for the Brazilian market, a fully crowd-sourced car, the Mio, incorporating more than 10,000 suggestions from volunteers.5 While we think this analysis may serve as a useful benchmark, wed be the first to acknowledge that business executives are best placed to interpret the results. We hope (continued on page 21)

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Q1 2011 Open source IP Exhibit 1 of 1 Exhibit

Will open competition gain traction in your industry?


Will open competition gain traction in your industry?
Likelihood that open and proprietary competitors will clash1 Lower risk Machinery not elsewhere classied2 Radio, television, and communications equipment Medical, precision, and optical instruments Computers and ofce machinery Pulp, paper, printing, and publishing Fabricated metal (excluding machinery) Electric motors, electricity distribution, lighting Furniture, consumer goods Textiles, leather, and footwear Chemicals (excluding pharmaceuticals) Rubber and plastics Pharmaceuticals Food and beverages Glass, ceramics, bricks, cement, concrete, and stone Basic metals
Pertaining to question 2 Pertaining to question 1 Value of proprietary solutions offered by traditional players

Higher risk

Coke, petroleum, and nuclear fuel Motor vehicles Other transport equipment (eg, aerospace, boats, rail)

Viability of open-source alternatives Pertaining to question 3 Technology complexity, indicating inadvertent overlap of proprietary and open technology

1 The 3 risk factors are presented in a single risk-prole bar for each industry; most data based on average gures from 200607. 2 Includes agricultural, energy-related, general-purpose, and special-purpose machinery, as well as machine tools, weapons, and

For more on methodology, see sidebar, Open competition: The data behind the risk proles. domestic appliances.

Source: Derwent Innovations Index, Thomson Reuters; EU KLEMS project; UK Community Innovation Survey 2009; UK Office of National Statistics

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Open competition: The data behind the risk proles


To illustrate the three-factor risk profilescapturing the value of proprietary solutions, the viability of open-source solutions, and the complexity of technologywe used the proxies described below. For the sake of simplicity, the three risk factors in the exhibit are combined in a single profile bar for each industry. Unless otherwise indicated, the data are based on average figures for 2006 and 2007 and normalized between zero and one for each risk factor across industries. These are the latest numbers available, and the structural factors they represent change only slowly over time. If anything, incentives to use open-source alternatives may be increasing, which would imply that our risk profiles have a conservative bias. 1.  The value of proprietary solutions is a function of two variables: the presence of private investors, derived from the number of companies in an industry, and an industrys attractiveness for private investors based on average profits per company.1 2.  The viability of open-source solutions as alternatives is based on four variables: the importance of complementary assets, measured by the inverse of R&D expenses over profits; softwares importance to an industry, based on capital formation in software as opposed to other kinds of capital formation; the hardware assets necessary for innovation, measured by capital formation in computing, communications, and other kinds of machinery and equipment; and the heterogeneity of user demand, measured by the importance of users and consumers as sources of innovation. 2 3.  Technology complexity indicates where risk is a function of the volume and spread of new technology. It is measured by the number of patent applications multiplied by the number of unique patent applicants. 3

 ource: UK Office for National Statistics. S Source: UK Office for National Statistics, the EU KLEMS project, and the 2009 UK  Innovation Survey. 3 Source: Derwent Innovations Index. 

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that the industry tableau weve presented and the questions weve raised will provoke a productive debate in your organization about the evolution of the IP landscape and what it means for you.

1 The report was commissioned by the

consultancy Open Source Risk Management and carried out by experts in the opensource community. 2 The alliance spent several million dollars to purchase patents held by third-party developers. To reduce the risk of litigation against users of open-source software, it pledged not to enforce these patents. 3 For details, see Oliver Alexy and Markus For specialized innovators, a strategic Reitzig, Private-collective innovation, competition, and rms counterintuitive discussion might start by determining the extent to which open inno- appropriation strategies, SSRN working paper, August 2011. 4 vation overlaps with core IP. The For details, see Joachim Henkel and Mark Tins, Die industrielle Nutzung und inverse is true for more integrated Entwicklung von Open-source Software: players, which could begin by Embedded Linux, in Bernd Lutterbeck, assessing the potential savings from Robert A. Gehring, and Matthias Brwolff, eds., Open Source Jahrbuch 2005, Berlin: open solutions, the legal risks Lehmanns Media, pp. 12338. they could entail, and the invest5 See Erik Markowitz, The case for letting ments required to reduce those your customers design your products, Inc. Magazine, September 20, 2011. risks through the creation of an IP-

free zone. For companies in both categories, relationships are crucial. Specialized innovators may find it desirable to work toward mutually beneficial royalty deals with suppliers and buyers that have adopted open solutions. Integrated players that want to pursue the IP-free option will need allies (which might even include established competitors) to share the cost of reshaping the ecosystem. Finally, in a world of more open competition, it may become increasingly important to look continually for ways to boost the competitive differentiation of core IP. That might involve extending existing products or technologies with proprietary services that are difficult for open communities to replicate. The authors are thankful for the valuable input from Peter Goodridge and Jonathan Haskel at Imperial College Business School. Oliver Alexy further acknowledges financial support from the Engineering and Physical Sciences Research Councils Centres for Innovative Manufacturing at Imperial College London. Oliver Alexy is an assistant professor of innovation and entrepreneurship at Imperial College Business School; Markus Reitzig is an assistant professor of strategic management and entrepreneurship at London Business School.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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2012 Number 1

Spotlight on open innovation

Wiring the open-source enterprise


Jacques Bughin Social technologies lie at the core of a new model that spurs user participation and speeds up product innovation.

Open innovation isnt a new phenomenon. The first Oxford English Dictionary was an open-source project: editors solicited the participation of hundreds of amateur volunteer readers. Fascinating examples of information sharing and innovative intellectual-property arrangements can also be found in the evolution of Cornish pumping engines in the 18th century and of blast furnaces in northern England during the 19th century. Software itself was distributed free of charge during the 1950s.1 But open innovation has been gathering force in recent years, thanks to the emergence of the Internet as a global information-sharing network; the increasing importance of digitizable, knowledge-based products and services; and the sheer volume of data being generated, processed, and stored by a wide range of enterprises. From a beachhead in software (see companion article, Managing the business risks of open innovation, on page 17), open innovation has spread to a range of industries that use external insights to boost internal R&D efforts or even rely on outside networks for core

product ideas. Our latest research on Web 2.0 technologies reveals that more and more executives are taking advantage of these opportunities and foresee the need for organizational change if their companies are to compete in a more open, networked environment. Porous company borders increase participation . . . We have found that nearly twothirds of the companies around the world that adopt a social-technology platform aim to collaborate beyond their own walls to share ideas and information with customers and suppliers. We call this organizational form the networked enterprise. The rising ability to connect creates a large, vibrant pool of participants: as many as 30 percent of Internet users say they would actively innovate using social technologies.2 Within this broader group are significant numbers of people, such as software developers and product designers, who make the most valuable contributions. The large number of open projects continues to grow rapidly at organizations such as the T-shirt company Threadless (which uses its customers design

Leading Edge

23

ideas to help create its apparel lines) and InnoCentive (a crowdsourcing network that companies in the pharmaceutical and other industries use to solve difficult problems).3 Our survey research suggests that the prospects for open innovation will only improve, as many executives expect a further blurring of boundaries between employees and people outside the enterprise (Exhibit 1). . . . improve the flow of product ideas . . . The two most important uses of social technologies, we found, are

Q1 2012 Bughin Exhibit 1 of 2 Exhibit 1

to underpin the processes companies use in scanning the external environment and to help them seek out new ideas (Exhibit 2), with social networks and blogs being the most widely deployed tools. We also found that the more extensively a company is networked, the more likely it is to use the Internet for these purposes. Thats important for open innovation because the knowledge economy has created increasingly virtual products and services from software to product designs that can easily be shared and amended by online communities. Research shows that consumers

Executives see organizational changes on the horizon that Executives see organizational changes on the horizon that may improve the prospects for open innovation. may improve the prospects for open innovation.
% of respondents,1 n = 4,261 Boundaries between employees, vendors, and customers will blur Teams will self-organize Decisions will be based primarily on examination of data rather than on opinion and experience Organizations formal hierarchy will become atter or disappear altogether Data used for decision making will be collected primarily through experiments Financial transparency will increase dramatically Internal markets or other voting mechanisms will be used to allocate resources (eg, talent, capital, ideas) Strategic priorities will be set from the bottom up Individual performance will be evaluated by peers rather than by managers Employees will have much more discretion in choosing which tasks to work on Employees will play a much greater role in selecting leaders Large companies and/or business units will disaggregate Compensation decisions will be made by peers rather than by managers 3 14 12 10 9 20 19 18 17 27 32 32 Likeliest organizational changes in next 35 years, without constraints 35

1 Respondents who answered none of the above or dont know are not shown.

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2012 Number 1

Q1 2012 Bughin Exhibit 2 of 2 Exhibit 2 Companies that use social technologies most often do so to scanthe the external environment and out seek out new ideas. scan external environment and seek new ideas.
% of respondents1 whose companies use at least 1 social technology in given process How companies are using social technologies Total, %, n = 3,103 Scanning external environment Finding new ideas Managing projects Developing strategic plan Allocating resources Matching employees to tasks Assessing employee performance Determining compensation Blogs, Social networking, n = 1,322 n = 1,728 40 29 Video sharing, n = 769 11 RSS,2 n = 642 Wikis, n = 809 Podcasts, n = 502 Microblogging, n = 654 13
2040% 1020%

Companies that use social technologies most often do so to

510%

<5%

75

14

73

36

29

11

10

12

13

55

19

12

11

17

43

16

11

30

10

29

11

26

20

1 Respondents who answered other are not shown; <10% of respondents use tagging, rating, mash-ups, and prediction markets for any 2 Really Simple Syndication.

of the tasks and are not shown.

are more likely to find value in products they had a hand in creating, a trend reinforced by the way new digital platforms are improving the economics of product versioning and bundling. Customized, complementary products and services can therefore be created by the crowd and widely distributed, often subsidizing core product offerings. . . . and lift returns on R&D For many companies, the return on R&D spending has steadily declined

as the cost of renewing high-quality product portfolios has mounted. Some companies have turned to open-source strategies to address this problem. One well-known example is Procter & Gamble, which has leveraged its R&D spending through an innovation network that taps the creativity and experience of more than 100,000 customers, former employees, and outside experts. P&G is far from alone. Our research shows that companies whose borders are open to

Leading Edge

25

creative engagement with suppliers, partners, and customers can reap significant benefits. In particular, the application of Internet technologies to scan external environments and seek outside ideas correlates statistically with market share improvements.4 Organizational change to catalyze contributions While the number of open-source projects is growing rapidly, research has shown that about 90 percent of them dont fully achieve their potential. Leaders will need to know how the innovation landscape is evolving and be ready to respond by following some basic tenets. Start at the grass roots. Our survey research indicates that nearly half of the early adopters of collaborative technologies promoted their use by mobilizing people on lower levels of the organization. Hierarchal, top-down controls rarely succeed, since most creative interactions are tacit and dynamic. Develop competencies at the edge. Companies best leverage social and knowledge networks by venturing beyond corporate boundaries, as P&G has done. But opening the gates of the enterprise doesnt guarantee a robust networkand could compromise valuable intellectual property. Success depends upon the ability to gain the trust of users, transparency, and a deft hand in managing interactions. Understand what makes participants tick. Users and consumers have different motives for contributing their time and skills.

For some, the goal is simply recognition; for others, rewards or revenue sharing may be necessary to induce valuable efforts. Determining what matters for your priority constituencies is crucial.

The world is evolving toward more frequent competition between the open-source and proprietary models for developing products and services. The seemingly tactical organizational issues discussed here should increasingly influence the innovations, intellectualproperty approaches, and strategic evolution of a wide variety of enterprises. They deserve a place on senior managements agenda.
1 Gastn Llanes, Technology sharing in open

2 Eric von Hippel, Horizontal innovation

source, Universidad Carlo III de Madrid, December 2007.

networksby and for users, Industrial and Corporate Change, 2007, Volume 16, Number 2, pp. 293315. 3 A mit Deshpande and Dirk Riehle, The Total Growth of Open Source, proceedings of the Fourth International Conference on Open Source Systems, Springer Verlag, Milan, September 710, 2008. 4 Our research cited in The rise of the networked enterprise: Web 2.0 nds its payday (mckinseyquarterly.com, December 2010) and How social technologies are extending the organization (mckinseyquarterly.com, November 2011) conrms that social technologies are starting to have a statistically and economically signicant impact on global-enterprise metrics such as prot margins and market share gains.

Jacques Bughin is a director in McKinseys Brussels office.


Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

A resource revolution
Why the world needs oneand how your business could shape it
Twenty years from now, the global resource landscape may look dramatically different. New McKinsey research on the outlook for energy, water, land, and steel describes how the emergence of billions of additional middle-class consumers will place a premium on resource productivity and innovation. Learn more about the implications for your business in our feature article summarizing the ndings. Then get some historical perspective from Harvards Niall Ferguson and two views from senior executives on the front lines of change. Finally, dive deeper with more thinking from McKinsey experts on the technological and market discontinuities around the corner.

On the cover

28 Mobilizing for a resource revolution Richard Dobbs, Jeremy Oppenheim, and Fraser Thompson 43 Voices on the resource revolution: Three experts weigh in

56 Five technologies to watch Matt Rogers 59 Competing for the home of the future Giorgio Busnelli, Venkie Shantaram, and Alice Vatta

27

Artwork by Dan Page

28

Mobilizing for a resource revolution


Richard Dobbs, Jeremy Oppenheim, and Fraser Thompson

Over the next quarter century, the rise of three billion more middle-class consumers will strain natural resources. The race is on to boost resource supplies, overhaul their management, and change the game with new technologies.

Progressively cheaper natural resources underpinned 20th-century global economic growth. But the 21st century could be different. Indeed, over the past ten years, rapid economic development in emerging markets has wiped out all of the previous centurys declines in real commodity prices. And in the next two decades, up to three billion people (and their spending power) will be added to the global middle class. Is the world entering an era of sustained high resource prices, leading to increased economic, social, and geopolitical risk? Similar questions have arisen in the past, but with hindsight the perceived risks proved unfounded. In 1798, land was at the center of such worries. In the famous Essay on the principle of population, Thomas Malthus fretted that rapid population growth would outstrip the worlds supply of arable land, producing widespread poverty and famine.1 But his dire vision never came to pass. Instead, the agroindustrial revolution swept across Britain and then the rest of Europe and North America, breaking the link between the availability of land and economic development. Malthusian theories have enjoyed brief revivals, notably in the Club of Romes report on the limits of growth, in the early 1970s. But a combination of technological progress, the discovery of (and expansion
1  Thomas Malthus, An essay on the principle of population (New York: Penguin, 1970);

the rst of the six editions of the essay was published in 1798.

Mobilizing for a resource revolution

29

into) new low-cost sources of supply, and more productive ways of using it intervened. These developments pushed downby almost half, in real termsthe price of an index of critical commodities (energy, food, steel, and water) during the 20th century. That reduction came despite demand for those resources growing as much as 20-fold during the period. (For more on 20th-century commodity trends, see A new era for commodities, on mckinseyquarterly.com.) Market forces, and the innovation they spark, could ride to the rescue in the 21st century too. However, the size of todays challenge should not be underestimated as we enter an era of unprecedented growth in emerging markets. Our recently completed research on the supplyand-demand outlook for energy, food, steel, and water suggests that without a step change in resource productivity and a technologyenhanced expansion of supply, the world could be entering an era of high and volatile resource prices.2 Nothing less than a resource revolution is needed.

The evolving resource landscape


From 1980 to 2009, the global middle class 3 grew by around 700 million people, to 1.8 billion, from roughly 1.1 billion. Over the next 20 years, it is likely to grow by an additional 3 billion, to nearly 5 billion people. The world has never before witnessed income growth of this speed and magnitude: China and India are doubling their real per capita incomes at about ten times the pace England achieved during the Industrial Revolution and at around 200 times the scale. In all likelihood, the expansion of the global middle class will continue the acceleration in demand for resourcesenergy, food, materials, water that has taken place since 2000. Demand will soar at a time when finding new sources of supply and extracting it is seemingly becoming more and more challenging and expensive, despite technological improvements in the main resource sectors. Compounding the challenge are stronger links among resources, which increase the risk that shortages and price changes in one resource can rapidly spread to others. Our analysis shows,
2 Our reportResource Revolution: Meeting the worlds energy, materials, food, and water

needsresulted from a joint research effort between McKinseys sustainability and resource productivity practice and the McKinsey Global Institute. Read the executive summary or download the full report at mckinsey.com/mgi. 3 Dened as having daily per capita spending of $10 to $100 in purchasing-power-parity terms. See Homi Kharas, The emerging middle class in developing countries, OECD Development Centre working paper, Number 285, January 2010.

Q1 2011 30 2012 Number 1 Resource productivity Exhibit 1 of 4

Exhibit 1 Tighter correlations across commodity groups are a key factor driving volatility higher than it has been in the past century.
Annual standard deviation (relative to average) of McKinsey Global Institutes commodity price index and key drivers,1 % 32 Key drivers of volatility Individual commodity price variance 19 14 13 7 7 4 Correlation within commodity groups Correlation across commodity groups2

11

192029 193039 194049 195059 196069 197079 198089 199099

200011

1 Drivers of commodity index volatility determined by covariance analysis at commodity index and commodity subindex level,

2Energy, metals, agricultural raw materials, and food.

based on annual changes in prices. For further details, see the methodology appendix of Resource Revolution: Meeting the worlds energy, materials, food, and water needs.

Source: FAOSTAT; Grilli and Yang commodity price index, 1988; International Monetary Fund (IMF); OPEC; Stephan Pfaffenzeller et al., A short note on updating the Grilli and Yang commodity price index, World Bank Economic Review, 2007, Volume 21, Number 1, pp. 15163; World Bank commodity price data; UN Comtrade; UN Food and Agriculture Organization; McKinsey Global Institute analysis

for example, that the correlation between critical commodities is now higher than at any point over the past century (Exhibit 1). Potential environmental deterioration, itself driven by growing consumption of resources, could also constrain growth in the production of some resources. Food is the most obvious area of vulnerability, but there are others. Greater water use, for example, perhaps coupled with changes in rainfall patterns, could have a material impact on the percentage of electricity (now roughly 15 percent) supplied by hydropower. But if the challenges are on a different scale from those of the past, so too is the potential technological know-how to address them. Techniques from the aircraft industry are transforming the performance of wind-turbine power generation. Advances in horizontaldrilling techniques, combined with hydraulic fracturing, have led to the rapid development of US shale gas, whose share of the overall US natural-gas supply climbed from roughly 2 percent in 2000 to upward of 20 percent today by some estimates. Developments in materials science and information technology hold the possibility of dramatically improving battery performance, thus changing the potential for storing electricity and, over time, diversifying energy sources for the transport sector. Organic chemistry and genetic engineering may help to foster the next green revolution, transforming agricultural productivity, the provision of bio-energy, and terrestrial

Mobilizing for a resource revolution

31

carbon sequestration. In sum, the world is not short of technological opportunities, and resource strains could accelerate the innovation race (for more on the potential for transformational change, see Five technologies to watch, on page 56).

The case for a resource revolution


To shed light on the road ahead, we created some illustrative scenarios. One involves an expansion of supply: more of it becomes available and the productivity with which resources are used continues to increase at base-case rates consistent with current policy approaches. Another is a productivity response scenario, which adds a fuller range of productivity-enhancing opportunities to the base case and fills the remaining gap with growth in supply. Our analysis suggests that its possible to meet the resource challenge through an expansion in supply and base-case productivityimprovement rates. However, the pace of supply expansion would need to be significantly faster than historic rates. For land, the annual pace of supply additions over the next 20 years would have to be almost triple the rate at which it expanded over the past two decades. Water consumption by 2030 would be 30 percent higher than it is today. Up to 175 million hectares of additional deforestation would take place. Carbon dioxide emissions could reach 66 gigatons, a level that might, according to the estimates of many scientists, lead to a rise in global average temperatures of several degrees Celsius by the end of the century.4 The supply expansion case would require roughly $3 trillion in investment capital a year, about $1 trillion more than recent spending. Both the capital costs and carbon dioxide emissions in this picture (and in the other scenarios we created) could be improved through greater growth in shale gas. However, its promise is subject to concerns which are not yet fully researchedabout the potential impact on air, water, and land. For a slightly higher price ($3.2 trillion per year), the world could pursue a fuller productivity response. Even in this scenario, much of the annual capital (about $2.3 trillion) would go to boost supply, but an additional $0.9 trillion would finance a wide range of opportunities
4 The Emissions Gap Report: Are the Copenhagen Accord pledges sufficient to limit

global warming to 2 C or 1.5 C? A preliminary assessment, UN Environment Program, November 2010.

