Corporate Engagements

The Breckinridge corporate bond research team identified five key climate change topics across sectors of the corporate market. Team members arranged engagement meetings with issuers and SMEs to explore the topics in depth.

During the first eight months of 2021, the team held nearly 30 direct engagement discussions with issuers and SMEs. These meetings were in addition to the numerous interactions the analysts had routinely with issuers and SMEs in the conduct of new security research and ongoing surveillance on the more than $7.8 billion in bonds managed across Breckinridge government/credit and fixed income portfolios as of June 30, 2021.

On July 28, 2021, Pensions & Investments quoted the Securities and Exchange Commission (SEC) Chairman Gary Gensler speaking at a Principles for Responsible Investing event. "Today, investors increasingly want to understand the climate risks of the companies whose stock they own or might buy," Mr. Gensler said. "Large and small investors alike, representing literally tens of trillions of dollars, are looking for this information to determine whether to invest, sell, or make a voting decision one way or another."

Equity investors are not the only ones who need this information; corporate, municipal, and securitized bonds investors need this information as well. The SEC is currently working on rulemaking for climate-risk disclosure and has received more than 550 comment letters—including ours—on the issue during a comment period that ended in June 2021. Consistent and detailed reporting serves investors well and would represent a significant improvement from the current rules and requirements around corporate ESG reporting broadly and corporate climate risk disclosure specifically.

During the last several years, our research analysts have conducted more than 260 direct engagement discussions with corporate bond issuers. The year 2021 has proven to be a critical year to focus on responses, adaptations, and mitigation strategies of corporate bond issuers to the clear and present risks of climate change.

Global systemically important banks (GSIBs) are seeking to limit risk and pursue opportunities associated with shifts in business and society in response to climate change. For example, green, social, sustainable, and sustainability-linked bonds as well as bank lending increased substantially in 2021.⁷ Banks with a proactive approach to financing sustainability initiatives may be better positioned to grow as climate-related transitions and broader social initiatives advance.

The global sustainable bond market has surpassed $3 trillion of issuance and shows no signs of slowing as the pandemic fuels demand for funds for environmental, social and governance purposes.
—"Global ESG Debt Market Tops $3 Trillion as Virus Spurs Issuance,”
Bloomberg, 6-10-21

We held engagement meetings with banks in four countries that held more than $6.6 trillion (USD) in assets collectively, as of December 31, 2020. The banks provide sustainable financing to customers and mitigate climate risk in their operations. Some have records of accomplishments that date back more than a decade, including one that traces its sustainable approach to its founding as a cooperative bank working with farmers.

Collectively, they have committed to delivering more than $1 trillion in sustainable financing, largely within the next 10 years (See Sustainable Bond Innovations Sparks Issuance, Boost Transparency). In their own operations, they have achieved already or are planning to achieve net zero GHG emissions well before the 2050 goal of the Paris Agreement. The banks also measure, document, and report on their climate risk management efforts.

Perhaps reflective of these banks’ long-term involvement with sustainability in lending and operations, our engagement meetings with GSIBs also revealed long-term working relationships with banking regulators and leading NGOs that are developing climate risk management strategies, activities, and procedures.

A challenge facing these banks is continuing to manage and measure sustainability in underwriting activities and loan portfolios, while encouraging sustainable operations among clients, and all within a highly competitive marketplace where other banks may not maintain the same standards and commitments to long-term climate change risk adaptation and mitigation.

Negotiating evolving climate regulations and political shifts is an additional test. During our engagement program, we identified GSIBs that are adopting procedures of the Partnership for Carbon Accounting Financials (PCAF). PCAF enables financial institutions to assess and disclose GHG emissions of loans and investments (including GHG emissions in Scope 3 categories) in addition to their own direct and indirect emissions (Scope 1 and Scope 2 category emissions). (For more on PCAF, see the accompanying article “PCAF (Partnership for Carbon Accounting Financials Sets Standards for Bank GHG Reporting”.)

In 2021, the Federal Reserve (Fed) created two new entities to regularly evaluate and respond to the threat of climate change to the financial system. The first, the Financial Stability Climate Committee, focuses on the broader financial system. The second, the Supervision Climate Committee, focuses on individual institutions. The work of the committees is intended to ensure that banks embed climate change in their business decisions.

