Working Paper: NBER ID: w22890
Authors: Harrison Hong; Frank Weikai Li; Jiangmin Xu
Abstract: We investigate whether stock markets efficiently price risks brought on or exacerbated by climate change. We focus on drought, the most damaging natural disaster for crops and food-company cash flows. We show that prolonged drought in a country, measured by the Palmer Drought Severity Index (PDSI) from climate studies, forecasts both declines in profitability ratios and poor stock returns for food companies in that country. A portfolio short food stocks of countries in drought and long those of countries not in drought generates a 9.2% annualized return from 1985 to 2015. This excess predictability is larger in countries having little history of droughts prior to the 1980s. Our findings support regulatory concerns of markets inexperienced with climate change underreacting to such risks.
Keywords: climate change; market efficiency; drought; stock returns; food industry
JEL Codes: G00; G02; G12; Q00; Q54
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| historical experience with droughts (N50) | underreaction to climate risks (G41) |
| Palmer Drought Severity Index (PDSI) (N50) | profitability ratios (G32) |
| Palmer Drought Severity Index (PDSI) (N50) | stock returns (G12) |
| drought conditions (Q54) | profitability ratios (G32) |
| drought conditions (Q54) | stock returns (G12) |
| shorting food stocks in drought-affected countries (Q02) | excess returns (D46) |
| Palmer Drought Severity Index (PDSI) (N50) | expected returns (G17) |