Reinventing climate investing: building equity portfolios for climate risk mitigation and adaptation

Abstract

ABSTRACTInstitutional investors are increasingly concerned with the material financial risks associated with global warming and the impacts of climate change on corporate financial performance and security returns. The challenge remains how to empirically quantify climate risk from an investment perspective and build investable portfolios that address the transition to a low-carbon economy. This study analyzes the available metrics for capturing climate-related investment considerations. We undertake a comprehensive review of the data characteristics for metrics such as carbon intensity, green revenue, and fossil fuel reserves, highlighting their coverage and distributional characteristics. These data characteristics are critical when integrating them into investment strategies. Building on our findings, we propose a framework for building climate strategies within public equities which rests on both mitigating the impact of climate risk today and adapting to climate risk in the future. This ‘mitigation and adaptation’ framework has enough flexibility to build portfolios at different levels of concentration, tracking error, and climate risk exposure. For example, we can build a portfolio which aligns with climate model projections. We illustrate our framework with a portfolio calibrated to align with the most conservative climate model projections, which seek to limit cumulative CO2 emissions to a threshold below the 2°C scenario.