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3. When novelty becomes risky: Mitigating Obsolescence Risk In The Equipment-as-a-Service Model

Introduction

The Equipment-as-a-Service (EaaS) model, with its potential to revolutionise the way Original Equipment Manufacturers (OEMs) operate, also brings with it a new set of challenges. One of these challenges is obsolescence risk. In this post, we'll examine what obsolescence risk entails, its main drivers, potential impacts, and discuss how OEMs can manage and mitigate this risk effectively.


Definition Of Obsolescence Risk

In earlier posts, we explored asset utilisation risk and residual value risk. Now, we'll focus on obsolescence risk, which is the risk that equipment becomes outdated or obsolete before the end of its expected service term. This could occur due to rapid technological advancements, changes in regulations, or shifts in market preferences. When equipment becomes obsolete, its usage and thus, the revenue generated from it, can significantly decline.


One of the most prominent examples of obsolescence risk can be seen in the energy storage industry. In recent years, the cost per kilowatt-hour capacity (kWh) of energy storage systems, especially for lithium-ion batteries, has been dropping significantly due to rapid advancements in technology and increased production scale. As a result, newer models of energy storage systems are not only more efficient but also more cost-effective.


Consider an OEM that has provided an energy storage system under an EaaS contract. If the cost per kWh storage falls dramatically during the service term, the provided equipment could quickly become uncompetitive, leading to reduced demand or even discontinuation of its use. Consequently, the OEM might face revenue shortfalls, as the income generated from the equipment would be lower than anticipated. This scenario perfectly illustrates the obsolescence risk inherent in the EaaS model.


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Drivers Of Obsolescence Risk

Obsolescence risk can be driven by several factors, including:


Technological advancements

Rapid technological developments can significantly contribute to obsolescence risk. For example, in the photography industry, the advent of digital cameras made traditional film cameras virtually obsolete in a relatively short span of time. A hypothetical example of an OEM offering film cameras-as-a-service would find themselves facing revenue shortfalls as demand for their equipment drastically declined.


Changes in market preferences

Shifts in consumer behaviour and market preferences can also lead to equipment becoming obsolete. A classic example is the shift from physical media to streaming services in the entertainment industry. OEMs that provided DVD players or related equipment under an EaaS model faced obsolescence risk as consumers increasingly opted for streaming services over physical DVDs.


Regulatory changes

Changes in laws or regulations can also render equipment obsolete. For instance, the implementation of stricter emission standards in many regions has led to the phasing out of certain models of diesel engines. OEMs offering these engines under an EaaS model have faced obsolescence risk as their equipment became non-compliant with the new regulations, leading to a decrease or even cessation of demand.


Economic factors

Economic factors such as inflation, recession, or changes in exchange rates can also lead to obsolescence risk. For example, during economic downturns, companies often cut back on capital expenditures, which can lead to decreased demand for certain types of industrial equipment. OEMs offering this equipment under an EaaS model may face obsolescence risk as their equipment is seen as less essential or too expensive to maintain.


Each of these drivers highlights the complex and multifaceted nature of obsolescence risk. As such, OEMs need to be aware of these factors and proactively manage this risk to ensure the longevity and profitability of their EaaS offerings.


Impact Of Obsolescence Risk

The primary impact of obsolescence risk is financial. If equipment becomes obsolete, its usage and the revenue generated from it can significantly decline. This can strain the OEM's financial health and disrupt its revenue forecasting. Moreover, obsolescence can lead to a decrease in the residual value of the equipment, affecting the OEM's balance sheet.


For example, let's consider the previous case of an OEM that provides an energy storage system under an EaaS model. They initially priced their service at a certain price per kWh, expecting the equipment to last for 10 years or more. However, due to rapid technological advancements, the price per kWh in the market drops to about 10% of that in just 5 years. Source. This sudden drop would make the OEM's offering uncompetitive, leading to a decrease in demand and hence, lower usage rates. If the OEM expected to generate a certain revenue level per year from this equipment, the sudden drop in demand could lead to a significant shortfall in their projected revenues.


See below graph, as an illustrative example of an energy storage case.

Acquisition cost (excl. purchase price): 3.000 €

Purchase price: 10.000 €

Lifetime: 10 years (minimum)


A new system, including cost of acquisition, is a better alternative already before 2 years has passed.



