Dissecting Climate Change Concern and Stock Market Instability

We propose an aggregate climate change concern index based on several indices from individual sources. In this paper, we define concern as attention to the risk of climate change and the negative consequences associated with that risk. Our results indicate that the aggregate climate change concern index has strong in-sample and out-of-sample predictability of the stock market risk premium.The index is derived using partial least squares (PLS), and the results are robust using scaled principal component analysis (sPCA) and principal component analysis (PCA). Moreover, the index can deliver significant economic gains for mean-variance investors in asset allocation. The predictability of the climate change concern index’s returns is due to the reversal of temporary price crashes (overreactions to climate change risk) and the stronger return forecasting ability for green stocks and in low air pollution periods.