The European apparel sector's environmental exposure is becoming increasingly visible. Waste management, carbon emissions, circularity, and physical climate risk are at the core of a sector largely fueled by larger volumes and ever lower prices.

Why it matters:  Exposure to new environmental taxes, regulations, or supply chain issues could disrupt apparel companies' plans for growth and profitability, in a sector that has been generally slow to prepare for it.

What we think and why:  Because environmental risks for the sector remain largely unpriced, they have so far not weighed materially on our credit ratings. Should these risks become financially more material, fast-fashion players could be most exposed. We foresee increasing regulatory scrutiny, notably regarding waste, albeit in the distant future. We also believe physical climate risks can increasingly affect the industry's supply chains.

Apparel's Environmental Exposure Is Multifaceted

The apparel sector has seen several big changes in the past few decades, from fast fashion to internet sales, and now ultra-fast fashion. Consumers have broadly adopted these new economic models, buying more and fueling revenue growth. But these developments have come at the cost of environmentally damaging externalities up and down the value chain. And the industry has so far made little progress in addressing and pricing in these negative impacts.

With governments and consumers paying increasing attention to environmental matters, are we getting any closer to a turning point?

The apparel industry's environmental footprint is significant.  Negative effects are felt during each phase of its long and complex value chain, in different ways and intensities. The most material impacts stem from the sector's high energy, water, and chemical use during textile production. There are also increasingly visible waste and pollution impacts from the garment-use and end-of-life stages (see table 1).

Table 1

The industry is responsible for a sizeable portion of greenhouse gas emissions.   According to consulting firm McKinsey in a 2020 report, the sector generates about 4% of global greenhouse gas emissions across its value chain, including through raw material processing, garment manufacturing, and garment care and disposal. Other studies, such as one in 2018 by environmental consultancy Quantis, suggest this number could be twice as high, at about 8%. Yet the absence of global carbon pricing means the sector often falls out of scope of any carbon tax.

Textile production is linked to about 20% of global clean water pollution, particularly from dyeing and treating fabrics.   This is according to reports by the Ellen Macarthur Foundation, and textile production also accounts for 4% of global freshwater withdrawals annually (particularly from cotton cultivation). The pollution from upstream operations mainly takes place in jurisdictions with relatively looser environmental regulations than in Western Europe, and are thus less exposed to litigation or compliance risks.

Polyester-based textiles, a rapidly expanding segment that has notably reduced costs and boosted sales of sportswear, are a key contributor to microplastics pollution.   This segment results in 8% of the microplastics that end up in the environment globally, according to the UN. Microplastics (particles of plastic less than 5 millimeters in size) are widely regarded as an increasing threat to the environment and human health. Yet knowledge of ecological and health risks from microplastic pollution remains shrouded in uncertainty. As a result, the sector has so far not faced any material financial risks related to its polyester usage.

More than 90% of used clothes end up in landfills or are incinerated because the apparel industry's recycling ecosystem is still nascent.  Globally, only 5%-10% of used clothes are recycled into new garments. According to Global Fashion Agenda, per capita fashion waste is about 17.5 kilograms annually and is expected to increase by about 60% between 2015 and 2030. This situation has recently drawn greater attention from regulatory bodies and consumers, due to the creation of massive landfills, notably in lower-income countries, or direct pollution of oceans. Solutions to address the issue are complex and likely expensive, and would take time to scale up. Regulatory incentives to change consumers' buying habits have so far had a minimal impact.

Exposure Is Also Often Understated And Will Mount As Growth Continues

Major apparel companies' average revenue increases have materially exceeded the GDP growth rates in countries where they operate (see chart 1). Sales volumes are expected to rise further in developing and emerging markets, deepening the industry's environmental challenges and adding to its multilayered environmental footprint. S&P Global Ratings believes this situation will increasingly urge the sector to find solutions.

