People and exponential growth
Humankind has many psychological flaws. One of the least recognised is an almost complete inability to understand the impact of compound interest. Our minds can deal with linear change well; if a new wall is half finished after ten days, all of us can predict that completion is likely within a further couple of weeks. But give us a problem involving percentage growth rates and almost all of us fail miserably.
This deep psychological flaw makes us underestimate the speed of changes in technology. The consequences of this for business, as it deals with the inevitable transition from fossil fuels to carbon-free energy, are profound. Most low carbon technologies, from electric vehicles to offshore wind power, are at early stages of development with market shares that scarcely register. But their growth rates are high, often reaching 40% or more. Largely unnoticed by the giants in their industries, they will take over markets far faster than most of us psychologically inadequate humans think possible.
In my presentations I often use an illustration to show how we all struggle to understand the speed of change. Imagine a market in which a new technology has fought for decades to obtain a 1% market share. (Think of solar photovoltaics or electric vehicles, which have approximately this share of global electricity production and new car sales today). If the innovation is now growing at 40% a year and this rate continues, how long will it be before it has captured 10% of sales? Most people answer with figures of many decades. The right answer is about seven years.
Moreover, even at 10% market share it is all too easy for us to think that the innovation can be ignored. It is still a small fraction of the available market and another human weakness – complacency – allows entrenched competitors to ignore the pace at which their market is being undercut. The old technology may still be growing in absolute terms even as the upstart gains 10% share, encouraging a comforting sense that all is normal.
But if growth continues at the same rate it will take only a further seven years for the market to be wholly taken over by the new technology. So the upstart will have taken only 14 years to get from one per cent market share to complete dominance.
“The typical large company cannot change fast enough.”
To make the point a different way, if an existing business waits until an insurgent technology has hit a 10% market share before it wakes up to the threat, it is probably doomed. The typical large company cannot change fast enough. Its sales will start falling soon, it will then typically haemorrhage cash and its credit rating will slump as lenders recognise the inevitability of decline. By then it is too late to counter the threat from the insurgent new product. Capital will have dried up, distribution channels defect to the new technology and the best employees will have left.
The novelist Ernest Hemingway has one of his characters ask another ‘How did you go bankrupt? ‘Two ways’, was the response ‘gradually and then suddenly.’ The competitors in the old energy economy, dominated by fossil fuels and internal combustion engines, are still mostly in the ‘gradual’ phase of their bankruptcy. The ‘sudden’ phase may arrive much sooner than they imagine.
The best known example of the how explosive growth transforms an entire industry is, of course, the arrival of the digital camera and its impact on conventional photography. Kodak, the dominant global producer of photographic film, can lay claim to having invented the digital camera in 1975. The company doesn’t appear to have actively commercialised the product and it was Sony that brought out the first consumer device in 1981, although this was an electronic, but not fully digital, camera.
The first true digital cameras were put on sale in the late 1980s. It took until about 1998 for the product to reach 10% or so of total camera sales. Film-based camera sales continued to grow at least until this date and industry participants could be forgiven for not realising that the ‘gradual’ phase of their destruction was well under way. Even by 2000, the threat from digital cameras to conventional film was far from understood. Here’s what the marketing material for one independent market research study said at the time:
‘While digital camera sales have not begun to erode film camera sales or film usage on a worldwide basis, steady market growth will inevitably begin to replace film camera adoption’.
Just five short years later, the conventional camera was all but finished. Agfa, the leading European photographic film manufacturer, went under in 2005. The delusions of those backing this company persisted well after others knew that the death knell for film had sounded. Just nine months before the final closure, its owners had said that ‘Agfa Photo will continue to play a leading role in the photographic industry’ It had descended ‘gradually and then suddenly’ into bankruptcy after ignoring the threat from digital. Konica stopped producing film in about 2006. Kodak struggled on until 2012, kept alive by a wider range of products.
Fuji was the only one of the four biggest global manufacturers of photographic film to prosper in the digital world. In the words of The Economist it survived because ‘It developed a three-pronged strategy: to squeeze as much money out of the film business as possible, to prepare for the switch to digital and to develop new business lines’. It had recognised the inevitable victory of digital cameras in the 1980s, long before digital had a significant market share and ran its business to engineer a successful transition. The lesson is that companies threatened by the global transition to low-carbon energy need to prepare well before the need becomes obvious.
Think of some of the key building blocks in the process of transition to a low-carbon economy: offshore wind, solar PV, electric vehicles and storage batteries. All of these technologies are still only insignificant fractions of much larger markets. Many people therefore believe they will still be immaterial for decades to come. Unlike Fuji, all the major oil companies – possibly with the exception of Total – are in denial about the possible speed of transition away from fossil fuels.
Even those who have closely followed the rapid growth of renewables, energy storage and EVs tend to assume that future progress will be quiet and undisruptive. One recent report from a very well-regarded fossil fuels investment analyst that suggested that the move away from oil, for example, would be a ‘slow, balanced transition’ which left the large international companies still in control of the energy business. The older technologies, he indicated, will fade very gently from view as the fossil fuel companies gradually ramp up their investment in low-carbon alternatives. The low-carbon revolution can be easily managed by the incumbents, he told us. If this isn’t unduly complacent, I don’t know what is.
Nevertheless, almost everybody seems now to recognise that the era of fossil fuels is drawing to a close. For example, the CEO of Shell says that solar power will eventually be the dominant source of electricity. And even the most cautious of car component manufacturers are now predicting an eventual end to the internal combustion engine. This is new; even three months ago many still saw an indefinite future for the petrol car. But none of us can know exactly how fast the switch to alternatives will take.
The crucial thing for us to understand is that fast growth of a new technology undermines the old companies in an industry more quickly than human psychology allows us to believe. The story of how the major competitors failed to predict the advance of digital cameras will be repeated across many industries in the next two decades.
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