A climate risk assessment of sovereign bonds’ portfolio.

Irene Monasterolo, Stefano Battiston

Publication: Working/Discussion Paper

Abstract

Aligning finance to sustainability requires metrics and methods to price forward-looking cli-mate risks and opportunities in financial contracts and in investors’ portfolios. Traditionalapproaches to financial pricing cannot incorporate the nature of climate risks, i.e. deep un-certainty, non-linearity, complexity and endogeneity. To fill this gap, we develop a frameworkfor climate-financial risk assessment and management under uncertainty. We consider a riskaverse investor with an information set given by past market valuation, information on futureclimate economic shocks, and utility maximization based on the minimization of the ClimateValue at Risk (VaR) in presence of incomplete markets. We then consider a disorderly pol-icy transition to 2◦C scenarios that leads to unanticipated shocks in economic trajectoriesof 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 climatepolicy shocks in sovereign bonds valuation introducing scenario- conditioned financial riskmetrics (Climate VaR, Climate Spread). We provide an application to OECD sovereignbonds of Austrian National Bank’s portfolio. We find that investments’ climate alignmentcan strengthen the sovereign fiscal and financial position by decreasing the climate spread.In contrast, misalignment can negatively affect countries’ economic competitiveness and fi-nancial stability, and thus the performance of investors who own such bonds. Our analysissupports investors’ portfolios risk management strategies in the low-carbon transition andand financial supervisors in the design of prudential risk measures.
Original languageEnglish
Publication statusPublished - 2019

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