When do carbon emissions matter for sovereign ratings? Governance and the pricing of transition risk

This paper investigates whether sovereign credit ratings uniformly price carbon transition risk. Using a panel of 145 countries from 2002 to 2024, we show that rating agencies penalize CO2 emissions only in countries with strong institutional quality. In weak governance nations, carbon exposure remains unpriced. This asymmetry suggests that sovereign transition risk is conditional on state capacity: high emissions threaten creditworthiness only when governments can credibly implement decarbonization policies. Our findings, which are robust to alternative proxies, estimators, and lagged effects, highlight that domestic governance is a crucial mechanism in the financial pricing of sovereign climate risk.