In September, the Prime Minister of Barbados, Mia Amor Mottley, addressed the United Nations General Assembly passionately on the subject of the escalating debt burdened by many developing nations and its impact on their ability to thrive.
In 2020, the average debt of low- and middle-income countries, excluding China, increased from 26% to 42% of their gross national income. In Latin America and the Caribbean, debt service payments accounted for an average of 30 percent of annual exports.
Simultaneously, these nations face the "triple crisis of climate change, pandemic, and now the conflict that is causing inflationary pressures that regrettably lead to people taking matters into their own hands," according to Mottley.
As a result of rising borrowing costs, high inflation, and sluggish economic growth, developing nations like hers are in a precarious position regarding climate change. Countries with high levels of debt have fewer resources for mitigating and adapting to climate change. However, climate change is increasing their vulnerability, which can increase their sovereign risk and thus their borrowing costs. Declining productive capacity and tax base can increase the likelihood of incurring debt. A vicious cycle exists.
Countries and international organisations are discussing "debt-for-climate swaps" as a means of addressing both issues concurrently. Amina Mohammed, Deputy Secretary-General of the United Nations, mentioned debt-for-climate swaps as one option for refinancing countries' "crippling" debt prior to the November 6-18, 2022 U.N. Climate Change Conference.
How debt swaps work
Debt-for-climate swaps permit countries to reduce their debt obligations in exchange for a promise to finance domestic climate projects with the released funds.
Since the late 1980s, they have been utilised to preserve the environment and address the liquidity crisis in developing nations such as Bolivia, Costa Rica, and Belize. These are typically referred to as "debt-for-nature swaps."
Under a complex debt-for-nature swap, Belize was able to reduce its debt in exchange for committing to designate 30% of its marine areas as protected areas and to spend $4 million annually for the next two decades on marine conservation.
The swap, arranged by The Nature Conservancy in 2021, entails the U.S.-based environmental organisation lending Belize funds at a low interest rate to buy back $553 million in commercial debt at a 45% discount. The Nature Conservancy raised funds from Credit Swisse through the issuance of "blue bonds" backed by the United States government, which gave the bonds an investment-grade credit rating.
Similarly, Costa Rica and the United States have completed two debt-for-nature swaps. Under the terms of the swaps, Costa Rica committed $53 million to conservation projects. It has already reverted its deforestation and planted over 60,000 trees.
Although debt-for-nature swaps have primarily been used for conservation, the same concept could be applied to climate change mitigation and adaptation activities, such as the construction of solar farms or sea walls. Some finance experts have suggested that debt-for-climate swaps could be structured in a way that would also encourage private-sector bondholders to exchange their holdings of national debt for carbon offsets.
Three requisites for effective debt-for-climate swaps
I am a member of the Climate Policy Lab at Tufts University's Fletcher School. Our experience with debt swaps can inform the design and implementation of climate-debt swaps.
First, the complexity of debt swaps' governance structures has limited their use. From 1987 to 2003, transactions were typically small, generating only about $1 billion in funding for the environment. A term sheet template for future debt-for-climate-change swaps could reduce the complexity and time and costs associated with these transactions.
Second, debt-for-climate swaps must alleviate the debt burden sufficiently to enable debtor nations to invest in climate adaptation and mitigation projects. In 2009, the United States created debt-for-nature swaps with Indonesia that were criticised for not doing enough to assist the Indonesian government in achieving its conservation objectives.
Another concern is referred to as "additionality" – ensuring that the swaps result in additional climate efforts, as opposed to efforts that have already been planned or paid for with international climate finance.
Debt-for-climate swaps can be a significant source of funding due to the widening gap between the amount of adaptation assistance reaching countries and the amount they need. Climate Policy Initiative, a non-profit research organisation, recently estimated that approximately 90 percent of the adaptation needs countries listed in their Nationally Determined Contributions – the climate change plans they submit to the United Nations – can only be met with assistance from development banks or other nations.
Experimenting regions with debt swaps
Several regions are evaluating debt-for-climate-change swaps.
In its Climate/Sustainable Development Goal Debt Swap, the Economic and Social Commission for Western Africa acts as a liaison between creditors and seven pilot countries. The initiative focuses on advancing sustainable development and climate objectives, including the creation of a more resilient agricultural sector.
Similarly, the Economic Commission for Latin America and the Caribbean plans to launch a Debt for Climate Adaptation Swap as part of the Caribbean Resilience Fund. Similar to Belize's debt swap, it aims to reduce the $527 million in debt in three pilot countries by issuing green bonds. By guaranteeing new bonds and lowering the credit risk, development banks would play a crucial role.
With carefully crafted debt-for-climate swaps and the assistance of international institutions, developing countries could increase their financing for urgently required climate mitigation and adaptation actions and reduce a portion of their heavy debt burden.