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ESG Focus: Manufacturing Revolution, Devolution and Evolution

ESG Focus | Feb 12 2020

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

The global manufacturing industry stands on the brink of disruption as a perfect storm of digitisation, AI, robotics, and big data transforms industry. Add circularity and ESG to the mix, and it promises to be a wild ride.

-Sustainability is one of the central themes of the 4th Industrial Revolution
-Technology that drives efficiency should find strong ESG and regulatory support
-Disruptors and first-movers offer opportunities for ESG impact investors
-Sustainable suppliers to sustainable disruptors may attract best-in-class investors

By Sarah Mills

The manufacturing industry, one of the world’s largest economic engines, stands on the brink of disruption, as a perfect storm of digitisation, AI, robotics, sustainability considerations, and big data transforms industry.

Much has been made of the fourth industrial revolution, which is expected to roll out over the next 10-15 years. The world’s manufacturing giants are positioning for change, developing nations are seeking to carve out opportunities and investors are taking their marks.

But much less has been made of the sustainability issues in the manufacturing revolution and their impacts on investors.

BlackRock, the world’s largest fund manager with US$6trn of assets under management, recently announced it has integrated environmental, social and governance (ESG) decisions into its investment process.

Many investors decried the move, claiming ESG considerations were designed to make investors pay for the fourth industrial revolution. Others welcomed it as an organising principle heading into extremely turbulent times.

Regardless, sustainability is one of the central themes of the fourth industrial revolution in that: advanced technologies bring greater resource efficiency; the most efficient are likely to not only be the most profitable but to also attract ESG investment; and in that fourth industrial revolution will coincide with, and enable, a regulator-driven shift to a circular economy.

Of all the world’s impending technological disruption, disruption in manufacturing is likely to prove the most geopolitically sensitive (short of cyber security and possibly blockchain), and is likely to create instability in global financial markets for some time.

But it will also breed great opportunity in the areas of digital technology, artificial intelligence, robotics, cyber security and design.

Geopolitical tensions meanwhile, aided by advances in digital design, are likely to incentivise localising or onshoring of manufacturing, all of which conveniently dovetail with sustainability/ESG themes for investors by reducing  emissions.

Manufacturing giants place sustainability front and centre

Manufacturing giants Germany and China have been preparing for more than a decade to defend their positions in the new world order.

Both have made huge steps towards building renewable energy stocks, and both have moved to substantially reduce fossil fuel dependence.

The United States has made it clear that it no longer perceives China to be a developing nation, has embarked on a largely unsuccessful trade war, and presaged a commitment to onshoring more of its manufacturing.

India, meanwhile, stands to benefit from Sustainable Development Goal (SDG) subsidies aimed at increasing the sustainable productivity of developing countries; while Japan, South Korea and Italy have largely taken a wait-and-see stance.

Shift to local on-demand manufacturing has an ESG frame

One of the more interesting reports to cross the ESG desk last year was Citi’s “Factory of the Future”.

The Citi report declares: “… we are now on the cusp of a new era of productivity, driven by the declining cost of technology (data and components), a pending explosion in wireless connectivity potential for industrial devices, and developments in advanced manufacturing, including robotics. Manufacturing will become “on demand” where we can order single bespoke items in real time, at the cost of mass production.

“… instead of raw materials and inputs assembled in large factories to produce identical products in massive scale (i.e., minimising unit costs via economies of scale) and then distributed to the end users, the rise of ‘distributed manufacturing’ allows fabrication and mass customisation of products in closer proximity of its end-market, helping improve the utilisation of local materials, customise products to better suit the customer, shorten lead times, maximise flexibility, and minimise waste”.

So for investors, this may be the area in which having the jump on ESG flows may prove a benefit. As the competition heats up, attracting trillions of dollars in ESG investment and sustainability tax breaks may make or break many companies and countries. At the very least it is likely to be a good guide to future performance, the thermal coal industry being one example.

One of the key sustainability impacts will be the location of manufacturers closer to end-markets or supply chains aided by developments in digital design, and the resultant reduction in freight costs. This may attract ESG best-in-class investments in such projects, which may also benefit from sustainability tax subsidies, and subsidies for onshoring.

Last year, Chevron Phillips Chemical and Qatar Petroleum announced the construction of a US$8bn petrochemical plant next to a coal seam gas mine on the US west coast that produces ethylene, the building block for plastic. Given the weak gas price and gas surpluses, the plant is diverting the gas to produce super cheap virgin plastic which is then shipped out on a train line located on site, slashing transport emissions and costs.

