To help with this process, Neuberger Berman’s Non-Investment Grade Credit team, in conjunction with the firm’s ESG Investing team, conducted its fourth annual roundtable discussion in May 2023 to highlight key industry trends, explain our approach to ESG and provide insights on managing the major shifts ahead. Attending issuers accounted for approximately $50 billion in high-yield issuance across various sectors, up from $44 billion at our inaugural roundtable. We provide some essential takeaways.
Our Approach: Engaging on ESG to Reduce Credit Risk
The Neuberger Berman Non-Investment Grade Team believes that properly managing material environmental, social and governance (ESG) risk factors reduces credit risk. In line with this view, we perform our ESG analysis through the lens of helping asset owners avoid defaults, which is one of the key drivers of returns over the long term. For over seven years, Neuberger’s systematic approach has focused on materiality for each sector, and we continue to evaluate companies on ESG factors that could create credit risk for their business or industry. Moreover, our internal data supports this approach, showing that companies with poorly-managed ESG risks have a much higher default rate than the market.
Neuberger Berman maintains a strong preference for remaining invested in and engaging with companies to help them improve their ESG risk management strategies rather than divesting. Given this proactive engagement platform, we are commonly used as a resource for issuers seeking guidance in developing their ESG strategies, determining which topics and frameworks to focus on and communicating the most important information to investors.
Finally, we note that clients looking to deploy capital into the high-yield and leveraged loan markets view ESG integration as a minimum cost of entry, which is a significant departure from perspectives as recent as five years ago. We find that asset owners are increasingly focused on the financial materiality of ESG factors that have the potential to influence the long-term risks and returns of their portfolios. Additionally, asset owners have noticed that many of the ESG risk mitigation efforts initially implemented by issuers have led to economic benefits. Given these trends, we expect demand from clients regarding asset managers’ consideration of ESG risks to continue to accelerate.
Best Practices in ESG Communication
When it comes to ESG communication, we primarily emphasize the importance of comparability across companies and thus, recommend that issuers align their reporting with common frameworks. The SASB Standards, the Task Force on Climate-Related Financial Disclosures’ (TCFD) recommendations, and the Science Based Targets initiative (SBTi) are three voluntary frameworks we find particularly helpful in aligning issuers with disclosure requirements and setting emissions reduction targets in line with the Paris climate agreement. Wherever possible, we also encourage issuers to create standalone ESG reports to provide stakeholders with easy access to ESG progress and highlights.
Moreover, we encourage companies to set ambitious yet achievable goals for ESG topics that may have a financially material impact on their business. Common feedback we receive from issuers who are hesitant to set targets relates to concerns that they are not yet where they’d like to be in terms of their ESG targets or data. However, we find that transparency is the primary concern for investors regardless of how advanced a company is in their ESG strategy, because it demonstrates that issuers are prioritizing material ESG concerns and considering potential future impacts to their business.
Additionally, we find that ESG topics of concern are expanding, and while climate continues to be a primary topic of focus in many sectors, there are also a number of social issues that can have a financially material impact for issuers. For example, businesses with less physical assets tend to have a significant focus on human capital, including workforce diversity, attracting and retaining talent and employee engagement. Further, we have seen negative financial impacts on companies that have failed to prioritize such topics. Additional notable social topics of investor concern include company supply chains from both the perspective of supply chain disruptions as well as global labor standards, cybersecurity, data privacy, and biodiversity.
Regulatory Landscape: ESG Disclosure Requirements Continue to Accelerate
We have seen a general push toward greater mandatory and standardized disclosure of environmental and social data globally. In the U.S., the Securities and Exchange Commission (SEC) has proposed rules that would require issuers to fortify disclosure of climate-related data, most prominently in Scope 1 (direct) and Scope 2 (purchased electricity, steam, heating and cooling) emissions, but also for those with material Scope 3 emissions (indirect emissions in the value chain). We expect this rule to be finalized in the coming months, however we would not recommend issuers wait to disclose given the greater industry trends in reporting. For example, many companies are already disclosing Scope 1, 2 and 3 emissions and waiting to do so can affect companies’ standing relative to peers.
Further, the European Corporate Sustainability Reporting Directive (CSRD) will soon apply to public and private companies with at least €40 million in revenues that do business in Europe, even if they are not domiciled there. This directive will require a much more expansive set of disclosures focused not just on emissions but other social indicators as well. Therefore, it is important for companies to consider the direction regulations are headed as well as their extraterritorial nature when developing their own disclosure plans.
Many asset owners are also subject to ESG-related regulations, and they look to managers to share that reality with companies by urging them to meet certain compliance standards. In this capacity, Neuberger Berman can serve as a conduit to ensure that capital and investments are aligned.
The Path to Net Zero
We believe it is ultimately up to each individual company to determine whether or not net-zero targets are appropriate given the nuances of each business. For example, some companies are inherently unable to reach net zero emissions due to their business models. However, for those who do decide to make a net-zero commitment, we encourage disclosure around how they intend to deliver on their commitments and what capital allocation is required to support them. For utilities, this may mean investing in lower carbon-generating assets, which will require appropriate pacing and capital allocation. For those businesses where the technology to reach net zero is not yet available, attention to related risks and explanations of how the company is testing or considering future technologies becomes important.
If an issuer does decide to make a net-zero commitment, investors want to get a sense of the capital allocation decisions that support the goal as well as the strategic choices embedded within it. Further, we consider setting interim targets to be a best practice if possible, as it gives investors a sense of the progress they can expect over time, whether that includes a steady reduction in emissions over a consistent timeline or a set of specific actions that lead to a more dramatic reduction in emissions in the longer term.
To summarize, we encourage companies to produce disclosure around the practical, tangible actions they will take to prepare for their planned future emissions reductions, and specifically, the capital allocation plans that will allow for those reductions.
Future Perspectives on ESG Investing
One forward-looking trend we’ve seen from institutional investors is an increasing reliance on quantitative ESG screens to exclude issuers from certain portfolios. As such, we recommend companies continue to keep a pulse on third-party scores from ESG ratings agencies, as they are continuing to rise in popularity for use in screening portfolios.
Additionally, we find that products with unique ESG characteristics are taking market share within an otherwise lackluster flow environment thus far this year within the broader high yield space. Given these observations, we encourage issuers to continue enhancing their ESG strategies, disclosures and goals to support investor analysis and third-party scoring outcomes, which can be the gatekeeper for inclusion in a portfolio.