Chart 1

Clothing supply chains are not immune to physical climate risk.  Most apparel production happens in countries highly exposed to physical climate risks (see table 2 and charts 2 and 3), such as India, Bangladesh, Pakistan, and Vietnam (see "Lost GDP: Potential Impacts Of Physical Climate Risks," published Nov. 27, 2023). These countries are already exposed to cyclones and typhoons, heatwaves, and flooding, and climate scenarios show that such events are likely to increase in frequency and severity. Production yields may also drop because of rising temperatures in some key locations. Apparel producers can opt to move their operations to still-cheap but less-at-risk locations, although industry ecosystems in those countries may be less developed (in some parts of Africa for instance).

Table 2

Volumes-Based Business Models Are Here To Stay, And Expanding

The share of disposable income spent on clothes during the last 60 years has remained stable or decreased, but the volume consumed has increased markedly. Fast-fashion and value retailers have transformed apparel supply chains. Compared with traditional clothing companies, they offer a different and much cheaper price proposition to consumers. Thanks to declining transportation costs and suppliers in low-income countries, they can also offer greater volumes to western consumers at comparatively lower cost.

Europe's established clothing brands have shifted their business models to adapt to the increasing competition.   Before the expansion of fast-fashion business models in the 1990s, established brands tended to rely on local garment producers and a network of independent retail chains, which came with a high price per item. They have since been increasingly seeking cheaper alternatives and replicating the models of early fast-fashion adopters, notably H&M and Inditex. This trend is further fueling the growth of textile waste, water consumption, and greenhouse gas emissions.

The business model of the accessible luxury segment, which has emerged over the past 10 years, is broadly similar to that of fast fashion and value retailers.   A sizeable proportion of the supplier base, for instance, is located in low-income countries with low environmental standards; and this segment's earnings also rely on volume growth. A notable exception is high-end apparel retailers, who maintain their focus on durable, high-quality products. As a result, the apparel industry comprises different operating models and profit-and-loss structures (see chart 4).

Chart 4

We see sizeable growth avenues for volume-based apparel business models, since consumers are still receptive to their value proposition.   This implies further pressures on the environment, but underpins overall resilient credit ratings in the sector. For example, in developed markets, fast-fashion brands release multiple collections per year (more than 20 for Inditex and 15 to 16 for H&M) to meet demand. Consumers' increasing environmental awareness has not appeared to affect their shopping behavior. Rising fast-fashion sales volumes and constant closet sizes indicate that clothes are given away or, more likely, thrown away, becoming waste in the current ecosystem.

We also anticipate significant growth for fast-fashion retailers in developing economies that will likely fuel earnings and ultimately support credit quality.  These economies include China, Indonesia, and India. The popularity of business models such as Shein's, which offers very low price points and constantly changing collections, demonstrates that demand for mass-market apparel remains high.

Market Players Think Circular Principles Could Limit Apparel's Environmental Impact

The Ellen MacArthur Foundation describes a circular economy as a shift away from the current take-make-dispose model toward a system in which waste and pollution are designed out, products and materials are kept in use, and natural systems are regenerated. With regards to the apparel industry, a typical garment would be designed to retain its highest value during its use, and then collected and re-circulated into the economy with no waste generated. According to the foundation's 2019 report "A New Textiles Economy: Redesigning fashion's future," this would involve:

• Phasing out using substances that may harm the environment, including those that shed microfibers (which would address chemical pollution and microplastics) in favor of safer, healthier materials;
• Increasing clothing use, for example, by designing and producing garments of higher quality and greater durability and providing access to garments via new business models such as clothing rental;
• Substantially improving recycling by aligning clothing design with recycling processes and advancing recycling technology; and
• Using resources more effectively, shifting to renewable inputs. This involves a large reduction of raw material inputs and, where using virgin materials is unavoidable, sourcing from renewable and regenerative sources.

We have used these principles to define circularity in this report.

Circularity Seems At Odds With Current Business Models

The earnings growth strategies of fast-fashion companies almost always rely on incremental growth of marginal profit, that is, on each additional unit sold. This implies a constant increase in volumes, entailing additional production that exacerbates environmental issues. One of the most environmentally friendly solutions could be to reduce volumes, but we believe that is also the most unlikely.

