Hedging Climate Change News

Abstract

We propose and implement a procedure to dynamically hedge climate change risk. To create our hedge target, we extract innovations in climate news series that we construct through textual analysis of high-dimensional data on newspaper coverage of climate change. We then use a mimicking-portfolio approach to build climate change hedge portfolios using a large panel of equity returns. 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. The resulting hedge portfolios outperform alternative hedging strategies based primarily on industry tilts. We discuss multiple directions for future research on financial approaches to managing climate risk.

Keywords: Climate Risk, Hedge Portfolio