Faculté des HEC

Université de Lausanne

Master of Science in Finance

SUSTAINABILITY AWARE
ASSET MANAGEMENT

Eric Jondeau
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 1/40
 SAAM
Lecture 7: Portfolio Construction under Climate Risks

Eric Jondeau

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 2/40
 Objectives of the Lecture
Several tools can be used in the fight against climate change.

- Regulation is an obvious tool (polluter pays)

However, governments have difficulties to coordinate (see COP)

- Monetary institutions (central banks) can play a role (financial regulation)

- What about finance institutions (banks, asset managers)?

Two main arguments (double materiality)

o Investing in polluting firms has an impact on the planet (fundamental risk)

o Investing in polluting firms is a source of risk for investors (market risk)

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 3/40
 Objectives of the Lecture
Readings
Cheng G., Jondeau E., and B. Mojon (2023), “Building Portfolios of Sovereign Securities with
Decreasing Carbon Footprints”,
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4207316

Fahlenbrach, R., and E. Jondeau (2021), “Greening the Swiss National Bank's Portfolio”,
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3906654

Jondeau E., B. Mojon, and L.A. Pereira da Silva (2021), “Building Benchmarks Portfolios with
Decreasing Carbon Footprints”, Swiss Finance Institute Research Paper No. 21-91

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 4/40
 Objectives of the Lecture

è Regulation of Climate Risks

- Assessing the Climate Performance of a Portfolio

- Building a Decarbonized Portfolio

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 5/40
 Regulation: United Nations
United Nations Climate Change Conference: Conference of the Parties (COP)

• COP 1: Berlin (1995)

• COP 3: Kyoto (1997) ® Kyoto Protocol
• COP 21: Paris (2015) ® Paris Agreement
• COP 26: Glasgow (2021)

The Kyoto Protocol is an international treaty that commits state parties to reduce
GHG emissions, based on the scientific consensus that:

(1) Global warming is occurring and

(2) It is likely that human-made CO2 emissions are driving it

The US did not ratify (dropped out in 2001), and Canada withdrew from the Protocol
in 2012.

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 6/40
 Regulation: United Nations
The Paris Agreement is an international treaty with the following goals:

• Keep a global temperature rise this century well below 2°C above pre-industrial
levels
• Pursue efforts to limit the temperature increase to 1.5°C
• Increase the ability of countries to deal with the impacts of climate change
• Make finance flows consistent with low GHG emissions and climate-resilient
pathways

Paris Agreement: where we are?

• 194 states have signed the Agreement (representing about 80% of GHG emissions)
• The US have recently rejoined the Agreement in 2021 (under Biden administration)
• Iran and Turkey have not signed the Agreement

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 7/40
 Regulation: Financial Regulators
“We don't need an army of actuaries to tell us that the catastrophic impacts of climate change
will be felt beyond the traditional horizons of most actors - imposing a cost on future
generations that the current generation has no direct incentive to fix.” (Mark Carney, 2015)

Some central banks, regulators and supervisors are already taking steps towards
integrating climate-related risks into supervisory practices

Network for Greening the Financial System (NGFS) (https://www.ngfs.net/):

Network of 83 central banks and financial supervisors created in Dec 2017

The NGFS recognized that “climate-related risks are a source of financial risk. It is
therefore within the mandates of central banks and supervisors to ensure the financial
system is resilient to these risks” (NGFS, 2018, p. 3).

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 8/40
 Regulation: Financial Regulators
Bank for International Settlements (BIS) (https://www.bis.org/): International
financial institution owned by central banks that “fosters international monetary and
financial cooperation and serves as a bank for central banks”. The BIS hosts the
Secretariat of the Basel Committee on Banking Supervision (BCBS) and has played a
central role in establishing the Basel Capital framework.
Climate-related risk drivers and their transmission channels (2021)
Climate-related financial risks – measurement methodologies (2021)

Task Force on Climate Related Financial Disclosures (TCFD) (https://www.fsb-

tcfd.org/): Established in December 2015 by the G20 Financial Stability Board. Its
objective is to improve and increase reporting of climate-related financial information.
Recommendations of the Task Force on Climate-related Financial Disclosures (2017)

