Establishing industry best practice: A net zero methodology for sovereign investors

Sovereign bonds arguably represent the deepest and most liquid part of global fixed income markets, and they play a prominent role in many institutional investors’ portfolios.¹ However, sovereign debt integration within net zero strategies has traditionally been low due to several barriers,² as well as the lack of an industry-agreed methodology.

"The Global Finance Journal found that there is evidence that climate transition risks are being gradually priced in sovereign bond yields...."

This could be set to change, with growing empirical evidence linking sovereign bond spreads with climate change. While research has historically focused on the impact of governance and social factors on sovereign bond spreads,³ we now see increasing analysis of how environmental factors could be having a direct impact. For example, recent research published in the Global Finance Journal found that there is evidence that climate transition risks are being gradually priced in sovereign bond yields and that countries with lower carbon emissions incur lower borrowing costs.⁴ Similarly, another study⁵ indicates that greater climate change‑induced vulnerability is arguably already resulting in higher sovereign borrowing costs. Research undertaken by the French central bank suggests countries also face the potential risk of stranded assets induced by potential policy missteps related to climate change.⁶ And under a “higher emissions” scenario,⁷ analysis suggest that sovereign borrowers could also experience downgrades to credit ratings.⁸

Developing and implementing best practice

The development of T. Rowe Price Associates’ net zero methodology for sovereigns follows our participation in the Sovereign Bonds and Country Pathways working group with the Institutional Investors Group on Climate Change (IIGCC).⁹ We also follow guidance from the Assessing Sovereign Climate‑related Opportunities and Risks (ASCOR) project run by The Grantham Institute at the London School of Economics. Selecting assets to meet individual net zero commitments has been a challenge for sovereign investors. The IIGCC working group has identified several barriers, including:

• Liability management restrictions—under which a great portion of sovereign holdings operate
• A limited number of prominent issuers (compared with the broader corporate universe, for example)
• Global policy framework issues (e.g., an inconsistency in definitions among countries’ Nationally Determined Contributions (NDCs), and discrepancies between commitments and the goals of the Paris Agreement).
• Engagement challenges, such as limited engagement opportunities with sovereigns.

CBDR+RC and “fair share”

The Paris Agreement intentionally embedded the concept of “fair share” and equity to reflect that developing countries may take longer to reach peak emissions and can take longer to reach net zero. 

When assessing the alignment of sovereign bonds within investment portfolios, there is a risk of implementing strategies that lead to systematically rebalancing away from emerging markets that may currently be more emissions-intensive but are making efforts toward a fair transition. The IIGCC recommends incorporating “fair share” considerations in line with the Common but Differentiated Responsibilities and Respective Capabilities (CBDR+RC) principles of the Paris Agreement. 

In line with IIGCC guidance, we intend to assign a “CBDR” category for every sovereign in the portfolio. This means distinguishing between developed economies with higher historic emissions liability and emerging markets and developing economies that are expected to potentially be given more time and which may require external support to meet their mitigation goals.

Developing a net zero methodology for select sovereign investors

We believe integrating sovereign bonds into net zero strategies could play an important role in fulfilling investors’ commitments to net zero alignment of their portfolios. In response to interest from clients and prospects with specific net zero targets, we have developed a net zero methodology for sovereigns—informed by the recommendations of the IIGCC and building on our existing corporate framework.

"We believe integrating sovereign bonds into net zero strategies could play an important role in fulfilling investors’ commitments to net zero alignment of their portfolios."

T. Rowe Price’s net zero investment framework has been designed to  provide a capability for select clients and prospects that can be applied to portfolios with specific client‑mandated net zero targets.

Our sovereign net zero sovereign methodology analyzes five criteria and assigns each sovereign a net zero status depending on how many criteria are met:

1. Ambition: A country’s long‑term target to achieve net zero by 2050.

2. Targets: In addition to 2050 targets, these include shorter-term 2030/2035 greenhouse gas (GHG) emissions reduction targets that are:

• Aligned with a 1.5°C pathway for high/upper middle‑income countries
• Aligned with a “fair share” pathway for low/low middle-income countries (see CBDR+RC and “fair share”).

Our model leverages targets included in countries’ NDCs submitted to the United Nations Framework Convention on Climate Change (UNFCC  C).¹⁰

3. Emissions performance: This assesses whether a country’s actual emissions align with its 1.5°C or “fair share” pathway.

