Debt-for-Climate Swaps Can Save the Planet. Why Aren’t They?

(Photo by iStock/piyaset)

Around the world, most developing countries face two crises: climate change and debt. Climate change is leading to more extreme weather events everywhere, but it particularly threatens the lives and livelihoods of millions of people in developing countries: Rising sea levels generated by global warming are an existential threat to island nations and coastal communities, and developing countries are particularly vulnerable because their economies often revolve around climate-sensitive sectors, such as agriculture and tourism. Moreover, developing countries typically lack key technologies and financial resources that could help them become more resilient to climate change and its impacts.

However, the debt crisis for developing countries is no less existential: Exacerbated by the slowdown of global growth, high interest rates, and reduced investment, developing countries owe approximately $9 trillion in external debt and the poorest among them spend over 10 percent of their export revenues on debt servicing. Governments representing deeply indebted nations are often unable to invest in health care, education, and other services, which, in turn, threatens their very political survival.

With all this in mind, academics and policy makers have called for the international community to prioritize debt-for-climate swaps, an initiative through which a nation’s debt is forgiven in exchange for investment in climate change adaptation and mitigation, thereby addressing both crises at once. In the simplest terms, a debtor nation will agree to stop making payments to the lender and to, instead, channel that money into local climate projects such as renewable energy or energy efficiency initiatives. In practice, these arrangements can be structured in various ways, and are often done so in coordination with foreign governments or nongovernment organizations, so long as the debtor country’s financial burden is relieved in exchange for a commitment to support climate initiatives. Debt-for-climate swaps are a variant of debt-for-nature swaps, which follow the same principle but tend to prioritize the protection of flora and fauna.

Since the first debt-for-nature swap was implemented in 1987, over 50 have been carried out across dozens of countries, typically emphasizing wildlife conservation. For example, the United States wrote off $30 million of debt for Indonesia in 2009, in exchange for a commitment to conserve the tropical forests of Sumatra, which are home to orangutans, tigers, elephants, and various other endangered species. France engaged in a similar swap with Cameroon in 2006, offering $25 million in debt relief in exchange for a pledge to protect forests in the Congo River Basin, the world’s second-largest rainforest and home to thousands of animal species.

In theory, debt-for-climate swaps can create win-win outcomes for creditors and debtors alike.

Debt relief arrangements that reduce deforestation, forest degradation, and land use can help to cut carbon dioxide emissions and the global warming that accompany them. Such efforts could also help to mollify the intensifying criticisms of multilateral lending institutions, particularly the International Monetary Fund (IMF) and the World Bank, which have been taken to task for failing to tackle the core challenges of our time, and China, which has been slammed for burying borrowers in debt through its Belt and Road Initiative and which has often financed pollution intensive projects by virtue of its focus on hard infrastructure.

Still, debt-for-nature swaps have existed for decades without being widely adopted or scaled up in the ways that their advocates envision. So why haven’t they caught on and how could they work better?

Large-scale swaps remain rare for at least three reasons.

1. Some creditors are unwilling or unable to offer them and some debtors will not accept them. On the creditor side, this can reflect political and economic interests as well as legal and institutional constraints. For example, some bilateral and multilateral creditors may see debt as a useful tool for maintaining leverage over borrowers or for geopolitical influence, a charge leveled at China as well as at Washington-based multilateral lending institutions. Other lenders may face legal barriers or bureaucratic hurdles to modifying or canceling debt contracts. For example, if a loan has been securitized and sold to investors then those investors’ rights must be taken into account before the original lender can alter the terms and conditions of the loan. Additionally, a lending organization could face legal challenges from shareholders if they feel that debt cancelation harms their interests.

For debtors, there may be political resistance, a lack of public support, or concerns about unintended consequences or trade-offs. For instance, some governments may perceive the imposition of environmental commitments as an infringement on their sovereignty. Others may worry that debt-for-climate swaps will raise questions about their ability to repay their debts, thereby reducing their access to credit markets. Moreover, some debtors may be concerned that debt-for-climate swaps will have negative social or economic impacts, such as displacing people from certain occupations, undermining food security or industrial development, or encouraging more borrowing or environmental degradation in anticipation of future swaps.

2. The design and implementation of debt-for-nature swaps may involve complex and lengthy negotiations among multiple stakeholders with different agendas and expectations, including creditors, debtors, multilateral institutions, environmental NGOs, local communities, and private sector actors. Each of these groups may have different preferences and priorities regarding the terms and conditions of the swap, such as the amount and type of debt to be swapped, the nature and scope of the environmental projects to be funded, the governance and monitoring mechanisms to ensure accountability and transparency, and the distribution of costs and benefits among the parties involved. Negotiating a mutually acceptable agreement among these diverse and sometimes conflicting interests may require considerable time, resources, expertise, and trust. Indeed, these agreements often take years of intense negotiations to come to fruition and negotiations are frequently interrupted by costly delays. For example, a 2015 agreement to swap debt for marine conservation and climate adaptation in the Seychelles took four years to negotiate, with on-the-ground dynamics changing considerably during this period.