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2012 Number 1

to use resources more efficiently. At current market prices, 70 percent of these resource productivity opportunities would have an

Q1 2011 internal rate of return of more than 10 percent. By 2030, the annual Resource productivity market value (at todays prices) of the resources they save would be Exhibit 2 of 4 around $2.9 trillion. Exhibit 2 Based on current resource prices, productivity opportunities could be worth $2.9 trillion in 2030.
Column height quanties cost efciency of investment (ie, cost of implementation divided by resource benet) Column width quanties annual resource savings calculated as resource volume saved (eg, barrels of oil) times todays price (eg, $100/barrel of oil) Columns falling below the horizontal axis represent net savings; those rising above it represent net costs

Cost efciency of investment from private investors perspective (labels indicate selected opportunities), $ spent for implementation per $ in total resource benet 7.0 5.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 0.5 1.0 Building envelopebasic retrot, commercial Lighting switch from compact uorescent to LEDcommercial

Energy

Water

Land

Steel

High-strength steelconstruction: columns and beams High-strength steelconstruction: rebars Light-duty electric vehicles Light-duty plug-in hybrid vehiclesgasoline

High-efciency new residential buildings

Municipal-water leakage Road freight shift

Food waste reduction in developing countriesprocessing, packing, and distribution Building envelopebasic retrot, residential

Building envelope advanced retrot, residential

500

1,000

1,500

2,000

2,500

Annual resource benet,1 2030 savings, $ billion


1 Based on current prices for energy, food, steel, and water at a discount rate of 10% a year. All values are expressed in 2010 prices.

For an interactive presentation of selected cost curve opportunities, visit mckinsey.com.

Mobilizing for a resource revolution

33

All told, the opportunities in our productivity response scenario could meet almost 30 percent of global demand for water, energy, land, and steel in 2030. They would also reduce global carbon emissions to 48 gigatons in 2030, about halfway to the target that the Intergovernmental Panel on Climate Change (IPCC) believes is consistent with limiting global warming to two degrees Celsius.5 To help prioritize these opportunities, we developed a resource productivity cost curve (Exhibit 2), which groups more than 130 potential resource measures into areas of opportunity and arrays them according to their economic attractiveness; the top 15 could, collectively, deliver roughly 75 percent of the total resource productivity prize. The top opportunities range from improving the energy efficiency of buildings to embracing more efficient irrigation systems. In combination, they suggest the potential for a resource productivity revolution comparable to the progress made in labor productivity during the 20th century. But capturing a significant proportion of this potentialup to 40 percent, by our estimateswill be difficult. After a century of cheap resources, few institutions, in either the private or the public sector, have made resource productivity a priority. In a global economy characterized by greater resource scarcity, companies, consumers, and countries that break with old patterns and take the lead on resource productivity should strengthen their competitive and economic position.

The resource agenda for business leaders


To thrive in an era of higher and more volatile resource prices, companies will need to pay greater attention to resource-related issues in their business strategies. The goal must be to improve a companys understanding of how resources will affect profits, produce new opportunities for growth and disruptive innovation, create new risks, generate competitive asymmetries, and change the regulatory context. For resource-supplying industries, higher and more volatile prices could deliver significant windfall gains. But they also could generate input cost inflation, technological discontinuities, and a regulatory and societal backlash. For resource-consuming industries, higher and
5  Our report also contains a third, climate response scenario, which describes what it would

take to achieve a carbon pathway that the IPCC believes is consistent with limiting global warming to no more than two degrees Celsius. Crucial elements of this scenario include a greater shift to power delivered through renewables; the incremental production of biofuels for use in road transport; and further abatement of carbon emissions in land use through the reforestation of degraded land resources, the improved management of timberland, and measures to increase the productivity of pastureland.

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2012 Number 1

more volatile input prices may be hard to pass through fully to consumers. In addition, such industries will probably face new challenges, especially in fast-growing emerging economies where resource scarcity, and therefore competition over access (for example, to water rights), will prove more acute.

A systematic approach
The strategic implications of resource-related trends will vary from company to company, of course. A starting point for many is simply to adopt a more systematic approach toward understanding how the changing resource landscape could produce new growth opportunities, create cost advantages versus less prepared competitors, and generate new stresses on the management of risk and regulation. Exhibit 3 provides a checklist for business leaders to address these critical priorities:
Pursue growth opportunities. Helping consumers and companies to

use or access resources more efficiently should be very good business in the years ahead. For instance, the fastest-selling elevator line in Otiss 150-year history is the Gen2, which uses up to 75 percent

Between 20 and 30 percent of the worlds food is wasted somewhere along the value chain.
AFP/Getty Images

Q1 2011 Mobilizing for a resource revolution Resource productivity Exhibit 3 of 4

35

Exhibit 3 A resource strategy checklist can stimulate valuable internal dialogue.


Growth Composition of business portfolio Innovation and new products New markets Guide investment and divestment decisions at portfolio level; decisions to be based on resource trends Develop resource productivity products and technologies to ll needs of customers and company (R&D function) Build a better understanding of resource-related opportunities in new market segments and geographies and develop strategies to capture them Improve revenue through increased share and/or price premiums by stressing resource efciency in marketing efforts Improve resource management and reduce environmental impact across value chain to reduce costs and improve products value propositions Reduce operating costs through improved internal resource management (eg, carbon, energy, hazardous materials, waste, water) Manage risk of operational disruptions (from resource scarcity, climate change, or community risks) Reduce reputation risks and get credit for your actions (eg, through proper stakeholder management) Mitigate risks and capture opportunities from regulation

Internal efciency

Green sales and marketing Sustainable value chains

Sustainable operations

Risk management

Operational-risk management Reputation management Regulatory management

less energy than conventional elevators. Major companies, such as General Electric and Siemens, are building resource productivity businesses by investing heavily in emerging clean-energy and cleanwater opportunities ranging from wind turbines to industrialenergy efficiency. And in technology centers such as Silicon Valley, a broad range of clean-tech investors and entrepreneurs seek profits by revolutionizing resource productivity. In fact, venture capitalist Vinod Khosla predicted in a recent paper that positive Black Swans will completely upend assumptions in oil, electricity, materials, storage, agriculture, and the like. 6
Boost internal efficiency. Companies have large, profitable oppor-

tunities to improve the efficiency of their resource use across the value chain. Consumer-packaged-goods manufacturers have cut their energy costs by up to 50 percent by pulling productivity levers that pay back their costs in less than three years. Wal-Mart Stores has implemented a sourcing strategy that aims to reduce supplier packaging
6 V inod Khosla, Black Swans thesis of energy transformation , Khosla Ventures white paper,

August 2011.

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2012 Number 1

from 2008 levels by 5 percent no later than 2013, for estimated direct savings of $3.4 billion.7 Capturing many of these supply chain opportunities will require much closer collaboration between upstream and downstream players.
Manage risk. As resource inputs to production processes become

increasingly scarce, companies need to develop a more sophisticated understanding of their exposure to different natural resources, including supply chain dependencies and regulatory risks. Steel, for example, is becoming ever more critical in the oil-and-gas sector because of the shift to offshore deepwater drilling. Steel production depends crucially on the supply of iron ore, which in turn relies heavily on the water used to extract it. Almost 40 percent of iron ore mines are in areas with moderate to high water scarcity, and a lot of steel is produced in places where water is relatively scarce. One major packaged-goods company recently discovered that even though natural resources account for just 35 percent of its current cost base, swings in their prices could easily account for more than 70 percent of likely changes in the companys overall cost structure during the years ahead. That company, like many in the packagedgoods and other industries, has long taken a fragmented approach to managing the supply of raw materials. A world with a greater correlation between resource prices will put a premium on a more integrated approach, including central coordination of raw-material strategy across business units and product designs that minimize rawmaterial risks. Input diversification strategiessuch as augmenting petroleum-based plastics with bioplastics or recyclable aluminum in bottlingmay rise in importance.

Four areas for action


To illustrate the business opportunity, well review 4 of the 15 resource productivity priorities that, collectively, represent 75 percent of the total productivity prize (Exhibit 4). These opportunities will give some companies a chance to build profitable businesses and help others to keep costs and risks in check.
Energy efficiency for buildings. Improving the energy efficiency of

residential and commercial buildings is the single largest opportunity identified in our research. Retrofitting them with improved envelopes above all, insulationas well as heating and cooling systems and
7 Roadmap to a Resource Efficient Europe, European Commission, September 2011.

Mobilizing for a resource revolution

37

water heaters, is a large opportunity, particularly in developed countries (see Competing for the home of the future, on page 59). Spotting it, emerging residential-scale energy-service companies are attempting to provide end-to-end turnkey efficiency services for home and small-business owners, attracting customers through guaranteed utility savings. Meanwhile, a broad range of companies can cut costs and boost returns on capital by making their buildings more energy efficient. Simply cleaning the dust and dirt off the coils of a buildings air-conditioning unit, says Walter Levy, CEO of the industrial-product manufacturer NCH, allows the unit to operate

Q1 2011 more efficiently and thereby lowers its energy consumption up to 10 perResource productivity cent. Companies are likelier to pursue such opportunities when Exhibit 4 of 4 they look at maintenance as a return on investment, says Levy.

Exhibit 4 Fifteen areas of opportunity represent 75 percent of the resource prize.


Energy Land Water Steel

Total resource benet in 2030,1 $ billion (in 2010 dollars) 696 266 252 167 155 145 143 138 138 134 132 115 115 108 106 892

Energy efciency in buildings Large-scale farm yields Food waste Municipal-water leakage Urban densication Iron and steel energy efciency Smallholder farm yields Transport efciency Electric and hybrid vehicles Land degradation End-use steel efciency Oil and coal recovery Irrigation techniques Road freight shift Power plant efciency Other2

1 Benet calculations reect current market prices for steel, food, water, and energy; adjusted to exclude energy taxes and

2For example, air transport, feed efciency, industrial-water efciency, municipal-water efficiency in areas other than leakage,

subsidies on energy, water, and agriculture and to include carbon price of $30 per metric ton. These adjustments raise total benets to $3.7 trillion, from the $2.9 trillion shown on the cost curve (Exhibit 2). steel recycling, and wastewater reuse.

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2012 Number 1

Food waste. The world generates about ten million tons of food

waste every day20 to 30 percent of all food along the value chain. In developed countries, the vast majority of waste occurs during processing, packaging, and distribution. Developing countries waste a significant share of their food after harvest because of poor storage facilities and an insufficient distribution infrastructure. More than 60 percent of the food opportunity lies in reducing perishable wastewhich requires modern cold-storage systems and better transport approaches. Both represent significant business opportunities, particularly in developing countries. So do business model innovations that address behavioral challenges. In Africa, for example, many farmers have resisted using metal silos, preferring to reduce the risk of theft by keeping grain stored in the safety of their own homes. Any savings from reducing food waste spill over to savings from the water and energy used in agriculture.
Next-generation vehicles. The future cost competitiveness of electric

and plug-in hybrid vehicles will depend on technological-learning rates in producing batteries and electrified engines versus internalcombustion engines, which are themselves not standing still. One company looking for opportunities in the evolution of vehicles is truck maker Navistar, which in 2011 announced a development agreement with EcoMotors to support that companys opposed-piston, opposedcylinder (OPOC) engine architecture. Opportunities also should abound for companies able to deliver breakthroughs in batteries. Our analysis suggests that if their costs fell to $100 per kilowatt hour by 2030 (from approximately $500 today and $250 in our 2030 base case), sales of electric vehicles could account for 30 percent or more of new-car sales.
High-strength steel. ArcelorMittal, the worlds largest steel company,

estimates that high-strength steel would reduce the weight of steel columns and steel beams by about 32 and 19 percent, respectively. Qube Design Associates has developed advanced reinforcing bars that weigh 30 percent less than conventional ones. High-strength steel represents a sales growth opportunity for companies such as these and major potential savings for any consumer of constructional steel: overall, we estimate, a modest increase in the penetration of highstrength steel could save 105 million tons of steel in 2030, a reduction of 9 percent. One major barrier to adoption is a lack of awareness among the many buyers of construction steel in emerging markets. But that may be changing: buildings such as the Shanghai World Financial Centre and Dubais Emirates Towers already incorporate high-strength steel.

Mobilizing for a resource revolution

39

Priorities for government leaders


The speed and scale with which business leaders increase the supply of resources and pursue the four productivity opportunities described above (or the 11 other high-priority ones highlighted by our research) will depend on the rules of the game established by governments. One critical challenge is the fact that officials at the ministries most relevant to the resource systemenergy, water, and agriculture are unlikely ever to have dealt with a global-resource market as complex as the one we have today. To respond to it, they will need new skills. Furthermore, many governments find it hard to coordinate strategicplanning activities across ministries. Water-related issues, for example, often fall between the responsibilities of the ministries for water, agriculture, urban development, energy, and the environment; land-use issues between those of the agriculture, forestry, energy, and environment ministries at the national level, with multiple other stakeholders at the provincial and district levels. The international system for development assistance exacerbates matters, since it has its own parallel set of international agencies, each with a vested interest in its own part of the agenda. This fragmented institutional approach means that governments may not sufficiently emphasize

Improving the energy efficiency of buildings is the worlds largest resource productivity opportunity. Here, workers in Beijing add insulation to the exterior of an apartment building.
Adrian Bradshaw/epa/Corbis

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2012 Number 1

The pace of electric-vehicle penetration will depend on developments in battery technology and government policy.
ANDY RAIN/epa/Corbis

the highest-priority resource opportunities, such as the 15 our research highlights. Beyond this transformation of institutional mind-sets and mechanisms, policy makers can act on three fronts to ease the path to a resource revolution.

Strengthen price signals


Uncertainty about the future path of resource prices at a time when they are particularly volatile means that it is difficult for investors to judge what returns they might make on their investment. Furthermore, fiscal regimes in many countries provide a disincentive to the productive use of energy, land, and water resources by subsidiz-

Mobilizing for a resource revolution

41

ing them to the tune of more than $1 trillion per year. Replacing these subsidies with market-based prices would improve the attractiveness of resource productivity opportunities to private-sector investors. So would putting a price on externalities, potentially including carbon emissions. Measures such as these are difficult to get right, though. Unwinding energy subsidies, for example, would require other means of protecting the poorer populations that the subsidies are often designed to support. Unwinding water subsidies may be even harder, given the impact on local agriculture and urban populations. And any new price signals must minimize the risk of competitive asymmetries while encouraging companies to continue providing the resource supplies that the world will need.

Address nonprice market failures


Under any combination of supply and productivity moves, meeting the global economys growing resource demands over the next 20 years will require investment to increase by 50 to 75 percent, to at least $3 trillion per year. Achieving this ramp-up in investment will require measures to overcome start-up challenges and reduce associated investment risks, especially in resource systems with long-lived assets and hence significant stranded-asset risk. Strengthening privatesector lending (especially to capital-constrained households, small businesses, and project developers) will be crucial too. The same goes for clarifying property rights, particularly in the agriculture and fishery sectors, and for addressing principalagent issues, such as those between building landlords who bear the cost of investments in efficiency and tenants who receive the benefits.

Build long-term resilience


In the face of these challenges, societys long-term resilience needs bolstering. Policy makers can help by raising awareness of resourcerelated risks and opportunities, creating appropriate safety nets to mitigate the impact of these risks on the very poor, and educating consumers and businesses to adapt their behavior to the realities of todays resource-constrained world. Action that strengthens the productivity of smallholdings would simultaneously expand the supply of resources and improve distributional outcomes. Providing universal access to modern energy services could cost less than $50 billion a year and transform the livelihoods of 1.4 billion people still suffering from basic energy poverty. Implemented the right way, such moves could also strengthen the resilience of ecosystems by encouraging better management of water and soil fertility, limit-

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2012 Number 1

ing fuelwood-related deforestation, and enabling rural communities to adapt to the evolving, but uncertain, impact of climate change.

Supply and productivity opportunities can address the growing demand for resources and the environmental challenges associated with the rise of three billion new middle-class consumers. But these opportunities raise fresh questions: can business and government leaders, not to mention consumers, move with the speed and scale needed to avoid a period of dramatically higher resource prices, along with their destabilizing impact on economic growth, welfare, and political stability? Or do we need a crisis, with its associated problems, to accelerate technological innovation and investment? The questions are big, and the stakes are high.
The authors would like to acknowledge Daniel Clifton, Nicholas Flanders, Kay Kim, Pranav Kumar, Scott Nyquist, Matt Rogers, Sven Smit, and Marc Zornes for their contributions to this article. Richard Dobbs is a director of the McKinsey Global Institute (MGI) and a director in McKinseys Seoul office; Jeremy Oppenheim is a director in the London office, where Fraser Thompson, a senior fellow of MGI, is based.

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Voices on the resource revolution

Niall Ferguson Laurence A. Tisch Professor of History at Harvard University

The resource landscape is likely to evolve unevenly in the coming decades, creating a wide variety of opportunities and threats for different companies, sectors, countries, and regions. Featured here are three experts with diverse vantage points that

Laurent Auguste President and CEO of Veolia Water Americas

highlight the scope and complexity of the changes on the horizon. Niall Ferguson, a historian at Harvard University, puts the recent commodity price boom in perspective and provides cause for cautious optimism. The CEO of Veolia Water Americas, Laurent Auguste, explains the risks posed by dwindling water availability and how the public and private sectors can respond. And the environmental chief of aviation giant Boeing, Mary Armstrong, shares insights into how the global company is seeking to reduce its resource footprint while still meeting the needs of customers.

Mary Armstrong Vice president of environment, health, and safety at Boeing

Niall Ferguson was interviewed by Rik Kirkland, a member of McKinsey Publishing in McKinseys New York office. Laurent Auguste was interviewed by Fraser Thompson, a London-based senior fellow of the McKinsey Global Institute, and Thomas Fleming, a member of McKinsey Publishing in the Chicago office. Mary Armstrong was interviewed by Allen Webb, a member of McKinsey Publishing in the Seattle office.

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2012 Number 1

If you were observing Earth with only a Bloomberg screen displaying commodity prices and you had a long-run time series, you would conclude that World War III was in progress right now.

Niall Ferguson
is the Laurence A. Tisch Professor of History at Harvard University, a senior fellow at the Hoover Institution at Stanford University, and a senior research fellow at Jesus College, Oxford. He is the author of ten books, most recently Civilization: The West and the Rest (Penguin Press, November 2011).

The past
Part of my job as a historian is to point out whats not new. Whats clearly not new is that with rapidly growing demand and relatively slow-growing supply, there is a risk of conflict over scarce natural resources. The interplay between the supply of and the demand for natural resources is one of the great themes of human history. For most of history, the scarce resource is just fertile land; then gradually, human beings developed an appetite for things they cant eat, such as precious metal.

Voices on the resource revolution

45

Whats also not new is that competition can lead to technological innovation. Were not a static species. When we hit a bottleneck and the price signals are screaming that theres not enough of this stuff, we do tend to innovate. But there are big lags, and sometimes bottlenecks can persist for much longer than one would imagine. Its in the nature of scientific discovery that it isnt especially elastic in the face of certain constraints.

The present
If you start from the trough of the financial crisis, what you find is a spike that affects nearly all commodities.1 The only ones that have gone down in price since early 2009 are natural gas, chicken, prawns, wood, and olive oil. I used to joke that this was great news if you were planning a surf-and-turf barbecue, but if you had any other plan in mind that involved natural resources, you could be paying 100 or 200 percent more for your raw inputs than you were just two and a half years ago. That gives you a sense of the extraordinary time we live in. The only previous periods Im aware of when there have been correlated spikes in the prices of nearly all commodities are World War I and World War II. If you were on another planet observing Earth with the assistance of only a Bloomberg screen displaying commodity prices and you had a pretty long-run time series, you would conclude that World War III was in progress right now. Youd be quite wrong. But you would have spotted that something extraordinary was happening, and the explanation is that weve got demand-side activity that actually is comparable in its magnitude to a world war. The growth of Chinas economy and many emerging markets is so rapidthese are almost unprecedented growth rates in terms of longrun economic historythat its like the demand shock of a war. Heres the way I think of it. If the rest of humanity consumed natural resources at half the lifetime rate of the average American, a really significant number of commodities would run out within a matter of 30 years. In some cases, rare earth metals for example, it would be within 10 years. Even copper, which we think of as a pretty plentiful base metal, would be gone within about 38 years. So the starting point for any discussion has to be that some of these things are in pretty finite supply and that the rapid growth of demandas emerging economies explode into life and catch up with the United Statesmeans that this is a burning issue for us now.
1  For more, see Richard Dobbs, Jeremy Oppenheim, and Fraser Thompson, A new era for

commodities, mckinseyquarterly.com, November 2011.

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2012 Number 1

The future
One or two surprising things have begun to emerge. The first is that we should be less worried about peak oil than some have argued for years, because it turns out that we can access oil in North America more easily than we had thought. Whether its tar sands, tidal deposits, or the use of fracking,2 it means that North America potentially could get back to self-sufficiency in energy over the next 20 years. I think you need to be keeping an eye on technological innovation. Its probably a mistake to bet against it, and to bet on static technology. The second thing to keep an eye on is a geopolitical story that is potentially game changing. In my view, the aftermath of the American empire is bound to be a time of great instability. The trend already is for the United States to reduce its military and other commitments in the greater Middle East. Fiscal constraints mean the United States cant afford not to do this. Its clear that the defense budget is going to be the biggest casualty of rising interest payments on the rapidly growing federal debt. If you spend time in the Middle East, you sense that the regional playersTurkey, Iran, the Saudisrecognize a new postAmerican order is coming and are really jockeying for position. The unknown quantity is China. As China relies more and more on the Middle East for its oil and is disappointed in alternative sources, we may find ourselves in a new mid-21st-century world in which its Beijing rather than Washington that starts to be an external player in the greater Middle Eastern drama. As the United States retreats from its hegemonic position in the greater Middle East, I do expect trouble. I think this is a pretty obvious historical danger zone. Its got all the ingredients for conflict: Youve got very youthful populations. Youve got this retreating empire, so there are opportunities to contest the postimperial order. Youve got tremendous ethnic division, which is often a source of great violence. And youve been subjecting the region to terrific economic volatility. It wouldnt be hard for even a small war to generate a huge upward movement in oil prices. So I would say, keep an eye on the good news from technology and dont underestimate the capacity of research and development to produce some big wins. But remember, there is this big downside risk in a very strategically sensitive part of the world, particularly from the point of view of energy commodities.
2 Hydraulic fracturing (or fracking) is the process of drilling underground to extract fossil

fuels such as shale gas.

