Bond issuer engagement at Breckinridge expanded during 2020. The information discovered during more than 100 meetings with bond issuers, as well as subject matter experts (SMEs) like Ceres and Union for Concerned Scientists, explored best practices in sustainability as corporations and municipalities are increasingly integrating ESG considerations into their operations.

Engagement is a valuable research strategy at Breckinridge. Through engagement, our analysts gain a deeper understanding of ESG factors relevant to sectors, industries and individual bond issuers. We also can gauge an issuer’s commitment to implementing those practices. In addition, meetings with SMEs add context and perspective to discussions.

Engagement at Breckinridge occurs with a subset of issuers within our large research coverage universe. ESG materiality varies among issuers, industries and sectors. Engagement meetings help to further refine our own research as conditions change. For example, during 2020, challenges posed by risks associated with COVID-19 and social unrest brought added dimensions to our discussions.

Thematic approaches guide engagement strategy

Reviewing the themes developed by the Breckinridge corporate and municipal research teams for 2020 highlighted some of the long-term, material concerns across sectors and industries. In addition, as events of 2020 unfolded—the COVID-19 pandemic and a contentious national conversation on issues related to social and racial justice—specific themes took on added relevancy.

2020 Breckinridge Engagement Themes

Corporate:

• Bank efforts to incorporate climate risks and diversity, equity and inclusion (DEI) in lending and underwriting
• Healthcare/pharmaceutical industry product quality and safety considerations
• Data security & privacy, labor management issues among retailers. Labor concerns heightened with the intensification of COVID-19 related restrictions that affected employees
• Efforts among real estate investment trusts (REITs) to reduce energy use of properties in their portfolios
• Initiatives among utilities to mitigate energy transition risks

Municipal:

• Assessing the revenue impact caused by COVID-19 on municipal budgets and planning
• Efforts among municipal bond issuers to consider equity in climate planning
• Hospital efforts to achieve pricing transparency required by the Affordable Care Act (ACA) and more recent executive orders
• Efforts of municipal utilities to address challenges when seeking to reach 100% carbon-free goals

Corporate engagement meetings highlight risks and responses.

An engagement theme focused on ESG risks related to product quality and safety shaped discussions with healthcare and pharmaceutical companies. Product quality and safety represent significant operational, financial and reputational risks for pharmaceutical companies. Discussions revealed best practices among selected engagement participants as well as areas for improvement and steps being taken to address them.

Through a series of engagements with six large U.S. banks, we noted a significant increase in activity intended to manage and mitigate climate risk through increased disclosures, assignment of board- and executive-level ESG management responsibilities for, risk assessments, regulatory oversight and capital raising and lending.

During a series of engagement meetings with retailers and companies in related sectors, we developed a deeper understanding of how management teams are seeking to manage ESG risks related to data privacy and security risks as well as their large labor forces. The issues are of increasing importance particularly with the trend to electronic commerce, which accelerated in 2020 as consumers adapted their shopping habits when COVID-19 concerns restricted economic activity.

We hosted six engagement meetings with retail, apartment and office REITS so as to better understand how they are addressing their environmental and emissions footprint. Based on our discussions, we were able to confirm that the energy consumption profiles of tenants can be difficult to change and noted a trend of toward green leases that grant tenants a share in capital expenditures associated with improvements in building efficiencies, a potential catalyst for positive change.

Engaging with municipalities brings deeper insights.

We engaged with public electric utilities to explore strategies to achieve decarbonization goals while continuing to deliver reliable power to business and residential customers. Engagements with five issuers revealed challenges, opportunities and varying levels of progress to date on advancements toward carbon-free operations.

Through engagement discussions with not-for-profit hospital systems, our municipal bond analysts for the sector assessed progress on pricing transparency in accordance with the ACA and recent regulations. In our view pricing transparency is a good governance characteristic. The analysts found that even eight years after ACA, information among hospitals surrounding price transparency and pay-for-value contracting is still broadly opaque, and preparations for current requirements for January 1, 2021 effectiveness is inadequate. Phased implementation for healthcare plans begins in January 2022.

As 2020 wore on, issues shifted, and engagement adapted.

Several ESG-related issues became more relevant as 2020 progressed. For example, within banking, ESG considerations in lending practices gained more attention as the nation focused on issues of social and economic justice. Similarly, with the March onset of COVID-19 spread, employers confronted labor issues related to health and safety as well as compensation. As COVID-19 forced restrictions on travel and drove unemployment higher, the potential for lower tax revenues increased, with implications for municipal bond credit worthiness.

Selected examples demonstrate how current events can influence the research goals related to long-term risks, as well as how responsive adaptation of our engagement agenda afforded Breckinridge analysts with new insights.

Our research team led engagements with representatives from seven cities to explore how the recession induced by COVID-19 affected municipal budgets and spending. Specifically, the analysts explored how executives were estimating revenues as well as managing spending and capital projects. In addition, discussions covered how the pandemic impacted sustainability initiatives. Each may have implications for future credit strength. The discussions revealed that while each city is monitoring key metrics to assess the recession’s effects, their approaches vary.

