A sustainable approach to portfolio allocation: Incorporating market-based climate transition risk exposure

Climate transition risk arises when shifts in climate policy, technology, and investor and consumer preferences revalue carbon-intensive business models. Despite its growing relevance for portfolio decisions, firm-level measurement remains difficult, especially in markets with sparse and uneven carbon disclosure. We propose an asset-level measure of climate transition risk exposure based on each stock's return sensitivity to the Polluting-minus-Clean (PMC) factor. Using a newly developed Climate Policy Uncertainty (CPU) index, we show that the return spread between low- and high-exposure stocks widens when policy uncertainty rises, implying hedging benefits of low-exposure positions. Building on these findings, we incorporate the transition risk exposure into a multifactor mean-variance allocation framework and evaluate performance out of sample. Portfolios that account for transition risk information deliver higher risk-adjusted performance than conventional benchmarks, as reflected in improved Sharpe and Sortino ratios. Overall, our evidence suggests that climate-related signals are economically meaningful for portfolio allocation.