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 9/40
 Coalitions
• One Planet Summit

www.oneplanetsummit.fr

• One Planet Sovereign Wealth Funds (OPSWF)

Funding members: Abu Dhabi Investment Authority (ADIA), Kuwait
Investment Authority (KIA), NZ Superannuation Fund (NZSF), Public Invesment Fund (PIF),
Qatar Investment Authority (QIA)
New members: Bpifrance, CDP Equity, COFIDES, FONSIS, ISIF, KIC, Mubadala IC, NIIF,
NIC NBK

• One Planet Asset Managers

Funding members: Amundi AM, BlackRock, BNP PAM, GSAM, HSBC Global AM, Natixis
IM, Northern Trust AM, SSGA
New members: AXA IM, Legal & General IM, Morgan Stanley IM, PIMCO, UBS AM

• One Planet Private Equity Funds

Members: Ardian, Carlyle Group, Global Infrastructure Partners, Macquarie Infrastructure and
Real Assets (MIRA), SoftBank IA

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 10/40
 Investors Alliances
Several initiatives by large asset managers around temperature alignment

• Climate Action 100+: an investor initiative to ensure the world’s largest corporate
GHG emitters take necessary action on climate change. In particular, the Action
objective states: “[…] reduce GHG emissions across the value chain, consistent with
the Paris Agreement goal of limiting global average temperature increase to well
below 2°C”

• Institutional Investors Group on Climate Change: an alliance of pension funds and

asset managers, with 33 trillion euros of combined AUM, that launched in May 2019
the Paris-Aligned Investment Initiative (PAII) to help investors understand what
alignment means in practice as well as identify and review methodologies and
approaches. The PAII is producing a framework to support asset owners and managers
to align their portfolios and strategies to achieving the goals of the Paris.

• Net-Zero Asset Owner alliance: an international group of institutional investors

(with over $4.6 trillion AUM) delivering on a bold commitment to transition their
investment portfolios to net-zero GHG emissions by 2050.

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 11/40
 Carbon Pricing
Polluter pays principle

• A carbon price is a cost applied to carbon pollution to encourage polluters to reduce

the amount of GHG they emit into the atmosphere
• Negative externality

Two instruments of carbon pricing

• Carbon tax directly sets a price on carbon by defining a tax rate on GHG emissions
or – more commonly – on the carbon content of fossil fuels

• Emissions trading scheme (ETS) (also called Cap-and-trade system) caps the total
level of GHG emissions and allows those industries with low emissions to sell their
extra allowances to larger emitters.

Carbon tax: the price is pre-defined, but the emission reduction outcome is not.

Some 40 countries and more than 20 cities, states and provinces already use carbon
pricing mechanisms
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 12/40
 Carbon Pricing
Share of global emissions covered by carbon pricing initiatives (ETS and carbon tax)

China
National ETS

Japan carbon tax

EU ETS

Source: https://www.carbontax.org/where-carbon-is-taxed-overview/
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 13/40
 Carbon Pricing: ETS
Trading Economics Carbon Emissions Allowances Prices are sourced from the EU ETS,
the world's largest cap and trade GHG emissions market (euro/tCO2)

Source: https://tradingeconomics.com/commodity/carbon
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 14/40
 Carbon Pricing: Tax
Prices in implemented carbon pricing initiatives

Country 2018 2019 2020 2021 2022

Sweden 139.11 126.78 133.26 137.24 129.89
Switzerland 100.90 96.46 104.65 101.47 129.86
Norway 64.29 59.22 57.14 69.33 87.61
Finland 76.87 69.66 72.24 72.83 85.10
France 55.30 50.11 6.98 52.39 49.29
Ireland 24.80 22.47 30.30 39.35 45.31
Iceland 35.71 31.34 30.01 34.83 34.25
Denmark 28.82 26.39 27.70 28.14 26.62
Portugal 8.49 14.31 27.52 28.19 26.44
United Kingdom 25.46 23.59 23.23 24.80 23.65
Slovenia 21.45 16.44 20.16 20.32 19.12
Spain 24.8 16.85 17.48 17.62 16.58
Latvia 5.58 5.06 10.49 14.10 16.58
Japan 2.74 2.60 2.76 2.61 2.36

