Hedging carbon risk with a network approach

ArXiv ID: 2311.12450 “View on arXiv”

Authors: Unknown

Abstract

Sustainable investing refers to the integration of environmental and social aspects in investors’ decisions. We propose a novel methodology based on the Triangulated Maximally Filtered Graph and node2vec algorithms to construct an hedging portfolio for climate risk, represented by various risk factors, among which the CO2 and the ESG ones. The CO2 factor is strongly correlated consistently over time with the Utility sector, which is the most carbon intensive in the S&P 500 index. Conversely, identifying a group of sectors linked to the ESG factor proves challenging. As a consequence, while it is possible to obtain an efficient hedging portfolio strategy with our methodology for the carbon factor, the same cannot be achieved for the ESG one. The ESG scores appears to be an indicator too broadly defined for market applications. These results support the idea that bank capital requirements should take into account carbon risk.

Keywords: Sustainable investing, Hedging portfolio, Climate risk, CO2 factor, Triangulated Maximally Filtered Graph, Equities (S&P 500)

Complexity vs Empirical Score

• Math Complexity: 7.5/10
• Empirical Rigor: 8.0/10
• Quadrant: Holy Grail
• Why: The paper employs advanced network theory concepts (TMFG, node2vec) and statistical methods, indicating high math complexity, while it provides a specific, backtest-ready methodology with empirical results on S&P 500 data and risk metrics, demonstrating strong empirical rigor.

  flowchart TD
    A["Research Goal: Hedge Climate Risk in Equities (S&P 500)"] --> B["Input Data: Historical Price Data & Risk Factors<br/>(CO2 Intensity, ESG Scores)"]
    B --> C["Core Methodology: Network Approach"]
    C --> D["Step 1: Triangulated Maximally Filtered Graph<br/>(Construct Asset Network)"]
    C --> E["Step 2: node2vec Algorithm<br/>(Extract Structural Embeddings)"]
    D & E --> F["Compute Correlations &<br/=> Build Hedging Portfolios"]
    F --> G["Key Findings & Outcomes"]
    G --> H["CO2 Factor:<br/>Successfully Hedged<br/>(Strong link to Utility Sector)"]
    G --> I["ESG Factor:<br/>Hedge Failed<br/>(Indicator too broad for market application)"]
    G --> J["Policy Implication:<br/>Bank Capital Requirements should<br/>incorporate Carbon Risk"]