Embracing carbon uncertainty in portfolio construction

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.