It follows a similar $10bn deal in Texas. Both projects received up to $1bn in subsidies from the Trump government and, as plastic producers, it is conceivable they could initially receive a best-in-class ESG rating for their reduced CO2 profiles (although it would be likely short-lived and could just as easily be offset by regulatory penalties), despite producing a fossil-fuel-based planetary scourge. 

It’s early days yet and the above examples, while relatively small change, are just the opening gambits in the ESG game.

For example, it is conceivable that a smart manufacturing facility could be located next to the Chevron plastic plant and gas mine, producing plastic products that will receive ESG ratings, such as medical devices, or body parts for light-weight electrical vehicles and flying taxis, and building materials – products that will either reduce fossil fuel consumption, or be of benefit to humanity in some respect as defined by the United Nations’ (UN’s) Sustainable Development Goals (SDGs). 

Or, as the digital revolution gains pace, the plastic could be shipped straight to localised 3D manufacturers; or the plant could potentially be converted to a recycling plant. Much would depend on the future of plastic, but the flailing fossil fuel industry and plastics industries are already placing their bets.

Technology and sustainability

Technological advances will be central to the sustainable revolution. According to the UN:

“A key enabler of sustainable development in the coming years will be the digital revolution, constituted by ongoing advances in artificial intelligence, connectivity, digitisation of information, additive manufacturing, virtual reality, machine learning, blockchains, robotics, quantum computing and synthetic biology. The convergence of those new digital technologies could be explosive, with many winners and losers.

“The digital revolution is already reshaping work, leisure, behaviour, education and governance. In general, those contributions can raise labour, energy, resource and carbon productivity; reduce production costs; expand access to services; and may even dematerialise production.”

This article will briefly cover core elements of the fourth industrial revelation and its implications for manufacturing, and  it lays the foundation for a second article to come on relevant SDG goals, and the manufacturing focus in ESG funds.

Digitisation and big data: The World Economic Forum expects emerging technologies will replace as much of the material supply chain as possible with digital information.

5G-enabled factories will spawn a digital revolution in product development and research and development, which will slash risks and costs, and in which manufacturing will be devolved as digital computational design becomes the central driver of commerce.

Products will be designed and developed in a virtual environment, cutting years of development time, will be digitally encoded, and then that product code or digital blueprint will most likely be shipped to local factories close to end markets. The phrase used to describe this process is distributed manufacturing. The resulting rise in R&D resource efficiency and transport emissions will likely attract an ESG rating.

For example, Citi’s report estimates that development times for aircraft can fall from 6 years to 2.5 years using digital tools, and machine commissioning times can be cut by -25%.

It is these type of savings that will allow consumers to access bespoke products at mass produced prices, which in turn will drive greater consumer demand and hasten the transformation of manufacturing.

Sustainability: From a sustainability perspective, manufacturing factories are expected to devolve into smaller factories located near population centres, reducing carbon footprints, while producing a wider range of more individualised products, through flexible, local, on-demand supply chains. 

Citi says these new factories will be easily integrated into human environments and become as common as cars or phones – suggesting they may become a mass market in and unto themselves.

The analyst expects these purpose-specific factories, aided by technological advances, should cut inventories and transport times, diversifiy the supplier base, optimise industry capacity and lower fixed assets; while differentiating the experience for the end customer and reducing consumer costs.

Zero-waste manufacturing, a combination of energy efficiency and circular manufacturing, will be a key trend that will likely find support from ESG investors.

It is expected that circular manufacturing, again enabled by technological advances, will unlock the trillion-dollar value of the waste market, reducing costs and emissions. Closed Loop Partners research found that US$2trn in annual US revenues could be generated from circular manufacturing and greenhouse emissions reduced by 500m tons of CO2 equivalent.. Accenture Strategy puts the potential economic growth from maximum resource useage at US$4.5trn by 2030, and as much as US$25trn by 2050. The Ellen MacArthur foundation found US$120bn in lost productivity in plastic waste alone.

It is also expected that there might be some changes to built-in-obsolescence. Fewer, better quality, bespoke products might deal with a large degree of fashion industry-related obsolescence, while government regulation and recycling through the implementation of circular manufacturing may redress much of the balance.

According to Forbes, engineering teams will be able to tune hardware obsolescence with precision thanks to advanced analytics using machine learning on top of petabytes of sensor data.

“As new regulations appear across the globe, and embedded software spreads across connected devices, the commercial strategy of planned obsolescence will increasingly inherit a governance paradigm. This will particularly be the case in single-use medical devices,” says Forbes.

