The Impact of Emissions on Stock Returns: A Multi-Factor Model Approach and Hedging with EUA Futures

Abstract

This study investigates the co-movements of European stock returns, EU Allowances (EUAs) and carbon price intensity factors based on weekly data from 2018-2023. For this investigation we use a multi-factor model to analyze the relationship. In addition, the paper presents an analysis of cross-hedging carbon risk in European equity portfolios using EUA futures. Hedging ratios are found by using an OLS estimator and a DCC-GARCH model. To evaluate the effect from the hedge ratios they are tested out-of-samples using rolling windows. Our results from the multi-factor analysis show that there is a positive and significant relationship between stock returns, EUA returns and the carbon price intensity factors for free, scope 2 and hedged emissions. Furthermore, the carbon price intensity reflecting firms’ paid emissions have a negative and significant relationship with stock returns. The results from analyzing hedging strategies find a short position in the EUA futures to be appropriate for variance reduction. The realized hedging effectiveness from the two approaches yields a positive result using the OLS approach and a negative result using the DCC approach. Furthermore, one out of the four hedged portfolios with OLS-based hedge ratios see an increase in annualized return, while all the hedged portfolios with the DCC-based hedge ratios see an increase in annualized return.