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COP27 | Debt-for-climate swaps in times of economic crisis

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Developed economies could write off a developing economy’s debts, unburdening them of repayments and interest, allowing them to redirect the money towards supporting their own loss, and damage costsCOP27 | Debt-for-climate swaps in times of economic crisis

With just a few days to go until the opening of COP27 of the UNFCCC, and with every day marked by multiple climate disasters in some part of the world or other, developing and vulnerable countries are set to put the spot light on their demand to the rich world to deliver on the promised and new climate finance to help them mitigate, adapt, and survive.

In the lead is the V20 group of finance ministers, who have announced their intent to stop payment on a combined $685 billion in debt until the International Monetary Fund (IMF) and the World Bank address Climate Change the way their nations see fit. Their goal is to create a plan to swap some of their debt for climate adaptation and conservation projects.

Formed in 2015, the V20 group of finance ministers is a dedicated co-operation initiative of 58 economies systematically vulnerable to Climate Change. It is currently chaired by Ken Ofori-Atta, Finance Minister of the Republic of Ghana.

The UN Conference on Trade and Development research shows that regions facing higher vulnerability to Climate Change are more likely to suffer from severe indebtedness. High debt payments mean countries have fewer resources for mitigating and adapting to Climate Change. Yet Climate Change is increasing their vulnerability, and that can raise their sovereign risk, increasing the cost of borrowing. Declining productive capacity and tax base can lead to higher debt risks. It’s a vicious cycle.

With the economic situation worsening in all developing economies countries, international organisations are talking about “debt-for-climate swaps” to help tackle both problems at the same time. UN Deputy Secretary-General Amina Mohammed mentioned debt-for-climate swaps ahead of COP27 as one option for refinancing countries’ “crippling” debt. Developed economies could write off a developing economy’s debts, unburdening them of repayments and interest, allowing them to redirect the money towards supporting their own loss, and damage costs.

A report by the European Network on Debt and Development (Eurodad) said 37 island and coastal countries that are home to some 65 million people, received just $1.5 billion in climate finance between 2016 and 2020. Over the same period, 22 of the nations paid more than $26.6 billion to their external creditors. Public debt levels in the island states had risen from an average of near 66 percent of gross domestic product in 2019 to nearly 83 percent in 2020, and were set to remain above 70 percent until 2025.

The average debt for low- and middle-income countries, excluding China, reached 42 percent of their gross national income in 2020, up from 26 percent in 2011. For countries in Latin America, and the Caribbean, the annual payments just to service that debt averaged 30 percent of their total exports.

One thing is clear, without substantial debt relief, debtor countries are forced to accelerate natural resource exploitation to pay the debt, side-lining these environmental ambitions, and hindering future economic security. It is, therefore, imperative to align debt restructuring with climate and development goals.

Debt-for-climate swaps allow countries to reduce their debt obligations in exchange for a commitment to finance domestic climate projects with the freed-up financial resources.

They have been used since the late 1980s to preserve the environment and address the liquidity crisis in developing countries, including Bolivia, Costa Rica, and Belize. Belize, for example, was able to lower its debt in exchange for committing to designate 30 percent of its marine areas as protected areas, and to spend $4 million a year for the next two decades on marine conservation under a complex debt-for-nature swap. While debt-for-nature swaps have been used mostly for conservation, the same concept could be expanded to Climate Change mitigation and adaptation activities.

A country’s debt rests with many creditors, ranging from multilateral funds to other countries. Each would have to be engaged and negotiated with to excuse the outstanding debt making difficult calls on which country receives debt relief first, and on what basis.

Some finance experts have suggested that debt-for-climate swaps could be structured in a way that could also encourage private-sector bond holders to exchange the national debt they hold for carbon offsets.

Debt cancellation mechanisms may bring relief to developing nations that are struggling with the impacts of Climate Change. However, rushing into such an ambitious policy could be disastrous without a rigorous feasibility study, and careful planning. Any agreement to cancel debt would likely require the excusing parties to be assured that the money will reach the most vulnerable communities on the ground and not be swallowed up by corruption or internal bureaucracies.