Climate change poses new challenges to portfolio management. In our yet-to-low-carbon world, investors face a trade-off between minimizing climate risk and maximizing the benefits of portfolio diversification. In January 2024, Review of Finance published Low Carbon Mutual Funds, which examines how investors and financial intermediaries make this trade-off. The Institute of Financial Technology of Chinese Min University (WeChat ID: ruc fintech) compiled the core part of the research. Author | marco ceccarelli, stefano ramelli, and alexander f.Wagner** Review of Finance Compilation |Xu Yizi1.Introduction
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 recognise that considering climate risk in investment decisions can bring benefits and costs to investors. On the one hand, avoid carbon-intensive"Brown"Assets can reduce investors' exposure to climate risk. Climate risks have not yet been fully reflected in terms of both practical consequences and societal responses, but many believe that this risk is underestimated in current assets** (Stlerbel and Wurgler, 2021). On the other hand, in our immature low-carbon economy, exclusion"Brown"assets, only those invested are considered to be"Green"will require investors to give up the opportunity to diversify. This trade-off is particularly pronounced in asset management, where diversification plays a crucial role in reducing overall investment risk (Markowitz, 1952).
In this article, the author examines how investors and asset managers navigate this trade-off. This paper focuses on commonality, which has a significant share of global financial markets, and uses a quasi-natural experiment involving a sudden increase in the availability and significance of information on carbon risks (climate transition risks, i.e., risk categories derived from the transition to a low-carbon economy), and draws conclusions.
This article begins by providing insights into the benefits and costs of green investment products. Existing research shows that companies with better environmental performance face lower climate-related risks and are priced accordingly. However, how the risk attributes of individual greens** translate to portfolio levels remains largely unexplored. The portfolio-level trade-offs highlighted in this context are consistent with the rationale for green investing.
Second, the authors add research on whether and why investors prefer socially responsible investment products. The responses of the quasi-natural experiments analyzed in this paper highlight the costs and benefits of socially responsible investment products, which are critical to understanding the complexity of investor behavior on sustainability issues. In terms of cost, low-carbon investments require investors to pay the price of less diversification in their sectors, at least in the short term. In contrast, Universal Sustainability Rating products are often based on a "best-in-class" methodology, precisely so that investors don't give up any sector diversification. In terms of benefits, the events we analyze can focus on investors' specific climate-related preferences. As documented by Hartzmark and Sussman (2019), the investors we studied have opted in on their own based on their general sustainability preferences**. Our results show that both the costs and benefits of low-carbon investments influence investor responses.
Third, this paper complements the research on the behavior of professional money managers. Some studies have viewed managers' behaviour as a function of traditional financial performance metrics, but in recent years, ESG factors, particularly climate-related considerations, have become increasingly important in the industry. For example, Krueger, Sautner, and Starks (2020) and Ilhan et al. (2023) provide survey evidence on the importance of climate risk for institutional investors. Bolton and Kacperczyk (2021a) show that institutional investors apply carbon-related screening, while Choi, Gao, and Jiang (2023) record a decrease in institutional investor investment in carbon-intensive domestic firms after 2015. Natural disasters (Alok, Kumar, and Wermers, 2020) or extreme heat events (Alekseev et al., 2021) lead to changes in climate risk perceptions. Gantchev, Giannetti, and LI (2022) examined managers' trading behaviour in terms of firm sustainability, focusing on the stress impact on firms. This paper examines how managers have contributed to positively changing their portfolio holdings in the wake of increased climate risk transparency in common industries.
2.Empirical data analysis
On April 30, 2018, Morningstar, the industry's foremost data provider, released a new portfolio carbon risk score metric derived from company-level data provided by Sustainalytics. The novelty of the Morningstar Portfolio Carbon Risk Score metric is that it has only a slight correlation with other portfolio metrics. Based on its new carbon risk scoring metric, combined with information on the relevant criteria for corporate fossil fuel participation (FFI), Morningstar has also released an eco-label for Co-Prosperity – the Low Carbon Designation (LCD). The authors used a large number of active European and U.S. samples to examine the reaction of investors and managers to the launch of the Morningstar Portfolio Carbon Risk Score and its associated LCD ecolabels.
Figure 1 shows the portfolio carbon risk score and LCD label as shown in the Morningstar report.
Figure 1Dimension characteristics
In this paper, the data are tailed at the 1st and 99th percentiles. On the basis of Hartzmark and Sussman (2019), the measure of normalized flow was also calculated: first, the authors divided the sample into deciles of the ** scale; Second, the authors ranked ** based on net traffic within the decile of each scale and calculated the percentile of the net traffic ranking. These percentiles correspond to normalized flow variables.
