Abstract
In response to the global transition to a low-carbon economy, carbon risk reduction in diversified portfolios has become imperative. We develop a new hedge approach to mitigate carbon risk, quantified as the carbon beta using a multi-factor model. By calculating a novel hedge ratio, investors are provided with an optimal allocation to a hedge asset, facilitating the effective reduction of carbon beta within their portfolios. Our findings highlight the effectiveness of this approach, which leads to carbon beta reductions without significant losses in risk-adjusted returns, implying that investors and fund managers can adopt this hedge strategy to moderate their carbon risk exposure. Compared to other carbon risk hedge methods, our approach only requires an investment in one more asset, making real-world applications relatively straightforward.
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