The future BAS: A review of market opportunities and developments

Over the past few months, there has been a lot of discussion in our industry about the future of the building automation system (BAS). It's an interesting topic because:

1. BAS implementations can be fairly archaic (see example 1 and example 2)
2. Many small commercial buildings do not have a BAS, and according to the Department of Energy's CBECS, 94 percent of all commercial buildings are less than 50K sq ft. Of these small commercial buildings, only 11 percent have a BAS. There is a large opportunity to drive adoption in this underserved market.
3. Building automation systems are usually upgraded every 5-10 years, and have heavy upfront purchase and installation costs - once you upgrade, there is little incentive to rip/replace until the end of that cycle.
4. Between increasing awareness of climate change and concern about transmitting Covid indoors, control systems are part of an effective mitigation strategy for all buildings.

My friend James Dice has been writing a number of great posts about the product and technical aspects of the future BAS. One core point from James' writing is that there are two likely futures for building automation systems:

• a scratch-built, modern BAS that totally replaces the traditional product, or,
•  a modern overlay solution that sits on top of the existing BAS.

In this post, I want to add some points to the business side. Is the market opportunity for future BAS offerings aligned with these two potential outcomes?

Stepping back, it's important to note that a lot of the major BAS and HVAC companies make money off products AND services. In fact, services can be a bigger share. This is because installation and ongoing maintenance of complex HVAC and control systems is costly and time consuming. This service-driven business model is a barrier to any modern solution that offers remote analytics, automated optimization, and other things we commonly see throughout the enterprise. A building might upgrade its building automation system every 10 years, but there are plenty of annual expenses paid to a service provider for maintenance (or to your own staff to do it in-house). The large companies that provide truck-based service and maintenance may prioritize these existing revenue streams over emerging, software-based revenue, even if it grows in the future. This can create an 'Innovator's Dilemma' situation, where new business models, which are disruptive to current revenue streams, are de-prioritized. Despite all of this, and the discussion below about the momentum of software- and cloud-based BAS, I do not believe that all services will be replaced with software. But there will be more advanced software that operates buildings, which does mean that there will be less demand for services within each building.

Getting into some details of this product and services breakdown, we have a few large, public HVAC and controls companies with detailed financials. Johnson Controls, which is among the largest in this cohort in the US, derives only 36 percent of total revenue from products, in its "global products" category. 40 percent is from services. The firm has a very extensive branch network and truck-based service team. Our friends at Credit Suisse have been highlighting this breakdown, even back in 2015. The graphic below shows the share of services for Johnson Controls, Trane (formerly Ingersoll Rand, IR, now Trane Technologies) and Carrier (formerly part of United Technologies, UTX).

Graphic from "Johnson Controls: Start-Stop Transitions Can Be Tricky; Neutral", Credit Suisse, Aug 24 2015.

Bottom line: There is a lot of service revenue in buildings.

What impact does this have on opportunity for a scratch-built, full stack, cloud connected BAS or a supervisory solution on top of the existing control system? Will they disrupt the service revenue? Does the existence of these services act as a headwind on technology adoption?

McKinsey recently touched on this very topic in a write up from late 2018, which is as insightful as it is prescient. For example: "...HVAC systems will monitor and adjust for ideal air quality, removing the “sleep-inducing” effects of a poor climate." This now has a broader meaning in the midst of a pandemic, but it does show that as the control systems become more functional, they will align with more use cases and trends in real estate (and increase in demand). These solutions will be able to deliver better experiences across the board (not just energy efficiency and thermal comfort). McKinsey's other key point is that buildings and the control systems will be easier to use (more self-serviceable, easier to install, etc). This means that stakeholders (owners, designers, vendors, etc) will need to change how they design, specify, operate and occupy buildings. The whole write up is good. And, reading between the lines, it does have some insight on the growing market for emerging BAS solutions.

Exhibit two in the write up has McKinsey's current and future market size estimates, which show a massive increase in "connected controls, intelligent building systems", from $4B globally in 2018 to $25B in 2025. That could be a layer on top of an existing BAS, or a new, modern BAS deployed instead of the traditional system (so, either of the two potential new offerings noted above: scratch-built or overlay). McKinsey doesn't highlight one of the other, but they do estimate that the market for "traditional building controls), a $54B market in 2018 (and over 2/3rds of the whole market in 2018), will be $55B in 2025. So, while there is almost no growth, those solutions aren't going away either. 

Graphic from "Laying the foundation for success in the connected-building era", McKinsey, October 12, 2018.

Not only are the traditional controls systems not expected to go anywhere in the next 5-7 years, they are projected to remain just over half of the entire market in 2025. As noted above, these traditional controls systems are almost always found in larger buildings. According to McKinsey, these buildings won't rip/replace an existing system, but they may invest in a layer on top to provide additional connectivity, integration with other systems, and analytics (which falls into the "connected controls, intelligent buildings systems" category). 

