Although capital deployment is strongly linked to enterprise value (EV) and financial health, it has always been difficult to manage. The chemical industry is no exception.
Our research finds that the chemical industry anticipates annual growth of 3 to 5 percent by 2030, a 4 percent increase in capital expenditures, and the reallocation of significant capital to meet strategic and operational objectives. At the same time, chemical companies have been grappling with cost pressures,1 a 26 percent increase in capital project expenses since 2020, industry-wide margin compression because of oversupply, and persistent inflation and increases in the cost of labor.
Moving forward, CFOs will likely need to strike a balance among strategies for capital allocation, updated expectations for project returns, and continuous improvement of project outcomes. Doing so entails driving improved transparency through the capital portfolio via financially focused communication between teams and up-to-date project management tools.
Managing capital in chemicals
Effective capital deployment in chemicals is intrinsically linked to a company’s overall value and financial well-being, and this link becomes particularly pronounced for companies whose ROIC is near their cost of capital. Our research shows ROIC increasing from 12.0 to 13.0 percent (an 8.3 percent improvement) can lead to a remarkable 22.0 percent surge in EV. Nevertheless, as ROIC continues to climb, the subsequent enhancement in EV becomes less pronounced. In fact, elevating ROIC from 20.0 to 21.0 percent (a more modest 5.0 percent boost) results in an 8.0 percent boost in EV.
When CFOs in chemicals delve into their capital portfolios to identify opportunities to improve ROIC by better capital management, they tend to discover a complex landscape of challenges, all of which are exacerbated by increasing project costs, ongoing labor shortages, and other macroeconomic headwinds. Those management challenges include the following:
- Highly technical projects. The inherent complexity of chemical projects, and insufficient communication between teams, often results in barriers to informed decision making.
- “Gaming the system.” Trust deficits between corporate and frontline operations can lead to projects being reframed as viable or successful when they may not be.
- Information asymmetry. Silos within projects, outdated KPIs, and a sprawling portfolio can obscure critical issues.
- Deprioritized capital capabilities. Controlling project capital expenditures is sometimes treated as just another lever rather than a core competency, undermining the strategic importance of capital management.
- Disruptions cascade through the portfolio. Overruns or delays in one area can limit the ability to fund or accelerate other projects.
Further complicating matters, average project costs have increased by approximately 26 percent since 2020. This increase necessitates a determined effort for companies to stay within budget to safeguard returns, particularly in the face of margin declines from highs in many subsectors in 2021 and 2022.
In this complex landscape, optimizing capital deployment has emerged as a pivotal task for CFOs because it directly affects a company’s financial health and overall value. Addressing some tough questions can help CFOs get started.
Optimizing capital management in chemicals: Five questions for CFOs
When navigating today’s challenging landscape, chemical CFOs can ask themselves the following five questions:
What is the best way to determine what and where to spend?
Trade-offs will always occur in a balanced portfolio, requiring active discussions across the C-suite to determine which projects best support business priorities.2 In this way, CFOs have four cash allocation avenues. First is sustaining and compliance capital expenditures, which typically make up about 1.5 to 2.0 percent of the asset base for top performers. The second avenue is growth capital expenditures, which are based on quantified risk-adjusted return targets and estimates based on historical ROIC. Third is strategic initiatives, which involves plotting investments to achieve commitments such as net-zero goals or M&A strategies. Last is other uses of cash, which require the balance of “should spend” with returns to shareholders.
How should my return expectations be different in a rising-interest-rate environment?
From 2022 to 2023, capital project costs increased by approximately 10 percent.3 To put this into perspective, a hypothetical $100 million project that boasted a 15 percent internal rate of return (IRR) in early 2022 required an investment of $110 million in late 2023 and yielded only a 12 percent IRR, assuming 3 percent margin compression (exhibit). Therefore, to attain returns similar to highs in 2022, companies will need to either reduce capital expenditures by 15 percent or improve gross margins by 10 percent. The most effective approaches often involve taking both actions.
Image description:
A horizontal line chart shows reducing capital expenditures for a $100 million project can improve internal rate of return by 2024. The line is intended to show how lower amounts of invested capital and gross margins can work together to improve internal rate of return. There are three points on the line:
- $100 million invested capital in early 2022 with margin compression of 0 percent and internal rate of return of 15 percent
- $110 million invested capital in mid-2023 with margin compression of –3 percent and internal rate of return of 12 percent
- $94 million invested capital in 2024 target with margin compression of –3 percent and internal rate of return of 15 percent
End of image description.
How can I improve project outcomes or control risk across my portfolio and on large projects?
CFOs wield substantial influence across five key stages of the project life cycle: concept development, design, pre–financial investment decision (FID), procurement and contracting, and execution.
In the concept development phase, CFOs can set the standard for project assessment by implementing rigorous criteria and evaluation processes. A forward-looking view of economics, particularly of feedstock and offtake agreements, is critical to consistency and quality on project business cases as well as preventing unpleasant surprises down the line. Engaging actively at this early stage can also help control the quality of the portfolio and give visibility to balance risk, return, and company objectives.
During the design stage, CFOs can challenge existing scopes and push divisions to undergo disciplined project scrubs to lower costs and push toward a return-based justification for major components. Examples include the following:
- Minimal technical solution. Guiding design teams to solve for the minimal technical solution is a critical role for the CFO.4 Often without the CFO’s counterbalance, business and design teams naturally gravitate toward larger projects that are sized (or oversized) for the best possible market conditions or with noncritical functionality, increasing costs and creating incremental risk in overruns in construction.
