Here is all you need to know about debt-for-climate swaps

Offering debt relief in lieu of climate action could allow rich countries to pay for their acts of historical injustice, while helping the poor ones manage mounting public borrowings and climate change challenges

By Bipsa Nanda
Published: Wednesday 03 May 2023

Illustration: Yogendra AnandCountries prominently vulnerable to climate change and the loss of natural biodiversity are often the ones least able to afford the investment to strengthen resilience.

This is because of their debt burden. Gradually, these factors combine to put the affected countries in jeopardy; they face prolonged fiscal crisis, which forces them to rely on the mercy and the aid of the international community to stay afloat.

International organisations and multilateral development banks exercise multiple types of measures to help highly vulnerable countries survive financial catastrophes caused by climate change impacts.

However, in the past decade, debt-for-climate swaps has grown relatively popular among low- and middle-income countries.

Multilateral development banks and multilateral organisations such as the United Nations Development Programme (UNDP) have also been advocating this instrument as a debt-relief measure.

According to an article by officials with the International Monetary Fund (IMF), debt-for-climate and debt-for-nature swaps seek to free up fiscal resources so that governments can improve resilience without triggering a fiscal crisis or sacrificing spending on other development priorities.

The concept is not new. Debt-for-nature swap first appears to have been used in the 1980s in Latin America, where the countries aimed to reduce unsustainable external debts and address worsening environmental conditions.

The concept of debt-for-climate swap was also envisioned around the same time by then deputy vice-president of Worldwide Fund for Nature, a conservation group.

It was introduced as a debt restructuring device that aims to combat climate change by ensuring that debt-ridden countries do not incur additional debt while addressing climate change locally.

In such cases, a new agreement would be worked out with a multilateral or bilateral partner to replace the terms of the initial loan agreement, which would direct the remaining debt on mutually agreed terms towards “green or blue” domestic investments—while green investments focus on projects or areas committed to preserving the environment, blue investments focus on sustainable use of ocean resources.

Relief for rich and poor alike

Whether for nature or for climate, debt swaps possess dual objectives: to promote specific investment and policy action on the one hand and some debt relief on the other. Acquisition of debt with some concession is the logic underlying the concept.

For instance, a debt-for-climate swap is an agreement between the creditor and a debtor by which the former forgoes a portion of the latter’s foreign debt, or provides it debt relief, in return for a commitment by the government to invest in a specific environmental project to, say, decarbonise the economy, develop climate-resilient infrastructure, or protect biodiverse forests or reefs. The utilisation of these swaps now stretches to finance enormous climate mitigation and adaptation projects.

Andrew Karolyi, dean, Cornell SC Johnson College of Business, tells Down To Earth why creditor countries should engage in debt-for-climate swaps.

For one, he says, the signatories to the Paris Agreement and the Glasgow Financial Alliance for Net Zero (GFANZ), a global coalition of financial institutions, have a commitment to provide financial assistance to developing countries to build clean, climate-resilient futures.

Debt-for-climate swaps are one way to fulfil their commitments. Second, debt-for-climate swaps are attractive instruments due to their transparency.

While they can reduce the level of indebtedness of a nation to private creditors or creditor nations, the concessional capital is assured to be directed to climate projects with third-party guarantors overseeing the escrow fund.

Transparency is key for assurance of commitment. “This is critical for debtor countries with less robust governance systems and with greater political instability,” he says.

The fact is debt conditions of many developing countries remain unsustainable due to consistent climate risk, and they might lack the fiscal space required for climate investment, even if it is financed on concessional terms.

Consider the climate-vulnerable island developing economies that are covered under the IMF-World Bank’s climate change policy. Debt-for-climate swaps offer an innovative way to make climate investments in these countries while creating the much-needed fiscal space.

At the same time, debt-for-climate swaps support climate investment by committing a country to swing their spending from debt service to an agreed public investment.

Creditor countries are primarily hesitant to go for debt-for-climate swaps unless it is structured to make sure that the public expenditure commitment towards climate action is superior in value to the remaining debt service.

However, conditional climate grants are designed and structured to make them impossible to divert and are targeted only for climate investment purposes. So the creditor countries trust and favour conditional grants.

It can be inferred that the debtor country would prefer swaps over conditional grants considering that swaps offer debt relief above what is needed to finance the climate investments (net debt relief), leading to a higher fiscal transfer and the creation of fiscal space.

