Climate change investment risk: optimal portfolio construction ahead of the transition to a lower-carbon economy
File(s)SSRN-id3281390.pdf (1.25 MB)
Working paper
OA Location
Author(s)
Benedetti, Davide
Biffis, Enrico
Chatzimichalakis, Fotis
Lilloy Fedele, Luciano Ruben
Simm, Ian
Type
Working Paper
Abstract
There is an increasing likelihood that governments of major economies will act within the
next decade to reduce greenhouse gas emissions, probably by intervening in the fossil fuel
markets through taxation or cap & trade mechanisms (collectively “carbon pricing”). We
develop a model to capture the potential impact of carbon pricing on fossil fuel stocks,
and use it to inform Bayesian portfolio construction methodologies, which are then used to
create what we call Smart Carbon Portfolios. We find that investors could reduce ex-post risk
by lowering the weightings of some fossil fuel stocks with corresponding higher weightings
in lower-risk fossil fuel stocks and/or in the stocks of companies active in energy efficiency
markets. The financial costs of such de-risking strategy are found to be statistically negligible
in risk-return space. Robustness of the results is explored with alternative approaches.
next decade to reduce greenhouse gas emissions, probably by intervening in the fossil fuel
markets through taxation or cap & trade mechanisms (collectively “carbon pricing”). We
develop a model to capture the potential impact of carbon pricing on fossil fuel stocks,
and use it to inform Bayesian portfolio construction methodologies, which are then used to
create what we call Smart Carbon Portfolios. We find that investors could reduce ex-post risk
by lowering the weightings of some fossil fuel stocks with corresponding higher weightings
in lower-risk fossil fuel stocks and/or in the stocks of companies active in energy efficiency
markets. The financial costs of such de-risking strategy are found to be statistically negligible
in risk-return space. Robustness of the results is explored with alternative approaches.
Date Issued
2020-06-06
Citation
2020
Copyright Statement
©2019 The Author(s).
Identifier
https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=3281390
Subjects
Climate Change
Carbon Pricing
Bayesian Analysis
Black-Litterman Model
Portfolio Theory
Publication Status
Published