Green Portfolios

We develop a long-horizon framework that merges Merton’s intertemporal portfolio theory with the damage-based logic of Nordhaus-type climate models. In this setting, equity investments can damage future production and consumption possibilities through their climate impact. We identify the Social Cost of Carbon (SCC) as a key determinant of both optimal portfolio allocation and equilibrium asset pricing. We derive a four-fund separation result and characterize equilibrium returns. Stocks that have a sufficiently adverse impact on the climate may appear to have positive alphas relative to the CAPM. Using US stock market data for 2007–2019, we estimate the SCC and show that, although the portfolio and pricing effects are moderate, climate externalities translate into measurable adjustments in the cost of capital, offering a tractable benchmark for integrating environmental damages into portfolio theory.