Get Green or Die Trying? Carbon Risk Integration into Portfolio Management
- Maximilian Görgen, Andrea Jacob, and Martin Nerlinger
- Journal of Portfolio Management
- A version of this paper can be found here
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What are the research questions?In 2015, 197 nations signed onto the Paris Agreement and committed to limiting global warming to less than 2 degrees C above preindustrial levels. Although the arguments are compelling, the drive to manage carbon risk presents quite a challenge for individual investors and portfolio managers. Although ESG investing spans the gamut of environmental issues, the specific case of carbon risk is complex. How do investors align portfolios to fight climate change? How do investors direct their investments toward “green” products? How can the exposure to carbon risk be measured? And if it can be measured, what return contributions are reasonable to expect? In this research, the authors propose a familiar capital-markets approach to measuring and managing carbon risk. They propose the estimation of a “carbon” beta for individual stocks, portfolios, or any financial product. The team’s returns-based approach to calculate the “carbon beta” is simple, established, and eliminates the need to obtain and execute on complicated, expensive data such as carbon emissions. The dataset used includes the constituents of the MSCI ACWI Investable Market Index, consisting of 23 developed markets and 26 emerging markets at all cap levels. Once carbon betas are estimated, quintile portfolios are constructed every quarter from 2010-2019. The 20% lowest carbon beta firms were assigned to Portfolio #1 and the highest carbon beta firms were assigned to Portfolio #5. A return series was then constructed for each of the five portfolios, and the results of the risk/return analysis are presented in Exhibit 3, below. The key questions analysed are as follows:
- What is the “carbon” beta and how is it measured?
- What are the risk and return profiles for various levels of carbon beta?
What are the Academic Insights?
- The carbon beta for stocks or portfolios is estimated consistent with the Carhart (1997) methodology. It is interpreted as the “sensitivity of firms’ stock price to shifts in the climate change-induced process of the economy.” Essentially, the carbon beta reflects the market’s estimate of climate change risk and is consistent with the interpretation of other risk factors in the Carhart model.
Why does it matter?The most important takeaway from this research is that the carbon beta as described and estimated in the paper is able to reflect and measure both green risk and brown risk. Investors should be aware of this potential risk/reward element in their portfolios. From a practical point of view, integrating carbon risk into portfolios and other products requires some due diligence. For example, high and low carbon risk portfolios exhibit different factor exposures. At the green end, the Value and Momentum factors are dominant, while Value and Size are predominant at the brown end. Since the decision to tilt towards one or the other end of the carbon risk spectrum, investors are well-advised to avoid simple measures of carbon risk and examine other sources of information about concurrent risks and expected returns
The most important chart from the paper
Portfolio management is confronting climate change more strongly and rapidly than expected. Risks arising from the transition from a brown, carbon-based to a green, low-carbon economy need to be integrated into portfolio and risk management. The authors show how to quantify these carbon risks by using a capital markets–based approach. Their measure of carbon risk, the carbon beta, can serve as an integral part of portfolio management practices in a more comprehensive way than fundamental carbon risk measures. Apart from other studies, the authors demonstrate that both green and brown stocks are risky per se, but there is no adequate remuneration in the financial market. In addition, carbon risk exposure is correlated with exposures to other common risk factors. This requires due diligence when integrating carbon risk in investment practices. By implementing carbon risk screening and best-in-class approaches, the authors find that investors can gain a desired level of carbon risk exposure, but this does not come without well-hidden costs.