To address the exponential growth of textile waste, while adhering to their key business features, some industry players argue that volumes can increase as long as more efficient recycling practices are pursued as part of a circular-economy strategy. Ideally, each piece of clothing no longer in use would be collected and recycled into new clothes. H&M, for instance, has publicly committed to doubling sales by 2030 (from reported 2021 figures) while also becoming more circular.

Beyond the current lack of regulatory or consumer incentives, we see significant hurdles to achieving circularity in the apparel industry, namely:

Unclear strategies.   Conceptually, circular economy principles involve a closed-loop system that greatly reduces production volumes. A sustainable model that also limits land and water use, as well as greenhouse gas emissions, could notably require consumers to have fewer clothes and use them for longer. These requirements contradict the business pillars on which the industry is founded, in particular, constant volume growth.

Lack of know-how and the slow pace of innovation across the supply chain.   Some retailers we rate say the industry lacks knowledge about separating fibers in blended items, the first step to recycling. Some technologies involving chemicals to separate blended fabrics are being developed but remain expensive and difficult to scale up. Although single-fiber garments would facilitate the recycling process, mixed fabrics offer certain practical characteristics that better align with consumers' clothing quality and longevity preferences, in particular for sportswear.

Limited recycling potential of certain fabrics.   Cotton is the apparel sector's second-most used material. It can be recycled once or twice, but the quality deteriorates rapidly, so new production is needed. This adds to the amount of waste. The same applies to polyester, the sector's most used material, to a lesser extent. Polyester is cheaper than cotton (see chart 5 and chart 6), hence its popularity, but it also creates an unaddressed microplastics problem during the washing process. According to apparel companies, polyester recycling does not seem to be a suitable answer to the sector's broader environmental issues.

Chart 5

Chart 6

No efficient or economically viable garment recycling system.  In our view, this is because the reuse or second-hand value of a garment is minimal, considering the item's initial very low market value in some cases, notably for fast-fashion products. A recycling ecosystem would require large investments that industry players appear to have no incentive to make, currently.

Recycled polyester being turned into clothes waste.   The share of recycled materials, notably polyester, typically increases in large apparel retailers' products. But some recycled polyester is from other sources of polyester, usually recycled plastic bottles. In some ways, this is counterproductive from an environmental standpoint. Instead of recycled plastic bottles being turned into new plastic bottles, the material ends up in a less efficient system, namely in clothes that are not being collected and are harder to recycle. In short, circularity breaks down.

Labor intensity of recycling clothing.   Some aspects of the textile industry are difficult to automate because textiles are highly deformable, so humans play a critical role in production. Labor costs therefore make the economics of circularity difficult to reconcile with low-cost apparel. The collection and treatment of used clothes would most likely happen in countries where the garments are consumed, and where labor costs are typically higher (such as developed markets). Even in a scenario of reshipping garments to low-cost countries, transport costs would increase, diluting the environmental benefit of recycling.

The design of clothing is only just starting to incorporate recycling potential.   For now, most clothes are not designed for recycling and therefore have no reusable value for retailers. This means the collection of garments no longer in use remains a drag on companies' earnings.

In conclusion, we are yet to see a credible, quantified business plan that reconciles the apparel industry's environmental goals and broader sustainability principles with prevailing volume-led business models. Few retailers have measured the financial impact of meeting overall environmental commitments, or have clearly framed what this could entail for their business should they meet their objectives.

The Biggest Challenges For Credit Quality Lie Ahead

Environmental risk management has so far had no tangible impact on European apparel companies' earnings (see chart 7). Measures to tackle these risks have generally been insufficient to trigger a material change in our credit metrics, since they had a limited impact on revenue, profitability, or investments. In addition, to our knowledge, access to external financing has not been materially affected by environmental considerations. As a result, the visibility and credit materiality of environmental risks remain limited for now. Other factors such as foreign exchange risk, supply chain disruptions, fashion risks, weather conditions for end consumers, and consumer sentiment still have a more prominent impact on earnings.

