Melrose Industries — Accelerating sustainability

This review focuses on the sustainability agenda, performance and opportunities at Melrose. The report is broken down into two sections: i) internal performance focusing on internal achievements against environmental, social and governance metrics and targets; and ii) environmental-led opportunities focusing on the decarbonisation opportunities the group is pursuing. The latest Edison financial review was released on 12 April.

The key to Melrose’s internal sustainability performance is GKN (97% of sales ex JVs in 2021), which was acquired in 2018. Given the group strategy to ‘buy, improve, sell’, improving its sustainability performance, both internally and externally, can potentially influence value as well as an ESG impact.

Internally the agenda has been developing in recent years both in terms of depth of measurement and in ambition, with key targets being set in 2021. In 2021 the group made progress in seven of the 10 sustainability metrics reviewed (two others could not be adjusted for disposals, and employee diversity was unchanged), albeit this was overshadowed by a tragic fatality in the aerospace division. These metrics were broadly in line with peers (five above and five below), as highlighted in Exhibit 1, albeit disclosure from peers is generally less granular. Key target initiatives set in 2021 include a 20% reduction in Scope 1 and 2 emissions intensity by 2025 from 2021 levels, 50% of electricity from renewable sources by 2025, less than 5% of waste to landfill by 2025 (zero by 2030) and lost time accident rate less than 0.1 (accidents per 200,000 hours). Achieving these targets should assist in promoting the group’s sustainability ratings.

External opportunities provide the greatest potential impact to the environment given GKN’s exposure to carbon intensive sectors including automotive (60%) and aerospace (34%), seen as a ‘hard to abate’ sectors. Continuous improvement of the current portfolio provides incremental efficiency benefits and therefore carbon reduction. The group also has an exciting portfolio of new products aimed at decarbonisation that have been supported by £153m invested in carbon reduction product development in 2021. EV powertrain opportunities are current/near-term, some, such as hydrogen storage or electric aerospace, are nearing commercialisation, while others, such as hydrogen powered aircraft, are rather more in the development stage.

This section reviews the key internal sustainability metrics and targets and compares performance to peers where possible; note disclosure from some peers is more limited. We have not provided an overall rating but have included the Melrose score from key ESG ratings agencies.

Melrose achieved a 14% reduction in absolute emissions and 6% in energy consumption in 2021 through a combination of underlying improvements and disposals. In 2021 the group invested c £10m on LED lighting retrofits, more efficient heating, ventilation and air conditioning (HVAC), renewable energy installations, insulation improvements and energy efficient equipment to improve energy consumption and lower its carbon footprint. Exhibits 2 and 3 show its performance since 2019, which was the first year to include GKN, acquired in 2018. 2020 usage declined due to COVID-19, while 2021 declines were largely due to the impact of disposals in the year, which are excluded. Adjusted for the disposals we estimate that emissions intensity (tonnes CO₂ per £m of sales), which increased on a headline basis, would have declined by 3%. Note that the figures are dominated by businesses acquired as part of the ‘buy, improve, sell’ strategy given the small size of Melrose’s core operations, primarily from the central head office which has been carbon neutral for the last three years.

At the end of 2021, 112 sites (74%) were certified to ISO 14001 standard (environmental management systems), and 28 sites (18%) had achieved ISO 50001 (energy management) certification.

Emissions intensity offers the best cross peer comparison, albeit different types of manufacturing (for example melting metal versus component assembly) will have different energy requirements. Melrose’s 2021 headline emissions intensity increased and is now above the peer average. This partially reflects the impact of disposals, albeit even adjusting for these our estimated 3% underlying improvement is behind the peer average of 8% in the year.

The group reported Scope 3 emissions (upstream and downstream emissions that occur in the company's value chain) for the first time in 2021. At 78,835 tonnes of CO₂ equivalent (tCO₂e) emissions, this included business travel, fuel-related well-to-tank, electricity transmission and distribution losses, and water supply, suggesting coverage of four of the 15 potential categories under the Greenhouse Gas Protocol. Given the high in-use emissions figures in aerospace and automotive, discussed in more detail later in this document, we would expect full Scope 3 disclosure to increase significantly. Note the company has committed to greater engagement with suppliers in 2022 to better understand its Scope 3 footprint.

Melrose has set out its emissions targets:

The renewable target appears challenging given that only 1.5% of electricity was generated from renewables in 2021 (up from 0.4% in 2020). Given the increasing cost parity between renewables and carbon intensive electricity, management intend to enter agreements to purchase renewable power where available. The emissions intensity target will require c 5% improvement a year, which compares to Edison’s estimate of a 3% reduction achieved in 2021. These targets appear closely aligned with the Paris 1.5% annual reduction requirement of 4.2% according to the Science Based Targets initiative (SBTi), although the renewables element is below their 80% 2025 threshold. Note these targets have not been submitted to the SBTi, which would also require further Scope 3 disclosure and analysis.

