Economists say debt forgiveness can be used to help low- and middle-income countries fight climate change but getting creditor nations to agree could be challenging.
With the Covid-19 pandemic exacerbating the crippling debt burdens faced by low- and middle-income countries, politicians, creditors, and development agencies are looking for answers that will not just defuse a debt crisis, but also help the world avoid climate disaster.
“Debt has been getting worse in the last few years, and it really started to reach dangerous proportions because of the pandemic,” says Paul Steele, chief economist at the International Institute for Environment and Development. “Debt service levels are unsustainable in some countries in the short term, so this has to be resolved in the next year or two.”
One of the most-discussed proposals involves so-called debt-for-climate swaps, which entails restructuring debt arrangements to free up money for climate-friendly projects, from infrastructure to conservation, green jobs, renewable energy and natural resource preservation.
The current international sovereign debt crisis affects almost all low- and middle-income countries across South America, the Middle East, Africa and East Asia. These nations had USD 14 trillion of external debt come due in 2020. While indebtedness has been rising for many years, it ballooned during the pandemic as international tourism collapsed, exports fell off and governments were obliged to increase health and social spending.
As major international action becomes inevitable, discussion about debt-for-climate swaps has intensified. There are many forms for such swaps. One option is to allow debtor nations to switch external debt payments to finance for domestic climate projects; another is to replace existing debt by issuing new debt that includes commitments to address climate change. Either way, such swaps not only reduce indebtedness, but catalyse green investment.
Some experts see debt-for-climate swaps being of particular use in middle-income countries, which own over 70 percent of non-developed world debt, and which often have more leeway than more debt-distressed nations.
“Debt-for-climate swaps could generate much-needed fiscal space for middle-income countries to focus on climate ambitions and economic recovery,” says Vikram Widge, a senior advisor at the Climate Policy Initiative.
One of the most successful examples of a debt-for-climate type agreement was between the Seychelles and a group of creditors led by the UK, France, Belgium and Italy. Referred to as a form of debt-for-nature swap because its aim was the conservation of the oceans around the Seychelles archipelago, the deal was inked in 2015.
As part of the swap, international environmental organization The Nature Conservancy bought Seychelles’ foreign debt at a discount and the Seychelles government promised to pay money to a special trust. This body, known as the Seychelles Conservation and Climate Adaptation Trust (SeyCCAT), also received private donations. SeyCCAT was then used to conserve 13 specially-created marine areas covering more than 85 percent of the nation’s coral reefs and shallow waters. It began making investments in 2018.
The model used in the Seychelles is just one possible option. In reality, there are few limits on the type of climate action that can be a part of a debt-for-climate swap — but they would be most effective if selected to promote both economic recovery and enhance funding for climate-smart activities. They should also encourage, not squeeze out, private investment.
Other island nations in the Pacific and Caribbean — which are particularly vulnerable to the consequences of climate change — as well as a host of low- and middle-income countries have already expressed interest.
“Frankly, if you’re in a position of debt distress anything that reduces your debt is welcome,” says Steele. “Even if it has a slight level of conditionality, it’s better than having to pay all your money to a foreign creditor. At least you’re going to be investing back in your own country.”
In order to make a significant difference, however, future debt-for-climate swaps need to be much bigger.
“Upscaling can be achieved by the use of budget support where debt is paid against climate and nature KPIs channelled through government budgets,” says Steele.
A second challenge is bringing on board all creditors, which include nations like China — which traditionally prefer bilateral agreements — and a host of private bond holders.
One catalyst for involving private creditors is likely to be the rise of environmental, social and corporate governance (ESG) commitments. Accepting some debt write-off in exchange for boosting ESG, particularly if an enforced debt haircut is the alternative, may become increasingly attractive.
“Given the plethora of corporate net-zero commitments, incorporating voluntary offsets as part of debt-for-climate swaps could provide an incentive for the private creditors to also participate,” says Widge.
Success will also require the involvement of credit rating agencies and the world’s major development banks, which hold much of the debt in question. At present, development banks are known to be wary of restructuring, which they fear could hurt their credit rating.
Whatever the hurdles, it seems only a matter of time before the political will to implement debt-for-climate swaps makes them a reality.
“The US administration is interested, the IMF is quite committed, and so are the World Bank and the UN,” says Steele. “There is a growing interest to turn some of these high-level policy discussions into pilots on the ground.”