Positioning for success in the chemical markets of the future

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Three recent trends illustrate significant recent changes in Europe’s chemical markets. First, high prices for natural gas and electricity are resulting in high production costs for energy-intensive chemicals. Second, a global oversupply of many chemicals is leading to depressed unit margins and lower volumes. And third, demand is shifting to sustainable chemicals.

For these reasons, many European players are focusing on how to rapidly improve their margins, typically via cost reductions. Although these improvements are essential in the short term, chemical players must not lose sight of what’s needed in the long term, particularly as it relates to the third point: creating low-cost supply positions in emerging markets for sustainable chemicals.

The difficult position of European chemical manufacturers

After the Russian invasion of Ukraine, European gas prices spiked—and took electricity prices with them. Although prices have fallen since highs in 2022, they remain at levels 50 to 100 percent higher than before 2020. In turn, European production costs for energy-intensive chemicals, such as polyurethanes, fertilizers, and PVC, are structurally higher than those of other regions.

Going forward, European energy prices are expected to settle into a new normal driven by imports of liquefied natural gas (LNG), notably from the United States.1Global Energy Perspective 2023: Natural gas outlook,” McKinsey, January 24, 2024. European gas prices therefore could be more than twice those of the so-called Russian gas era, reflecting the cost of developing and shipping new gas supplies to Europe. And with no energy or growth advantage, European production of energy-intensive chemicals could stay at the right end of the cost curve, albeit with less of a disadvantage than in 2022. Over the longer term, rising CO2 prices (around €60 to €130 per metric ton of CO2 from 2030 to 2050)2Global Energy Perspective 2023, McKinsey, October 18, 2023. and the phase out of free allowances in the EU Emissions Trading Scheme3 will likely contribute to players remaining on the right-hand side of the cost curve, where there is often little margin for producers.

For chemicals with less energy intensity and with a cost base more closely tied to oil prices than to natural gas and electricity, including major packaging plastics such as polyethylene and polypropylene, European producers could stay in the middle of the cost curve. However, players in China and other regions have created significant new capacity in the past decade. Coupled with relatively lower demand growth, there are substantial overcapacities in many value chains, which are expected to remain until 2030 (Exhibit 1).

Overcapacity in chemical production is expected to increase in Western Europe in several value chains.

This could keep margins and sales volumes depressed for European players, given that the profitability of European chemical manufacturers depends on factors outside their direct control. Players with medium to high costs are profitable mostly during supply shortfalls, either because of structural undercapacity or because the industry fails to keep its existing production assets running. This also means that returns to such businesses will be volatile and highly sensitive to the supply–demand balance. Overall, investors require a risk premium to compensate for this, and thus, valuations are low.

Demand is transferring to sustainable chemicals

There is now a clear signal of increased demand for more-sustainable chemicals. Europe’s low overall demand growth means that, to a large degree, this will be a zero-sum switch for which demand for fossil-fuel-based or high-emission chemicals is reduced while demand for sustainable chemicals grows. For example, when Unilever switches to at least 25 percent recycled plastics for its packaging by 2025,4 demand for fossil or high-emission packaging plastics will likely be reduced as demand for sustainable chemicals increases. In the long term, a share of the market could also be reserved for sustainable production, starting with mandates for recycled content in packaging. As a result, suppliers for fossil or high-emission chemicals on the right side of the cost curve could become obsolete.

Three reasons for the shift

Several reasons illustrate the potential for a substantial demand shift.

The first is that many countries and industry players that use chemicals have committed themselves to large shifts. Some have committed to using recycled content, specifically, and others to greenhouse gas (GHG) reductions.

The second reason is that the costs for the transition seem manageable. Although the increase of production costs can be substantial at the commodity level, particularly around energy, feedstocks,5Sustainable feedstocks: Accelerating recarbonization in chemicals,” McKinsey, October 26, 2023. and processing, this usually translates into only a small, single-digit percentage increase in the final price for consumers.

