The authors are independent contributors to the Global Risk Institute and are solely responsible for the content of this article.
Despite widespread recognition that the climate is changing, there is substantial uncertainty around the exact climate trajectory as well as the economic consequences of climate change. As a result, financial market participants have an increasing demand for hedging against future realizations of climate risk. However, hedging these risks through traditional insurance or futures contracts is difficult, both because climate risk is non-diversifiable and because it will materialize over long horizons. As a result, it would be hard for any counterparty to credibly guarantee to pay claims during a climate disaster event that might materialize in many decades. Financial market participants are therefore largely constrained to self-insure against climate risk.
In Hedging Climate Change News, Engle’s team propose an easily implementable approach for constructing climate risk hedge portfolios using publicly traded assets. Their proposed methodology follows a dynamic hedging strategy using insights from asset pricing theory. Rather than buying a security that directly pays off in the event of a future climate disaster, they construct portfolios that have short-term returns that hedge news about climate change over the holding period. By hedging, period by period, the innovations in news about long-run climate change, an investor can ultimately hedge long-run exposure to climate risk.
The first step is to construct a time series that captures news about long-run climate risk starting from the observation that events that contain information about changes in climate risk are likely to lead to newspaper coverage. The approach extracts a climate news series from textual analysis of news sources and constructs two complementary indices that measure the extent to which climate change is discussed in the news media. The first is calculated as the correlation between the text content of the Wall Street Journal each month and a fixed climate change vocabulary, which is constructed from a list of authoritative texts published by various governmental and research organizations. It associates increased climate change reporting with elevated climate risk, based on the idea that climate change primarily rises to the media’s attention when there is an increasing cause for concern. An alternative approach is to directly differentiate between positive and negative news about climate risk in its index construction. It constructs a second climate news index designed to focus specifically on bad news about climate change and applies sentiment analysis to climate-related articles to measure the intensity of negative climate news monthly.
The second step is to construct portfolios that hedge innovations in these news series and seek to systematically explore which stocks rise in value and which stocks fall in value on the heels of negative climate change news. By constructing portfolios that overweight stocks that perform well on the arrival of such news, an investor will have a portfolio that is well-positioned to increase in value whenever negative news about climate change materializes. Continued updating of this portfolio based on new information about the relationship between climate news and stock returns will pay off over time as climate change materializes.
These hedge portfolios use standard methods in the asset pricing literature and compute the portfolio of all equities that best approximates the movement over time of the climate news hedge target. This results in a well-diversified portfolio with a return which isolates the exposure to that target. Investors can then hedge their climate risk exposure by trading this portfolio, that is, by going long and short its underlying components with appropriate weights.
Engle’s team use firm-level environmental performance scores constructed by the Environmental, Social, and Governance (ESG) data from MSCI and Sustainalytics to proxy for firms’ climate risk exposure. When compared to alternative hedge portfolios that add simple industry bets their ESG-characteristic-based mimicking portfolios procedure produces hedge portfolios that perform better than the alternatives.
This paper provides a rigorous methodology for constructing portfolios that use relatively easy-to-trade assets (equities) to hedge against climate risks that are otherwise difficult to insure and is a starting point for further exploration aimed at using climate change news to effectively hedge against climate change risk.
Related Research Project: A Financial Approach to Environmental Risk