The Impact of Carbon Risk Mitigation on Optimal Portfolio Composition

Climate change and the concomitant adaptations to it pose major challenges for companies and confront them with new risks. Investors must consider these risks when shaping their investment portfolio. This study investigates portfolio optimization in an expected utility framework under a carbon risk constraint. To illustrate the implications of the carbon risk constraint, we consider a financial market with only one risk-free and two risky assets, one green and one brown. We find conditions under which the imposition of the carbon risk constraint leads to an increase in the green investment and a decrease in the brown investment. Surprisingly, an increased investment in the brown asset can also be optimal under certain conditions. Further, we employ different carbon risk metrics to compare the resulting optimal portfolios.