Net Zero Investment Portfolios - Part 1. The Comprehensive Integrated Approach
103 Pages Posted: 13 Dec 2022
Date Written: October 13, 2022
The emergence of net zero emissions policies is currently one of the most important topics among asset owners and managers. It considerably changes portfolio allocation and the investment framework of both passive and active investors. The academic literature generally concludes that implementing net zero portfolios and sustainable investing is not costly. Moreover, some investors have chosen to implement highly dynamic decarbonization pathways with a continuous reference to business-as-usual benchmarks. The goal of this paper is to participate in the debate on climate investing by showing that it is not a free lunch. Net zero investment portfolios may involve some substantial costs in terms of tracking, diversification, and liquidity risks.
The decarbonization pathway requires the net zero emissions scenario to be defined. Transforming this absolute scenario into an intensity-based scenario is not straightforward because it involves a carbon budget. Once the scenario is established, it is important to assess the metrics that capture the different dimensions of a net zero emissions policy, particularly the self-decarbonization and the green intensity of issuers. Then we can combine these different figures to define the objective function involved in optimizing net zero portfolios by considering the asset class. For instance, bond portfolios and equity portfolios are not constructed in the same way. The objective of this comprehensive integrated approach is to deal with the multi-faceted dimensions of net zero investing. Another method establishes a core-satellite portfolio, where decarbonization and transition dimensions are segregated.
If we focus on the comprehensive integrated approach, our results show that net zero investing goes beyond the simple exercise of dynamic decarbonization. Compared to a business-as-usual benchmark, the tracking error cost may be relatively high, especially for equity portfolios. Moreover, the diversification risk is critical for equities and bonds because we see significant deformation of investment universes. Of course, these results depend on the parameter values we use. Nevertheless, they clearly indicate that climate investing is not just a tilt of traditional investing. In this context, the reference to business-as-usual benchmarks is not always relevant. Of course, this situation is transitory until the world is on the right track to becoming a net zero economy, but at that time, we will again observe a convergence between business-as-usual and climate investing, and a growing correlation between the market and net zero portfolios.
Keywords: climate change, net zero emissions scenario, decarbonization, transition, greenness
JEL Classification: G11, Q5
Suggested Citation: Suggested Citation