Paris alignment a win-win for capital allocation
The biggest question for capital allocation in sustainable finance is how to capture externalities – most importantly the wider cost of emissions – without excessively adversely affecting performance. L-Bank acted as dual studies partner for research by graduate student David Alexander Jablonski, which finds that there may be a performance benefit from investment in a Paris Agreement-aligned portfolio.
The following text is extracted and adapted from Climate Finance: Study of the Steering Impact of Paris Alignment regarding Climate-Optimal Capital Allocation using an Index-Based Equity Portfolio by David Alexander Jablonski.
In its sixth assessment report, the Intergovernmental Panel on Climate Change (IPCC) shows that the climate system has changed to an unprecedented extent. It is scientific consensus that global warming is directly driven by greenhouse gas emissions from human activities. According to the IPCC, widespread impacts of human-induced climate change are now pervasive.
The problem of climate change arises with the use of the climate system as a global common good, which consists of the absorption of CO2 emissions by the earth’s atmosphere or carbon sinks. Benefits of economic activity are captured primarily by the producing state, while the effects of the generated CO2 emissions are imposed on the entire world. Conversely, the individual state alone bears the costs of its climate protection measures, from which everyone benefits.
The near-linear relationship between greenhouse gas emissions and climate change is reflected in the outstanding importance of emissions as an area of action for international climate policy.
The Paris Agreement marked a turning point in that, for the first time, all parties to the UN Framework Convention on Climate Change were held accountable for protecting the climate system. It moved away from the Kyoto Protocol’s top-down imposed commitments, replacing them with self-determined efforts to limit global warming to 1.5°C that the Paris Agreement calls nationally determined contributions (NDCs).
Climate economics continues to provide an explanatory model for the dubious progress of international climate policy. The Kyoto Protocol and the Paris Agreement are both characterised by uncoordinated and non-binding cooperation that encourages free riding.
This corresponds to nations deliberately refraining from reducing emissions to benefit from climate protection measures taken by others. The collapse of the Kyoto Protocol into an uncooperative equilibrium can be explained by the non-binding design of its cap-and-trade approach. Structural defects of the Paris Agreement are evident in the uncoordinated and voluntary nature of the NDCs.
Although COP26 was able to bring 1.5°C back into reach with the Glasgow Climate Pact and further commitments, exactly how the momentum generated will be translated into effective measures is still opaque. It remains doubtful to what extent the gap between signalled ambitions and actual efforts can be closed.
The fact that climate change has not yet been addressed internationally in a coordinated or binding manner marks an alarming but reversible development. Climate economics further proposes market-based approaches centred on the social cost of carbon to internalise the climate change externality. The concept of the Climate Club, which enforces a uniform CO2 price through coordinated cooperation, can overcome the issue of free riding.
“The generation, aggregation, and dissemination of information through pricing allow for differentiation in capital allocation in relation to climate change. The role of capital markets, then, is to direct financial resources toward decarbonisation by pricing and monitoring climate risks.”
The Paris Agreement and EU policies explicitly involve the financial system. Development banks, as part of the public financial sector, have a key role to play in mobilising capital, enabling adaptation and counteracting market failures resulting from climate change.
Climate finance is inextricably linked to the concept of climate-resilient development and is specifically aimed at supporting climate change mitigation and adaptation. Blended finance as a capital structuring approach of ‘blending’ financial and social motives catalyses investments in developing countries from the private sector. The combination of blended finance and climate finance used by development banks manifests the key role of finance in achieving the Paris climate goal.
The current coalition agreement in government and the climate protection amendment of the state of Baden-Württemberg includes emissions reduction of 65 per cent compared with 1990 levels by 2030 and net zero emissions by 2040. This is a binding reference frame for L-Bank’s goal of being largely climate-neutral by 2030.
