Climate Change Investment Risk: Optimal Portfolio Construction Ahead of the Transition to a Lower-Carbon Economy

35 Pages Posted: 3 Dec 2018 Last revised: 7 Oct 2019

See all articles by Davide Benedetti

Davide Benedetti

Imperial College Business School; Pension Insurance Corporation

Enrico Biffis

Imperial College Business School

Fotis Chatzimichalakis

Impax Asset Management

Luciano Ruben Lilloy Fedele

Impax Asset Management

Ian Simm

Impax Asset Management

Date Written: October 7, 2019

Abstract

There is an increasing likelihood that governments of major economies will act within the next decade to reduce greenhouse gas emissions, probably by intervening in the fossil fuel markets through taxation or cap \& trade mechanisms (collectively ``carbon pricing''). We develop a model to capture the potential impact of carbon pricing on fossil fuel stocks, and use it to inform Bayesian portfolio construction methodologies, which are then used to create what we call Smart Carbon Portfolios. We find that investors could reduce ex-post risk by lowering the weightings of some fossil fuel stocks with corresponding higher weightings in lower-risk fossil fuel stocks and/or in the stocks of companies active in energy efficiency markets. The financial costs of such de-risking strategy are found to be statistically negligible in risk-return space. Robustness of the results is explored with alternative approaches.

Keywords: Climate Change, Carbon Pricing, Bayesian Analysis, Black-Litterman Model, Portfolio Theory

JEL Classification: G11, C61

Suggested Citation

Benedetti, Davide and Biffis, Enrico and Chatzimichalakis, Fotis and Lilloy Fedele, Luciano Ruben and Simm, Ian, Climate Change Investment Risk: Optimal Portfolio Construction Ahead of the Transition to a Lower-Carbon Economy (October 7, 2019). Available at SSRN: https://ssrn.com/abstract=3281390 or http://dx.doi.org/10.2139/ssrn.3281390

Davide Benedetti

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

Pension Insurance Corporation ( email )

14 Cornhill
EC3V 3ND
United Kingdom

Enrico Biffis (Contact Author)

Imperial College Business School ( email )

Imperial College London
South Kensington campus
London, SW7 2AZ
United Kingdom

Fotis Chatzimichalakis

Impax Asset Management

30 Panton Street
London, SW1Y 4AJ
United Kingdom

Luciano Ruben Lilloy Fedele

Impax Asset Management

30 Panton Street
London, SW1Y 4AJ
United Kingdom

Ian Simm

Impax Asset Management ( email )

30 Panton Street
London, SW1Y 4AJ
United Kingdom

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