Voices on the resource revolution

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Businesses and communities will be increasingly exposed to challenges associated with a lack of water.

Laurent Auguste
is president and CEO of Veolia Water Americas, part of Veolia Water, the worlds largest water services company.

Under pressure
Industries and businesses should understand that water will become one of the critical elements responsible for ensuring the reliability of their operations. Put simply, if you dont have reliable access to water, you cannot run any business; and if you are unsure about the reliability of your access to water, then youve got a challenge in terms of making investment. Water will ultimately impact the decision-making processes of investors and companies as they decide where to locate their facilities. And the challenges associated with water are growing: theres research that says by 2030 the gap between availability and need will be about 40 percent.3 Veolia recently conducted research with the International
3 For more, see Giulio Boccaletti, Merle Grobbel, and Martin R. Stuchtey, The business

opportunity in water conservation, mckinseyquarterly.com, December 2009.

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2012 Number 1

Food Policy Research Institute (IFPRI) that shows that today about 20 percent of the worlds GDP is produced in water-scarce areas. By 2050, if we go on with business as usual it will be 45 percent. This means that businesses and communities will be increasingly exposed to challenges associated with a lack of water. With smarter management of water resources, we could reduce this economic exposure to only about 30 percent. To avoid being surprised, companies should make water part of their strategic planning and risk assessment. Some companies understand this and are already ahead of the gamestarting with the food and beverage industry and companies such as Coca-Cola, Pepsi, and SABMiller. Obviously, water is a key ingredient of their products. Other companies are probably behind, and they should consider what the future looks like to avoid exposure to operational or reputational riskparticularly in cases where there might be competition between a company and the local community having access to an important part of the water resource. There was a case recently in India where a large steel company wanted to establish itself in a particular location but faced challenges from farmers.4 It was really a trade-off between giving the steel mill access to the water resource versus having enough water for farming. These types of challenges are likely to increase as we move toward having a larger concentration of people in cities. Today, 50 percent of the worlds population lives in large cities; we are moving toward 70 percent. The greater density in certain cities will most certainly put more pressure on water resources. The landscape is changing, and theres a greater need to raise awareness because a resource that used to be considered infinite is under pressure. We need to manage that resource in a smarter way.

The municipal challenge


The main challenge with water is that theres a lack of good management of water resources. Cities typically are in charge of water, for example, but a watershed is usually much larger than a city. So a mayor will make decisions about water management without necessarily having the big picture.
4 For more, see the case study Steel and water: Insufficient water supplies could impact

future businesses, on GrowingBlue.com.

Voices on the resource revolution

49

Awareness is also a very big issue. People in the developed world definitely take water for granted. In some large US cities such as Chicago, for example, most homes dont even have meters, and many residents pay water bills based on the width and height of their buildings, so people basically dont have to be concerned about their consumption of water and have no incentive to reduce it. And rates across the country are pretty lowoften lower than what people pay for their monthly telephone bill. Even for mayors whose cities require substantial investment in water infrastructure, its difficult to consider raising rates because people consider water essential, so therefore it should be basically free. But what is free has no perceived value. The challenge is to find the right balance, recognize the real value of water, and set rates accordingly. This doesnt mean we shouldnt be creative in terms of rate structures to make sure water is affordable, but first we need to find the right balance.

Aeration tanks, such as these in Milwaukee, Wisconsin, are used to treat municipal wastewater.

Bryan Spear/Veolia Water Americas

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2012 Number 1

The Fujairah power and desalination plant, in the United Arab Emirates, produces 156 million gallons of fresh water per day.

Stphane Lavou/Picture library Veolia Environnement

Another challenge with water is that it is local. And since it is local, people manage it in isolationin siloswithout necessarily understanding the level of performance thats possible, or without seeing the good ideas developed in other parts of the world. Part of what we do at Veolia, therefore, is to work with our industry colleagues, scientists, academics, and NGOs5 to share these stories and make available the data, relevant case studies, and best practices so that decision makers can better understand their situations and begin to find solutions.6

Water innovations
One of the nice things with water is that, unlike oil, you can reuse it a number of times. Indeed, water is too precious to use only one time. So at Veolia, we like to speak of wastewater treatment plants as bio refineries. Whether it comes from a municipal or industrial activity, we should think of wastewater as a resource for energy or for recovering
5 Nongovernmental organizations. 6 For example, Veolia Water helped establish GrowingBlue.com to increase awareness

about water-related issues. Contributors range from Columbia University to the Nature Conservancy.

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51

raw materials. This is something I believe well see more and more of in the future. There are new technologies that allow us to produce energy from wastewater treatment, and also to separate whats in wastewater to recover some of these resources. We are, for instance, focusing on phosphate these days. Phosphate is an essential resource for fertilizer (and therefore food), but as a global resource, phosphate is limited, concentrated in countries such as Morocco. Being able to recover phosphate from wastewater and prevent it from reaching the sea and being wasted is a good strategy. More and more, I think well see companies use wastewater as a resource. Consol Energy, for example, is a large mining company that operates in West Virginia. Theyve been under a consent decree from the US Environmental Protection Agency to have better treatment of their wastewater, and so they are putting in place a very advanced solution to do this. But they also see it as a potential business opportunity. Because they are in the shale gas area and theres a growing need to treat the frac water7 that these mines produce, the company recognizes that sharing their facility might help them get more business in the future. By addressing one challenge, they are potentially creating a business opportunity for themselves. Another interesting example of turning a water challenge into an opportunity is Singapore. Singapore has been buying water from outside the country, and this is something they consider a risk. So what theyve done in response is develop a wastewater treatment plant that enables the reuse of wastewater for industrial purposes. This treated waterwhich theyve branded NEWateris brought to the level of pure water, which is necessary for production in the semiconductor and electronics industries. This is obviously very attractive to businesses because they dont have to treat the water themselves, and it has supported the development of an industry cluster. Finally, theres the recent example of the cosmetics company LOral, which is moving to reduce both the carbon footprint and water footprint of its facilities around the world. With Veolias support, theyve begun in Suzhou, China, by reviewing processes to minimize their water consumption, increase reuse, and even turn their wastewater into energy. I believe this will be critical for LOral for both their public image and also in terms of reducing their operational risk. Such moves will be increasingly important in China and other countries where challenges of water availability are a concern.
7 Frac water is the byproduct of hydraulic fracturing.

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2012 Number 1

Over the last 40 years, weve improved fuel efficiency by 70 percent. Weve got to continue to drive efficiency into those airplanes.

Mary Armstrong
has been Boeings vice president of environment, health, and safety since 2007.

The business imperative


Driving environmental strategy into our business strategy is a real imperative. Aviation is responsible for 2 percent of man-made CO2 globally, and air travel is growing at about 5 percent per year. Energy and fuel are our biggest focus areas because thats where our biggest environmental footprint is across the life cycles of our products. Over the last 40 years, weve improved fuel efficiency and therefore CO2 emissions by 70 percent. Our latest airplane platforms, which include the 787, are a 20 percent improvement over the airplanes that the 787 will replace in the f leet. Thats where our biggest impact is. Weve got to continue to drive environmental efficiency into those airplanes. We are trying to drive the commercialization of a sustainable aviation biofuel industry. Weve worked with the agriculture industry, university researchers, some of our customers, and airports: how will you drive the right feedstockswhich will depend on the region of the world youre

Voices on the resource revolution

53

insuch that we can get a biofuel that competes with aviation fuel but is sustainable? Camelina is a crop that might work. Eventually, wed like to see algae. We think thats very promising; algae grows all over. We also continue to look at the opportunity for fuel cells. We even have an unmanned airplane that is solar powered. Those are all things that were pursuing, and innovation will get us there eventually. But itll be a long time before we can electrify an airplane, and we cant wait that long.

Meeting the management challenge


When I was asked to take this role, our CEO, Jim McNerney, said, I want you to drive environmental thought and capability across how we operate the Boeing Company. I thought to myself, This is going to be interesting because one little group at the corporate headquarters is certainly not going to be capable of doing that well. One of the first things we did was to establish an environment, health, and policy council at the corporate level, led by Jim. That policy council meets twice a year; driving environmental thought into how we run the business comes directly from the CEO. This was always a we conversation. This was never corporate telling us, Weve got to go do this among all the other millions of things were doing. It was, This is a big risk to our business. And this is something that our CEO considers very important. We put together a one-page strategy and brought it back to the policy council and said, This is what we think youre asking us to do. Once we had a strategy together, then everybody owned it.8 One of the things Jim was most interested in is how you work across the company and really drive this into how we operate. We brought folks together; many times we were just connecting the dots, introducing parts of the company to one another. I would sit in the back of the room and listen. For example, we had the commercial side of our business all excited about sustainable biofuels, and we had the defense side kind of wondering why they were there. Then all of a sudden our Department of Defense customers, like the Navy and the Air Force, started asking about biofuels. The gratification is really, really high when you can bring these folks together and they say afterward, I had no idea that I could get so much from listening and applying some of those ideas to how wed solve problems.
8 For more about Boeings environmental strategy, see the companys 2011 Environment

Report, on boeing.com/environment.

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Pursuing efficiencies
We looked across the enterprise and invested in building systems and in energy improvements in lighting systems. Early on, we determined that any major building renovation, and any brand-new building, would meet the LEED9 silver standards. We built that into our building standards across our company because, as we looked at the life cycles of these buildings, that was a good business decision. In Charleston, South Carolina, weve just finished our big final-assembly facility. As we built it, we said, Were going to be building the most energy-efficient airplane in the world, the 787; we want a facility that represents that energy efficiency. So, we committed to 100 percent renewable energy out of that site. Twenty percent of that is coming from solar-photovoltaic 10 generating capacity on the top of the final-assembly buildinga big, ten-acre building. South Carolina Electric & Gas supplies the other 80 percent of the power that we need through a renewable-power contract.
Boeing researchers are investigating the pongamia plant as a potential biomass source. Once mature, it can grow in areas that are not suitable for food crops.

Several years ago, Boeing helped start the AFRA, which is the Aircraft Fleet Recycling Association.11 The goal, eventually, is to be

Boeing

able to take an airplane at the end of its useful life and move it right back into the cradle, if you will, of raw materials for new airplanes. There are a lot of good business opportunities here. Were looking at carpets. In a 777, you might replace the carpet 20 times across the life of an airplane. Were working with a company in the southeastern part of the US; theyve come up with a process where they can recycle airplane
9  LEED, or Leadership in Energy and Environmental Design, is administered by the US Green

Building Council and uses a rating system to promote sustainable building and development practices. 10 Photovoltaic capacity, colloquially known as solar power, generates electrical power by converting solar radiation into direct-current electricity. 11  AFRA members include original-equipment manufacturers such as Boeing, aircraft disassemblers, parts distributors, aircraft insurers and appraisers, materials recyclers, and technology developers. Airbus has a similar initiative, the Process for Advanced Management of End of Life Aircraft (PAMELA) project, to recycle aircraft parts.

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carpets back to airplane carpets. Thats really what this environmental strategy is about: its about delivering new, innovative solutions that not only drive environmental improvements but also drive business improvements.

Working with suppliers


The supply base has a much larger environmental footprint than we do inside our four walls. We have more than 16,000 supBoeings new 787 final-assembly building, in South Carolina, features thin-film solar laminate panels on its roof.

pliers. Moving into the supply base requires a different approach. Youve got to come in on cost targets. Youve got to have high quality, no defects. Youve got to

Boeing

deliver on time. And now you also have to provide a strong environmental program. All four of those things are required. I can remember being on the agenda for our supplier conference. It was just remarkable because the whole room was interested in how to participate, what they could do. In many cases, the suppliers knew more than we did. The suppliers recognize that if they can reduce their environmental footprint, its going to save them money. And if we can figure out how we work togetherwhere Boeing might change what we require because it would allow a supplier to, for instance, use recyclable packaging or containersthen we all win. Were also working in other ways to improve the efficiency of the aerospace supply chain, such as recently helping form the International Aerospace Environmental Group (IAEG).12 Although its initial focus is on creating an industry approach to meeting governmental requirements for chemical usage and reporting, theres also a major emphasis on reducing supply chain wastefor example, identifying priority chemicals for conservation, and developing a standardized reporting method for greenhouse gas emissions.
12IAEG was launched in September 2011. Its founding members are Airbus (with its parent

EADS), Boeing, Bombardier Aerospace, Dassault Aviation, Embraer, GE Aviation, Northrop Grumman, Rolls-Royce, SAFRAN, United Technologies, and Zodiac Aerospace.

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Five technologies to watch


Matt Rogers

Innovation in energy technology is taking place rapidly. Five technologies you may not have heard of could be ready to change the energy landscape by 2020.

Recent breakthroughs in natural-gas extraction highlight the speed with which game-changing technologies can transform the natural-resource landscape. Just over the horizon are otherssuch as electric vehicles, advanced internal-combustion engines, solar photovoltaics, and LED lighting that are benefiting from the convergence of software, consumer electronics, and traditional industrial processes. Each has the potential to grow by a factor of ten in the next decade.
Placing rapidly evolving technologies such as these on a resource cost curve, however, is difficult: their impact could be very big or very small. And thats even more the case for technologies that require significant scientific and engineering innovations to reach commercial scale at viable cost. This article describes five technologies that could start arriving in earnest by 2020 or so: grid-scale storage, digital-power conversion, compressorless air conditioning and electrochromic windows, clean coal, and electrofuels and new biofuels. Not all of these will succeed in the market; they will earn a place only if they can outperform the rising bar defined by other rapidly advancing technologies. But even if only some of them pan out, those could transform the energy landscape. Its possible, in fact, that the development of energy technologies is approaching a tipping point that will generate increases in energy productivity on a scale not seen since the Industrial Revolution. Leaders of companies and countries who neglect what is happening on the margins today risk being pushed to the margins themselves in the nottoo-distant future.

Five technologies to watch

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Grid-scale storage
The large-scale storage of electricity within electric power grids allows power generated overnight to meet peak load during the day. Today, this kind of grid storage costs about $600 to $1,000 per kilowatt hour (kWh) and can be used only when the local geology supports pumped-hydro or compressedair storage systems. Innovations using flow batteries, liquid-metal batteries, flywheels, and ultracapacitors could reduce costs to $150 to $200 per kWh by 2020 and make it possible to provide grid storage in every major metropolitan market. At these prices, by 2020 the United States alone would want to build more than 100 gigawatts (GW) of storage (the capacity equivalent of the current US nuclear-generation fleet). That much storage capacity would be transformative: currently, our power grid tends to use only 20 to 30 percent of its capacity because we build it to meet very high demand peaks. With storage, we can flatten out those peaks, reducing capital requirements for transmission and distribution and making power much cheaper to deliver. Power companies also could use storage to smooth variability in the supply of weather-dependent renewables, such as solar and wind power, thereby converting them from intermittent power sources into much more reliable ones.

Digital-power conversion
Large-scale high-voltage transformers, developed in the late 1880s, set the stage for the widespread development of the electrical grid. Virtually the same technology is still in use today. A typical transformer costs $20,000, weighs 10,000 pounds, and takes up 250 cubic feet. High-speed digital switches made of silicon carbide and gallium nitride have been developed for high-frequency power management for everything from military jets to high-speed rail. They use 90 percent less energy, take up only about 1 percent as much space, and are more reliable and flexible than existing transformers. Todays advanced applications include consumer electronics and variable-speed industrial drives for manufacturing. As such applications expand and the major semiconductor manufacturers begin to produce these technologies at scale, they could replace conventional transformers in the utility industry (at less than one-tenth the cost) by 2020. China is particularly well positioned to benefit from adopting digital-power electronics because of the scale of its planned grid expansion.

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2012 Number 1

Compressorless air conditioning and electrochromic windows


Today, it costs about $3,000 to $4,000 a year to run a high-efficiency air conditioner in a hot region, and even the efficient windows now commonly used allow 50 percent of the cooling energy to escape. New compressorless air conditioners dehumidify the air with desiccants rather than the traditional compress/decompress refrigeration cycle. Electrochromic window technologies change the window shading, depending on the temperature difference between outside and inside. These technologies offer the potential to cut home-cooling bills in half. Advanced windows also could slash heating costs by half, allowing the sun to warm houses while keeping the cold outthe new windows are often better than the standard attic insulation in cold-climate homes today. These technologies are expensive now, but by 2020 they should cost only about half as much to install as current state-of-the-art cooling and window technologies do.

Clean coal
Today, carbon capture and sequestration (CCS) costs $8,000 to $10,000 per kilowatt (kW). Innovative processes now under development could help coal-fired generators to capture more than 90 percent of their carbon dioxide, at a cost of less than $2,000 per kW. If the technology is viable by 2020, it would be possible for nearly 70 percent of the roughly 200 US coal plants currently slated for closure in that year to stay open for decades. The same goes for similar plants in China and Europe. Without supportive carbon regulations, though, we are unlikely to see clean coal deployed at scale. Coal without carbon sequestration will always be cheaper than coal with it. On current course, though, coal with carbon sequestration could become cheaper, more reliable, and more widely deployable than many renewable technologies.

Biofuels and electrofuels


With crude-oil prices approaching $100 a barrel, market shares for biofuels such as cane and corn ethanol are rising rapidly. Although secondgeneration cellulosic biofuels have proved harder to make than many had hoped five years ago, innovative start-ups focused on cellulosic and algae-based biofuels are starting to create high-margin specialty chemicals and blendstocks, generating cash now and suggesting a pathway to deliver biofuels at $2 a gallon or less by 2020. At the same time, biopharmaceutical researchers are developing electrofuel pathways that feed carbon dioxide, water, and energy to enzymes to create long-chain carbon molecules that function like fossil fuels at one-tenth the cost of current biofuels. The key question is whether these new technologies can be scaled. If they can, todays constraints on biofuelsthe declining quality of available land and food for fuel trade-offsmay diminish.

Matt Rogers is a director in McKinseys San Francisco office.

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Competing for the home of the future


Giorgio Busnelli, Venkie Shantaram, and Alice Vatta

Companies from a wide range of sectors are preparing for a time when the real money lies in helping households save energy rather than consume it.

The coming resource revolution could disrupt many industries. One prominent example: the European home energy market, where energy consumption is growing more slowly as efficiency measures begin to take hold, and where companies in sectors ranging from high tech and consumer electronics to retailing and construction are eyeing opportunities. Our research indicates (see the illustration and exhibit on the following spread) that if selected existing technologies were deployed to their fullest extent by 2020, a new home could consume around 90 percent less energy from the grid than it does today.1 As a result, utilitiesin competition or cooperation with new players from other industriesmay soon have to earn a growing share of their profits by helping households to save energy rather than to consume it.

The marketplace is already crowded. We found that, across industries, more than 200 companies, many of them leaders in their segments, are operating or exploring ways to compete. Developing or acquiring new capabilities will be essential. Players must, for example, help customers overcome investment barriers by providing financing options perhaps through partnerships with banks or even by creating financial units. Many also realize that they have to join hands to cover effectively a new and complex value chain: manufacturing, retailing, installation, maintenance, devices that connect appliances, IT integration and data management, and enabling services such as financing, insurance, and consulting.
1  Our research covers four countries

Germany, Italy, Sweden, and the United Kingdomwhich, combined, make a good proxy for the European market.

Explore our interactive exhibit on this topic in Winning the battle for the home of the future, on mckinseyquarterly.com.

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Companies in diverse sectors are starting to play a variety of roles in building the home of the future.

New value chains in building fabrics Makers of insulation materials sell their products through a grocery retailer, and a power utility offers eco-efficiency consulting and installs the products.

New value chains in central systems A consumer electronics group makes heat pumps, an Internet retailer sells them, an insurers credit unit offers financing options, and the service arm of a whitegoods maker delivers, installs, and services the pumps. New partnerships in smart applications A utility company partners first with a software company and with a maker of controllers and sensors to develop a home network linking all appliances. Then it teams up with a whitegoods firm whose machines can be programmed to start at the time of day when electricity is cheapest.

Competing for the home of the future

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A broad range of technologies are likely to increase gradually their share of the residential energy markets value pool.
Energy needed from the grid, baseline consumption = 1001
Current demand 32 28 Potential reduction 7 1 Demand remaining in 2020 20 13 100

1 Baseline consumption index: 1-kilowatt consumption of all fuels = 100. Assumes 2010 volume and fuel mix; gures reect

weighted average of Germany, Italy, Sweden, and United Kingdom. Figures do not sum to 100, because of rounding.

Central systems Electric heat pump, nanotechnologies (eg, membrane in air-conditioning unit), energy-efficient lighting Building fabrics Insulation of roof and walls with aerogel, active windows, double-shell building Appliances and electronics (those with most advanced potential for reducing energy consumption) Advanced washing machines, refrigerators, and freezers; energy-efficient televisions and other electronics Smart applications Home area network Microgeneration Solar photovoltaic (PV) systems, mini combined heat and power, micro wind

The authors would like to acknowledge Antonio Volpin for his contribution to the development of this article. Giorgio Busnelli is a principal in McKinseys Milan office, Venkie Shantaram is a principal in the London office, and Alice Vatta is an associate principal in the Rome office.