Risk Management Strategies

Managing obsolescence risk requires a comprehensive strategy that incorporates technological, operational, and contractual approaches:


Technological strategies - Low

While it's a given that OEMs should embrace emerging technologies and regular upgrades to keep the equipment current and competitive, predictive analytics and machine learning can add an edge by helping forecast technological trends and potential obsolescence. This allows OEMs to adapt their equipment ahead of time. Additionally, IoT devices can be used to monitor the equipment's performance and identify any signs of obsolescence.


Operational strategies - Low

Maintain a dynamic and flexible operational model. This involves regularly assessing the current state of the equipment and the market trends, and making necessary adjustments, enabled by e.g., IoT technology.


Contractual strategies - High

Implement flexible EaaS contracts that allow for equipment upgrades or replacements in response to technological advancements. This could involve creating provisions for the early termination or modification of contracts in the event of significant technological advancements, thereby reducing the risk of maintaining obsolete equipment.


Additionally, the EaaS contract could be priced in a way that the equipment is fully paid off after 2-3 years, and the ownership then transfers to the customer. This could be a mutually beneficial strategy, providing a predictable revenue stream for the OEM, while giving the customer the option to own the equipment and manage its obsolescence risk.


Financial strategies - Low

To mitigate the financial impact of obsolescence risk in the EaaS model, OEMs can explore financial tools such as off-balance sheet financing. This approach involves working with specialised financial institutions that assume equipment ownership and financing responsibilities while the OEM retains service and maintenance duties. Off-balance sheet financing offers advantages such as financial flexibility, improved cash flow predictability, and access to expertise in managing obsolescence risk. Careful consideration of terms and selection of reputable financial partners are crucial when implementing off-balance sheet financing as a risk mitigation strategy in the EaaS model.



Remember, the mitigation potential of each strategy varies depending on a variety of factors, including the specific circumstances of the OEM, the nature of the equipment, and the broader market conditions. Therefore, these rankings are not absolute and could vary based on these factors.


Case Example

The concept of "stranded assets" has become a significant concern within the energy sector, particularly for fossil fuel-based energy assets like coal-fired power plants. These assets are at high risk of becoming obsolete before the end of their expected service life due to factors related to sustainability.


Consider an oil and gas company that has invested heavily in a coal-fired power plant, expecting it to operate for several decades. However, due to a combination of regulatory changes pushing for reduced carbon emissions, advancements in renewable energy technologies, and shifts in consumer preferences towards more sustainable energy sources, the demand for coal-based energy starts to decline.


As a result, the power plant may become economically unviable long before the end of its expected life span - the plant and equipment has become "stranded assets". The company, if operating under an Energy-as-a-Service model, would face severe obsolescence risk as the revenue generated from the power plant would be significantly lower than anticipated.


As of 2022, it’s estimated that over $1 trillion of oil & gas assets risk becoming stranded as a result of policy action on climate and the rise in alternative energy sources. Source.


This scenario perfectly illustrates the obsolescence risk inherent in the EaaS model, particularly in sectors such as energy where the push for sustainability and the rapid pace of technological advancements can lead to assets becoming obsolete much faster than anticipated.


Conclusion

Obsolescence risk represents a significant challenge in the Equipment-as-a-Service model, driven by various factors including rapid technological advancements, shifts in market preferences, regulatory changes, and economic factors. The impacts of this risk can be profound, affecting an OEM's financial health, disrupting revenue projections, and impacting the residual value of the equipment.


However, with a comprehensive and proactive approach, OEMs can effectively manage and mitigate this risk. Technological strategies involving embracing emerging technologies and leveraging predictive analytics can help in anticipating potential obsolescence. Operational strategies such as maintaining a dynamic and flexible operating model can ensure the OEM remains agile and responsive to market trends. Contractual strategies, including flexible EaaS contracts and innovative pricing models, can help in managing the contractual aspects of obsolescence risk. While financial strategies can be more challenging due to the transfer of risk to entities with fewer mitigation options, they can still provide some level of financial protection.


In conclusion, while obsolescence risk is an inherent part of the EaaS model, it is not insurmountable. With careful planning, foresight, and strategic action, OEMs can successfully navigate this risk and continue to reap the benefits of the Equipment-as-a-Service model. As the EaaS model continues to evolve, OEMs that effectively manage obsolescence risk will be better positioned to succeed in this dynamic and competitive landscape.

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