Environmental policy and equity prices

Abstract

The information quality hypothesis suggests that, theoretically, the relationship between expected returns and conditional volatility is ambiguous and depends on the precision of the information signal, hence, it is affected by investors’ level of uncertainty. When investors’ uncertainty increases, the relationship may become negative. Using environmental policy as an imprecise signal of future economic performance, I find that a newspaper-based environmental policy-related uncertainty indicator (EPN) has a low correlation with equity market volatility, but has a significant negative impact on expected returns. A managed equity market portfolio that takes less (more) risk when the past EPN-related uncertainty is high (low) produces significant equity-risk-adjusted alphas. In particular, I show that EPN-timing is profitable, because it foresees the attractiveness of the mean-variance trade-off. Overall, an EPN-managed equity portfolio generates an annualized equity-risk-adjusted alpha of 5–6%. Interestingly, I find that the uncertainty around environmental policy is on average lower and, therefore, the strategy performs better during periods when the Republicans control the senate.