On the Value of Input Efficiency, Capacity Efficiency, and the Flexibility to Rebalance Them

A common characteristic of basic material manufacturers (which account for 85% of all industrial energy use) and of cleantech manufacturers is that they are price takers in their input and output markets. Variability in those prices has implications for how much a manufacturer should invest in three fundamental types of process improvement. Input price variability reduces the value of improving input efficiency (output produced per unit input) but increases that of capacity efficiency (the rate at which a production facility can convert input into output). Output price variability increases the value of capacity efficiency, but it increases the value of input efficiency if and only if the expected margin is small. Moreover, as the expected input cost rises, the value of input efficiency decreases. A third type of process improvement is to develop flexibility in input efficiency versus capacity efficiency (the ability to respond to a rise in input cost or fall in output price by increasing input-efficiency at the expense of capacity efficiency). The value of this flexibility decreases with variability in input and output prices if and only if the expected margin is thin. Together, these results suggest that a carbon tax or cap-and-trade system may reduce investment by basic material manufacturers in improving energy efficiency.