International diversification of investments in climate change mitigation

Abstract

Numerous studies have shown that international emissions trading can significantly lower the costs of greenhouse gas (GHG) abatement. Economic models, however, ignore the substantial economic and political risks associated with investments in developing countries, where—according to these models—a large share of global GHG abatement takes place. We use a mean-variance approach to compute international portfolios of carbon abatement activities that balance low abatement costs and investment risks. Expected returns are derived from marginal abatement cost curves. The volatility of the growth rate of regional carbon dioxide emissions is used as an indicator of investment risk. We find, first, that well-diversified portfolios can significantly reduce investment risks. Second, the least-risk portfolio is distinct from the cost-efficient allocation based on equalization of marginal abatement costs, and much more costly to implement. This indicates that existing models which neglect investment risks overestimate the cost-savings due to international emissions trading.