Embracing carbon uncertainty in portfolio construction
Summary
Focus
We study how to build sovereign bond portfolios that integrate financial and environmental considerations simultaneously. We introduce the concept of carbon returns, defined as the negative change in carbon emissions for a given country, paralleling the concept of financial returns. This allows us to apply traditional portfolio optimisation algorithms to both financial and carbon returns to guide portfolio choices.
Contribution
Most portfolio construction methods treat carbon emissions as deterministic paths, based on either historical data or forward-looking values tied to a specific scenario. That ignores uncertainty. Central to our approach is the introduction of carbon returns, treating the carbon footprint of individual countries as a random variable rather than a deterministic one. Working with carbon returns brings two benefits. First, it rewards real reductions to greenhouse gas emissions, instead of simply favouring today's low emitters. Second, it is more robust: carbon return distributions vary less across carbon accounting choices than emission levels do. This gives public investors a simpler and more practical way to align climate goals with financial return objectives.
Findings
Using the financial and carbon return profiles of each country, we apply a risk-based method inspired by hierarchical risk parity to build sovereign fixed income portfolios. The method balances each country's contribution to tail risk in both financial and carbon outcomes, measured by expected shortfall. Applying it to developed market sovereign bonds, we show that investors can align decarbonisation goals with financial performance, in tests using past data and in forward-looking exercises, while offering options to suit different investor preferences.
Abstract
We propose a framework for constructing fixed-income portfolios of sovereign bonds that integrates financial and environmental considerations. Central to our approach is the introduction of carbon returns, a concept analogous to financial returns, modeled as random variables to capture the inherent uncertainty of future carbon emissions. Based on the financial and carbon return profiles of individual countries' sovereign bonds, we employ an algorithm inspired by Hierarchical Risk Parity (HRP) to construct portfolios that balance each country's contribution to the portfolio's tail risk, as measured by expected shortfall, of financial and carbon returns. Focusing on developed market sovereign bonds, our results demonstrate that it is possible to design portfolios that effectively align decarbonization objectives with financial performance, both in-sample and out-of-sample, while accommodating diverse investor preferences.
JEL classification: G11, G28, Q54, Q56
Keywords: carbon footprints, sovereign debt, portfolio optimization, risk parity
