Working Paper

Do Sustainable Investment Strategies Hedge Climate Change Risks? Evidence from Germany's Carbon Tax

Abstract: It is difficult to assess the effectiveness of investment strategies that screen companies based on environmental criteria to hedge climate change risk because physical risks have not yet fully materialized and policies to combat climate change are usually widely anticipated. This paper sidesteps these limitations by analyzing the stock market response to plausibly exogenous changes in expectations about the level of a carbon tax in Germany. The risk-adjusted return on two sustainable investment approaches---screening companies based on environmental scores and on firms' carbon footprint---around the carbon tax news reveals that firms with a high environmental score did not perform any better than those with a low environmental score. In contrast, the stock price of firms with low carbon emissions increased in value relative to those with a high carbon footprint. Carbon intensity explains the cross-sectional reaction to the carbon tax news because it predicts revisions in expected profitability.

Keywords: Climate risk; Portfolio choice; Stock returns; Carbon pricing; ESG;

JEL Classification: G38; G11; Q54; G14;

https://doi.org/10.17016/FEDS.2022.073

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2022-11-04

Number: 2022-073