Climate change risk has received increasing attention from the asset management industry in recent years. A growing number of asset managers are taking initiatives to integrate climate change risk into their portfolio decisions. Some are even committing themselves to help combat climate change risk by joining the Net Zero Asset Managers Initiative, a group of international asset managers committed to supporting the goal of achieving net-zero greenhouse gas emissions (primarily carbon dioxide) by 2050 or sooner, in line with global efforts to limit warming to 1.5 degrees Celsius.
Asset managers are realizing that climate change poses material risks to businesses, given the uncertainties surrounding its effects and implications:
- Physical risks such as extreme weather events and sea level rise can lead to damage to property and infrastructure, resulting in direct financial losses.
- Climate change can also affect resource availability, as certain resources are likely to become scarcer due to shifts in extreme weather patterns. This can make the existing economic system unsustainable.
- To mitigate and adapt to climate change, the global economy may need to undergo a paradigm shift towards green economic pathways. Economic networks and operations optimized under the old paradigm may become obsolete as a result of this shift. Transition risks, such as the move towards low-carbon energy sources, can lead to stranded assets, as investments in fossil fuels and carbon-intensive assets become less valuable.
- In the intermediate term, uncertainties regarding the timing of climate mitigation policies pose a challenge to business decision-making and planning.
Climate-risk integration in portfolio management is a growing area of research, with many different methodologies being developed and tested. For example, Andersson et al. (2016) proposed a dynamic investment strategy that allows long-term investors to hedge climate risk without sacrificing financial returns. The strategy begins with using the constituent stocks of a benchmark index (such as the S&P 500 index or the Nasdaq 100 index) to construct a decarbonized portfolio. This is accomplished by reweighting the stocks to minimize the tracking error with respect to the benchmark index, subject to the constraint that the portfolio’s carbon intensity must be smaller than a given threshold. The carbon intensity of a firm is measured by the normalized carbon footprint of the firm.
An alternative approach is to implement a complete exclusion of composite stocks with the highest carbon intensity. Subsequently, the remaining stocks are reweighted to minimize the tracking error in relation to the benchmark index. Back-testing has demonstrated that portfolios constructed using these decarbonization methods have achieved comparable or even superior financial returns when compared to the benchmark index.
Like the uncertain nature of the climate change process, the long-term outperformance of portfolios that integrate climate risk compared to their traditional counterparts depends on various factors, such as the trajectory of climate change, the timing of policy changes, and investor awareness. It is reasonable to expect that as the market increasingly recognizes the importance of climate change risk, portfolios that incorporate such risk will gain a substantial competitive edge over counterparts that do not.
Disclaimer: The Content is for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice.
References:
Andersson, M., Bolton, P., & Samama, F. (2016). Hedging Climate Risk. Financial Analysts Journal, 72(3), 13–32. https://doi.org/10.2469/faj.v72.n3.4
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