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E-MailMarco Ceccarelli is an Assistant Professor at Vrije Universiteit, Stefano Ramelli is an Assistant Professor at the University of St. Gallen, and Alexander F. Wagner is a Professor of Finance at the University of Zurich. This post is based on their article forthcoming in the Review of Finance.
How should investors behave in the face of climate–related risks and the energy transition to a low carbon world? To answer this question, it is important to recognize that accounting for climate risks in investment decisions brings investors both benefits and costs.
On the one hand, shunning carbon–intensive, “brown” assets can reduce an investor’s exposure to climate risks. These risks have arguably yet to fully materialize, both in terms of physical consequences and societal reactions. On the other hand, in our not–yet–low carbon economy, excluding “brown” assets and investing only in those considered “green” requires investors to forego opportunities to diversify. This trade–off is particularly salient in asset management, where portfolio diversification, not only the features of individual securities, plays a crucial role in reducing overall investment risk.
In a recent paper, we study how investors and asset managers navigate this trade–off. We focus on the mutual fund industry, which represents an important share of global financial markets, and exploit a quasi–natural experiment involving a sudden increase in both the availability and salience of information on carbon risk (climate transition risk), i.e., the class of risk deriving from the transition to a lower carbon economy. On April 30, 2018, Morningstar, the most important data provider in the mutual fund industry, released a new Portfolio Carbon Risk Score derived from firm-level data provided by Sustainalytics, which Morningstar has controlled since 2017. The novelty of Morningstar’s Portfolio Carbon Risk Score is highlighted by the fact that it correlates only mildly with other portfolio metrics, based on previously available environmental scores from Sustainalytics, Refinitiv, and MSCI KLD. Based on its new carbon risk score, combined with relatively standard information on firms’ fossil fuel involvement, Morningstar also issued an eco–label for mutual funds – the Low Carbon Designation (LCD). We use a large sample of active European and US mutual funds to study investors’ and fund managers’ reactions to these information shocks produced by the publication of Morningstar’s Portfolio Carbon Risk Score and its associated LCD eco–label.
We use the following conceptual framework guiding our empirical analyses. The extant literature has focused on the risk properties of individual green securities. For example, some studies argue that firms with lower carbon emissions are expected to be less risky than other firms due to lower exposure to climate-related uncertainties (e.g., Bolton and Kacperczyk (2021, 2023)). Similarly, other studies argue that shareholders of firms polluting more require a risk premium (Hsu et al., 2023) and so do, at least recently, shareholders of firms with a more negative biodiversity footprint (Garel et al., 2024).
However, how the risk properties of individual green securities translate to the portfolio level is still largely unexplored and, as we show, not obvious. In particular, one may naively think that the risk properties of low carbon funds should mirror those of their low carbon holdings. Such, we find, is not the case. The investment risk of a portfolio depends not only on the variance of its individual holdings’ returns, but also on the covariance of these returns (Markowitz, 1952). Empirically, while low carbon funds have lower exposure to climate risks, their volatility is not lower than that of more conventional funds. In fact, we find that the mutual funds with the lowest carbon risk scores have higher volatility than those with median scores. The source of this result is the high degree of industry concentration (Kacperczyk et al., 2005) of low carbon funds. These funds overweight IT, retail, and healthcare fi while they underweight energy, materials, and utility firm. Beyond the industry concentration, the fact that low carbon funds hold fewer stocks does not significantly further explain their surprisingly high volatility. Overall, low carbon funds hold assets that, although individually less risky, have a high degree of covariance, limiting risk–sharing. (That said, low carbon investing can come in different shapes. For instance, Andersson et al. (2016) and Bolton et al. (2022) outline approaches to reducing carbon risk with small tracking errors and sector–weighted deviations.)
In light of this trade-off, how did mutual fund investors react to the April 2018 information shock? Funds receiving the “Low Carbon Designation” enjoyed a substantial increase in their monthly flows relative to other funds. The economic impact of the LCD label corresponds to an average increase in flows of approximately 36 basis points each month through the end of 2018; this increase is equal to about two–thirds of the effect on flows caused by a one–standard–deviation stronger monthly financial performance. Importantly, at the margin, investors should attempt to strike a balance between the risk benefits of portfolio diversification and those of low carbon investing. Of two otherwise-equal LCD-labeled funds, investors should prefer the one with higher perceived risk-adjusted returns. This is precisely what we find.
Next, we employ a dataset of monthly portfolio holdings to study the reactions of fund managers to the release of Morningstar’s portfolio and firm-level carbon risk information. We show that, after April 2018, fund managers actively rebalanced their portfolios to reduce their carbon risk. On average, relative to the period before the publication of Morningstar’s carbon risk metrics, mutual funds reduced their position in the average high carbon risk fi by about 0.17 basis points of their assets under management per month. This effect is economically meaningful, considering that the median monthly position change is zero for the whole sample and 2.8 basis points for non–zero position changes.
Importantly, funds with higher ex–ante industry concentration reacted more strongly to the release of the new carbon risk information. For these funds, shifting to lower carbon risk assets is less likely to decrease (and may even increase) their diversification. They are also likely to serve clients who are less interested in broad diversification in the first place. Also importantly, we find that when managers reduced their positions in stocks with a score of medium or high carbon risk, they did so more aggressively for those with a higher return covariance with the remainder of the portfolio, consistent with an attempt to preserve diversification.
Overall, our results indicate that both the cost and benefit sides of low carbon investing should (and do) shape investor responses. They confirm climate risks to be a key consideration in the mutual fund industry and provide new insights into how climate-related information can re-orient capital flows in a low carbon direction. By highlighting the existing tension—at least in the short run—between the management of climate risks and traditional mean–variance portfolio considerations, we hope to provide practical implications and stimulate further research into the behavior of investors and fund managers during the transition to a low carbon economy.
