Commentary

The Battle for Data has Just Begun

Pascal Blanqué, Group Chief Investment Officer at Amundi, considers the alpha opportunities which may arise as ESG data gaps narrow.

As investing in ESG factors has taken off worldwide, regulatory scrutiny has also naturally intensified. Regulators are asking for additional data disclosure from asset managers to ensure the proper inclusion of ESG principles in the investment process and avoid greenwashing.

Demand for data is not only driven by regulators, but also by investors. Integrating ESG into the investment process is about understanding the impact of ESG factors’ dynamics on the current and future valuation of a company, for which data are a crucial element. ESG investing is in essence reconfiguring the entire investment value chain to the point where it is now converging with fundamental analysis, as valuation models start to also incorporate ESG elements.

The perception that investing in ESG factors necessarily means sacrificing performance is history, having been widely challenged. These factors are now firmly accepted as being at least neutral or even complementary to the classical portfolio metrics of risk and return.

Window of opportunity

Initially, the main aim was to deliver a defensive portfolio by excluding companies that were most exposed to ESG risks, given the likelihood that some of these risks could well materialise and dent performance through re-ratings. The upshot is that ESG risks are no longer seen as far off. Being able to identify and factor them in can equip investors with a distinctive competitive edge.

Hence, over time, a growing body of investors have adjusted their approach to include ESG scores in their assessment. The underlying idea is to target excess market returns (alpha) by exploiting prevailing market inefficiencies that do not reward companies because of the lack of credible accounting frameworks, mandatory disclosure requirements and reliable data associated with ESG investing, which brings us to the next point.

The demand for better quality data on and more rigorous reporting requirements of listed companies has intensified over the past two years. In the European Union, the Sustainable Finance Disclosure Regulation in 2021 was a key milestone. For its part, the Securities and Exchange Commission in the US is likely to unveil ESG-related disclosure rules by the end of this year, while the IFRS will publish climate-related disclosure standards in 2022.

As a result, investors have a crucial window of opportunity in front of them, as increasing data disclosure will create alpha opportunities arising from the gradual closing of existing informational inefficiencies. This will come with the convergence of fundamental and ESG investing. This may help also discover whether the risk factors embedded in ESG investing are unique and idiosyncratic or whether they can be readily proxied by a traditional risk factor like quality, since they share common traits.

Path to convergence

For now, there are opposing forces at work. On the one side is the activist role played by various global coalitions of like-minded investors – such as Climate Action 100+ and the Net-Zero Asset Managers Initiative – who are persuading their investee companies to improve their ESG practices and the reporting structures around them.

Demand from institutional investors is already strong and increasing, while retail investors have room to catch up, as their appetite for ESG is still poised to increase much further. Both these trends could accelerate the convergence.

On the other side, any convergence will be slow on account of the huge data gap. For example, temperature scores are now emerging as a complementary tool to other existing climate-oriented metrics, such as carbon footprint and waste management. Yet, it is clear that very few companies worldwide have set the net zero target on a temperature score basis. Simply put, there are pronounced data inconsistencies among providers and no unique approach to creating a portfolio with a net zero objective.

The current infrastructure of data and skills has a very long way to go before meeting the needs of investors who want to follow granular themes. This is the time to further invest into ESG, as the battle for data has only just begun, and the winners will be able to grasp the alpha opportunities still present in multiple areas.

Effecting change, achieving alpha

The most prominent opportunity is in understanding and interpreting the dynamics of ESG ratings in trying to identify the future leaders in key ESG metrics. Through engagement and favouring companies on a virtuous path, ESG can become an important tool in effecting change.

A second area of opportunity relates to the emergence of global ESG themes driven by powerful narratives built into the market and society. As mentioned previously, the net zero emissions initiative is one of them. The focus on tackling social inequality will likely be the next one as this is a central focus of governments and companies as we recover from the pandemic. In a recent analysis, we have found that the social pillar, in particular with regards to working conditions, has been a key driver in US stocks’ performance after the Covid-19 crisis.

Regarding emerging markets and small cap companies, we continue to see strong inefficiencies amid a lack of data, both in the traditional and the ESG world. Here is where there is the strongest potential for alpha generation by engaging with companies to support them as they embrace a positive path on the ESG front.

The journey towards rising ESG adoption will not be linear. Much will depend on the push coming from the overall ESG ecosystem which comprises of regulation, coalitions and investor demand. This will be key to trigger a positive feedback loop between additional data availability, further ESG adoption and its increasing impact on prices. ESG investing must continue to gather pace to capitalise on these opportunities, which will further accelerate the convergence towards mainstream investing.

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