Carbon pricing and sovereign credit risk: A threshold analysis of policy design and economic structure for climate-fiscal resilience

The transition to a low-carbon economy requires carbon-pricing mechanisms that safeguard fiscal stability and sovereign creditworthiness. However, their implications for sovereign risk remain contested, with prior research yielding fragmented results. This study provides the first systematic cross-country evidence of the carbon pricing–sovereign risk nexus, accounting for policy design, economic structure, and institutional thresholds. Using quarterly data from 21 developed and emerging economies (2015Q2–2024Q1) that integrates sovereign risk, governance, and carbon pricing indicators, we employ advanced econometric approaches, including Fixed Effects with Driscoll–Kraay corrections, Dynamic Panel Threshold Regression, bootstrap bias-corrected estimators, and quadratic specifications to capture heterogeneous and nonlinear effects. Three key findings emerge. First, policy design is decisive: Emissions Trading Systems (ETS) significantly raise sovereign risk, carbon taxes are broadly neutral, and hybrid regimes consistently reduce spreads, underscoring their fiscal credibility. Second, economic structure conditions outcomes: In diversified economies, sovereign risk is shaped mainly by energy dependence and governance, whereas in fossil fuel–dependent economies, carbon pricing becomes a direct risk channel. Third, institutional capacity is a threshold. Threshold and quadratic analyses confirm an inverted U-shaped relationship between regulatory quality and sovereign risk, with cut-offs at 1.45 (ETS), 1.64 (tax), and 1.51 (hybrid). Carbon pricing lowers risk under weaker institutions but becomes destabilizing once governance exceeds these levels, whereas hybrid regimes remain stabilizing. By embedding institutional thresholds, this study reconciles prior conflicting evidence and demonstrates that hybrid carbon pricing frameworks anchored in robust governance are the most effective in enhancing climate-fiscal resilience and sustaining sovereign creditworthiness.