Working Paper: NBER ID: w25734
Authors: Robert F. Engle III; Stefano Giglio; Bryan T. Kelly; Heebum Lee; Johannes Stroebel
Abstract: We propose and implement a procedure to dynamically hedge climate change risk. To create our hedge target, we extract innovations from climate news series that we construct through textual analysis of high-dimensional data on newspaper coverage of climate change. We then use a mimicking portfolio approach based on a large panel of equity returns to build climate change hedge portfolios. We discipline the exercise by using third-party ESG scores of firms to model their climate risk exposures. We show that this approach yields parsimonious and industry-balanced portfolios that perform well in hedging innovations in climate news both in-sample and out-of-sample. The resulting hedge portfolios outperform alternative hedging strategies based primarily on industry tilts. We discuss multiple directions for future research on financial approaches to managing climate risk.
Keywords: climate change; hedging; financial risk; ESG scores
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| climate news innovations (Q55) | performance of hedge portfolios (G11) |
| ESG scores (Q51) | performance of hedge portfolios (G11) |
| hedge portfolios (G11) | correlation with climate news innovations (Q54) |
| hedge portfolio based on Sustainalytics ESG scores (G11) | correlation with WSJ climate change news index innovations (Q55) |
| ESG-based approach (Q56) | effectiveness of hedge against climate risk (Q54) |