Bank for International Settlements publishes working paper proposing carbon returns approach for sovereign bond portfolio construction

The Bank for International Settlements has published a working paper that sets out a framework for building sovereign bond portfolios that combine financial and environmental objectives. The paper introduces “carbon returns,” defined as the negative change in a country’s carbon emissions, so that decarbonization can be treated in a way analogous to financial returns and incorporated into portfolio optimization. Rather than assuming emissions follow a fixed path, the framework models future carbon outcomes as uncertain and uses a risk-based allocation approach inspired by Hierarchical Risk Parity to balance countries’ contributions to tail risk in both financial and carbon terms. Using developed market sovereign bonds, the paper finds that portfolios can be designed to align decarbonization goals with financial performance in both historical and forward-looking tests. It argues that focusing on carbon returns rewards actual emissions reductions instead of simply favoring countries that already have low emissions, and that return distributions are less sensitive to carbon accounting choices than absolute emissions levels. The methodology relies on expected shortfall as the key risk measure and, because carbon data are limited, uses copula-based simulations to estimate joint carbon-return distributions. The paper presents eight portfolio configurations that vary the weight given to financial versus carbon data, with results showing that portfolios with more financial inputs reduce financial tail risk while those with more carbon inputs reduce carbon tail risk. The views expressed are those of the authors and do not necessarily reflect those of the BIS or its member central banks.