Climate change investment risk: optimal portfolio construction ahead of the transition to a lower-carbon economy

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 t...

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Bibliographic Details
Published in:Annals of operations research Vol. 299; no. 1-2; pp. 847 - 871
Main Authors: Benedetti, Davide, Biffis, Enrico, Chatzimichalakis, Fotis, Fedele, Luciano Lilloy, Simm, Ian
Format: Journal Article
Language:English
Published: New York Springer US 01.04.2021
Springer
Springer Nature B.V
Subjects:
Analysis
Business and Management
Carbon
Carbon taxes
Climate change
Combinatorics
Finance
Fossil fuels
Fuel industry
Greenhouse gases
Laws, regulations and rules
Methods
Operations research
Operations Research/Decision Theory
Pricing
Risk
Risk management
S.I.: Recent Developments in Financial Modeling and Risk Management
Securities
Socially responsible investments
Stocks
Taxation
Theory of Computation
United Kingdom
Climate change
Portfolio theory
Carbon pricing
Bayesian analysis
Black–Litterman model
ISSN:0254-5330, 1572-9338
Online Access:Get full text
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Summary: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.
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ISSN:0254-5330
1572-9338
DOI:10.1007/s10479-019-03458-x