The Impact of Climate Change Risk on Long-term Asset Allocation

Abstract

We propose a framework for long-term cross-asset portfolio choice in which the estimation of the covariance matrix is subject to climate risk. We model the future volatility and correlation of assets as a linear function of three types of forward-looking variables: their long-term future average, climate-aware projections of economic indicators, and scenarios for the temperature anomaly. We analyze the shifts from a baseline 60/40 equity/bond allocation when taking climate risk into account. We find that these changes are small and mostly favorable to bonds if the focus is on the estimation of risk components. Including climate-driven expected returns in the optimization substantially alters the compositions, but this time to the benefit of equities. In all cases, the risk-adjusted returns decrease, often significantly, when taking climate impact into account.

Keywords: Asset allocation, climate change

JEL Classification: G11, C53, Q54