Illustration by Chris Philpot Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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Inside P&Gs digital transformation


CEO Robert McDonald wants to make the consumer goods giant the worlds most technologically enabled company. Heres how.

Robert McDonald is a CEO on a mission: to make Procter & Gamble the most technologically enabled business in the world. To get there, the 31-year company veteran and former US Army captain is overseeing the large-scale application of digital technology and advanced analytics across every aspect of P&Gs operations and activitiesfrom the way the consumer goods giant creates molecules in its R&D labs to how it maintains relationships with retailers, manufactures products, builds brands, and interacts with customers. The prize: better innovation, higher productivity, lower costs, and the promise of faster growth. McKinseys Michael Chui and Thomas Fleming recently sat down with McDonald at P&Gs Cincinnati headquarters to talk about the nature and progress of the companys digitization initiative, as well as its implications for P&Gs people and culture. An edited summary of the interview follows.

Visit this articleInside P&Gs digital revolution on mckinseyquarterly.com to learn more about McDonalds leadership philosophy, as well as how his experience as a US Army Airborne Ranger informs his approach to leading P&G.

Artwork by Daniel Hertzberg

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Real-time insights
Our purpose at P&G is to touch and improve lives; everything we do is in that context. With digital technology, its now possible to have a one-on-one relationship with every consumer in the world. The more intimate the relationship, the more indispensable it becomes. We want to be the company that creates those indispensable relationships with our brands, and digital technology enables this. One way is through consumer feedback. In 1984, when I was the Tide brand manager, I would get a cassette tape of consumer comments from the 1-800 line and listen to them in the car on the way home. Then, back at the office, Id read and react to the letters wed received. Today thats obviously not sufficientyouve got blogs, tweets, all kinds of things. And so weve developed something called consumer pulse, which uses Bayesian analysis to scan the universe of comments, categorize them by individual brand, and then put them on the screen of the relevant individual. I personally see the comments about the P&G brand. This allows for real-time reaction to whats going on in the marketplace, because we know that if something happens in a blog and you dont react immediatelyor, worse, you dont know about itit could spin out of control by the time you get involved. The technology also lets us improve things that are working. For example, were rolling out a product called Downy Unstopables, a fragrance addition you can add to your wash, and the real-time comments from consumers about the products characteristics are helping us figure out how best to join in the discussion through our marketing efforts.

From factory to shelf


From an operational standpoint, we also believe that to be successful weve got to continue to improve productivity, and being digitally enabled allows for that as well. So were digitizing our operations everywherefrom our manufacturing plants to the stores where consumers purchase our products. We believe digitization represents a source of competitive advantage. In our manufacturing plants, for example, we have systems that allow people to use iPads to download data off the production line in real time and communicate that to a place where we roll the data up. Were not there yet, but we envision a system where I could literally

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Robert McDonald

Vital statistics Born June 20, 1952, in Gary, Indiana Married, with 2 children Education Graduated with a BS in engineering in 1975 from the US Military Academy, West Point Earned an MBA in 1978 from the University of Utah

Career highlights P&G (1980present) President, CEO, and chairman of the board (2010present) President and CEO (200910) Chief operating ofcer (200709) Vice chairman, global operations (200407) Regional vice president, Japan, P&G Asia (199699) General manager, Philippines, Asia/PacicSouth, P&G Far East (199194) Brand manager, Tide (198486) US Army (197580) Captain

Fast facts Recipient of the Inaugural Leadership Excellence Award, presented by Stockdale Center for Ethical Leadership at the US Naval Academy and Harvard Business Review Recipient of the Presidents Leadership Award, Far East Council, Boy Scouts of America Fellow of the Royal Society for the Encouragement of Arts, Manufactures and Commerce Member of the West Point campaign cabinet

see, on my laptop, any product at any moment as it goes through the manufacturing line of any one of our plants. And what Id love to be able to do is see the costs of that product at the same time. Its challenging because accounting systems arent designed today for operationsthey tend to look backwardbut were working on integrating our operational system with the financial system to move in that direction. In transport and logistics, we created a digitally enhanced operational program we call Control Tower, which lets us see all the transportation were doing: inbound, outbound, raw materials, finished product. Were probably the second- or third-largest user of trucks in the United States, and through this technology weve been able to reduce deadhead movement1 by about 15 percent. This reduces costs and carbon monoxide. In circumstances where we use distributors, a similar interface, called Distributor Connect, lets us link directly with them and help them run their business. This benefits all of us by improving service and reducing inventory across the supply chain.
1  When trucks are empty or not optimally loaded.

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We want to be digitally connected to retailers too. For example, we use and support GDSN,2 which is basically a standardized data warehouse that allows us to do commerce with our retail partners in a totally automated way, with no human intervention. The industry association GS1 did a study a few years ago that found that 70 percent of orders between retailers and suppliers had errors. But if everyone used a common data warehouse like GDSNwhere the data are kept dynamically correctthat number goes down to virtually zero, and it saves millions of dollars in doing commerce together. Another thing we do is to use our scale to bring stateof-the-art technology to retailers that otherwise cant afford it. Imagine a small store in the Philippines,
Virtual diapers: P&G uses modeling and simulation tools to speed up innovation and lower costs.

for examplea country where I used to live. We can provide sophisticated ordering applications to help people there run their businesses better than they would be able to otherwise. We have mobilephone applications that allow retailers to order

from us wirelessly or, if they dont have a wireless capability, to order when they go back to their office and set the phone in a base. Its very easy to use. We also have performance standards that retailers in developing markets can visualize on their phones. For example, we believe you should arrange your store in a certain way to maximize consumer sales. If you have a store that partners with P&G on this, you can call up the performance standards on your phone, hold it up, look around your store, and compare it with what you see. Eventually, I want to be able to take a picture of the shelf, have it digitally compared, and then automatically send action steps back to the retailer to help rearrange the shelf for maximum consumer sales. Thats where were going. In fact, some applications like these will probably come back to the developed world as improvements because theyll be simplertheres no question that progress will be accelerated by the leapfrogging of technology. Inevitably, everythings got to be usable on the smallest, cheapest device possible because thats whats going to get the broadest distribution in a developing market.
2 Global Data Synchronisation Network.

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Digitizing innovation
Data modeling, simulation, and other digital tools are reshaping how we innovate. The way we used to do innovation research required a lot of work and time setting up consumer panelsyou need the right distribution of races, ages, and so forth to make them representative. Now, with the amount of data we have available, the n is so large that by definition we can immediately have a representative group. When you design a disposable diaper the traditional way, for example, by the time you get to the point where you make a prototype, the prototype itself has cost thousands of dollars, if not more, and it was all made by hand. Now, using modeling and simulation, you can go through thousands of iterations in seconds. The key is that youve got to have the data. So the advantage for P&G is our scale. We have operations in around 80 countries, our products are sold in almost every country, and we touch more than four billion consumers every day. Imagine all those data points. We can literally fit any virtual diaper to any baby anywhere in the world.

P&Gs virtual wall uses multiple projectors to simulate store shelves for faster consumer testing.

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P&Gs high-tech conference room (dubbed Business Sphere) allows company leaders to harness massive amounts of data to make real-time business decisions.

Were even digitizing the creation of molecules. For example, in the research and development for our new dishwashing liquid, we used modeling to predict how moisture would excite various fragrance molecules so that throughout the dishwashing process you get the right fragrance notes at the right time. We did that all virtually. I think that digital technology will even help us identify new service components to our consumer products that wouldnt otherwise be immediately obvious. For example, say youre a consumer concerned about the environment. You go to one of our packages and photograph the QR3 code. We then could download for you all the ingredients in the product and their biodegradabilityor tell you where the product was produced, the quality of the water, or how weve reduced carbon emissions in the plant. We cant do that today, but its an aspiration.
3 Quick Response.

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Improve data at the source


P&G employees have a cockpit interface on their computers that they help design. It has certain tolerances for the metrics that are important to them. When we go outside those tolerances, either negatively or positively, an alarm goes off. Then we can click down and understand whats going on and react to it, because we feel that time compression or operating in real timeis a competitive advantage. Similarly, every Monday morning we have a meeting with our leadership team all over the worldphysically and virtuallywhere we review the business for the previous week and click down on all this data. And everyone signs up for the principles behind thisits real time and continuous; it gives us the ability to click down to find causality, make decisions, and then move on. As we apply those principles each week, the challenge becomes the data source. Ill use the Philippines again as an example. If a company we buy syndicated data from goes into stores in the Philippines once every two months and does a handheld questionnaire audit, then it doesnt matter if we meet every Monday or not. Our datas not going to be very good. So weve been working with all our data partners to help them understand that our need is for real-time data. For us its really constraint theoryunderstanding where the constraint in our data is and pushing it all the way to the data source. Then, change the data source. For companies like ours that rely on external data partners, getting the data becomes part of the currency for the relationship. When we do joint business planning with retailers, for example, we have a scorecard, and the algorithm is all about value creation. Getting data becomes a big part of the value for us, and its a big part of how we work together. We have analytic capabilities that many retailers dont have, so often we can use the data to help them decide how to merchandise or market their business in a positive way. It would be heretical in this company to say that data are more valuable than a brand, but its the data sources that help create the brand and keep it dynamic. So those data sources are incredibly important. Therefore, we go to the extreme to protect whatever consumer data we get. Its a board-level enterprise risk-management issue for us. We have very clear firewalls between one retailer and another and strict policies for example, about how long a cooling off period you need to have when

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When youve actually done a simulation, you truly realize the importance of the data; its classic garbage in, garbage out.

working on projects with different retailers. All of this comes with our strategy of being the most digitally enabled company in the world. We cant do that without being an industry leader on data security and privacy.

The digital workforce


When I started with P&G, in 1980, almost nothing was digital. Back then, our Management Systems Divisionas we called it thenhad mainframe computers, but our people did more work on phone systems than on computers. And whenever I would get together with them, I would ask, How many of you have coded BCD? 4 or, Have you ever done a Monte Carlo simulation? Nobody would raise a hand. They didnt have those kinds of skills. More than two decades later, as vice chairman of global operations, I and my colleague Filippo Passerini, who today is the CIO of P&G,5 began to put together some very clear strategies to hire people with different skills. We needed people with backgrounds in computer modeling and simulation. We wanted to find people who had true mastery in computer science, from the basics of coding to advanced programing. When youve actually done a simulation, you truly realize the importance of the data; its classic garbage in, garbage out. Weve come a long way toward meeting our goals today, but we still have further to go. For example, we established a baseline digital-skills inventory thats tailored to every level of advancement in the organization. We have a training facility to make sure that if youre in a particu4 Binary-coded decimal, a digital-encoding method for decimal numbers. Each digit is 5 See From internal service provider to strategic partner: An interview with the head of

represented by its own binary sequence.

Global Business Services at P&G, mckinseyquarterly.com, July 2008.

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lar area, youre competent on the systems for that area. This goes for senior managers too; we have an area in the facility where we can pull the curtains, so to speak, and work with senior managers privately so we dont embarrass anyone. But weve got to have the standards for everyone because otherwise well dumb the organization down to the lowest common denominator. Ultimately, though, P&G has been pretty good about hiring for analytical thinking. We hire very good people and then train them. I remember the day I joined the company and one of the managers a few levels up said, Throw away your MBA textbooks and well teach you; well give you another MBA. And I think thats still practical and relevant today. Nonetheless, analytical-thinking skills have become even more important to this company. We need to come up with the ideas to innovate, and those innovations are always informed by data.
Michael Chui is a senior fellow of the McKinsey Global Institute and is based in McKinseys San Francisco office; Thomas Fleming is a member of McKinsey Publishing and is based in the Chicago office.

Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com. All photos in this article P&G. All rights reserved.

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How China is innovating


74 A CEOs guide to innovation in China Gordon Orr and Erik Roth 84 Chinese innovation: Snapshots from the automobile, semiconductor, and pharmaceutical industries

Special report

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Workers produce solar-cell modules in a factory in Chinas Jiangsu Province.

How much innovation is occurring in China? A lot more than many people realize. Chinese companies, well known for skillfully imitating competitors offerings, are increasingly creating innovative products in both the business-to-consumer and business-to-business sectors. But progress isnt uniform across industries, and basic productdevelopment skills are at best nascent within a typical Chinese enterprise. In this special report, McKinsey experts and senior executives on the front lines of innovation in China provide a close-up view of todays landscape and what it means for both multinational and domestic companies.

Imaginechina/Corbis

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A CEOs guide to innovation in China


Gordon Orr and Erik Roth

Dynamic domestic players and focused multinationals are helping China churn out a growing number of innovative products and services. Intensifying competition lies ahead; heres a road map for navigating it.

China is innovating. Some of its achievements are visible: a doubling of the global percentage of patents granted to Chinese inventors since 2005, for example, and the growing role of Chinese companies in the wind- and solar-power industries. Other developmentssuch as advances by local companies in domestically oriented consumer electronics, instant messaging, and online gamingmay well be escaping the notice of executives who arent on the ground in China. As innovation gains steam there, the stakes are rising for domestic and multinational companies alike. Prowess in innovation will not only become an increasingly important differentiator inside China but should also yield ideas and products that become serious competitors on the international stage. Chinese companies and multinationals bring different strengths and weaknesses to this competition. The Chinese have traditionally had a bias toward innovation through commercializationthey are more comfortable than many Western companies are with putting a new product or service into the market quickly and improving its performance through subsequent generations. It is common for products to launch in a fraction of the time that it would take in more

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developed markets. While the quality of these early versions may be variable, subsequent ones improve rapidly.1 Chinese companies also benefit from their governments emphasis on indigenous innovation, underlined in the latest five-year plan. Chinese authorities view innovation as critical both to the domestic economys long-term health and to the global competiveness of Chinese companies. China has already created the seeds of 22 Silicon Valleylike innovation hubs within the life sciences and biotech industries. In semiconductors, the government has been consolidating innovation clusters to create centers of manufacturing excellence. But progress isnt uniform across industries, and innovation capabilities vary significantly: several basic skills are at best nascent within a typical Chinese enterprise. Pain points include an absence of advanced techniques for understandinganalytically, not just intuitivelywhat customers really want, corporate cultures that dont support risk taking, and a scarcity of the sort of internal collaboration thats essential for developing new ideas. Multinationals are far stronger in these areas but face other challenges, such as high attrition among talented Chinese nationals that can slow efforts to create local innovation centers. Indeed, the contrasting capabilities of domestic and multinational players, along with the still-unsettled state of intellectual-property protection (see sidebar, Improving the patent process), create the potential for topsy-turvy competition, creative partnerships, and rapid change. This article seeks to lay out the current landscape for would-be innovators and to describe some of the priorities for domestic and multinational companies that hope to thrive in it.

Chinas innovation landscape


Considerable innovation is occurring in China in both the businessto-consumer and business-to-business sectors. Although breakthroughs in either space generally go unrecognized by the broader global public, many multinational B2B competitors are acutely aware of the innovative strides the Chinese are making in sectors such as
1  Commercialization differs from shanzhai, or copycat innovation. Many executives in the

developed world misunderstand shanzhai, believing that it is purely the replication of an innovation developed in another market. Although this does occur, products developed through the shanzhai approach incorporate features specically for the Chinese market. Shanzhai is quite prevalent in consumer products categories such as packaged goods and electronics. It can also be found in the business-to-business domain, where local companies produce knockoffs of successful foreign products or business models.

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Improving the patent process


In innovative sectors such as biotechnology, electric vehicles, pharmaceuticals, and solar energy, the number of patent applications from Chinese companies is rising. In fact, Huawei and ZTE ranked among the worlds top five corporate patent registrants by volume in 2010. Intensifying patent activity reflects a growing recognition that intellectual property is essential to value. As this mentality takes hold, domestic innovators may pressure the government to create a more modern intellectual-property system. Currently, China recognizes three categories of patents: invention (what most people elsewhere think of as worthy of a patent), utility (a new use for something that already exists), and design. Invention patents run for 20 years, the others only for 10. Patent reformsuch as reducing the duration of design or utility patents and raising the bar for what can be registered in those categorieswould be a powerful way for the Chinese government to signal its seriousness about promoting indigenous innovation. If China decides to move ahead with patent reform, a desire for global consistency could well make it a high-priority multilateral issue. Without patent reform, companies must rely on one of two strategies for protecting intellectual property. The first is to continue to outrun the competition by developing increasingly innovative solutions or building in protection through complex integration that is difficult to reverse-engineer. The second is to create easily identifiable technology signatures that would be hard to refute in legal proceedings.

communications equipment and alternative energy. Interestingly, even as multinationals struggle to cope with Chinese innovation in some areas, they seem to be holding their own in others.

The business-to-consumer visibility gap


When European and US consumers think about what China makes, they reflexively turn to basic items such as textiles and toys, not necessarily the most innovative products and rarely associated with brand names. In fact, though, much product innovation in China stays there. A visit to a shop of the Suning Appliance chain, the large Chinese consumer electronics retailer, is telling. There, you might find an Android-enabled television complete with an integrated Internet-browsing capability and preloaded apps that take users straight to some of the most popular Chinese Web sites and digital movie-streaming services. Even the

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picture quality and industrial design are comparable to those of highend televisions from South Korean competitors. We observe the same home-grown innovation in business models. Look, for example, at the online sector, especially Tencents QQ instantmessaging service and the Sino Corporations microblog, Weibo. These models, unique to China, are generating revenue and growing in ways that have not been duplicated anywhere in the world. QQs low, flat-rate pricing and active marketplace for online games generate tremendous value from hundreds of millions of Chinese users. Whats keeping innovative products and business models confined to China? In general, its market is so large that domestic companies have little incentive to adapt successful products for sale abroad. In many cases, the skills and capabilities of these companies are oriented toward the domestic market, so even if they want to expand globally, they face high hurdles. Many senior executives, for example, are uncomfortable doing business outside their own geography and language. Furthermore, the success of many Chinese models depends on local resourcesfor example, lower-cost labor, inexpensive land, and access to capital or intellectual propertythat are difficult to replicate elsewhere. Take the case of mobile handsets: most Chinese manufacturers would be subject to significant intellectual property driven licensing fees if they sold their products outside China.

Successes in business to business


Several Chinese B2B sectors are establishing a track record of innovation domestically and globally. The Chinese communications equipment industry, for instance, is a peer of developed-world companies in quality. Market acceptance has expanded well beyond the historical presence in emerging markets to include Europes most demanding customers, such as France Tlcom and Vodafone. Pharmaceuticals are another area where China has made big strides. In the 1980s and 1990s, the country was a bit player in the discovery of new chemical entities. By the next decade, however, Chinas sophistication had grown dramatically. More than 20 chemical compounds discovered and developed in China are currently undergoing clinical trials. Chinas solar- and wind-power industries are also taking center stage. The country will become the worlds largest market for renewableenergy technology, and it already has some of the sectors biggest companies, providing critical components for the industry globally.

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Chinese companies not only enjoy scale advantages but also, in the case of solar, use new manufacturing techniques to improve the efficiency of solar panels. Success in B2B innovation has benefited greatly from friendly government policies, such as establishing market access barriers; influencing the nature of cross-border collaborations by setting intellectualproperty requirements in electric vehicles, high-speed trains, and other segments; and creating domestic-purchasing policies that favor Chinese-made goods and services. Many view these policies as loading the dice in favor of Chinese companies, but multinationals should be prepared for their continued enforcement. Despite recent setbacks, an interesting example of how the Chinese government has moved to build an industry comes from high-speed rail. Before 2004, Chinas efforts to develop it had limited success. Since then, a mix of two policiesencouraging technology transfer from multinationals (in return for market access) and a coordinated R&D-investment efforthas helped China Railways high-speed trains to dominate the local industry. The multinationals revenue in this sector has remained largely unchanged since the early 2000s.

Wind turbine manufacturing in Chinas Shandong Province.


Guo Xulei/Xinhua Press/Corbis

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But it is too simplistic to claim that government support is the only reason China has had some B2B success. The strength of the countrys scientific and technical talent is growing, and local companies increasingly bring real capabilities to the table. Whats more, a number of government-supported innovation efforts have not been successful. Some notable examples include attempts to develop an indigenous 3G telecommunications protocol called TDS-CDMA and to replace the global Wi-Fi standard with a China-only Internet security protocol, WAPI.

Advantage, multinationals?
Simultaneously, multinationals have been shaping Chinas innovation landscape by leveraging global assets. Consider, for example, the joint venture between General Motors and the Shanghai Automotive Industry Corporation, which adapted a US minivan (Buicks GL8) for use in the Chinese market and more recently introduced a version developed in China, for China. The model has proved hugely popular among executives. In fact, the market for vehicles powered by internal-combustion engines remains dominated by multinationals, despite significant incentives and encouragement from the Chinese government, which had hoped that some domestic automakers would emerge as leaders by now. The continued strength of multinationals indicates how hard it is to break through in industries with 40 or 50 years of intellectual capital. Transferring the skills needed to design and manufacture complex engineering systems has proved a significant challenge requiring mentorship, the right culture, and time. We are seeing the emergence of similar challenges in electric vehicles, where early indications suggest that the balance is swinging toward the multinationals because of superior product quality. By relying less on purely indigenous innovation, China is trying to make sure the electric-vehicle story has an ending different from that of its telecommunications protocol efforts. The governments stated aspiration of having more than five million plug-in hybrid and battery electric vehicles on the road by 2020 is heavily supported by a mix of extensive subsidies and tax incentives for local companies, combined with strict market access rules for foreign companies and the creation of new revenue pools through government and public fleet-purchase programs. But the subsidies and incentives may not be enough to overcome the technical challenges of learning to build these vehicles, particularly if multinationals decline to invest with local companies.

