Projects

Role and Value of Innovation

The Role and Value of Innovation in the Pulp and Paper Industry

Background

Purpose, Goals and Literature Review

The global economic downturn of the late-1980s and early-1990s significantly changed the competitive landscape for the P&P industry. Ince (1999), for example, notes that prices and capacity utilization became much more volatile during the 1990s due to increased globalization of markets and the effects of changing export demand for US producers. High supply and low demand combined to produce very low prices and returns. During this downturn the industry suffered from excess production that was in part induced by the combination of highly capital-intensive production, excess capacity developed in the 1970s, and the inflexibility of contracts related to input procurement, transportation and labor.1 A new paper machine costs several hundred million dollars and has a long life span of over several decades. Given the high capital-intensity, it makes economic sense to run the paper machine close to full utilization to recoup the fixed costs.2 At low levels of utilization and production, the average cost of production is high due to higher average fixed costs and the firm is more likely to make losses, given that prices are typically determined in broader global markets. Hence, even during periods of low demand, producers traditionally tried to recoup their fixed costs by maintaining high production. As Douglas (2001) notes, paper mills have historically seen maximum tonnage as their primary goal and have run the machines at high operating rates. This led to supply far exceeding demand, resulting in low prices and returns.

Against the backdrop of global overcapacity and the changing nature of international markets, the US pulp and paper (P&P) industry has been undergoing a fundamental transformation. Some of the changes in the industry include: (i) Increased focus on innovation and attaining cost-efficiencies in, for example, the areas of waste reduction, process management and energy conservation; (ii) Better production management to strive for balance between demand and supply; (iii) Mergers and acquisitions (M&As) to increase synergies and cost-efficiency; and (iv) Greater integration of the US industry into global markets and managing the consequent increases in volatility in prices and returns due to export market fluctuations.

Motivated by observations from the industry and some preliminary investigations conducted by the co-PIs,3 our goal is to use firm-level data to analyze the overall productivity growth of firms, identify specific types of innovations that contribute to this overall productivity growth, the manner in which innovations translate to gains into cost-efficiency and profitability, and the firm-specific and broader factors that hinder or facilitate innovation. During this period, firms have also been undertaking consolidation via M&As. Our visits to a few mills in Europe and the US highlighted the rather intricate and complementary strategies being pursued by some firms related to innovations and M&As as ways to improve the bottom line. Given this, any study of the impact of innovations will be incomplete if we do not control for the impact of M&As. Controlling for M&As will enable us to provide a relative assessment of innovation versus M&As: for example, which strategy is likely to make a greater contribution to efficiency gains and the bottom line? This will provide insights into an important question for the industry about whether M&As are working as a strategy to gain competitiveness and efficiency ( Douglas , 2001). Regarding our main focus, at the end of the day we hope to be able to deliver an important message: those companies that underestimate the impact of innovation on their bottom line and do not actively engage in this process are likely to lose their competitive advantage in the longer-run.

Innovation

Several characteristics of this industry make innovation a critical component of firm strategy.First, equipment manufacturers through supplier alliances spearhead most of the process-related technological innovation. Hence, the state of the art equipment and technology is available to both incumbent firms and new entrants all over the world. This implies that paper machines are not likely to be the key source of differences in competitive advantage across firms.4 In spite of the state of the art technology being readily accessible to all firms, there are large differences in the vintage of machines being used, and in firm performance. The vintage varies not only across firms, but also within firms and even within mills, with newer machines providing higher-speeds, greater capacity, and energy and materials savings.5 Given this, when we consider firms such as UPM-Kymmene, International Paper, Weyerhauser, Stora-Enso, Georgia-Pacific, among others, that have access to the same machines, it is not necessary that the competitive positions of these firms in the global markets are the same. Second, our discussions with various industry managers revealed that firms might not have substantial power to differentiate their products from that of their competitors and obtain higher prices. (We are mainly concerned about the commodity markets and coated and uncoated paper, and not niche paper types.) The main reason is that the underlying technologies to make different types of paper are common knowledge. If a firm develops a specific new type of paper, this will be relatively easy, least for the dominant firms in the industry, to imitate that technology. In short, after controlling for machine vintage effects, it appears that neither paper machines (the key physical capital in this industry) nor a strategy of product differentiation is likely to be the cornerstone to gaining competitive advantage over one’s rivals.

