Time-varying Environmental Betas and Latent Green Factors

Summary:

In this working paper entitled "Time-varying Environmental Betas and Latent Green Factors", the authors study whether the US stock market is pricing exposures to climate risks through the lense of a latent linear factor model with time-varying betas estimable by an extension of the instrumented principal component analysis (IPCA) of Kelly, Pruitt, and Su (2019).

In their specification, the factor loadings are allowed to be functions of both “financial” and environmental (“green”) company specific characteristics, such as ESG ratings and carbon intensity. They extend the original IPCA model to allow for the presence of different sets of orthogonal factors whose loadings are driven by only one of the two types of characteristics.

Their extension allows

1. to identify and estimate latent green factors from a large panel of stock returns without defining (and constructing) them ex-ante, as typically done in the climate finance literature,

2. to interpret their factors as purely “green” or “financial” factors. They identify one “green” factor which is important for the out-ofsample pricing of stocks in the Energy and Utilities sectors, above and beyond “financial” factors, which suffice to explain the cross section of stock returns of the stocks in the other sectors.