The Climate Finance Trap

Emerging and Developing Economies (EMDEs) have been at the centre of COP 27 this year. This also reminded us of their crucial role in the fight against climate change as those economies account for two-thirds of global greenhouse gas emissions (including China), and are also the countries that are most vulnerable to climate hazards. As such, these economies require significant financing in the upcoming years to mitigate and adapt to the physical effects of climate change. However, most of the financing provided by the developed economies is mainly composed of loans, which adds to the high debt levels of EMDE countries. Not to forget the rising interest rate environment, which leads to higher sovereign borrowing costs. These factors lead to the so-called “debt trap”, which makes it difficult for most of those regions to meet pressing climate financing needs.

Is Climate Finance pushing EMDE countries into a debt crisis?

As explained in our Sustainaweekly note from last week (see here), there is a huge external financing shortfall for EMDEs to mitigage and adapt to climate change and there is a lack of support from ‘rich countries to ‘poorer’ countries. Indeed, the commitment taken during COP15 to mobilize jointly USD 100bn per year by 2020 to help developing countries in their climate mitigation and adaptation is lagging. Furthermore, the “debt trap’’ has also been the subject of many discussions at COP27 given the significant rise of sovereign borrowing costs this year. As highlighted by the OECD report (see here), loans represented the biggest share of the financial instrument split in both bilateral and multilateral public finance in 2016-2020. Thus, this adds to the debt sustainability issue most of EMDEs are already facing.

This concern was stressed in the summer by the IMF Managing Director Kristalina Georgieva, who asserted that one-third of all developing countries and two-thirds of low-income countries are at risk of debt distress. Particularly as the external debt stocks continue to expand on the back of loan-based financing provided by advanced economies. As shown in the graph below, the proportion of countries in debt distress, or at high risk of debt distress has been continuously rising and has now reached around 60%. Moreover, the rise in interest rates worldwide is an additional headwinds for EMDEs facing a slower economic recovery with government deficits rising since the pandemic. Not to forget the appreciation of the US dollar this year, which causes a higher risk for those economies as most of their debt are dollar-denominated. Therefore, all of these factors combined add to the difficulties of servicing debt for many EMDE countries.

Other climate financing alternatives are needed

Aside from the need to have the rich countries meet the USD 100bn commitment in the coming years, it seems clear that EMDEs need more flexibility and less budget-constraining financing support. One approach would be to increase the proportion of grants relative to loans as these precipitate more and more countries into unstainable debt levels. This also refers to a greater reliance on more concessional than on non-concessional finance. Put simply, concessional finance represents a range of products offering below-market interest rates, which makes it a cheaper borrowing facility. Another alternative discussed during COP 27 is a loss-and-damage facility, which would help channel funds from rich countries that contributed the most to global emissions historically, to countries that are on the front lines of climate change.

Sustainable debt issuance expected to continue to rise in the following years

Another alternative to climate finance for EMDEs is Sustainable Instrument issuance. As we can see in the graph below, those financial products already grew significantly in 2021. As of September 2022, 40 sovereign borrowers had issued USD308 billion in those thematic bonds, eighteen of those were from Emerging markets. One advantage for EMDEs in using this market is of course diversification. Indeed, this helps countries diversify their debt mix and spread the risk over different debt instruments. In addition, this also increases the access to financing for countries that would otherwise find difficulty in attracting enough demand in the financial markets if not offering a high (risk) compensation.

Second advantage for EMDEs to issue sustainability debt instruments is to lower borrowing costs. Given the rise in interest rates and the budget constraints of most EMDEs countries to deploy fiscal support, this can offer a (slightly) cheaper funding alternative. Indeed, as shown by an IMF study (see here), their greenium estimate is on average a 30.4bp for USD-denominated bonds which makes it much larger than that for advanced economies, which is on average just a few basis points currently (see our piece on the Bund greenium here). Additionally, as the sustainable debt market becomes larger, this will also help to improve liquidity in the market and also attract the private sector to issue more in this market. Therefore, we do expect EMDEs to play a bigger role in global sustainability financial markets in the coming years and increase their share of green financing in their debt mix. However, it is worth noting that sustainability bonds remain debt instruments while the coupons of such bonds can vary widely between Developing countries and thus, only alleviate modestly the debt trap issue.

This article is part of the SustainaWeekly of 21 November 2022