Third, regulations are signaling a strong longer-term market. For example, the European Union’s Packaging and Packaging Waste Regulation requires 55 percent of plastics to be recyclable by 2030,6 which implies significant buildup of technologies and recycling supply chains over the next few years. Similar proposals are being made to mandate 25 percent recycled feedstock for plastics used in the automotive industry7 or even for a share of all chemicals feedstock to come from nonfossil sources.8

Multiple complementary measures to meet low-emission footprints

Interim targets for reducing emissions (in some cases, by up to 50 percent) can be reached via extensive energy efficiency measures and the procurement of renewable energy.9Sustainable feedstocks: Accelerating recarbonization in chemicals,” McKinsey, October 26, 2023. In part due to the broad use of such measures in response to tightening EU regulations to reduce GHG emissions, European chemical production tends to have substantially lower emissions than other regions, according to our research.10Net-Zero Europe: Decarbonization pathways and socioeconomic implications, McKinsey, December 3, 2020. This is a competitive advantage that the industry has not yet realized because most value chain participants continue to work with global average-emissions data per product instead of site-specific data. The European industry can actively market its footprint advantage if it succeeds in creating clarity and harmonization on approaches to the allocation of emissions. Furthermore, players can quickly add further measures with well-established and emerging technologies (such as heat from waste) to keep (and potentially increase) strategic distance from their overseas competitors.

Ultimately, however, the ability to meet the demand for recycled or net-zero chemicals will require European players to go further, changing to sustainable feedstocks derived from recycling, biomass, or atmospheric CO2, or to innovate inherently lower-footprint products.

Green premiums and other evidence for large-scale shifts in demand

The opportunity to achieve higher prices for more-sustainable chemicals is no longer just theory. For example, currently available and high-quality plastic recyclates command a price premium over virgin grades by as much as 60 percent. For virgin-like recyclates resulting from new technologies, price premiums are likely to be even higher, as indicated by first price signals in nascent markets with the small quantities available today. In some instances, committed offtake prices for chemically recycled polyethylene terephthalate (PET) are typically 25 to 50 percent higher than the market price for virgin PET. Equally, petrochemical players and other offtakers are currently willing to pay premiums of one to two times that of naphtha prices for oil derived from plastics waste via pyrolysis.

Another indicator is that brand owners and other chemical end users are investing in sustainable sources for established chemicals, either directly or via offtake agreements. For example, Michelin invested in a jointly owned tire-recycling plant with start-up Enviro11 and expects a significant portion of butadiene to be sourced from biobased sources.12 PepsiCo also signed an offtake agreement with Eastman for its planned PET recycling facility.13

Although less frequently, chemical end users are investing in new, sustainable products that may partially substitute established fossil or high-emission products. On this point, Unilever entered into an exclusive partnership with Evonik to scale production of novel biosurfactants.14 And Refresco, Terphane, and other PET fiber and PET plastic end users (for beverage bottles) have signed offtake agreements for Avantium’s planned biobased PEF (polyethylene furan-2,5-dicarboxylate, a PET substitute) plant.15

New success criteria

Chemical manufacturers often have a hard time committing to investments in sustainable chemicals because they are not certain that the required price premiums will be realized. In some cases, procurement departments believe there will be a small price premium at best, which can create the impression that sustainability does not sell. However, our work indicates that success is possible but requires a change in approach that plays to the new market’s success factors.

  • Consumer brand owners are the key players for sustainable demand. This is an empirical observation, given that most large-scale offtake agreements and investments come from brand owners. Furthermore, brand owners ultimately bear the costs of sustainable chemicals and therefore reap the benefits from consumer pricing and demand. Only they can ultimately decide which premiums are worthwhile.
  • Cost-effectiveness is key. Even when consumer brand owners see a business case in buying sustainable chemicals, they typically do not want to pay more of a premium than necessary. Simply stated, this is good management practice. In all the examples for investments and offtake agreements listed in this article, supply is arguably one of the lowest-cost options for sustainable chemicals or materials in the long term, albeit more costly than current fossil fuel or high-emission options.
  • Scale and materiality matter. To help consumer brand owners reach their targets, the sustainable supply must be large in terms of total demand. Therefore, chemical manufacturers will need to show their customers a route to large-scale supply.
  • Deals are best struck at the top-management level. Because investment and offtake commitments are large and involve cost increases, they cannot be undertaken by procurement alone. Instead, they will need to involve top managers from the business, including executive board members.
  • There is no silver bullet—scale-up risks exist. Multiple technologies and routes to scale across the portfolio are required to secure sufficient viable feedstock and new products.

What can be done in the years to come

Looking at other markets that are transferring to sustainable products illustrates the urgency to act. Take the automotive industry as an example: our research shows that although most new car sales are still internal-combustion-engine vehicles, new entrants focused solely on electric vehicles have created significantly more value for shareholders and are now valued at around 80 percent of incumbents. Similarly, valuations of incumbent utilities in the power sector started to decrease when it first became clear that renewable-energy sources would be the dominant drivers of future growth in generation, long before renewable energy reached a substantial share of the market.16 By analogy, chemical players will need to focus on the emerging sustainable product markets—or risk being overtaken.