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Four priorities for innovators in China


Theres no magic formula for innovationand that goes doubly for China, where the challenges and opportunities facing domestic and multinational players are so different. Some of the priorities we describe here, such as instilling a culture of risk taking and learning, are more pressing for Chinese companies. Others, such as retaining
A Chinese-built high-speed train at the Wuhan Railway Station, in Wuhan, China.
Guo Xulei/Xinhua Press/Corbis

local talent, may be harder for multinationals. Collectively, these priorities include some of the critical variables that will influence which companies lead Chinas innovation revolution and how far it goes.

Deeply understanding Chinese customers


Alibabas Web-based trading platform, Taobao, is a great example of a product that emerged from deep insights into how customers were underserved and their inability to connect with suppliers, as well as a sophisticated understanding of the Chinese banking system. This dominant marketplace enables thousands of Chinese manufacturers to find and transact with potential customers directly. What looks like a straightforward eBay-like trading platform actually embeds numerous significant innovations to support these transactions, such as an ability to facilitate electronic fund transfers and to account for idiosyncrasies in the national banking system. Taobao wouldnt have happened without Alibabas deep, analytically driven understanding of customers. Few Chinese companies have the systematic ability to develop a deep understanding of customers problems. Domestic players have traditionally had a manufacturing-led focus on reapplying existing business models to deliver products for fast-growing markets. These push models will find it increasingly hard to unlock pockets of profitable growth. Shifting from delivery to creation requires more local research and development, as well as the nurturing of more market-driven organizations that can combine insights into detailed

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Chinese customer preferences with a clear sense of how the local business environment is evolving. Requirements include both research techniques relevant to China and people with the experience to draw out actionable customer insights. Many multinationals have these capabilities, but unless they have been operating in China for some years, they may well lack the domesticmarket knowledge or relationships needed to apply them effectively. The solutionbuilding a true domestic Chinese presence rather than an outpostsounds obvious, but its difficult to carry out without commitment from the top. Too many companies fail by using fly over management. But some multinationals appear to be investing the necessary resources; for example, we recently met (separately) with top executives of two big industrial companies who were being transferred from the West to run global R&D organizations from Shanghai. The idea is to be closer to Chinese customers and the network of institutions and universities from which multinationals source talent.

Retaining local talent


Chinas universities graduate more than 10,000 science PhDs each year, and increasing numbers of Chinese scientists working overseas are returning home. Multinationals in particular are struggling to tap this inflow of researchers and managers. A recent survey by the executiverecruiting firm Heidrick & Struggles found that 77 percent of the senior executives from multinational companies responding say they have difficulty attracting managers in China, while 91 percent regard employee turnover as their top talent challenge. Retention is more of an issue for multinationals than for domestic companies, but as big foreign players raise their game, so must local ones. Chinese companies, for example, excel at creating a communitylike environment to build loyalty to the institution. That helps keep some employees in place when competing offers arise, but it may not always be enough. Talented Chinese employees increasingly recognize the benefits of being associated with a well-known foreign brand and like the mentorship and training that foreign companies can provide. So multinationals that commit themselves to developing meaningful career paths for Chinese employees should have a chance in the growing fight with their Chinese competitors for R&D talent. Initiatives might include in-house training courses or apprenticeship programs, perhaps with local universities. General Motors sponsors projects in

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which professors and engineering departments at leading universities research issues of interest to the automaker. That helps it to develop closer relations with the institutions from which it recruits and to train students before they graduate. Some multinationals energize Chinese engineers by shifting their roles from serving as capacity in a support of existing global programs to contributing significantly to new innovation thrusts, often aimed at the local market. This approach, increasingly common in the pharma industry, may hold lessons for other kinds of multinationals that have established R&D or innovation centers in China in recent years (see Pharmaceutical innovation: AstraZenecas experience in China, on page 93). The keys to success include a clear objective for instance, will activity support global programs or develop Chinafor-China innovations?and a clear plan for attracting and retaining the talent needed to staff such centers. Too often, we visit impressive R&D facilities, stocked with the latest equipment, that are almost empty because staffing them has proved difficult.

Instilling a culture of risk taking


Failure is a required element of innovation, but it isnt the norm in China, where a culture of obedience and adherence to rules prevails in most companies. Breaking or even bending them is not expected and rarely tolerated. To combat these attitudes, companies must find ways to make initiative taking more acceptable and better rewarded. One approach we found, in a leading solar company, was to transfer risk from individual innovators to teams. Shared accountability and community support made increased risk taking and experimentation safer. The company has used these innovation work groups to develop everything from more efficient battery technology to new manufacturing processes. Team-based approaches also have proved effective for some multinationals trying to stimulate initiative taking (for more on one companys approach, see Automotive innovation in China: The view from General Motors, on page 85). How fast a culture of innovation takes off varies by industry. We see a much more rapid evolution toward the approach of Western companies in the way Chinese high-tech enterprises learn from their customers and how they apply that learning to create new products made for China (for a perspective on the evolution of Chinas semiconductor sector, see Semiconductors: A new source of Chinese innovation? on page 89). That approach is much less common at state-owned enterprises, since they are held back by hierarchical, benchmark-driven cultures.

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Promoting collaboration
One area where multinationals currently have an edge is promoting collaboration and the internal collision of ideas, which can yield surprising new insights and business opportunities. In many Chinese companies, traditional organizational and cultural barriers inhibit such exchanges. Although a lot of these companies have become more professional and adept at delivering products in large volumes, their ability to scale up an organization that can work collaboratively has not kept pace. Their rigorous, linear processes for bringing new products to market ensure rapid commercialization but create too many hand-offs where insights are lost and trade-offs for efficiency are promoted. One Chinese consumer electronics company has repeatedly tried to improve the way it innovates. Senior management has called for new ideas and sponsored efforts to create new best-in-class processes, while junior engineers have designed high-quality prototypes. Yet the end result continues to be largely undifferentiated, incremental improvements. The biggest reason appears to be a lack of crosscompany collaboration and a reliance on processes designed to build and reinforce scale in manufacturing. In effect, the technical and commercial sides of the business dont cooperate in a way that would allow some potentially winning ideas to reach the market. As Chinese organizations mature, stories like this one may become rarer.

China hasnt yet experienced a true innovation revolution. It will need time to evolve from a country of incremental innovation based on technology transfers to one where breakthrough innovation is common. The government will play a powerful role in that process, but ultimately it will be the actions of domestic companies and multinationals that dictate the pace of changeand determine who leads it.
Gordon Orr is a director in McKinseys Shanghai office, where Erik Roth is a principal.

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Chinese innovation: Three snapshots


Chinese innovation is evolving in diverse ways and at an uneven pace across a range of different industries. Presented here are ground-level views from three of them: automobiles, semiconductors, and pharmaceuticals.

Automobiles: Kevin Wale President and managing director, GM China

General Motors and its Chinese joint-venture partners sold more cars in 2010 in China (2.35 million units) than in the United States (around 2.2 million units). In an edited version of an interview with McKinseys Glenn Leibowitz and Erik Roth, GM China president Kevin Wale explains the importance of teambased innovation efforts in China and describes GMs rapidly growing Advanced Technical Center in Shanghai. He also observes that innovation in Chinas auto industry is more about commercialization models than technical achievements. While automotive innovation has had years to take hold, innovation on the leading edge of the semiconductor business remains nascent. But barriers that once held back local chip makers now appear to be eroding. This means global players will face some tough trade-offs in the years ahead. The challenge: how to participate in Chinas growthwhich may well require joint ventures with domestic playerswithout sacrificing valuable intellectual property. McKinseys Bob Dvorak, Sri Kaza, and Nick Santhanam describe this dilemma and present a few ideas for multinational companies trying to overcome it. Finally, Steve Yang, head of R&D for Asia and emerging markets for the global drugmaker AstraZeneca, articulates some key differences between pharma development in China and Western markets. The starting point: different disease prevalence (gastric and liver cancer, for example, are more prevalent in China). In an edited version of an interview with McKinseys Jeremy Teo, Yang describes new models of innovation that could emerge from China, as well as the longterm commitment to talent development that will be needed for AstraZenecas Chinese research center to reach its innovative potential.

Semiconductors: Robert Dvorak, Sri Kaza, and Nick Santhanam McKinsey & Company

Pharmaceuticals: Steve Yang Vice president and head of R&D for Asia and emerging markets, AstraZeneca

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Kevin Wale

Automotive innovation in China: The view from General Motors

Innovation through commercialization


Theres probably more innovation in going to market and in thinking about new business opportunities than there is in technical innovation. Technical innovation is lagging behind the rest of the world in maturity. The country is trying to get there as quickly as it can but doesnt have the deep graduate research capability that the rest of the world has. What China does better than any place else in the world is to innovate by commercialization, as opposed to constant research and perfecting the theory, like the West. When the Chinese get an idea, they test it in the marketplace. Theyre happy to do three to four rounds of commercialization to get an idea right, whereas in the West companies spend the same amount of time on research, testing, and validation before trying to take products to market. The electric vehicle is a good example. The Chinese view is that its not going to be perfect, and theyre not trying to make it perfect from day one. Theyve got a few more series of improvements to go, and theyll work on them in parallel with finding out what the customer really likes and adapting to that. Thats an innovative way of doing innovation, something that the rest

Imaginechina/Corbis

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of the world is struggling to understand. In our business in China, if we dont innovate through or with commercialization, were going to lag behind our competitors.

The power of teamwork


Were trying to set up a small unit that is designed to focus on what some people call innovation, but what I call predator versus prey. Everyones coming after us, and we want to stay the predator. The only way to do that is by having people who are focused on who is doing what to us and where the opportunities are. We find the deployment of small task teams is by far the best approach to drive these innovative ideas. Take OnStar,1 for instance, which was actually quite innovative for this market. The way we did it was well ahead of others. These systems are released by code, and theyre now up to OnStar 8. We deployed the absolute latest and went straight to 8; we didnt start at 1. It was a calculated risk that we could make a business model that could benefit from this technology and cover the significant cost and technical support required to support that. Being out there, it feels like youre in the Wild West. Four to five of you are in a team. You dont have a lot support, but a lot of responsibility. In our joint ventures, were happy to take innovation from suppliers any day of the week. We encourage suppliers to come up with new ideas. We have a lot of local technology in our cars. Our people wanted to lead
1 OnStar, a subsidiary of GM, is a vehicle safety, security, and information service system.

What China does better than any place else in the world is to innovate by commercialization, as opposed to constant research and perfecting the theory, like the West.
Kevin Wale is the president and managing director of GM China, which he has led since 2005.

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and they worked with suppliers to develop new ways of doing things. Lighting systems and infotainment are pretty much at the cutting edge of whats available.

R&D and advanced design centers in China


We wanted to take advantage of some of the great talent thats going to be coming out of the universities. Theyre going to be coming out in droves. Theyre not at the advanced graduate stage, simply because they dont have the mentors in the system, but they will be coming out, and theres plenty of good talent now that we can staff. We also want to do research and applied development that is close to the biggest market in the world. It really is very easy to ignore the realities of life when you dont confront them every day. So we want to make sure that we have activity in the market, with people who speak the language, understand the culture, and confront that culture every day. The first building thats going up is a battery lab. With the electric vehicle, there will be a lot of suppliers, a lot of government support; the rules will be different, and the applications will be different. We want to be here, where we will be learning that every day and reacting to it every day. Its the same research capability we have in Detroit, but were able to do the work here and frame it around real local knowledge. We also will have an advanced design center here for the same reason. Its hard to imagine doing advanced design without taking into account the influence of the largest and fastest-growing market in the world. So were putting in a starting point where we will have the basis for future creativity in the country. The leader of our R&D is a local Chinese who has worked in R&D in China and has excellent connections with the local universities. We also have excellent connections with universities, and we run multiple projects through a program called PACE2 and through cooperative development. That will be the starting ground for recruiting. Also, were offering more internships than we normally do because we want to take the best young technical talent. Initially, we will supplement them with skilled researchers from the rest of the world, primarily the United States. But at the end of the day, we will use local
2 Partners for the Advancement of Collaborative Engineering Education.

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skilled talent. We dont see a problem for the size of what were doing here. Its a big site, but its not a big number of people at a particular timeprobably 300 people to start withamong all those areas: design, advanced research, powertrain engineering.

Integration with global product development


Id say with a fair degree of confidence that we integrate our Chinese operations fully into our global operations better than anyone else in the world. If were working on a global program, well be doing serious work down the road the same way as theyre doing it in the United States or Germany. Our engineering centers two years ago introduced the subcompact Chevrolet Sail, which was completely designed here. The low-cost passenger vehicle was difficult to provide out of a global solution because we were trying to cater to too many global needs. That opened the opportunity for the Sail. We were able to focus on addressing a solution that wasnt going to come out of a global package. The latest Buick GL8 minivan was introduced here and was done pretty quickly through capability that is built here in China, using a combination of on-the-job mentoring, coaching, and expert assistance from overseas, as well as a very structured development process from our global team. The GL8 is an old GM architecture that no one else wanted, but its a terrific product for China. It has turned into an unbelievably good-looking and highly desirable car. I cant tell you how many senior executives and CEOs ring me up trying to speed up their provision of the GL8. The Baojun brand is a lower-priced sedan aimed at consumers who live outside of Chinas major markets. Its just a massive opportunity in China, and the ability to meet the income needs and transportation needs of that group of people was never going to be met by GM in a traditional sense.
Kevin Wales commentary was drawn from an interview with Glenn Leibowitz, an editor in McKinseys Taipei office, and Erik Roth, a principal in the Shanghai office.

For the full version of this interview, see Innovation in China: An interview with GM Chinas president, on mckinseyquarterly.com.

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Robert Dvorak, Sri Kaza, and Nick Santhanam

Semiconductors: A new source of Chinese innovation?

The semiconductor industry is a powerful example of the tension surrounding Chinas potential for innovation. The countrys leaders understand the important role silicon plays in product innovation,3 so for two decades they have sought to create a more potent domestic semiconductor industrywith mixed results. China purchases 33 percent of the worlds chips ($100 billion worth), using them both in products sold domestically and in exports. But most of the Chinese industry competes in commoditized areas such as chip assembly and testing, and Chinese semiconductor companies hold 4 percent or less of the most prized segments of the global value chain in chip design and manufacturing. This article highlights four obstacles that have kept the country in check, the potential for their impact to diminish, and the resulting challenge for global producers that have been reluctant to share key elements of intellectual property (IP) with Chinese players.

Shifting winds
Structural changes in the industry and the marketplace, coupled with new industrial policies that promote next-generation technologies and technology transfers from abroad, are combining to weaken the barriers that have held China back.
3 See Andr Andonian, Christoph Loos, and Luiz Pires, Building an innovation nation,

whatmatters.mckinseydigital.com, March 2009.

Qilai Shen/In Pictures/Corbis

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Chips designed for Chinas needs


Chinese players have exerted little influence on semiconductor design, technology standards, or chip selection for major product categories such as mobile phones, laptop computers, and LCD televisions. Most decisions about design and functionality come from global champions and ref lect the preferences of consumers in Europe, Japan, and the United States. But that dynamic is shifting, along with the rising economic power of Chinas middle class, with its increasingly diverse needs. Some Chinese companies are now moving to the forefront of a built in China, for China movement. Their clout is likely to mean that more semiconductor platforms will be designed locally. Consider the fact that in 2010, Chinese consumers purchased 19 percent of all PCs sold throughout the world, 18 percent of the LCD TVs, 14 percent of the mobile phones, and 26 percent of the automobiles (all by unit volume). Chinas manufacturers, meanwhile, are leveraging this domestic scale to sell in global markets: Lenovo now ranks second in global PC sales and ZTE fourth in the manufacture of handsets. Huawei ranks among the top three world players in all segments of telecom equipment.

Export controls lose their bite


The home governments of leading semiconductor manufacturers have long banned the sale of leading-edge manufacturing technology to China. Current controls by Taiwan and the United States, for example, bar the export of equipment used to make chips below the 65-nanometer threshold.4 As a result, Chinese manufacturers are at least two generations behind the highest-performing 32-nanometer chips. Market changes, however, are eroding the impact of these bans. Leadingedge semiconductors represent only 14 percent of global demandhalf the market share of 2003as fewer devices require the highest levels of processing power.5 Thats particularly true of devices favored by Chinas new consumers, whose purchases often involve entry-level mobile phones and TVs. The result: a more level playing field for Chinas players, some of which can now use manufacturing processes that are two generations behind to mass-produce chips that represent sizable markets (for example, analog integrated circuits and microcontrollers).
4 A designation of the size of semiconductor processing units or nodes. Lower numbers

represent greater processing power, with more modes per chip. Controls generally apply to the two most recent generations of semiconductors. 5 At the same time, semiconductor manufacture is reaching the limits of Moores law, which predicts that the performance of semiconductors will rise rapidly while costs decrease. This phenomenon has allowed China to catch up in trailing-edge technologies.

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Reordering Chinas high-tech zones


Chinas industrial planners made missteps in early efforts to incubate a semiconductor industry. Rather than concentrate investments and incentives in one geographic area, as the Taiwanese did with Hsinchu Science Park, government officials dispersed their bets, financing fabrication sites in 19 cities. This fragmentation hindered the establishment of a vibrant semiconductor ecosystem with clusters of manufacturing prowess and design talent. China has corrected its course, however, and now is concentrating more investment in a smaller number of citiesfor instance, Chengdu, Dalian, and Shanghai. These centers have a stronger base of expertise, as well as a critical mass of manufacturers and suppliers. They are attracting investment from global leaders and developing more broadly based value chains in areas such as wireless communications systems.

A new regime for technology transfer


Foreign players own most of the IP across the semiconductor value chain, and the lions share of revenue streams for the design of semiconductors and the processes used to manufacture them goes to non-Chinese companies. While the Chinese have found ways to acquire or piece together IP to build a strong position in many industries, the challenge in semiconductors is uniquely difficult because of the complexity of chip design and manufacturing and the high level of materials science that is required. China, however, has one of worlds best-funded and ambitious tech industry policies, and acquiring semiconductor know-how and IP remains a high priority. Increasing Chinas chances for success is a new, twopronged initiative that will increase the pressure on global companies to share their IP with Chinese partners. The first part involves steppedup investments and new policy directives that will advance large, nextgeneration technology platforms such as cloud computing, the Internet of Things,6 and hybrid electric vehicles. These three markets represent tens of billions of dollars in opportunities for global and domestic semiconductor companies. The second part sets targets for indigenous innovation, with the goal of reducing dependence on foreign technologies to 30 percent, from the current 50 percent. Government purchases of products and services, from mobile phones to cloud-computing networks, will favor products that incorporate high levels of domestically developed technology.
6 For more, see Michael Chui, Markus Lffler, and Roger Roberts, The Internet of Things,

mckinseyquarterly.com, March 2010.

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Strategic choices for global players


For global semiconductor players, the dilemma is clear: how to participate in what will probably be the worlds most dynamic technology growth environment while safeguarding core IP and know-how. These companies must remember that China seeks to use transferred IP and manufacturing methods to create its own champions that can compete with global countries around the world, not just in the local market. The experience of high-speed rail players provides a cautionary tale. Global companies were encouraged to form partnerships with Chinese ones to develop a national high-speed network. Some foreign companies favored a relatively restrictive sharing of IP, but a classic prisoners dilemma7 scenario played out: the attractiveness of market access gave global players a powerful incentive to ditch hard-line positions. In the end, industry partnerships were formed on less restrictive terms. Within three years, Chinese companies had absorbed key elements of the core technology, and since 2007 they have won nearly $20 billion in new rail contracts. Global semiconductor players thus will need to be clear about the terms of engagement with potential partners. Chinas complex fabric of national, provincial, and local policy makers and companies creates a considerable opportunity for customized strategies. Forming ventures with strictly delineated IP transfer terms is the obvious solution. Global leaders such as GE (in rural health care) and ABB (in electric motors and power transmission) are exploring alternatives. One option is for foreign companies to launch indigenous R&D centers with Chinese universities and institutes and to focus these facilities
The full version of this article originally appeared in the inaugural issue of McKinsey on Semiconductors (September 2011), available on mckinsey.com.

on developing technologies for unproven but promising next-generation domestic markets. Multinationals that participate in such ventures align themselves with Chinas goals while they contain IP risks to markets that are still evolving. Another approach is to focus on local product development in partnership with downstream players such as auto manufacturers. This strategy helps multinationals meet local-technology requirements and provides for more active risk management.
7 The prisoners dilemma, a situation analyzed in game theory, shows why two individuals may

fail to cooperate, despite the fact that cooperation would seem to be advantageous for both.

The authors would like to acknowledge the contributions of Rajat Mishra and Sid Tandon to the development of this article. Bob Dvorak is a director in McKinseys Silicon Valley office, where Sri Kaza and Nick Santhanam are principals.

