Get Green or Die Trying? Carbon Risk Integration into Portfolio Management

Abstract

Portfolio management is confronted with climate change – stronger and more rapidly than expected. Risks arising from the transition process from a brown, carbon-based to a green, low-carbon economy need to be integrated into portfolio and risk management. We show how to quantify these carbon risks by using a capital markets-based approach. Our measure of carbon risk, the carbon beta, can serve as an integral part to portfolio management practices in a more comprehensive way than fundamental carbon risk measures. Apart from other studies, we demonstrate that both green and brown stocks are risky per se, but there is no adequate remuneration in the financial markets. In addition, carbon risk exposure is correlated with exposures towards 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, we find that investors can gain a desired level of carbon risk exposure, but this does not come without well-hidden costs.

Keywords: ESG investing, portfolio construction, equity portfolio management, carbon risk, climate change

JEL Classification: G11, Q54