Environmental policy and equity prices

Area of Science:

• Economics
• Finance
• Political Science

Background:

• The information quality hypothesis posits that investor uncertainty influences the relationship between expected returns and volatility.
• Environmental policy is explored as an imprecise signal for future economic performance.

Purpose of the Study:

• To investigate the impact of environmental policy uncertainty on equity market returns and volatility.
• To assess the profitability of an investment strategy based on environmental policy uncertainty.

Main Methods:

• Development of a newspaper-based environmental policy uncertainty indicator (EPN).
• Analysis of the correlation between EPN and equity market volatility.
• Examination of EPN's impact on expected returns.
• Construction and evaluation of a managed equity portfolio using EPN-based risk adjustments.

Main Results:

• EPN shows a low correlation with equity market volatility.
• EPN has a significant negative impact on expected returns.
• An EPN-timing strategy generates substantial equity-risk-adjusted alphas (5-6% annualized).
• The strategy is more effective during periods of lower environmental policy uncertainty, such as when Republicans control the senate.

Conclusions:

• Environmental policy uncertainty is a key factor affecting expected stock returns.
• An investment strategy that times risk based on EPN is profitable.
• Political control of the senate influences environmental policy uncertainty and investment strategy performance.