Our discussions will mill managers and selected industry experts revealed that innovations that deliver steady gains in cost-efficiencies in the dimensions of waste reduction, process management, and energy savings, among others, may be crucial to maintaining and enhancing competitive advantage. The significance of such innovations was highlighted in a CPBIS sponsored study (Ghosal, 2003). Further, these discussions revealed that cost-efficiency gains from innovations could be as high as 3% per year, with waste reduction accounting for about 0.5-0.75% per year and energy saving about 2% per year. The mills we have visited suggested that through such types of innovations alone, they can effectively increasing production by about 1.5-2% per year, setting aside improvements due to new capital investments. This may seem like a small annual increase, but its cumulative impact can be large and firms that successfully implement such innovations are likely to gain competitive advantage over their rivals in the long-run. For example, from the early 1980s to the current period, such gains would amount to about 40-50% increase in production with the same capital investment made in the early 1980s.6 Finally, research and development expenditures, as traditionally measured, are typically very low in the P&P industry – accounting for much less than 1% of sales revenues. However, some of the mills we visited indicated that while only 1-2% of their revenues may explicitly go toward innovation activities, up to one-third of their technical personnel devote significant time to these innovations. Overall, our initial fact-finding missions confirms the strategic importance of innovations that include chemicals, mixing, pulping and other process improvements, energy savings, and debottlenecking.

Apart from our observations, some of the writings in the literature confirm this. Bjorkman, Paun, and Jacobs-Young (1997, p.80) note that for the first half of the 1990s, most investments by US and Canadian firms were typically not for new production capacity but for incremental increases in production efficiency, especially environmental improvements.7 Nilsson et al. (1995) indicate that wood for pulping represents 21% of the total material and energy costs in this industry, while the corresponding numbers for energy, wood pulp and chemicals are 17%, 15% and 6% respectively. Some examples of the incremental energy savings measures include firing the recovery boiler at higher solid content, improving the efficiency of paper drying by reducing overall heat loss, using less air and higher heat extraction from each unit of steam used for drying. In the area of waste reduction for example, using fresher wood chips results in less chemicals and processing and reduces pollution, leading to a lower unit cost (for production and cleanup) and higher paper quality.

Economic theory has long recognized the significance of innovations and provides sophisticated models of economic decision-making under various forms of technological progress. Gort and Klepper (1982, p.634) state that innovations, learning-by-doing, and ongoing improvements compress the profit margins of less efficient producers who are unable to imitate the leaders. Eventually, the less efficient firms are forced out of the market. The fittest survive. Several papers build on the above theme and provide additional insights: e.g., Klepper and Graddy (1990), Jovanovic and MacDonald (1994), Audretsch (1995) and Klepper and Simons (2000). These models assume: (1) a distribution of production efficiencies across incumbent firms, (2) improvements in production efficiency levels due to learning-by-doing and imitation, and (3) a relatively low probability of successful innovations. Each time period gives rise to innovation opportunities to lower unit production costs, and innovators enjoy greater profit margins than imitators due to their innovative activities. These improvements in production efficiency result in downward pressure on prices. As a consequence, inefficient firms exit from the industry or are acquired by the more efficient firms. The probability of exit/failure is lower for successful innovators. Overall, these theories provide a sound basis for understanding changes in profitability and market shares among incumbent firms.8

Our preliminary investigation suggests that after the early-1990s recession, many firms embarked on an efficiency drive, which included greater emphasis on process management, innovation, and restructuring of the supply chain. While there is some anecdotal evidence regarding the role of innovations in this sector, there is very little in terms of systematic documentation, empirical analysis and quantification of the effects that could facilitate strategic decision-making at the firm level. This project will help document the kinds of innovation and cost minimization activities that are taking place in the industry, analyze the economic drivers, facilitators and impediments to innovations, and provide the industry with an analysis of these measures and their impact on firm profitability and competitiveness, while controlling for the impact of mergers and acquisitions and some other factors such as firm size, union versus non-union status, and the vintage of the machines. Next, we briefly discuss why it is important to control for M&As when examining the effects of innovations on firms’ profitability and competitiveness.

