Carbon Risk Integration: Interaction Between Carbon Risk and Traditional Risk Factors

Categories: Industry/Sector Analysis, General Market Analysis, ESG, Investor Education, Equity Investments

Country or region: Asia Pacific (Overall)

Summary:
We argue that a pure, unconstrained, carbon-efficient portfolio outperformed a carbon-inefficient portfolio, as well as the underlying benchmark, on an absolute return basis, but underperformed on a risk-adjusted basis due to the portfolio having higher volatility.


Reference URL: https://www.indexologyblog.com/2018/04/02/carbon-risk-integration-interaction-between-carbon-risk-and-traditional-risk-factors/



Abstract

The discussions on the merits of carbon awareness investing are evolving, and in a previous blog, we discussed how investors are interested in progressing from the current data-driven carbon emission framework to a risk-analysis-driven, two-degree pathway paradigm. The shift has been largely spurred by the Financial Stability Board (FSB) and recommendations from its Task Force on Climate-related Financial Disclosures (TCFD).

Investors who seek to move forward with a risk analysis approach believe that carbon risk will be imminently priced in sooner rather than later and may want to position their existing portfolios in anticipation of this. So far, carbon prices have already been implemented in 40 countries and 20 cities and regions.[1] Research by Trucost estimated that average carbon prices could increase more than sevenfold to USD 120 per metric ton by 2030,[2] as regulations aim to limit the average global temperature increase to 2 degrees Celsius in accordance with the Paris Agreement.

In response to this, Trucost has created a carbon pricing tool designed to help companies estimate internal carbon prices by modeling the progressive tightening of the spread between carbon prices today and in the future, considering science-based price scenarios and national climate change commitments. If a company understands the true cost of carbon, it can be empowered to make better business decisions to hedge against carbon exposure.

Despite the advancements in carbon pricing data and their potential implementation and use, it is somewhat premature to dismiss carbon-footprint-data-based portfolios in the belief that they would measure only part of the carbon pricing risk and would not be forward looking enough to provide a complete estimate of carbon risk exposure. In fact, we would argue that carbon footprint and carbon efficiency data could be rather useful for institutional investors that are already implementing factor-based investing strategies and wish to further align their entire investment process with low-carbon initiatives. We aimed to delve deeper into the interaction between carbon risk and traditional, well-established risk factors, and we have presented our findings in our paper, “Carbon Risk Integration in Factor Portfolios.”

In the paper, we argued that a pure, unconstrained, carbon-efficient portfolio outperformed a carbon-inefficient portfolio, as well as the underlying benchmark, on an absolute return basis, but underperformed on a risk-adjusted basis due to the portfolio having higher volatility. Moreover, we discussed how the carbon-efficient portfolio exhibited unintended sector and factor biases. Using the correlation of carbon intensity with style factors, we demonstrated a stylized framework in which carbon-efficient portfolios (both unconstrained and sector relative) could be combined with traditional risk factors to lower carbon intensity while maintaining the target factor exposure.

Through this analysis, we merged two powerful trends that are shaping the investment industry and provided a framework that could be used by institutional investors that wish to be sustainability-driven while focusing on achieving the risk/return profiles that are specified in their investment mandates. We showed that carbon-efficient factor portfolios could be a meaningful part of the core equity strategic and tactical asset allocation process.

In forthcoming blogs, we will discuss the construction of carbon-efficient investment portfolios.

[1] https://www.carbonpricingleadership.org/who/

[2] http://www.irena.org/DocumentDownloads/Publications/Perspectives_for_the_Energy_Transition_2017.pdf

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Date of original publication:

04/02/2018


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