Common Shocks and Climate Risk in European Equities

ABSTRACT We examine the contribution of a shock to climate concern to the observed outperformance of a portfolio of European green stocks relative to a brown benchmark. We show, first, that an information set given by 1‐month stock return and realized volatility of each stock constituent (and their cross‐sectional averages) improves the (in‐sample) forecasting performance for the return series relative to the traditional market risk factors proxied by Fama–French portfolios. Moreover, the identification of the shock to climate concern occurs in two stages: First, we compute the historical decomposition based on a Panel SVAR fitted to the return and volatility of each green and brown portfolio constituent. Then, the contribution of the first common shock to the historical decomposition of returns is purged of macroeconomic forecast errors, and the residual is interpreted as the innovation to climate concern. The empirical evidence is robust to a number of different selections of stocks entering the green and brown portfolio.