Impact of climate risk on clean water investments: Does crude oil act as a hedge?

Water investments play an increasingly important role in sustainable finance, yet their response to climate policy uncertainty (CPU) under different market conditions remains poorly understood. This study examines the regime-dependent influence of CPU on water equity performance using monthly data for the First Trust Water ETF (FIW) and the Invesco Global Water ETF (PIO) from 2007 to 2024. A Markov regime-switching VAR framework is employed to capture nonlinear dynamics that conventional linear models may overlook. The results reveal two distinct volatility regimes with contrasting CPU effects. In low-volatility periods, CPU is associated with higher returns, indicating that climate-policy developments can signal investment opportunities when markets are stable. During high-volatility periods, CPU exerts a negative influence-consistent with rising discount rates applied to long-term water-infrastructure cash flows. Regime persistence differs across ETFs: FIW exhibits frequent, short-lived transitions, whereas PIO displays more persistent states. A complementary DCC-GARCH analysis shows that crude oil provides a relatively cost-effective hedge for water portfolios, while technology ETFs offer substantially weaker hedging performance. Overall, the findings highlight the importance of regime-sensitive portfolio strategies for investors and emphasize that policymakers should consider prevailing market conditions when communicating climate initiatives. The study demonstrates that nonlinear models are essential for uncovering climate-finance linkages that linear approaches fail to detect. • Climate policy uncertainty significantly affects water equity markets. • In low-volatility regimes, it boosts performance in water-focused ETFs. • In high-volatility regimes, it reduces water ETF performance. • Oil serves as an effective and low-cost hedge for water ETFs.