ESG Perspectives

ESG Best Practices: Appreciate, Integrate, Collaborate, Demonstrate

(For a glossary of ESG-related terms, please click this link.)

Best practices can be working standards intended to achieve preferred outcomes. In developing best practices, companies, regulators, or governing bodies—which are among the groups seeking to develop best practices for a specific procedure, business, or industry—can balance the unique qualities of an organization with practices that it has in common with others.

While a specific best practice may be applicable or appropriate for one organization, it may not apply or be suitable for another organization. In our experience, implementing a best practices approach in environmental, social, and governance (ESG) research begins with a clear understanding of ESG basics and how they may expand the investment process. This article explores best practices that, at Breckinridge, guide our ESG investment research efforts 

In brief, a systematic approach to ESG research in combination with fundamental security analysis and issuer engagement is intended to widen an analyst’s view and lengthen an analyst’s focus.

In the case of fixed income investing, we view ESG analysis an additional lever for a research analyst to pull through an in-depth review of material non-financial indicators to complement a traditional credit analysis.

Industrywide, ESG labelled strategies continue to grow rapidly. In 2020, ESG assets managed by registered investment companies totaled $3.10 trillion, up 19 percent from $2.61 trillion in 2018, according to the U.S. SIF Foundation.

Application of ESG approaches has developed and broadened over time

Breckinridge integrated an ESG approach in its research process more than a decade ago. More recently, credit ratings agencies have added ESG factors to help assess the creditworthiness of issuers. (See Bond Rating Agencies Upgrade Their Municipal ESG Capabilities and Credit rating agencies turn attention to ESG risk.1)

Broader recognition of ESG materiality and wider availability of ESG assessments from rating agencies may also highlight the value of independent ESG analysis developed through a proprietary investment approach.

Complementary Views in the Security Research Process

Fundamental analysis is key to a bottom-up, active, fixed-income investment management approach. Balance sheet strength, valuations, and exposure to quantifiable risks, such as interest rate risk and credit risk, are essential in evaluating a potential investment.

We believe that a detailed ESG analysis can enhance our credit research process through facets of sector-based materiality, risk identification, and direct issuer engagement.

  • Sector Materiality Matters. Material factors are those that have enough significance or relevance as to make a tangible impact on an investment. Understandably, various ESG factors may express greater or lesser materiality in different sectors. For instance, high carbon emissions and environmental liabilities potentially can be more material in the energy sector, while access to healthcare and product quality and safety may be more pertinent in the pharmaceuticals sector.
  • Risk Management is Critical. An area where we believe ESG integration can make a meaningful contribution is through bottom-up analysis that can identify dormant liabilities that could negatively impact creditworthiness, bond spreads or in an extreme case affect the ability of a bond issuer to repay bondholders and meet other financial obligations. For example:
    • A corporation might be infringing on human rights through exploitative labor practices in its supply chain and could face reputational damage.
    • A city that addresses the differing needs of local neighborhoods inequitably may experience population declines, with negative implications for future tax revenues.
    • A manufacturer might be negligent in its handling of harmful wastewater and could face regulatory fines.
    • A public utility that falls behind on transitioning to a low-carbon future may end up with a less diverse energy mix to meet customer demand. They may also face increased regulatory risk resulting in potential fines.
    • A mortgage pool that includes a disproportionate amount of mortgages on properties in flood- or drought-prone regions may experience disruptions in cash flows from more frequent or intense storm events.

By incorporating thoughtful ESG risk analysis that may point to strengths and weaknesses in areas such as those listed above, an experienced analyst can utilize this information to help assess long-term creditworthiness and by extension the relative value or attractiveness of an issuer’s bonds.

  • Engagement with bond issuers. An important part of active fixed income investing is engaging in dialogues with the issuers of bonds on material credit and ESG factors. Engagement is an opportunity to ask questions and develop a better understanding of what the management of the company or government entity is doing to address ESG issues.

    A thorough preparation for an ESG issuer engagement should arguably integrate data from respected third parties as well as an organization’s own analysis of financial and non-financial factors. Leading organizations such as the Sustainability Accounting Standards Board can provide relevant research that helps to shape internal analysis.

