The Bank for International Settlements (BIS) has outlined how a radically rebalanced sovereign securities portfolio could have achieved a 41 percent reduction in carbon intensity over five years with only “marginal” cost to financial performance.
In a working paper published on Thursday, the central banking group presented the strategy, which “rewards sovereign issuers that have made stronger efforts in reducing carbon intensity, measured by total domestic emissions per capita”.
If adopted between 2014 and 2019, sovereign portfolios would have seen a reduction in carbon intensity of 41 percent, the paper suggested.
By comparison, the business-as-usual (BAU) portfolio, which was benchmarked against JPMorgan’s Government Bond Indices, would only have achieved 14.1 percent carbon intensity reduction.
“We show that portfolio decarbonisation – reallocating funds from sovereign securities of high-emitting countries to those of low-emitting countries – can deliver a material reduction in a sovereign portfolio’s overall carbon footprints,” the study concluded.
The report, Building portfolios of sovereign securities with decreasing carbon footprints, was authored by BIS economists Gong Cheng and Benoît Mojon, and academic Eric Jondeau.
The trio argue that passive investors could use their strategy as a “new Paris-consistent benchmark” to construct a net-zero portfolio “while tracking closely the risk-adjusted returns of a business-as-usual (BAU) benchmark”.
They note that this would require a “massive rebalancing”, including the shedding of a significant proportion of US and Chinese securities.
Such a “radical” rebalancing would see the weight of US securities fall from 37.6 percent to 20.8 percent, while Chinese holdings would be reduced from 3.31 percent to 0.27 percent. In contrast, the weighting of Italy and Spain would be increased among advanced economies, and the weighting of the Philippines and Colombia among emerging markets.
Importantly, the authors note, their proposed portfolio “retains the same creditworthiness as the BAU benchmark without entailing materially higher foreign exchange risks”.
They also suggested that overall, “the cost of decarbonisation is marginal in terms of financial performance”.
One of the takeaways from the paper is that sovereign bond issuers face potentially large transition risks if investors collectively rebalance their portfolios towards countries with lower carbon footprints.
It also highlights that little work has been done on greening investors’ sovereign holdings, despite the asset class being one of the biggest.
In December, Magnus Billing, CEO of Sweden’s largest pension fund Alecta, told Responsible Investor that unless governments step up their climate efforts, the fund will struggle to meet its net-zero ambitions, given the requirement to hold substantial amounts of sovereign debt.
A constrained version of the net-zero portfolio is also explored in the BIS text. It factors in limitations such as a requirement that a country’s share in the portfolio cannot fall below 50 percent or exceed 150 percent relative to the BAU benchmark.
Under these constraints, however, the portfolio can only achieve a 30 percent cumulative reduction in carbon intensity, 11 percentage points lower than the unconstrained portfolio but still much higher than the BAU benchmark.
BIS’s paper relies on a consumption-based carbon emission metric, scaled by population, to estimate carbon intensity. Its authors argue that this approach “captures carbon leakages, especially in advanced economies, as people there tend to consume more imported goods and services”.
But they also acknowledge that if a production-based measure was used instead of a consumption one, overweighted countries such as India and the Philippines could be “massively underweighted or excluded”.
Greenhouse gas emissions data for the working paper was taken from Trucost, the environmental data firm owned by S&P.
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