Climate Investing

3Portfolio Construction with Climate Risk Measures

With the 2015 Paris Agreement, the development of ESG investing and the emergence of net zero emission policies, climate risk is certainly the most important topic and challenge for asset owners and managers today, and will remain so for the next five years. It considerably changes portfolio allocation and the investment framework of both passive and active investors. The goal of this chapter is to conduct a survey of the various climate risk measures that are available in the asset management industry and the practices of portfolio construction that use these metrics. Therefore, the first part of this chapter lists the different climate risk metrics – for example, carbon footprint, carbon transition pathway, carbon transition and physical risks. The second part is dedicated to portfolio optimization, in particular portfolio decarbonization and portfolio alignment (Paris-based benchmarks and net zero carbon objective). Among the different findings, two are of great importance to investors. First, portfolio decarbonization is more difficult when we include scope 3 carbon emissions. In fact, optimizing using the sum of scopes 1, 2 and 3 emissions leads to a portfolio with a higher risk of tracking error than using direct plus first tier indirect carbon emissions. Second, portfolio alignment is more complex than portfolio decarbonization. Since aligning portfolios with scope 3 is becoming the standard approach to climate portfolio ...