A Climate Risk Assessment of Sovereign Bonds’ Portfolio

Abstract

A climate risk assessment of sovereign bonds' portfolio. PaperOriginal Citation:Monasterolo, Irene ORCID: https://orcid.org/0000-0001-5423-6009 and Battiston, StefanoA climate risk assessment of sovereign bonds' portfolio. AbstractAligning finance to sustainability requires metrics and methods to price forward-looking climate risks and opportunities in financial contracts and in investors' portfolios. Traditional approaches to financial pricing cannot incorporate the nature of climate risks, i.e. deep uncertainty, non-linearity, complexity and endogeneity. To fill this gap, we develop a framework for climate-financial risk assessment and management under uncertainty. We consider a risk averse investor with an information set given by past market valuation, information on future climate economic shocks, and utility maximization based on the minimization of the Climate Value at Risk (VaR) in presence of incomplete markets. We then consider a disorderly policy transition to 2 • C scenarios that leads to unanticipated shocks in economic trajectories of fossil fuel and renewable energy sectors, estimated using Integrated Assessment Models.We model the shock transmission from the change in sectors' Gross Value Added to firms' profitability and to sovereign fiscal revenues. We then introduce the forward-looking climate policy shocks in sovereign bonds valuation introducing scenario-conditioned financial risk metrics (Climate VaR, Climate Spread). We provide an application to OECD sovereign bonds of Austrian National Bank's portfolio. We find that investments' climate alignment can strengthen the sovereign fiscal and financial position by decreasing the climate spread.In contrast, misalignment can negatively affect countries' economic competitiveness and financial stability, and thus the performance of investors who own such bonds. Our analysis supports investors' portfolios risk management strategies in the low-carbon transition and and financial supervisors in the design of prudential risk measures. 1

Returns behavior of ESG ETFs in the COVID‐19 market crash: Are green funds more resilient?

“…Some studies have argued that green investments used in mitigating climate change have a favorable effect on firm financial performance (e.g., Battiston & Monasterolo, 2019; Krueger, 2015). Other studies report mixed results on the performance of green funds and whether they outperform traditional funds.…”