A low-cost position in new sustainable markets could generate higher margins with less volatility

An attractive feature of the new markets is that supply functions will likely be steep. For a player on the left side of a steep supply curve, profits are substantial throughout a cycle (even when supply is long), and volatility is relatively low. Therefore, chemical manufacturers that can create low-cost positions on new supply curves could see their valuations drastically increase.

One reason for this steepness is that different technologies with different costs need to be used to meet demand. The lowest-cost options cannot serve all demand for sustainable supply. For example, mechanical recycling can achieve relatively low costs and major environmental benefits. As markets support investments into more advanced and intense processing, we expect mechanically recycled plastic to grow faster than ever before and even to dominate sustainable supply in some segments, such as PET packaging. To serve the full market, however, other technologies are also expected to be necessary (Exhibit 2). Mechanical recycling struggles to use mixed and contaminated waste streams (where most end-of-life plastics are found) in applications that require high performance and consistency or high purity (such as for medical or food-grade applications) without large losses along the way. Much of early demand is for these high-performance, high-purity applications, notably in packaging, meaning that other technologies will need to be used in addition to mechanical recycling to meet demand—even if they come at a higher cost.

To meet circularity demand, the European chemical industry needs to go beyond mechanical recycling.

Beyond the need for different technologies for different applications, key cost factors differ substantially between locations. For example, in some places, such as Iberia and the Nordics, there is great existing or potential capacity for low-cost renewable electricity. For such reasons, GHG footprints and costs can vary significantly between regions.17Sustainable feedstocks: Accelerating recarbonization in chemicals,” McKinsey, October 26, 2023.

There is a limited window of opportunity to secure low-cost feedstock for recycling or biobased routes

In the short term, every chemical company can take immediate measures related to renewable energy and resource efficiency for their own production—and request their suppliers do the same. This could even be part of the selection of suppliers and their specific supplying plants. Overall, these are low-cost, high-return actions for sustainability and economics.18Decarbonizing the chemical industry,” McKinsey, April 12, 2023.

However, in a substantial number of cases, these actions will not suffice to move the supply from fossil or high-emission chemicals to the sustainable market. Brand owners often expect supply from recycled materials or biomass, demonstrating circularity or radically reduced emission footprints. This is most often not possible without a change in feedstock as well. From our experience regarding sustainable feedstock for chemicals,19Sustainable feedstocks: Accelerating recarbonization in chemicals,” McKinsey, October 26, 2023. we have observed three facts that apply to the chemical industry:

  • Chemical manufacturers should obtain offtake agreements. Fossil fuel–based products tend to be cheaper. Therefore, to reduce the risk of investing in new capacity for sustainable production, manufacturers will need some certainty regarding demand for higher-cost sustainable products.
  • Recycling will be the safest route from an economic and sustainability standpoint. Biomass is a valid alternative to recycling and could become a part of the array of solutions needed, but players will need to take great care to benefit from economic and sustainability claims. Although biomass can enable lower-emission footprints, there is significant variation depending on the feedstock used. Likewise, the variation in costs for biomass routes is higher. That is especially true for Europe, where the use of first-generation biomass has been criticized. And although players can switch to second-generation biomass, doing so often increases costs above the recycling route.
  • Feedstock will be the dominant cost driver. Sustainable feedstock, especially biomass and waste, is fundamentally constrained and is also in high demand from competing applications, such as fuels. Expanding recycling will likely entail increasing the availability of plastic currently mixed with other waste and employing new recycling technologies that can deal with mixed plastic and contaminated feedstocks not fit for today’s conventional mechanical recycling. To secure a low-cost position, players will need to create long-term access to this feedstock at scale and at advantaged terms, which is likely only possible during a short time window until all lower-cost sources are locked up (as recently seen in waste vegetable oils).

It’s worth noting that, although technology development has made recent strides, for many routes, there are multiple similarly viable technologies available today—and the differences between them are not as decisive as feedstock access. Thus, players can always start with one or two sufficiently good technologies—self-developed or acquired—and then concentrate on building feedstock access and securing offtake agreements.

Chemical producers in Europe will need to move quickly to implement sustainable routes before feedstock becomes unavailable. From there, companies can take the necessary steps toward brand owner involvement to secure supply and offtake and thus enable the building of new production at scale. Finally, when building their future supply routes and establishing their position on the new cost curves for sustainable chemicals, players can choose to establish partnerships and close collaborations with a range of new technology start-ups, including waste gasification or pyrolysis to convert waste and biomass. Getting these steps right could mean the difference between falling behind competitors or staying ahead of the curve.

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