Debt-for-climate swaps have become a movement within development finance over the past few months. Several exhort actions in these fiscally constrained times to help with debt relief and to promote a green recovery. There are also proposals for addressing the nexus of climate and health. Others advise caution before jumping into one of these transactions, arguing that such a swap may not be the most efficient way of achieving mutually desired goals.
The main idea is to offer debt relief to countries that need it in exchange for specific action on climate goals, which sounds great. But are these swaps really a good idea? And if so, what hurdles must be overcome to get to the opportunities beyond?
First and foremost, all concerned must get on the same page with regard to intended outcomes. As Ulrich Volz, director at the Centre for Sustainable Finance in the University of London’s School of Oriental and African Studies, and his team eloquently say, the goal should be to provide “developing countries the fiscal space at a critical time to address the three crises they are facing: the health and social crisis, the debt crisis, and the climate and environmental crisis.” This, I hope, all can agree on.
Next, there are questions of size and structure.
One option could be to do a larger version of previously successful debt-for-nature swaps, which have usually been under $50 million, such as the recent marine conservation transaction done by The Nature Conservancy and the Seychelles. However, these structures are based on conservation organizations purchasing distressed debt in the secondary market at a discount and then working with the borrower government to capitalize a conservation trust that benefits from the reduced debt burden.
While such a structure could remain an option, there are many challenges to this approach, including ensuring that a host country, given its economic condition and governance, is able to deliver the planned outcomes. This hurdle increases if swaps for much larger amounts are, in fact, the desired outcome.
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More meaningfully, would it be better if the borrower and lender countries negotiated a swap more directly? This could be structured closer to what the term “debt for climate” implies, with an incentive for some debt relief in the form of forgiveness. Or perhaps it could be a swap based around the debt of a public institution to undertake a specific activity, such as the work being done to help South Africa’s Eskom restructure its debt while accelerating retirement of coal.
The second issue is which countries to target. While many argue that swaps should be focused primarily on countries that need debt relief, there are other and better ways of providing this relief, like expanding and extending the International Monetary Fund- and World Bank-supported Debt Service Suspension Initiative or even restructuring and reissuing debt for more successful future debt service. Furthermore, many countries that need debt relief may not be in a position to commit much to climate outcomes.
Nevertheless, to be successful at scale and mobilize significant capital, debt-for-climate swaps should probably focus on countries that are able to service their debt and that — in exchange for some reduction or forgiveness of the debt as an incentive — would be willing to redirect the debt service cash flows into mutually agreed use of proceeds from the swap. In this arrangement, target countries are likely to be the larger emerging market borrowers that are working toward ambitious climate action plans but need extra help here.
But there have also been changes in who the creditors are. As one World Resources Institute blog post noted, “China dwarfs the other bilateral official creditors.” So most swap arrangements are likely to need China’s engagement and support. Most other donor creditor countries are going to want this.
In addition, most creditor countries want private holders of sovereign bonds to also participate in such swaps so that all the benefits of the implied debt relief can flow to the borrowing country. This will be challenging, as the private sector invested to get a return and can’t relabel the debt as official development assistance.
However, perhaps incentives could be provided for the private sector to participate. Given the plethora of corporate net-zero commitments, the expected use of voluntary offsets to achieve those goals is expected to surge.
In fact, Mark Carney, former governor of the Bank of England, has convened a Taskforce on Scaling Voluntary Carbon Markets that has a report out for consultation about how we should prepare for a voluntary offsets market that should be worth tens of billions of dollars annually rather than the $300 million it currently is. This means we will likely have an offsets market with liquidity and longevity with associated financing and hedging products.
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So, in exchange for a swap or restructuring, could private holders of sovereign bonds get recognized offsets — nature-based or even emissions reductions in the near term — that could be used to meet market demand and hence have significant value? And if we could pull this off, then what could the proceeds be used for?
There are a variety of actions for a sustainable recovery and longer-term resilience that need to be undertaken, and most need public funds — which, of course, most countries don’t have much of for now.
The best options are likely those that also mobilize private capital for an even larger impact and could include nature-based solutions, such as reversing nature loss, protecting biodiversity, regenerative agriculture, and forestry; supporting critical interventions at the nexus of health and climate, like cooling to address extreme heat, cold chain extensions critical to vaccines, and avoiding future health costs by addressing air pollution; and also realizing the benefits of accelerated retirement of coal power that is suitably replaced with renewables.
The European Climate Foundation, Climate Policy Initiative, and Oxford Sustainable Finance Programme at the University of Oxford are investigating debt-for-climate swaps in the context of a program to support a greener, more just, sustainable, and resilient recovery. We look forward to views on these ideas as we work to develop an investment blueprint for debt-for-climate swaps.