For investors, the work of these committees means that the Fed and other bank regulators will require that banks gather climate-relevant information in a consistent way. Such information is needed so that regulators can enforce a consistent set of standards and evaluate and manage risks across the system.

As sources of financing for business and community growth, GSIBs and large banks hold a powerful and essential position from which they can address and influence sustainability across sectors and economies. The banks we conducted engagements meetings with are leaders relative to peers on issues related to sustainability and climate risk in their operations and those of their borrowers. Nevertheless, the management teams we met with acknowledge there is much work left to be done to achieve their targets for sustainable lending and net zero operations. As such, they are positioned to lead a transformation of financing with sustainable goals in mind, while the world’s economy transitions to a low carbon future.

PCAF Sets Standards for Bank GHG Reporting

Our engagement discussions with financial institutions, such as global banks, over the past few years led us to conclude that most were in the very early stages of accounting for GHG emissions in their lending or investment portfolios.

Financed emissions is a major source of Scope 3 emissions for the sector. They also represent a significant percentage of a bank’s entire GHG footprint. Poor visibility into the emissions profile of a lending client is an ESG risk for the institution.

A key reason for the banking sector’s lack of traction on emissions accounting was due to fact that a globally recognized reporting framework has not existed, until recently.

PCAF published the first edition of its “Global GHG Accounting and Reporting Standard for the Financial Industry” in November 2020. The effort was started by a group of Danish banks in 2015. In 2021, 149 financial institutions, mostly commercial banks, with over $48 trillion in assets collectively, have committed to measuring and reporting on the GHG emissions embedded in their portfolio of loans and investments. The standards provide guidance on GHG quantification and disclosure for six assets classes including listed equity and corporate bonds, business loans on unlisted equity, and project finance.

PCAF is planning to relaunch its revised and expanded standard for consultation ahead of United Nations Climate Change Conference (COP26) in November 2021, in Glasgow, Scotland. The PCAF standards are a welcomed development for the banks and financial institutions where Breckinridge invests. We expect that the standards will provide several benefits including much needed transparency to a bank’s portfolio level climate risks.

Additionally, alignment with the standards provides an important foundational element for banks as they seek to achieve their zero-carbon goals, as well as asset managers committing to the net-zero asset managers initiative.

For example, Accenture research conducted in May shows that almost three-quarters (71%) of U.S. banks can monitor and assess their carbon footprint today.
“Banks Increasingly See Climate Risk As Top Priority”
Forbes, January 29, 2021

Companies in the energy sector face among the most material risks to their businesses as the world transitions to a low- or no carbon economy. As they wrestle with existential challenges that they will face in the long-term as oil, gas, and coal use declines, fossil-fuel companies also will be expected to reduce current GHG emissions to comply with regulations and, as one executive we talked to during our engagement program described as, “what society demands.”

We held engagement meetings with companies across energy subsectors including oil and gas exploration and production, pipelines, refining, and oil field services. During the meetings, we examined how companies across the energy value chain are managing climate transition risk.

Our engagement discussions focused on how the oil and gas sector can decarbonize its own operations (Scope 1 and 2 emissions) and reduce the emissions of the products and services the sector provides (Scope 3 emissions). It is estimated that 88 percent of the sector’s emissions are from Scope 3,⁸ so this was a key area of focus. (For more on the GHG reduction challenges across Scopes 1, 2, and 3 emissions among Global Systemically Important Banks (GSIBs), see Sustainable Financing: Funding the Journey to a Sustainable Economy).

The companies we spoke with have comprehensive plans to reduce their Scope 1 and 2 GHG emissions. In fact, most of the net-zero goals in the sector currently only include Scope 1 or Scope 1 and 2 emissions. These plans include operational efficiencies, investing in renewables or signing purchase power agreements for renewable power generation, and electrifying vehicle fleets. One company proactively reset its baseline year for reduction comparisons to account for corporate changes and acquisitions and divestitures in accordance with the Greenhouse Gas Protocol.

Reducing Scope 3 emissions is where we found the greatest divergence across companies.

While several companies are innovative in their responses to business transition risk and GHG reductions, others appear to be ignoring signs that their peers in the U.S. and overseas acknowledge. Across the U.S. energy sector, the intensity and intent of risk management approaches vary widely among companies.

