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How debt-for-climate swaps can help fund the energy transition

A debt-for-climate swap plan is expected from the International Monetary Fund and the World Bank ahead of COP26. If fit for purpose, it could be highly effective in addressing spiralling low and middle-income country debt and the climate crisis.

Developing country debt has been rising for the past 20 years but has “ballooned with the Covid pandemic”, says Paul Steele, a chief economist at the UK-based International Institute for Environment and Development. External debt owed by emerging markets and developing countries reached approximately $11trn (€9trn) in 2020. Servicing it has left countries without the funds to meet immediate social and economic needs, let alone invest in long-term climate goals.

A woman arranges dried fish at the deserted fish market in Rufisque, Senegal, the world’s most impoverished region. (Photo by Sellou/AFP via Getty Images)

Efforts by the International Monetary Fund (IMF) and the G20 to address the debt crisis do not go far enough, say the authors of the report Debt Relief for a Green and Inclusive Recovery by the Global Development Policy Center at the University of Boston, US, the Heinrich Böll Stiftung and the Centre for Sustainable Finance at SOAS, University of London. They cite three main failings of the G20’s Common Framework for Debt Treatments Beyond the Debt Service Suspension Initiative (DSSI), aimed at helping the worlds poorest countries restructure their debt on a case-by-case basis.

First, the initiative doesnt address the unsustainable debt faced by many middle-income countries; secondly, there is no mechanism to properly engage private creditors; and thirdly, it fails to align newfound fiscal space with globally shared climate and development goals”.

Failure to tackle the linked challenges of debt relief and green development will expose these countries, many of which are already among the most vulnerable to climate change, to even greater distress further down the line, says Nicola Ranger, head of climate and environmental risk research at the Oxford Sustainable Finance Programme.

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If these countries, some of whom are growing very rapidly, make investments now in higher-carbon infrastructure, they will be locked into that infrastructure for decades to come, which will increase their transition and resilience risks,” says Ranger. There is a real and urgent need to support these countries now on a low-carbon development pathway as part of the Covid recovery.”

The IMF, the World Bank, the UN and the Organisation for Economic Cooperation & Development are working towards this goal. In April 2021, a technical working group bringing together representatives from the four institutions was launched to examine how the challenges of climate and debt can be integrated. The IMF and World Bank plan to present their ”green debt swap” instrument in time for the COP26 negotiations in November.

Debt-for-nature – but much, much bigger

The specifics of a debt-for-climate swap – in which international creditors offer debt relief in exchange for accelerated coal closures and a shift to renewables – will vary from country to country, but the concept will be the same.

First, a creditor will agree to reduce debt, either by converting it into local currency, lowering the interest rate, writing off some of the debt, or through a combination of all three. The debtor will then redirect the saved money towards initiatives aimed at increasing climate resilience, lowering greenhouse gas emissions or protecting biodiversity.

The idea builds on the debt-for-nature swaps first conceived in the 1980s. These swaps began as small, trilateral deals, with NGOs buying sovereign debt owed to commercial banks to redirect payments towards nature projects. They later evolved into larger, bilateral deals between creditors and debtors.

Climate swaps will differ from past deals in two ways.

The first is scale. While most debt-for-nature transactions are still below $50m, debt for climate swaps will need to address the factmany billions, perhaps trillions of dollars of debt will need to be restructured, relieved, and forgiven”, says the US-based Institute for Governance and Sustainable Development.

Secondly, to deliver wide-reaching, long-term climate goals, deals will need to be programme rather than project-based, with delivery and budget accountability resting with the host governments, not international NGOs.

You need national ownership,” says Steele. It is very important that government, parliament and civil society in-country are engaged in discussions to identify the key performance indicators against which the debt reductions will be paid. These indicators need to be based on existing government policy commitments, but which lack support and financing.”

Climate programmes

One way of ensuring this happens at scale would be to ensure debt-for climate programmes are embedded in national post-Covid green recovery plans.

Many countries are being encouraged to use labour-intensive nature programmes to maximise employment for people who lost their livelihoods during Covid, such as tree planting schemes, watershed management, and soil and water rehabilitation,” says Steele.

Public funds could also be used to mobilise private capital. Global think tank the Climate Policy Initiative (CPI), which has published a debt-for-climate blueprint focused on middle-income countries, suggests several possibilities. These include kick-starting the early retirement of mid-age coal power plants or the roll-out of energy efficiency projects, through debt relief.