Issuer engagement can help to uncover context around ESG issues. It can shine a light on the way that management thinks, acts, reacts, and plans around various sustainability issues. In the end, all of that can influence decisions to invest in, avoid, or either overweight or underweight exposure to a certain security, industry or sector.

For security issuers, the engagement process can help management stay in touch with and better understand investor concerns and preferences for standardized reporting methods. All in all, engagement between investors and issuers can be part of a healthy ongoing dialogue that can lead to an improved understanding of material ESG issues.

Finally, engaging subject matter experts can add context to issues and factors that can help inform ESG analysis. Collaborating and sharing knowledge and insights with peers, academics, and non-governmental organizations can build shared goals for mutual benefit.

Walking the Talk Adds Credibility and Demonstrates Commitment

Investing in a manner that integrates ESG analysis is based on our conviction that the best organizations from a sustainability perspective integrate ESG into the firm’s culture, identity, and operating practices.

At Breckinridge, we view our B Corp status as a statement in support of our pursuit of long-term positive impact for our clients, employees, and the communities in which we live, work and invest. Being a certified B Corp is an important signal that can attract employees and help to foster socially responsible practices by holding the organization accountable and demonstrating its ongoing commitment to sustainability.

Part of that is our commitment to make ongoing charitable donations of 1% of gross revenues and to support our employees’ volunteer time with three paid volunteer days per year.

Another measure of an organization’s commitment to walking the talk with regard to ESG performance is the regular publication of a Corporate Sustainability Report (CSR: See the 2021 Breckinridge CSR here: Persistence Towards Progress). A CSR is an accounting of the organization’s progress on the path to more sustainable operations as well as a sign of its commitment to continuous improvement.

Investors seeking an ESG-focused fixed income investment manager may want to consider the manager’s approach to many of the issues reviewed in this article when making their selection.

A pdf of this article is available here. 

[1] Credit rating agencies turn attention to ESG risk, Financial Times, February 23, 2019.

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ESG: Offering Signposts on the Investment Journey

On a journey, signposts can provide important information about what may lie ahead. With more information, a traveler can make more informed decisions along the way.

In a similar way, environmental, social and governance (ESG) analysis can add information for investors as they make their way on their investment journey. While no investment approach is a guarantee to positive outcomes, like signposts along the roadway, ESG factors can highlight risks, suggest outcomes, or help align preferences, as investors plot their course.

A PDF version of this article is available here. 

 

Prepared for Investment Professional and Institutional Use.

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DISCLAIMER

This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.

Any estimates, targets, and projections are based on Breckinridge research, analysis, and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.

Performance results for Breckinridge’s investment strategies include the reinvestment of interest and any other earnings, but do not reflect any brokerage or trading costs a client would have paid. Results may not reflect the impact that any material market or economic factors would have had on the accounts during the time period. Due to differences in client restrictions, objectives, cash flows, and other such factors, individual client account performance may differ substantially from the performance presented.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.

Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions.

There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.

Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.

Net Zero alignment and classifications are defined by Breckinridge and are subjective in nature. Although our classification methodology is informed by the Net Zero Investment Framework Implementation Guide as outlined by the Institutional Investors Group on Climate Change, it may not align with the methodology or definition used by other companies or advisors. Breckinridge is a member of the Partnership for Carbon Accounting Financials and uses the financed emissions methodology to track, monitor and allocate emissions. These differences should be considered when comparing Net Zero application and strategies.

Targets and goals for Net Zero can change over time and could differ from individual client portfolios. Breckinridge will continue to invest in companies with exposure to fossil fuels; however, we may adjust our exposure to these types of investments based on net zero alignment and classifications over time.

Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.

The effectiveness of any tax management strategy is largely dependent on each client’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the client is not the most effective for every client. Breckinridge is not a tax advisor and does not provide personal tax advice. Investors should consult with their tax professionals regarding tax strategies and associated consequences.

Federal and local tax laws can change at any time. These changes can impact tax consequences for investors, who should consult with a tax professional before making any decisions.

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