Abstract
These days we are witnessing a deep change in the characteristics of the type of energy that our economies are supplied with. A clear trend is that sustainable and green energies are decisively replacing traditional fossil fuel-based sources of energy. For various reasons, this fundamental change implies an increasing risk in investments on portfolios heavily based on traditional energy industries. What is less known, is that these industries have returns that show a very low correlation with sustainable fossil fuel-free stock portfolios making them an appealing tool for portfolio managers to design properly diversified investments. In this study we examine this and related phenomena proposing statistical methods to implement the expected shortfall (ES), the challenging risk measure recently adopted by the financial regulator. We obtain evidence that a newly proposed backtesting procedure for the ES based on multinomial tests is an adequate and simple method to validate these risk measures when applied to a highly volatile stock index. Backtesting results of the ES show that flexible heavy-tailed distribution α–stable performs well for modelling the loss distribution. These results are even improved when the variances of fossil fuel price returns are included as external regressors in the GARCH model variance equation. In this case, the ES computed from the four considered loss distributions perform properly.
Highlights
The debate on the role of fossil fuels in climate change affects all facets of society
While there is a move towards divestment in fossil fuels, replacing investment in the traditional energy sector with other sustainable investments, individual and institutional investors seek to balance risk and expected return
In the case of the traditional energy industry, the literature focuses risk quantification based on Value-at-Risk (VaR) but there is scarce work regarding the new trend-setting topic of the Expected Shortfall (ES) backtest (Backtesting is the process of comparing daily actual and hypothetical profits and losses with model-generated measures to assess the conservatism of risk measurement systems)
Summary
The debate on the role of fossil fuels in climate change affects all facets of society. A better diversification of portfolios of large institutional investors could increase investments in sustainable companies, based on globalized financial flows, indirectly providing more resources for project funding aimed at environmental protection or sustainable development In this context, it is relevant to examine which measurements of the risk inherent in investing in the traditional energy industry are more adequate, in combination with a thorough analysis to discriminate suitable methods for validating risk measurement models. In January 2016, the “Fundamental Review of the Trading Book” proposes to replace the well-established VaR with another risk measure, the expected deficit (ES), for the calculation of capital requirements for market risk (see in particular “Minimum capital requirements for market risk,” or the current version of January 2019,)) This change is challenging for portfolio and risk managers because it is not clear which validation method the regulator and the industry should use to test the proposed risk measure, that is, it is not clear how to evaluate the goodness of the ES risk measure.
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