Adapting ESG-linked issuance for emerging market sovereigns’ Net Zero ambitions

Middle- and high-income emerging markets are unlikely to receive climate investment grants or debt-for-climate swaps, but still have an important role in climate mitigation. Issuance structures such as ESG-linked bonds could be adapted to suit the situation of these markets, especially those that need more than just ‘green’ investment to achieve Net Zero targets.

  • An IMF report casts doubt on the prospects of significant ‘scale-up’ of debt-for-climate swaps compared to other forms of climate investments
  • Other forms of climate investment, such as ESG- and other sustainability-linked bonds, hold promise, particularly for climate investment in medium- and high-income emerging markets where KPIs can more easily be standardized
  • The same mechanisms used in the corporate sector may not work as well for sovereign ESG-linked instruments, but alternative structures may be feasible and could be used to support climate investments in lower-income, climate-vulnerable developing countries

An IMF working paper casts a shadow on the use of debt-for-climate swaps in many circumstances while providing validation in other cases. The central cautionary point is that grants and full debt restructuring for developing countries have the potential to achieve more for the same or lower cost. One exception where climate-conditionality is clearly preferable is in the case of debt restructurings that leave vulnerabilities to climate risks that could lead to more debt restructurings. Another situation where debt-for-climate swaps show potential is for middle-income countries whose debt space is limited when compared to their climate mitigation and adaptation needs.

One of the main reasons not to prioritize ‘scale-up’ of debt-for-climate swaps is that they are generally complex, protracted exercises with outcomes no better (and often worse) than direct climate investments. Climate investments can often be made faster than executing more complex arrangements to buy back debt funded with climate-contingent debt that is cheaper than market-rate debt. The challenge in debt-for-climate swaps is that the cost weighs heaviest on a single donor/creditor or a small group of the same unless the climate investment is put at a higher priority compared to future debt service, which is often very difficult to do in practice.

If climate investments cannot be prioritized over future debt service, the amount of debt relief needed through debt-for-climate swaps will significantly exceed the climate investment amount. The benefit from the debt relief will accrue to the country, but with significant free-rider benefit for non-participating creditors in the debt-for-climate swaps. The latter group benefits from a reduction in outstanding debt that increases their risk of loss in case of adverse economic outcomes.

Because the climate investment can often not be prioritized over other debt service payments, there needs to be a larger principal amount of the debt swap than the amount of climate investment to make sure that the resulting investment will be made even if there is a subsequent economic crisis that forces the debtor country to choose between climate investment and debt repayment.

One possible situation that may offer a more compelling way forward can be seen in middle- and high-income emerging markets whose financial situation is strong but where uncertain physical and transition risks could undermine fiscal sustainability. These types of countries are more often than not donors rather than recipients of development grants, and so they are unlikely to find terms of debt-for-climate swaps as compelling as do lower-income and more highly indebted countries.

Countries that face significant long-term physical and transition risks can proceed more deliberately but the scale of the risk will require rapid scale-up of climate investments to mitigate their direct and indirect risks. For these countries, many of which are large energy exporters with Net Zero targets, there will be hundreds of billions of dollars in investments needed in their economic transition. For example, the Net Zero transition planned for the UAE which targets 2050 is estimated to require $681 billion of investment, including $163 billion for renewable energy, as well as another $500 billion required within the next 30 years (a mix of government and private sector investments).

In these situations where the green bond market is limited in available funding, ‘transition bonds’ would be more suitable, but the market hasn’t developed as rapidly as the green bond market. The working paper suggests ESG-linked bonds as an alternative if standardized KPIs can be developed. This market was opened earlier this year to sovereign issuers, with a climate-focused sustainability-linked bond (SLB) issuance by Chile.

ESG-linked bonds and sukuk linked to KPIs connected with Nationally Determined Contributions (NDCs) under the Paris Agreement and longer-term national Net Zero targets take a different route than debt-for-climate swaps. Instead of targeting a reduction in current debt, the focus shifts towards replacing existing issuance with ESG-linked instruments that can provide more fiscal space in the future if targets are met.

However, one consideration that might be worth exploring is whether the traditional structure of SLBs designed for corporate financing is suitable for sovereigns. In a traditional SLB, KPIs are set as pass/fail binaries for a specific date in the future, with a step-up in the coupon if the KPIs are not met. Combined with the new issue discount and the benefit that investors get when KPIs are not met, the incentives are misaligned.

Today’s ‘greenium’ may be as large or larger than the penalty if KPIs are missed. The ‘greenium’ is reflective of a shortage of supply compared to today’s demand. The pressure is on investors pursuing sustainability-linked investments to be less selective when demand is much greater than supply (which happened until very recently),with benefit down the road from the coupon step-up if KPIs aren’t met, providing a disincentive to careful oversight of the KPIs themselves.

An alternative way to align incentives, particularly on long-term risks such as climate change, is to use a step-down rather than step-up coupon for sovereign sustainability-linked issuance. This matches the benefit to the issuing sovereign closer in time to when the risk mitigation from meeting climate KPIs will materialize (in the future rather than today). If the risk mitigation is uncomplete (targets not met), then the coupon remains at its initial level, reflecting today’s uncertainty about the success of future risk mitigation efforts.

In line with the broader discussion above about debt-for-climate swaps, the ESG-linked instrument focused on climate mitigation and adaptation could be designed to retain the step-down coupon amount. Rather than reducing the financing cost for the sovereign each year it is triggered, the issuer could continue to pay the same coupon with the step-down portion pre-committed to high-impact investment into climate adaptation or Just Transition projects, or used for climate investments into lower-income countries’ through climate investment grants.

Debt-for-climate swaps and inclusion in debt restructuring are gaining attention, particularly where countries whose contributions to climate change are disproportionately sized to the level of climate-related risks they face. However, many countries won’t find debt-for-climate options a good fit as they look to rapidly scale up their financing for climate change mitigation and adaptation. ESG-linked sovereign issuance could fill the gap by matching the financial returns for investors commensurate with evolving risk levels, and even provide funding for Just Transition or debt-for-climate swaps for more vulnerable countries.

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Promoting adoption of responsible finance in Islamic markets & Islamic finance. CEO @RFIFoundation.

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Blake Goud

Promoting adoption of responsible finance in Islamic markets & Islamic finance. CEO @RFIFoundation.