Which clean energy sectors are attractive? A portfolio diversification perspective

Abstract

Clean energy assets have opened up new investment opportunities for market participants. How to construct an efficient clean energy stock portfolio and how it would perform in comparison to traditional assets remain unclear. To fill this gap, this paper investigates optimal allocation within the clean energy stock market. Specifically, the risk and return characteristics of individual clean energy stock sub-sectors are examined. Optimization techniques are used to generate the desired clean energy stock allocation. The performance is compared to the equity market benchmark and dirty energy stocks. The results show that the risk and return on clean energy stock sub-sectors vary significantly. Clean energy stocks generally underperform the overall equity market but outperform dirty stocks. For investors looking to decarbonize their portfolios, the minimum-tail risk strategy is superior to the minimum-variance strategy. The index that tracks developers and operators of renewable energy projects provides the best risk-adjusted returns for investors with moderate risk tolerance and is effective at mitigating the volatility risk of dirty assets. The wind and energy storage indices, however, are the preferred options for reducing the tail risks of dirty assets. The findings shed light on the efficacy of clean energy portfolio optimization strategies and the heterogeneous diversification benefits across clean energy stock sub-sectors, which has important implications for investors constructing clean energy portfolios to meet investment objectives.