A radical approach to cost reduction at climate tech companies

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Soaring temperatures, shrinking glaciers, and rising sea levels provide a constant reminder that climate change is intensifying. Many governments, corporations, and individuals have already attempted to reduce emissions by adopting new green tech and want to expand these efforts to prevent a humanitarian crisis. The McKinsey Platform for Climate Technologies represents one such effort, and it focuses on executing and scaling critical climate solutions.1What would it take to scale critical climate technologies?, McKinsey, December 1, 2023. Despite such initiatives, however, several obstacles are preventing green technologies from gaining traction, most notably: the high material, energy, and production costs associated with the climate tech products that mitigate or reverse the effects of human activity on the environment.

High production costs prompt many climate tech companies to add a “green premium” to the price of their products, which could discourage potential buyers. Given the urgency to reduce emissions, climate tech companies should try to encourage product adoption by tackling high costs. For best results, the cost target should be on par with more carbon-intensive alternatives and be best in class against similar green solutions. Their efforts might benefit from an innovative approach that simultaneously enables both rapid cost reduction and production scaling. It involves five elements: ambitious target setting, high-paced innovation, end-to-end supply chain improvements, design to value, and excellence in capital expenditures.

Scale and cost: The dual challenge for climate tech companies

Historically, energy and material-related technologies have taken decades or even centuries to scale. For example, it took more than 100 years for coal to become a dominant energy source and about 85 years for oil to do so.2 More recently, the adoption timelines have shortened a bit, with solar power requiring about 30 years to reach a scale that allows it to be cost competitive with coal and gas-fired power; for onshore wind, the same transition took about 15 years.3 The faster adoption rates mean that new competitors may take market share from older alternatives more quickly, putting pressure on all companies to reduce unit cost and keep prices as low as possible.

Climate tech companies that want to accelerate uptake and achieve scale face more intense challenges related to supply chain coordination and risk management than companies in traditional industries, because their success often hinges on other unscaled green technologies. As one example, the production of green ammonia, which is now being piloted, requires both cheap renewable-energy sources, which are in short supply, and cost-efficient electrolyzer technology, which is still in early development. In any supply chain, a vendor misstep, such as a delayed delivery of a component, could have a ripple effect that slows production or stops deliveries.

Controlling costs may also be particularly difficult for green businesses because of several interrelated factors:

  • A lack of standardization or industrialization of core components. Companies now rely on more expensive, custom-made spare parts and solutions. There are, for instance, more than 100 unique electrolyzer models in the hydrogen industry.
  • Volatile cost of materials and components. These unpredictable shifts can ultimately affect prices for green products. Consider lithium prices, which increased ten times between 2020 and 2022.
  • Volatile power costs. Major costs swings are common. For example, the cost of electricity in the European Union shifted greatly between 2019 and 2023, with the lowest levels below zero and the highest at hundreds of euros per megawatt hour. Such changes can have a major impact on the cost of green products, because their core components often have high energy requirements. Increased power costs can also affect other parts of the value chain.
  • Capital expenditure overruns in major production facilities for green products or commodities. These overruns often occur because of industry immaturity and unpredicted costs. In some recent battery gigafactory projects in the European Union, actual capital expenditures exceeded estimates by 40 to 70 percent.
  • Production delays that increase cost and time to market. Start-of-production delays have averaged more than ten months in the new EU battery gigafactories.
  • A focus on costly technologies and a slow shift to more efficient solutions. As one example, companies have invested more than $8 billion in cement carbon capture and storage, rather than shifting to green cement, which could cost two to three times less than traditional cement.

When attempting to reduce costs, companies can benefit from a comprehensive, balanced approach that considers these issues as well as other interdependencies and sector-specific factors that may increase expenses. While businesses across industries must address cost issues whenever they develop innovations, green companies are under pressure to move very quickly, both to remain competitive and to encourage uptake of climate tech solutions. Despite the fact that many green solutions are on a trajectory to reduce costs, only some will achieve cost parity with incumbents by 2030, unless their manufacturers take more radical action.4What would it take to scale critical climate technologies?, McKinsey, December 1, 2023. If companies cannot become cost-efficient, their products may remain niche—and that’s especially true for green commodities that must compete with carbon-intensive alternatives in markets where buyers have traditionally focused on cost.

The current approach to cost mitigation

Recognizing the imperative to reduce costs, companies in some green industries have already forged ahead. For example, the cost per watt for solar panels dropped by about 90 percent from 2010 to 2020,5 and they are now a strong alternative to fossil fuel–based electricity generation (Exhibit 1). This radical improvement shows that companies can set substantial cost reduction goals and may even surpass their initial targets. Their savings will result from various strategies, including faster, lower-cost execution; technological improvement; economies of scale; process enhancements; and greater efficiency within procurement and sourcing.

