Martin Nerlinger

Portfolio management is confronting climate change more strongly and rapidly than expected. Risks arising from the transition from a brown, carbon-based to a green, low-carbon economy need to be integrated into portfolio and risk management. The authors show how to quantify these carbon risks by using a capital markets–based approach. Their measure of carbon risk, the carbon beta, can serve as an integral part of portfolio management practices in a more comprehensive way than fundamental carbon risk measures. Apart from other studies, the authors demonstrate that both green and brown stocks are risky per se, but there is no adequate remuneration in the financial market. In addition, carbon risk exposure is correlated with exposures to other common risk factors. This requires due diligence when integrating carbon risk in investment practices. By implementing carbon risk screening and best-in-class approaches, the authors find that investors can gain a desired level of carbon risk exposure, but this does not come without well-hidden costs.

We use the COVID-19 pandemic period in 2020 as an exogenous shock event to assess in how far climate risks measured by carbon exposure have entered and established themselves in the valuation of global stocks. We find that carbon intensity affected returns significantly negatively during a time of high uncertainty. However, carbon-intensive stocks could make up for their additional losses in the recovery period. In line with their high risk exposure towards stranded assets and climate policy uncertainty, carbon-intensive stocks face higher risk levels in more stable economic times thus justifying a carbon premium.

We investigate carbon risk in global equity prices. We develop a measure of carbon risk using industry standard databases and study return differences between brown and green firms. We observe two opposing effects: Brown firms are associated with higher average returns, while decreases in the greenness of firms are associated with lower announcement returns. We construct a carbon risk factor-mimicking portfolio to understand carbon risk through the lens of a factor-based asset pricing model. While carbon risk explains systematic return variation well, we do not find evidence of a carbon risk premium. We show that this may be the case because of: (1) the opposing price movements of brown firms and firms becoming greener, and (2) that carbon risk is associated with unpriced cash-flow changes rather than priced discount-rate changes. We extend our analysis to different geographic regions and time periods to confirm the missing risk premium.

Carbon emissions are nowadays an important driver of the value of a firm. We are the first to analyze the potential of carbon emissions data in enhancing the accuracy of firm valuations using the similar public company methodology with multiples. Using carbon emissions has a potential to improve firm valuation accuracy in two separate ways. First, we construct multiples based on carbon emissions (CEM) which are able to estimate firm values. And second, we create more precise peer groups by including carbon emissions (CEPG) in the composition process. To gain deeper insights, we are conducting further analyses, e.g. by measuring the accuracy of carbon emissions peer groups and carbon emissions multiples at valuing carbon intensive or carbon inefficient firms. We extend our study by looking at firms in countries with carbon pricing or by taking ESG and SDGs concerns into account. Overall, we find that CEPG improves the accuracy of firm valuations in more than three quarters of all cases whereas CEM have limited use. Therefore, we recommend analysts, asset managers and investors to include carbon emissions data into their peer group composition.