DEBT-4-CLIMATE PRESENTATION

DEBT AND CLIMATE : INTERCONNECTED CHALLENGES

The correlation between climate vulnerabilities and fiscal risks is undeniable, although it's essential to recognize that this relationship doesn't always imply causation. However, countries grappling with the harsh impacts of climate change often find themselves in a financial bind hindered by the weight of existing debt. The intertwining challenges of climate and debt create a precarious situation, particularly for those nations least equipped to invest in resilience due to budgetary constraints.

On one hand, climate change exacerbates debt vulnerabilities, impacting countries' productive capacity, diminishing their tax base, and incurring fiscal costs, especially in the aftermath of natural disasters. This, in turn, amplifies the expense of external borrowing.

On the other hand, existing debt issues restrict fiscal space, limiting investments in climate mitigation and adaptation. This dual causation further complicates the challenge, exacerbating both the consequences of climate change and the difficulties associated with debt.

DEBT-FOR-CLIMATE SWAPS
TO PHASE OUT OF OIL ?

DEBT-FOR-CLIMATE SWAPS

Still relatively small, debt swaps have funded development or nature-related spending of approximately $1.2 billion. In contrast, the Brady Plan delivered an aggregate debt reduction of $65 billion, and climate grants to developing countries in 2019 amounted to $17 billion (IMF)

Debt-for-climate swaps draw inspiration from established models such as "debt-for-nature" or "debt-for-development" swaps. In this innovative approach, a country's debt is reduced in exchange for commitments to specific spending or policies, with the fiscal cost aligning with the debt reduction.

Tripartite swaps are nowadays the most common operation, the NGO extends funds to the debtor country at below-market interest rates, contingent on two conditions. :

The debtor utilizes the funds to buy back commercial debt at a discount.
A portion of the resulting debt relief is allocated to finance climate-related actions or investments.

The primary goal of these swaps is to release fiscal resources, allowing governments to enhance resilience without triggering fiscal crises or sacrificing spending on other crucial development priorities. Additional benefits may include an upgraded sovereign credit rating, exemplified by Belize, resulting in more affordable government borrowing.

Debt and climate challenges could theoretically be addressed separately through debt relief, fiscal adjustments and climate finance options, it is crucial to ensure that these initiatives do not undermine traditional debt relief or concessional finance.

OPTIMAL CONDITIONS FOR DEBT-FOR-CLIMATE-SWAPS

Understandably, debt-for-climate swaps may not always be the optimal approach, When the debt is sustainable, conditional grants are more efficient means of supporting climate action, as debt relief from swaps subsidize non-participating creditors. Conversely, in cases of unsustainable debt, comprehensive debt restructuring operations typically take precedence, potentially including climate conditionality.

A sweet spot arises when certain conditions align:

Efficient Climate Mitigation and Adaptation Measures
High Fiscal Risks but Sustainable Debt

Debt-for-climate swaps are relevant when a comprehensive debt restructuring might incur reputational costs or economic disruptions and when the country lacks fiscal space to finance essential climate investments, even with concessional terms

BELIZE BLUE BOND CASE STUDY

PITFALLS IN DEBT-FOR-CLIMATE SWAPS

High transaction costs. Implementing debt swaps involves the identification of a suitable project, coordination among various stakeholders, and protracted negotiations, lasting 2-4 years as per OECD standards. The inclusion of performance monitoring indicators in swaps places significant administrative burdens, especially in settings with limited capacity, necessitating the establishment of parallel structures for project implementation and monitoring.

High monitoring costs. The fragmented nature of transactions has led to the formulation of performance metrics specific to each project, posing a challenge to scalability.

Permanence risks. Actions and policies extending into the future potentially create an incentive to backtrack once debt relief is granted or facing difficulties in meeting obligations due to fiscal shocks over time.

POTENTIAL APPLICATIONS : OIL PHASE OUT AND CARBON MARKETS

In the IMF working paper on 'Debt-for-Climate Swaps: Analysis, Design, and Implementation,' the authors recommend embracing a programmatic approach to enhance a nation's decarbonization strategy, giving precedence to comprehensive energy sector reforms over isolated measures.

This method holds potential advantages when nations seek funding to diversify their economy beyond oil extraction. In such instances, the government may undertake specific actions, like abstaining from new oil development, as a vital element of the transition strategy. It also facilitates the mobilization of climate financing, potentially including debt swaps.

The climate investment unlocked through a debt-for-climate swap could generate carbon credits through mitigation efforts that would not have been possible without the swap. The benefits are twofold: the debtor country reduces its debt, and the creditor gains carbon credits to support their mitigation objectives.

A notable instance is the successful 2005-2007 debt-for-wind-power swap between Spain and Uruguay under the now defunct Clean Development Mechanism (CDM), where Spain earned certified emission reduction credits. Establishing a new mechanism akin to the CDM could facilitate the adoption of debt-for-climate swaps