Optimal diversification and the transition to net zero : a methodological framework for measuring climate goal alignment of investor portfolios

Overview & Synopsis

The thesis seeks to develop a framework to measure the alignment of financial portfolios with climate goals, taking as point of departure both traditional modern portfolio theory and financial risk analysis frameworks, as well as climate science. It represents the first attempt to develop science-based benchmarks for financial portfolios. The framework uses as the starting point the concept of ‘optimal diversification’ based on the modern portfolio theory and efficient market hypothesis. Under this theory, optimal strategies involve buying the ‘market portfolio’. It posits that a 2°C aligned, science-based portfolio strategy is not aligned with such a strategy. Such a science-based portfolio strategy, in turn, may make sense for financial institutions that consider multiple objectives (e.g. financial and non-financial) or financial institutions that think markets are mispricing financial risks associated with the transition to a low-carbon economy and that associated low-carbon, or 2°C aligned strategies can outperform the market. Under the assumption that the transition to a low-carbon economy presents a risk factor, for which the thesis provides a range of theoretical evidence, portfolio strategies can seek to buy the ‘2°C market’ by managing ‘optimal diversification’ to the 2°C aligned technology set, in addition to managing sector exposures. The model thus extends the logic of diversification to reduce risk, intrinsic to the modern portfolio theory, from asset class to sector and technology level.Following the development of the model, a range of insurance companies, asset managers, and portfolio managers tested the model. In total, over 250 institutional investors have applied the model to date. In addition, the model has been tested on around 10,000 funds. Moreover, two European central banks have applied the model internally as part of 2°C scenario analysis of their regulated entities (pension funds and insurance companies). As part of a feedback survey with 25 investors, 88% said the framework was equally or more relevant than existing climate assessments, and 88% said they were likely or very likely to use the methodology moving forward.