Carbon Emissions, Net-Zero Transition, and Implications for Equity Portfolio Risk

Climate change is reshaping the global financial landscape, affecting industries, regions, and companies in varied ways. Its impact introduces two distinct risks: physical risk, stemming from direct environmental changes such as severe weather, and transition risk, arising from reducing the corporate carbon footprint. “Carbon Emissions, Net-Zero Transition, and Implications for Equity Portfolio Risk” evaluates how these risks impact US companies, focusing on the pricing of carbon risk and its implications for investors.

Using a factor-based framework, the authors, a team from Allspring Global Investments, quantify the bias in the risk forecasts associated with reported carbon emission exposure. The paper demonstrates for investors how this framework can be used to measure and manage carbon emission–related risk in investment strategies.

This paper seeks to quantify the relationship between a company’s carbon emission footprint, its transition to net zero, and the expected distribution of its future stock returns as reflected in listed option prices.

The Twin Risks of Climate Change

Physical risks are direct consequences of climate change, such as flooding, droughts, and storms. These risks affect companies based on their geographical location rather than their emissions. For instance, a company in a low-emission industry could still face significant operational challenges if located in a flood-prone area.

Transition risks are defined by the US Environmental Protection Agency as “those associated with the pace and extent at which an organization manages and adapts to the internal and external pace of change to reduce greenhouse gas emissions and transition to renewable energy.” Companies with high emission footprints face greater exposure to these risks, including stricter regulations and reputational harm. Policies such as the European Union’s Green Deal and emission trading systems create an environment where carbon-intensive business models are increasingly vulnerable. This raises the question: Are financial markets appropriately pricing carbon risk?

Carbon Intensity

This paper examines whether carbon intensity—defined as the ratio of a company’s Scope 1 and 2 emissions to its revenue—affects security prices in equity and option markets. It evaluates the impact of emissions on both individual securities and portfolio-level risks, by addressing two key dimensions:

1. Carbon intensity as a risk factor: Carbon intensity serves as a proxy for a company’s exposure to climate-related risks. Firms with higher carbon intensity are more likely to face financial challenges due to carbon regulations and market penalties. This measure enables investors to estimate climate-related risks in portfolios, regardless of the asset class.
2. Options market insight: Option data reveal how investors perceive the future risks of high-intensity companies. These risks often translate into increased volatility, reflecting the heightened uncertainty for such firms in a world moving toward decarbonization.

In underscoring the importance of actively managing carbon risk, the paper delivers the following key recommendations for investors:

• Measure and monitor carbon intensity. Company-specific carbon intensity provides a consistent metric to assess climate risk across securities and portfolios. This measure aligns with global standards, such as those recommended by the Task Force on Climate-Related Financial Disclosures (TCFD).
• Incorporate carbon risk into investment models. Carbon intensity should be treated as a risk factor in the same way as growth, value, or momentum. By doing so, investors can improve risk forecasting and avoid underestimating portfolio volatility. 
• Adapt to regional and sectoral differences. Carbon risks vary by region and industry, requiring tailored approaches. Markets with stricter regulations or greater exposure to transition risks may exhibit higher carbon-related biases in pricing.
• Leverage opportunities in carbon pricing. Regulatory uncertainty and technological advancements, such as carbon capture and alternative energy, create opportunities for investors to gain an edge by forecasting carbon risk impacts.

Conclusion

Despite progress in incorporating climate risks into financial models, challenges remain. Among them are regulatory uncertainty; evolving policies and standards complicate the integration of carbon risk into investment strategies. Another challenge is data limitations; the lack of consistent, high-quality emission data continues to hinder accurate risk assessment. Finally, technological impact presents a challenge; such innovations as fusion energy or advanced carbon capture could drastically alter the trajectory of carbon-related risks, adding complexity to forecasting efforts.

The paper highlights the growing significance of carbon intensity as a financial risk factor. Carbon-related risks have had economic and statistical implications comparable to traditional financial factors, making them critical for investment decision making. The authors assert that as markets become increasingly climate conscious, investors who actively measure and manage carbon risk will be better positioned to navigate the transition to a low-carbon economy. Incorporating emission intensity into risk models and investment strategies offers not only a defensive mechanism but also a potential source of outperformance for forward-looking investors.

Five Key Takeaways:

1. Company-specific carbon intensity is a critical risk factor. A company’s carbon intensity, measured as its emissions relative to revenue, directly impacts its financial risks and should be actively managed in investment decisions.
2. Option markets reflect investor climate risk perceptions. Option data show that companies with high carbon intensity face increased downside risk because investors anticipate higher risks for businesses unprepared for climate regulations.
3. Carbon risk impacts portfolio performance. Portfolios with high carbon exposure show greater-than-expected volatility, indicating that carbon risk cannot be fully diversified away and should be addressed systematically.
4. Investors should integrate carbon risk into strategies. Carbon intensity should be treated like other financial risk factors (e.g., growth or momentum) and incorporated into portfolio management to avoid underestimating risks.
5. Opportunities and challenges lie ahead. Regulatory uncertainty and technological advancements, such as carbon capture and alternative energy, offer both risks and opportunities for investors who can anticipate their impacts on carbon-related factors.

The Authors

Gregoire Campos, Portfolio Analyst, Systematic Core Equity, Allspring Global Investments, Charlotte, North Carolina

Harindra de Silva, CFA, Senior Portfolio Manager, Co-Head of Alternative Equity, Allspring Global Investments, Los Angeles

Megan Miller, CFA, Senior Portfolio Manager, Head of Options Solutions, Allspring Global Investments, San Francisco