Temperature Anomalies and Climate Physical Risk in Portfolio Construction

TL;DR

This paper develops novel temperature anomaly metrics to measure climate risk in portfolios, integrating them into optimization models to enhance resilience against climate shocks, supported by empirical backtesting results.

Contribution

Introduces Climate Risk Exposure and Climate Exposure Volatility metrics that incorporate extreme temperature event probabilities into portfolio optimization frameworks.

Findings

Extreme temperature events negatively impact most sectors.

Climate risk metrics improve portfolio resilience.

Climate-aware strategies outperform traditional benchmarks.

Abstract

Driven by the increasing frequency and intensity of natural disasters and chronic climate threats, we investigate the impact of physical climate risk on global equity portfolios. By employing a panel regression analysis on sectoral returns, we provide statistical evidence that extreme temperature events exert a negative effect on most sectors. We introduce two novel metrics based on these temperature anomalies, Climate Risk Exposure and Climate Exposure Volatility, in order to measure the environmental vulnerability of a portfolio. Unlike available static country-level indices, these metrics incorporate the time varying probability of extreme events and their relations with firm-specific asset intensity. We integrate these measures into a multi-objective portfolio optimization framework. This approach extends the traditional Mean-Variance paradigm, allowing investors to construct portfolios that are resilient to physical climate shocks without sacrificing diversification. Finally, we conduct a backtesting analysis to show the practical benefits of incorporating these climate risk metrics into the investment process, evaluating how climate-aware strategies perform relative to traditional benchmarks.