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ESG Sector Review: Industrial Capital Goods
Industrial capital goods include a range of products and services, including electrical equipment, construction machinery, engineering and industrial machinery, that are key to the global manufacturing supply chain. Technology advancements in this sector has been a key driver for manufacturing productivity and efficiency, since the dawn of the industrial revolution, and still is now.
What are the ESG considerations that come at play when it comes to the manufacturing process and product development of industrial capital goods? Demand is closely tied with industrial production - what is its role and how is it reacting to the demands of a “green” economy?
The ESG Context
Some of the World’s Biggest Ghg Emitters but a Key Part to Play in Decarbonisation
Heavy capital goods manufacturers are some of the world’s top emitters of greenhouse gasses (GHGs). They consume large amounts of energy powered by fossil fuels or electricity. A company’s energy consumption profile varies depending on the type of manufacturing activities involved. For example, a company that focuses on assembling typically uses more purchased electricity, as opposed to on-site fuel combustion, compared to a company that focuses on converting raw materials into finished products.
Industry manufacturers are incentivised to reduce their GHG emissions in order to lessen their operational energy costs, but also in the face of regulatory, customer and investor pressures to lower their environmental footprints. Looking beyond companies’ own operational activities, focus is increasingly placed on their Scope 3 emissions – those coming from upstream (outsourced) activities such as material sourcing and transportation – which is where the sector’s main ESG risks lie.1
We see some proactive machinery companies actively review their supplier’s carbon footprints and seek to implement recycling systems for machines at the end of their first useful life.2 For example, Larsen & Toubro Limited has started putting Environmental and Social Code of Conducts in supplier agreements.3 Another example is Techtronic Industries who has expanded their Product Repair and Refurbishing Program: in 2020, up to 808,000 products were repaired through service centres and almost 500,000 refurbished products were sold.4 Such circularity efforts can have a positive impact on the prices they can charge for their machines, as well as opening new avenues for profitable new services.
As we transition into a “net zero” world, industrial capital goods are enablers of this decarbonisation; the provision of sustainable and low-carbon machinery products will directly and indirectly influence the GHGs emitted from industrial processes. Consequently, we see priorities of product designs to shift accordingly to cater for the demands of a “green” economy and changes in customer preferences.
Automation and Digitalisation Changing the Landscape for Human Capital Management
“Manufacturing involves repetitive and manual tasks, and is inherently dangerous. Automation could reduce injuries as well as improve operational efficiency.
- Marcus Chu, Investment Analyst (Mirae Asset)”
Industrial manufacturing is a labour-intensive process, relying on a large workforce, that also exposes employees to injuries due to heavy machinery moving equipment, electrical hazards and others. Automation and digitalisation are key themes in the modern world that has and is projected to have significant impacts on jobs, impacts will be felt in the mid-2020s according to a PwC report.5
For example, it’s projected that by 2025, 10-15% of jobs in manufacturing, transportation and storage, and wholesale and retail trade will have high potential for automation. By 2035, the range of jobs with high automation potential will be closer to 35-50% for those sectors.6 It is also projected that four industry groupings—computers and electronic products; electrical equipment, appliances, and components; transportation equipment; and machinery—will account for around 75% of robotics installations during the next decade.7
Notwithstanding automation potentially substituting jobs in this sector, automation will boost manufacturing productivity; wider adoption of robots for example may increase output per worker to up to 30% over the medium term. 8 Automation will also result in savings in labour costs; the average manufacturing labour costs are expected to be 33% lower in South Korea and 18-25% lower in China, Germany, the United State and Japan in 2025 than they otherwise could have been.9
The ESG Road Ahead
Each industrial capital goods company is uniquely exposed to multiple end markets, and demand is closely tied to that of end markets. As end markets become disrupted due to the uncertainties of a decarbonising world, the disruptions are similarly felt by industrial capital goods companies.
Disruptions to industrial capital goods companies are primarily driven by changes to operational fuel consumption at end markets, also known as Scope 1 greenhouse gas emissions. For example, the transportation sector accounts for approximately 70% of global crude oil consumption, a fossil fuel whose demand will likely to fall as the world decarbonises.10 As demand for crude oil begins to decline, an entire value chain of machinery products and services exposed to the crude oil industry will be disrupted, including products like huge pumps and off-highway vehicles used in oil and gas extraction to the machinery used to run large-scale refineries.
As customers in end markets (some of which are emissions-intensive sectors like power generation, properties, transportation) work to meet their corporate carbon reduction targets and/or to support national carbon commitments, the need for low carbon equipment fleet will grow. This puts the industrial capital goods sector in a unique position to be enablers of the low carbon transition and a key part of the solution to decarbonisation. Priorities for the product design of machineries and equipment will change to place more focus on qualities such as energy efficiency and recyclability.
Moreover, decarbonisation trends such as electrification opens up new market opportunities for the industrial capital goods sector. A report from CDP (previously known as the Carbon Disclosure Project) alluded that electrification is the biggest opportunity for the sector, with products linked to micro-grids and energy storage with greatest potential and expected to see fast growing end markets.11 For example, total demand for energy storage is expected to grow to 125GW by 2030, requiring investment of around $103 billion.12
Industrial capital goods companies are increasingly involved in clean technology solutions particularly in the renewables space. For example, wind turbine generators are one of Riyue Heavy Industry’s main products, with wind power contributing approximately 80% of its operating revenue.13 For solar power, companies such as LONGi Green Energy Technology manufacture mono-crystalline silicon wafers for photovoltaics panels.14
Looking ahead, the dynamics and demands of a ‘green’ economy will have direct impacts on industrial capital goods companies. Whilst companies need to examine their existing businesses and markets to assess the potential impacts of market pressures in the 2020s and beyond driving towards greener products and services, new business opportunities will certainly arise for new technologies and business models. It is estimated that there could be a US$12 trillion opportunity for industrial capital goods companies through to 2050.15
2 Boston Consulting Group, October 2020
3 Larsen & Toubro Limited Integrated Report, 2020
4 Techtronic Industries, 2020
5 PwC, February 2018
6 The World Economic Forum, February 2019
7 Boston Consulting Group, September 2015
8 Boston Consulting Group, September 2015
9 Boston Consulting Group, September 2015
10 Boston Consulting Group, September 2015
11 CDP, July 2018
12 Bloomberg New Energy Finance (BNEF), July 2018
13 Futubull, November 2021
14 LONGi Solar, November 2021
15 Boston Consulting Group, October 2020
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