Climate change is a major global challenge, yet we face a striking lack of investment tools to embed climate impact into investment decisions. Therefore, we developed a portfolio optimiser that finds the best trade-off between expected returns, risk and a portfolio’s “temperature”. The optimiser offer two approaches:
The first approach asks investors to indicate a temperature target for their portfolios, which the optimiser then uses as a constraint in the optimisation process. Specifically, we extend the traditional Markowitz mean-variance optimisation with a linear constraint on a third dimension: portfolio temperature. We find that the relationship between a portfolio’s temperature and its risk/return profile is not linear. Lowering a portfolio’s temperature to 2.5°C barely hurts its expected returns and volatility. However, lowering temperature further comes at the cost of lower risk-adjusted returns.
The second portfolio optimisation approach makes investors’ contribution to climate change an explicit factor of their well-being. That is, we add a preference for low temperatures to a standard utility function. A “temperature-aversion” coefficient summarises that preference. Temperature-aversion rising widely would cut hotter stocks’ funding, incentivising firms to improve their climate alignment.
Three-dimensional optimisers have immediate practical implications; they can help asset managers craft the asset allocation offering the best risk, return and climate impact given each client’s preferences. With climate awareness rising, we expect three dimensional optimisers to become widespread.
- Equity investors can lower their portfolio’s temperature to 2.5°C without hurting risk-adjusted returns. Lowering temperature further is progressively more costly.
- Asset allocators can lower their portfolio’s temperature at a moderate cost to risk-adjusted returns. Our optimiser allows each investor to find his or her best risk, return and climate impact trade-off.
- Rising climate awareness may benefit colder stocks and hurt hotter ones. Investors caring slightly more about climate implies large portfolio shifts. Moreover, equity investors can lower portfolio temperature to 2.5°C without hurting Sharpe ratios—leaving hotter stocks particularly vulnerable.
Our paper in the Journal of Impact and ESG Investing describes the optimiser in more detail.