Source: World Bank Carbon Pricing Dashboard, https://carbonpricingdashboard.worldbank.org/map_data

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 15/40
 Objectives of the Lecture

- Regulation of Climate Risks

è Assessing the Climate Performance of a Portfolio

- Building a Decarbonized Portfolio

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 Physical versus Market Measures
There are two main topics related to decarbonization due to double materiality

Measure impact of firms on climate Exclude firms because of their

(physical measure)
è impact on climate

Measure impact of climate risk on firms è Exclude firms because of their

(market measure) exposure to climate risk

Next questions:

- Portfolio decarbonization based on current carbon emissions (physical measure)

- Carbon factors (next lecture)

- Portfolio decarbonization based on carbon beta (market measure) (next lecture)

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 17/40
 Physical versus Market Measures

https://www.msci.com/www/blog-posts/how-to-evaluate-climate-metrics/03644475407

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 18/40
 Concepts – Carbon Metrics
Several ways to measure carbon impact of a portfolio:

1- Carbon footprint

2- Proportion invested in “green” and “brown” sectors

3- Avoided emissions

4- Green-brown metrics

5- Benchmark

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 19/40
 Carbon Intensity Measures
It is natural to normalize carbon emissions relative to a metric of size, quantity or value.
Firms in the same industry usually use a physical intensity, financial institutions use a
monetary intensity for their portfolio.

- Physical intensity measures the carbon emissions of a product or a service relative to

the quantity produced: (in kgCO2e per unit)

Cradle-to-gate: from
the production to the
store

Cradle-to-grave:
entire life of the
product

Source: Lhotellier, Less, Bossanne, and Pesnel (2017), ADEME report

- Monetary intensity measures the carbon emissions relative to some monetary value

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 20/40
 Monetary Carbon Intensity Measures
To compare carbon emissions between firms of different size, normalization is required.
A natural indicator is the carbon emissions relative to the revenues (sales) of the firms:
𝐸!,#
𝐶𝐼!,# =
𝑅𝑒𝑣!,#

(1) Economic carbon intensity: Volume of carbon emissions (in tons of CO2
equivalent) per million dollars of revenue (tCO2e/mln $). It measures the carbon
efficiency of the portfolio:
'! (%)
(%)
∑ !() !,# 𝐸!,#
𝑜
𝐶𝐼!,# = ' (%)
∑!()
!
𝑜!,# 𝑅𝑒𝑣!,#
where
- 𝐸!,# is the amount of carbon emitted by firm i in year t
- 𝑅𝑒𝑣!,# is the revenue generated by the firm
(%) (%)
- 𝑜!,# = 𝑉!,# /𝐶𝑎𝑝!,# is the fraction of the equity of the firm held in the portfolio
(%)
- 𝑉!,# is the dollar value invested in firm i
- 𝐶𝑎𝑝!,# is the market capitalization of firm i in year t
- 𝑁# the number of firms available in year t
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 21/40
 Monetary Carbon Intensity Measures
The carbon intensity can be rewritten as
(#)
'! 𝑉%,!
∑ '!
𝑜
(#)
𝐸 ∑ %() 𝐶𝑎𝑝 𝐸%,! '! 𝛼
(#)
(#) %() %,! %,! %,! %,! 1
𝐶𝐼! = ' (#) = (#)
= - (#)
𝐸%,!
∑%() 𝑜%,! 𝑅𝑒𝑣%,! %() 𝐶𝑎𝑝%,!
'! 𝑉%,! 𝛼*,!
!
'!
∑%() 𝑅𝑒𝑣%,! ∑*()
𝐶𝑎𝑝%,! 𝐶𝑎𝑝*,! 𝑅𝑒𝑣*,!
𝑅𝑒𝑣%,!
(#)
'!
(#) 𝐶𝑎𝑝%,! 𝐸%,! '!
(#) (#) 𝐸%,!
'!
(#) (#)
𝐶𝐼! = - 𝛼%,! = - 𝛼%,! 𝜔%,! = - 𝛼%,! 𝜔%,! 𝐶𝐼%,!
(#) 𝑅𝑒𝑣*,! 𝑅𝑒𝑣%,! 𝑅𝑒𝑣%,!
%()
∑' !
𝛼
*() *,! 𝐶𝑎𝑝*,!
%() %()