Chart 7

Reducing direct and indirect emissions is within reach but, for scope 3, the way forward is more complex and costs more difficult to quantify.   Most of the apparel companies we rate have aligned their targets with the Science-Based Targets initiative and adopted the Fashion Industry Charter for Climate Action. This implies they aim to achieve net zero emissions by 2050, including scope 3 emissions, which notably covers production (upstream) and waste management (downstream) and is the retail industry's most pressing challenge. Reducing scopes 1 and 2 appears more achievable, since emissions linked to garment distribution and sales are not typically significant, and we expect the associated financial costs to be manageable as well, with little effect on credit quality.

Fast-fashion businesses such as H&M, Next, Primark, and Decathlon have steadily decreased their scope 1 and 2 emissions without compromising financial performance (see table 3).  However, their scope 3 emissions have risen in most instances and from a much larger base. This is because greenhouse gas emissions associated with producing cotton and polyester, and garment manufacturing, are significant and difficult to control. And some countries where cotton is produced (for example Pakistan), or where garments are made (such as Bangladesh), have not yet invested materially in the transition from fossil fuels to low-carbon energy. Furthermore, suppliers' thin operating margins and economic vulnerability make large transformative investments, in boilers in particular, and access to fresh capital difficult. We understand the supply chain's flexibility, which allows retailers to rapidly shift from one supplier to another, makes it difficult for suppliers to count on long-term financial support for their energy transition.

We also believe that if apparel retailers were to change their supplier base to countries with more renewable energy, this would likely increase labor and production costs and lead to a different value proposition. How companies will meet net-zero scope 3 commitments without a step change in their price point remains unclear to us. That said, pressure from stakeholders to meet this target appears low at present, so we don't perceive a material financial burden stemming from companies' decarbonization plans.

Table 3

Waste management is not yet a central focus of companies' sustainability strategies.   In our view, this is because there are few, if any, meaningful incentives for companies to do so at this stage, although changes are in the making. It is also unclear whether, if waste from the apparel industry were to fall under stricter regulation, the responsibility of managing negative externalities would fall on apparel retailers. If that were to be the case, it could have implications for companies' business models, since it would translate into sizeable investments and, potentially, changes to the supplier base. Despite its increasing environmental importance, waste is unlikely to disrupt the apparel industry soon. This is because preliminary regulation projects on waste don't appear to price in externalities to a point that would change the industry's fundamentals, and we understand the responsibility to tackle this issue would not fall on retailers directly.

Retailers are making progress on sustainable sourcing, though much still needs to be done.   Most of the listed apparel companies have committed to fostering the development of more sustainable business models (see chart 8). H&M, Primark, and Next have measured their intake of sustainably sourced materials. But their definitions vary, and the data are difficult to interpret and compare. We observe though that sustainable and organic cotton production has increased substantially around the globe, consistent with these companies' efforts (see chart 9).

Chart 8

Chart 9

That said, many retailers try to abide by Better Cotton Initiative's (BCI's) requirements for better environmental and social farming practices. But even under BCI standards, water consumption and average greenhouse gas emissions remain significant. This points to the difficulty in finding a truly sustainable material likely to replace cotton or polyester at scale and with similar cost features (see chart 10).

Chart 10

Regulations Are Only Slowly Tightening So Not Yet Hampering Results

We believe regulation could be key to changing the behavior of clothing companies and consumers. Yet the various current European regulatory frameworks have not reduced the apparel industry's sector's environmental footprint or curbed its volume-led nature. Equally important is that they have not resulted in any material additional financial costs for the sector.