The cost per watt for solar panels dropped by about 90 percent from 2010 to 2020.

While the solar panel example is encouraging, only a few green businesses can claim such impressive results to date. In our experience, most climate tech companies do not include cost mitigation in their top three strategic priorities. Instead, they rely on a combination of subsidies, green premiums, and the actions of other stakeholders in the value chain, such as cost reductions, to compete against more traditional companies with lower prices (but higher emissions). Those climate tech businesses that do attempt to reduce costs may not recognize the full opportunity for cost mitigation and only make incremental improvements; in most cases, they also remain highly dependent on prices set by external suppliers, such as those for electricity, and thus have limited ability to reduce the costs of these inputs.

Many climate tech businesses may take a limited approach to cost reduction because they do not think they can reach the levels that more traditional businesses attain. But our work suggests that significant decreases are possible in multiple segments, despite the challenges involved, and those companies that focus on costs now may gain scale and become future market leaders. Cost leaders—companies that have taken the lead in reducing costs—have greater appeal to investors. Unlike the period from 2020 to 2021, when green-business funding flourished, investors may now restrict their interest to companies that have a clear plan for reducing costs.

An innovative approach to cost reduction at climate tech companies

When cost reductions allow companies to scale their products rapidly, that may lead to lower prices. Those, in turn, encourage product adoption and help reduce emissions. At present, the adoption rates for many green solutions are falling short of the trajectory needed to get to net-zero emissions by 2030 (Exhibit 2).6What would it take to scale critical climate technologies?, McKinsey, December 1, 2023. Green hydrogen production, for example, would need to increase by 55 percent annually to achieve that goal. Such gains will not be possible if companies continue their current approach to cost mitigation. To accelerate progress and achieve rapid scaling, they can follow a more aggressive cost reduction strategy with five major elements.

Adoption of many green technologies is falling short of the trajectory required to get to net-zero emissions by 2030.

1. Ambitious target setting

All cost leaders consistently set ambitious targets—so ambitious, in fact, they may initially seem unattainable. But the high targets prompt companies to discuss and discover innovative solutions and optimize operations, frequently allowing them to achieve their goals.

Many leading companies have succeeded by basing cost targets on what is theoretically possible, rather than simply setting an arbitrary percentage goal. First, they construct a detailed, bottom-up view of the lowest possible costs for each product, assuming ideal circumstances, and consider competitive benchmarks.

By establishing theoretical minimum costs, companies can identify the sources of the most significant improvements, including the scale, pace, and source of any decreases (for instance, a specific location). In our experience, companies can quickly translate their theoretical goals into actionable cost mitigation plans tailored to their needs, thereby stimulating innovation and efficiency throughout their organizations. Consider Syre, a polymer recycling company. While the current prices for recycled polymer are higher than those for virgin polyester, Syre has concluded that they could be 40 percent lower, based on cost reductions that are theoretically possible, and is attempting to achieve that goal.

2. High-paced innovation

Green businesses are fundamentally defined by their capacity for innovation, especially their ability to challenge old ways of producing and consuming resources. But discovering the most efficient solutions is both costly and time-consuming, presenting a problem for businesses that have limited funding and must scale quickly to be competitive.

Leading companies across industries are increasingly turning to artificial intelligence (AI) to expedite and refine the innovation process, and this, in turn, could help decrease costs. Google DeepMind, for instance, has used deep learning to predict structures for 2.2 million new materials that might enhance solar cells, batteries, computer chips, and more. Out of these, over 700 have been synthesized in laboratories and are currently under evaluation.7 In addition to improving product performance, many of the new materials may be less expensive.

The impact of AI on research and development extends beyond the laboratory, and businesses have achieved major improvements, including cost reductions, by applying it in different settings. A European truck designer and manufacturer, for example, increased the number of daily design simulations by more than 1,000-fold and reduced the time required to set up new designs by over 50 percent through the use of deep learning surrogates. Such early experiments with AI have already produced some tangible bottom-line improvements across industries, underscoring its potentially transformative power to reduce costs at green businesses.

3. End-to-end supply chain industrialization and integration

Many companies in established industries tend to overlook their supply and value chains during cost mitigation efforts. Others, however, have successfully decreased expenses by eliminating inefficiencies in these areas and, in some cases, by eliminating certain steps entirely.

Although vertical integration is not necessarily effective in established supply and value chains, it may be very effective in emerging industries, including climate tech. For example, companies might take control of feedstock or produce energy in-house to secure supply and control unit costs. Tesla has established lithium refinery plants to ensure that there is a sufficient supply for battery production. This, in turn, allows the company to manufacture and sell automobiles at scale more efficiently. In addition to giving Tesla more control over the value chain, vertical integration allows the company to customize and refine production processes, both for upstream elements, such as batteries, and for downstream elements, such as points of sale. From a cost perspective, vertical integration guarantees Tesla access to raw materials during shortages at a competitive rate.

