Decarbonization Factors

Abstract

In the face of accelerating climate change, investors are making capital allocations seeking to decarbonize portfolios by reducing the carbon intensity of their holdings. To understand the performance of portfolio decarbonization strategies and investor behavior toward decarbonization, the authors construct decarbonization factors that go long low-carbon-intensity and short high-carbon-intensity sectors, industries, or companies. They consider several portfolio formation strategies and find that strategies that lowered carbon emissions more aggressively performed better. Decarbonization factor returns are associated with contemporaneous institutional flows into the factors. Buying decarbonization factors when coincident flows are positive while selling when they are negative produces significantly positive alphas. Combining decarbonization factors that have positive contemporaneous flows would provide investors with significantly superior returns and continuous exposure to low-carbon portfolios. The results are more pronounced in Europe relative to the United States. The results suggest that institutional investor flows contain information about anticipated fundamentals related to climate change developments. <b>TOPICS:</b>ESG investing, portfolio construction, analysis of individual factors/risk premia, performance measurement <b>Key Findings</b> ▪ The authors develop six strategies to decarbonize a portfolio of US and European-listed equities and find that these decarbonation factors generate positive returns from 2009–2018. ▪ After controlling for traditional factors, they find that the decarbonization factors that achieve greater carbon reduction also deliver greater alphas. ▪ They measure institutional flows into and out of the decarbonization factors and find that going with the concurrent flows on low-carbon strategies improves investor returns. This result suggests that institutional flows contain information about climate-related fundamentals.