Exhibit 5 highlights the range of targets set by peer companies, including commitments to SBTi (note ‘committed’ under the SBTi is the first stage of registering to set a target).

Finally note that Melrose provides a comprehensive analysis of emissions and energy consumption by type, offering far greater granularity than peers.

The group generated 162,000 tonnes of waste in 2021, an increase of 8%, ahead of the 2% organic top-line growth before accounting for the impact of disposals (historical information required to provide adjustments is not available). Intensity increased to 23.6 tonnes per million pounds. GKN operations entail high levels of cutting and grinding, leading to significant amounts of swarf and therefore higher amounts of scrap. Hence the importance of waste treatment. Recycling increased to 87% (from 81%, predominantly in house) while landfill reduced 41% to 9,175 tonnes or 5.7% of all waste.

Melrose’s stated landfill target is 5% of total waste by 2025 and zero landfill by 2030. It does not currently have a stated recycling or overall waste reduction target.

Peer comparison depends significantly on actual processes (assembly generally having lower waste than manufacturing). Exhibit 7 provides a view of waste intensity versus recycling, albeit many companies are yet to fully disclose such information. The preferred space in the chart is the bottom right quartile (as minimum waste, maximum recycling as a company’s processes will permit).

Total water usage has been declining but the intensity has been increasing. Key reasons behind this include increased measurement, moving from 80% of sites reporting in 2019 to 100% in 2021, reduced activity due to the pandemic and the impact from disposals made in 2021, which were less water intense (historical figures on disposed companies are not available). In 2021 Melrose assessed that 20% of sites are located in areas of ‘extremely high’ baseline water stress and a further 15% located in areas of ‘high’ baseline water stress. Details of actions to reduce stress in these regions are expected going forward. Note management intends to report water usage to CDP in 2022 and develop group-wide reduction targets. This should assist with the somewhat limited disclosure in certain areas such as water recycling.

While emissions are a key focus for sustainability for many companies, the shift to a circular economy is also gaining increasing attention. In this respect, 88% of Melrose products by sales are recyclable (own internal survey covered 49% of sales) and 60% of input materials were from recycled or remanufactured content (survey covered 63% of group sales).

2021 saw positive continuous improvement in the key metrics, but this was overshadowed by a fatal incident at the group’s Aerospace division site in Papendrecht, the Netherlands. Excluding this tragic event, good progress has been made in recent years with lost time accidents at 0.06 per 200,000 hours (equivalent to approximately one per 1,600 employees in the year), within management’s target of below 0.1. Exhibit 10 puts Melrose at the top end of peers for lost time accidents in 2021 (a number of companies still do not report) or in line with the average looking at Melrose’s average since the acquisition of GKN.

Part of the programme for safety is driven by ISO 45001 (occupational health & safety). 74% of sites (inclusive of office, production and testing sites) within the group were certified at the end of 2021, including 100% of GKN Automotive production sites and test centres.

Employee voluntary attrition was 9% in 2021. This puts Melrose in the mid-range of peers (50% of peers reporting) at 2% to 26% - lower in Japan/South Korea and higher in North America. With limited standards and comparables, key is the decline from 10% the previous year. In terms of training, Melrose’s average is 23 hours per employee, up from 13 hours and the highest in its peer group (35% reporting). Melrose training spend per employee was £209 up from £166. Melrose has a £10m five-year skills fund focused on training in the UK.

Overall group employee diversity remains at only 20% women, arguably reflecting the heavy manufacturing nature of the business and puts Melrose in the mid-tier of peers (average 19.5%). Diversity increased at the executive committee level to 36% from 35%. Melrose does not provide an ethnicity or age breakdown of employees.

Board diversity has risen to 42% women at December 2021 from 30% in 2020, operating above the Hampton-Alexander Review target of 33%, and has one director from an ethnic minority background in line with the Parker Review.

Prior to acquisition, GKN had a significant pension deficit issue. Melrose made commitments of ‘up to £1 billion’ of additional funding on acquisition. By the end of 2021 Melrose had made £0.35bn of additional cash contributions while internal performance and other measures had added a further £0.75bn. As a consequence, funding levels have risen from 78% to 107% with the GKN 2016 scheme risk profile further reduced through a buyout with a major insurer. The trustee approval to halve the annual funding to £30m a year further highlights the improved position.

