Climate Sensitivity and Predictable Returns

Abstract

The paper finds that firms' exposure to temperature changes predicts stock returns. We use the sensitivity of stock returns to abnormal temperature changes to measure firm-level climate sensitivity. Stocks with higher climate sensitivity forecast lower stock returns. A trading strategy that exploits the return predictability generates risk-adjusted returns of 3.6% per year from 1931 to 2017. Further, climate sensitivity also predicts lower firm profits. Our results are robust to controlling for macroeconomics conditions and asymmetric return sensitivity to temperature changes. Overall, these findings are consistent with stock markets underreacting to firms' climate sensitivity.

Keywords: climate change, climate risk, market efficiency, return predictability

JEL Classification: G14, G40