Hedging Climate Change News

Abstract

We propose and implement a procedure to dynamically hedge climate change risk. We extract innovations from climate news series that we construct through textual analysis of newspapers. We then use a mimicking portfolio approach 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. We discuss multiple directions for future research on financial approaches to managing climate risk.

Low‐carbon transition risks for finance

“…Sanguine expectations about returns in sunrise sectors (operating mainly via arrow B) could in principle lower the financial sector repercussions just described as more investors are hedging their exposure to highcarbon assets with investments in lower-carbon alternatives (Andersson, Bolton, & Samama, 2016;Engle, Giglio, Kelly, Lee, & Stroebel, 2020). However, as we have seen in Section 2, it might also be possible-at least in the medium term-that a "mania" about low-carbon risks ultimately destabilizes the financial system.…”

The Power of ESG Ratings on Stock Markets

“…Our paper is also complementary to a broader literature investigating the impact of ESGrelated risk on asset prices. Both theoretical and empirical papers have examined whether sustainability should be included in a modified CAPM (Pedersen, Fitzgibbons, andPomorski (2020), andPástor, Stambaugh, andTaylor (2021)), specific ESG-related risk factors (Hong and Kacperczyk (2009), Hong, Li, and Xu (2019), Bolton and Kacperczyk (2021) and Hsu, Li, and Tsou (2020)), and drivers of investors' preferences for sustainable investments (Bia lkowski and Starks (2016), Barber, Morse, and Yasuda (2021), Riedl and Smeets (2017), Krueger, Sautner, and Starks (2020), Ilhan, Sautner, andVilkov (2021), andEngel, Giglio, Kelly, Lee, andStroebel (2020)). 7 Our finding that investors' assessment of the level of ESG risk in a firm a↵ects stock returns adds to this debate.…”

Climate Risk and Commodity Currencies

“…For example, Kozlowski et al (2018) use word embeddings to produce richer insights into cultural associations and categories than possible with existing methods in the field of sociology, while Thorsrud (2018), Larsen and Thorsrud (2019), Baker et al (2016), andHansen et al (2018) use text as data to measure business cycle developments, uncertainty, and monetary policy. In particular, by focusing on climate change, this article relates to Engle et al (2020) who propose a news-based climate risk measure for dynamically hedging climate change risk. However, their index essentially measures how much climate change is focused upon in the news, whereas our word embedding approach measures in what context it is focused upon.…”

“…In terms of commodity currencies, the difference between how much and what context matters. Indeed, when using the climate risk index proposed by Engle et al (2020) to explain exchange rate fluctuations, the estimated coefficients of climate risk are inconsistent regarding their sign and often insignificant.…”