Geopolitical Risk, Climate Risk and Financial Innovation in the Energy Market

Abstract

In this study, we look into how financial innovations, specifically Exchange-Traded Funds (ETFs) related to energy, can help hedge against geopolitical and climate-related risks. The research emphasizes the importance for investors to effectively manage these risks during periods of uncertainty. Our study aims to achieve two main objectives: firstly, to assess the potential for financial innovations in mitigating climate and geopolitical risks, and secondly, to compare their effectiveness with traditional defensive assets such as gold. We develop a predictive model tailored to our data's specific characteristics and find that energy-related ETFs can effectively hedge against both geopolitical and climate risks, with a particularly strong potential for geopolitical risk. Our results also show that ETFs outperform gold in hedging against these risks. Additionally, the forecast precision of our risk-based models against an alternative (or benchmark) model for both in- and out-of-sample periods are evaluated, and we find that the risk-based models better perform than the benchmark model, which does not consider these specific risks. These findings offer valuable insights for investors who are looking to hedge against risks like geopolitics and climate, distinct from broader market and economic fundamental risks such as inflation.

Keywords: Energy Market, Exchange-Traded Funds [ETFs], Financial innovation, geopolitical risk, Climate Risk, Hedging