A modelling framework for projections of equity portfolio returns under climate transition scenarios

Investors have a growing awareness that climate transition risks (such as carbon pricing policy) are among the new risk drivers of the financial system. One of the relevant implications of a shock in carbon price is the increase in business costs, which may diminish profitability and affect capital market returns, especially for the most polluting firms. We propose a modelling framework for medium-term projections of returns of stocks and portfolios under different climate transition scenarios. Specifically, we include a new green factor into the classic capital asset pricing model (CAPM) to capture a firm's exposure to climate policy risks. We then project to 2030 the factors in the CAPM conditional on different carbon price pathways (released by Network for Greening the Financial System (NGFS)) using a large Bayesian vector autoregression (VAR) model. Finally, we project the stock returns of each firm in the portfolio under different transition scenarios. Our results suggest that mining and quarrying and transportation and storage firms are expected to suffer more than those in other sectors under a disorderly transition compared to a hot-house world or an orderly transition scenario. These results may represent adequate support for investors to prepare portfolios for such risks under uncertainty about the timing of carbon policy introduction.t Body]