Portfolio holdings data
In order to study the trading decisions of the ** manager, this paper calculates the ** change expressed in the AUM benchmark point of the previous month, denoted as:
3.Conceptual framework
A conceptual framework to guide empirical analysis is developed in this section. First confirmed, based on existing literature (e.g., Engle et al., 2020;Bolton and Kacperczyk, 2021a), low carbon alone is less risky than other companies, both in terms of exposure to negative climate change news and volatility in real returns.
Start with a brief consideration of the role of carbon risk on a single **. Some literature suggests that green assets have the property of insurance against climate risks. In Figure 2, we confirm this using company-level carbon risk metrics published by Morningstar. Panel A shows the relationship between a company's carbon risk score and its return load to negative climate-related information. For the approximately 2,500 international companies covered by Sustainalytics, we regressed to each company's monthly returns on the three FAMA-French Global Factors and Engle et al (2020) standardized news-based climate change risk indexes. The authors returned to each company's monthly return based on three FAMA-French global factors and a standardized news-based climate change risk index by Engle et al. (2020). The estimated coefficient loading on negative climate news (firm) represents the company's response to negative climate news (similar to"Climate Beta") and deduct the impact of market, size and value factors. With Engle et al(2020) Consistently, a company's carbon risk is inversely correlated with the load of negative climate information (p<0.).001), i.e., low-carbon risk companies outperformed other companies in months with higher negative news loads. Panel B shows that companies with lower carbon risk also have lower average real volatility. In fact, negative climate information load (firms) is inversely correlated with earnings volatility (p<0.).001), which explains its variation of about 275%。
Figure 2: The authors then shift their focus to the portfolio level. One may be naïve to assume that the risk profile of low-carbon** should reflect the risk profile of the low-carbon assets they hold. This article finds that this is not the case. A portfolio's investment risk depends not only on the variance of the returns it holds individually, but also on the covariance of those returns (Markowitz, 1952). As a rule of thumb, low-carbon** is not less volatile than traditional**, while its climate risk exposure is lower.
In Figure 3, the authors analyzed a cross-section** of 6,310 common sources of 12-month average portfolio carbon risk scores as of April 2018. 
Figure 3Panel A shows that, on average, companies with lower scores** hold less volatile. This result comes intuitively from their tilt towards low-carbon companies, which, as we have noted, are generally less risky and less exposed to climate-related risks. (To obtain an LCD ecolabel, a portfolio carbon risk score of less than 10 is required.) )
However, as Panel B shows, the relationship between carbon risk and portfolio volatility at the ** level is not monotonous: ** with a lower level of carbon risk holds fewer risky assets, but its overall portfolio risk is not lower than ** near the market average, and may even be higher than ** near the market average, i.e., a portfolio carbon risk score close to 10.
Panel C shows that low carbon** has relatively high normalized portfolio volatility.
Panel D in Figure 3 shows the relationship between carbon risk and industry concentration when the size and category of the sector are controlled。The resulting U-shaped curve confirms that the volatility of low carbon** reflects a smaller sector diversification index.
Overall, low-carbon** holdings have a higher degree of covariance, although the individual risk is low, limiting risk diversification. The above analysis illustrates the fundamental trade-off faced by investors and managers: on the one hand, reducing climate risk exposure by allocating more green**. On the other hand, in a world where we have not yet achieved low carbon, they are detached from the status quo and miss opportunities for diversification.
4.Investor reactions
This section examines the public offering investors' response to Morningstar's April 2018 release of the Portfolio Carbon Risk Score and its LCD ecolabel. While other studies have documented investor responses to general sustainability characteristics (e.g., Hartzmark and Sussman, 2019), this paper uses this quasi-natural experiment to gain insight into the behavior of co-customers when exposed to carbon risk.
The article first intuitively explores the low-carbon investment model. During the pre-release period (April 18, 2017), the net flows of Europe** (Panel A), which was identified as low carbon, were very similar to those of others**. After April 2018, the flow of low-carbon ** began to rise continuously compared to other **. In the U.S. (Panel B), low-carbon** showed lower flows than conventional** prior to launch, but again experienced similar fluctuations as described above. Here, too, the information shock triggered a relative rise in LCD** traffic. 
