Hedging Climate Change News

Can investors hedge the risk of climate change using stocks they already trade?

Robert Engle, Stefano Giglio, Bryan Kelly, Heebum Lee, and @ohannes Stroebel build two climate news indices from textual analysis of newspapers in "Hedging Climate Change News".

They then apply a mimicking portfolio approach using MSCI’s and Sustainalytics’ environmental scores to construct hedge portfolios of US stocks and test it over the 2009-2016 period.

Their main conclusions include:

• Portfolios of US stocks can hedge climate change news by tilting toward firms with stronger environmental scores and away from weaker ones, without requiring a bets on energy companies.
• Portfolios built on Sustainalytics environmental scores tracked #climate news better than any other approach the authors examined, reaching correlations as high as ~30%.
• The same method using MSCI environmental scores or energy sector ETFs performed noticeably worse, showing that the climate exposure measure decides whether a hedge works, not the technique itself.
• Dirty versus clean industry membership explained only 10% to 20 % of the variation across firms, with most differences emerging within industries rather than between them.
• Low-scoring sectors included personal services, water transportation, and motion pictures rather than oil and gas, so an effective #hedge looks different from a simple short on fossil fuels.
• The protection is not free: in the short run the hedge carries a lower Sharpe ratio than a standard efficient portfolio, and wider adoption would bid up the price of the best hedging stocks.

These results show a partial hedge can be assembled today from liquid equities using environmental score tilts, rather than waiting for thin and costly bespoke climate derivatives.

Using ESG ratings to quantify climate #risk exposure offers a complement to outright divestment, which removes exposure but pays nothing when climate news worsens.

Even though these scores can track climate news, the study highlights different providers deliver materially different hedges, which reinforces well-known concerns about rating divergence.

The hedge also targets news about climate change, which is a constructed text-based proxy, rather than realised damages, and does not separate physical risk from regulatory and transition risks.