Melrose’s executive pay is orientated towards a long-term incentive scheme linked directly to shareholder value creation, with executive directors’ salaries and bonus opportunity being deliberately pegged below peers. The current long-term incentive scheme is due to crystallise on 31 May 2023. Melrose’s pay structure has received strong shareholder support, most recently at the AGM on 5 May 2022 when the director’s remuneration report (DRR) received over 97% approval. In 2021, the CEO’s salary increased by 12.4%. However, this partly reflected the pandemic reductions undertaken in 2020 and a more meaningful measure is the 6% (3% pa) increase from the 2019 level. At £551k, this is well below the peer group average: 2020 UK 31 to 100 industrial, manufacturing and engineering companies with a lower quartile of £771k, median of £859k and upper quartile of £954k (source: Spirax-Sarco remuneration report). The median ratio for CEO to employee pay for 2021 was 29:1 (median UK pay £37k).

Sustainability was historically included within the ‘strategic targets’ of the executive bonus scheme but split out with explicit objectives for the first time in 2021. The targets were 80% based on financial metrics (EPS growth) and 20% on strategic objectives including sustainability at 4% (Exhibit 13). Peer group CEO bonus targets include sustainability at 0% to 25%. The sustainability objectives are split into i) publish sustainability targets and commitments; ii) publish inaugural Task Force on Climate-Related Financial Disclosures (TCFD) disclosures (a requirement for all main market listed companies from December 2021); and iii) improve sustainability benchmarking scores and external disclosure.

No qualifications were made by the auditors in their opinion statement. Of note were comments on the loss-making contract provisions (£167m at December 2021). The accounts comment on the complexity of assessing these provisions and that the loss-making provisions in Automotive are no longer material. However, they also comment that ‘there is still a heightened risk due to the wider macroeconomic factors that impact the valuation of the loss-making sales already identified, but also increases the risk that additional contracts may have now become loss-making. Therefore there is still a heightened risk around the completeness of loss-making sales’.

The company maintains a straightforward tax structure, often unwinding the complexities of previous owners. This generally assists in any disposal. The current underlying corporate tax rate is 22%.

The group had gross debt of £1,365m at 31 December 2021 (net debt £950m). This comprised two bonds acquired with GKN (£450m maturing in 2022 and £300m maturing in 2032) with the remainder from bank debt. None of these facilities carries sustainability-linked targets.

Key ratings agencies views on Melrose can be found on page 8 of the company’s Sustainability Report or from the relevant agencies:

The ‘improve’ element of Melrose’s strategy includes enhancing the growth profiles of the businesses acquired. Sustainability and decarbonisation offer some of the fastest-growing markets for industrial companies and hence opportunities for Melrose subsidiaries. This has been highlighted though Nortek and the investment in StatePoint Technology, which enables savings of up to 30% for energy consumption and up to 90% for water usage on cooling systems. A key market has been in the fast-growing data centres arena. This development no doubt assisted with the disposal of Nortek Air Management in 2021.

Scope 3 ‘in-use’ emissions generally account for around 75% of emissions in automotive and more than 90% in aerospace. As a consequence, Melrose can make the greatest difference to its total emissions through development of its end-products.

Hence Melrose has significant opportunity to participate in the decarbonisation of the economy as these sectors look to improve efficiencies and convert to zero emissions power sources. This will also have a significant impact on Melrose’s overall emissions. This can clearly be seen in the automotive sector, where the shift to electrification is accelerating. The average internal combustion engine (ICE) car emits around 1.5tCO₂e a year. Almost two million battery electric vehicles (BEV) were sold globally, excluding China, in 2021, which translates to annual savings of 3mtCO₂e. GKN has a market share of c 50%, suggesting that vehicles with GKN product will be saving c 1.5mtCO₂e a year. While Melrose cannot take all the credit for this, given the input from other suppliers, it compares to group Scope 1 and 2 internal emissions of 723,360tCO₂e in 2021.

To promote development in this direction, Melrose has set out the following targets:

To support such activities, Melrose continues to invest in R&D which stood at £201m or 3.0% of sales in 2021 (ex JVs). This increase in intensity, as shown in Exhibit 16, is despite the inevitable cost to the group’s key margin targets. Melrose also states that it invested more than £153m in products aimed at cutting emissions in 2021.

An internal review found that revenue from products designed to increase fuel efficiency and/or reduce emissions was £1,039m in 2021. This equates to c 15% of sales, although we note that this review only covered 49% of group sales.

Attention tends to be focused on the game-changing technologies but much of GKN’s development is incremental and can still have a significant environmental impact. This includes:

Melrose points to GKN Automotive’s position in disconnect all-wheel drive (AWD) technology, which helps reduce AWD-related CO₂ emissions by up to 80% through increased efficiency (30%), reduced weight (20%) and increased durability (25%). Management estimates that the 525,000 systems sold in 2021 will reduce vehicle emissions by more than 45,000 tonnes of CO₂ annually.

