The Market Measure of Carbon Risk and its Impact on the Minimum Variance Portfolio

TL;DR

This paper introduces a market-based measure called carbon beta, which assesses stock sensitivity to carbon risk and can be used to improve minimum variance portfolio strategies, complementing traditional fundamental metrics.

Contribution

It proposes and demonstrates the use of carbon betas as a new market-based measure of carbon risk for portfolio construction, extending beyond fundamental approaches.

Findings

Carbon betas are correlated with traditional carbon intensity metrics.

Using carbon betas in portfolio optimization reduces overall risk.

The approach offers a forward-looking perspective on carbon risk management.

Abstract

Like ESG investing, climate change is an important concern for asset managers and owners, and a new challenge for portfolio construction. Until now, investors have mainly measured carbon risk using fundamental approaches, such as with carbon intensity metrics. Nevertheless, it has not been proven that asset prices are directly impacted by these fundamental-based measures. In this paper, we focus on another approach, which consists in measuring the sensitivity of stock prices with respect to a carbon risk factor. In our opinion, carbon betas are market-based measures that are complementary to carbon intensities or fundamental-based measures when managing investment portfolios, because carbon betas may be viewed as an extension or forward-looking measure of the current carbon footprint. In particular, we show how this new metric can be used to build minimum variance strategies and how they impact their portfolio construction.