Net-Zero Carbon Portfolio Alignment

Abstract

We outline a simple and robust methodology to align portfolios with a science-based, carbon budget consistent with maintaining a temperature rise below 1.5oC with 83% probability. We show how to keep the tracking error at a negligible level. This approach works for both passive and active managers. It also establishes an exit roadmap for carbon-intensive corporates, thereby generating a form of competition to decarbonize within each sector. We also discuss four sources of risks: uncertainty around a rapidly shrinking carbon budget, time impacts on decarbonization rates, implementation risk due to market-wide selling pressure, and uncertainty about taxes on polluting companies.

Keywords: carbon neutrality, optimal portfolio, tracking error

JEL Classification: G12, G23, G30, D62