Can Debt-for-Climate Swaps Help Heavily Indebted Developing ... - Columbia | SIPA Center on Global Energy Policy

Can Debt-for-Climate Swaps Help Heavily Indebted Developing Countries Address Climate Priorities? - Center on Global Energy Policy at Columbia University SIPA | CGEP

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Rising debt levels and the ravages wrought by climate change present acute threats to achieving sustainable development goals in emerging market and developing economies (EMDEs).

Policymakers globally are discussing possible mechanisms to address fiscal and climatic challenges in EMDEs simultaneously.

Debt-for-climate swaps can be classified into two broad types: “bilateral” or “multilateral” debt swaps, which are negotiated directly with one or more official creditors, and “tripartite” debt swaps, in which a sovereign buys back its bonds from private investors to retire them with the help of a loan from a third party.

After the first debt-for-climate swap was executed by Bolivia in 1987, more than 100 similar transactions were engineered during the 1980s and 1990s, but numbers peaked in 1993 and were followed by a sharp decline.

While the number of deals annually does not compare with the early 1990s, the recent batch of executed swaps makes up for the lower number by the size of debt covered.

In this commentary, the authors find that intrinsic features and the experience so far of debt-for-climate swaps suggest they could become a valuable tool—even if they are no silver bullet and may need to be complemented by additional instruments—to address fiscal and environmental problems. These swaps offer a realistic option to help, for example, vulnerable small island developing states (SIDS) respond to specific challenges

Key Features of Debt-for-Climate Swaps

To better understand the scalability and applicability of debt-for-climate swaps, it is worthwhile to derive lessons from recent deals (see Appendix for details). Key aspects of these transactions are:

- Credit enhancements: Arguably the most critical feature of these swaps for investors, as well as for the sovereign, is the extent of the guarantee or insurance provided by a third party. In all deals, the new bond’s principal was either fully or partially guaranteed (or insured) by highly accredited institutions. Additional credit enhancement features were also sometimes included; for example, a loan was extended to Seychelles on attractive terms to lower its interest payment burden. Not surprisingly, the new bonds issued as part of the swaps carry high investment-grade ratings.
- Approach for retiring old debt: Three different approaches were used to retire existing debt in the recent deals. First, the case of Seychelles involved bilateral negotiations, which are typically not complicated because the money is owed to a few developed countries.
- Fiscal savings achieved: The reduction in the notional amounts of bonds following debt-for-climate swaps varied considerably, with almost no change in Barbados to as much as a 60 percent reduction in Ecuador.
- Conservation commitments and governance structures: In all four deals, the new instrument was labeled a “blue bond” because at least part of the funds unlocked by the swap via debt relief and reduced interest payments go toward marine conservation and promotion of the marine economy—for example, expansion of marine protected areas and better management of priority fisheries in Seychelles.

Challenges to Broad-Brush Applications

Following the completion of the debt-for-climate swap by Seychelles in 2018, the Nature Conservancy—which played a pivotal role in this deal and others that followed—estimated that a similar model could apply to up to 85 countries.

A seminal International Monetary Fund paper

Several barriers may impede the successful execution of a debt-for-climate swap:

- Lack of political commitment: Since credit enhancements are necessary for a deal to succeed, it is imperative that the international institution providing the guarantee is convinced by a state’s pledge to rebuild its fiscal position and execute ambitious conservation policies. Without strong, high-level political commitments by the sovereign, external partners may be unwilling to provide this guarantee.
- Hesitancy by sovereign states: Some governments may not see the merits of spending on environmental objectives amid a debt solvency or liquidity crisis, which may be a more immediate determinant of their political future. Additionally, while they could realize long-term savings on interest payments, swaps entail complex and time-consuming negotiations as well as high transaction costs for sovereigns, which may increase political pressure on the government.
- Balance sheet limitations: While as much as $2 trillion of debt has been identified as potentially eligible for debt-for-climate restructuring,
- Limited investor appeal: The combination of a high coupon and an investment-grade rating may entice some investors to the new bond, but others may balk at its illiquidity and the complexity of the arrangement. Other factors constraining the allure of debt-for-climate swaps include only partial redirection of realized savings toward conservation spending, limited ability to legally enforce conservation pledges, remaining fiscal risks in the absence of a comprehensive debt restructuring, and conceding part of the financial return for a nature-based solution.

Considerations for Swaps

Despite the challenges, interest in debt-for-climate swaps is growing, as mentioned earlier, raising the question of under what circumstances and for what types of sovereigns and debt profiles they could be most applicable. Elements for consideration could include:

- Degree of debt distress: Recent transactions have either been carried out by sovereigns under intense debt distress (Belize), some level of debt distress (Ecuador), or normal financing conditions (Barbados). None of these states were in default. The applicability of debt-for-climate swaps for sovereigns in default is more complex given the need to first address the insolvency problem.
- Importance of conservation efforts: De-risking these instruments implies using the balance sheets of bilateral partners and multilateral organizations, which poses limits on the amount of debt that can be guaranteed. As such, a couple of considerations are: (1) how critical the environmental priorities financed by the debt-for-climate swaps are to the sovereign’s fiscal outlook and (2) how relevant they are to global biodiversity and conservation goals. These factors might facilitate assessing whether debt-for-climate swaps are the most appropriate instrument, or whether other climate financing tools (for example, thematic bonds or conditional loans or grants) could be a better fit. These criteria might also affect their marketability to private investors. For example, conservation of Ecuador’s Galápagos Islands and Belize’s coral reefs benefit these countries economically via tourism while also protecting biodiversity assets of global significance.
- Credibility of a country’s institutions: While the issuance of debt-for-climate swaps could reinforce climate governance, their success requires strong institutional commitments in the use of proceeds for the specific conservation goal.

Conclusion

Debt-for-climate swaps will not solve the widening crisis of indebtedness facing EMDEs, nor are they game-changers for the difficulties these countries face in attracting appropriate financing for climate mitigation and adaptation projects. That said, as this commentary has argued, under the right conditions debt-for-climate swaps can help particular subcategories of vulnerable states find new financing for environmental priorities while protecting livelihoods and improving a country’s fiscal outlook. It is no coincidence that climate-vulnerable and heavily indebted SIDS—such as Barbados and Seychelles—have been among the keenest adopters of the mechanism, as it provides these states with hitherto unavailable resources for adaptation projects that focus on combating oceanic biodiversity loss and supporting the livelihoods of coastal communities. Similar spending priorities associated with swap commitments have been on evidence in Belize, Ecuador, and Gabon,

Moreover, debt-for-climate swaps—as opposed to straightforward debt restructuring, for example—have an important signaling function for sovereigns to underline their commitment to both environmental and fiscal goals. As such, they can also be valuable for building institutionalized partnerships and ensuring accountability vis-à-vis investors, international organizations, and domestic populations.

Appendix

Notes

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