Climate Change Risk in Stock Markets

Abstract

Climate change is becoming a common threat to the world and has been studied by scholars in various fields. In the field of finance, many papers have discussed financial market efficiency toward climate change in order to better manage related risks. Our work focuses on the topic of climate change risk in the stock market. We use long-term trends of a newly released climate index, Actuaries Climate Index (ACI), as proxies for climate change risk. As a type of production risk, ACI trends have an adverse impact on the agricultural production and corporate profitability of agriculture-related companies. We find significant predictability of climate change risk on corporate profits. This motivates us to further test the predictability of the ACI on stock returns. We construct a risk-adjusted stock trading strategy that adjusts to climate change risk. 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 suggests the predictive ability of the ACI and creates potential arbitrage opportunities in the stock market. 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, these conclusions are no longer attainable when we look at strategy returns in shorter periods. From subsample tests, we find that our strategy performs considerably well in terms of abnormally positive returns before 2015. But the predictability on stock returns degenerates quickly over a short period of time in 2017. This "overturn" of market inefficiency highlights the importance of follow-up studies and we suggest that future research could be devoted more toward discovering evidence about market efficiency and the impact of climate events on investors' attention toward climate change risk.