While electronics manufacturing services companies face complex challenges from looming environmental regulations in Europe, some industry watchers say the changes could be a positive for the industry over the long term.

The Restriction on Hazardous Substances (RoHS, pronounced ro-hoss or ross) law will take effect in the European Union on July 1. The law bans lead, cadmium, mercury, hexavalent chromium and two polybromides in all electronic products shipped to the EU.

EMS companies such as

Celestica

(CLS) - Get Report

,

Jabil Circuit

(JBL) - Get Report

,

Flextronics

(FLEX) - Get Report

,

Plexus

(PLXS) - Get Report

and

Benchmark Electronics

(BHE) - Get Report

, among others, make the building blocks of these products -- or the actual product itself -- and have been modifying their facilities and manufacturing processes to prepare for the transition.

"It affects every single electronics product, because they are assembled using leaded solder," says Dan Shea, chief technology officer of Toronto-based Celestica.

After years of preparation, EMS companies appear ready to meet the new regulation but admit that there are bound to be a few hiccups.

"I don't think anyone will get through this without some cuts and bruises," says Eric Austermann, director of environmental services for Jabil, one of many of the sector's companies that has seen its stock slump in the early summer selloff.

Some sectors are exempt from the lead requirement and only need to remove five of the six banned substances. "Mission critical" areas such as high-end communications, enterprise infrastructure, medical and aerospace and defense, for instance, are exempt from the lead-free rule, at least for now.

But companies that violate the RoHS rule will be subject to different penalties, depending on the individual country.

European countries aren't alone in tightening environmental restrictions. In March 2007, China -- which does not have a good reputation for responsible environmental practices -- will enact its Cleaner Production Promotion Law, dubbed China RoHS. The law is stricter and does not include any exemptions.

"For any of the large OEMs

original equipment manufacturers that are trying to capture the Chinese market, they're going to find themselves in a bit of a quandary," Shea said. "The Chinese government has made sure that many of the Chinese companies were well aware that this was coming."

With the European law about to take effect, "the EMS companies are facing a nightmare" of inventory and supply-chain headaches, says Jim Walker, a vice president of research for semiconductor manufacturing at Gartner.

But it won't affect the sector in the long term, he says. "This is just a phase-in issue, like unleaded gas -- we all accepted it, we all phased it in. Every time you introduce something new, there is some emotional and financial impact."

For the past several years, EMS providers have been busy testing more environmentally friendly solder formulas. While the reliability of lead has been proven for over 50 years, lead-free solders and components (resistors, capacitors and diodes) are relatively new and have required more testing, Shea said.

The new lead-free solder requires higher temperatures to melt the solder and assemble the components, and higher temperatures translate to higher energy costs, says Walker, who doesn't own shares of any of the companies mentioned.

And quality is still an issue, wrote analyst Richard Kugele of Needham & Co in a Monday note. Lead-free solder increases risk of short-circuiting, so until such technical issues are resolved, "the quality risk in medical equipment alone will support continued demand for many lead-based solder components for at least the next few years."

In addition, keeping leaded parts separate from the lead-free parts is a major challenge. Component companies need to relabel parts and certify those that are lead-free. Adding to the complexity, some printed circuit boards also have a mixture of leaded and non-leaded parts on the card.

EMS companies can't just ditch lead altogether, as some companies and sectors are exempt from the law and still require leaded parts, while products shipped to other parts of the world don't have lead-free restrictions (such as the U.S.). "Basically what you have is twice the number of parts," says Walker. "You have the new parts and the old parts."

In general, EMS companies such as Celestica assemble printed circuit boards and other materials that make up the guts of brand-name consumer electronics products like cell phones, gaming consoles or computers and high-end telecommunications equipment.

The EMS companies sometimes work with their customers, companies including

Apple

(AAPL) - Get Report

or

Hewlett-Packard

(HPQ) - Get Report

, both considered OEMs, to design the product itself, or handle product repair.

With the new regulations boosting the amount of work necessary to transition to RoHS compliance, some of these OEMs, especially the mid-size or smaller companies, may turn to outsourcing work to EMS firms to ensure that they are RoHS-compliant. Celestica's "green services" unit, for instance, provides consulting, a product-conversion service and specialized lab equipment to help OEMs meet compliance requirements.

"These guys are the subject-matter experts," says Richard Stice, an equity analyst with Standard and Poor's. "It's more efficient for the OEMs

to use the EMS companies. The RoHS compliance adds another catalyst for more outsourcing."

"I think it will definitely be a net positive in terms of the EMS industry overall," Stice says. He and his firm have no affiliation with any of the companies mentioned and do not do any investment banking.

"When they are producing the products now, there may be higher costs, but a lot of the infrastructure is already built in," Stice says. "So there may be costs that they can pass on to the OEM or the consumer."

Other analysts agree that there are opportunities for companies in the EMS sector to benefit from the transition, especially those that are prepared and known for execution.

"The

EMS industry could drive increased service-related revenues as customers look for assistance in working through the blocking-and-tackling of the transition process," JPMorgan analyst Tom Dinges wrote in a recent note. He also noted that limited market-share gains for better-prepared companies seem likely.

Still, Dinges said in an interview that he doesn't see RoHS compliance as a "tipping point" for the EMS industry but as one of many reasons an OEM might decide to outsource. He said it also provided opportunities for the companies to grow in new markets last year.

JPMorgan has an investment-banking relationship with Benchmark, Jabil and

Solectron

( SLR), another EMS provider.

Needham's Kugele wrote that he still expects "some scrambling" ahead of the imminent deadline, and that investors will continue to hear about compliance and industry issues for the next 12 to 18 months.

With that in mind, he recommends that clients focus on the "best-executing players in our universe" such as Jabil, Plexus and Benchmark. Needham has an investment-banking relationship with Plexus and Benchmark.