The ESG Risk Atlas

May. 21 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.

Branded Consumer Non-Durables, Durables, And Tobacco

This industry includes the following subsectors: apparel, accessory stores, and related products (footwear and accessories); beverages (nonalcoholic and alcoholic), including spirits and soft drink bottlers; food (including packaged and branded) and kindred products; personal care and cosmetics; and household products.

Environmental exposure (Risk Atlas: 3)

The global anti-plastic movement is an outcome of inherent environmental risks, which have so far not translated into far-reaching or quantifiable government policy actions. Still, we believe it is subject to the evolution of policy-making across the world. Over the medium to long term, it is possible that sudden regulatory action on waste management will make the industry bear the cost of switching to more environmentally friendly packaging solutions or pay for the treatment of product waste before such costs can be passed on to end consumers. However, many companies are already taking strategic actions that and may help improve operational efficiency ahead of such a transition, including developing smaller, more automated manufacturing bases, as well as improving productivity in warehousing, logistics, and shared services and reducing, reusing, and reinventing packaging. Another environmental risk is tiny plastic particles from synthetic clothing, which make their way into water when washed.

We believe the consumer durables sector has a modestly higher environmental risk than the non-durable sector because consumer durables can significantly contribute to hazardous and non-hazardous solid waste generation and energy use. Refrigerators, for example, can release harmful chemicals when thrown out, so there is growing importance around solid waste management and materials recovery. In addition, energy-using durables such as kitchen appliances and electronic equipment can contribute significantly to environmental degradation as they are one of the fastest-growing sources of residential energy use.

Social exposure (Risk Atlas: 3)

Social risks surround consumer behavior, human and safety management, social diversity in the workplace, and demographics. Consumers are increasingly focused on health and wellness, which has resulted in a loss of market share for some categories of goods such as carbonated nonalcoholic beverages, beer, and cereal. This is partly due to the additives, preservatives, sugar content, and chemicals in products being linked to consumer health issues, as well as consumers' busy lives. Rising obesity rates--now considered a worldwide public health crisis--have also been linked to greater consumption of the additives and preservatives found in many processed foods and beverages.

Governments have developed or are developing ways to stem the obesity rate because of its impact on healthcare resources and increasing healthcare costs. To encourage consumers to make healthier choices, governments are providing educational programs and food guidelines, as well as implementing mandatory labeling and in some regions taxes (i.e. on sugary drinks). Governments are also stepping up efforts to reduce alcohol consumption because of its impact on consumer health and injuries.

Packaged foods have been particularly hit because consumers have switched buying patterns to store peripheries, where fresh products are, and away from the center-of-store area where shelf-stable products are sold. Consumer products companies are thus investing more in innovation, reformulating products, increasing transparency on labels, and engaging in ongoing merger and acquisition activity to find ways to accelerate sales growth and keep pace with consumers.

Other risks in the industry include social media marketing, which we consider an area of potential social risk due to emerging data privacy laws and because of growing consumer sensitivities around factual accuracy and respectful attitudes to different social groups. Safety management is also a relevant factor for the industry given the risks to reputation and profitability from product recalls. This risk is partly offset by regulatory requirements, corporate focus on preserving brand equity, and by the relatively small volume impact from any product batch entering the market.

We believe that the tobacco sector has the highest social risk given the widespread awareness of the adverse health effects of smoking and its impact on healthcare costs and resources. The sector has stringent regulatory requirements including restrictions on the promotion, marketing, packaging, labelling, and usage of tobacco products. The secular decline of combustible cigarette usage is accelerating because of a combination of health concerns, increasing regulations in developed markets, and greater availability of reduced-risk products. The decline could accelerate further because the U.S. Food and Drug Administration (FDA) is aiming to reduce the nicotine content of combustible cigarettes and ban menthol cigarettes. Several countries like France are steadily raising cigarette prices. Companies within the sector continue to perform well because they have been able to offset volume declines with prices, and in some cases are diversifying away from combustible cigarettes through new growth-oriented investments such as e-cigarettes and cannabis. Companies' operating performances and credit metrics could deteriorate if the decline in combustible cigarettes accelerates further and they cannot offset the impact with price increases or alternative tobacco-related products.

Governance

We see governance issues as idiosyncratic. In most cases, governance does not significantly affect ratings. Tobacco, alcoholic beverage, and cannabis companies require greater management oversight given their need to interact with regulators and public officials. Also, there are a number of companies that have significant family ownership or voting control. We do not believe that these companies' governance unduly benefits the families/trusts over other stakeholders.