Sovereign debt, climate crisis, and global financial system

The threat of debt distress or default is exacerbated by the climate crisis and presents a serious challenge for climate-vulnerable developing countries around the globe

Rising debt levels and fiscal constraints are a key challenge for developing countries across the globe. The threat of debt distress or debt default is further exacerbated by the climate crisis, which causes additional risks and requires significant investment to fulfil national obligations and build long-term resilience.

For climate-vulnerable developing countries facing serious debt-related challenges—including Sri Lanka—it is therefore crucial to understand the climate-debt nexus and identify ways to reconcile the need for green economic growth, debt sustainability, and climate action.

Connecting debt and climate change

“Sovereign debt” describes funds borrowed by a country from a creditor, which could be, for example, another country, a multilateral institution, or the private sector. The resulting debt must be repaid with interest over a specified period in line with contractual terms and conditions. If a country faces difficulties in servicing its debt on time or in full, it experiences debt distress, which can lead to debt default and a range of associated financial, political, and/or reputational costs and consequences.

Climate change can interlink with debt in several ways. On the one hand, climate impacts and climate-induced loss and damage can exacerbate countries’ debt problems by forcing them to borrow funds for relief, recovery, and reconstruction efforts that exceed their available budget allocations. On the other hand, high and/or unsustainable debt constrains the fiscal space of governments and hinders them from funding adaptation and resilience-building measures, rendering them more vulnerable in the mid and long term. Furthermore, climate vulnerability and lack of resilience can also increase debt ratings and the costs of borrowing, especially from private creditors.

Existing debt also reduces the ability of countries to invest in climate action and fulfil their commitments under the Paris Agreement, such as those submitted via the Nationally Determined Contributions (NDCs). In some cases, high debt can incentivise governments to look at unsustainable options with higher short-term returns, such as fossil fuels or the unsustainable exploitation of natural resources. Additionally, a sizeable proportion of global climate finance is currently provided in the form of loans, thereby creating additional debt for the countries receiving it.

Other considerations related to climate change and debt could include the supply side and existing subsidies for sectors such as energy and agriculture; the role of climate technology transfer and deployment in creating debt; legal frameworks and governance gaps; the integration of climate-related indicators into debt sustainability and financial health assessments; and relevant climate negotiation agenda items, such as the loss and damage fund, adaptation finance, or the new collective quantified goal on climate finance, which will be a centrepiece of this year’s World Climate Conference (COP29).

Responding to unsustainable debt

Creditors and debtors have a range of instruments and mechanisms that can address debt distress and enhance debt sustainability. This includes, for example, debt suspension and climate-resilient debt clauses; debt restructuring, rescheduling, or refinancing; debt cancellation; debt swaps (including debt-for-climate and debt-for-nature swaps); insurance mechanisms (such as parametric insurance or sovereign risk pools); bonds (including catastrophe bonds, resilience bonds, or green and blue bonds); and tax reform.

However, many debt-related challenges remain and are exacerbated by the worsening climate crisis. There is a need to strengthen the way in which the interlinkages between debt and climate change are addressed at the global as well as national level.

A research study conducted by non-profit think tank SLYCAN Trust found that out of 194 countries which have submitted their NDCS—core climate commitments under the Paris Agreement—only around 12% directly refer to debt or financial reform. Most of the countries that include references to these aspects are in Latin America and the Caribbean, Asia-Pacific, and Africa, highlighting the urgency of this issue particularly for countries of the Global South.

Revamping the global financial architecture

In the last few years, several proposals for reforming or improving the global financial architecture have been brought forward. This includes the Bridgetown Initiative, the Paris Pact for People and Planet, the Ubuntu Initiative, or the V20 Accra-Marrakech Agenda, as well as existing efforts such as the Common Framework for Debt Treatment, the G20 Debt Service Suspension Initiative, the Global Sovereign Debt Roundtable, or special funds and initiatives under the IMF.

These proposals address aspects such as an overhauled multilateral legal framework; improved access to emergency liquidity for climate-affected developing countries; debt forgiveness or suspension; incorporation of climate risks and investments into credit ratings and lending criteria; climate-contingent debt instruments and clauses; or a reform of financial institutions and arrangements.

The last meeting of the Conference of the Parties to the UNFCCC and the Paris Agreement (COP28), which ended in December 2023 in Dubai, saw the launch of initiatives such as the Leader’s Declaration on a Global Climate Finance Framework, the Joint Taskforce on International Taxation, the Global Expert Review on Debt, Nature, and Climate, or the Climate Justice Forum announced by Sri Lanka.

The COP28 cover decision (the “UAE Consensus”) includes a reference to developing countries affected by “increasing impacts of climate change compounded by difficult macroeconomic circumstances,” and the growing gap between their financial needs and the means provided to them. However, it doesn’t explicitly mention debt and doesn’t yet directly address debt sustainability through key workstreams on adaptation, loss and damage, climate finance, or the Global Stocktake.

Key considerations and the path ahead

Debt, lending, and economic investment and development operate in an ecosystem of bi- and multilateral legal frameworks, institutions, and agreements. The climate crisis and the need for ambitious climate action has significant implications for debt sustainability, financial health, and the balance sheets of vulnerable developing countries.

2024 marks a key year for climate finance under the UNFCCC process and will see the continuation of discussions around global financial reform. Building critical capacities and allocating resources to avoid debt distress or default in the context of climate change is an important task for both individual countries and the global community. Following the initiatives launched at COP28 and throughout the last years, there is an opportunity to create a more equitable and climate-smart financial architecture that includes countries, multilateral institutions, and the private sector.

(The writer works as Director: Research and Knowledge Management at SLYCAN Trust, a non-profit think tank based in Sri Lanka. His work focuses on climate change, adaptation, resilience, ecosystem conservation, just transition, human mobility, and a range of related issues. He holds a Master’s degree in Education from the University of Cologne, Germany and is a regular contributor to several international and local media outlets.)