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ESG Industry Report Card: Capital Goods

Highlights

Key environmental factors for capital goods companies include managing energy efficiency and carbon emissions of products and processes. Automation has helped these companies be energy efficient and less reliant on skilled labor.

Environmental remediation is a key factor for some companies where they have legacy liabilities or have inherited them through past acquisitions.

Social risks are generally limited but are related to the scarcity of skilled labor and safety. Safety has improved somewhat as a result of automation, as fewer skilled workers are needed, thus preventing accidents.

The ESG Risk Atlas

Jun. 03 2019 — To calibrate the relative ranking of sectors, we use our environmental, social, and governance (ESG) Risk Atlas (see "The ESG Risk Atlas: Sector And Regional Rationales And Scores," published May 13, 2019). The Risk Atlas provides a relative ranking of industries in terms of exposure to environmental and social risks (and opportunities). The sector risk atlas charts (shown below) combine each sector's exposure to environmental and social risks, scoring it on a scale of 1 to 6. A score closer to 1 represents a relatively low exposure, while 6 indicates a high sectorwide exposure to environmental and social risk factors (for details see the Appendix). This report card expands further on the Risk Atlas sector analysis by focusing on the credit-specific impacts, which in turn forms the basis for analyzing the exposures and opportunities of individual companies in the sector.

Environmental Exposure (Risk Atlas: 3)

The biggest environmental risks considered for the capital goods sector are carbon emissions reduction in some of its main end markets and resource management. Changing regulation and market dynamics (such as tighter energy and carbon regulations and growing use of renewable technologies) are shaping demand for industrial equipment and services.

As companies in the capital goods sector produce their end products, they typically need to develop processes and incur compliance costs that meet with required environmental standards and mitigate possible costs/fines to remediate or address environmental matters such as emissions, water use, and waste disposal. Historically, incidents of environmental claims, such as asbestos or pollution related liabilities, have resulted in meaningful fines or financial obligations, though in many cases these were largely manageable and absorbed by the issuer's balance sheet capacity or cash flow generation. Examples include several lawsuits against 3M alleging that its use and disposal of perfluorochemicals led to the contamination of drinking water in multiple locales throughout the U.S. and Emerson Electric's litigation relating to a variety of asbestos-related personal injury claims.

Social Exposure (Risk Atlas: 2)

In considering social risk, we focused on the sector's exposure to changing consumer behavior and human capital management. Changing consumer behavior is driving increased automation at production plants and shifts in the skillset of its labor force to meet targeted operating efficiency strategies. Automation, digitalization, and robotics are global trends in the capital goods industry and create new opportunities for improved growth and profitability, both for providers and users of technology. However, at the same time they will fundamentally change the work environment for employees in the manufacturing industry. Safety management and customer engagement are also important factors in an issuer's competitive advantage, supported by strong brand name recognition, through product quality and technical leadership.

Governance

Governance factors are generally neutral to the ratings in the capital goods sector, though we note the majority of the ratings are speculative grade and many are under private equity ownership. 

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