Man Institute uses RavenPack data to measure Climate Change Attention in bias-revealing study

September 11, 2023

The study tested the stock market's pricing of climate change risks, uncovering surprising results and an investment opportunity.

A recent study by researchers of the Man Institute, tested the efficiency of the stock market in pricing climate change risks. In their research, “The Climate News Anomaly: Is the Stock Market Efficient in Pricing Climate Change Risks?” authors Ben Zhao, Ksenia Tsocheva, Matt Goldklang and Ed Fang reveal the market's apparent inability to fully grasp the significance of climate-related news, which might actually be an opportunity for investors.

A key part of the study was measuring Climate Change Attention - the level of awareness and focus that both the public and investors have on news and developments of climate change-related issues. The researchers used three different methods to measure this attention, all of which showed similar patterns. They looked at Google Trends data, used natural language processing models, and relied on the Climate News Index, which counts climate-related headlines in news articles. This Index was calculated using RavenPack news headline data and provided a reliable measure of climate change attention.

The main findings of the research shed light on an interesting market anomaly related to climate change news:

There is an underreaction to climate change news

The researchers found that investors tend to underestimate the impact of climate change news on stock prices. They observed that stocks connected to climate change topics, known as "green" stocks, consistently outperform stocks less related to climate change, known as "brown" stocks, by around 5.9% annually. This outperformance couldn't be explained by conventional financial factors.

Stocks connected to climate change topics, known as green stocks, consistently outperform stocks less related to climate change, known as brown stocks, by around 5.9% annually.

Attention to climate change matters

Interestingly, the degree of outperformance of green stocks is also linked to how much attention investors pay to climate change risks. Even when investor attention to climate change is low, green stocks still perform better than brown stocks. This discovery challenges the traditional risk-return relationship that financial models often rely on, and suggests that investors should consider climate-change risks when making investment decisions.

Which stocks are the most climate-exposed?

To figure out how individual stocks were affected by climate change news, the researchers examined the sensitivity to changes in the Climate News Index over the past five years, at stock level. They found that stocks related to renewable energy tended to have higher exposures, while traditional energy stocks had lower exposures. Additionally, green stocks were generally found to be greener in terms of carbon emissions and renewable energy generation.

Exposure to climate news persists

The study also found that historical exposure to climate change news tends to continue into the future. Stocks that were positively exposed to climate news in the past were likely to remain positively exposed. This suggests that the market doesn't quickly adjust to changing climate news.

Stocks related to renewable energy tended to have higher exposures, while traditional energy stocks had lower exposures.

Challenging traditional models

Perhaps the most significant finding was that a simple investment strategy based on climate change news exposure consistently generated excess returns of 5.9% per year. This level of excess return is surprising because in a fully efficient market, such returns shouldn't exist. The study tested this strategy against various asset-pricing models, and the excess returns remained significant, challenging traditional financial models' assumptions.

Investor attention matters

The study further explored two potential explanations for the climate-change-related stock returns: risk premium and behavioral bias. The risk premium idea suggests that green stocks should have lower expected returns because they provide a hedge against climate risks. However, the data didn't support this notion. Instead, the study's findings align more with the behavioral bias explanation, suggesting that the market tends to overlook the significance of climate change news.

For instance, researchers observed that "brown" stocks do not outperform "green" stocks when climate change attention is low. They divided the sample into two categories based on the intensity of climate change attention using the Climate News Index: high attention periods (increasing Climate News Index) and low attention periods (decreasing Climate News Index), as illustrated in the figure below. During periods of high attention, the long/short portfolio's return aligns with their expectations by following the increasing trend in climate attention.

The results indicate that investors may be underestimating the impact of climate change risks on stock prices. This discovery challenges traditional financial models, and suggests that there may be opportunities for investors to capitalize on the market's inefficient pricing of climate-related risks. Ultimately, this study highlights the importance of considering climate change exposure when making investment decisions in today's evolving financial landscape.

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