lmproving the EU SFDR Paris-Aligned Benchmark for Net-Zero portfolio construction

Abstract

In this paper, we show that without the analysis of firm-specific emission reduction behaviour, asset managers run the risk of long-term underperformance due to exposure to climate-related risk. We do this by applying and improving forward-looking firm-specific forecasting methods. We construct a Net-Zero portfolio (NZP) for the European market and find a 95% reduction in carbon exposure without significantly sacrificing risk-adjusted return, and with minimal tracking error to a benchmark portfolio. We show that the expected 2030 EPS of our NZP is not affected (–0.15%) by EU-ETS Carbon pricing, while a conventional or EU Paris aligned portfolio might risk significant underperformance (–15.4%) in the medium term. With this, we illustrate how the NZP is better protected against the financially material carbon risks and conclude that this method should be preferred over traditional ESG-factor investing.