At COP28 hosted in Dubai, eight Multilateral Development Banks (MDBs), Development Finance Institutions (DFIs), and other international organizations, published a joint declaration to collaborate to scale nature-linked sovereign financing.[1] By promoting credit enhancement instruments for sustainability-linked sovereign financing and debt-for-nature swaps, institutions like the Inter-American Development Bank (IDB) and the United States International Development Finance Corporation (DFC) intend to mobilize greater private sector capital into nature.[2] This declaration, accompanied by the creation of a Task Force on Sustainability-Linked Sovereign Financing, reflects the current and growing global attention to battle nature loss.
2023 ended as the hottest year on record, demonstrating the need to maximize global efforts to enhance climate action and limit warming to 1.5ºC.[3] Currently, the world is facing a triple crisis: debt, nature loss, and climate change.[4] Protecting nature is essential to tackle climate change and achieve a sustainable and livable future.[5] Consequently, there has been an increasing emphasis on scaling nature finance through innovative financing mechanisms, such as sustainability-linked sovereign financing and debt-for-nature swaps. Both are financial instruments whose purpose is to finance sustainability goals.
Sustainability-linked sovereign bonds (Sustainability-Linked Bonds, or SLBs) or loans (Sustainability-Linked Loans, or SLLs) are performance-based instruments that tie the cost of capital to predefined sustainability targets. While the government (debtor) can use the proceeds of the instrument for general purposes, they will have to commit to specific action(s), such as the elaboration and implementation of policies and regulations or investments to achieve climate and nature commitments, for which the financial and/or structural characteristics of the instrument can vary depending on the achievement of these objectives (see Figure 1). The climate and nature commitments and their respective indicators are defined by the debtor, and are based on supply-side drivers of sustainable development.[6] Sustainability-linked finance not only increases nature financing by defining ambitious nature goals, but it also can alleviates a country’s debt predicament as issuers have the opportunity to attract investors interested in environmental impacts and possibly lower their borrowing costs.[7]
Figure 1. Example of sustainability-linked sovereign financing structure
Debt swaps are financial instruments that have been applied by some countries to mitigate their debt burden since the crisis in the 1980s.[8] Nowadays, a new instrument called debt-for-nature swaps has emerged, which uses debt conversions to provide relief in exchange for financing projects for nature. Debt-for-nature swaps have been applied in countries with low credit ratings and consequently their debt had a discounted value in the secondary market. These instruments can be structured in the following way: a third-party organization interested in environmental impact (foundations, NGOs, etc.) can buy the entirety or part of the debt outstanding from a creditor/investor at a discount, and then exchange the debt with the government (debtor) against local currency to be invested in the biodiversity conservation fund (see Figure 2).[9] Therefore, the third-party can benefit from the discount on the sovereign debt to maximize resources to attend conservation issues in the country.
Figure 2. Example of debt-for-nature swaps structure
Innovative instruments like sustainability-linked sovereign financing and debt-for-nature swaps are effective mechanisms that can help solve the triple interconnected crisis many developing countries and emerging markets are facing. In addition, boosting these instruments can address the current gap on finance for nature. The State of Finance for Nature 2023 revealed that US$5 trillion private finance flows have a direct negative impact on nature.[10] Such impact is accentuated by the financial gap resulting from the fact that nature-based solutions (NbS) are critically underfunded, even though they have been recognized as efficient strategies to reduce GHG emissions.[11] NbS are actions inspired and supported by nature that can help reduce biodiversity loss and address various social challenges, as they protect, conserve, restore, sustainably use and manage natural resources.[12]
More and more, innovative financial instruments are viewed as beneficial instruments for governments to incentivise private investment into scaling NbS. Following Chile’s footsteps, Uruguay’s inaugural SLB was designed in a two-way pricing structure based on the independent achievement of each SPT for its two KPIs, one of which focused on nature, safeguarding forest ecosystems through policies and regulations in order to maintain native forest area.[13] In addition, Uruguay’s SLB was accompanied by the development of innovative advancements and policies such as the development of its environmental footprint of livestock production.[14]
Recent examples of debt-for-nature swaps have also been proof of successful ways to finance nature. In May 2023, Ecuador’s debt-for-nature swap became the largest debt-for-nature swap completed, proving new possibilities for emerging economies.[15] Through the Galápagos Marine Bond, which consisted of a $85 million credit guarantee from the IDB and a $656 million of political-risk insurance from the DFC, the government of Ecuador waived $1.6 billion of its debt for a $656 million impact bond.[16] The government of Ecuador will use the proceeds of the bond to create the Galápagos Life Fund, to finance the conservation of the Galápagos Marine Reserve and the Reserva Marina Hermandad for the next 18.5 years.[17] The government’s climate resilience activities will protect a 322-km radius around the Galápagos archipelago, which will help maintain the ecosystem’s integrity.[18]
As one in five countries is experiencing fiscal and financial stress, and as many of these countries have undergone negative impacts on their biodiversity,[19] one can expect to see a 2024 where an escalation of innovative financing solutions for nature will take place. Such expectations can be supported by the latest encouragements from governments to promote debt-for-nature swaps[20] and scale nature finance,[21] as well as for future possible sovereign issuers[22] and MDBs’ developments on nature-based solutions.[23] Looking forward, countries can build on this momentum and further catalyze investment towards nature-based solutions.