In another discussion conducted in association with the Union for Concerned Scientists (UCS), our analysts found parallels between how municipalities are confronting challenges presented by the pandemic and how they are incorporating equity considerations in climate planning. Science and experience show that climate change disproportionately impacts vulnerable communities and can exacerbate problems across racial, gender, and economic disparities. Integrating equity considerations in municipal planning for climate change supports achieving climate change plans, municipal growth and credit quality.

The analysts observed that the impact of climate change and the pandemic disproportionately affect vulnerable populations. The threats are invisible and exponential in nature and spread regardless of politics or borders. Participants in the engagement meetings discussed the benefit of early action to limit damage, cost and duration; the importance of integrated responses and shared responsibilities; and the need for broad engagement that includes vulnerable communities.

Our thematic engagement on equity considerations in climate change planning added to our previous engagement discussions on the subject. Specifically, in 2018 our analysts spoke with representatives of a large Southern state-capital city. The city had studied managing heat islands. Heat islands are urbanized areas that experience higher temperatures than outlying areas because buildings, roads and other infrastructure absorb and re-emit the sun's heat more than natural landscapes such as forests and water bodies. The study suggested additional tree cover, roof cooling, pavement cooling, more grass/trees in barren areas, and energy efficiency programs. Our discussions in 2020 regarding equity considerations in climate change planning revealed similar strategies to address heat stress in cities.

ESG interest advances in 2020, and engagement supports the trend.

During 2020, the interest in sustainable investing and the incorporation of ESG characteristics into the research process continued to grow. For example, FactSet reported a record-high number of S&P 500 companies cited ESG on earnings calls in the third quarter. In December, the second largest stock exchange by market capitalization, NASDAQ, asked the Securities and Exchange Commission to approve new listing rules related to board diversity, a key ESG factors. In November, the Federal Reserve recognized climate change as a key to financial stability in the U.S.

In our own engagement with a government-sponsored enterprise (GSE) active in the mortgage investing markets, our research into the effects of climate risks in performance of securitized bonds drew interest. We, and representatives of the GSE, agreed to continue to discuss climate risk implications for securitized bonds to advance understanding and risk management strategies.

Our own assessments of the quality of our corporate engagement meetings during the last three years supports the view that bond issuers are more attentive than they have been in the past both to their reporting about ESG issues that they are addressing and to their progress in addressing them. Figure 1 illustrates the quality of corporate engagement calls in 2018 and 2020, as assessed by our research team. The assessments rate the informational value of a call and the quality of the reporting provided by the issuer.

In our view, improved articulation of a sustainability strategy reflects improved sustainability reporting. Our own experience echoes analysis by the Governance and Accountability Institute, which found that 90% of S&P 500 companies published a CSR in 2019, up from 20% in 2011.¹ In addition, improved sustainability reporting can enhance how a company’s sustainability strategy is articulated externally and can help drive progress across the organization. As we heard from a major pharmaceutical company during a recent engagement discussion, its efforts to become a leader in the quality of its ESG reporting has been very central to their sustainability approach. Company representatives noted how reporting helps “to identify key material ESG trends, opens the door to conversations internally, and assists management in navigating through such issues as the pandemic.”

Our analysts noted a meaningful increase in the percentage of calls during which a “well-articulated” strategy was discussed, meaning that we believe there is a clear sustainability strategy in place. The percentage of calls revealing, what we would consider to be, an “inadequate” or “underdeveloped” strategy each has declined during the last three years. Only a minor increase in the number of companies who have sound reporting but had an uninformative call was noted during the same period.

Expanded engagement discussions enhance understanding.

Our collaboration in engagements with other sustainability experts helps expand our view and understanding of key ESG issues. For example, we collaborated during 2020 with Ceres, a sustainability non-profit organization. With Ceres, we conducted engagement discussions on ESG issues with a global food and beverage company and a diversified financial services company. With Climate Action 100+, we convened engagement meetings with an earth-moving and mining equipment manufacturer, a major retailer and a defense contractor. Climate Action 100+ is an investor initiative to ensure the world's largest corporate greenhouse gas emitters take action to address climate change, curb emissions and strengthen climate-related financial disclosures.

Engagement will continue to play an important role in the Breckinridge investment process. During 2021, climate change will be among the key themes our analysts will explore with issuers across corporate and municipal sectors.

Over the course of nearly a decade, as our engagement program has evolved we have noted increasing understanding among many bond issuers of the value of a well-articulated program designed to address ESG risks. Progress and growth achieved in 2020 is serving as the basis for planning for 2021 and the years ahead.

[1] https://www.globenewswire.com/news-release/2020/07/16/2063434/0/en/90-of-S-P-500-Index-Companies-Publish-Sustainability-Reports-in-2019-G-A-Announces-in-its-Latest-Annual-2020-Flash-Report.html

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