Getting under the bonnet of ESG in autos: Investors should assess social components as well as green ones
Analyst Nesche Yazgan discusses the future of the car industry and how it could impact workers
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To date, almost all news articles pertaining to ESG issues in the autos industry have focused on the ‘E’ – driving the fight against climate change through the reduction of carbon emissions, amongst other things – but little attention has been paid to the social implications of pushing these environmental issues. The E, S and G components are all equally important, and it is essential to remain cognisant of the ramifications of promoting one over another.
Politicians have been able to avoid this discussion so far, because the industry has been benefiting from benign macroeconomic conditions, generating handsome profits to pay for the transition costs from internal combustion engine vehicles (ICE) to electric vehicles (EV).
But the cycle, which had already started weakening globally before Covid, is now firmly in recession - and car companies do not fare well in recessions. Historically, layoffs have been common practice and this time these companies may be forced to go way beyond that.
Point and case
Germany, one of the world’s main industrial hubs for auto manufacturing, is an interesting case study: the government clearly wants consumers to buy ‘green’ cars, with subsidies being pushed and targets set. But consumers have yet to embrace this idea - for various reasons, ranging from long distances being arguably more practical with a combustion engine, all the way through to the economics of driving a diesel. As a result, electric vehicles still make up just 4% of cars sold in Germany. Yes, there are incentives and this percentage has been increasing, but it is nowhere near sufficient to make EVs profitable and have a positive impact on the original equipment manufacturers (OEM) bottom-line.
Interestingly, though, when the automotive industry was plunged into crisis during Covid, the German government refused to limit incentives for new car sales only on EVs (not even hybrids were included), which means the industry hasn’t shown the type of recovery we had after the 2008 financial crisis. And given the weak economic outlook for the EU as we head into 2021, we wouldn’t be surprised to see increased restructuring in view of this cyclical outlook.
The transition to EV is commendable and, in our view, ICE is not sustainable in the long term, but the economic reality of this undertaking is far more complex than when the German government forced utility companies to abandon nuclear energy. The automotive industry is more cyclical and does not have the stable cash flows of utilities. It also has to accommodate greater demands on its balance sheet because of its fixed cost structure, its dependency on economic cycle, its high R&D and capex demands, and its elevated pension payments.
In the last five years alone, German OEMs increased their spending massively into new technologies, made possible thanks to good profitability. But what to do now the economic outlook is more difficult, profits are heading down and the government is discouraging consumers from buying the cash cow products that have been paying for these investments in transition technologies?
Under these circumstances, one wonders how much longer car companies will be able to avoid radical restructuring measures.
So what does this mean for ‘S’?
The answer to this question may be rooted in another question: How many parts make up a car? If we take a look at a standard combustion engine vehicle, it is made up of roughly 2,600 parts. Most of these parts come from suppliers and are assembled at OEM plants. For an electric vehicle, this number falls to around 600.
It’s easy to see that such a reduction in core components equates to a far smaller supply chain and a higher likelihood of more vertically integrated OEMs, in contrast to the outsourcing craze of the last 30-40 years. One well-known ICE is already showing how far this vertical integration can go, stretching from lithium mining to full assembly line.
But such integration and the shortening of supply chains is likely to cause a tectonic shift within the entrenched supplier universe of traditional OEMs, with significant impacts on mass employment. It is also clear that OEMs themselves will need far fewer workers to put together an EV vehicle than an ICE one.
With the prospect of significant layoffs ahead, one has to wonder how employee demographics at European OEMs will change. How many active employees will be supporting the existing retiree base of these companies, which have been some of Europe’s biggest mass industrial employers over the last decades? How disruptive will the powerful labour unions be in making this transition happen?
An industry that hasn’t seen a shakeup in its product line up for more than 100 years is now being asked to accomplish a major structural shift in less than a decade. We doubt all will be successful. We think it will be very costly and disruptive for business models. What we do not know is the consumer response to this product change and the extent to which government incentives will boost it. If consumers are slow to embrace new EV products, companies may struggle to generate enough cash flow to pay for the hefty R&D and capex demands as well as upcoming restructurings. In our opinion that would not be good for equity or for the credit stories of these companies.
That’s why we believe it is so vital to apply ESG analysis in its totality when looking at a particular sector. A company that looks good in terms of its E ambitions may run into trouble if it has a complex and inefficient business model, and that could cause significant problems on the S and G side, down the road.
Yes, the E aspect has become more measurable thanks to significant efforts in developing green financing frameworks including the EU Taxonomy. But ESG analysis is not just about the E dimension and it isn’t a black and white story: there is often a lot of grey that connects the E, the S and the G.
Nesche Yazgan is a Senior Corporate Analyst at BlueBay Asset Management