Portfolio Construction with Climate Risk Measures

Abstract

Because of the 2015 Paris Agreement, the development of ESG investing and the emergence of net zero emission policies, climate risk is certainly the most important topic and challenge for asset owners and managers now and will remain so over the next five years. It considerably changes portfolio allocation and the investment framework of both passive and active investors. The goal of this paper is to conduct a survey of the various climate risk measures that are available in the asset management industry and the practices of portfolio construction that use these metrics. Therefore, the first part of this paper lists the different climate risk metrics -- e.g., carbon footprint, carbon transition pathway, carbon transition and physical risks. The second part is dedicated to portfolio optimization, in particular portfolio decarbonization and portfolio alignment (Paris-based benchmarks and net zero carbon objective). Among the different findings, two are of great importance for investors. First, portfolio decarbonization is more difficult when we include scope 3 carbon emissions. Indeed, optimizing using the sum of scopes 1, 2 and 3 emissions leads to a portfolio with more tracking error risk than using direct plus first tier indirect carbon emissions. Second, portfolio alignment is more complex than portfolio decarbonization. Since aligning portfolios with scope 3 is becoming the standard approach to climate portfolio construction, the impact on portfolio management may be substantial, and the divergence between carbon investing and traditional investing will increase.

Keywords: Climate change, risk measure, carbon emissions, reduction scenario, carbon trajectory, net zero emission, optimized portfolio, decarbonization, portfolio alignment, index portfolio

JEL Classification: C61, G11, Q54