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Steve Yang

Pharmaceutical innovation: AstraZenecas experience in China


Whats different about China
There are many unique disease mechanisms in China. Gastric and liver cancers, for example, have high prevalence and, in many cases, could have different populations or different disease etiologies. That presents a white space on which R&D innovation can focus. We can use what we have learned in the West to understand this situation and to try to develop new medicines against those diseases. I hope that will open up new markets and help us meet unmet medical needs of patients in China and the rest of Asia. Also very important is that China and, to some extent, India have shown the world the importance of conducting R&D with more resource efficiency, particularly by focusing on externalization. This could mean strategic outsourcing of certain R&D functions. It could also mean collaborating with academics or biotech companies, and thats an area in which I believe China can offer tremendous potential not only for our local R&D operation but also for our global R&D. Finally, theres Chinas urbanization. There are consequences to the migration to megacities with populations of more than 20 million. In these environments, people will increasingly have a more sedentary lifestyle. In such an environment, with high-density living, how do

Peter Ginter/Science Faction/Corbis

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We are giving scientists the mandate not only to do good science but also to become good leaders and good managers.
Steve Yang is vice president and head of R&D for Asia and emerging markets at AstraZeneca, which he joined in January 2011.

we continue to help people live a healthy lifestyle, prevent disease, and improve the quality of living? And the challenges and opportunities go beyond just inventing the next pill or vial for injection, to fundamentally thinking about what, with so many people living together, the best way is to prevent disease or at least slow down disease and some of the chronic disease progressions. That is something I dont think the world has really tackled before. The scale of such innovation is where China can offer ground for experimentation.

Progress to date
We have made great progress and built a solid foundation. Our Innovation Center China was announced in 2006 as part of a $100 million investment we made in China, and it was launched in October 2007. During the four years since then, we have accumulated a lot of data, contributed to global oncology research in the area of biomarkers and translational science, and built credibility and a strong team locally. We are ready to expand our mission to become a drug discovery center, with a special focus on cancers prevalent in Asia, such as gastric and liver cancers. But the journey has just started. If you use as a measure the time needed to develop a new drug, we still have a long way to go. It takes 10 to 15 years to take an idea all the way from a scientists hypothesis to products on the market. There is a Chinese saying that you may have a destiny, and that final destiny may be very bright, but the road that leads there is inevitably windy and full of challenges. Thats the case at both the strategic and operational levels. On a day-to-day basis, managing turnover and retaining and developing talent can be challenging, although in AstraZeneca R&D we are fortunate to have a turnover rate well below the industry average. Also, AstraZeneca is a multinational company, and the majority of our senior leaders, our resources, and our stakeholders are thousands of miles and many time zones away. Constantly gathering their support and commitment is very important.

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Finally, we have seen a significant improvement in the IP environment. But, because of the rapid development of the legislative environment and the regulatory framework, there is a constant flow of amendments to policies on the IP law. In many cases, it took some time for the government, the legislature, and enforcement agencies, as well as industry, to understand fully what those new regulations meant. Thats just natural growing pains. In IP law, there has been a recent commitment reflecting the governments increasing understanding of the importance of IP, but we hope to have more clarity around how those new laws will be interpreted and enforced.

The talent situation


There are a large number of scientists available, trained either overseas or locally. We have seen significant quality of talent both in the returnee population and in the locally educated population. There are disciplinesfor example, chemistry and general biologythat tend to follow this trend. There are also disciplines that are highly specialized and require decades of training. In those areas, the talent, particularly those with experience, is in short supply. Examples would be toxicologists, pathologists, statisticians, and clinicians. Thats one dimension to look at: the technical competency of the talent. The other dimension, given the fast growth of the markets, includes the leadership and management capabilities of the talent. In many cases, companies like ours need to ramp up our efforts quickly, so we are giving the scientistsparticularly the scientific leadersthe mandate not only to do good science and to drive projects but also to become good leaders and good managers. If we use those criteria, the number of individuals who possess all these skills is smaller. But in general, we are optimistic. From our own experience, we can recruit talent overseas and locally. And to support our portfolio, our mission, and, more important, the Innovation Center China, we have an excellent record in retaining and continuously developing those colleagues.
Steve Yangs commentary is drawn from an interview with Jeremy Teo, an associate principal in McKinseys Shanghai office.
For the full version of this interview, see Innovating in Chinas pharma market: An interview with AstraZenecas head of R&D in Asia and emerging markets, on mckinseyquarterly.com.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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Artwork by Lloyd Miller

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Working out of debt


Karen Croxson, Susan Lund, and Charles Roxburgh

An update of our research on the efforts of developed countries to work out from under a massive overhang of debt shows how uneven progress has been. US households have made the greatest gains so far.

The problem The deleveraging process that began in 2008 is proving to be long and painful, with many countries struggling to reduce debt during a sluggish economic recovery. Why it matters National economic prospects depend on how deleveraging plays out. Historical experience suggests that excessive debt is a drag on growth and that GDP rebounds in the later years of deleveraging. What to do about it Companies active in countries that are experiencing deleveraging should closely monitor progress toward targets that historically have coincided with economic improveTo read more on what history can teach us about todays economic environment, see Understanding the Second Great Contraction: An interview with Kenneth Rogoff, on page 108.

ment. These include banking-system stabilization, structural reforms, growing exports and private investments, and housing-market stabilization.

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The deleveraging process that began in 2008 is proving to be long and painful. Historical experience, particularly postWorld War II debt reduction episodes, which the McKinsey Global Institute reviewed in a report two years ago, suggested this would be the case.1 And the eurozones debt crisis is just the latest demonstration of how toxic the consequences can be when countries have too much debt and too little growth.
We recently took another look forward and backat the relevant lessons from history about how governments can support economic recovery amid deleveraging and at the signposts business leaders can watch to see where economies are in that process. We reviewed the experience of the United States, the United Kingdom, and Spain in depth, but the signals should be relevant for any country thats deleveraging. Overall, the deleveraging process has only just begun. During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the worlds ten largest developed economies (for more, see Deleveraging: Where are we now? on page 132). Private-sector debt has fallen, however, which is in line with historical experience: overextended households and corporations typically lead the deleveraging process; governments begin to reduce their debts later, once they have supported the economy into recovery.

Different countries, different paths


In the United States, the United Kingdom, and Spain, all of which experienced significant credit bubbles before the financial crisis of 2008, households have been reducing their debt at different speeds. The most significant reduction occurred among US households. Lets review each country in turn.

The United States: Light at the end of the tunnel


Household debt outstanding has fallen by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011 in the United States. Defaults account for about 70 and 80 percent of the decrease in mortgage debt and consumer credit, respectively. A majority of the defaults reflect financial distress: overextended homeowners who
1 The full report, Debt and deleveraging: The global credit bubble and its economic

consequences (January 2010), is available online at mckinsey.com/mgi.

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lost jobs during the recession or faced medical emergencies found that they could not afford to keep up with debt payments. It is estimated that up to 35 percent of the defaults resulted from strategic decisions by households to walk away from their homes, since they owed far more than their properties were worth. This option is more available in the United States than in other countries, because in 11 of the 50 states including hard-hit Arizona and Californiamortgages are nonrecourse loans, so lenders cannot pursue the other assets or income of borrowers who default. Even in recourse states, US banks historically have rarely pursued borrowers. Historical precedent suggests that US households could be up to halfway through the deleveraging process, with one to two years of further debt reduction ahead. We base this estimate partly on the long-term trend line for the ratio of household debt to disposable income. Americans have constantly increased their debt levels over the past 60 years, reflecting the development of mortgage markets, consumer credit, student loans, and other forms of credit. But after 2000, the ratio

Q1 2011 of household debt to income soared, exceeding the trend line by MGI Deleveraging about 30 percentage points at the peak (Exhibit 1). As of the second Exhibit 1 of 4 quarter of 2011, this ratio had fallen by 11 percent from the peak;

Exhibit 1 Although the debt ratio of US households remains high, they may be halfway through the deleveraging process.
US household debt as % of gross disposable income, quarterly, seasonally adjusted
Historical Projected Trend line based on 19552000 data

140 130 120 110 100 90 80 70 60 50 40 30 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q2 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2013
Source: Haver Analytics; McKinsey Global Institute analysis

11%

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at the current rate of deleveraging, it would return to trend by mid2013. Faster growth of disposable income would, of course, speed this process. We came to a similar conclusion when we compared the experiences of US households with those of households in Sweden and Finland in the 1990s. During that decade, these Nordic countries endured similar banking crises, recessions, and deleveraging. In both, the ratio of household debt to income declined by roughly 30 percent from its peak. As Exhibit 2 indicates, the United States is closely tracking the Swedish experience, and the picture looks even better considering that clearing the backlog of mortgages already in the foreclosure pipeline could reduce US household debt ratios by an additional six per-

Q1 2011 MGI Deleveraging As for the debt service ratio of US households, its now down to Exhibit 2 of 4
11.5 percentwell below the peak of 14.0 percent, in the third

centage points.

Exhibit 2 In the United States, household deleveraging may have only a few more years to go, while in Spain and the United Kingdom it has just begun.
Household debt, % of gross annual disposable income1 Credit boom 170 160 150 140 130 120 110 100 90 80 70 60 0 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 United States 11 Spain 4 United Kingdom 6 Deleveraging Reduction since deleveraging began

Sweden, historical example

32

Years before and after deleveraging, where 0 = rst year2


1 Total household debt outstanding and annual disposable income for Spain, United Kingdom, and United States as of Q4 in given year. 2For Sweden, 1998; Spain, 2007; United Kingdom and United States, 2008.

Source: Statistics Sweden, Haver Analytics; McKinsey Global Institute analysis

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quarter of 2007, and lower than it was even at the start of the bubble, in 2000. Given current low interest rates, this metric may overstate the sustainability of current US household debt levels, but it provides another indication that they are moving in the right direction. Nonetheless, after US consumers finish deleveraging, they probably wont be as powerful an engine of global growth as they were before the crisis. Thats because home equity loans and cash-out refinancing, which from 2003 to 2007 let US consumers extract $2.2 trillion of equity from their homesan amount more than twice the size of the US fiscal-stimulus packagewill not be available. The refinancing era is over: housing prices have declined, the equity in residential real estate has fallen severely, and lending standards are tighter. Excluding the impact of home equity extraction, real consumption growth in the pre-crisis years would have been around 2 percent per annumsimilar to the annualized rate in the third quarter of 2011.

The United Kingdom: Debt has only just begun to fall


Three years after the start of the financial crisis, UK households have deleveraged only slightly, with the ratio of debt to disposable income falling from 156 percent in the fourth quarter of 2008 to 146 percent in second quarter of 2011. This ratio remains significantly higher than that of US households at the bubbles peak. Moreover, the outstanding stock of household debt has fallen by less than 1 percent. Residential mortgages have continued to grow in the United Kingdom, albeit at a much slower pace than they did before 2008, and this has offset some of the 25 billion decline in consumer credit. Still, many UK residential mortgages may be in trouble. The Bank of England estimates that up to 12 percent of them may be in some kind of forbearance process, and an additional 2 percent are delinquent similar to the 14 percent of US mortgages that are in arrears, have been restructured, or are now in the foreclosure pipeline (Exhibit 3). This process of quiet forbearance in the United Kingdom, combined with record-low interest rates, may be masking significant dangers ahead. Some 23 percent of UK households report that they are already somewhat or heavily burdened in paying off unsecured debt.2 Indeed, the debt payments of UK households are one-third higher than those of their US counterpartsand 10 percent higher than they were in 2000, before the bubble. This statistic is particularly problematic because at least two-thirds of UK mortgages have variable interest rates, which
2 NMG Consulting survey (2010) of UK households.

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expose borrowers to the potential for soaring debt payments should interest rates rise. Given the minimal amount of deleveraging among UK households, they do not appear to be following Sweden or Finland on the path of significant, rapid deleveraging. Extrapolating the recent pace of UK household deleveraging, we find that the ratio of household debt to disposable income would not return to its long-term trend until 2020. Alternatively, its possible that developments in UK home prices, interest rates, and GDP growth will cause households to reduce debt slowly over the next several years, to levels that are more sustainable but still higher than historic trends. Overall, the United Kingdom needs to steer a difficult course that reduces household debt steadily, but at a pace that doesnt stifle growth in consumption, which remains the critical driver of UK GDP.

Spain: The long unwinding road


Since the credit crisis first broke, Spains ratio of household debt to disposable income has fallen by 4 percent and the outstanding stock of household debt by just 1 percent. As in the United Kingdom, home mortgages and other forms of credit have continued to grow while consumer credit has fallen sharply. Spains mortgage default rate climbed following the crisis but remains relatively low, at approximately 2.5 percent, thanks to low interest rates. The number of mortgages in forbearance has also risen since the crisis broke, however. And more trouble may lie ahead. Almost half of the households in the lowest-income quintile face debt payments representing more than 40 percent of their income, compared with slightly less than 20 percent for low-income US households. Meanwhile, the unemployment rate in Spain is now 21.5 percent, up from 9 percent in 2006. For now, households continue to make payments to avoid the countrys conservative recourse laws, which allow lenders to go after borrowers assets and income for a long period. In Spain, unlike most other developed economies, the corporate sectors debt levels have risen sharply over the past decade. A significant drop in interest rates after the country joined the eurozone, in 1999, unleashed a run-up in real-estate spending and an enormous expansion in corporate debt. Today, Spanish corporations hold twice as much debt relative to national output as do US companies, and six times as much as German companies. Debt reduction in the corporate sector may weigh on growth in the years to come.

Q1 2011 Working out of debt MGI Deleveraging Exhibit 3 of 4

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Exhibit 3 If forbearance is factored in, up to 14 percent of UK mortgages could be in difcultyidentical to the percentage of US mortgages in difculty today.
% of residential mortgages in difculty, 2011 United Kingdom1 14.2% 2.2 Delinquent United States2 14.2% 4.5 In foreclosure

12.0

In forbearance

8.3

Delinquent

1.4

In forbearance

1 UK delinquency data as of Q2 2011, represents mortgage loans >1.5% in arrears. UK forebearance data based on worst-case estimates 2US delinquency and foreclosure data as of Q1 2011; delinquency represents mortgage loans >30 days delinquent.

from Bank of England Financial Stability Report, June 2011.

Source: Mortgage Bankers Association, United States; Bank of England; McKinsey Global Institute analysis

Signposts for recovery


Paring debt and laying a foundation for sustainable long-term growth should take place simultaneously, difficult as that may seem. For economies facing this dual challenge today, a review of history offers key lessons. Three historical episodes of deleveraging are particularly relevant: those of Finland and Sweden in the 1990s and of South Korea after the 1997 financial crisis. All these countries followed a similar path: bank deregulation (or lax regulation) led to a credit boom, which in turn fueled real-estate and other asset bubbles. When they collapsed, these economies fell into deep recession, and debt levels fell. In all three countries, growth was essential for completing a five- to seven-year-long deleveraging process. Although the private sector may start to reduce debt even as GDP contracts, significant public-sector deleveraging, absent a sovereign default, typically occurs only when GDP growth rebounds, in the later years of deleveraging (Exhibit 4). Thats true because the primary factor causing public deficits to rise after a banking crisis is declining tax revenue, followed by an increase in automatic stabilizer payments, such as unemployment benefits.3
3 See Fiscal Monitor: Navigating the Fiscal Challenges Ahead, International Monetary Fund,

May 2010.

104 MGI

Q1 2011 2012 Number 1 Deleveraging Exhibit 4 of 4

Exhibit 4 Signicant public-sector deleveraging typically occurs after GDP growth rebounds.
Average of relevant historical deleveraging episodes (Sweden and Finland in 1990s) Deleveraging Recession 10-year historical trend 12 years Downturn starts; leveraging continues 3% 23 years Downturn continues; deleveraging begins 45 years Economy bounces back; deleveraging continues

Real GDP growth, annual average Private: ratio of private-sector debt to GDP, change in percentage points Public: ratio of publicsector debt to GDP, change in percentage points

3%

1%

3%

60

26

87

15

21

30

Source: Haver Analytics; International Monetary Fund (IMF); McKinsey Global Institute analysis

A rebound of economic growth in most deleveraging episodes allows countries to grow out of their debts, as the rate of GDP growth exceeds the rate of credit growth. No two deleveraging economies are the same, of course. As relatively small economies deleveraging in times of strong global economic expansion, Finland, South Korea, and Sweden could rely on exports to make a substantial contribution to growth. Todays deleveraging economies are larger and face more difficult circumstances. Still, historical experience suggests five questions that business and government leaders should consider as they evaluate where todays deleveraging economies are heading and what policy priorities to emphasize.

1. Is the banking system stable?


In Finland and Sweden, banks were recapitalized and some were nationalized. In South Korea, some banks were merged and some were shuttered, and foreign investors for the first time got the right to become majority investors in financial institutions. The decisive resolution of bad loans was critical to kick-start lending in the economicrebound phase of deleveraging.

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The financial sectors in todays deleveraging economies began to deleverage significantly in 2009, and US banks have accomplished the most in that effort. Even so, banks will generally need to raise significant amounts of additional capital in the years ahead to comply with Basel III and national regulations. In most European countries, business demand for credit has fallen amid slow growth. The supply of credit, to date, has not been severely constrained. A continuation of the eurozone crisis, however, poses a risk of a significant credit contraction in 2012 if banks are forced to reduce lending in the face of funding constraints. Such a forced deleveraging would significantly damage the regions ability to escape recession.

2. Are structural reforms in place?


In the 1990s, each of the crisis countries embarked on a program of structural reform. For Finland and Sweden, accession to the European Union led to greater economies of scale and higher direct investment. Deregulation in specific industry sectorsfor example, retailingalso played an important role.4 South Korea followed a remarkably similar course as it restructured its large corporate conglomerates, or chaebol, and opened its economy wider to foreign investment. These reforms unleashed growth by increasing competition within the economy and pushing companies to raise their productivity. Todays troubled economies need reforms tailored to the circumstances of each country. The United States, for instance, ought to streamline and accelerate regulatory approvals for business investment, particularly by foreign companies. The United Kingdom should revise its planning and zoning rules to enable the expansion of successful high-growth cities and to accelerate home building. Spain should drastically simplify business regulations to ease the formation of new companies, help improve productivity by promoting the creation of larger ones, and reform labor laws.5 Such structural changes are particularly important for Spain because the fiscal constraints now buffeting the European Union mean that the country cannot continue to boost its public debt to stimulate the economy. Moreover, as part of the eurozone, Spain does not have the option of currency depreciation to stimulate export growth.
4 See Kalle Bengtsson, Claes Ekstrm, and Diana Farrell, Swedens growth paradox,

mckinseyquarterly.com, June 2006; and Swedens Economic Performance: Recent Developments, Current Priorities (May 2006), available online at mckinsey.com/mgi. 5 A Growth Agenda for Spain, McKinsey & Company and FEDEA, 2010.

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A rebound of economic growth in most deleveraging episodes allows countries to grow out of their debts, as the rate of GDP growth exceeds the rate of credit growth.
3. Have exports surged?
In Sweden and Finland, exports grew by 10 and 9.4 percent a year, respectively, between 1994 and 1998, when growth rebounded in the later years of deleveraging. This boom was aided by strong exportoriented companies and the significant currency devaluations that occurred during the crisis (34 percent in Sweden from 1991 to 1993). South Koreas 50 percent devaluation of the won, in 1997, helped the nation boost its share of exports in electronics and automobiles. Even if exports alone cannot spur a broad recovery, they will be important contributors to economic growth in todays deleveraging economies. In this fragile environment, policy makers must resist protectionism. Bilateral trade agreements, such as those recently passed by the United States, can help. Salvaging what we can from the Doha round of trade talks will be important. Service exports, including the hidden ones that foreign students and tourists generate, can be a key component of export growth in the United Kingdom and the United States.

4. Is private investment rising?


Another important factor that boosted growth in Finland, South Korea, and Sweden was the rapid expansion of investment. In Sweden, it rose by 9.7 percent annually during the economic rebound that began in 1994. Accession to the European Union was part of the impetus. Something similar happened in South Korea after 1998 as barriers to foreign direct investment fell. These soaring inflows helped offset slower private-consumption growth as households deleveraged. Given the current very low interest rates in the United Kingdom and the United States, there is no better time to embark upon investments. Those for infrastructure represent an important enabler, and today there are ample opportunities to renew the aging energy and transportation networks in those countries. With public funding limited, the private sector can play an important role in providing equity capital,

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if pricing and regulatory structures enable companies to earn a fair return.

5. Has the housing market stabilized?


During the three historical episodes discussed here, the housing market stabilized and began to expand again as the economy rebounded. In the Nordic countries, equity markets also rebounded strongly at the start of the recovery. This development provided additional support for a sustainable rate of consumption growth by further increasing the wealth effect on household balance sheets. In the United States, new housing starts remain at roughly one-third of their long-term average levels, and home prices have continued to decline in many parts of the country through 2011. Without price stabilization and an uptick in housing starts, a stronger recovery of GDP will be difficult,6 since residential real-estate construction alone contributed 4 to 5 percent of GDP in the United States before the housing bubble. Housing also spurs consumer demand for durable goods such as appliances and furnishings and therefore boosts the sale and manufacture of these products.

At a time when the economic recovery is sputtering, the eurozone crisis threatens to accelerate, and trust in business and the financial sector is at a low point, it may be tempting for senior executives to hunker down and wait out macroeconomic conditions that seem beyond anyones control. That approach would be a mistake. Business leaders who understand the signposts, and support government leaders trying to establish the preconditions for growth, can make a difference to their own and the global economy.
6 In 2010, residential real-estate investment accounted for just 2.3 percent of GDP, compared

with 4.4 percent in 2000, before the housing-bubble years. Personal consumption on furniture and other household durables added about 2 percent to growth in 2000.

