The world’s climate goals will not be achieved if we don’t deal with the growing debt crisis.
The World Bank estimates that low and middle-income countries will owe half a trillion dollars in debt payments over the next five years.
Under such a burden, plus the aftershocks of Covid-19 and rising food and fuel prices, these nations will soon not be able to cope with the impact of climate change on their 6.6 billion citizens, let alone join international efforts.
Traditional collective action through the multilateral system and sovereign creditor clubs has largely failed to provide meaningful relief to poor and climate vulnerable countries. And as the economic losses and damages of intensifying climate catastrophes pile up, the toxic links between debt and climate change deepen.
Take the case of Malawi, already one of the poorest countries in the world, which was recently ravaged by the longest and most severe cyclone in recorded history.
The storm killed more than 600 people and displaced hundreds of thousands, with devastating long-term impacts on infrastructure and livelihoods. This was the third extreme weather event to hit the country in the last 13 months, and the country now faces a debt burden which is nearly two-thirds its gross domestic product (GDP).
The situation is similar in Pakistan, another country facing deep debt distress, where major floods devastated the country last year, leading to thousands of deaths, damage and economic losses of more than $30 billion and costs of reconstruction estimated to be over $16 billion.
A recent International Monetary Fund (IMF) loan will not even cover a tiny fraction of this amount, while its conditions require increased electricity charges and other burdens.
Bold new thinking and action is needed to address this escalating crisis. Fortunately, there were some signs of this happening on the sidelines of this year’s IMF and World Bank Spring Meetings.
One promising route is to reward climate-ravaged, debt-burdened countries with better loan terms for meeting ambitious climate, nature, or other sustainability performance targets.
So-called ‘sustainability-linked sovereign debt’, linking nature and climate goals with reduced debt repayments, may be an idea whose time has come – provided it can be deployed at scale.
Connecting sovereign debt payment terms to nature and climate action can provide essential and immediate relief while investing in reduced risk and improved resilience for tomorrow.
The idea is straightforward: countries borrow money on the condition of meeting the sustainability targets tailored to fit their existing commitments, such as emissions reductions or stopping deforestation, for which they are rewarded with lower borrowing costs.
On meeting these targets, the borrowing countries benefit from, for example, longer repayment schedules and lower interest rates on national debt.
Green bonds as such are not new. Since 2011, more than $2 trillion worth have been issued by countries and companies. What is new is to reward the issuer of the debt through lower interest rates.
Last year, Chile and Uruguay both successfully issued sustainability-linked sovereign bonds that saw them turn their voluntary national commitments under the Paris Agreement into binding and rigorously monitored financial commitments.
Another subset of performance-linked approaches are debt-for-nature swaps, which provide relief in return for a government commitment to undertake nature and climate specific work such as protecting coral reefs. This approach has been used in Barbados, Belize and the Seychelles.
Encouragingly, discussions indicate a growing interest among other low and middle-income countries and investors to adopt a programme of sustainability-linked sovereign bonds or debt-for-nature swaps, including from the Sustainable Debt Coalition of African Governments committed to collective action in addressing the debt-climate-nature crisis.
These potential solutions are, however, not without challenges. To date, countries that have issued sustainability-linked sovereign debt have faced high transaction costs and lengthy negotiations.
Proponents of sustainability-linked debt point out that costs should come down as processes become increasingly standardised and benefits become better recognised.
Clearly, a country’s cost of raising financing should be linked to its capacity to repay it. However, in today’s financial markets, in which long-term debt is bought and sold, the focus is on a narrow set of short-term metrics, such as interest rates, inflation and public debt levels.
Little or no account is taken of the debtor country’s resilience to climate change, its pathways to reduced emissions or the state of nature on which the economy depends.
Vulnerable countries urgently need impartial assistance and capacity to manage these complex procedures, without having to pay high costs for such assistance from private parties.
They will need support from creditor nations and multilateral and regional development banks, which can act as guarantors of sustainability-linked debt. In this way, countries can invest in greater climate resilience to underpin their future sustainable prosperity.
This could be a turning point from academic consensus to meaningful action, at scale. Anything less may rightly be considered a failure.
Jayati Ghosh is professor of economics at the University of Massachusetts Amherst.
Simon Zadek is executive director at NatureFinance.
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