No carbon tax applies to European apparel companies.   The sector is not directly exposed to a carbon tax and the EU has no plans to extend its emissions trading system to apparels. This is mainly because most of the sector's emissions are scope 3, which are more difficult to standardize and properly quantify. Investors' focus remains largely on decarbonization, and apparel companies are increasingly communicating their net-zero strategies. However, we believe regulatory pressure--such as sectorwide decarbonization targets--will remain manageable for the sector from a credit-risk standpoint.

Due diligence obligations are becoming stricter but seem manageable.   Similarly, regulatory initiatives to improve the supply chain's environmental impact have so far not had any material credit implications. The EU aims notably to make the industry more circular and encourage companies to better manage downstream waste, which may eventually lead to stricter regulations. The European Commission's Corporate Sustainability Due Diligence Directive (CSDDD), if adopted, is likely to set obligations for apparel companies operating in the EU.

Under the proposed CSDDD, companies will be responsible for human rights abuses and environmental harm throughout their global value chains. All the apparel companies we rate will also need to adopt a transition plan to limit greenhouse gas emissions in line with the EU's objective of limiting global warming to 1.5 degrees Celsius by 2050. We understand that, failing to comply with the CSDDD could expose companies to litigation and associated fines. Likewise, making unsubstantiated claims about eco-friendly products or not having a clear road map and strategy to achieve net zero emissions, including scope 3, could be seen as misleading consumers and investors, adding to potential litigation risks. But the CSDDD has not yet been adopted (and member states would have two years to transpose it once adopted), unlike the Corporate Sustainability Reporting Directive. Consequently, the CSDDD has not yet had financially material consequences for companies.

The impact of a proposed waste framework directive is likely to be financially immaterial.   Notably, the proposal calls for new requirements for the ecological design of garments that facilitates easier recycling. It also features an Extended Producer Responsibility (EPR) scheme that should foster the development of a system to collect and reuse textile waste. The proposed directive aims to clarify the definitions of "reuse", "waste", and "circularity" to limit the inappropriate use of circular concepts in companies' sustainability reports. The EPR will introduce a polluter-pays model, under which clothing producers and distributors pay a fee per garment to a dedicated body, which in turn is responsible for managing those garments at the end of their life, coordinating with all key stakeholders.

Preliminary assessments by the European Commission would not translate into profound disruptions, in our view. This is because the cost per item under such an EPR scheme would be low (typically lower than one €1 per item), therefore translating into limited incentive to consume less, since we would expect the increased cost to be transferred to the consumer. For a similar reason, although some countries, such as France, already have an EPR scheme, results have been mixed. The industry can easily absorb the fee and continue to expand its volumes. This appears to contradict the sustainability principle that resources are finite in nature.

Climate And Regulation Could Increasingly Influence Credit Quality

A rise in environmental risks could come from several quarters. Worsening physical climate risks have already made the apparel industry's earnings base more volatile, often via supply-chain disruptions. Unseasonal weather, while less extreme, has resulted in missed sales targets and led to overstocking and high discounts that pressure earnings and cash flows. The regularity and severity of such weather events are likely to increase and require companies to adapt faster. In addition, although the majority of consumers remain sensitive to prices, this could change over time. These factors cast a shadow over apparel companies' prospects in the long term, unless they adjust their strategies.

What's more, the future role of regulation remains uncertain. The regulatory environment doesn't appear to be moving toward big changes, like directly pricing carbon emissions. Yet we cannot rule out an unforeseen development that could radically alter our current assumptions for the industry.

Related Research

• Lost GDP: Potential Impacts Of Physical Climate Risks, Nov. 27, 2023
• The Credit Impact Of Water Risk, Oct. 30, 2018

External Research

• Report 1: Fashion's Climate Breakdown and its Effect for Workers, September 2023
• Preferred Fiber & Materials Market Report, October 2022
• Measuring Fashion: Insights from the Environmental Impact of the Global Apparel and Footwear Industries study, 2018, Quantis
• Circular Economy — Challenges for the Textile and Clothing Industry, Malgorzata Koszewska, 2018
• Ellen MacArthur Foundation, A new textiles economy: Redesigning fashion's future, 2017