From Pledges to Portfolios: Integrating Countries' Climate Commitments into Sovereign Bond Investments

Abstract

This paper explores the integration of Nationally Determined Contributions (NDCs) into the construction of net-zero (NZ) portfolios of sovereign bonds. Based on both backward-looking (2015-2021) and forward-looking (2021-2030) analyses, we compare the effectiveness of scenarios using constant greenhouse gas (GHG) intensities and NDC-based trajectories in reducing the portfolio's GHG intensity while minimizing the tracking error relative to the business-as-usual benchmark. The backward-looking exercise reveals that NDC-based portfolios achieve similar GHG intensity reductions with lower tracking errors compared to constant-intensity scenarios, demonstrating their efficacy in building an NZ portfolio. Conversely, constant-intensity strategies require more aggressive rebalancing, leading to higher tracking errors and uneven allocations. In the forward-looking exercise, the more ambitious second round of NDCs announced before COP26 enables substantial GHG intensity reductions at a marginal financial cost. Overall, our results highlight the potential of NDCs as a forward-looking tool to align sovereign bond portfolios with climate objectives while maintaining financial performance. However, imposing weight restrictions by country or region, to ensure more equitable investment between advanced and emerging economies, significantly limits the ability to meet reduction targets and increases tracking errors.

Keywords: Net-zero investment, Sovereign bond portfolio, Portfolio carbon footprint, Climate change, Nationally determined contributions

JEL Classification: G11, Q56