Hedging Climate Risk

Abstract

This paper presents a simple dynamic investment strategy that allows long-term passive investors to hedge climate risk without sacrificing financial returns. We illustrate how tracking error can be almost eliminated even for a low carbon index that has 50% less carbon footprint than its benchmark. By investing in such a decarbonized index, investors are holding in effect a “free option on carbon”: as long as the introduction of significant limits on CO2 emissions is postponed our low carbon index obtains the same return as the benchmark index, but when CO2 emissions are integrated by the market, it starts outperforming the benchmark.