The group is involved in a number of varied projects, some already revenue generating and some still in the development stage. These include:

The pathway to zero emission vehicles is now well established and even accelerating – EV (battery and plug-in hybrids) sales grew 108% in 2021 accounting for 4.6% of the global light vehicle market source: Jato Dynamics). EV motors operate at higher rotation speeds and produce higher torque than ICE motors. This necessitates different dynamics for the drivetrain (taking the power from the motor to the wheels). Complex six- or eight-speed gearboxes are no longer required, often using a single speed system. This might appear to eliminate complexity but brings in other challenges such as the wider performance envelope (speed and torque) which the drive system is required to handle. GKN has been moving up the value and technology chain from driveshafts to propshafts and into AWD systems providing the group with complete integration and software capabilities. These competences, along with specialist third parties as highlighted in Exhibit 17, have enabled GKN to develop a complete eDrive solution. The three-in-one system effectively integrates an electric motor and inverter together with the single-speed transmission module that scales up the torque. It also includes power management, clutch and torque vectoring and can obviously be linked with GKN’s traditional products such as sideshafts (delivering the rotational power to the wheels).

By 2021, GKN had already delivered more than 1.5m systems to customers. Continued success can be seen by the order intake of c £5bn of ‘life of programme’ new contracts in 2021, of which nearly 50% were for electric vehicle platforms.

The importance of in-use emissions is perhaps best demonstrated by Airbus. In 2019 (ie pre-pandemic) Airbus’s Scope 1 and 2 emissions were 954ktCO₂e whereas Scope 3 indirect CO₂ emissions from ‘use of sold product’ were 736,003 ktCO₂e. The air transport industry has committed to halving CO₂ levels by 2050 from a 2005 baseline, some way short of the Paris 1.5° target, and to be neutral by 2060. This reflects the difficulty in achieving reductions, with the sector falling into the ‘hard to abate’ part of the economy.

Potential from existing products is not being ignored, as highlighted by GKN Aerospace’s ‘Wing of Tomorrow’ programme. Led by Airbus UK, the aim is for an improved composite-based wing for single aisle aircraft, offering the potential for improved performance and significant CO₂ savings. GKN Aerospace is investing more than £25m in the programme over three years. On the more futuristic side, GKN is using its hydrogen, composite and electrical wiring expertise to help develop and supply components to a range of zero emissions aircraft.

GKN is involved with a number of electric aircraft start-ups including:

H2GEAR is a collaborative project (GKN Aerospace partnering with Intelligent Energy, Aeristech, Newcastle University, The University of Manchester and University of Birmingham) to develop a hydrogen propulsion system for sub-regional aircraft (less than 100 passengers). The project aims to deliver a ground test of a complete 1MW powertrain, including the hydrogen storage, fuel cells, power management system and an electric motor by 2026. GKN is the lead partner, with the project being run out of the company’s Global Technology Centre in Bristol. GKN brings hydrogen storage, aero-engine (from Volvo Aero), aero electrical technology (from Fokker) and manufacturing experience. Intelligent Energy brings fuel cell expertise and Aeristech high-speed electrical engines. This initial feasibility and test stage is a £54.4m project (GKN has committed £31.8m, of which £13.3m will be grant funded through Aerospace Technology Institute/Innovation UK).

Hydrogen is expected to provide a key element to solving global decarbonisation. The IEA expects global hydrogen demand to grow at least five-fold by 2050. Europe is pushing further, as highlighted by the UK targets published in 2021 (Exhibit 181), which have already seen the short-term 2030 targets doubled as part of the 2022 British energy security strategy.

Energy storage is an important element of decarbonisation, particularly given fluctuations from renewable energy sources such as wind and solar. Traditionally, hydrogen is stored as a high-pressure gas or a cryogenic (low temperature) liquid. Chemical storage offers an alternative technology through hydrogen bonding with a compound in a reversible reaction. Benefits claimed by the GKN storage system include long life (15 years+), low pressure, no capacity losses and 100% recyclability. The system generates heat on regeneration which, along with the weight of metal hydride, makes such a technology best suited to stationary storage solutions.

Melrose established GKN Hydrogen as a separate business unit in 2021. Commercialisation is expected to commence in 2023 with three scale products in testing: HY2MINI 16.5–420 kWh, HY2MEDI 0.5–2 MWh and H2MEGA >8.8MWh, benefiting from the modular design of the system.

HiiROC has developed Thermal Plasma Electrolysis process to convert gas (methane) into hydrogen and carbon black. The result is ‘turquoise hydrogen’ (a low-emission hydrogen dependent on the thermal process being powered with renewable energy and the carbon being permanently stored or used) with none of the CO₂ emissions that arise from traditional steam methane reformation and utilising a fifth of the energy of water electrolysis. The GKN collaboration aims to combine HiiROC’s H2 generation technology with current hydrogen storage technology from GKN Hydrogen and GKN Aerospace expertise. Investors Wintershall Dea and VNG have recently announced a 400kg/day hydrogen facility in Germany using HiiROC technology, due to be operational in 2023. The business raised £21m in November 2021 for development and trials in which Melrose participated.