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LINKING SOVEREIGN DEBT WITH CLIMATE AND NATURE TARGETS

Fiona Stewart,  Lead Financial Sector Specialist in the Finance, Competitiveness and Innovation Global Practice, The World Bank
Samantha Power, Sustainable Finance Specialist, The World Bank


 

As countries move beyond the pandemic many are struggling to fund the relief and recovery packages needed to get their economies back on track. Public debt increased by $12 trillion in 2020 according to the Institute of International Finance, exacerbating already high levels of debt in some emerging markets*. It is clear that unprecedented investment is needed to enable countries to recover and transition to climate and nature-smart economies.

Policy makers, the private sector, and investors are asking whether the solutions to these challenges can be linked. In fact, these connections are already being made by financial markets. In 2019 and 2020, sustainability-linked loans and bonds (tying a company’s interest rate to its performance on key sustainability indicators) were issued by many companies for the first time. According to J.P. Morgan, global issuance of sustainability-linked bonds could reach $120-$150 billion in 2021 – compared with $8.9 billion in 2020. Investors know that through these instruments they can drive risk mitigation and management and are hence willing to accept a lower interest rate.

It is clear that unprecedented investment is needed to enable countries to recover and transition to climate and nature-smart economies.

The market for sovereign bonds that finance sustainable development is also developing quickly. Total issuance of sovereign sustainability-labelled bonds (which promise to use their proceeds to finance sustainable development) reached $71.5 billion in 2020, with 17 nations having issued these (according to the Climate Bonds Initiative). Many of these bonds were oversubscribed as investors aim to integrate ESG criteria across their portfolios and take steps to align their portfolios with the goals laid out in the Paris Agreement, as is indicated in Article 2.1c.

Linking financial instruments to NDCs and nature targets

The question is whether sovereign debt markets are ready to complement these ‘use of proceeds’ instruments with ‘performance-linked’ instruments, which tie interest rates or refinancing mechanisms to the achievement of  sustainability goals. Sustainability-linked bonds could provide a way to link sovereign financing with national climate and nature commitments.

These bonds would be issued for general budget spending, like any other government debt, but with a link to a refinancing mechanism if climate or nature targets are met. Targets could include countries' Nationally Determined Contributions (NDCs) to the Paris Agreement or nature-related targets set in advance of COP15. Many countries have already made commitments to set aside 30 percent of their land and waters for conservation by 2030. However, we know that resource constraints are a barrier to the implementation of these plans for many countries.

Results-based, sustainability-linked bonds could complement the labelled bond market by linking financing to outcomes rather than to expenditures. This change would make the bonds more scalable and tradable, as traditional benchmark securities, helping to avoid fragmentation of general government bond markets. Difficulties around resource intensive budget tagging and project identification could also be avoided. These instruments would allow countries to raise debt to address immediate Covid-response needs, while signalling commitments to medium-term goals that both contribute to sustainable development and reduce potential financial risks.

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Reducing risk and raising targets

As governments and investors become more aware of the systemic risks arising from the degradation of nature, it is sensible for them to work together to transition to a nature-smart economy. Sovereign debt investors have always had an interest in countries strategically managing their capital – it is now time they also prioritize natural capital. By investing in sustainability outcomes, investors reduce portfolio risk and the level of systemic risk they will be exposed to in the future.

 

Multilateral development banks (MDBs) have a long history of providing finance linked to the design and implementation of policy actions. Access to sustainability-linked financing could help mitigate government debt funding pressures by reducing the cost and risk of a country’s debt portfolio. Rollover financing could be secured for targeted sovereign debt after a specific period, rewarding governments for meeting robust and measurable climate or nature policy commitments. MDBs could also play a key role in setting credible, measurable targets.

Sustainability-linked sovereign bonds could also help governments overcome short-term political incentives to degrade natural capital. Over time, as the achievement of sustainability goals can be more measurably tied to growth, fiscal stability, and financial performance, financial markets may ‘reward’ countries meeting ambitious targets with lower-cost debt.

The pandemic has served as a stark reminder that planetary and human health are interconnected and that economies can only thrive on a healthy planet.

Ultimately, by linking lower debt rollover risks to key climate and nature targets, sustainability-linked sovereign bonds could help prevent debt defaults, reduce the risk of future debt distress, drive climate mitigation and adaptation, and conserve nature-promoting economic resilience and the sustainable recovery that’s needed in the world today.

Reprinted from the Perspective One series with kind permission of ForestLAB and the African Conservation Development Group.

*https://blogs.worldbank.org/climatechange/my-word-my-bond-linking-sovereign-debt-national-sustainability-commitments?cid=SHR_BlogSiteTweetable_EN_EXT