Investors can construct portfolios that reduce their exposure to energy transition risks without sacrificing financial gains, according to researchers.
In a paper on “smart carbon portfolios”, the researchers – from Impax Asset Management and the Centre for Climate Finance and Investment at Imperial College Business School – argued that governments of major economies were increasingly likely to act within the next decade to reduce man-made greenhouse gas emissions, probably by intervening in fossil fuel markets through taxation or cap-and-trade mechanisms.
“The 200% rise in European carbon allowances prices over the past 12 months has been a wake-up call for investors in energy-intensive industries,” the researchers wrote.
In 2017, the EU agreed a major reform of its scheme for carbon emissions trading. Prices of allowances were driven upwards in anticipation of a reduction in supply under a “market stability reserve” facility that came into effect in January.
“We find that investors could significantly reduce ex-post risk by lowering the weights of some fossil fuel stocks with correspondingly higher weightings towards companies active in energy efficiency,” the researchers wrote.
“While there is considerable uncertainty about the timing of transitions to future carbon pricing regimes, we anticipate that expectations will drive changes in asset valuation”
The results of their work, they said, showed that “the financial costs of reducing carbon risk are found to be statistically negligible”.
“While there is much more work to be done, our work generates evidence that investors can substantially reduce their exposure to carbon pricing without sacrificing ex-ante financial gains.”
According to the Impax and Imperial College researchers, many institutional investors recognised that climate change posed financial risks, but did not have the quantitative models to address their exposures.
They said strategies such as underweighting sectors with high carbon footprints – for example, airlines – were “naïve” risk management policies. Such measures “misread” energy transition risks and could also reduce long-term portfolio returns.
The paper described an alternative risk management approach that they said had the benefit of using “some of the standard tools of investment management”.
The researchers’ work focused on creating carbon sensitive portfolios to be implemented based on forecasts.
“While there is considerable uncertainty about the timing of transitions to future carbon pricing regimes, we anticipate that expectations will drive changes in asset valuation,” the researchers said.
The end results of their approach, they said, were portfolios that allowed an investor to hedge against the shift to a world with carbon pricing without altering the investor’s targeted risk-return balance.
Ian Simm, chief executive of Impax Asset Management, said: “Companies and investors are under increasing pressure to use forward-looking scenario analysis to assess their climate change risks. This research goes beyond the generic guidelines and demonstrates, in a practical way, that scenario analysis can be used not just to assess risk, but effectively manage it as well.”
The executive summary of the paper can be found here.