In 2017, the EU parliament approved a resolution to ensure a longer lifetime for products and proposed fiscal incentives for products based on quality, durability and ease of repair.

France has enacted fines of up to EUR300,000 and prison terms of two years for manufacturers who plan for devices to stop functioning after a time.

ISSOP is a mark awarded by Spain’s Foundation for Energy and Sustainable Innovation without Planned Obsolescence, certifying environmentally respectful goods and services, without planned obsolescence, preferably by fair trade, contributing to emissions reduction and correct waste management.

All of this suggests a likely growth in the after-market for parts, and easily replaceable components (replaceable by the user rather than a specialist, further cutting emissions) – again a good market for highly accurate digital design.

There will also be an increased focus on data and water resource usage. A McKinsey study with the Ellen MacArthur Foundation estimated that this will save US$630bn a year by 2025 in the EU manufacturing sector alone.

Robotics and AI: The devolution and increased efficiency of manufacturing will also be enabled by developments in robotics.

The Citi report says the development of relatively autonomous multi-tasking robots that work with people through a combination of augmented reality and "cobots" (collaborative robots) and artificial intelligence, will allow more than one product to be produced in a factory, potentially reducing emissions.

The only limits will be on the types of products produced. For example, a plastics factory can only produce plastic products.

A new generation of more flexible soft and "origami robots" (made from a single sheet of material) will also be able to complete a broader range of functions. For example, scientists have just developed a robot hand that can sweat. This will have help prevent machines from overheating.

In January, a research team of roboticists and scientists produced the world’s first “living robots” from stem cells – a new life form dubbed a "xenobot". It has been described as a new class of artefact: a living programmable organism”. The mind boggles. The robots of tomorrow, will be dexterous, nimble, flexible and adaptable.

Prices for robots are plummeting and are expected to continue to fall. Citi estimates the cost of operation for an advanced robot will be as low as $4 an hour in the near future. This will again allow for higher quality, more durable products to be supplied to consumers for lower cost, attracting ESG interest.

Robotics will be interesting from an ESG perspective given they also represent the most obvious means of replacing low to mid-skilled labour, and the UN’s sustainable development goals (SDGs) which largely guide ESG investment, take a strong stance on labour. It is estimated that 40% of United States jobs will be at risk of automation by 2030.

The disruptors – opportunities for ESG investors.

Digitisation will spawn a plethora of platforms, software, systems and processes that will disrupt the industry given manufacturers persistent search for shorter development lead times, cheaper production costs and reduced inventories. 

Vertical software, owners and interpreters of data, suppliers of advanced manufacturing systems, suppliers of connectivity, 5G and infrastructure, the Internet of Things market, robotics and blockchain, cyber security, and data-managed services, are all on the list, and are likely to offer fertile ground for ESG impact investors and start-up investors. Many sectors are expected to post compound annual growth rates of up to 60% out to 2025.

Strong demand is tipped for supporting industries. Plastic, silicone, paper and food compounds, connectors and sensors will be keenly sought and offer opportunities for best-in-class ESG investors, given manufacturers will be honing the circularity and efficiency of their supply chains.

On the flip-side are the disruptees

The manufacturing industry is preparing for profound disruption on nearly every front. The automotive industry is not only dealing with the advent of electronic vehicles and digitisation, but the challenges of a circular economy. Ditto for the plastics industry and regulation. The fashion industry will face challenges on the labour front and from the growing availability of bespoke manufacturing. 

Battle grounds will likely emerge between traditional industrial automation suppliers and technology companies as the old-tech/new-tech divide widens.

The tech industry, while primarily a disruptor, will also face challenges, particular in manufacturing, arising from e-waste. E-waste initiatives will be in strong demand as governments crack down on the sector.

Sovereign nations will also prove victims to disruption. As robots replace labour, then opportunities for labour arbitrage disappear, encouraging onshoring of operations closer to end markets and earning the favour of regulators and ESG investors. Some may respond by nationalising key assets.

Many companies have already moved factories outside of China in response to the US trade war, although so far at no detriment to the Chinese market, according to Michael West News. Initially Asian countries will still benefit from cheap labour but this will slowly erode as more productive robots roll out.

Supply chains will also be disrupted. Freight, transport, raw materials, labour, will likely be turned on their head, and the first movers with superior platforms are likely to have the edge. They will also be facing their own sustainability compliance and ESG investing issues.

It’s early days yet and developments over the next five years will likely point the way ahead. Expect the pace to escalate from 2025. By 2030, it should be full throttle.

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