We present a simple dynamic investment strategy that allows long-term passive investors to hedge climate risk without sacrificing financial returns. We illustrate how the tracking error can be virtually eliminated even for a low-carbon index with 50% less carbon footprint than its benchmark. By investing in such a decarbonized index, investors in effect are holding a “free option on carbon.” As long as climate change mitigation actions are pending, the low-carbon index obtains the same return as the benchmark index; but once carbon dioxide emissions are priced, or expected to be priced, the low-carbon index should start to outperform the benchmark.
Andersson et al. (Sat,) studied this question.