where
(%) (%) (%) (%) '! (%)
- 𝛼!,# = 𝑉!,# /𝑉# is the weight of firm i in the portfolio (𝑉# = ∑!() 𝑉!,# )
(%) *+,",! ' (%) *+,$,!
- 𝜔!,# = / ∑/()
!
𝛼/,#
-.%",! -.%$,!

Remark: Only when all firms have the same revenue per market value, one has
'!
(%) (%)
𝐶𝐼# =1 𝛼!,# 𝐶𝐼!,#
!()
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 22/40
 Carbon Intensity Measures
(2) Weighted-average carbon intensity: Portfolio's exposure to carbon-intensive
companies, expressed in tCO2e/mln $:
'! '!
(%) (%) (%) 𝐸!,#
𝑊𝐴𝐶𝐼# = 1 𝛼!,# 𝐶𝐼!,# = 1 𝛼!,#
𝑅𝑒𝑣!,#
!() !()
(3) Carbon footprint: Total carbon emissions for a portfolio normalized by the market
value of the portfolio (“financed emissions”). It expresses the amount of annual carbon
emissions that can be allocated to the investor per million dollars invested in the portfolio
(tCO2e/mln $):
'! '!
(%) (%) 𝐸!,# 1 (%)
𝐶𝐹# = 1 𝛼!,# = (%) 1 𝑜!,# 𝐸!,#
𝐶𝑎𝑝!,# 𝑉
!() # !()

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 23/40
 Carbon Exposure Measures
Example of a Portfolio’s Scope 1–3 Carbon Metrics (2019)
Portfolio value: $100 billion
Market weights: based on market cap, Portfolio weights: my choice
Walmart Southern Exxon Portfolio
Company Mobil
Scope 13 emissions (mln tonnes) (𝐸!,# ) 59.8 96.6 227.3
Revenue (bln $) (𝑅𝑒𝑣!,# ) 514.4 20.7 255.6
Scope 13 intensity (tonnes/mln $ rev) 116.3 4673.8 889.3 Ownership:
Market cap (bln $) (𝐶𝑎𝑝!,# ) 337.2 66.8 295.3 The investor
Relative market weight 0.482 0.096 0.422 100.0 holds fraction
(%) 0.095/1000 of
Ptf market value (mln $) (𝑉!,# ) 31.9 12.5 55.6 100.0 the market
(%)
Ptf weight (𝛼!,# ) value of
0.319 0.125 0.556 100.0 Walmart
(%)
Ownership (𝑜!,# ) (1/1000) 0.095 0.187 0.188
Ptf WA intensity (tonnes/mln $ rev) 37.1 584.5 494.1 1115.8
Ptf intensity (tonnes/mln $ rev) -- -- -- 660.7
Ptf footprint (tonnes/mln $ invested) 56.6 180.8 427.7 665.2
Source: Trucost (2021).
𝛼!,# × 𝐶𝐼!,# (%)
𝑜!,# × 𝐸!,# /𝑉#
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 24/40
 Avoided Emissions
Avoided emissions are emission reductions that occur outside of a product’s life cycle
or value chain, but as a result of the use of that product.

Examples of products (goods and services) that avoid emissions

- low-temperature detergents
- fuel-saving tires
- teleconferencing services

Scope 1 and 2 emission reductions due to energy-saving and energy-mix process, do not
qualify as “avoided emissions”

Emissions avoided by a company through the sale of low-carbon products / services lead
to the reduction of the direct (Scope 1 and 2) emissions of the user or client.

