Get Green or Die Trying? Carbon Risk Integration into Portfolio Management

Abstract

Portfolio management is confronting climate change more strongly and rapidly than expected. Risks arising from the transition from a brown, carbon-based to a green, low-carbon economy need to be integrated into portfolio and risk management. The authors show how to quantify these carbon risks by using a capital markets–based approach. Their measure of carbon risk, the carbon beta, can serve as an integral part of portfolio management practices in a more comprehensive way than fundamental carbon risk measures. Apart from other studies, the authors demonstrate that both green and brown stocks are risky per se, but there is no adequate remuneration in the financial market. In addition, carbon risk exposure is correlated with exposures to other common risk factors. This requires due diligence when integrating carbon risk in investment practices. By implementing carbon risk screening and best-in-class approaches, the authors find that investors can gain a desired level of carbon risk exposure, but this does not come without well-hidden costs.

TOPICS: Portfolio construction, ESG investing, risk management

Key Findings

• ▪ We describe a capital markets–based approach to measuring carbon risk that stems from the transition from a carbon-based to a low-carbon economy.

• ▪ Investors can integrate carbon risk into their portfolios using carbon beta but must be aware of the associated portfolio return, risk, and factor exposures.

• ▪ Different portfolio strategies can achieve a desired level of carbon risk exposure. However, the risk is not remunerated proportionally in the financial market.