Clients who care about climate change may want that their investments do not contribute excessively to climate change. Yet, traditional portfolio optimisers do not take climate impact into account: they look for the best trade-offs between financial risk and return only. We add climate impact as a third dimension into portfolio optimisation tools. Hence, our portfolio optimisers help find the best trade-off between risk, return and climate impact for each client. More precisely, our tools help minimise climate impact while maximising expected returns and minimising risk. We find that asset allocators can improve their portfolio’s climate alignment at a moderate cost to risk-adjusted returns. Intuitively, climate-aligned assets are diverse enough to offer significant diversification opportunities.
Our research has asset pricing implications, too. Increasing climate awareness may boost better climate-aligned assets and hurt climate offenders. Markets tend to reward better environmental practices. Yet, equity valuations do not seem to reflect climate alignment yet. Three factors may magnify repricing dynamics. First, investors can lower an equity portfolio’s climate alignment to 2.5°C without hurting its risk-adjusted return. Such fact leaves less climate-aligned stocks particularly vulnerable. Second, investors willing to pay -if only a little in terms of risk-adjusted returns- to fight climate change would imply large portfolio shifts away from climate offenders towards better climate-aligned companies. Third, climate-aligned assets are scarce (only 6% of stocks are aligned below 2°C, for example). Such scarcity may exacerbate upward pressure on their price.
Investors have yet to act forcefully on climate change. A key investor concern is that fighting climate change may expose investors to excessive portfolio risks by forcing them to invest only in “green” sectors. Another is that doing so may lower returns. Our research shows that both fears are misplaced. We also offer a framework for global investors that aims to defeat climate change.
In our experience, a common strategy to fight climate change is to invest in “green” sectors. Yet, putting too many eggs in one basket can be risky. Hence, investors tend to invest only a small portion of their assets in green sectors. Unfortunately, a small allocation means a small impact. The International Energy Agency (IEA) offers an alternative strategy. The IEA designs plausible climate transition paths for the world economy. Under such scenarios, all sectors and geographies need to cut carbon emissions. We built a database on firms’ climate alignment using the IEA’s scenarios. Few businesses appear to be consistent with a 2°C scenario (only 6% of listed firms are). Yet, most sectors and geographies have firms below 2°C. All these firms are part of the solution. Hence, investors can fund climate solutions without putting all their eggs in the same basket. For example, simple portfolios investing in climate-aligned stocks raise a global equity portfolio’s volatility (a measure of risk) by only one percentage point. Such moderate increase in risk implies that investors could allocate significant capital to fighting climate change.
Moreover, investors could lower the climate footprint of all their assets. We analyse firms with a sub 2°C climate alignment. Two thirds of their better alignment appears to reflect idiosyncratic efforts, rather than operating in the right sectors or regions. A corollary is that all firms adopting their sector’s best practices could cut global emissions by about two thirds. Investors could pressure firms to do so. Shareholders can engage with management. Moreover, they can vote at general assemblies. Empirical studies suggest that successful engagement on environmental issues creates financial value. Hence, fighting climate change may boost investment returns.
Overall, our paper illustrates that investors can fight climate change in two ways: funding climate-aligned firms (which increases portfolio risk only moderately); and/or engaging all firms to lower their climate footprint (which does not raise risk and may even boost returns).
Sustainable index investing is becoming mainstream. Arvella developed a framework to select ESG index managers. Contrary to popular belief, we believe “passive” investing can promote sustainability. Index managers can fund firms with better ESG practices. They can also force change through voting and engagement. Unfortunately, ESG marketing claims are often stronger than ESG actions. For example, 37% of 425 sustainable index funds have an lower ESG score than their parent non-ESG benchmark; only 9% have an ESG score at least 10% higher than the non-ESG benchmark; and 16% of funds use derivatives forgoing their right to vote, a key lever to promote sustainability. Our paper also highlights the potential investment biases -such as style, country and sector- that may arise by using ESG index funds.