Drought and energy stock markets in the United States

Abstract

Amid increasing concerns about the impact of climate change on financial asset pricing, this paper investigates how drought risk affects stock returns in the U.S. energy sector over a thirty-year period (1990-2019). To this end, we ranked energy companies based on the long-term trend of the Palmer drought severity index (PDSI) to compare stock performance between groups experiencing the most significant increases and decreases in drought risk. Our analysis indicates that firms located in drought-prone regions have lower stock returns than those in regions with decreasing drought risk, particularly since 2010. This finding is noteworthy, as the average PDSI trend gap between regions at high risk of drought and those at low risk has widened during this period. We further divide our sample of energy companies into two subsectors-fuel production and electric utility-and find that the stock prices of both subsectors have been negatively affected by drought risk since 2010. The study underscores the energy sector's dependency on water availability, suggesting novel implications for policymakers and investors in assessing the financial impacts of drought risks in their climate-related decision-making.