Climate Uncertainty and Information Transmissions Across the Conventional and ESG Assets

Abstract

We examine the effect of climate uncertainty on the spillover effects across the European conventional and ESG financial markets via novel measures of physical and transitional climate risk proxies obtained from textual analysis. While the conventional stock market index serves as the net shock transmitter to ESG assets, we find that shock transmissions between the two asset classes are significantly lower during periods of high climate uncertainty, suggesting that ESG investments can offer conventional investors diversification benefits against climate-driven shocks. Indeed, by comparing a forward-looking investment strategy conditional on the level of climate risk to the passive investment strategy, we show that investors who are worried about physical climate risks could utilize ESG equity sector portfolios as a diversification tool during periods of high physical climate uncertainty. In contrast, ESG bonds are found to be particularly useful in managing transition risk exposures that are associated with policy uncertainty and/or business transitions with respect to environmental policies. The findings have important implications for investors and policymakers regarding the role of climate uncertainty as a driver of informational spillovers across the conventional and ESG assets with important insights to manage climate risk exposures.

Keywords: Climate risk, ESG investments, Dynamic connectedness, Hedging