Avoided emissions contribute to the overall objective of reducing total emissions at the
macroeconomic level

Difficult to include in a carbon footprint measure

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 25/40
 Objectives of the Lecture

- Regulation of Climate Risks

- Assessing the Climate Performance of a Portfolio

è Building a Decarbonized Portfolio

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 26/40
 Exclusion/Best-in-Class Strategies
We assume an investor who does not want to invest in highly polluting firms. We define
a highly polluting firm as a firm with a high carbon intensity.

1- Define a threshold of the carbon intensity above which a given firm is excluded

2- Define the threshold as corresponding to a given number of firms to exclude or,

preferably, to a fraction of the market value of the portfolio that is excluded

3- Decide what to do with the proceeds of the exclusion:

o Reinvest proportionately in the remaining firms (exclusion approach)

o Reinvest in the firms with the lowest carbon intensity in the same countries or
sectors as excluded firms (best-in-class approach with same region-sector
exposures)

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 27/40
 Exclusion Strategy
Strategy rule:

1- Define the list of firms to be excluded from the BAU benchmark portfolio as the firms
with the highest carbon intensity 𝐶𝐼!,# :
'!
𝐼0,# = {11-2",! 34%,!5 }!()
where 𝑞6,# is the carbon intensity threshold corresponding to a probability 𝜃 of the
carbon intensity distribution (say 99%). The targeted “exclusion probability” is (1 − 𝜃)
𝑞6,# is defined such that the sum of the market weights of excluded firms,
(7 )
∑' !
! () !,# 1{-2",! 34%,! } , is as close as possible to the targeted probability, (1 − 𝜃)
𝛼

'
2- Define the number of excluded firms as 𝑁0,# = ∑! ()
!
1{-2",! 34%,! } .

3- The proceeds, which represent a fraction (1 − 𝜃) of the BAU benchmark market

value, are reallocated proportionately to all stocks remaining in the portfolio

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 28/40
 Exclusion Strategy: Logic

The exclusion or
best-in-class
strategy benefits
from the extreme
asymmetry in the
distribution of
carbon intensity

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 29/40
 Exclusion Strategy: Weights
Vector of weights:

(% ) (7 )
𝛼!,# = 0 for 𝑖 ∈ 𝐼0,# with 1 𝛼!,# ≈ 1−𝜃
!∈2&,!

(% ) (7 ) 1
𝛼!,# = 𝛼!,# I ( )
J for 𝑖 ∈ 𝐼2,#
∑!∈2',! 𝛼!,#7

where 𝐼2,# is the list of firms included in the portfolio (complementary to 𝐼0,# )

Very effective
... but impact on regional and sectoral exposures

• Firms from the utilities, energy, and materials are excluded

• Proceeds are reinvested into financials, healthcare or IT
• Severe underweighting of Emerging countries

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 30/40
 Exclusion Strategy: Performance

Source: Jondeau, Mojon, and Pereira da Silva (2021). Intensity and footprint are in tonnes CO2e/million $.

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 31/40
 Excluded Firms across Sectors

Source: Jondeau, Mojon, and Pereira da Silva (2021). Intensity and footprint are in tonnes CO2e/million $.

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 32/40
 Excluded Firms across Countries

Source: Jondeau, Mojon, and Pereira da Silva (2021). Intensity and footprint are in tonnes CO2e/million $.

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 Best-In-class Strategy: In practice
Carbon intensity Scope 1-3 (tCO2e/$ mln revenue)

Massive Marginal
reallocation reallocation

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 34/40
 Best-In-class Strategy
Strategy rule:

1- Denote by 𝑅! and 𝑆! the region and sector of firm i. The indicator variable 1{*" (<,=" (>}
is equal to 1 if the firm belongs to region r and sector s and 0 otherwise.

! '
2- Denote the set of firms in region r and sector s by 𝐼# (𝑟, 𝑠) = {1*" (<,=" (>} }!() . The list
of firms to be excluded (𝐼0,# ) in region r and sector s is

! '
𝐼0,# (𝑟, 𝑠) = {11*" (<,=" (>,-2",!34%,!5 }!()

(7 ) (7 )
A proportion 𝜃# (𝑟, 𝑠) = ∑!∈2&,! (<,>) 𝛼!,# / ∑!∈2!(<,>) 𝛼!,# of the market value is excluded.

