Climate Change Risk and Agriculture-Related Stocks

Abstract

Climate change becomes a common threat to the world and has been studied by scholars in various fields. In the field of finance, many papers discuss the financial market efficiency toward climate change in order to better manage related risk. Our work focuses on the topic of climate change risk in the stock market. We use the long-term trends of the newly released climate index, Actuaries Climate Index (ACI), as proxies for climate change risk. As a genre of production risk, ACI trends have an adverse impact on agricultural production and corporate profitability of agriculture-related companies. We find significant forecasting power of climate change risk on corporate profits. This motivates us to further test the existence of forecasting power on stock returns. We construct a long-short stock trading strategy that adjusts climate change risk to conduct the test. With a one-year holding period, our non-overlapping strategy earns positive returns with zero cost at the beginning over a 26-year test period. The outperformance strongly suggests the predicting ability of the ACI. Thus, the stock market is believed to be inefficient toward climate change risk. We get similar results and conclusions for different versions and extensions of the non-overlapping strategy. However, by subsample tests, we find that the forecasting power on stock returns degenerates quickly in a short period in 2017. This strange "overturn" remains unclear due to limitations of data and brings the importance of follow-up studies.

Keywords: Extreme Climate, Climate Change Risk, Return Predictability, Market Efficiency

JEL Classification: G10, G14