Climate, biodiversity and debt Climate, biodiversity and debt

Even prior to the outbreak of the COVID-19 pandemic, four out of ten developing countries were nearing unsustainable debt positions, according to a report published by the Center for Global Development. This latest shock has served to exacerbate budget deficits and debt positions, as developing countries seek to implement countercyclical fiscal stimulus to ramp up vital healthcare and social services, as well as to spark economic recovery.

This fiscal expansion has taken place in a context of sharply declining tax receipts, as repeated lockdowns and restrictions, designed to flatten infection curves, prevent wider economic activity. This also comes in the context of climate and biodiversity emergencies which represent underlying destabilisers of economic activity and threaten to reverse progress across all Sustainable Development Goals (SDGs). With 1.5 degrees Celsius warming effectively locked in, substantial investment in green infrastructure will be required for the prevention and mitigation of climate-breakdown-related effects.

Debt service relief initiatives launched by multilateral facilities such as the World Bank and IMF will provide much needed short-term support but still fail to address the issue of long-term sustainability, as new debt issuances drive up cost of capital in a self-perpetuating cycle. Improved access to global capital markets has channelled non-concessionary credit from the developed world seeking to escape a historically low-market return environment and has subsequently facilitated further debt build-up. Consequently, a range of Sub-Saharan countries such as Angola, Zambia and Mozambique have seen sovereign debt levels rise beyond 100 percent of GDP and the IMF projects gross public debt will rise to 48 percent of GDP in LICs in the next year.

Clearly, decisive government response is required and policymakers have seen the coincidence of structural transitions in the context of automation and climate as the perfect storm to rally around a “Green Recovery” - most notably the Biden administration in the US.

However, the scale and complexity of the challenge means the financial sector will also need to step up product innovation to facilitate this transition. Innovation in sovereign debt markets has lagged behind private markets, where corporates have embraced the idea of tying bond pricing to various sustainability-linked Key Performance Indicators (KPIs). The time has come for a new wave of innovative sustainable debt solutions.

The pandemic has catalysed the growth of asset classes and products which now assess and tie performance against environmental, social and governance (ESG) metrics. Megatrends in the shape of a generational demographic transition, as millennials become the main holders of capital, in addition to an increasing recognition that “climate risk is investment risk” has moved the needle for institutional investors. Additionally, there is an emerging recognition of the investment opportunity presented by this displacement, supported by the growing body of evidence backing the notion that investing based on ESG principles can be an important source of Alpha.

The private sector has been quicker to respond to the evolving market landscape with the provision of new sustainable debt products. The arsenal of such instruments has become increasingly standardised and grown substantially to include (amongst others): green, blue, SDG and sustainability-linked bonds. What characterises these different products is the use of proceeds. Green bonds target KPIs related to terrestrial biodiversity and climate, blue bonds raise capital to fund positive marine and ocean-based projects, whilst SDG and sustainability-linked bonds finance broader social and developmental outcomes. Private debt markets have assumed responsibility and capitalized on the opportunity by generating the requisite financing solutions - sovereign debt instruments must now follow suit.

The current economic conditions provide a compelling opportunity to deploy multi-purpose tools capable of financing a green and socially equitable recovery from COVID-19, whilst tackling the triple crises of biodiversity loss, climate change and unsustainable debt. To date, there has been an inability to replicate concepts with a proven track record of delivery in the private sector, evidenced by the fact sovereign green bond issuances have been few and far between.

However, innovative solutions which integrate nature into sovereign debt markets, such as Nature-Performance-Bonds (NPBs) and Debt-For-Nature Swaps, present a potential solution in overcoming the systemic failure to deliver workable mechanisms for efficient and scalable debt relief.

NPBs are a novel sovereign debt instrument developed by the Finance for Biodiversity Initiative (F4B), linking coupon and principal repayments with success in protecting or enhancing a country’s natural capital. These allow for general use of proceeds, ensuring that local knowledge is leveraged in determining where capital can be best allocated, whilst ensuring nature-based KPIs are met through a positive incentivisation mechanism which downscales coupon and principal payments depending on the outcome of a rigorous Monitoring, Reporting and Verification (MRV) process.

The flexibility of the instrument allows for both a new issue or restructuring of existing debt, catering to a variety of sovereign debt profiles. The blended finance structure is built to incorporate a range of investor profiles, from sovereign creditors and multilateral facilities - which de-risk the product on concessional terms - to private investors on a baseline coupon that is closer to commercial rates. Pakistan is set to issue a $1 billion dollar NPB in 2021, as it seeks to finance its transition away from coal and towards renewable energy. The Debt-For-Nature Swap is a more established instrument due to its simplicity, as it can only facilitate a debt restructure whereby the debtor country’s debt stock is reduced in exchange for commitments around nature conservation. This was implemented most recently in 2016, with the Republic of Seychelles’ US$21.6 million sovereign debt restructured at a discount in exchange for marine conservation and climate adaption pledges. The results so far have been extremely encouraging as by March 2020 all debt-related payments had been met on time and 32 percent of country’s waters were certified as protected.

Much like with the current healthcare pandemic, swift and decisive action is required to prevent the combination of prolonged damage and contagion when tackling the triple crises of debt, biodiversity and climate. Capital markets as ever will play a crucial role, with the key being the emergence of sovereign debt products that reflect the scale, complexity and symbiotic nature of the problems confronting our societies. The recent boom in corporate sustainable debt products presents a potential blueprint - whilst the initial successes in the rollout of a new range of sovereign debt products suggests a reason for concerted optimism going forward.

For more information on how to tackle ESG-related issues, please visit our ESG page or contact a member of the team.