4. Decarbonization strategy: Whether a country has robust plans in place to achieve its GHG reduction targets. This builds on guidance from the ASCOR, and includes the elements shown  in Figure 3.

5. Budget/capital allocation alignment: We also assess if a country’s budget and climate spending indicators are consistent with its mitigation and adaptation goals.

Dissecting commitments for a more in‑depth analysis

As of July 2025, only two countries of the 114¹¹ analyzed are classified as “Achieving,” thanks to being carbon sinks.¹² While the majority of countries that we have analyzed fall into either the “Committed” or “Not Aligned” categories, it is important to note the considerable variation even within these two buckets. For example, within the same group, some countries are on the cusp of “Aligning,” while others require significant action to improve their targets and decarbonization strategies. With this in mind, we have taken a more granular approach by incorporating additional analysis. This involves sorting countries into subcategories—indicating whether “some action,” “more action,” or “significant action” is required to improve a country’s net zero status.

For example, based on our assessment, one Northern European sovereign currently sits at the quality end of the “Not Aligned” bucket and could be upgraded to “Committed” if it decided to declare an explicit 2050 net zero target, which is currently absent from its detailed and ambitious decarbonization goals.

Conversely, based on our assessment, one large Latin American sovereign stands at the bottom end of the “Committed” bucket because of its publicly stated goal to reach net zero by 2050. However, these goals are not currently substantiated by interim targets, credible strategy, or budget, signaling that significant action is required to be upgraded from “Committed” to “Aligning.”

In line with the CBDR-RC and “fair share” principles embedded in the Paris Agreement, and consistent with the IIGCC’s recommendation(s), we actively consider a country’s level of development and income in our analysis.

For this exercise, when evaluating ambition, each sovereign is assessed relative to its income cohort—either high/upper-middle income or low/lower-middle income—depending on its level of economic development.

For high and upper-middle income countries, a sovereign is considered “nearly aligned” only if it is both on a 1.5°C pathway and within the first quartile of its income peer group.

Similarly, for low and lower-middle income countries, “nearly aligned” status requires that the sovereign is on a “fair-share” pathway and within the first quartile of its respective income cohort.

We therefore view sovereigns with targets above the median but not within the first quartile, after adjusting for level of development and income, as “unambitious”.

Why investors should avoid aggregating net zero targets for corporate credit and sovereign debt

The IIGCC recommends that net zero targets and methodologies applied to portfolios that hold both corporate credit and sovereign bonds are not aggregated, proposing, instead, that they currently be reported separately for the following reasons:

• For portfolios that hold both corporate credit and sovereign bonds, aggregating net zero targets and methodologies is likely to lead to double counting of emissions.
• While both corporate credit and sovereign debt benefit from bondholder engagement, it is important to note that there are nuances in how this engagement is undertaken. 
• Aggregation can fail to recognize important nuances in both asset classes. For example, the ingrained income bias is a sovereign investing phenomenon that happens when unadjusted metrics, such as environmental, social, and governance indicators, could lead to capital being intentionally or unintentionally deployed away from developing nations and toward developed nations if investors simply compare indicators without regard for stage of development.

Realistic portfolio targets and active dialogues

When it comes to net zero alignment targets for sovereigns, we lean on the recommendations of the IIGCC. We advocate for in-scope portfolios¹³ to set five-year targets for gradually increasing the percentage of bond allocation to sovereigns that are categorized as “Aligned” or “Achieving,” rather than imposing overly prescriptive or unrealistic targets. While engagement can play an important role in this process, in some instances, engagement with sovereign entities can involve nuances that are not always present with corporates. Overall, we believe that maintaining an active dialogue with sovereigns can help investors gain insights and make a material difference over time—while providing feedback and sharing perspectives on disclosures, net zero pathways, and issuance of labeled bonds.

Conclusion: Country commitments continue to evolve

We believe that government- and state‑level action will be pivotal to achieving the global transition to net zero. As more countries update their nationally determined contributions and actively channel capital toward meeting their NDCs, the sovereign net zero landscape will continue to evolve. Investment industry collaboration with the IIGCC on sovereign net zero target setting and guidance has arguably been crucial in ensuring consistency and helping select investors meet their mandate-specific commitments to net zero alignment. T. Rowe Price’s net zero investment framework is designed to align with this best industry practice, while providing a structured approach to evaluating where sovereigns are on their net zero journey—focusing on in-depth analysis, achievable goals, and engagement across both developed and emerging economies.