[Paper Review] Measuring and Managing Carbon Risk in Investment Portfolios

Théo Roncalli, Théo Le Guenedal+3 more|arXiv (Cornell University)|Aug 30, 2020

Financial Markets and Investment Strategies27 references4 citations

TL;DR

This paper proposes a dynamic, market-based approach to measuring and managing carbon risk in equity portfolios using a time-varying brown-minus-green (BMG) risk factor and carbon beta estimation via the Kalman filter. It demonstrates that carbon risk is systematically priced in financial markets, with significant regional and sectoral differences, and shows that incorporating carbon betas improves minimum variance and enhanced index portfolios by reducing both absolute and relative carbon risk.

ABSTRACT

This article studies the impact of carbon risk on stock pricing. To address this, we consider the seminal approach of Görgen extsl{et al.} (2019), who proposed estimating the carbon financial risk of equities by their carbon beta. To achieve this, the primary task is to develop a brown-minus-green (or BMG) risk factor, similar to Fama and French (1992). Secondly, we must estimate the carbon beta using a multi-factor model. While Görgen extsl{et al.} (2019) considered that the carbon beta is constant, we propose a time-varying estimation model to assess the dynamics of the carbon risk. Moreover, we test several specifications of the BMG factor to understand which climate change-related dimensions are priced in by the stock market. In the second part of the article, we focus on the carbon risk management of investment portfolios. First, we analyze how carbon risk impacts the construction of a minimum variance portfolio. As the goal of this portfolio is to reduce unrewarded financial risks of an investment, incorporating the carbon risk into this approach fulfils this objective. Second, we propose a new framework for building enhanced index portfolios with a lower exposure to carbon risk than capitalization-weighted stock indices. Finally, we explore how carbon sensitivities can improve the robustness of factor investing portfolios.

Motivation & Objective

• To develop a dynamic, time-varying measure of carbon risk in equity portfolios using the BMG risk factor.
• To assess how different climate-related dimensions—carbon intensity, emissions exposure, management, and climate scores—are priced in the market.
• To improve portfolio construction by integrating carbon beta into minimum variance and enhanced index strategies.
• To compare market-based carbon risk (carbon beta) with fundamental-based risk measures (e.g., carbon intensity) in portfolio optimization.
• To evaluate whether the BMG factor functions as a standalone risk factor in asset pricing and portfolio management.

Proposed method

• Estimates time-varying carbon beta using a Kalman filter on a multi-factor model, enabling dynamic tracking of systematic carbon risk.
• Constructs a BMG risk factor using firm-level data from Trucost and MSCI, based on carbon intensity, emissions exposure, climate change score, and environmental risk.
• Applies the BMG factor to extend the Fama-French-Carhart model, enabling estimation of stock-specific carbon betas.
• Reformulates minimum variance and enhanced index portfolio optimization with constraints on absolute or relative carbon risk exposure.
• Tests multiple specifications of the BMG factor to isolate which climate-related dimensions drive market pricing of carbon risk.
• Compares the performance and risk characteristics of portfolios optimized using carbon beta versus fundamental carbon metrics.

Experimental results

Research questions

• RQ1 How does the time-varying nature of carbon beta affect the measurement of systematic carbon risk in equity portfolios?
• RQ2 Which climate-related dimensions—carbon intensity, emissions exposure, management quality, or climate scores—are most priced in by financial markets?
• RQ3 To what extent does incorporating carbon beta improve the risk-adjusted performance of minimum variance and enhanced index portfolios?
• RQ4 How do portfolios optimized using market-based carbon risk (carbon beta) differ from those using fundamental carbon metrics (e.g., carbon intensity) in terms of risk and return?
• RQ5 Can the BMG factor be considered a distinct, systematic risk factor in asset pricing, comparable to size, value, or momentum?

Key findings

• Carbon risk is systematically priced in financial markets, with European equities exhibiting negative carbon betas and North American equities positive ones, indicating a transatlantic divide in market perception.
• Carbon intensity and emissions exposure are the most effective proxies for the Carima factor, explaining a significant portion of the BMG factor’s explanatory power.
• The correlation between market-based carbon beta and fundamental carbon intensity is weak (below 30%), highlighting a divergence between market pricing and direct environmental metrics.
• Managing absolute carbon risk (zero BMG exposure) leads to a different portfolio construction than managing relative carbon risk (negative BMG exposure), resulting in distinct optimal portfolios.
• Enhanced index portfolios optimized using carbon betas show improved robustness and lower carbon risk exposure compared to capitalization-weighted benchmarks.
• The BMG factor functions as a distinct risk factor in portfolio management, particularly enhancing minimum variance strategies by reducing unrewarded financial risk linked to carbon exposure.