3. Swaps may not be effective enough. Debt-for-nature swaps typically involve only a small fraction of a country’s total external debt and, therefore, they may not significantly reduce its debt burden or improve its creditworthiness. For example, a 2021 debt-for-nature swap in Belize offered it debt relief worth 12 percent of its GDP, but this was only a small dent in the 125 percent that its total debt amounted to at the time. Furthermore, debt-for-nature swaps may not free up enough revenues for the debtor country to finance environmental programs. For example, a study of one debt-for-nature swap carried out in 2009 between the US and Indonesia found that the value of the swap was too small to create meaningful budgetary room for Indonesia or to generate positive indirect economic effects on the country. Additionally, debt-for-nature swaps generally do not address root causes of environmental degradation, such as weak governance, corruption, or market failures and, therefore, they do not ensure long-term sustainability outcomes.

Each of these challenges must be tackled head-on. To do so, the World Bank and the IMF, as the world’s largest multilateral creditors and major players in the global financial system, should leverage their financial resources and policy influence.

These organizations have spearheaded large-scale debt relief programs in the past, leading the formation of the Heavily Indebted Poor Countries (HIPC) Initiative in 1996, and they can do so again by undertaking three broad strategies.

1. These organizations must address cautiousness among lenders and borrowers to pursue debt-for-climate solutions. To do so, they can reform existing debt relief programs, such as the World Bank’s Debt Service Suspension Initiative and the IMF’s Catastrophe Containment and Relief Trust to allow and encourage borrowers to request debt-for-climate swaps. Additionally, they can leverage their considerable networks, including partners in governments, civil society groups, media outlets, and academic institutions, to publicize the benefits and potential of debt-for-climate swaps to their shareholders, stakeholders, and partners. Particular efforts should be made to address and assuage the political and logistic concerns of lenders and borrowers.

The case should be made to lenders that debt relief can carry geopolitical benefits in the form of positive public relations. As noted above, multilateral lending institutions and bilateral creditors alike have come under fire for their lending practices and debt-for-climate swaps can help to offset these criticisms. Likewise, the multiplier effects of climate adaptation efforts should be emphasized for borrowers. For example, evidence suggests that climate adaptation initiatives help to attract foreign direct investment to climate vulnerable countries, meaning that money spent on climate initiatives to usher in debt relief will come back to countries via outside investment and the economic growth that it produces. The IMF and World Bank can also provide technical and financial assistance to countries that are interested in pursuing debt-for-climate swaps but lack the resources to carry out the necessary feasibility studies, negotiations, project designs, and monitoring, while offering policy advising to overcome legal and bureaucratic impediments to debt-relief arrangements.

2. Lenders from the private sector must be invited and incorporated into debt-for-climate plans and frameworks. To accomplish this, the IMF and World Bank can coordinate and collaborate with other creditors to align their policies and practices on debt swaps. Bringing together economic policymakers, private banks, credit and ESG rating agencies, and other relevant parties can encourage new actors to participate in climate-oriented debt relief, while establishing a common framework can reduce the transaction costs associated with doing so. Many private banks, under pressure from regulators and clients, have declared their commitment to tackling the climate crisis and so there may be more interest in climate-oriented debt-relief than is often assumed. This interest can be charged further with proper incentives. For example, if engaging in these swaps carried benefits in terms of lenders’ ESG ratings then doing so could bring ESG-driven customers and investors to private banks.

3. The impediments to debt-for-climate swap effectiveness must be addressed. To do so, the IMF and World Bank can use their resources to shape program designs, to target the right loans and borrowers, and to build in accompanying mechanisms to address root causes of environmental degradation. The World Bank and IMF can steer these arrangements towards larger loans by providing guarantees or subsidies to creditors who agree to participate in debt-for-climate swaps. This can increase the impact of these swaps, as well as attract more creditors and lenders. Additionally, these organizations can create mechanisms to open up more fiscal space for borrowers by linking debt relief to green fiscal reforms or revenue mobilization measures. This can ensure that the freed-up resources are used efficiently and effectively for climate action, while improving the debt sustainability of borrowers. Finally, the IMF and World Bank can nudge debt-for-climate swaps toward borrower countries that are not plagued by some of the poor political and economic institutions that are associated with environmental degradation.

Unfortunately, this latter approach will probably prevent debt-for-climate swaps from reaching some of the most highly indebted and climate-vulnerable countries, such as Afghanistan, Sudan, and Zimbabwe. However, given their unsustainable debt levels, these countries will be better off receiving large-scale debt restructuring, as opposed to dollar-for-dollar swaps. This raises a critical point regarding debt-for-climate swaps, which is that they are not a panacea for addressing either the environmental or debt crises. They are one tool—potentially a powerful tool—but they need to be complemented by other measures, such as increasing official development assistance, enhancing domestic resource mobilization, improving governance and transparency, and reforming global financial rules and institutions.

This caveat notwithstanding, when well-designed and properly understood, debt-for-climate swaps are a valuable and viable instrument that, with the suggested modifications, can simultaneously contribute to relieving debt distress, promoting environmental sustainability, and supporting social and economic development. By embracing debt-for-climate swaps, international lenders can demonstrate their commitment and leadership in addressing the interlinked challenges of climate change and debt, thereby contributing to a more resilient and equitable future for all.

Read more stories by Jonas Gamso.