Opinions

Debt, risk management and climate action

By Vositha Wijenayake 

 

Two years into the Covid pandemic, many developing countries are facing or potentially looking at a debt crisis. 

The International Monetary Fund (IMF) has indicated problems that relate to debt sustainability in countries of the Global South, especially low-income countries. However, the number of middle-income countries that are facing similar high debt-related burdens is on the rise, which presents the need to better understand how countries need to find pathways to address debt through ways that are innovative, sustainable, and climate resilient.

 

Climate resilience

 

In many countries, existing debt situations have the potential to impede investments for climate resilience. This encompasses much-needed finance for actions focused on addressing climate risks and building the resilience of vulnerable countries and communities. 

Furthermore, it is important that countries apply measures that integrate investments related to climate resilience into debt management. This could also include actions related to climate-proofing public finances.

Exacerbated climate vulnerabilities will increase the cost of capital of countries that are highly vulnerable to climate change, such as Sri Lanka. This interlink presents a situation in which higher climate vulnerability results in higher cost of debt, which could also restrict investments into climate resilience and in turn contribute to heightening climate vulnerabilities.

 

Climate action

 

Experts see debt forgiveness as an option that could help low- and middle-income countries to better address climate impacts while alleviating economic difficulties. An example of such a measure is debt-for-climate swaps that refer to debt restructuring that facilitates climate action. 

In practice, such a swap would focus on funding climate-friendly projects from different sectors, such as actions focused on climate-resilient and climate-friendly agriculture, clean and renewable energy, or ecosystem conservation aimed at reducing greenhouse gas emissions and storing carbon.

These swaps could be particularly beneficial for middle-income countries, which represent over 70% of non-developed world debt. By swapping debt for climate, countries could generate green finance that contributes to scaling up climate ambition as well addressing existing vulnerabilities. The swaps could be implemented by allowing debtor nations to convert external debt payments to instead finance domestic climate projects or to replace existing debt by new debt that is tied to climate-related commitments.

Examples of such debt-for-climate swaps include the case of Seychelles, where foreign debt was bought at a discount and a commitment was made by the government to set up a special trust called the Seychelles Conservation and Climate Adaptation Trust (SeyCCAT), which focuses on the coastal environment and biodiversity. 

SeyCCAT has the ability to receive different forms of donations, contribute to actions which focus on climate resilience, and relieve existing debt that brings down the resilience levels of the nation.

This is only one example and there are a myriad of options which could be implemented as part of a debt swap. However, it would be important to identify those which are focused on economic empowerment and climate resilience which could lead to higher private sector investments for climate finance. 

 

Green recovery

 

Among key components that could lead to a green and climate resilient recovery interlinked to debt relief are climate commitments by debtor countries which present ambitious actions aligned with the Paris Agreement.

However, many countries that suffer due to debt are countries that are also highly climate-vulnerable while only emitting small amounts of greenhouse gases. In these cases, it is important to align the requirements of ambition with aspects of addressing climate risks and scaling up resilience, which will provide a more holistic approach to addressing climate impacts. This could be done by setting up different forms of climate risk management mechanisms, including risk finance and risk transfer options.

It is also important that these climate commitments are country-driven and country-owned, generated through processes that are evidence-based and not ad hoc. A swap built on ad hoc actions could result in the exacerbation of existing vulnerabilities and thereby undermine investments into scaling up climate resilience. 

Additionally, scaling up investments in risk financing tools and instruments could also form a central component of debt relief. This includes Climate and Disaster Risk Finance and Insurance (CDRFI), which could contribute to managing and reducing existing vulnerabilities and risks while providing opportunities for scaling up climate action and enhancing climate investment.  

 

V20 proposals for debt restructuring

 

In 2021, the Finance Ministers of the Vulnerable Twenty (V20) group, which represents 55 climate-vulnerable countries around the world including Sri Lanka, made a Statement on Debt Restructuring for Climate-Vulnerable Nations. This statement highlighted a debt restructuring initiative for countries that are burdened by debt. The V20 proposal and initiative represent a climate-debt swap which includes the reduction of debts and debt servicing of developing countries based on plans which aim at climate resilience and prosperity.

From proposal to implementation, it would be important to consider how proposed debt swaps and related activities could be built on existing national mechanisms and the processes that countries own. This would help to maximise the benefits of existing resources and avoid duplication of investment. 

Furthermore, technical capacity-building on the application of different forms of debt swaps that could generate, accelerate, or scale up climate action and green recovery could contribute to country-owned solutions for unsustainable debt situations. 

Similarly, information-sharing and knowledge management processes could contribute to an exchange of experiences and lessons learnt that enhances the effectiveness of debt-for-climate swaps. Examples and success stories, concepts, and the innovative application of these concepts could support countries to better understand the potential application of a debt-swap integrating common elements to scale up investment potential and contribute to a successful debt relief aligned with climate resilience on all levels and for all stakeholders.