Portfolio hedging through a novel equity index based on the verified emissions of EU ETS-regulated firms

Abstract

We build an equity index based on EU ETS-regulated listed firms. The weights of our index reflect the cross-sectional heterogeneity in the firms’ environmental performances measured in terms of verified rather than estimated or self-reported emissions. By using a DCC-GARCH model, we estimate optimal weights and assess the hedge effectiveness of the EU ETS index across multiple asset classes. The index provides robust hedging benefits, particularly during Phases III and IV of the EU ETS, aligning with stricter environmental policies. Portfolio optimization techniques show that incorporating the EU ETS index enhances risk-adjusted performance. Our findings offer actionable insights for investors seeking to minimize financial risks.