Dissecting climate change risk and financial market instability: Implications for ecological risk management

Abstract

AbstractThis research investigates the impact of climate challenges on financial markets by introducing an innovative approach to measure climate risk, specifically the aggregate climate change concern (ACCC) index. The study aims to assess and quantify the potential influence of climate change and risk‐related factors on the performance and dynamics of financial markets. In this paper, concern is defined as the attention paid to the risk of climate change and the associated negative consequences. The findings demonstrate that the aggregate index exhibits robust predictability of market risk premiums, both within the sample and out‐of‐sample. By comparison, the index contains additional information beyond 14 economic predictors and 12 risk/uncertainty indexes in forecasting stock market return. In addition, the index proves valuable for mean–variance investors in asset allocation, leading to significant economic gains. The study identifies the index's ability to capture the reversal of temporary price crashes caused by overreactions to climate change risk. Furthermore, it exhibits stronger return forecasting capability for green stocks, non‐state‐owned enterprise (non‐SOE) stocks, and stocks in regions with low air pollution. Particularly during periods of low air pollution and relaxed regulation, the index displays an enhanced ability to forecast returns. The study's findings provide valuable insights for policymakers and financial institutions as they address 21st‐century environmental challenges. Moreover, these findings can inform the design of adaptive measures and interventions aimed at mitigating ecological risks and promoting sustainable economic growth.