Thought Leadership

Low temperature and low regret? The trade-offs and opportunities when bringing climate change factors into a risk-return framework

17 February 2022

Authors: Rahil Ram, Iancu Daramus

Trade-offs lie at the heart of investing; the preference of more risk-averse investors for the stability of bonds relative to more volatile, but potentially more profitable equities is one classic example. Yet there are no guarantees – as ever, much will depend on investment beliefs. 

Investment beliefs also play a key role in the context of climate-aligned and impact investing. For some, applying any climate-related restrictions to the investment universe will necessarily lead to suboptimal capital allocation, as shunned stocks compensate new investors through higher returns. For others, companies lagging on sustainability may be at risk of obsolescence, as changes in technology, regulation and consumer preferences contribute to permanently depress their cash flows – so restrictions can serve as downside protection.

The reality, as always, is nuanced. Investors ‘restricting’ themselves to the tech sector would have generated oversized returns over the past decade; whilst those avoiding energy may have missed out on the oil and gas price rally of recent months.

Rather than search for a single, definitive answer, the ESG for Investors platform equips investors with tools to explore a variety of scenarios and stress-test their beliefs. It provides a big-picture view of the trade-offs investors face when thinking beyond the risk-return framework.

The Climate Optimiser leverages academic research and investment expertise to capture the trade-offs between risk, return and climate impact (measured as the implied temperature rise of a portfolio). Simply put – what is the cost of ‘turning down the heat’ in my portfolio?

Let us start with a conservative assumption – the existence of a ‘greenium’, whereby climate-aligned equity and bond funds have lower returns and higher volatility than their ‘standard’ counterparts. 

Source: Fulcrum Asset Management LLP, Bloomberg, Trucost. We have assumed that broad market indices are aligned with the circa 3°C of global warming implied by the window of uncertainty around current government policies, and modelled historical correlation between representative funds.  

Yet even under this conservative scenario, there are opportunities for climate-conscious investors. The optimiser shows that it is possible to reduce the implied temperature of this portfolio from ‘red’ (3°C) to ‘orange’ (2.7°C) without a significant impact on expected return.

Source: ESG for Investors, Fulcrum Asset Management LLP

Investors can thus begin to build their climate allocation upon such ‘low-regret’ areas. But they may wish to go further. In a previous post, we have argued that markets are already starting to reward companies taking action to address their emissions and working to provide low-carbon solutions.

One might thus believe that reducing the implied temperature can help position a portfolio for future upside – or at the very least, not require a sacrifice in return. A slight change in this one assumption – bringing the expected annual return of the climate-aligned equity fund in line with the 6.5% assumed for the global equity index fund, keeping all else equal – leads to a wholly different opportunity set. Here, temperature alignment is actually a driver, rather than a detractor of return, at least up to the point of meeting the upper temperature target (2°C) of the Paris Agreement.

Source: ESG for Investors, Fulcrum Asset Management LLP

It must be borne in mind that the ultimate goal of aligning portfolios is to help decarbonize the real economy – and, as of yet, there is substantial uncertainty whether policy-makers will strengthen policies to bring the global economy in line with a well-below 2°C pathway.

Yet it is precisely under uncertainty that the need grows for tools to navigate the transition. We believe the Climate Optimiser can help investors demonstrate to regulators and their beneficiaries how they are considering climate change mitigation as part of their investment process and strategic asset allocation.

As with all optimisers, the tool is sensitive to the assumptions used, but instead of focusing on the micro (assumptions), we believe that the tool highlights the macro, bringing climate change at the heart of portfolio construction. 

About the Authors

Rahil Ram

Rahil is a Director at Fulcrum Asset Management and is involved in portfolio strategy, portfolio implementation, research, sustainability and idea generation for the discretionary macro and thematic strategies. Prior to joining Fulcrum, Rahil was a strategist within the Asset Allocation team at Legal & General Investment Management for five years, during which time he completed his Masters’ in Actuarial Management from Cass Business School and qualified as an Actuary in 2017.

Iancu Daramus

This content is provided for informational purposes and is directed at professional clients as defined in Directive 2011/61/EU (AIFMD) and Directive 2014/65/EU (MiFID II) Annex II Section I or Section II or an investor with an equivalent status as defined by your local jurisdiction.  Fulcrum Asset Management LLP (“Fulcrum”) does not produce independent Investment Research and any content disseminated is not prepared in accordance with legal requirements designed to promote the independence of investment research and as such should be deemed as marketing communications.  This document is also considered to be a minor non-monetary (‘MNMB’) benefit under Directive 2014/65/EU on Markets in Financial Instruments Directive (‘MiFID II’) which transposed into UK domestic law under the Financial Services and Markets Act 2000 (as amended). Fulcrum defines MNMBs as documentation relating to a financial instrument or an investment service which is generic in nature and may be simultaneously made available to any investment firm wishing to receive it or to the general public. The following information may have been disseminated in conferences, seminars and other training events on the benefits and features of a specific financial instrument or an investment service provided by Fulcrum.Any views and opinions expressed are for informational and/or similarly educational purposes only and are a reflection of the author’s best judgment, based upon information available at the time obtained from sources believed to be reliable and providing information in good faith, but no responsibility is accepted for any errors or omissions. Charts and graphs provided herein are for illustrative purposes only. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Some of the statements may be forward-looking statements or statements of future expectations based on the currently available information. Accordingly, such statements are subject to risks and uncertainties. For example, factors such as the development of macroeconomic conditions, future market conditions, unusual catastrophic loss events, changes in the capital markets and other circumstances may cause the actual events or results to be materially different from those anticipated by such statements. In no case whatsoever will Fulcrum be liable to anyone for any decision made or action taken in conjunction with the information and/or statements in this press release or for any related damages. Reproduction of this material in whole or in part is strictly prohibited without prior written permission of Fulcrum Copyright © Fulcrum Asset Management LLP 2024. All rights reserved.

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