How debt-for-climate swaps can help solve low-income countries’ crushing debt and environmental challenges at the same time

Barbados Premier Mia Amor Mottley addressed the nation’s parliament in the United Nations General Assembly in September concerning the increasing debt that many countries in the developing world are enduring and the increasing impact on their ability to prosper.

The average level of debt for countries with low and middle incomes, with the exception of China and India, was 42 percent of their gross annual earnings at the end of 2020. That’s an increase from 26% in 2011. For countries of Latin America and the Caribbean, The annual installments to pay off the debt averaged 30 percent of their overall exports.

In the meantime, they are also confronted with the ” triple crisis of climate change, of pandemic and indeed now the conflict that is leading to the inflationary pressures that lead regrettably to people taking circumstances into their own hands,” Mottley added.

The rising cost of borrowing, coupled with the high rate of inflation and slow economic growth, have put developing countries such as hers in a challenging situation in the face of climate change. A high level of debt implies that the nations are less equipped to mitigate as well as respond to the effects of climate change. However, climate change is causing an increase in the vulnerability of countries, which could increase their sovereign risk and increase the costs of borrowing. A decrease in the capacity of production and tax base could lead to an increased risk of default. It’s an endless cycle.

As a possible solution, nations and international organizations are discussing of “debt-for-climate swaps” to help solve both issues simultaneously. U.N. Deputy Secretary-General Amina Mohammed spoke of debt-for-climate swaps in advance of meeting in November of 2022 U.N. Climate Change Conference as one possibility to refinance nations’ “crippling” debt.

How do debt swaps work

Swaps for climate change allow countries to lower their obligations to repay debt in exchange for an agreement to finance projects for climate change in their own countries using the funds that are freed up.

They’ve been in use since the end of the 1980s to protect the environment as well as address the liquidity shortage in emerging countries like Bolivia, Costa Rica, and Belize. They are often referred to by the name of “debt-for-nature swaps.”

Belize is an example of this. It was able to reduce its debt by the commitment to declare 30 percent of its marine areas as protected areas and to spend an annual sum of $US4 million over the next two decades for the conservation of marine habitats under a complex debt-for-nature swap.

The swap, which will be held for 2021 by the Nature Conservancy, involves the U.S.-based environmental organization lending funds at a very low interest cost to Belize to purchase back $553 million worth of commercial debt at a discount of 45 percent. It is believed that the Nature Conservancy raised funds from the investment bank Credit Swisse via the issuance of “blue bonds” backed by the U.S. government, which granted the bonds a high investment grade credit.

In the same way, Costa Rica has carried out two debt-for-nature swaps in conjunction with the United States. Through the swaps, Costa Rica agreed to allocate $53 million to conservation initiatives. Costa Rica has already planted over 60,000 tree species and reversed the deforestation process.

Low-income Pacific Island nations such as Kiribati, Tuvalu, and the Marshall Islands are fighting to safeguard their land from sea level rise and erosion using sea walls such as this one. Climate swaps that are financed through debt could allow for the financing of these projects without increasing their debt. Mario Tama/Getty Images

Although debt-for-nature swaps are typically used for conservation purposes, the same idea could be expanded to include climate adaptation and mitigation activities, for example, the construction of solar farms and sea walls. Certain experts in finance had proposed that swaps for climate change debt might have been structured in a manner that could encourage private sector bondholders to swap their national debt to offset carbon emissions.

Three key elements to a successful swap of climate debt

I work for my colleagues from the Climate Policy Lab at the Fletcher School at Tufts University. Our experience with debt swaps provides an opportunity to learn from the creation and implementation of debt-for-climate exchanges.

The first is the intricate governance arrangements for debt swaps restricted their application. In the past, the transactions were typically tiny, generating only about $1 billion in financing for the environment between 1987 and 2003. The use of a model term sheet for future climate swaps based on debt could simplify the process and speed up the process and expenses required.

In addition, the swaps require a reduction in the burden of debt to allow countries with debt to invest in mitigation and adaptation to climate change. For example, in 2009, the U.S. created debt-for-nature swaps with Indonesia in 2009, which were criticized for not taking enough action to aid the Indonesian government in reaching its conservation targets.

Another issue is called “additionality” – ensuring that the swaps result in additional climate initiatives, as opposed to funding efforts that are already planned and already funded by global climate funds.

With the increasing gap among the levels of adaptation aid that is reaching countries, as well as the amount they require for climate change, swaps of debt can be an effective source of financing. Climate Policy Initiative, a non-profit research organization, has recently estimated that 90 percent of the needs for adaptation countries as adaptation needs in the Nationally Determined contributions – which are the climate change plans they present in the U.N. – can be only met through the assistance of development banks or other nations.

Regions experiment with debt swaps.

Some regions are experimenting with the possibility of swapping climate debt for credit.

The Economic and Social Commission for Western Africa has created a Sustainable and climate-friendly Development Goal debt swap that serves as a mediator between the creditors as well as seven countries that are pilots. The program focuses on the advancement of sustainable growth and climate goals, including the development of more resilient agriculture.

In addition, as an element of the Caribbean Resilience Fund, the Economic Commission for Latin America and the Caribbean intends to begin launching the debt-for-climate Adaptation Swap. The idea is to cut down on the debt of $527 million across three test countries through the issue of green bonds, which are similar to Belize’s Debt Swap. Development banks could be a key part of the process of securing new bonds and decreasing the risk of credit.

By implementing carefully planned climate swaps that international institutions back, countries in need could increase their financing to fund urgently needed climate adaptation and mitigation measures and ease the burden of their debt burden.

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