L-Bank’s strategic positioning in climate protection is exemplified by the financial compensation of CO2 emissions generated in daily operations. A more effective lever for a development bank with a focus on international capital markets is – apart from development activities – the climate-optimal allocation of capital in the investment portfolio.
Although the efficiency of capital markets is a debated topic, it can be argued that asset prices to some extent reflect available value-relevant information. Crucial here is the recognition that rational expectation uncertainty regarding climate change and socioeconomic transition constitute multilayered financial risk factors that can be reflected in asset prices.
The generation, aggregation, and dissemination of information through pricing allow for differentiation in capital allocation in relation to climate change. The role of capital markets, then, is to direct financial resources toward decarbonisation by pricing and monitoring climate risks.
Using elements of portfolio theory as influencing factors for rational allocation decisions with the aim of maximising financial value can be subsumed under the shareholder value approach. However, the interests of stakeholders can also be included in the investor’s utility function.
Following stakeholder theory, the environmental and social impacts associated with an investment become benefit components and successive influencing factors. The consideration of stakeholders’ interests in the decision-making process is particularly relevant for funding agencies due to their non-profit mission as public institutions.
“A Paris alignment-integrated investment approach can reconcile financial and nonfinancial components of investor utility in an incentive-compatible manner, in that improvements in the risk-return dimension go hand-in-hand with improvements in the climate dimension.”
In the Jablonski study, climate impact was integrated into an investment approach following best practice for measuring Paris alignment. Using the MSCI Europe Index of equities – which covers 85 per cent of the market capitalisation of 15 developed countries – this approach was applied to an index- based equity portfolio.
Transferred to climate change, an investor with a risk- and climate-sensitive utility function is conceivable. Decisions under the climate impact influence factor of this archetype aim at a climate-optimal allocation with the highest achievable risk-adjusted return. Without specifying the utility function in more detail, the idea can be formulated qualitatively as a higher-dimensional extension of the efficiency frontier from a line to a climate-efficiency surface.
From a portfolio theory perspective, climate impact as an influencing factor for allocation decisions is rooted in risk aversion with respect to climate risks, nonfinancial components of investor utility and decarbonisation strategies, or a mix thereof.
Positive effects of corporate sustainability on financial value show temporal congruences with the long-term horizon of stakeholder capitalism. The extension of the investor utility function to include climate impact constitutes a stakeholder value approach. The climate impact factor is not only justifiable in terms of portfolio theory but can be incorporated to internalise external effects in allocation decisions.
The results obtained provide an answer to the question of the extent to which an investment portfolio can be managed by measuring Paris alignment.
A key finding of the study is that an index-based equity portfolio can successfully approach a climate-optimal capital allocation with the help of portfolio management based on Paris alignment. Contrary to the intuitive assumption that a primary optimisation of the climate impact of an index-based equity portfolio would require concessions in risk-adjusted returns, the results show an increase in Sharpe ratio.
According to the empirical results, a climate-optimal capital allocation is not only achievable but uncompromisingly desirable under portfolio theory risk-return considerations. A key finding of the study is that an index-based equity portfolio can successfully approach a capital allocation that is consistent with limiting global warming to 1.5°C with the help of portfolio management based on Paris alignment.
A Paris alignment-integrated investment approach can reconcile financial and nonfinancial components of investor utility in an incentive-compatible manner, in that improvements in the risk-return dimension go hand-in-hand with improvements in the climate dimension. Overall, the findings support the compatibility of stakeholder value approaches with regard to climate effects with shareholder value objectives.
The approach presented in this thesis can be characterised by its generalisability with respect to various asset classes and transferability to different investor groups.
From L-Bank’s point of view, the consideration of sovereigns and government institutions as bond issuers – which has been excluded so far due to data gaps for these assets – is particularly relevant. The present work can serve as an impetus for research contributions that take up the idea of the climate factor in portfolio theory. Based on the findings, further empirical studies in the realm of climate finance could focus on portfolio allocations that diversify across multiple asset classes and regions.
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