A Silver Lining for Climate-Tilted Bond Portfolios?
Key findings
- When comparing a market-value-weighted basket of Group of 7 (G7) sovereign bonds with a hypothetical climate-tilted basket, the climate-tilted basket had lower production emission intensity.
- However, this was largely driven by GDP growth rather than falling emissions.
- The silver lining is that GDP and emissions may have started to decouple for the climate-tilted basket of G7 sovereign bonds as opposed to the market-value-weighted basket.
Some sovereign-bond investors seeking to support climate mitigation might be interested in the idea of increasing their exposure to issuers with lower carbon emissions. Would this have been a good approach? To find out, we compared the production emission intensity of a hypothetical market-value-weighted basket consisting of Group of Seven (G7) sovereign bonds with a hypothetical climate-tilted basket of G7 sovereign bonds.[1] We also took a deeper look at the drivers of emissions for both baskets to help investors as they seek to align their investments with their climate goals.
Production emission intensity fell through 2022, driven by GDP growth
While a climate-tilted basket of G7 sovereign bonds showed promise in terms of lower production emission intensity, the overall reduction was closely tied to GDP growth. Emissions in 2022 may have started to decouple from GDP for the climate-tilted basket, however; and though one year is not a trend, this could be a positive sign for future sustainability efforts and this approach.
As shown in the exhibit below, production emission intensity was consistently lower for the climate-tilted basket from 2006 to 2022.[2] It also decreased significantly for both hypothetical baskets during this period. The reason behind this trend was nuanced, however. Emissions — while lower for the climate-tilted basket — still increased, and GDP more than doubled for both samples. As a result, the main driver for the decrease in production emission intensity for both was the magnitude of GDP growth, and not falling emissions.
Production emission intensity declined, though emissions continued to rise
Scope 1 emissions (excluding LULUCF), PPP-adjusted GDP and production emission intensity weighted by the constituents in the portfolios. Data as of June 1, 2024. Source: International Monetary Fund, World Bank, MSCI ESG Research
GDP may be taking a back seat
As in many cases, you need to look deeper to get the full story. We used the Kaya identity to examine emissions drivers for both baskets of sovereign bonds.[3] This identity shows that emissions are equal to the product of three factors: GDP, energy intensity of GDP (defined as energy consumption divided by GDP) and carbon intensity of energy (defined as emissions divided by energy consumption).
Emissions may have started to decouple from GDP for the climate-tilted basket
Data as of June 1, 2024. Source: United States Energy Information Administration, IMF, World Bank, MSCI ESG Research
The silver lining for the climate-tilted G7 basket may be that the three-year compound annual growth rate of emissions in 2022 may have started to decouple from GDP. This is notable because reducing emissions at the expense of socioeconomic outcomes might not be socially or politically palatable. Instead, sovereigns' emissions reduction may be more effectively achieved through reducing energy intensity of GDP and carbon intensity of energy.[4] On the other hand, it's less evident that any decoupling between emissions and the same two economic factors has begun for the market-value-weighted basket.
In conclusion, despite GDP driving a reduction in production emission intensity for the G7, investors may be able to achieve decarbonization in their sovereign debt portfolio through a climate tilt. There is also evidence that sovereign emissions and GDP growth have started to decouple when applying such a tilt to this basket of sovereign bonds. Governments that can most effectively reduce energy intensity of GDP and carbon intensity of energy could be successful in achieving decarbonization without sacrificing economic development.
1 The Group of 7 (G7) is the U.S., U.K., Canada, France, Italy, Germany and Japan. The weights for these baskets were derived from the methodologies of the MSCI Government Bond Index — Developed Markets (MGBI-DM) and the MSCI Developed Markets Climate Tilted Government Bond Index. Both are USD-denominated.2 Production emission intensity is defined as Scope 1 excluding land use, land-use change and forestry (LULUCF) divided by the PPP-adjusted GDP of the sovereign in question. For more information on the methodology, see: “Total Portfolio Footprinting Methodology,” MSCI ESG Research, May 24, 2024. (Client access only.)3 Yoichi Kaya noted in 1995 that a country's CO2 emissions are a function of population, economic wealth (GDP per capita), energy intensity of GDP (energy consumption divided by GDP) and carbon intensity of energy (emissions divided by energy consumption). In other words, emissions equal the product of those four factors. Source: Enno Schröder and Servaas Storm, “Economic growth and carbon emissions: the road to 'hothouse Earth' is paved with good intentions,” Institute for New Economic Thinking, November 2018.4 Alexander Schober and Michael Ridley, “A Deeper Look at Sovereign Carbon Emission Reduction,” MSCI ESG Research, July 1, 2024. (Client access only.)
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