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.
Given the growing impetus to tackle climate change, it is seems inevitable that carbon emissions will be penalized more heavily in the future. While various emissions mitigating measures already exist, including fuel excise duties and emissions trading systems, the scope and effectiveness of these methods is currently limited. Thus, one can expect an increasing focus on carbon taxation as a mechanism to curb emissions.
From a corporate perspective, the cost implications of carbon taxes will likely become more punitive going forward. And in terms of investments, traditional valuation metrics – such as price-to-earnings (P/E) ratios – do not yet reflect the costs of carbon emissions. In anticipation of likely future developments, we examined the impact of incorporating a hypothetical carbon tax in valuation ratios.1
Factoring in carbon pricing results in downward adjustments in valuations to account for unrecognized liabilities
Our research is related to a recent stream of literature that modifies traditional valuation metrics by incorporating intangibles, such as knowledge capital, organizational capital and brand value.2 However, whereas these studies adjust valuations upwards by identifying unrecognized assets, factoring in carbon pricing results in downward adjustments in valuations to account for unrecognized liabilities.
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.
We also examined the long-term characteristics of carbon-tax-adjusted value strategies. In one of our analyses, we evaluated how carbon taxes reduce the carbon footprint of a value portfolio. 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.
In our research paper, we also scrutinized the impact of carbon taxes on the portfolios’ value exposure. We observed that the EBITDA/EV exposure of the top quintile portfolio was virtually unaffected by carbon taxes up to USD 50, and slowly began to decay after that. Even at a carbon tax level of USD 1,000, a large part of the base case EBITDA/EV exposure still remained.
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 outperformance of the top quintile portfolio was effectively immune to carbon tax levels up to USD 100. At higher tax levels, the 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.
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 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.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.