3- The proceeds are reinvested in the same region-sector in the set of firms with the
lowest carbon intensity with a cumulative market value approximately the same. The set
'!
of overweighted firms is defined as 𝐼?,# (𝑟, 𝑠) = {1@* (<,= (>,-2 A4 }
B !()
.
" " ",! %! (),*),!

The overall set of overweighted firms is given by 𝐼?,# = O𝐼?,# (𝑟, 𝑠)P<,> .
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 35/40
 Best-In-class Strategy
Vector of weights:

(% ) (7 )
𝛼!,# = 0 for 𝑖 ∈ 𝐼0,# with 1 𝛼!,# ≈ 1−𝜃
!∈2&,!

(% ) (7 )
𝛼!,# = 𝛼!,# for 𝑖 ∈ 𝐼2,#

(7 )
(% ) 7 ( )
∑/∈2&,!(*" ,=" ) 𝛼!,#
𝛼!,# = 𝛼!,# I1 + ( )
J for 𝑖 ∈ 𝐼?,#
∑/∈2,,! (*" ,=" ) 𝛼!,#7

(7 ) (7 )
where ∑/∈2,,! (*" ,=" ) 𝛼!,# ≈ ∑/∈2&,!(*" ,=" ) 𝛼!,#

Very effective

... with the same region-sector exposures as the benchmark

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 36/40
 Best-In-class Strategy

Source: Jondeau, Mojon, and Pereira da Silva (2021). Intensity and footprint are in tonnes CO2e/million $.

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 Exclusion/Best-in-Class Strategies
Reduction of portfolio carbon emissions (2005-2020) – Scope 1+2+3 upstream

All Exclusion approach Best-in-class approach

firms 99% 90% 75% 99% 90% 75%
Weighted avg carbon intensity 440 362.5 222.8 139.9 364.2 243.2 168.1
Reduction (in %) (–) (17.6) (49.3) (68.0) (17.2) (44.6) (61.9)
Carbon footprint 535 425.6 263.3 161.6 426.6 284.7 184.9
Reduction (in %) (–) (20.7) (51.2) (70.0) (20.6) (47.2) (65.7)
Carbon intensity 422.2 356.2 218 128.4 356.9 245.4 160.2
Reduction (in %) (–) (16.4) (49.7) (70.7) (16.2) (42.6) (62.8)

Annual. return (in %) 8.67 8.69 8.93 9.15 8.68 8.69 8.69
Annual. volatility (in %) 16.3 16.3 16.1 16.4 16.2 16.1 16.3
Sharpe ratio 0.53 0.53 0.55 0.56 0.53 0.54 0.53
Tracking error (in %) (–) 0.09 0.71 1.71 0.07 0.44 1.06

Source: Jondeau, Mojon, and Pereira da Silva (2021). Intensity and footprint are in tonnes CO2e/million $.

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 Portfolio Optimization with Carbon Risk
Minimum Variance Portfolio
We consider the Global Minimum Variance (GMV) Portfolio, which solves the program

1 D
min 𝛼# Σ#E) α#
C 2
𝑠. 𝑡. 𝛼#D 𝑒 = 1

The solution is:

G)
∗
Σ #E) 𝑒
𝛼# = D G)
𝑒 Σ#E) 𝑒

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 39/40
 Portfolio Optimization with Carbon Risk
Adding Restrictions
Fundamental-based risk management: We restrict the exposure of the portfolio to
carbon intensity (idiosyncratic carbon risk)

- Individual threshold: 𝛼!,# = 0 if 𝐶𝐼!,# ≥ 𝐶𝐼#E

- Portfolio threshold: 𝐶𝐼(𝛼# ) = ∑' E

!() 𝛼!,# 𝐶𝐼!,# ≤ 𝐶𝐼#

where 𝐶𝐼(𝛼# ) is the weighted average carbon intensity of the portfolio

The program to solve is:

1
min 𝛼#D Σ#E) α#
C 2
𝛼#D 𝑒 = 1
𝑠. 𝑡. [
𝐶𝐼(𝛼# ) ≤ 𝐶𝐼#E

MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 40/40