The authors wish to thank Toos Daruvala and James Manyika for their thoughtful input, as well as Albert Bollard and Dennis Bron for their contributions to the research supporting this article. Karen Croxson, a fellow of the McKinsey Global Institute (MGI), is based in McKinseys London office; Susan Lund is director of research at MGI and a principal in the Washington, DC, office; Charles Roxburgh is a director of MGI and a director in the London office.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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Understanding the Second Great Contraction: An interview with Kenneth Rogoff

The economist and coauthor of This Time Is Different explains what history can teach us about the global downturn and why climbing out of it is still rife with risks.
Continued economic stagnation in Europe and the United States, along with renewed uncertainty about the health of the debt-ridden global financial system, has been raising fresh concerns about the prognosis for economic recovery and even the potential for a relapse into crisis. A big part of the problem, as Harvard economist Kenneth Rogoff points out in This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, September 2009), the best-selling academic book he coauthored with fellow economist Carmen Reinhart, is that we are working through a recession linked to a deep financial crisisa powerful amplifying mechanism with long-lasting effects. Reinhart and Rogoffs work, based on investigations of empirical data from 800 years of financial crises, shows that such downturns are exceptionally deep and long lasting, as well as unprecedented in the United States since World War II. McKinseys Bill Javetski and Tim Koller recently visited Rogoff in his Cambridge, Massachusetts, office to ask where we are in the recovery time line and why Rogoff thinks that a bout of moderate inf lation may help the world regain economic health. Rogoffs outlookthat the balance of current economic risks tilts more to the downside than the upsideis sobering but essential reading for business leaders and policy makers trying to make sense of todays uncertain environment.
The Quarterly: What does history tell you about where we are on the

time line of the economic contraction weve been living through?


Kenneth Rogoff: The historical experience gives a very clear view

that the aftermath of a financial crisis brings slow and halting growth, sustained high unemployment, and surging public debtwith the overhang of public and private debt being the most important impediment to a normal recovery from recession.

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It has been utterly remarkable how the United States has been tracking the averages of postwar deep financial crises across a broad range of indicators. On average, it takes four and a half years to get back to the same per capita GDP where you started out and about the same amount of time for unemployment to stop rising. Indeed, we havent yet gotten back to the same per capita GDP where we started. Our perspective is that we have never left the recession; were still very much in it. I hope in another two or three years things will be feeling more normal. But there are a lot of difficulties to traverse before we get there.
The Quarterly: You distinguish between normal recessions and those

accompanied by a deep financial crisis. Are there many recessions marked by such a crisis?
Kenneth Rogoff: There have been many across the world, but for

the United States this is the first one since World War II. A financialcrisis recession is a very different animal from a normal recession. At least quantitatively, its not as bad now as it was in the Great Depression. Nevertheless, Reinhart and I argue that the right name for

Kenneth Rogoff

Vital statistics Born March 22, 1953, in Rochester, New York Married, with 2 children Education Graduated with a BA in economics in 1975 from Yale University Earned a PhD in economics in 1980 from the Massachusetts Institute of Technology (MIT)

Career highlights Harvard University (1999present) Professor, economics and public policy Princeton University (1992 99) Professor, economics and international affairs University of California at Berkeley (198991) Professor, economics University of Wisconsin at Madison (198588) Professor, economics

Fast facts Awarded Deutsche Bank Prize in Financial Economics in 2011 Served as economic counselor and director of the research department of the International Monetary Fund (August 2001 to September 2003) Elected member of the American Academy of Arts & Sciences and the Econometric Society Earned life title of international grandmaster of chess by World Chess Federation in 1978

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this downturn is the Second Great Contraction, building on the title of Milton Friedman and Anna Schwartzs famous book about the Great Depression.1
The Quarterly: Is there any way to accelerate our pullout from this

contraction?
Kenneth Rogoff: Its not easy, because a postfinancial-crisis recession

is characterized by an overhang of private and public debt that is much more severe than it is after a normal recession. There are many mortgages still under waterperhaps 25 percentand people are more cautious about extending their borrowing than they were before 2007. That leads to slower consumption growth. Businesses in turn invest more slowly. In 2008, policy makers placed too much confidence in the Keynesian idea that you can jump-start the economy with a big temporary stimulus and then step back and watch the private sector take over. Of course, Reinhart and I argued otherwise, based on the results of a seven-year research project, and our results certainly were acknowledged by practitioners, academics, and policy makers. Nevertheless, most policy makers and markets still insisted, Well, yes, maybe that is how things always were in the past, but this time its different because the policy response was so aggressive. In fact, the policy response is always very aggressive. Every country does everything it can to claw its way back from a deep financial crisis. So, unfortunately, there is no easy out. Perhaps the best chance would be to find a way to get ahead of the mortgage defaultsthat is, to have restructurings and debt forgiveness, albeit with some kind of quid pro quo. That is very hard to do. But if there were a way to write down and forgive some of the mortgage debt, that would be money well spent. In ten years, we will probably end up forgiving a big chunk of it. As Carmen has noted, this is a little like Third World debt that was carried on the books forever, even though it was a joke.
The Quarterly: What other policy responses would make sense? Kenneth Rogoff: Beyond that, we need to think about long-run

structural reform. Most financial crises have at their root very, very high leverage. To hit the nail on the head, I think we have to do something
1 Milton Friedman and Anna Jacobson Schwartz, The Great Contraction, 19291933,

Princeton, NJ: Princeton University Press, 1964.

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about the prevalence of nonindexed debt instruments. I would start with changing our corporate-tax law and any overt incentives that favor debt. Obviously, the US home mortgage tax deduction makes no sense, given the risk that debt entails. I understand the political imperative, but lets not subsidize debt in an overt way. I think public-finance experts need to methodically go through the system and strip debt subsidies out. And then Id say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders.2 If in 200 or 300 years were experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation clauses into debt that make it a little less vulnerable to systemic risk.
The Quarterly: Financial innovation, in the form of derivatives,

credit default swaps, and other instruments, was supposed to make the world a safer place. Did they have a rolegood, bad, or neutralin creating the crisis?
Kenneth Rogoff: Financial innovation is always a piece of financial

crises, and financiers are always ahead of the regulators. In This Time Is Different, we discuss how in the 1300s and 1400s the Catholic Churchwhich was the regulator at the time, of coursehad very strict usury laws. The financiers got around them by thinking of very clever devices, including denominating loans to be repaid in a foreign currency. You give the money in a weaker currency and require the repayment in a stronger currency, which, of course, everyone perfectly well understood to be equivalent to paying interest. There are countless examples over the ages. The transatlantic cable led to huge financial innovation. Innovation is always ahead of the regulators.
The Quarterly: Does that mean we should be cautious about the

supposed benefits of financial innovation?


Kenneth Rogoff: I think financial innovation has been overly

blamed for everything. Financial-sector lobbying is another matter regulators of the financial sector lost sight of the risks.
2 Robert Shiller is a professor of economics at Yale University and cocreator of the Case

Shiller House Price Index, one of the most widely used methods of measuring performance in that industry.

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The Quarterly: Is the size of the banks an important factor? Can they

get too big?


Kenneth Rogoff: I believe that size is overrated as the issue. There

is this view that if we can just break up the big banks into smaller ones, we wont have a problem. But if you look at systemic crises, usually a lot of banks are doing the same thing. So if we take one big bank and break it up into ten smaller banks that act similarly, Im not sure how much we really would have bought ourselves. The incentives that would make a big bank go whole hog in one direction would probably make ten smaller banks do the same thing.
The Quarterly: Youve advocated allowing inflation to increase as

one kind of remedy. Can you explain?


Kenneth Rogoff: There are no quick fixes. But I do think that this is

a period when we shouldnt be worried about raising inflation slightly. Indeed, moderate inflation, I would say, is exactly the prescription for a Great Depressiontype scenario or a Japan-type scenario. It lowers real interest rates, helps facilitate housing price adjustment (the real price still needs to come down in many places), and modestly shortens the typical long post-crisis deleveraging period. Ive pushed the idea, for some time, that were in a Great Contraction, not in a typical recession, and one has to analyze the problem differently. Unfortunately, there is still a risk that this thing could get much, much worse. The biggest problem is the global overhang of debt. After publishing our book, Carmen Reinhart and I did a study that looked at the impact of public debt on growth. When debt gets over a certain levela good marker is 90 percent of GDPit is linked to lower growth. If elevated inf lationIve suggested 4 to 6 percent for a few years somewhat reduces real debt levels, that would be welcome. Of course, I do get a knee-jerk reaction from many people saying that even slightly elevated inflation is anathema; wed be going back to the bad old days of the 70s. And my answer is that this could still be much worse than the 70s. Ive worked my whole career on designing central banks and promoting tools and institutions for containing inflation. But right now, given a once-in-80-years downturn, you have to balance the risks.
The Quarterly: Is that the right approach for Europe as well? Kenneth Rogoff: Absolutely, though of course they have a political

tightrope to walk. Still, how much should they worry about whether

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inflation is under 2 percent right now when the euro could fall apart in the next year or two? Please understand, the European Central Bank is under tremendous political pressure, and theyre not the main source of the problem. But I dont see how they would want to be in a situation where theyd go out of business in a year and say, Well, the euro may have fallen apart, but we never had inf lation expectations go above 2 percent. Inflation is not a panacea, but this is a once in eight or ten decades situation where it would be helpful.
The Quarterly: Is it naive to pretend that some or much of this debt

isnt going to have to be restructured at some point?


Kenneth Rogoff: By any historical benchmark, Greece, Portugal,

and probably Ireland are way over the line. Their debts should be dramatically reducedfor Greece by at least 60 percent or 70 percent. Portugal probably 40 to 50 percent. Ireland is more complicated because its difficult to disentangle whats government debt and whats bank debt. The big problem is Irelands bank debt. But the government has guaranteed it. Had the eurozone officials done all this a year ago and, importantly, cast an ironclad safety net over the remainder, perhaps we would be looking at this in the rear window.
The Quarterly: What indicators would you look to for signs that

were finally starting to get out of this?


Kenneth Rogoff: Job growth and unemployment. I dont expect

unemployment to come down again to 4 or 4.5 percent until the next time the economy overheats. That level was never normal. More likely, when this is all over, unemployment will settle down at around 6.5 or 7 percent. Until weve seen unemployment come down to a level like that, things will remain precarious. I should note that the most reliable measure, though, isnt unemployment; its employment. In addition to unemployment rising, the participation rate in the economy has fallen, and that too needs to come back.
Bill Javetski is a member of McKinsey Publishing and is based in McKinseys New Jersey office; Tim Koller is a principal in the New York office.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

Applied Insight
Tools, techniques, and frameworks for managers

115 Beware the inside view 118 The human factor in service design

124 How leaders kill meaning at work

Artwork by Keith Negley

115

Beware the inside view


Daniel Kahneman

The Nobel laureate recalls how an inwardly focused forecasting approach once led him astray, and explains why an external perspective can help executives do better.

In the 1970s, I convinced some officials in the Israeli Ministry of Education of the need for a curriculum to teach judgment and decision making in high schools. The team that I assembled to design the curriculum and write a textbook for it included several experienced teachers, some of my psychology students, and Seymour Fox, then dean of Hebrew Universitys School of Education and an expert in curriculum development. After meeting every Friday afternoon for about a year, we had constructed a detailed outline of the syllabus, written a couple of chapters, and run a few sample lessons. We all felt we had made good progress. Then, as we were discussing procedures for estimating uncertain quantities, an exercise occurred to me. I asked everyone to write down their estimate of how long it would take us to submit a finished draft of the textbook to the Ministry of Education. I was following a procedure that we already planned to incorporate into our curriculum: the proper

way to elicit information from a group is not by starting with a public discussion, but by confidentially collecting each persons judgment. I collected the estimates and jotted the results on the blackboard. They were narrowly centered around two years: the low end was one and a half, the high end two and a half years.

A shocking disconnect
Then I turned to Seymour, our curriculum expert, and asked whether he could think of other teams similar to ours that had developed a curriculum from scratch. Seymour said he could think of quite a few, and it turned out that he was familiar with the details of several. I asked him to think of these teams when they were at the same point in the process as we were. How much longer did it take them to finish their textbook projects? He fell silent. When he finally spoke, it seemed to me that he was blushing, embarrassed by his own answer: You know, I never realized

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this before, but in fact not all the teams at a stage comparable to ours ever did complete their task. A substantial fraction of the teams ended up failing to finish the job. This was worrisome; we had never considered the possibility that we might fail. My anxiety rising, I asked how large he estimated that fraction was. About 40 percent, he said. By now, a pall of gloom was falling over the room.

quit. After a few minutes of desultory debate, we gathered ourselves and carried on as if nothing had happened. Facing a choice, we gave up rationality rather than the enterprise. The book was completed eight years later. By that time, I was no longer living in Israel and had long since ceased to be part of the team, which finished the task after many unpredictable vicissitudes. The initial enthusiasm for the idea in the Ministry of Education had waned, and the textbook was never used.

This article is an edited excerpt from Daniel Kahnemans Thinking, Fast and Slow, published in 2011 by Farrar, Those who finished, how long did Straus and Giroux it take them? (US), Doubleday I cannot think of any group that (Canada), and finished in less than seven years, Allen Lane (UK). Seymour said, nor any that took

more than ten. I grasped at a straw: When you compare our skills and resources to those of the other groups, how good are we? How would you rank us in comparison with these teams? Seymour did not hesitate long this time. Were below average, he said, but not by much. This came as a complete surprise to all of usincluding Seymour, whose prior estimate had been well within the optimistic consensus of the group. Until I prompted him, there was no connection in his mind between his knowledge of the history of other teams and his forecast of our future. We should have quit that day. None of us was willing to invest six more years of work in a project with a 40 percent chance of failure. Yet although we must have sensed that persevering was not reasonable, the warning did not provide an immediately compelling reason to

Why the inside view didnt work


This embarrassing episode remains one of the most instructive experiences of my professional life. I had stumbled onto a distinction between two profoundly different approaches to forecasting, which Amos Tversky1 and I later labeled the inside view and the outside view. The inside view is the one that all of us, including Seymour, spontaneously adopted to assess the future of our project. We focused on our specific circumstances and searched for evidence in our own experiences. We had a sketchy plan: we knew how many chapters we were going to write, and we had an idea of how long it had taken us to write the two that we had already done. The more cautious among us probably added a few months as a margin of error. But extrapolating was a mistake. We were forecasting based on the information in front of us, but the chapters we wrote first were easier than others and our commitment

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to the project was probably at its peak. The main problem was that we failed to allow for what Donald Rumsfeld famously called unknown unknowns. At the time, there was no way for us to foresee the succession of events that would cause the project to drag on for so long: divorces, illnesses, crises of coordination with bureaucracies. These unanticipated events not only slow the writing process, but produce long periods during which little or no progress is made at all. Of course, the same must have been true for the other teams that Seymour knew about. Like us, the members of those teams did not know the odds they were facing. There are many ways for any plan to fail, and although most of them are too improbable to be anticipated, the likelihood that something will go wrong in a big project is high.

given case-specific information that the womans son is the starting center of his high school basketball teamyou will adjust your estimate. Seymours comparison of our team to others suggested that the forecast of our outcome was slightly worse than the baseline prediction, which was already grim. The spectacular accuracy of the outside-view forecast in our specific case was surely a fluke and should not count as evidence for the validity of the outside view. However, the argument for the outside view should be made on general grounds: if the reference class is properly chosen, the outside view will give an indication of where the ballpark is. It may suggest, as it did in our case, that the inside-view forecasts are not even close.
1 Kahneman and Amos Tversky, who taught

How an outside view can help


The second question I asked Seymour directed his attention away from us and toward a class of similar cases. Seymour estimated the base rate of success in that reference class: 40 percent failure and seven to ten years for completion. His informal survey was surely not up to scientific standards of evidence, but it provided a reasonable basis for a baseline prediction: the prediction you make about a case if you know nothing except the category to which it belongs. This should be the anchor for further adjustments. If you are asked to guess the height of a woman and all you know is that she lives in New York City, for example, your baseline prediction is your best guess of the average height of women in the city. If you are now

at Stanford University, were long-time collaborators and worked together to develop prospect theory. When Kahneman was awarded the Nobel Prize six years after Tverskys death, he told the New York Times: I feel it is a joint prize. We were twinned for more than a decade. See Erica Goode, A conversation with Daniel Kahneman; on prot, loss and the mysteries of the mind, the New York Times, November 5, 2002.

Daniel Kahneman is professor emeritus of psychology and public affairs at Princeton Universitys Woodrow Wilson School of Public and International Affairs. He was awarded the 2002 Nobel Prize in Economic Sciences for his seminal work in prospect theory, which challenges the rational model of judgment and decision making.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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Artwork by Dieter Braun

The human factor in service design


John DeVine, Shyam Lal, and Michael Zea Focus on the human side of customer service to make it psychologically savvy, economically sound, and easier to scale.

Poor customer service isnt a headache just for consumers; its a problem that vexes senior managers too. Balancing the trade-offs between the cost of services and the customer experience benefits they provide is difficult. Ensuring that frontline workers can efficiently and consistently execute service offerings across a far-flung organization is harder still. Along the way, many com-

panies lose sight of what makes human beings tickfor instance, by overlooking well-known principles of behavioral science when delivering servicesand thus unwittingly predispose customers to dissatisfaction. At the same time, the customer service landscape is changing as social media and new mobilephone technologies give com-

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panies unprecedented access to data on customer interactions, while the technologies are changing the nature of the interactions themselvesfor example, by amplifying the speed and impact of customer complaints.

How human is our service?

Three questions
Against this backdrop, some organizations are making strides in the design and delivery of services. By focusing more thoughtfully on the human side of customer service, these companies are lowering costs by 10 percent or more while improving customer satisfaction scores by up to 30 percent. In this article, well look at three such companiesa provider of cable-TV and Internet services, a technology company serving small and midsize businesses, and a car rental company. From their experiences, weve distilled three interrelated questions that CEOs and other senior executives should ask themselves before they introduce new services or conduct a reality check on the health of existing ones. Taken together, the questions can help spur productive conversations among top-team members, raising the odds that a companys services will be both efficient and effective.

Its no secret that the quality of a companys service interactions matters greatly in creating a positive experience with customers. Yet few companies focus on how customers form opinions about those interactions. By applying wellknown principles of psychology and behavioral science to service designs and working harder to understand what really motivates and irritatescustomers, companies can begin improving the experience quickly and at low cost.1

Consider the experience of the cableTV provider that looked to behavioral science to help improve its widespread reputation for bad service. The company started by examining the characteristics of its most important customer interactions phone calls initiating new service and quickly identified several pain points. The calls, for example, typically contained off-putting directives from agents, as well as dead periods when customers felt that their time was wasted. Worse, the calls often ended with awkward billing discussions and legal disclosures. The company completely redesigned the calls. First, credit verifications occurred earlier, and in the background, while agents helped customers set up their accounts. This approach eliminated awkward silences, as well as the frustrations that arose at the end of calls if customers were found not to be creditworthy. This new approach also allowed customers to feel more in control,

For more about using large-scale data gathering to shape strategy, see Seizing the potential of big data, on mckinseyquarterly.com.

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by adding simple choices to the conversation: How do you want your billing to be set up? for example, or How would you like your installation to be conducted? By reframing as choices what had previously been directives, the company found that consumers began rating the interactions more positively. Agents were also coached to end the calls on a high noteanother human preference that behavioral scientists have identifiedby surprising customers with a coupon for a free product. Replacing what had been a stilted and highly scripted ending (a lot of fine print and disclosures, admitted one sales agent) with a bonus offer helped customers to view the calls more positively, introduced them to the companys product catalog, and ultimately drove higher sales.

companies can turn service weaknesses into strengths and even spot possible new service offerings. A rental-car company, for example, recognized that its valuesegment customers became more anxious than its premium customers did at the prospect of finding assigned cars in crowded lots. (The reason, in large part, was that value-segment customers traveled infrequently and were less familiar with the rental process than the premium customers were.) This observation led the company to introduce a successful and, for travelers, less stressful pick any car option.

How economic is our service?

