Understanding sovereign debt responses in the context of global climate negotiations

2024 is a pivotal year for finance under the global climate negotiation process and presents an opportunity to further highlight the climate-debt nexus

Around the world, countries are facing mounting debt, debt distress, and debt default. As governments are working towards green growth, sustainable development, poverty reduction, adaptation, and mechanisms to address climate-induced loss and damage, they are in danger of accumulating unsustainable debt or becoming unable to service existing debt. As stated in the IMF’s 2023 Annual Report, “debt vulnerabilities and risks remain elevated, with 15% of low-income countries currently in debt distress and 45% of low-income countries and 25% of emerging market economies at high risk of debt distress.”

Building on my previous column on sovereign debt, the climate crisis, and the global financial system (DailyFT 19.02.2024), the below further explores available debt response options and how they can connect to policy processes related to climate change. As outlined earlier, climate impacts can compound debt levels and existing macroeconomic challenges in a variety of ways, potentially leading to a vicious cycle of climate-induced loss and damage and rising sovereign debt, particularly for climate-vulnerable developing countries. Conversely, investment in climate action—be it emission reduction, adaptation, or addressing loss and damage—can also lead to fresh debt, while high debt levels can prevent countries from decisive climate action and sustainable development efforts.

Debt and the multilateral climate change negotiations

This year, finance will be a pivotal focus for negotiations under the United Nations Framework Convention on Climate Change (UNFCCC), which will culminate with the determination of a new collective quantified goal on climate finance (NCQG) at the upcoming 29th meeting of the Conference of the Parties (COP29) in Azerbaijan in November 2024. Besides the NCQG, finance will also be a key element of negotiations and technical work around the Loss and Damage Fund, the Global Goal on Adaptation, the follow-up to the first Global Stocktake, the just transition work program, and the workstreams on technology transfer.

For example, the governing decision of the newly established Loss and Damage Fund directly references “debt sustainability” multiple times. As stated in the decision, the Fund will make use of “triggers, climate impact relevant indicators, debt sustainability considerations and criteria developed by the Board” for its provision of finance, and may deploy “a range of additional financial instruments that take into consideration debt sustainability,” such as grants, highly concessional loans, guarantees, direct budget support, policy-based finance, equity, insurance mechanisms, risk-sharing mechanisms, pre-arranged finance, and performance-based programs.

In general, debt has begun to explicitly enter the climate change negotiations, with the cover decision of the last major climate summit, COP28, noting the critical need for non-debt instruments to support developing countries, as well as highlighting the growing gap between the needs of developing countries and the support currently provided, especially those facing “the increasing impacts of climate change compounded by difficult macroeconomic circumstances.” In conjunction with the existing reform proposals and initiatives outlined in my previous column, this suggests an urgent need for closer investigation of the debt-climate nexus and its consideration into both debt response instruments and climate-related policy processes at the national and global level.

Interconnections and debt responses

Inputs received during a recent London workshop with global experts conducted by SLYCAN Trust, a non-profit think tank working on climate change, highlighted a range of connections between sovereign debt and the climate change negotiations as well as the variety of existing debt response options and instruments.

On the one hand, there are already climate-specific instruments and provisions related to debt, such as debt-for-climate swaps, green bonds, catastrophe bonds, or ringfenced legal frameworks for green capital. For example, climate-resilient clauses can be included in debt agreements to allow for the suspension of debt in case of disasters or other climate-related shocks outside the borrower’s control. If such an event takes place, the debt can then be deferred to provide fiscal breathing space, allowing the borrowing country to repay its debt over a longer period according to pre-arranged conditions. This not only helps countries to reduce their default risk and retain liquidity for addressing climate-induced loss and damage, it also protects creditors and strengthens the resilience of their overall portfolio.

Similarly, climate insurance schemes, especially parametric ones, can reduce the protection gap between insured and uninsured assets, helping countries to avoid unexpected financial burdens and convert them into predictable premium payments over a longer period of time. This includes insurance at the national level, but also regional sovereign risk pools—such as the African Risk Capacity or the Caribbean Catastrophe Risk Insurance Facility—and insurance at the meso- or micro-level, which can reduce the burden on central governments and leverage risk diversification. On the other hand, there are proposals and conversations around integrating climate considerations into existing debt instruments and processes, such as debt sustainability analysis or the work of credit rating agencies. This is challenging, however, as there is no single international institution and no overarching body of rules to regulate borrowing and lending at the global level, although there are several principles and guidelines. In particular, sovereign insolvency processes lack clearly defined rules, which is further compounded by a diverse creditor base, the complexity of debt instruments, and the greater role of bilateral creditors that are not represented in the Paris Club, making debt restructuring more difficult as all players have to agree on comparable treatment. 

Other challenges for developing countries can include gaps in institutional or technical capacity regarding contracting arrangements and related legal obligations, especially when it comes to understanding interlinkages between different kinds of instruments, the legal implications of debt restructuring, or coordination between different ministries and institutions. Closing these gaps is crucial to ensure that legal agreements around debt protect both parties and ensure fairness, equity, and justice. Furthermore, countries are often forced to rely on external capital for climate investments, such as research or technology deployment, and may have issues with lack of data or credible projections for climate impacts and related risks.

Conclusions

While individual debt response instruments play an important role for country’s portfolios and balance sheets, there is a need to also look at larger and more systemic reform. For this, governments, multilateral institutions, the finance sector, regulators, adjudicators, credit rating agencies, insurers, and other key public and private actors need to find ways to work together and collaboratively transform the global financial system at scale and at speed.

Debt poses a real and tangible challenge for many developing countries and can lead to increasing vulnerability or prevent ambitious climate action. Both from the climate and the debt side, there is a need to enhance existing multilateral frameworks and ensure access to emergency liquidity, scale up climate-responsive debt instruments and clauses, and provide adequate and timely means of implementation for climate action that do not cause additional debt, allowing countries to invest in climate change mitigation, adaptation, and addressing loss and damage.

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.)