Incorporating carbon taxes into a Value strategy at a stock level is equivalent to imposing carbon footprint constraints on the overall portfolio. Our new research explores this mathematical relationship and provides more clarity on the implicit assumptions behind decarbonizing investment portfolios.
- Value strategies are effectively decarbonized with carbon taxes in the USD 10-100 range
- Value exposure decays as carbon taxes increase, but at a slow rate
- The effect of a carbon tax on historical returns is minimal up to the USD 100 level
Mathematical relationship between carbon taxes and carbon footprint constraints
Our research demonstrates that applying a carbon footprint reduction constraint to a value portfolio is mathematically the same as following a carbon-tax-adjusted value strategy. This means that a certain percentage of carbon footprint reduction corresponds to a specific level of carbon tax, and vice versa. This insight provides more clarity on the implicit assumptions behind decarbonizing investment portfolios, while it also gives us an economic interpretation to portfolio footprint reduction targets.
In our investigation, we analyzed a sample of developed market stocks for the period December 1985 to August 2021. We first compared a carbon-tax-adjusted value strategy and a value portfolio optimized with a carbon budget constraint, to illustrate the equivalence between the two approaches.
For the carbon-tax-adjusted value approach, we sorted stocks into five quintile portfolios based on their carbon-tax-adjusted earnings before interest, taxes, depreciation and amortization/enterprise value (EBITDA/EV) ratios. For solving the optimization problem with a carbon budget constraint, we used the SciPy linear programming functionality, where portfolio weights were restricted between 0 and 5/N, with N being the total number of available stocks.
Figure 1 displays the weighted average EBITDA/EV and CO2/EV levels of top quintile carbon-tax-adjusted value portfolios at different carbon tax levels, along with portfolios optimized with various carbon budgets (as a percentage of market carbon footprint), as at end August 2021. The dots, which represent optimal portfolios given a specific carbon tax and carbon constraint, lie on exactly the same curve. This illustrates that the maximum exposure to EBITDA/EV for a certain carbon footprint can be achieved by using either a tax or a portfolio constraint. This curve can be seen as the value-carbon efficient frontier.
Figure 1 | Simulated portfolio levels of EBITDA/EV for various carbon tax and carbon constraint levels
We also examined the long-term characteristics of carbon-tax-adjusted value strategies. In one of our examinations, we evaluated how carbon taxes reduce the carbon footprint of a value portfolio using a simulated analysis. Figure 2 shows the percentage reduction in the carbon footprint of the top quintile portfolio, measured against the base case top quintile portfolio without a carbon tax, as well as the equally-weighted universe of all stocks.
We observed that the largest carbon tax effect occurred in the USD 10-100 range. For the top quintile portfolio, a carbon tax of USD 10 led to an 18% lower carbon footprint compared to the base case; a USD 50 tax resulted in a 39% lower carbon footprint; and a USD 100 tax amounted to a 49% lower carbon footprint. We also noted that carbon tax levels below USD 10 did not have a significant impact, while those above USD 100 had a progressively smaller effect on the portfolios.
Figure 2 | Simulated average carbon footprint (CO₂/EV) reduction of carbon-tax-adjusted value (EBITDA/EV) top quintile portfolios versus base case value portfolio
The impact of carbon taxes on performance
Furthermore, we analyzed the impact of carbon taxes on returns. To do this, we sorted stocks into five quintile portfolios on their carbon-tax-adjusted EBITDA/EV ratios at the end of every month, and then computed the return of the five quintiles over the subsequent month. Figure 3 illustrates that the simulated outperformance of the top quintile portfolio was effectively immune to carbon tax levels up to USD 100. At higher tax levels, the simulated performance began to deteriorate, but it took a carbon tax of over USD 20,000 to fully wipe out the performance of the top quintile portfolio.
Figure 3 | Simulated cumulative outperformance of carbon-tax-adjusted value (EBITDA/EV) top quintile portfolios versus equally-weighted universe over time
In conclusion, our research empirically found that carbon taxes up to USD 100, corresponding with a portfolio carbon footprint reduction of about 50%, had little effect on the characteristics and the simulated performance of the long side of an EBITDA/EV value strategy. However, to increase the carbon footprint reduction to 70%, the assumed carbon tax would need to rise from USD 100 to about USD 5,000. Such a level does not seem realistic, and it would also have an adverse effect on the performance of the value strategy.
1 See: Blitz, D., and Hoogteijling, T., November 2021, “Carbon-tax-adjusted value”, working paper.
2 See: Park, H., October 2019, “An intangible-adjusted book-to-market ratio still predicts stock returns”, Critical Finance Review, forthcoming; Lev, B., and Srivastava, A., March 2020, “Explaining the recent failure of value investing”, working paper; and Arnott, R. D., Harvey, C. R., Kalesnik, V., and Linnainmaa, J. T., January 2021, “Reports of value’s death may be greatly exaggerated”, Financial Analysts Journal.