To formally test this perceived effect on traffic, the authors performed the following type of difference-in-difference regression (difference-in-difference regression) on the traffic of **i from April 2017 to December 2018:
The main variable is the interaction item lcd*post. The LCD represents ** that first received the LCD label in April 2018, and Post T is an indicator variable with an observation equal to 1 after that date. x i, t-1 is a vector that represents the lagged control variable of the ** plane over time. These variables, based on previous literature, may affect financial flows. These control variables are monthly returns for the previous three months, logarithm of AUM AUM, return volatility, length of time since inception, change in general sustainability ratings (globes), and changes in overall financial performance ratings (stars). δ represents a month-by-month categorical fixed effect. Represents the fixed effect of the payment country. is the error term.
table3 reports the corresponding results.
table 3
Overall, the economic impact of LCD tags equates to an average increase of approximately 36 basis points per month of traffic by the end of 2018; This increase is equivalent to about two-thirds of the impact of an increase in one standard deviation in monthly financial performance on traffic. Ahead of the new data, investors are likely to use Morningstar's Sustainability Globes as an indicator of their carbon exposure. In addition, the traffic premium for the highly performing LCDs** on a risk-adjusted basis is even more pronounced. The results of this paper confirm the strong appeal of low carbon** and the reluctance of investors to invest in those sectors of the economy that are most affected by climate risks.
5.Common ** reaction
The article uses a dataset of monthly portfolio holdings to examine managers' responses to Morningstar's portfolio and company-level carbon risk information releases. This paper finds that after April 2018, managers actively rebalanced their portfolios to reduce carbon risk. On average, the co-owner's position in companies with average high carbon risk decreased by about 0. per month relative to the period before the release of the Morningstar Carbon Risk Indicator17 basis points of assets under management (AUM). Considering that the median monthly position change for the entire sample is zero, the non-zero position change is 28 basis points, this effect makes economic sense. Managers' response to carbon risk is not only a one-time rebalancing of their portfolios, but also an ongoing process of integrating new information into flow-driven investment decisions after the initial shock. In particular, we observed that those who experienced significant reductions in flows were more active than others in high-carbon risk assets, while those who experienced a significant increase in flows increased their exposure to low-carbon risk assets. Further cross-sectional evidence suggests that, as we expect, ex-ante industry concentrations** are more responsive to new information releases on carbon risks. For these**, a shift to low-carbon risk assets is unlikely to reduce (and perhaps even increase) their diversification. They may also serve clients who are less interested in broad diversity first. Importantly, this paper finds that when managers reduce their positions with medium or high carbon risk**, they are more aggressive in reducing those with higher covariance** with the rest of the portfolio's returns, consistent with efforts to maintain diversification.
6.Conclusions and Recommendations
What are the implications of climate risk for portfolio investment and management? The authors provide conceptual and empirical evidence of the fundamental trade-offs investors face between minimizing carbon exposure (i.e., the category of climate risk that arises from the transition to a low-carbon economy) and maximizing their diversification opportunities in a world that is not yet low-carbon.
Studying the behavior of market participants facing such trade-offs is essential to better understand the role of financial markets in the energy transition. Using a large sample of European and U.S. co-owners, we analysed the reactions of investors and managers to the Morningstar Carbon Risk Measure released in April 2018, which had an impact on the availability of climate risk information for Co-Industries. Compared to other similar **, the traffic of the new "low-carbon" label of Morningstar has increased significantly. This flow effect is more pronounced in higher risk-adjusted returns**, which is consistent with the view of marginal investors striking a balance between climate risk and traditional risk. The impact is even greater for periods when investor maturities are longer and climate risks are high.
* The manager also reacted to the new information. After April 2018, **managers are active** high-carbon risk enterprises. This low-carbon shift is even more pronounced for those with fewer losses on portfolio diversification. In addition, among high-carbon companies, managers are more active in those with higher return covariances with their portfolios, i.e., those that are less useful for diversification purposes.
Overall, the authors' findings confirm that climate risk is a key consideration for common** sectors and provide new insights into how climate-related information can reorient capital flows towards a low-carbon direction. By highlighting the tension that exists between climate risk management and traditional mean-variance portfolio considerations, at least in the short term, the authors hope to stimulate further research into the behaviour of investors and managers during the transition to a low-carbon economy. 
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Edited by Xu Yizi
Editor-in-charge: Li Jinxuan.
Further reading: FinTech**, Green Finance, Assets and Energy MarketsDigital Transformation and Corporate EnvironmentGreen InnovationNexusIMF |Crypto Carbon: How Much Is the Correction Tax? nber |Bitcoin and CO2 Emissions: Evidence from Everyday Production Decisions.