Quantifying Transition Risk: Will Sovereign Bonds Keep Their Cool?

Sovereign debt comprises over half of the global fixed-income market.¹ Yet institutional investors may not have comprehensive tools and data to assess and disclose sovereign-bond transition risk. In particular, they may want to track country-specific alignment with the goals of the Paris Agreement, a forward-looking proxy for low-carbon transition risk.² While state signatories pledged to align policies with specific global temperature goals in 2015, not all demonstrate the same progress. A delayed policy response to the low-carbon transition may increase fiscal strain, which could in turn be reflected in bond spreads over time.³

Our model finds significant divergence between temperature trajectories of G20 nations. This divergence may indicate varying degrees of sovereign transition risk, which investors can easily integrate into their overall portfolio assessment.

Using MSCI’s new Country Scope 1 Emissions ITR (Sovereign ITR), we estimate a global warming value for each country based on how much it exceeds its 1.5°C carbon budget and extrapolate such overshoot to the world. We group countries into the following categories:

• 1.5°C aligned: Countries are aligned with the most ambitious goal of the Paris Agreement, to limit the rise in global mean temperature to 1.5°C above preindustrial levels. 
• 2°C aligned: Countries meet the Paris Agreement’s minimum objective. 
• Misaligned (2-3.2°C): Countries are not aligned with the Paris Agreement goals. 
• Strongly misaligned (>3.2°C): Countries exceed the business-as-usual climate scenario. 

Our model highlights significant differences in climate-goal alignment among G20 sovereign issuers, reflecting distinct decarbonization targets, historical emissions and carbon-budget limits.

Crucially, we build in a fair-share consideration: Less developed countries receive proportionally more budget to reflect challenging trade-offs around decarbonization and economic growth. This is a design choice advocated by the Institutional Investors Group on Climate Change (IIGCC) to “avoid creating incentives to rebalance away from countries most in need of capital to finance the transition.”⁴

*The degree Celsius ITR (by 2100) if the world economy had the same over- or undershoot level of carbon budget as the country analyzed. The assessment is based on comparing sovereign-specific 1.5°C aligned budgets (reflecting both scientific assumptions by the Network for Greening the Financial System (NGFS) and fair-share considerations) with the relevant sovereign-specific adjusted emissions trajectory (projected emissions based on a country’s stated targets are adjusted based on the country's emissions-reduction performance since the Paris Agreement and the annual rate needed to achieve its emissions targets). For further details on different scenarios and the underlying data available, see Country Scope 1 Emissions Implied Temperature Rise (ITR) Methodology. Data as of April 2025. Source: MSCI ESG Research  

Some developed G20 sovereigns like Canada and Australia are strongly misaligned, mostly driven by: 

• Relatively high ongoing and projected emissions, that remain well over the 1.5ºC budgets due to a fairly high dependence on fossil fuel energy. 
• Stricter 2020–2050 budget limits due to historically high emissions. 

Other developed nations, including Italy and Japan, fall into the misaligned category, reflecting slow emission reductions against modelled net-zero pathways, but to a lesser extent than the strongly misaligned category. 

Emerging G20 economies like India, Indonesia and Mexico face a balancing act. They benefit from relatively larger carbon budgets due to fair-share considerations. However, economic growth in these economies increases emissions pressures, placing them at the upper bound of the 2°C aligned category, nonetheless. 

At the portfolio level, temperature alignment provides investors with a practical approach for evaluating overall alignment with climate goals and identifying potential exposure to transition-related risks and opportunities.

Below we illustrate how temperature-alignment data from individual sovereign issuers can be aggregated at the portfolio level.

Note: This is an illustrative example for the 2024 ITR reference year. *Sovereign Portfolio ITR = 1.55°C + portfolio relative over- or undershoot × Global Net Zero Budget × TCRE. 1.55°C is the baseline temperature rise of the REMIND NGFS Net Zero 2050 scenario. For further details, see Country Scope 1 Emissions Implied Temperature Rise (ITR) Methodology. Source: UN Environment Programme Emissions Gap Report 2024, MSCI ESG Research

A similar logic may be applied to multi-asset-class portfolios, aggregating temperature-alignment data across both corporate and sovereign-bond holdings. This may help institutional investors address a coverage gap in temperature-alignment analysis across their portfolios. Without sovereign-bond coverage, investors may only be able to assess alignment for a fraction of their portfolio. 

As countries face mounting pressure to accelerate low-carbon transitions, temperature alignment offers investors a structured, intuitive way to assess transition risk in sovereigns. Quantifying sovereign transition risk — a potential “climate spread” — may support more informed investment decisions.⁵

It may also support investors in addressing elements of disclosure frameworks, such as the EU Corporate Sustainability Reporting Directive’s transition plan disclosure and the recommendation of the Task Force on Climate-related Financial Disclosures to track alignment with a well-below 2°C pathway.⁶

Beyond reporting, investors can use this analysis to inform engagement with sovereign issuers and guide climate-action plans. Sovereign ITR offers a scenario-based perspective on future transition pathways, capturing the evolving nature of transition plans, while complementing traditional metrics like emissions intensity or fossil fuel subsidies.

This point is underscored by the Dutch central bank in a recent research paper, which states that an ITR-type methodology for sovereign bonds “provides a more nuanced and accurate assessment of transition risks, revealing opportunities that static measures might overlook.”⁷