Despite the widespread recognition that the climate is changing, there is substantial uncertainty around the exact climate trajectory and as well as the economic consequences of climate change. As a result, financial market participants have an increasing demand for hedging themselves against future realizations of climate risk. However, hedging these risks through traditional insurance or futures contracts is difficult, both because climate risk is non-diversifiable and because it will materialize over long horizons. As a result, it would be hard for any counterparty to credibly guarantee to pay claims during a climate disaster event that might materialize in many decades. Financial market participants are therefore largely constrained to self-insure against climate risk.

In Hedging Climate Change News, we propose an easily implementable approach for constructing climate risk hedge portfolios using publicly traded assets. Our proposed methodology follows a dynamic hedging strategy using insights from asset pricing theory. In our proposed approach, rather than buying a security that directly pays off in the event of a future climate disaster, we construct portfolios that have short-term returns that hedge news about climate change over the holding period. By hedging, period by period, the innovations in news about long-run climate change, an investor can ultimately hedge her long-run exposure to climate risk. In the short run, such a portfolio differs from the Markowitz mean-variance efficient portfolio, and will thus exhibit a lower Sharpe ratio; but in the long run, the dynamic hedging approach will compensate investors for losses that arise from the realization of climate risk.

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