- Standardization. Ensuring design teams push for standardization where appropriate has proven repeatedly to reduce overall project cost and risk.5 A simple question a CFO could ask is, “Which additional systems or components of our design could be built with established industry-standard specifications, rather than tailoring to our own unique specs?”
Prior to FID, CFOs can lead an independent review team that takes a due diligence approach similar to those in private equity.
According to our recent analysis of more than 500 global projects, the average cost overrun for major projects is 79 percent above the initial budget, and the average schedule overrun is 52 percent above the initial schedule. 6 These misses can often be attributed to project teams relying on overly optimistic projections informed primarily by backward-looking data or data and projections provided by entities (internal or external) with a vested interest in seeing the project move forward. What’s more, many of these overruns could have been prevented if executive teams had performed diligence similar to the level they would typically do ahead of any potential M&A transaction of a similar materiality.
Therefore, a growing number of leading companies are executing independent reviews ahead of FID, led by a small team that is not associated with the project itself, for any project that could materially affect the company’s financial performance if it underperformed in development or operations. These efforts bring independent data and perspectives into the following areas:
- capital expenditures: project cost and duration projections as well as probability ranges
- operating expenditures: benchmarking projected production costs once the project is operational
- revenue: independent views of projected sales volumes and market prices under multiple economic and market scenarios
- geopolitics, supply chain, and regulatory concerns: where applicable, independent views on potential shocks to the project
- value improvement: opportunities to improve the performance or derisk the project in any of these areas
- integrated project economics modeling: an independent view of the project economics that can be compared with the project team’s model
Ideally, these independent reviews are conducted with external data and independent modeling simulations to validate and challenge estimates, plans, and budgets. This allows CFOs to test if there is any padding that can be reduced as well as if the projections are realistic (a fact that is often discovered only when it is too late).
In the procurement and contracting phase, the involvement of CFOs is crucial for evaluating the value of joint ventures and other partnerships not only for a single project but also for the overall portfolio. Financial leadership also plays an essential part in avoiding project complacency, and CFOs can push for benchmarks against the broader industry and continual assessment of contracting strategy to avoid stagnancy within the broader portfolio.
In the execution phase, CFOs can play a pivotal role in maintaining controlled communication with stakeholders while ensuring a financial mindset stays paramount and transparency is maintained through progress updates and ongoing decisions.
How can I focus the technical project teams on financial outcomes?
As with most major changes in organizational cultures, CFOs can take the following four actions to encourage their technical project teams to adopt a financial perspective:
- Role modeling. Set an example by approaching major projects as independent businesses. In addition, CFOs can be selective in appointing project directors who possess a CFO mindset, financial acumen, and experience developing a specific type of project.
- Developing talent and skills. Foster financial expertise within the project team to seamlessly integrate financial language. On this point, a member of the finance team can “hold” the business case and accelerate the timeline. This individual can also facilitate team development with direct coaching as well as tactical tools such as project templates shared with the team.
- Fostering understanding and conviction. Communicating the financial impact alongside technical information becomes more convincing when framed as a compelling story. Real-life examples tailored to the technical group’s context can be especially effective.
- Reinforcement mechanisms. Reinforce the use of financial terms by structuring approval decisions and project updates with the desired terminology. Structurally, appointing a project sponsor with direct profit-and-loss responsibility for the final project helps keep incentives aligned, and any such sponsor should continue the focus on feedback and direct, visible coaching toward financial communication.
These efforts combine to cultivate a financial mindset that permeates the entire organization, aligning technical teams with the broader financial objectives.
How can I drive transparency on major projects to better predict what’s coming?
In addition to developing a pre-FID, independent view of the likely trajectory of projects, CFOs have three interdependent levers at their disposal to enhance capital project transparency throughout the projects’ life cycles7:
Integrating new technical solutions. CFOs should be able to “drill down” into the data, often literally double-clicking into charts or graphics to see the important data at a granular project level—for example, a CFO can look into the weekly average installation rates for piping in a critical section of a new plant and ask questions early if productivity is slipping, before the project falls behind schedule. This is a challenge when project data is widely distributed and locked away behind silos. Creating transparency requires implementing not only a unified technical infrastructure to streamline data but also the visualization and KPI selection that bring senior attention to vital issues as they arise. On this point, modern tools often incorporate automation to ensure relevant teams are alerted as problems arise, and predictive insights and risk mitigation warnings can help inform rapid and proactive decision making.8
Improving performance management processes. With the data available, a project structure and process are needed to make informed decisions. This includes structured meetings with up-to-date data aggregated into an easily understandable performance dashboard. The subsequent discussions and associated decisions can be supported by clear escalation paths and dedicated spaces for decision making (already hallmarks of healthy performance management teams).
Nurturing project leaders with the right mindsets, capabilities, and behaviors. Selecting project members, particularly leaders, with core leadership skills is essential. Effective project management across an organization requires rewarding and building these capabilities. Constructive conversations and coaching are just as vital as project “skills,” such as lean construction. And building a culture of effective project management requires encouraging activist leadership and cultivating a problem-solving culture—a team’s capability is part of the foundation for improved transparency in capital projects.
It is vital to note that although each of these levers is valuable on its own, they are much more effective when combined. Tools, systems, and people should all work together to create transparency and results.
Today, chemical CFOs face a pressing dilemma: balancing the pursuit of shareholder returns amid escalating costs. Implementing solutions to address critical questions often requires challenging the status quo operating model. And CFOs who get these points right can significantly improve EV by ensuring they do not sanction projects that should not be sanctioned; improving the economics up front by optimizing design, sourcing, and execution planning; and actively managing construction and buildup.
