5 ways to align debt with climate and development goals

As G7 leaders gather on 11-13 June to discuss the urgent need to incorporate climate action into global pandemic recovery plans, it’s worth remembering that a precursor to policy action is the ability to afford it.

UN Conference on Trade and Development research shows that regions facing higher vulnerability to climate change are more likely to suffer from severe indebtedness. Less fiscal space means less capacity to respond to disasters, perpetuating a vicious cycle that forecloses debt sustainability and therefore, climate action.

Pre-pandemic research by the G20 Foundations Platform calculated that the world needs 2.2% of GDP invested annually to deliver commitments from the 2030 Sustainable Development Goals and Paris Agreement, or around $800 billion per year for low-income countries (LICs).

But without substantial debt relief, debtor countries face pressure to accelerate natural resource exploitation to pay debt, sidelining these environmental ambitions and hindering future economic security. It is therefore imperative to align debt restructuring with climate and development goals.

The historic economic crisis in the wake of the COVID-19 pandemic has been disproportionately borne by LICs. In March 2020 alone, investors pulled $80 billion out of developing countries, causing massive currency market disruption and pushing dollar-based debt repayment commitments out of reach for many nations. Thus began the most severe global debt crisis in decades. Worse yet, international trade plummeted, making hard currency – necessary for debt repayments – scarce.

In response, the G20 developed the Debt Service Suspension Initiative (DSSI) to suspend LICs’ bilateral debt repayments. The DSSI has been extended twice and is currently expected to expire at the end of 2021. To prevent a wave of defaults in 2021, the G20 also developed a Common Framework for Debt Treatments beyond the DSSI, establishing expectations for a coordinated approach to debt workouts for DSSI-qualifying countries.

While these initiatives undoubtedly helped, they are insufficient for the scale of the current debt crisis.

Firstly, they don’t include middle-income countries (MICs), some of which also face staggering debt burdens and severe climate vulnerability, and where most of those projected to be pushed into poverty live. Secondly, these initiatives have no participation from private lenders, who comprise about one-fifth of LIC debt and about three-fourths of MIC debt, and who have shown no signs of volunteering relief. Additionally, DSSI participation has already impacted market access: ratings agencies have downgraded countries applying for the Common Framework. Lastly, these initiatives were made without any multilaterally-mandated debt workout system, relying on ad hoc policy-making by creditor countries, decreasing accountability for citizens in indebted countries and perpetuating unpredictability.

Additionally, the pandemic’s overarching lesson is that nation-first approaches crumble in the face of global challenges. The only option is to address the cycle of climate and sovereign debt vulnerabilities at its root.

These five steps can help address this:

This could include climate-aligned debt restructuring and should compel private and public creditors to participate. Debt-for-climate swaps – currently gathering support in this vein – are a modern extension of traditional debt-for-nature swaps, where creditors and debtors negotiate to restructure or relieve existing debts to create more fiscal space for climate, environmental and development commitments. Innovative approaches, such as the Debt Relief for a Green and Inclusive Recovery proposal, could help indebted countries strengthen climate change mitigation and adaptation efforts in conjunction with debt relief.

Particuarly for countries that face further loss and damage, or are unable to mount low-carbon transitions. A major challenge remains, however, in how climate and nature vulnerabilities and broader development priorities are considered in debt sustainability analyses (DSA), which prioritize repayment over long-term sustainability. The recent Dasgupta Review explored the relationship between economics and nature, offering path-breaking suggestions on how governments can adopt measures of “comprehensive” or “inclusive wealth” in their national accounting – a move that could support ongoing efforts to tune DSAs to long term sustainability ambitions.

While recent incorporation of climate change mitigation costs are a welcome step, much work remains in this area. Specifically, climate change adaptation risks (from the expected increase in natural disasters) and climate transition risks (from downward shocks to global fossil fuel demands) can present complex planning challenges and countries may need more IMF support.

There should be a greater role for “sustainability-linked”, or "green bonds". New “nature performance” bonds can be used for any purpose but link repayment terms to sustainability benchmarks, facilitating immediate recovery while incentivizing long-term sustainability goals (and therefore making them affordable). If designed correctly, such instruments can open market access to development finance that prioritizes climate and environmental action, while disciplining creditors with the reality that climate and nature impacts will affect solvency risks.

When the stakes are so high, ad hoc policy actions perpetuate uncertainty and exacerbate the long-term economic and climate risk cycle. A multilateral process could formalize much-needed climate measures, such as an interest-free moratorium on debt payments in the aftermath of a climate disaster.

Building a path out of the debt cycle for developing countries is fundamental to facilitating a green and just transition and achieving shared climate and development goals. Without far-reaching transformation, this ambition is off the table.

It’s time for leaders to stay true to the rhetoric and follow these five steps to align climate action with the debt relief the moment demands.