The problem with many energy efficiency programmes is that they tend to be done piecemeal because there isnt the budget to roll them out fully, but a climate-for-debt swap could provide a substantial amount of money upfront, the impact of which would multiply once you mobilise private capital,” says Vikram Widge, a senior advisor at CPI.

Debt relief could also be used as payment to compensate developing countries for leaving fossil fuels in the ground. Johnny West at OpenOil, a German company providing financial analysis on natural resource assets, suggests governments sign an agreement with international creditors to receive debt relief in exchange for not developing fossil fuel reserves. Such an agreement should be signed initially for a ten-year period, he says.

This approach could have a significant impact. The 76 countries classified by the UK Jubilee Debt Campaign as having high debt service requirements have proven oil reserves of around 380 billion barrels, and gas reserves of around 600 trillion cubic feet – equivalent to somewhere between 300 and 400Gt of carbon dioxide.

Getting everyone involved

A comprehensive debt-for-climate swap programme will need to involve private and public creditors to ensure maximum fiscal space is created to drive green growth. It also addresses the political challenge that if creditor nations accept a debt cut, then they often dont want the private sector to get a free pass,” says Widge.

Voluntary measures failed to mobilise private sector involvement in the DSSI. The IMF should make debt-for-climate programmes in heavily indebted countries conditional on governments seeking the same level of debt relief from private and public creditors, argue the authors of the Debt Relief for a Green and Inclusive Recovery report.

The private sector can be incentivised to accept a write-off on investments since in countries in debt distress, companies may anyway be facing a reduction in payments.

Restructuring the debt under a debt-for-climate swap is a way for the private sector to get at least some of that money back and have it invested it in a good cause for pro-poor climate and nature action,” says Steele.

In addition, private creditors that agree to debt relief could be offered emissions offsets from the climate projects.

If restructured debt repayments are being invested in nature-based solutions, such as protecting or restoring forests, or in the early retirement of coal plants, the transaction can be structured with offsets bundled in with the new debt,” says Widge. These can be new kinds [of offsets], like a high-quality ‘no-coal’ offset designed to help halt emissions from operating mid-age coal plants. Private investors get cash and offsets, which they can monetise in the market, and the country gets implicit partial debt relief.”

There is no liquid market for these offsets yet, but buyers could be found that would commit to buying these credits at a pre-determined price – or at least a price floor, if they are linked to a future market price.

“We might need to issue a regular bond that pays cash for principal and interest to the investors, but the country (or state or company doing the project) directly sells the offsets to a pre-identified buyer in a separate transaction,” said Widge. “Overall, the impact to the country will be the same and may be easier in the near term.”

Alternatively, the swaps involving private sector creditors could be linked to existing emissions credits.

The EU has expressed interest in debt-for-climate swaps and so you could look at linking credits to the EU Emissions Trading Scheme,” says Steele. Alternatively, for Chinese creditors, they could be linked to some of the many emission credit schemes in China, which are growing with China’s commitment to net-zero carbon emissions by 2060.”

China, as the largest bilateral creditor of developing country debt, will need to play a crucial role in debt-for-climate swaps – and is not necessarily averse to doing so. Beijing has engaged in debt relief already through the DSSI and could be convinced to do so for climate and nature goals under the right international framework.

The UN has been in touch with the minister of environment in China to discuss the idea of debt management for climate and nature, and there seems to be some willingness to look at it in greater detail,” says Steele. China is quite interested in nature-based solutions to achieve its climate commitments by investing in other countries across the world.”

China will host the Convention on Biodiversity in October, one of the objectives of which is to increase finance to prevent global biodiversity loss. Beijing could use the platform to spearhead its own debt-for-nature swaps solution.

Bigger than the Green Climate Fund

Ultimately, multiple solutions will be needed to address the debt and climate crises faced by low and middle-income countries.

We need everything to happen, and on all levels – increasing private sector action and concessional finance to support investment in low-carbon, resilient infrastructure as well as targeted budget support, building technical capacity and supporting policy change,” says Ranger.

However, if debt-for-climate swaps can be deployed on the scale proposed their value would be in the many billions of dollars and they will play an increasingly significant role within this suite of solutions.

Debt swaps could even be more effective at providing finance for developing countries to respond to the climate crisis than the UN Green Climate Fund, which so far only has $8.3bn in confirmed funding.

This is where the money is, and this is how to engage the ministries of finance that we need to drive real policy change in climate and nature in these countries,” says Steele.

Leigh Elston is an energy journalist based in Maputo, Mozambique.