No really, what do climate risk indices measure?

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A couple of weeks ago, New York Fed researchers published a short piece analyzing the behavior of a range of text-based climate risk indices.  These are calculated by comparing the language used in different news sources against a pre-determined benchmark text.  The idea is that if the sources mimic the benchmark, climate risks are “making news” – which in turn suggests awareness of the risks are heightened, too.

These indices were developed with the aim of identifying climate-related risk factors that may be useful for optimizing portfolio construction.  In its basic form, the capital asset pricing model (CAPM) helps map the expected return of a portfolio for a given amount of volatility.  The market, however, is not perfectly efficient.  Over time, experience and research has uncovered additional factors that empower investors to beat this baseline methodology.

If the market is mispricing climate risk, it should be possible to identify a factor that captures this mispricing and aids with portfolio construction. Investors should then be able to hedge against climate risk and make more money, more safely.  

There are other possibilities – for example, a hoped-for factor may be redundant because climate risk is already priced, or because it simply does not exist.

I wanted to dig into this a little more, so I downloaded De Nard, Engle and Kelly (2024) (which has the great advantage of being free to view).  They developed a risk factor based on New York Times and Wall Street Journal reports and combined it with Fama and French’s famous three-factor model to construct an indicative portfolio. Looking at the five-year performance of this portfolio, while the return is solid, volatility is also somewhat elevated.  This is reflected in the one- and three-year returns, which are lower than those posted by ETFs tracking the S&P 500.