We noted in several instances that renewables—wind, solar, low-carbon alternatives such as biofuels, renewable diesel, and hydrogen—are being pursued to augment or replace fossil fuels (For related information, see Climate Risk Mitigation at the Point of Sale and Driving Change: Transportation Sector Faces Challenges in Climate Change Reponses, reports on our engagements with retailers and transportation companies, respectively, in 2021). In addition, carbon capture and storage (CSS) technology is being developed, deployed, and is operating by some companies with early successes.

Responses to climate concerns across the sector are not uniform, however. During one engagement discussion, we learned that the company’s GHG reduction targets are not comprehensive, science based, or reflective of any anticipation of a transition away from fossil fuels. Instead, the company expects persistent fossil fuel demand and seeks to be a low-cost provider. However, this company leads in reducing methane emissions from gas flaring at well sites, which is a positive contribution to reducing emissions.

The world’s energy system is transforming rapidly, yet current progress lags global climate ambition.
—International Renewable Energy Agency

Another company advocated for political and regulatory incentives to support technology development. We believe coordination across governments globally is needed to incentivize shifts in demand for lower-emitting products and services. Governmental coordination could also incentivize energy companies to transition their businesses as well. Incentives could include carbon taxes, or subsidies for development of electric vehicles (EV), CCS, and renewable fuels, as examples.

While advocacy among investors and other stakeholders is needed, the absence of government efforts can dissuade companies from large-scale investments in clean technology because of lower expected returns compared with traditional oil and gas businesses.

We continue to see divergence in management’s focus on energy transition among U.S.-based and non-U.S.-based companies (For more on this subject, see Carbon Transition Risk Engagements Reveal Global Disparities). This may change in the U.S. with the focus on climate change from the Biden Administration and a return to the Paris Agreement (For more on this subject, see Changed Power Structure in DC May Support Environmental Initiatives).

Notably, the U.S. Senate passed the Infrastructure Investment and Jobs Act on August 10, 2021, which includes substantial investments in energy efficiency, clean tech, EV charging stations, EV batteries, and CCS, among other initiatives. Following Senate approval, the bill moved to the U.S. House of Representatives for consideration.

In the absence of advancing sector-level efforts in line with those of non-domestic energy peers, we believe that U.S. energy companies overall will lag in contributions to stemming the effects of climate change and the risks it presents to the sector’s future performance.

The material water scarcity and water stress risks that confront global food and beverage companies are intensified by the effects of climate change. Given a high reliance on water in operations and supply chains as well as increasing water stress and scarcity globally, food and beverage companies can be exposed to supply disruptions and added costs.

During 2021, we held engagement meetings with global food and beverage manufacturers that produce major branded products across cereals, pastas, snacks, baking products, yogurt, soft drinks, spirits and beer, and frozen foods. During our engagement meetings, we examined strategies companies employ to mitigate water risk and enhance its efficient use and conservation.

An important conclusion of our discussions is that companies with effective water scarcity and stress strategies in place also tend to provide best-in-class ESG disclosure, which is important for investors seeking to integrate material ESG factors into security analysis. Companies lagging in responses to water resource risks also tend to lag in reporting on other ESG factors.

Food and beverage companies addressing water supply and management risks reported success in working with key stakeholders that are drawing from the same watersheds as the companies. Collaborating with local communities, governments, nonprofits, and NGOs create a sense of accountability, as well as strengthen cooperative efforts to protect and maintain watersheds.

Food and beverage companies also engaged with suppliers to mitigate risks of water supply disruptions or shortages. This strategy addresses the fact that the majority of the companies’ water use is in supply chains, and specifically in agricultural supply chains.

Regenerative agriculture is proving to be a strategy gaining acceptance among leading food and beverage companies. Traditional farming tends to deplete key resources including soil and water. Regenerative agriculture can enrich soil, promote biodiversity, improve water quality, and capture carbon.

Shifting both crop and pasture management globally to regenerative systems is a powerful combination that could drawdown more than 100% of annual CO2 emissions, pulling carbon from the atmosphere and storing it in the soil.
—The Rodale Institute, September 2020.

Additional strategies we discussed with food and beverage sector bond issuers are resiliency and restoration of watersheds, implementing drip irrigation rather than flood irrigation, and developing water management strategies and effective reporting.

Overall, our 2021 engagement with food and beverage companies highlighted best practices in water risk management in the food and beverage sector. We were able to better assess the performance relative to peers of each company we engaged with about this material ESG factor.