On the other hand, conditional grants are set to, at most, cover cost of an investment and require economic dislocation.

Hope for small island countries

Small wonder that small island developing states (SIDS) are eyeing this innovative financial instrument to address the two challenges they face: adapting to increasing climate risk and recovering from financial distress.

Servicing debt entails continuing payments, which diminishes national budgets for developmental projects, including adaptation to climate change and disaster risk reduction, further increasing their vulnerability to climate change. It is like being trapped in an endless circle of misery.

In the international debt relief debate, the Caribbean SIDS are pivotal as their vulnerabilities to climate change are unique and internationally recognised.

Caribbean SIDS account for five of the world’s 10 most tourism-dependent economies. But the COVID-19 pandemic resulted in a 73 per cent drop in international tourist arrivals in 2020, and has aggravated the region’s debt crisis.

In debt-for-climate swaps, bilateral and multilateral debt relief could enable SIDS to reduce their external debt while investing the liberated funds in national climate adaptation and mitigation programmes. And the success stories of a few economies show the potential of the financial instrument.

Consider Seychelles. In 2017, this small African country announced the successful conclusion of negotiations for a debt-for-adaptation swap under a tripartite model.

The Nature Conservancy (TNC), a US-based environmental organisation, bought $22 million of its debt in exchange for a promise to create 13 new marine protected areas.

After the conclusion of Seychelles’ debt swap, TNC has announced that they expect to replicate this model in Grenada, an island country in the West Indies, for a $60 million debt swap and then in other Caribbean islands in the coming years.

In 2021, Belize, a country on the northeastern coast of Central America that is bordered by the Caribbean Sea to the east, reduced its debt by 10 per cent of its GDP and acquired funds to protect the world’s second-largest coral reef by striking a $553-million swap deal with TNC.

In another such debt-for-nature swap negotiated with Portugal, the European country has proposed an initial €12 million (about $13 million) of scheduled debt and climate funds to assist Cape Verde, an archipelago of 10 volcanic islands located in the central Atlantic Ocean, in switching to cleaner energy supplies.

For Sri Lanka, climate is the saviour

Sri Lanka, which ranked in the top 10 countries most affected by climate-induced disasters from 2018 to 2020, is highly vulnerable to climate change catastrophes.

A report by the World Bank in 2018 outlined that approximately 19 million Sri Lankans will be living in moderate or severe climate change hotspots by 2050. Being an island nation, Sri Lanka will also fall prey to rising sea levels.

It goes without saying that Sri Lanka deserves financial help for the reparation of climate-caused disasters.

The sovereign debt crisis in Sri Lanka in 2022 attracted worldwide attention. A state-wide emergency was declared after President Gotabaya Rajapaksa fled the country following months of mass protests.

The confidence in the Srilankan currency further shrunk during the crisis, causing difficulty in borrowing money from the international markets.

According to UNDP, Sri Lanka owes approximately $45 billion in long-term debt to creditors, which requires immediate financial assistance. The island country has already benefited from 16 IMF bailouts and is currently negotiating the 17th.

However, bailouts have three pre-requirements: financing packages, “structural reforms,” and macroeconomic conditions, all of which will require significant policy changes. Media reports suggest that Sri Lanka therefore is in talks for a debt-for-nature swap deal of up to $1 billion in climate-focu-sed finance.

The deal, if succeeds, might free up some of Sri Lanka’s exhausted domestic revenue and create fiscal space to incentivise climate-oriented developmental projects with relatively low economic dislocation.

The cash flow would enable Sri Lanka to stabilise its economy without further incursion of debt. The debt burden would be reduced, and foreign reserves would be saved.

Like everything, debt-for-climate swap also has its downside. There are certain circumstances they are apt for, and somewhere they fail to serve the purpose.

The main problem with principal financial instruments is that they disturb the already strained economy in exchange for assistance. However, debt-for-climate swap creates the much-needed fiscal space without causing policy disruptions.

Swaps are mainly advantageous for small developing countries. However, the scaling up of the debt swap is still much lower than grants as creditors do not see their gain in this deal. Debt swaps can only be successful if the creditors are not rigid on returning the debt’s whole value.

Rich countries have a responsibility to support poorer nations. This demands the dispensation of debt to poorer countries in the Global South due to the Global North’s climate debt from disproportionately higher emissions.

Bipsa Nanda is a student of International Relations at Pondicherry University

This was first published in the 1-15 April, 2023 print edition of Down To Earth

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