A tale of two risks: Differential diversification roles of clean energy sector stocks in physical and transition climate risk management

The increasing severity of climate-related events has heightened concerns about climate risks’ impact on financial markets. Although clean energy sectors are considered potential hedging instruments, the heterogeneous nature of both climate risks and clean energy sectors requires a detailed analysis of their risk diversification dynamics. This study examines the risk diversification effects of different clean energy sub-sector stocks on physical and transition climate risks, focusing on sector-specific characteristics and tail risk behavior. Using daily observations from 11 clean energy sub-sector indices and two climate risk indices from 2010 to 2023, we analyze conditional correlation, tail risk dependence, and dynamic portfolio allocation. Our findings reveal that clean energy sectors demonstrate significant but heterogeneous risk diversification effects across climate risk types and time periods. In particular, transition risk exhibits higher baseline volatility but achieves superior diversification benefits compared to physical risk. Infrastructure-based clean energy sectors show more stable diversification patterns than production-based sectors, with fuel cell sectors displaying limited hedging effectiveness. Furthermore, tail risk reduction effects exceed traditional risk measures but are accompanied by increased volatility. These findings provide valuable insights for climate risk management through targeted allocation strategies within the clean energy sector.