Hedging financial risks with a climate index based on EU ETS firms

This paper proposes a stock market index that captures the environmental performance of firms regulated by the European Union Emissions Trading System (EU ETS). Unlike alternative methods based on market capitalization, ESG scores, and Scope 1 and 2 estimated emissions, the proposed approach relies on total verified emissions to better reflect firms’ carbon abatement efforts. A DCC-GARCH model is employed to estimate the hedge ratios, optimal weights, and hedge effectiveness of the index across various asset classes. The proposed index offers superior hedging performance compared to the European Union Allowances (EUAs), a common benchmark for tracking carbon abatement, although hedging with the EU ETS index tends to be more expensive. The proposed index constitutes a valuable tool for investors seeking climate-conscious equity investments in carbon-intensive firms with strong environmental performance. • Investment toward a low-carbon economy is required to reduce climate finance risks. • We build an equity climate index based on listed firms in the EU ETS carbon market. • The EU ETS index provides more effective hedging than EUA against other asset classes. • Optimal weights suggest overweighting our index against volatile financial assets. • Our index supports investments in firms with efficient environmental performance.