Optimizing portfolios under carbon risk constraints: Setting effective constraints to favor green investments

Abstract

Climate change and its concomitant adaptations pose significant challenges for companies and confront them with new risks. Investors must consider these risks when shaping their investment portfolio. This study investigates portfolio optimization under a carbon risk constraint in an expected utility framework. 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 identify 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, such as carbon intensity and Brown-Green-Score, to compare the resulting optimal portfolios.