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

Abstract 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.