We can tackle sovereign debt and climate finance - here's how

One resounding message from COP27 in Sharm el-Sheikh is that our global community must urgently move from “talking the talk” to “walking the walk” regarding climate finance.

The biggest hurdle is money. The climate and biodiversity crises loom large – but sadly, so does the gap in global finance. Estimates for the cost of emerging market countries’ adaptation to climate change range from $140-300 billion per year by 2030. Not to mention the costs of energy transition and mitigation efforts and the rest of a country’s development agenda.

So where will this money come from? Access to grants and low-cost concessional finance is limited. With rising interest rates in advanced economies and the subsequent “risk off” environment in the international capital markets, emerging market countries that previously had market access have mainly lost it. Debt burdens – which include official debt service payments postponed throughout the pandemic – are increasingly difficult to refinance and sovereign debt restructuring practices are cumbersome and time-consuming.

To solve these two financial challenges – climate finance and sovereign debt – we need to find creative, scalable solutions. Failure to do so quickly will create a downward spiral where debt crises undermine the capacity of countries to adapt to climate change, making them less creditworthy and even less able to finance adaption and mitigation. The result will be countries figuratively drowning in debt while literally drowning in rising seas and catastrophic floods.

The Nature Conservancy recently supported debt conversion deals for Belize and Barbados, with credit enhancement through the US Development Finance Corporation and the Inter-American Development Bank. In each case, the countries took on conservation and climate commitments to improve coastal management and resilience as well as improve local economies and improved their overall fiscal positions.

This model can address the debt and climate finance challenges by explicitly linking sovereign debt issuance and refinancing to a country’s environmental performance. The starting point is a country’s own national environmental goals.

And there are other recent examples that point to other scalable models. Chile and Uruguay recently issued the world’s first sovereign sustainability-linked bonds, both were over-subscribed. These bonds are tied directly to meeting national climate targets and offer an additional payment to investors if the country fails to meet key greenhouse gas emission reduction and renewable energy deployment targets. In the case of Uruguay, there is a symmetrical step-down in the coupon if the country exceeds its performance targets.

Many other developing countries are eager to consider climate- and nature-related key performance indicators (KPIs) as part of their debt issuance and debt workout operations. They see the environmental sustainability linkage as enhancing their attractiveness to capital markets, and they see the additional resources accelerating the implementation of agreed environmental goals. And private investors have shown significant interest to invest in these kinds of deals.

The current limiting factor in scaling this approach is the ability of public agencies to provide the necessary credit enhancement to make these transactions investment grade. This critical gap needs to be filled to leverage vastly more private investment that can help both finance developing countries balance sheets affordably and drive better climate and nature outcomes. That in turn will necessitate an explicit mandate to leverage private capital, a capital increase - in order to not crowd out current lending capacity - and a more sophisticated toolbox.

Multilateral development banks (MDBs) could use their balance sheets more effectively and efficiently and issue fit-for-purpose guarantee instruments to de-risk sovereign credit markets. The current ratio of public investment to private investment in climate finance has been, disappointingly, roughly 4:1 – that is, it takes over four dollars of public money to leverage one dollar of private money. To succeed in meeting climate finance targets, the MDBs need to reverse that ratio.

The Bretton Woods institutions also have a critical leadership role. Standing behind them are 450 Public Development Banks which collectively invest some $2.3 trillion annually and account for 10% of total global investment. The Finance In Common Summit process provides a mechanism to get all of them to replicate the alignment requirements and leverage goals of the MDBs.

Nature has been telling us for years that the planet is in trouble and the cry may finally be loud enough for those of us who live here to listen. Finance is at the heart of fighting the dual crises of climate change and biodiversity loss. We need to see a more robust financial toolbox to link sovereign debt, climate and nature and leverage private finance. It is time to act.

For more information on reforming debt and climate finance, visit Potomac Group LLC here.