Carbon-Tax-Adjusted Value

Abstract

The authors examine the effects of incorporating a potential tax on carbon emissions into a value investment strategy. They show that in a portfolio optimization problem, a carbon tax at the stock level is mathematically equivalent to a carbon constraint at the portfolio level. Using this insight, the authors derive a value–carbon efficient frontier that reflects the trade-off between a high value exposure and a low carbon footprint. Empirically, they find that carbon taxes up to $100, corresponding to a portfolio carbon footprint reduction of about 50%, have little effect on the characteristics and performance of the long side of a value strategy. More aggressive footprint reduction targets require progressively higher, less realistic carbon tax levels that do erode the magnitude of the value premium.