Reinventing climate investing: building equity portfolios for climate risk mitigation and adaptation

ABSTRACT

Institutional investors are increasingly concerned with the material financial risks associated with global warming and the impacts of climate change on corporate financial performance and security returns. The challenge remains how to empirically quantify climate risk from an investment perspective and build investable portfolios that address the transition to a low-carbon economy. This study analyzes the available metrics for capturing climate-related investment considerations. We undertake a comprehensive review of the data characteristics for metrics such as carbon intensity, green revenue, and fossil fuel reserves, highlighting their coverage and distributional characteristics. These data characteristics are critical when integrating them into investment strategies. Building on our findings, we propose a framework for building climate strategies within public equities which rests on both mitigating the impact of climate risk today and adapting to climate risk in the future. This ‘mitigation and adaptation’ framework has enough flexibility to build portfolios at different levels of concentration, tracking error, and climate risk exposure. For example, we can build a portfolio which aligns with climate model projections. We illustrate our framework with a portfolio calibrated to align with the most conservative climate model projections, which seek to limit cumulative CO₂ emissions to a threshold below the 2°C scenario.

KEYWORDS:

• Environmental finance
• ESG
• Impact investment
• Institutional investors

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No potential conflict of interest was reported by the authors.

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Notes

1 The carbon pricing instruments put together by about 40 nations and over 20 sub-nations cover about 12% of the annual global GHG emissions. The world’s two largest emitters (US and China) are now home to carbon pricing instruments (see The Intergovernmental Panel on Climate Change’s 5th Synthesis Report: http://www.ipcc.ch/ar5/syr/)

2 The GIC was formed in December 2012, the joint initiative of four leading climate change investor groups—IIGCC (Europe), INCR (United States), IGCC (Australia & New Zealand) and AIGCC (Asia).

3 In fixed income, for instance, we would have to address mapping multiple bond issuances to the ESG databases. For equities, it is typically a one-to-one mapping.

4 Tracking error is defined as the standard deviation of monthly excess returns (where excess returns are defined as monthly index returns minus the returns of the cap weighted universe during the same month), annualized. For portfolio optimization, an ex ante estimate (forecast) of tracking error is used based on a risk model.

5 The RCPs have been developed using IAMs as input to a wide range of climate model simulations to project their consequences for the climate system. These climate projections, in turn, are used for impacts and adaptation assessment. The RCPs are consistent with the wide range of scenarios in the mitigation literature. The scenarios are used to assess the costs associated with emission reductions consistent with particular concentration pathways.

6 For average daily volume (ADV), we use the 20-day average. Trading (both buying and selling) in any single security is limited to 20% of its 20-day ADV.