As public sentiment shifts to favor environmentally friendly businesses,9 a retailer can leverage sustainability principles to attract and retain new clients. Companies that authentically integrate and publicly communicate progress on climate risk mitigation may be positioned for stronger future growth.

We believe that energy efficiency can be a powerful strategy to improve customer service, demonstrate commitment to sustainability, and achieve environmental goals. Our 2021 program of engagement with retail sector companies explored how they manage climate risks including GHG emissions, energy efficiency across store networks, and employee safety as it relates to hazardous materials.

We held engagement meetings with national general merchandise dollar store operators and companies operating retail locations selling aftermarket auto parts, supplies, equipment, accessories, and tools. In total, the companies operate more than 34,000 retail locations collectively in the western hemisphere as of December 31, 2020.

Our engagement meetings found companies with sustainability efforts that ranged from proactive to perfunctory. Compared with big-box omnichannel retailers, we engaged with companies that tend to focus their operations on brick-and-mortar stores. As a general rule, aftermarket automotive and dollar store sub-segments seem to lag the broader retail peer landscape when it comes to tackling climate change challenges in their operations.

We hypothesize that this could be a result of elevated consumer price-sensitivity in these subsegments. When customers are focused on price as a key differentiator, issuers may be incentivized to pursue sustainability initiatives only within the confines of prioritizing price and convenience, rather than pursuing wholesale strategy changes.

Through large-scale manufacturing, shipping materials, supply chain processes, and powering stores, the global retail industry is a staggeringly large contributor of carbon emissions.

- "Consumers demand action on climate change — and it's time for retailers to listen"
Retail Dive – February 21, 2020

For example, several companies reported energy use and GHG emissions reductions by converting to interior LED lighting and more efficient heating/ventilation/air conditioning infrastructure, while committing to setting science-based targets for Scope 1 and 2 emissions (their own direct and indirect emissions). In one notable example, the company’s chief sustainability officer is working with a third-party consultant which recommends strategies to achieve energy efficiency.

Several companies see supply chain engagement as an opportunity to reduce Scope 3 GHG emissions (all other indirect emissions). Their efforts include prioritizing suppliers that are seeking to cut GHG emissions or encouraging existing suppliers to make improvements. One retailer, for example, is working to source products from cargo carriers certified by the Environmental Protection Agency’s SmartWay program.

These examples of innovative efforts serve as a contrast to another retailer that has yet to appoint a sustainability leader, does not have any stated GHG emissions reduction target, and is not systematically measuring energy consumption price/supply risks.

More than one of our engagement discussions highlighted that, similar to issuers in other economic sectors, issuers in the retail sector face a wide range of reporting/disclosure requests from investors, which can cause confusion. Those committed to leadership in reporting consistently disclose information according to at least one recognized framework, while exploring potential strengths and weaknesses of others; these efforts demonstrate genuine commitments to communication.

Like other issuers, retailers face myriad ESG challenges beyond those in the environmental sphere. We were curious about the interplay between labor management and environmental practices. We explored company policies and practices that encourage employee performance to avoid environmental harm or proactively address chemical and hazardous waste risks.

Efforts to reduce energy consumption, advance environmental goals, to minimize waste, and to reduce and recycle hazardous waste could have substantial positive effects on a retailer’s competitive positioning.

America’s transportation sector has a multifaceted role in responding to the risks of climate change. GHG emissions, hazardous pollutants, and fuel efficiency are central challenges for the sector.

To explore how sector leaders are responding to threats and opportunities of physical climate change risks and preparing for a transition to a low-carbon economy, we held engagement meetings with companies that engage in freight delivery over rails, primarily deliver packages and parcels over roads, and provide logistical support to freight haulers.

Through our discussions, we learned that railroads consider the physical risks of climate change, including more frequent adverse weather conditions, to be a greater material risk than road-transportation companies.

The rail companies’ heightened concern is due to maintenance of the expansive in-place network of thousands of miles of track. Aging track degraded by weather must be replaced or refurbished while tracks at risk of flooding should be raised. The increase in extreme weather events brought on by climate change directly impacts the physical infrastructure that railroads must have to operate.

One railroad executive said “arguably all” of a rail company’s capital expenditures (capex) are sustainability focused. As a practical matter, non-maintenance capex targets lower costs, not all of which is through fuel efficiency.

