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2024 Feb/26
Impact of carbon risk in the Korean economy and the importance of portfolio carbon neutrality Research Papers 24-06 PDF
Park, Hyejin
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In recent years, the international community has been demanding for more extensive and intensified greenhouse gas reduction efforts and actions to promote climate change response, which has become a major challenge and issue for companies and capital market participants. The Korean government has declared carbon neutrality by 2050, revised 2030 NDC upward and proposed detailed implementation plans. Also, the EU has announced a proposal to introduce a carbon border adjustment mechanism, which might accelerate internal and external efforts for climate change. In this regard, the carbon price is expected to increase gradually, and there is a global consensus that the carbon price must increase further than the current level to achieve the goal of carbon neutrality in 2050.

Based on this background, this study aims to estimate the impact of rising carbon prices on Korean companies and industries through a simple model, and this study is purposed to to highlight the importance of carbon risk and the need to proactively manage the carbon risk for domestic companies and capital market participants. In addition, by investigating and introducing various decarbonization investment methodologies that have been discussed and utilized overseas, we hope to help domestic financial investment companies and institutional investors effectively manage their portfolios’ carbon risk.

The results of our analysis of the impact of carbon price increases on domestic companies are as follows. First, the increase in carbon price, which is generally following the carbon neutrality pathway, leads to an increase in financial losses for companies in almost all industries. Second, this increase in financial losses leads to a worsening of credit risk, such as default. This trend is more pronounced in industries with high GHG emissions. Finally, we examine the impact of carbon risk in a model that takes into account the interaction among industries and find that the cost shock of carbon emissions is estimated to have significant spillover effects not only on high-carbon industries, but also on their associated low-carbon industries. The results of this empirical analysis suggest the importance of carbon risk for domestic companies and capital market participants and the need to prepare for it in the future.

Next, we investigate portfolio construction methodologies that investors can use to effectively manage carbon risk. Regarding this subject, our findings can be summarized as follows. First, internationally, there has been an ongoing discussion about how to reduce the carbon risk of a portfolio while still having similar risk-return characteristics to benchmark indices. Second, the key to these low-carbon investment methodology is to minimize the uncertainty of capital returns and the potential for greenwashing while maintaining the carbon neutrality of the portfolio. It is the most important to provide decarbonization incentives for companies in the portfolio by managing portfolios in such a way that investors could continue to invest and take engagement to the firms as a shareholder. Third, by applying the decarbonizing portfolio construction methodology used abroad and using GHG emission data of listed companies in the Korean stock market, the simple empirical results show that by setting appropriate parameters, an optimal portfolio can be constructed that achieves carbon neutrality of the portfolio while minimizing the opportunity cost for investors. Based on the contents of this paper, we expect that the Korean capital market will be able to utilize those decarbonizing investments methodologies in various ways in the future.

The impact of carbon risk on domestic companies and the implications of decarbonization methods and practices that have been consistently utilized overseas are quite clear. However, the Korean capital market still has not yet been able to vitalize decarbonizing investments for the most of domestic investors. Carbon risk is likely to materialize in the near future, and Korea economy will not be an exception. As we move toward carbon neutrality, the impact on invested companies and portfolios will be clear if the carbon price reaches the adequate level. Therefore, investors need to consider carbon risk as a material risk to their investment portfolios and promote efforts and actions to response the risk. Voluntary efforts by domestic companies and industries will be also important, but it is very critical that investors, as shareholders of companies, set carbon neutrality targets and promote sustainable investing for the future.