Similarly, behavioral science indicates that customers dislike unexpected changes and are more satisfied when they can stick to their habits during service interactions. A B2B sales group at a technology company took this tendency into account when it significantly redesigned its sales processes for small-business customers. The company augmented its traditional sales blitz approachmultiple reps targeted many clients at once, common in B2B settingsby assigning a specific service champion to each client. A consistent point of contact improved customer satisfaction and helped free up the sales reps time for additional selling.2 Finally, by thinking harder about what makes customers tick,

The service offering that the rental-car company implemented was grounded in a clear economic rationale. The pick-any-car option was not only more efficient to operate than the old system but also created valuable revenue opportunities: the economy- and luxury-car choices were parked next to each other, so value-segment travelers with families were frequently tempted to splurge on larger, more expensive vehicles. Many executives miss opportunities such as these when they overlook the full economic impact of customer service. In practice, of course, trade-offs among service levels, revenues, and costs are complex. Mastering the challenge requires developing an integrated view of the economics across a range of customer touch points. Often, tools such as breakpoint analysis, which can help

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By thinking harder about what makes customers tick, companies can turn service weaknesses into strengths and even spot possible new service offerings.

determine customers actual sensitivity to service changes, are a good place to start. The rental-car company, for example, conducted such an exercise and learned that its value-segment customers were more amenable to driving used cars than it had previously assumed. Received wisdom in the industry held that consumers balked when vehicles reached 30,000 or so odometer miles. Yet a quantitative and qualitative analysis showed that customers would accept cars with higher mileage if the costs were relatively low, the cars were clean, and the company offered a well-crafted maintenance and reliability guarantee. Determining the breakpoints opened the company up to a whole range of higher-mileage vehicles it hadnt considered before and thus represented a significant potential for savings. Similarly, the technology companys sales group found that wide variations in service levels were acceptable when it returned its customers telephone inquiries. Executives knew, of course, that calls about the accuracy of orders required an immediate response but hadnt realized that the companys B2B customers were willing to wait up to a week for answers to other types

of inquiries. Getting a handle on the different breakpoints allowed the service champions to work efficiently while still focusing their immediate attention on service hot spots. The cable companys managers conducted similar analyses as they focused on its inefficient (and, for customers, frustrating) scheduling system for in-home installations. The company had considered narrowing its appointment window the block of time in which it promised to arrive at a customers home to one hour, from four. But after studying the sensitivities of customers, the company found that the duration of the appointment window was less important to them than having drivers actually arrive sometime within it. Furthermore, the sweet spot for efficiency and customer satisfaction came at the two-hour mark. Optimizing for service better than that wasnt worth the additional cost. To be sure, the cable companys executives looked closely at other basic cost drivers, and also balanced them against service outcomes. The company recognized, for example, that customers hated it when its employees didnt have the necessary equipment on the day of an installation and had to schedule a second visit. Worse, any time the installers

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spent driving back to the distribution center was time they couldnt use to educate customers about using the new equipment or to sell spurof-the-moment service upgrades. An analysis of supply chain and inventory levels for modems and video equipment helped the company to improve its on truck availability in a significant way. This and other process changes helped double the amount of time installers spent educating customers, and that led to a 10 percent increase in additional sales made on the day of installation.

by giving frontline workers a clearer sense of what was required of them and how to prepare for it. The new flow of the calls, said one call center employee, makes things easier for the customers, representatives, and technicians. Similarly, the technology companys B2B sales unit identified the handful of most common situations its call agents faced each day. It then created a simple checklist of procedures to help standardize the way agents handled these situations; processes had varied considerably before, making communication between sales teams in different regions difficult. The new approach improved the consistency of service and made it far easier for the company to roll out changes across its more than two dozen widely dispersed regional markets. As these examples imply, making services scalable involves more than standardizing processes: companies must ensure that their employees have the organizational capabilities necessary to carry out the tasks involved. Indeed, any suspected skill gaps should sound warning bells across the C-suite, even if a new service offering is economically sound and psychologically savvy. This lesson was understood by the rental-car companys senior team, which became concerned about the scalability of one of its new service ideas: a system allowing customers to check in while riding on the shuttle buses from an airport to the companys rental facility. The company had piloted the service at smaller locations, where it was successful. By making customers

Can our people scale it up?


When putting together services that are economically attractive and grounded in a good understanding of what motivates customers, companies shouldnt overlook their own employeesthe other human beings involved in a transaction. Companies give themselves a big edge when they design service processes that a widely distributed workforce can easily adopt, understand, automate, and execute.

The cable companys call center managers, for example, worked with sales agents to prepare them for the handful of scenarios that were most common, most likely to lead to dissatisfaction, or both: repair inquiries, as well as problems with the Internet, particular channels or channel bundles, and billing. Taking this more modular approach to calls helped improve the quality of training, which in turn helped improve service outcomes and the operational efficiency of calls. Better still, the moves dramatically improved employee satisfaction

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feel, for example, that their time on the buses was better used, the new system made the long ride less annoying. Moreover, the service offered considerable potential for agents to promote vehicle upgrades during the rides. Nonetheless, as the company experimented with this approach at its larger locations, executives began having second thoughts about its scalabilityin particular, whether agents were fully prepared to sell in the new way. Ultimately, the executives tabled the implementation of the new approach until they could study the situation further and determine if the organization was ready for the changes.

Further, as more and more customer data become available, some companies are investing in advanced analytics to understand customer interactions and channel preferences at a much more granular level. By focusing on the end-to-end nature of services as customers see them (from, say, order to provision) these companies can spot troubleand design new servicesmuch more quickly and successfully.
1  Of course, leading companies use a variety

of approachesin addition to behavioral scienceto help identify customer pain points and to suggest new service offerings. These techniques may include quantitative assessments of trends among customers, competitors, and technologies, as well as ethnography. 2 See Olivia Nottebohm, Tom Stephenson, and Jennifer Wickland, Freeing up the sales force for selling, mckinseyquarterly .com, July 2011.

Postscript: Organizing for action


While the decision to postpone the new service wasnt easy for the rental-car companys executives, at least they were in a position to make the call. Too often, we find that siloed decision making and implementation plans make it difficult for companies to involve the broad range of people required to change customer service priorities. By contrast, the best companies weve studied establish teams with a rotating, cross-functional membership to review key services periodically. The most successful teams include a range of roles, from frontline salespeople and marketing managers to practitioners of lean production and Six Sigmaand even behavioral psychologists.

John DeVine is a principal in McKinseys Miami office, Shyam Lal is a director in the San Francisco office, and Michael Zea is a principal in the Stamford office.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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How leaders kill meaning at work


Teresa Amabile and Steven Kramer Senior executives routinely undermine creativity, productivity, and commitment by damaging the inner work lives of their employees in four avoidable ways.
As a senior executive, you may think you know what Job Number 1 is: developing a killer strategy. In fact, this is only Job 1a. You have a second, equally important task. Call it Job 1b: enabling the ongoing engagement and everyday progress of the people in the trenches of your organization who strive to execute that strategy. A multiyear research project whose results we described in our recent book, The Progress Principle,1 found that of all the events that can deeply engage people in their jobs, the single most important is making progress in meaningful work. Even incremental steps forwardsmall winsboost what we call inner work life: the constant flow of emotions, motivations, and perceptions that constitute a persons reactions to the events of the work day. Beyond affecting the well-being of employees, inner work life affects the bottom

Artwork by Francesco Bongiorni

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line.2 People are more creative, productive, committed, and collegial in their jobs when they have positive inner work lives. But its not just any sort of progress in work that matters. The first, and fundamental, requirement is that the work be meaningful to the people doing it. In our book and a recent Harvard Business Review article,3 we argue that managers at all levels routinelyand unwittinglyundermine the meaningfulness of work for their direct subordinates through everyday words and actions. These include dismissing the importance of subordinates work or ideas, destroying a sense of ownership by switching people off project teams before work is finalized, shifting goals so frequently that people despair that their work will ever see the light of day, and neglecting to keep subordinates up to date on changing priorities for customers. But what about a companys most senior leaders? What is their role in makingor killingmeaning at work? To be sure, as a high-level leader, you have fewer opportunities to directly affect the inner work lives of employees than do frontline supervisors. Yet your smallest actions pack a wallop because what you say and do is intensely observed by people down the line.4 A sense of purpose in the work, and consistent action to reinforce it, has to come from the top.

Four traps
To better understand the role of upper-level managers, we recently dug back into our data: nearly 12,000 daily electronic diaries from dozens of professionals working on important innovation projects at seven North American companies. We selected those entries in which diarists mentioned upperor top-level managers868 narratives in all. Qualitative analysis of the narratives highlighted four traps that lie in wait for senior executives. Most of these pitfalls showed up in several companies. Six of the seven suffered from one or more of the traps, and in only a single company did leaders avoid them. The existence of this outlier suggests that it is possible for senior executives to sustain meaning consistently, but thats difficult and requires vigilance. This article should help you determine whether you risk falling into some of these traps yourselfand unknowingly dragging your organization into the abyss with you. We also offer a few thoughts on avoiding the problems, advice inspired by the actions and words of a senior leader at the one company that did so. We dont claim to have all the answers. But we are convinced that executives who sidestep these traps reduce their risk of inadvertently draining meaning from the work of the people in their organizations. Those leaders also will boost the odds of tapping into the motivational power of progress something surprisingly few do.

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We surveyed 669 managers at all levels of management, from dozens of companies and various industries around the world. We asked them to rank the importance of five employee motivators: incentives, recognition, clear goals, interpersonal support, and progress in the work. Only 8 percent of senior executives ranked progress as the most important motivator. Had they chosen randomly, 20 percent would have done so. In short, our survey showed that most executives dont understand the power of progress in meaningful work.5 And the traps revealed by the diaries suggest that most executives dont act as though progress matters. You can do better.

Trap 1

Mediocrity signals
Most likely, your company aspires to greatness, articulating a high purpose for the organization in its corporate mission statement. But are you inadvertently signaling the opposite through your words and actions? We saw this dynamic repeatedly at a well-known consumer products company well call Karpenter Corporation, which was experiencing a rapid deterioration in the inner work lives of its employees as a result of the actions of a new top-management team. Within three years of our studying Karpenter, it had become unprofitable and was acquired by a smaller rival. Karpenters top-management team espoused a vision of entrepreneurial cross-functional business teams. In theory, each team would operate autonomously, managing its share of the companys resources to back its own new-product innovations. During the year we collected data from Karpenter teams, the annual report was full of references to the companys innovation focus; in the first five sentences, innovation appeared three times. In practice, however, those top managers were so focused on cost savings that they repeatedly negated the teams autonomy, dictated cost reduction goals that had to be met before any other priorities were, andas a result drove new-product innovation into the ground. This unintended, de facto hypocrisy took its toll, as a diary excerpt from a longtime Karpenter product engineer emphasizes: Today I found out that our team will be concentrating on [cost savings] for the next several months instead of any new products. . . . It is getting very difficult to concentrate on removing pennies from the standard cost of an item. That is the only place that we have control over. Most of the time, quality suffers. It seems that our competition is putting out new products at a faster rate. . . . We are no longer the leader in innovation. We are the followers. This employees work had begun to lose its meaning, and he wasnt alone. Many of the other 65 Karpenter professionals in our study felt that they were doing mediocre work for a mediocre companyone for which they had

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previously felt fierce pride. By the end of our time collecting data at Karpenter, many of these employees were completely disengaged. Some of the very best had left. The mediocrity trap was not unique to Karpenter. We saw it revealed in different guises in several of the companies we studied. At a chemicals firm, it stemmed from the top managers risk aversion. Consider these words from one researcher there: A proposal for liquid/medical ltration using our new technology was tabled for the second time by the Gate 1 committee (ve directors that screen new ideas). Although we had plenty of info for this stage of the game, the committee is uncomfortable with the risk and liability. The team, and myself, are frustrated about hurdles that we dont know how to answer. This companys leaders also inadvertently signaled that, despite their rhetoric about being innovative and cutting edge, they were really more comfortable being ordinary.

Trap 2

Strategic attention deficit disorder


As an experienced leader, you probably scan your companys external environment constantly for guidance in making your next strategic moves. What are competitors planning? Where are new ones popping up? Whats happening in the global economy, and what might the implications be for financing or future market priorities? You are probably brimming with ideas on where youd like to take the company next. All of that is good, in theory. In practice, we see too many top managers start and abandon initiatives so frequently that they appear to display a kind of attention deficit disorder (ADD) when it comes to strategy and tactics. They dont allow sufficient time to discover whether initiatives are working, and they communicate insufficient rationales to their employees when they make strategic shifts. Karpenters strategic ADD seemed to stem from its leaders short attention span, perhaps fueled by the CEOs desire to embrace the latest management trends. The problem was evident in decisions at the level of product lines and extended all the way up to corporate strategy. If you blinked, you could miss the next strategic shift. In one employees words: A quarterly product review was held with members of the [top team] and the general manager and president. Primary outcome from the meeting was a change in direction away from spray jet mops to revitalization of existing window squeegees. Four priorities were dened for product development, none of which were identied as priorities at our last quarterly update. The needle still points north, but weve turned the compass again.

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At another company we studied, strategic ADD appeared to stem from a top team warring with itself. Corporate executives spent many months trying to nail down a new market strategy. Meanwhile, different vice presidents were pushing in different directions, rendering each of the leaders incapable of giving consistent direction to their people. This wreaked havoc in the trenches. One diarist, a project manager, felt that rather than committing herself to doing something great for particular customers, she needed to hedge her bets: The VP gave us his opinion of which target candidates [for new products] may t with overall company strategybut, in reality, neither he nor anyone in our management structure knows what the strategy is. It makes this project a real balancing actwe need to go forward, but need to weigh commitments very carefully. If high-level leaders dont appear to have their act together on exactly where the organization should be heading, its awfully difficult for the troops to maintain a strong sense of purpose.

Trap 3

Corporate Keystone Kops


In the early decades of cinema, a popular series of silent-film comedies featured the Keystone Kopsfictional policemen so incompetent that they ran around in circles, mistakenly bashed each other on the head, and fumbled one case after another. The title of that series became synonymous with miscoordination. Our research found that many executives who think everything is going smoothly in the everyday workings of their organizations are blithely unaware that they preside over their own corporate version of the Keystone Kops. Some contribute to the farce through their actions, others by failing to act. At Karpenter, for example, top managers set up overly complex matrix reporting structures, repeatedly failed to hold support functions (such as purchasing and sales) accountable for coordinated action, and displayed a chronic indecisiveness that bred rushed analyses. In the words of one diarist: Last-minute changes continue on [an important customers] assortments. Rather than think through the whole process and logically decide which assortments we want to show [the customer], we are instead using a shotgun approach of trying multiple assortments until we nd one that works. In the meantime, we are expending a lot of time and effort on potential assortments only to nd out later that an assortment has been dropped. Although Karpenters example was egregious, the company was far from alone in creating chaotic situations for its workers. In one high-tech

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company we studied, for example, Keystone Koplike scenarios played out around the actions of a rogue marketing function. As described in one engineers diary, the attempts of many teams to move forward with their projects were continually thwarted by signals from marketing that conflicted with those coming from R&D and other key functions. Marketers even failed to show up for many key meetings: At a meeting with Pierce, Clay, and Joseph, I was told that someone from marketing would be attending our team meetings (nally). The meeting also gave me a chance to demonstrate to Joseph that we were getting mixed signals from marketing. When coordination and support are absent within an organization, people stop believing that they can produce something of high quality. This makes it extremely difficult to maintain a sense of purpose.

Trap 4

Misbegotten big, hairy, audacious goals


Management gurus Jim Collins and Jerry Porras encourage organizations to develop a big, hairy, audacious goal (BHAG, pronounced bee-hag)a bold strategic vision statement that has powerful emotional appeal.6 BHAGs help infuse work with meaning by articulating the goals of the organization in a way that connects emotionally with peoples values. (Think of Googles stated mission to organize the worlds information and make it universally accessible and useful.) At some companies, however, such statements are grandiose, containing little relevance or meaning for people in the trenches. They can be so extreme as to seem unattainable and so vague as to seem empty. The result is a meaning vacuum. Cynicism rises and drive plummets. Although we saw this trap clearly in only one of the seven companies we studied, we think it is sufficiently seductive and dangerous to warrant consideration. That company, a chemicals firm, set a BHAG that all projects had to be innovative blockbusters that would yield a minimum of $100 million in revenue annually, within five years of a projects initiation. This goal did not infuse the work with meaning, because it had little to do with the day-to-day activities of people in the organization. It did not articulate milestones toward the goal; it did not provide for a range of experiments and outcomes to meet it; worst of all, it did not connect with anything the employees valued. Most of them wanted to provide something of value to their customers; an aggressive revenue target told them only about the value to the organization, not to the customer. Far from what Collins and Porras intended, this misbegotten BHAG was helping to destroy the employees sense of purpose.

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Avoiding the traps


Spotting the traps from the executive suite is difficult enough; sidestepping them is harder stilland wasnt the focus of our research. Nonetheless, its instructive to look at the one company in our study that avoided the traps, a creator of coated fabrics for weatherproof clothing and other applications. We recently interviewed its head, whom well call Mark Hamilton. That conversation generated a few ideas that we hope will spark a lively discussion in your own C-suite. For example: W  hen you communicate with employees, do you provide strategic clarity thats consistent with your organizations capabilities and an understanding of where it can add the most value? Hamilton and his top team believed that innovating in processes, rather than products, was the key to creating the right combination of quality and value for customers. So he talked about process innovation at every all-company meeting, and he steadfastly supported it throughout the organization. This consistency helped everyone understand the strategy and even become jazzed about it.  an you keep sight of the individual employees perspective? The best C executives we studied internalize their early experiences and use them as reference points for gauging the signals that their own behavior will send to the troops. Try hard to remember when you were working in the trenches, Hamilton says. If somebody asked you to do a bunch of work on something they hadnt thought through, how meaningful could it be for you? How committed could you be? D  o you have any early-warning systems that indicate when your view from the top doesnt match the reality on the ground? Regular audits to gauge the effectiveness of coordination and support processes in areas such as marketing, sales, and purchasing can highlight pain points that demand senior managements attention because they are starting to sap meaning from your peoples work. In Hamiltons view, senior executives bear the responsibility for identifying and clearing away systemic impediments that prevent quality work from getting done. Hamiltons company was doing very well. But we believe that senior executives can provide a sense of purpose and progress even in bad economic times. Consider the situation that thennewly appointed Xerox head Anne Mulcahy faced in 2000, when the company verged on bankruptcy. Mulcahy refused her advisers recommendation to file for bankruptcy (unless all other options were exhausted) because of the demoralizing signal it would send to frontline employees. What we have going for us, she said, is that our people believe we are in a war that we can win.7 She was right, and her conviction helped carry Xerox through four years of arduous struggle to later success.

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As an executive, you are in a better position than anyone to identify and articulate the higher purpose of what people do within your organization. Make that purpose real, support its achievement through consistent everyday actions, and you will create the meaning that motivates people toward greatness. Along the way, you may find greater meaning in your own work as a leader.
1  Teresa Amabile and Steven Kramer, The Progress Principle: Using Small Wins to Ignite Joy,

Engagement, and Creativity at Work, Boston, Massachusetts: Harvard Business Review Press, August 2011. 2 See Sangeeta Agrawal, James W. Asplund, James K. Harter, Emily A. Killham, and Frank L. Schmidt, Causal impact of employee work perceptions on the bottom line of organizations, Perspectives on Psychological Science, July 2010, Volume 5, Number 4, pp. 37889. 3 See Teresa Amabile and Steven Kramer, The power of small wins, Harvard Business Review, May 2011, Volume 89, Number 5, pp. 7080. 4 See Robert Sutton, Good Boss, Bad Boss: How to Be the Best . . . and Learn from the Worst, New York: Business Plus, 2010; and Suttons related article, Why good bosses tune in to their people, mckinseyquarterly.com, August 2010. 5 Lower-level managers were even less likely to recognize the power of progress: only 5 percent of all survey respondents ranked it rst among the ve factors we asked about. 6 See James C. Collins and Jerry I. Porras, Building your companys vision, Harvard Business Review, September/October 1996, Volume 74, Number 5, pp. 6577. 7 William W. George and Andrew N. McLean, Anne Mulcahy: Leading Xerox through the perfect storm (A), Harvard Business School Case 9-405-050, January 2005.

Teresa Amabile is the Edsel Bryant Ford Professor of Business Administration at Harvard Business School. Steven Kramer is an independent researcher and writer.
Copyright 2012 McKinsey & Company. All rights reserved. We welcome your comments on this article. Please send them to quarterly_comments@mckinsey.com.

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Extra Point

Deleveraging: Where are we now?


Q1 2011 Extra Point The financial crisis highlighted the danger of too much debt, a message Exhibit 1 of 1
that has only been reinforced by Europes recent sovereign-debt challenges. And new McKinsey Global Institute research shows that the unwinding of debtor deleveraginghas barely begun. Since 2008, debt ratios have grown rapidly in France, Japan, and Spain and have edged downward No only glance in Australia, South Korea, and the United States. Overall, the ratio of debt to GDP has grown in the worlds ten largest economies.

Domestic private- and public-sector debt1 as % of country GDP, Q1 1990Q2 2011 (or latest available), quarterly data

From Q1 2008 to Q2 2011 Rapid growth in debt2 Deleveraging

Japan 500 United Kingdom

450

400 Spain 350


United Kingdom

France Italy South Korea United States


Italy

300
Germany

Germany Australia Canada


Canada

250

200 0 2000 2002 2004 2006 2008 2010 Q2 2011

1 Dened as all credit-market borrowing, including loans and xed-income securities. Some data have been 2Dened as an increase of 25 percentage points or higher.

revised since our Jan 2010 report.

Source: Haver Analytics; national central banks; McKinsey Global Institute analysis

For the story behind these top-line numbers, see Working out of debt, on page 96.

Copyright 2012 McKinsey & Company. All rights reserved.

Copyright 2012 McKinsey & Company. All rights reserved. Published since 1964 by McKinsey & Company, 55 East 52nd Street, New York, New York 10022. ISSN: 0047-5394 ISBN: 978-0-9829260-2-4 Cover illustration by Dan Page McKinsey Quarterly meets the Forest Stewardship Council (FSC) chain of custody standards. The paper used in the Quarterly is certified as being produced in an environmentally responsible, socially beneficial, and economically viable way. Printed in the United States of America.

Highlights: Mobilizing for a resource revolution includes new McKinsey research, insights from executives at Boeing and Veolia Water, and commentary from historian Niall Ferguson A CEOs guide to innovation in China, including perspectives from the leaders of AstraZenecas and General Motors Chinese operations New thinking from the McKinsey Global Institute and economist Kenneth Rogoff on the deleveraging process and global economic conditions The human factor in service design Procter & Gamble CEO Robert McDonald on his companys digital transformation Where open innovation could be headed Nobel laureate Daniel Kahneman on how to avoid forecasting mistakes

ISBN: 978-0-9829260-2-4

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