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Hedging climate change news

Climate change threatens financial resilience. This column introduces two indices of climate change news and a strategy to use them to build a portfolio that hedges the risk of negative climate news. The method improves climate risk hedging both in and out of sample. To stimulate further research, the time series have been made publicly available.

In September 2015, Mark Carney gave a speech in which he argued that:

“[T]he combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity.”

More recently, in March 2019, Glenn Rudebusch of the San Francisco Fed wrote: 

“In coming decades, climate change – and efforts to limit that change and adapt to it – will have increasingly important effects on the US economy. These effects and their associated risks are relevant considerations for the Federal Reserve in fulfilling its mandate for macroeconomic and financial stability.”

And a few weeks later, Fed Chairman Jay Powell wrote to Senator Brian Schatz of the Senate Committee on Banking, Housing, and Urban Affairs that:

“[A]lthough addressing climate change is a responsibility that Congress has entrusted to other agencies, the Federal Reserve does use its authorities and tools to prepare financial institutions for severe weather events.” 

In other words, there is now widespread policy and industry interest in managing the financial risks from climate change.

Problems of managing climate risk exposure

Unfortunately, it is not easy for firms or investors to manage exposure to climate. A possible approach would be to look for ways to hedge against future realisations of climate change, but finding effective hedging strategies is non-trivial. Hedging climate risk through traditional insurance or futures contracts is difficult because climate risk is non-diversifiable and will materialise over a long horizon. As a result, it would be hard for any counterparty to credibly guarantee to pay claims if a climate disaster materialises many decades from now – and so financial market participants are constrained to self-insure against climate risk (e.g. Anderson et al. 2016). 

We propose an easily implementable approach for constructing climate risk hedge portfolios using publicly traded assets (Engle et al. 2019). It is a dynamic hedging strategy that uses insights from asset pricing theory. Rather than buying a security that directly pays off in a future climate disaster, our approach continuously constructs and updates portfolios that have short-term returns that hedge news about climate change over the holding period. By hedging innovations in news about long-run climate change period-by-period, an investor can ultimately hedge long-run exposure to climate risk. 

In the short run, such a portfolio would differ from the Markowitz mean-variance efficient portfolio, and would thus have a lower Sharpe ratio. Over time, however, the dynamic hedging approach would compensate investors for losses that arise from the realisation of climate risk. 

Time series of climate risk news

The first step in implementing a dynamic hedging strategy for climate risk is to construct a time series that captures news about long-run climate risk. We can then use innovations in this news series as a target to construct climate hedges. 

The news series starts from the observation that events containing information about changes in climate risk are likely to lead to newspaper coverage. Therefore, we extract a climate news series from textual analysis of news sources. We construct two complementary indices to measure the extent to which climate change is discussed in the media:

  • The correlation between the text content of the Wall Street Journal each month and a fixed climate change vocabulary, which we construct from a list of authoritative texts published by various governmental and research organisations. This index thus associates increased climate change reporting with news about elevated climate risk, based on the idea that media attention to climate change primarily occurs when there is increasing cause for concern. Figure 1 shows a time series of this index. It rises during periods with significant climate-related events, such as UN climate change conferences. 

Figure 1 Climate change news index, 1984-2017

Source: Engle et al. (2019) using data from the Wall Street Journal.

  • An alternative approach to index construction is to directly differentiate between positive and negative news about climate risk. We construct a second climate news index to focus specifically on bad news about climate change that applies sentiment analysis to climate-related articles. It measures the intensity of negative climate news in a given month. We make the time series for both climate risk measures available here

Portfolio construction

The second step in our dynamic hedging strategy is to construct portfolios that hedge innovations in these two news series. We explore which stocks rise in value and which stocks fall in value when (negative) news about climate change materialises. We can then construct portfolios that overweight stocks that perform well when there is negative news, creating a portfolio that is likely to increase in value when there is negative news about climate change. Portfolio updates, based on new information about the relationship between climate news and stock returns, would lead to a portfolio that pays off as climate change materialises. 

We form our hedge portfolio using standard methods in asset pricing – in particular, we compute the portfolio of all equities that best approximates the movement over time of the climate news hedge target. This mimicking portfolio will be well-diversified, and its return isolates the exposure to that target. Investors can then hedge their climate risk exposure by going long and short, trading its underlying components with appropriate weights. 

There is a challenge when we try to implement this approach: we observe a limited number of months of climate news, but have a large set of assets that we could use to form hedge portfolios. We might construct hedge portfolios by data mining that would perform very well in-sample but would not be stable in future. 

To address this, we use characteristics that proxy for a firm's exposure to climate risk to parsimoniously parameterise the weights of the hedge portfolios. For example, one characteristic might be the carbon footprint of each firm. When there is news about increasing climate risk, investors might buy low-carbon-footprint stocks, and sell high-carbon-footprint stocks. If this were the case, we would be able to construct a portfolio that increases in value when there is negative news about climate risk using thousands of long and short positions based on just this parameter. We implement this characteristics-based approach by using firm-level environmental performance scores constructed by the environmental, social, and governance (ESG) data providers MSCI and Sustainalytics to proxy for firms' climate risk exposure. 

When we compare the hedge portfolios constructed using our approach to hedge portfolios that add simple industry bets (such as positions in the energy ETF XLE) to standard Fama-French factors, we find that our ESG characteristic-based mimicking portfolios procedure produces hedge portfolios that perform better in hedging innovations in climate risk. That is, our portfolios deliver higher in-sample and out-of-sample correlation with those innovations. 

A starting point

This is a rigorous methodology for constructing portfolios using relatively easy-to-trade assets to hedge against climate risks that would otherwise be difficult to insure. We do not view our hedge portfolios as the definitive best hedges against climate risk, but they are a starting point. We are making our climate risk time series publicly available to encourage other researchers so that they can explore additional ways to construct climate hedges.

For example, future research might distinguish between different types of climate-risk news, such as news about risks of physical damages from climate change and news about regulatory risk related to government responses to climate change. These two risk measures are clearly related, but distinct. 

Certain investors may also choose to hedge against local climate risks. Our focus has been on global climate change news – our indices do not capture news about local climate events, because they would be covered in the Wall Street Journal, or even in a larger cross-section of newspapers.

Further research may also explore other measures of firms’ climate risk exposures, or to expand the pool of potential hedge assets beyond US equities. For example, including commodities and real estate as potential hedge assets may be a promising direction. 

References

Andersson, M, P Bolton, and F Samama (2016), "Hedging Climate Risk", Financial Analysts Journal 72(3): 13-32.

Carney, M (2015), "Breaking the Tragedy of the Horizon–climate change and financial stability", speech given at Lloyd’s of London, 29 September.

Engle R F, S Giglio, B T Kelly, H Lee, and J Stroebel (2019), "Hedging climate change news", NBER working paper 25734.

Powell, J H (2019), Letter to Senator Brian Schatz, 18 April.

Rudebusch, G D (2019), "Climate Change and the Federal Reserve", FRBSF Economic Letter 2019-09.

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