Climate change has been a dominant topic not only since the German elections. However, while many other relevant topics lose importance over time, climate change is likely to remain permanently on the agenda in the coming decades.
It is therefore not surprising that, from a portfolio management perspective, climate-relevant issues are also increasingly taking center stage and becoming a central issue in portfolio construction. Ultimately, the entire discussion revolves around the question of to what extent and in what way asset managers have the opportunity to respond to climate change. This is because climate change has various effects on portfolios.
On the one hand, there are likely to be stocks or even entire industries that will suffer directly from rising CO2 prices. This applies above all to regions where CO2 emissions trading limits emissions. This includes Europe in particular, but also China, for example. On the other hand, there are stocks and industries that could suffer indirectly from climate effects – these include insurance companies, for example, whose claims increase as a result of extreme weather events. Finally, on the other hand, individual stocks or even entire industries may benefit from climate change and associated government intervention, government subsidization, and changes in demand.
At first glance, it seems easy to avoid climate-related risks and take advantage of resulting opportunities by significantly reducing the carbon footprint of your portfolio as a portfolio manager. However, this is not a perfect solution – after all, insurance companies, for example, have a comparatively small carbon footprint and yet carry a greater medium-term “climate risk”.
In principle, each stock in an investment universe would have to be assigned a climate risk score, which would consist of a CO2 price sensitivity and other less quantifiable variables. This information could be used to construct a portfolio with significantly lower climate risks than the benchmark. However, anyone who thinks that this is already the solution is probably very much mistaken. This is because such an optimized portfolio would entail other, new “risks” in the form of a sector allocation that deviates significantly from the benchmark or in the form of a factor skyline that deviates massively from the benchmark. If these parameters are controlled, the attractiveness in terms of climate risks decreases.
One would get a little more leeway if one allowed short selling; if one could short sell stocks with high climate risks and at the same time raise the gross exposure to over 100%, one could probably construct portfolios in which the trade-off between “climate attractiveness” and other objectives could be resolved to a considerable extent. However, the truth is that this possibility of portfolio construction is not feasible for the vast majority of investors and is rather only a possible theoretical approach.
In practice, however, there is another interesting possibility to hedge at least part of the climate risks of a portfolio. Assuming that a certain part of the actual risks is related to the development of the CO2 price, a direct hedge via the purchase of EU emission rights seems possible here. While EU emission rights cannot be booked directly into a portfolio, there are now vehicles that track the price of EU emission rights well and can be added to a portfolio.
But here again, a question arises that can only be answered to a limited extent. The question is how much EU emission rights have to be mixed in to achieve an appropriate hedge. At least econometrically, this question can only be answered inadequately on the basis of past data. For example, if one calculates the correlation between the weekly returns of the prices of EU emission rights and the weekly returns of the DAX over weekly rolling one-year periods, positive correlation coefficients could be observed in 441 out of 521 rolling annual periods since the end of 2010.
Economically, this is implausible at first glance, since rising CO2 costs should in themselves have a negative effect on share prices. On the other hand, however, CO2 prices and share prices have several common drivers. These include the business cycle, but also the general risk appetite of investors. It is therefore not very useful to be able to determine a supposedly perfect hedge on the basis of simple regression analyses. It is probably even better to determine a suitable investment level for EU emission rights as a hedge on the basis of plausibility considerations.
If one now holds EU emission rights in the portfolio, one might get the idea that one is doing something good for the environment just by doing so. The argumentation could be as follows: By buying emission rights, their price rises, so that the rights become scarcer and thus fewer are emitted. And because you also hold rights yourself, they can no longer be used to legitimize emissions. So you would have killed two birds with one stone. Unfortunately, this argument is not correct.
For one thing, emission rights will hardly be used less if they become more expensive. This is because the concept of EU emissions trading is based on the quantity effect and not on the price effect. Politicians determine how many emission rights are available to legitimize emissions, and the price ultimately determines who holds and uses these rights.
Now, if the price goes up, some companies holding those rights will probably be inclined to sell them. But there will always be a buyer for whom it is worthwhile to continue to legitimize emissions with them, even at a higher price – after all, it is by definition a market-clearing price; for every seller there is a buyer.
In this context, it is inconceivable that expensive rights are only held permanently and not used and never sold – that would be completely absurd from an economic point of view. In the end, every valid right in the hands of an economically acting company will also be used for the legitimization of emissions. So it remains to be said that a change in the CO2 price has hardly any influence on the reduction path of CO2 emissions.
On the other hand, it also does not help the environment if rights are temporarily withdrawn from the market by holding them in a depository for a few years. After all, climate protection is about emissions that extend over many decades. For the climate, it is comparatively irrelevant whether emissions occur now or in seven or ten years.
The only thing that matters is the total amount of emissions; their distribution over time is largely secondary. This can be seen from the many possible and in some cases very different reduction paths described by the Intergovernmental Panel on Climate Change, all of which would be compatible with a 1.5 degree target.
No matter how you look at it: Managing climate risks is not a simple undertaking. One should not believe that simple answers and solutions exist here. The issue is complex and challenging. Nevertheless, there is no reason to bury our heads in the sand. The climate challenges will be with us for decades. This road may be rocky, but at the same time, the learning curve that comes with it should not be underestimated. So there is a lot to be said for the fact that this challenge, too, will be mastered – just like many other challenges of the past decades.
By Dr. Christian Jasperneite
Source: Fundsresearch, published 10/2021