To his point, however, more efficient railroad operations will use fewer diesel-powered locomotives to move longer trains and more freight with less idling time. Considering that railroads are four times more fuel efficient than typical diesel-powered trucks,10 a more productive and fuel-efficient business model could further reduce GHG emissions and improve on-time performance relative to road-based freight.

When it comes to transition risks, rails will face reduced freight volumes and revenues in a low-carbon economy. Fully, 30 percent of one railroad’s annual revenues 10 years ago was attributed to coal. In 2020, that total had slipped to 13 percent.

In the face of declining revenues, railroads will need to increase efficiency to maintain or improve earnings. Intermodal business is a potential solution to railroads’ top-line woes, but that is a lower-margin business.

Conversely, road-based transportation companies are more focused on the transitional risks associated with climate change when compared with physical risks. By focusing on alternative fuel vehicles, leveraging route optimization software, facility automation and drones, road-based transportation companies seek to reduce costs and mitigate the risk of losing market share.

One package delivery company seeks to reach its carbon neutrality goal by 2040—an industry first within the transportation sector. The company intends to cut emissions to zero for its ground fleet and invest in research that will help to sequester C0₂ from the atmosphere to help offset emissions stemming from the company’s aircraft operations. The company will support biofuel and CCS developments (For related information, see Climate Risk Mitigation at the Point of Sale, a report on our engagements with retailers in 2021, and U.S. Lags, Despite Successes in Addressing Energy Transition Issues, a report on our engagements with energy sector companies in 2021).

While physical climate change risks are the primary concern for issuers across the railroad sub-sector, these companies are also developing solutions to further improve their emissions profile such as hydrogen-powered locomotives that could advance fuel cell and battery technology retrofits on existing locomotives, although the technology is in its early stages.

For companies that primarily use road-based transportation, natural-gas powered vehicles and improved logistics are yielding emissions improvements in the near term, while EVs, drone deliveries and CCS technologies may drive future improvements.

Railroads face higher physical risks associated with climate change than the other transportation companies but may have greater opportunities associated with climate change transition risk, as they may be able to take market share from long-haul trucking if they can leverage their edge in cost efficiency and continue to operate with a lower relative emissions footprint.

Road-based transportation companies face higher potential climate-related transition risks related to potential carbon costs and elevated fleet transition costs for efficiency during a transition to a low- or no-carbon economy.

Transportation is one of the most exposed industries to carbon emissions as a material ESG issue. Most of this exposure stems from fuel and other energy costs, which can constitute up to 30 percent of revenues for major companies.”
—Sustainalytics, Transportation Industry Report, 2020

Hydrogen Is a Promising Source of Low- or No-Carbon Energy

Hydrogen’s primary use today is as raw material for such industrial applications as oil refining and in the production of ammonia for fertilizer. However, the chemical element is a promising source of low or no-carbon energy in a net zero pathway. During engagements in 2021, we discussed hydrogen-based fuel cell technology with bond issuers exploring the technology as a solution to cut emissions from locomotives, a major portion of a railroad’s carbon footprint.

Breckinridge partnered with MIT Sloan’s Laboratory for Sustainability Business for the past several years on a variety of research projects. In 2021, we collaborated with the student team to study the energy sector’s exposure to climate transition risk. As part of the research, the team evaluated hydrogen as an emerging new technology and its potential impact on the demand for oil and gas.

Conclusions from the project include the expectation that hydrogen will not create major market disruptions within the next 10 years. Investments in infrastructure projects are expected to distribute hydrogen, which could serve as a new, diversified source of revenue for midstream companies. Currently, hydrogen can be blended with natural gas and shipped through pipelines. However, the blend ratio of 15% hydrogen to 85% natural gas limits the transportation potential.

In addition, ongoing research and development is anticipated to insert hydrogen into heavy transportation, specifically in marine shipping and rail. Challenges to more widespread usage include hydrogen’s physical properties. Its volumetric density is 3.2 times lower than natural gas and 2,700 times lower than gasoline, which makes it harder to handle and store. Another factor stunting hydrogen’s growth is fact that it is currently expensive to produce. However, green hydrogen, formed through an electrolysis process with green energy and water as the sole inputs, is expected to be cost competitive by 2030.

Innovation could be accelerated through government invention and incentives. For example, it was reported in early 2021 that over 30 countries have published hydrogen development plans and have pledged government funds to drive adoption.