But I believe the bigger opportunity, which aligns with the "scratch-built, new BAS" offering, is in the small commercial building market. I don't foresee that buildings with a traditional control system, which can cost $1-$7.50 per square foot, will spend an additional 50 percent on the advanced connectivity layer on top of the BAS. But, McKinsey estimates that the "connected BAS" market becomes half the size of the traditional BAS market (a traditional BAS market that is made up largely of big buildings).

Side note: To clarify, if the "connected BAS" market also is within the big buildings, it is going to add a significant additional cost to the average building (roughly HALF of what the average building spends on the existing BAS). To talk numbers, a big building would spend $3.75/sq ft on the "connected BAS" features, over 10 years to get to this market size (a amount that is half of the max spend on a traditional BAS). But we think this is unlikely, because it is far more than what most current "connected" solutions actually cost. Most of these connected smart building solutions today are $0.05 - $0.20/sq ft / year. That's no more than half what you'd expect to spend, to align with the McKinsey market size estimates (again, if all this market growth is in the larger commercial buildings). 

But, given that there are many more small commercial buildings in the market (again, they are 96 percent of all commercial buildings in the US), these facilities could spend on lightweight control systems, and pay prices that are in line with current market rates, which would get closer to the market size estimates that McKinsey is projecting. Of course, there are many small buildings, but they are much smaller than office class A buildings. This would impact revenue from solutions sold on a $/sq. ft, basis, but I believe there would be a base cost to install a lightweight BAS. Significant revenue could still be derived because there are so many small commercial buildings. And, yes, these estimates are global, but I firmly believe that some of that growth will still come in developed markets. A fair bit also will be in developing economies, where - like jumping over land-line phones - buildings may jump over the traditional BAS.

Of course, there is not yet a consensus on this. Some larger buildings will certainly adopt new technologies that look like overlay technologies. Recently, Gartner published analysis and a survey on what workers will demand in the coming years from their offices. Smart and healthy building features will rule the day! Most of the offices run by the larger companies, with more sensitivity to these worker expectations, will remain in larger buildings (either as a hub office, or a space rented within a larger commercial real estate building) and deploy these connected technologies. We do see some investment in the supervisory "modern overlay" option in larger buildings, but aren't sure that it will be a standard option in larger buildings (partially because the traditional BAS market will persist, and partially because the average prices and market sizing numbers don't appear to work out).

Adding another opinion, Credit Suisse more recently touched on this topic, noting that the larger OEMs are absolutely preparing to sell connectivity and modern technology solutions as components of the traditional BAS. 

Shift to Smart Buildings: In our view, digital acceleration requires not only having the right products/solutions, but the required salesforce skills to sell them. This was a topic at our Smart Buildings event. Historically, building equipment was sold as a capital project with attached maintenance hours. Going forward, these digital solutions will be sold as opex, efficiency, and IT projects. Over the last 18 months, JCI has made upgrades to its field salesforce while partnering with firms like Microsoft, which positions JCI well.

Emphasis added. Quote from "Spotlight on HVAC: End Market Demand, Digital Transition, and Industry Structure & Valuation in Focus – AHR Expo 2020 Preview", Credit Suisse, January 2020.

So, there is some nuance in all of this: The spend on what McKinsey calls "connected controls, intelligent building systems" does seem to be relevant across large and small buildings. But given the current costs of traditional BAS, the permanence of these solutions (usually deployed for 10 years), and the strong service-based offerings in this market, there are limits to how big the "connected BAS" market will be in large buildings. The traditional BAS is not going anywhere, at least not yet, while more solutions targeted at small commercial buildings are likely to be available. 

Moreover, much of the momentum right now is focused on the smaller commercial buildings. We also think that this is where we'll see significant adoption of "scratch-built" BAS offerings that are cloud-connected and deliver a modern experience. This could very likely be the majority of McKinsey's "connected BAS" market. These small buildings, like restaurants, retail, and even smaller professional buildings or offices, usually don't have control systems today, and won't be encumbered by fitting a legacy product with a modern one. Looking at the market, there are plenty of relevant developments: 

• Schneider recently announced that it is forming a new company with Huck Capital to deliver microgrids to small commercial buildings. There likely will be a controls angle to manage demand.
• ABB acquired Cylon and also announced a partnership with Verdigris, which recently launched its own cloud-based control solution.
• JCI launched Verasys, a small commercial building control system, in 2017
• Gridpoint continues to scale and recently wrote about their ability to provide demand flexibility during the California blackouts in August. This does fit nicely with the launch of Verasys from JCI and Schneider's recent microgrid announcement.
• Novar (from Honeywell) is still available and has a strong position in the market.
• Site Controls (from Siemens) is still available and has a strong position in the market.
• Emerging players like Passive Logic, 75F and Hank appear to be most comfortable in these small and mid-sized buildings that don't already have a BAS.

It does appear that a lot of the market momentum is in small commercial buildings (and we agree that this is white space in the market), which will be dominated by the "scratch-built" BAS offerings. And while we see opportunities for both the "scratch-built" and "overlay" BAS options, we see a lot of growth and innovation amongst markets that have smaller buildings without existing control systems. There will be a complete upgrade cycle of traditional BAS offerings, in the largest buildings, but it may not happen in the next few years.