Opinion

Hedging Climate Change News

Professors Robert F. Engle and Johannes Stroebel

By Robert Engle, Stefano Giglio, Bryan Kelly, Heebum Lee, Johannes Stroebel

By hedging innovations in news about long-run climate change period-by-period, an investor can ultimately hedge long-run exposure to climate risk.

By Robert Engle, Stefano Giglio, Bryan Kelly, Heebum Lee, Johannes Stroebel

In September 2015, Mark Carney gave a speech in which he argued that:

“[T]he combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity.”

More recently, in March 2019, Glenn Rudebusch of the San Francisco Fed wrote: 

“In coming decades, climate change – and efforts to limit that change and adapt to it – will have increasingly important effects on the US economy. These effects and their associated risks are relevant considerations for the Federal Reserve in fulfilling its mandate for macroeconomic and financial stability.”

And a few weeks later, Fed Chairman Jay Powell wrote to Senator Brian Schatz of the Senate Committee on Banking, Housing, and Urban Affairs that: 

“[A]lthough addressing climate change is a responsibility that Congress has entrusted to other agencies, the Federal Reserve does use its authorities and tools to prepare financial institutions for severe weather events.”

In other words, there is now widespread policy and industry interest in managing the financial risks from climate change.

Problems of managing climate risk exposure
Unfortunately, it is not easy for firms or investors to manage exposure to climate. A possible approach would be to look for ways to hedge against future realisations of climate change, but finding effective hedging strategies is non-trivial. Hedging climate risk through traditional insurance or futures contracts is difficult because climate risk is non-diversifiable and will materialise over a long horizon. As a result, it would be hard for any counterparty to credibly guarantee to pay claims if a climate disaster materialises many decades from now – and so financial market participants are constrained to self-insure against climate risk (e.g. Anderson et al. 2016). 

Read the full VoxEU article.
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Robert Engle is the Michael Armellino Professor of Management and Financial Services and the Director of The Volatility Institute. Johannes Stroebel is the David S. Loeb Professor of Finance and the Boxer Faculty Fellow.