The Role of Mergers and Acquisitions

The 1990s have seen a spate of M&As in the P&P industry, with some of the main drivers being the desire to increase efficiency and better management of production.9 Douglas (2001) notes that the wave of M&As is an effort to combat poor financial performance by the North American paper industry and increased global competition. Lehman Brothers analyst James Flicker noted (October, 1998) that the US paper industry must restructure to remain globally competitive; market fragmentation and overcapacity are serious problems. The industry’s hope is that through consolidation, paper manufacturers can manage capacity more efficiently, reduce marketing, sales and engineering costs and improve returns by creating a better balance between supply and demand. Anecdotal evidence appears to suggest that innovating firms are often the more efficient ones that seek to acquire the less efficient non-innovators. In essence, one can view M&As as an attempt by the US P&P firms to become more cost-efficient. Given this, any study that aims to examine the link between specific types (and overall) innovation and firms’ profitability and competitiveness must control for other complementary strategies like M&As.

Since the literature is well established, we only provide a brief discussion of mergers. For the P&P industry, mergers broadly fall into the horizontal or vertical category. The literature suggests that horizontal mergers are more representative of what occurred in the P&P industry in the 1990s and consistent with the industry’s objectives of reducing overcapacity, modernizing some mills and bringing better balance between demand and supply. Benefits of horizontal mergers include economies of scale and scope, combining complementary capabilities and potentially gain some pricing power.10 In contrast, vertical mergers may arise from technological economies; transactions costs economies because of the inability to contract all contingencies reliably with input suppliers in the absence of vertical mergers; and market imperfections such as downstream moral hazard problems. 11 The finance and management literature also provides several efficiency hypotheses regarding causes of M&As (Weston et. al., 2001) such as inefficient management of the target firm, diversification, financial synergies, strategic realignment and under-valuation of the target firm by the market. The academic literature on quantifying the economic effects of mergers is rather limited; there are also relatively few economic studies on the US P&P industry in part because of the difficulty in quantifying the benefits of M&As. Examples include Ohanian (1993, 1994), Smith (1997), Caves and Christensen (1997).12 Pesendorfer (1997) examines the M&As in the paper and paperboard industry of the mid-1980s and concludes that in majority of the acquiring firms efficiency increased following acquisition. Overall, myriad forms of efficiency gains are an important motivation behind mergers, hence the need to control for them.

1 It is common knowledge that there is global overcapacity (Ince, 1999; Douglas, 2001). The origins of this overcapacity are due in part to events in the 1970s. As noted by Kates (2002), in the late-1970s producers took advantage of high demand and prices and heavily invested in new capacity. Given the longevity of the paper machines, these machines are still active today and contributing to global overcapacity and production. Ghosal (2003) describes evidence on the inflexibility of contracts in earlier years.
2 The P&P industry has one of the highest capital-intensities in the US manufacturing sector.
3 These were highlighted in selected mill trips made by both the authors in Northern Europe and the US . Some of the details are presented in Ghosal (2003) and Nair-Reichert (2002).
4 See Nair-Reichert (2002) for more details.
5 For example, Stora Enso’s Maxau-Wolfsheck mills in Karlsruhe ( Germany ) have paper machines in current use that were installed between 1964 and 1988 with widely differing production capacities. Similarly International Paper’s Eastover mill ( US ) has paper machines that were installed in 1984 and 1991. In addition, given the longevity of the paper machines, even if a new entrant purchased a 10-20 year old machine, it is very likely to be technologically advanced, receptive to modernization and rebuilds to make it even more efficient.
6 The cumulative productivity graphs in Ghosal (2003) vividly display this aspect.
7 Environmental regulation appears to be an important driver of the changes that have occurred. For example, the bleaching technologies noted in Norberg-Bohm and Rossi (1998).
8 Ghosal (2003) provides a review of the theory and empirical evidence.
9 Data on M&As shows that the total number of mergers in the industry was significantly greater during the 1990s as compared to 1980s. The impetus for the mergers in the 1990s comes from the major players in the industry like International Paper, Stora Enso, UPM-Kymmenne , Georgia -Pacific, Weyerhauser, among others, who are attempting to reduce overcapacity, modernize older and inefficient mills, obtain control over output and better manage production over cyclical fluctuations in local and global markets.
10 See, for example, Salant, Switzer and Reynolds (1983), Perry and Porter (1985) , Farrell and Shapiro (1990), Deneckere and Davidson (1985) and Shy (1995, Ch.8).
11 See Williamson (1975), Arrow (1975), Greenhut and Ohta (1976), Perry (1980, 1989), Salop and Scheffman, (1983), Crocker, (1983) and Grossman and Hart (1986).
12 Ohanian (1993, 1994) provides historical studies of the industry from 1900-1940. Smith (1997) examines environmental aspects while Caves and Christensen (1997) find that short-run price competition is highly sensitive to capacity utilization.

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