Unraveling the Link between Environmental Metrics and Stock Returns: An In-Depth Analysis of Climate Risk Premiums and Climate News Hedge Portfolios

Abstract

This thesis examines a broad range of E(SG) scores and real environmental metrics’ cross-sectional and time-series effect on excess stock return, in the European market from December 2010 to December 2022. The objective is to analyze how E(SG) scores and environmental metrics differ in their ability to capture climate risk exposure. Through Fama MacBeth regressions and characteristics-based portfolio sorting, the study reveals a compelling insight; adopting an investment strategy that goes long environmental underperforming firms (i.e. ”brown”) and short overperforming firms (”green”) results in statistically significant risk premiums ranging from -7.83% to 5.22% annually. Furthermore, our analysis reveals a weak relationship between environmental metrics and E(SG) scores, extending existing research on ESG disagreement. Finally, using a mimicking portfolio approach we show that our sample of environmental variables proves insufficient in hedging innovations in climate change news.