Credit Alpha and CO2 Reduction: A Portfolio Manager Perspective

Abstract

This paper discusses the challenges of carbon-dioxide emission measurement on corporate credit portfolios. We illustrate how it can be difficult to translate traditional CO2 reductive strategies into incentives for portfolio managers. As an alternative approach to the footprinting techniques commonplace in equities, we introduce the ECOBAR model which looks at CO2 missions from an ordinal standpoint and takes a risk-based approach to measuring this in credit portfolios. We build out the model to encompass important credit alpha factors such as short positions, leverage and derivatives as well as explicit green investments such as green bonds. We apply the model on two sets of data, where the first is a historical real traded investment-grade credit portfolio and the second is a systematic CDS trading strategy. In the traded portfolio, we find that it has been possible to own a clearly CO2 efficient portfolio whilst still generating average alpha of 4.5 percentage points per annum. In the CDS-based strategy, alpha loss turns out to be insignificant with reasonable investment constraints on high-CO2 emitting issuers. We conclude that there is a good potential for low-CO2 strategies in a variety of operational, mainstream credit trading settings.

Keywords: Credit, green bonds, sustainable finance

JEL Classification: G12, Q01