The Market Measure of Carbon Risk and its Impact on the Minimum Variance Portfolio

Abstract

Like environment, social, and governance investing, climate change is an important concern for asset managers and owners and a new challenge for portfolio construction. Until now, investors have mainly measured carbon risk using fundamental approaches, such as with carbon intensity metrics. Nevertheless, it has not been proven that asset prices are directly affected by these fundamental-based measures. In this article, the authors focus on another approach, which consists of measuring the sensitivity of stock prices with respect to a carbon risk factor. In the authors’ opinion, carbon betas are market-based measures that are complementary to carbon intensities or fundamental-based measures when managing investment portfolios; carbon betas may be viewed as an extension or forward-looking measure of the current carbon footprint. In particular, they show how this new metric can be used to build minimum variance strategies and how it affects portfolio construction. <b>TOPICS:</b>ESG investing, portfolio construction, tail risks, fundamental equity analysis <b>Key Findings</b> ▪ Measuring carbon risk is different if we consider a fundamental-based approach by using carbon intensity metrics or a market-based approach by using carbon betas. ▪ Managing relative carbon risk implies overweighting of green firms, whereas managing absolute carbon risk implies having zero exposure to the carbon risk factor. The first approach is an active management bet, whereas the second is an immunization investment strategy. ▪ Both specific and systematic carbon risks are important when building a minimum variance portfolio and justify combining fundamental and market approaches to carbon risk.