Temperature sensitivity, mispricing, and predictable returns

Abstract

We examine the relation between temperature changes and firm performance using a novel time-varying measure of firm-level temperature sensitivity. We find that firms with higher temperature sensitivity have lower future profitability and riskier corporate policies. These firms are also overpriced and earn lower average future returns, as market participants are slow to correct the mispricing. Nonlocal institutional investors allocate higher portfolio weights to firms with high temperature sensitivity and sell-side equity analyst forecasts are less accurate for these firms. Together, these results suggest that financial markets underreact to information about firm-level temperature sensitivity, which generates predictable patterns in returns. A trading strategy that exploits this mispricing generates an annualized risk-adjusted return of over 4% during the 1968-2020 period.