Vertical integration can also reduce costs by increasing resource efficiencies in certain industries, including climate tech. In the steel industry, for instance, vertical integration significantly reduces transportation needs and the energy required for reheating intermediary products.

While vertical integration generates cost benefits, as well as benefits related to supply chain management, capital expenditures, quality, and time to market, it also requires businesses to go beyond their core capabilities. As an alternative, companies might want to engage in strategic partnerships for the most critical parts of the supply chain. This strategy allows companies to use their partners’ strategic expertise while controlling volumes, unit costs, and the design of R&D programs.

4. Design to value

As companies attempt to minimize unit costs while optimizing quality, they may benefit from design to value (DTV). This approach has three main goals:

  • reducing product costs by decreasing the materials needed or by changing the specifications (for instance, swapping a copper component for one made of a less expensive material)
  • increasing product performance and appeal by ensuring that it has attributes that customers truly value and by potentially removing features that are underused or carry little weight during a purchase decision
  • helping companies determine how they can expand their supplier base

Although DTV is entrenched in established industries, few emerging climate tech companies have experience undertaking the detailed product analysis that it requires. Most of them have just converted their technologies into products, and they may still be learning about them (for example, determining what attributes customers value most).

Companies begin the DTV process by establishing a cost baseline for a product, as well as possible levers for reducing it. The impact varies by industry, and the savings potential is generally higher for more complex products. For example, the potential margin impact is generally about 30 to 60 percent for electrolyzer manufacturers that apply DTV, compared with about 5 to 20 percent for automotive and industrial goods manufacturers.

An electrolyzer manufacturer identified up to 50 percent “should cost” savings—in other words, what the cost should be, considering all circumstances—for some essential components. Specifically, DTV revealed that suppliers were overcharging for certain components, such as bipolar plates and manifolds. The analysis also helped the company identify more than ten suitable new suppliers for core equipment, including large-scale rectifiers and manifolds. As another example, a wind turbine manufacturer applied DTV to identify areas where costs were about 20 percent higher than they were for its competitors, because of higher engineering specifications that did not provide an advantage in the local market.

For green businesses, dual-mission DTV may be most appropriate. In addition to providing the cost improvements and feature enhancements that arise through routine DTV, the dual-mission approach is also designed to improve the carbon footprint of the product itself—for instance, by eliminating carbon-intensive components where possible.

5. Excellence in capital expenditure management

Many green products are produced in manufacturing facilities that are new or heavily retrofitted, thus requiring high capital investment. To become cost competitive with traditional businesses, climate tech companies should ensure that their capital projects follow all best practices and avoid unnecessary expenditures.

One major consideration is plant location, since this can often be one of the greatest cost drivers. Companies can benefit from a thorough understanding of how building expenses and associated costs vary in different areas and then factor this into their decisions. They should also consider how quickly the building process can proceed in their chosen locations, since a protracted timeline could increase both costs and time to market. Some tasks, such as permitting, may be extremely complex in certain countries, which could delay or slow progress. Other factors, such as labor shortages, may also complicate building timelines.

If companies build small manufacturing plants, their unit costs will be higher. Therefore, small-scale production should usually be confined to the pilot or demo phases, when they are validating their technology. If companies hold back, they may lose market share to competitors that rapidly increase capacity and scale. Of course, building larger plants comes with a higher capital expenditure risk, making it especially critical to get the process right and optimize costs.

Deploying a plant-as-a-product (PaaP) strategy can help companies excel at capital expenditure management through its focus on three activities:

  • following the principles of value engineering by clearly defining the goals for each project
  • applying lean best practices, such as modular design, for all construction activities, in combination with rigorous performance management at the floor level
  • breaking down organizational silos and encouraging communication to increase the speed of decision making

An automotive company that applied the PaaP approach had capital expenditures that were 75 percent lower for its fourth plant, compared with the first. Simultaneously, it increased design output by over threefold and cut its footprint and time to market by half. All of these levers directly decreased total cost.

Decreasing the production ramp-up period, which typically has a low yield and high burn rate, can also optimize capital expenditures. Most best-in-class companies begin by creating pilot, or “mother,” battery-cell lines and then typically ramp up other lines in sequence. The best performers will achieve more than 90 percent yield within 12 months of production starting.

Climate tech companies should strive to rapidly reduce costs in order to accelerate scaling and make their products more affordable; no other activity can do more to reduce prices, attract buyers, and encourage the widespread adoption of green solutions. Scaling will require three elements: the vision to imagine all potential cost reductions, the courage to deploy new technologies (including AI), and the discipline to execute with speed and precision. While these measures may sound simple, they all require a detailed understanding of cost drivers and potential solutions, including new digital tools. Companies with the right combination of vision, courage, and discipline can help lead the planet to a greener future—and that’s a goal they all share.

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