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Will Fashion Care About ESG if it Knows Investors Are Watching?

Fashion’s planet-polluting ways are getting a second look from its financiers, which are scrutinizing apparel and footwear companies’ environmental, social and corporate governance (ESG) activities—or lack thereof.

And the bottom line for fashion is that brands could see their credit take a tumble if they fail to clean up their act.

The sector’s impact on land, air and sea is well documented. Fashion belches out 8 percent of global greenhouse gas emissions, outweighing those of “all international flights and maritime shipping combined,” credit analysts at Moody’s Investors Service, led by Guillaume Leglise, wrote in a report published Wednesday, citing a survey from Quantis, an environmental impact assessor.

Fashion ranks No. 2 in industrial water consumption, behind only the water-guzzling agricultural sector. On the pollution front, dyeing and finishing textiles accounts 20 percent of total global waters sullied through commercial activity.

As if that’s not dire enough, emissions and pollutions are likely to worsen without urgent action. With emerging markets like India fueling new demand and greater consumption, fashion will almost inevitably exact a larger, more harmful toll on the Earth by the end of the decade, and could triple by 2050. The apparel industry could account for 25 percent of global carbon by 2050, according to the Ellen MacArthur Foundation, and if the status quo remains intact, the sector is “unlikely to comply with the 1.5 degree global warming limit set by the Paris Climate Change Agreement,” analysts wrote in the report, which examined the long-term sector challenges confronting European fashion retail and apparel firms.

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“Companies face increased public scrutiny about the industry’s environmental impact. Production practices put increasing strain on raw material resources, which will increase input costs in the longer term. In response, companies will invest to decarbonize their supply chains to reduce energy emissions and contain rising production costs,” Leglise said. “Small companies which were already suffering before the pandemic will struggle to adapt, while international brands with scale and stronger margins will fare better. European companies face more regulatory scrutiny for now.”

European nations have already taken steps to curb the sector’s impact. France adopted a law last year banning companies from destroying unsold clothing by 2023, a move that seems directed at headline-making actions by actors like Amazon and Burberry. In 2019, Germany introduced the Green Button certification mark to distinguish socially and ecologically produced textiles while the French government is mulling a mandatory tag affixed to garments outlining the eco impact of their production.

Moody’s analysts pointed out that investors in Europe aren’t the only ones keeping tabs on sustainability. U.S. investors are increasingly sizing up ESG commitments when making investment decisions. On the financial side, VF Corp. last year issued the first green bond in the fashion industry, while Burberry, Adidas and H&M are the first in Europe to issue sustainability bonds.

Fashion retailers and apparel firms will be forced to adapt their value chains towards a “reduce-reuse-recycle” model.

Companies that want to avoid reputational risk will prioritize responsible sourcing strategies, and gradually improve their sourcing transparency and social practices in their supply chains. However, while large international brands and luxury firms have the financial means to adapt versus their smaller peers, they also have more complex supply chains. And the complexities could result in greater risk because they are well-known brands with public sustainability targets.

Companies like Adidas, Ralph Lauren Corp., VF Corp., Levi Strauss & Co., H&M and Zara owner Inditex have already started to adopt circular business models. However, “input costs will increase as production practices put increasing strain on material resources,” effectively crimping profitability, at least for the short term.

Water is scarce in some cotton-producing countries like China and India. “Cotton prices recently rose to a near two-year high in part because of dry weather conditions in the U.S.,” analysts noted, adding that scientists “expect water consumption needs will exceed supply by 2030.” Furthermore, labor costs in Asia are on the rise, and climate changes is another risk. Rising sea levels threaten some of fashion’s biggest manufacturing locales, from China and Vietnam to Bangladesh and India. This could drive suppliers and laborers to relocate, disrupting production and possibly inflating costs.

Analysts said that some fashion firms are increasingly using power purchase agreements, or PPA, to support the energy transmission of their upstream operations in Asia. A consortium of international brands and retailers including Nike, PVH and H&M is pushing authorities to greenlight PPA. “By upgrading their facilities, suppliers can make significant savings, with some of these savings ultimately passed on to apparel firms,” they said. Firms like Nike, Burberry, Next, JD Sports, Marks & Spencer, H&M and Target could also look at developing renewable energy sourcing. Moody’s said some companies might be reluctant to invest in their supply chains because doing so could mean loss of sourcing flexibility since they’d be tied to specific manufacturers or countries.

Because the industry relies on a fragmented supply chains, apparel firms face responsible sourcing risks. Consumers are scrutinizing companies’ environmental footprint and the treatment of workers. And while a supply chain partner’s sustainability credentials rarely have a negative impact on credit consequences, companies in the spotlight face reputational risks that could prompt consumer boycotts. Boohoo, for one, was linked to domestic suppliers with poor labor practices akin to sweatshop-like conditions. “Retailers Next and Asos dropped Boohoo goods from their websites in response,” analysts said, which “shows that embracing responsible sourcing strategies is gaining importance in an industry with complex supply chains where subcontracting—often without the brand’s knowledge—is common practice.”

And as consumers become more environmentally and socially aware, they are driving new business models, such as renting or buying secondhand clothing. While apparel firms will need to strengthen investments in product quality and sustainable materials, companies in the fast fashion sector and mid-price and small discount firms with limited resources are likely most at risk from changing consumer habits.

Despite burgeoning interest in sustainability, its move to the mainstream “will be gradual,” analysts said. Younger generations are more willing to pay for sustainable products but their purchasing power remains limited. Until Gen Z and other young cohorts have the financial firepower to turn intent into action, affordability will remain a key driver of consumers’ purchasing decisions, even more so now as many lower paid workers’ disposable income had declined due to the pandemic.

The analysts also noted a rise in cyber risks for apparel companies, particularly as sales growth is rising from e-commerce, making customer data and analytics increasingly important. And retailers are at high risk for a cyber attack because of the vast amounts of payment and personal consumer data they collect. A KPMG study found that one-fifth of consumers said they would shop elsewhere after a data breach, while one-third would not buy from that retailer for an extended period.

“But data protection regulation is also increasing, and compliance breaches can tarnish a brand’s reputation or result in steep fines,” the report said. While European laws tend to be more stringent, any company using online and data analytics is vulnerable to data protection risks and potential cyberattacks.