Carbon Tail Risk

Abstract

Strong regulatory actions are needed to combat climate change, but climate policy uncertainty makes it difficult for investors to quantify the impact of future climate regulation. We show that such uncertainty is priced in the option market. The cost of option protection against downside tail risks is larger for firms with more carbon-intense business models. For carbon-intense firms, the cost of protection against downside tail risk is magnified at times when the public’s attention to climate change spikes, and it decreased after the election of climate change skeptic President Trump.

Is the ESG portfolio less turbulent than a market benchmark portfolio?

“…In their meta-analysis of the results of around 2200 studies on the relationship between ESG criteria and the corporate financial performance (CFP), Fried et al (2015) conclude that around 90% of studies find a non-negative ESG-CFP relationship, the vast majority of studies report positive results and the positive ESG impact on CFP seems stable over time. Ilhan et al (2019) show that companies with poor ESG profiles, as measured by higher carbon emissions, are at higher extreme risk. In their comparative study between ESG portfolios and other conventional ones, conclude that over a period of 5 years, the ESG portfolio "US large-cap ESG index" offers the highest return of all benchmarks on average.…”

“…For example, the ESG portfolio "MSCI USA ESG Select" excludes one of the major oil producers, i.e., Exxon Mobil. Indeed, companies with poor ESG profiles, measured by higher carbon emissions, present a higher extreme risk (Ilhan et al 2019). However, stocks in the renewable energy sector, such as Sunrun Inc. and SolarEdge Technologies Inc., have recently witnessed strong performances and have largely outperformed technology winners, such as Amazon, Apple, and Facebook.…”

Sustainable investing in equilibrium

“…Bolton and Kacperczyk (2019) argue that investors demand compensation for exposure to carbon risk in the form of higher returns on carbon-intensive firms. Ilhan, Sautner, and Vilkov (2019) show that firms with higher carbon emissions exhibit more tail risk and more variance risk. Engle et al (2019) develop a procedure to dynamically hedge climate risk by constructing mimicking portfolios that hedge innovations in climate news series obtained by textual analysis of news sources.…”

Climate Change Scenario Analysis for Public Market Investors

“…and technological risks, according to a study covering the S&P 500 from 2010-2017. 16 • Stocks of carbon-intensive firms underperform low carbon-emitting firms during periods of abnormally warm weather, according to a study covering global equities from 2001-2017. 17 • Investors have begun requiring a higher risk premia for carbon-intensive assets since the Paris Agreement.…”