Natalia Velázquez is an Analyst at HPL, graduated with a Bachelor’s Degree in International Relations from the Instituto Tecnológico Autónomo de México (ITAM). In HPL, she has supported 19 consultancy projects related to sustainable finance research, market guidance development, and the preparation and structuring of thematic bonds for development banks, commercial banks, and corporates in LAC. Natalia has also contributed to the execution of sustainable finance studies for multilateral development banks and international organizations.
References
[1] Multilateral Development Banks (MDBs) (2023). JOINT DECLARATION: Regarding Credit Enhancement of Sustainability-Linked Sovereign Financing for Nature & Climate. Available here.
[2] Inter-American Development Bank (IDB) (2023). Eight International Organizations and Development Finance Institutions Join Forces to Boost Innovative Financing for Nature and Climate. Available here.
[3] Johny Wood for World Economic Forum (2023). This year set to be hottest ever recorded, and other nature and climate stories you need to read this week. Available here.
[4] Nature Finance (2023). Innovative Financing Instrument Offers Lasting Solution to Climate and Debt Crises. Available here.
[5] Green Climate Fund (2023). Making blended finance work for nature-based solutions. Available here.
[6] Nature Finance (2023). MoreforLess Scaling Sustainability-linked Sovereign Debt. Available here.
[7] Stian Reklev for CarbonPulse (2023). COP28: Major development banks to ramp up sustainability-linked funding to battle nature loss, climate change. Available here.
[8] Patrick Greenfield for The Guardian (2023). Are debt-for-nature swaps the way forward for conservation? Available here.
[9] International Institute for Sustainable Development (IISD) (n.d.). Innovative Financial Instruments for Climate Adaptation. Available here.
[10] UNEP (2023). State of Finance for Nature 2023. Available here.
[11] Green Climate Fund (2023). Making blended finance work for nature-based solutions. Available here.
[12] Ibid.
[13] Uruguay’s Ministry of Economy and Finance (MEF) (2022). Uruguay’s Sovereign Sustainability-Linked Bond (SSLB) Framework. Available here.
[14] Uruguay’s Ministry of Environment (2022. La Huella Ambiental. Available here.
[15] Inter-American Development Bank (IDB) (2023). Ecuador Completes World’s Largest Debt-for-Nature Conversion with IDB and DFC Support. Available here.
[16] Ibid.
[17] Ibid.
[18] Marc Jones and Rodrigo Campos for Reuters (2023). Ecuador seals record debt-for-nature swap with Galapagos bond. Available here.
[19] Nature Finance (2023). Innovative Financing Instrument Offers Lasting Solution to Climate and Debt Crises. Available here.
[20] Genevieve Redgrave for Environmental Finance (2023). COP28: Debt-for-nature swaps encouraged by France, Colombia and Kenya. Available here.
[21] Genevieve Redgrave for Environmental Finance (2023). COP28: 18 countries join pledge to scale nature finance. Available here.
[22] Thierry Ogier for LatinFinance (2023). Brazil plans SLB debut by early 2024. Available here.
[23] Inter-American Development Bank (IDB) (2023). Multilateral Development Banks Announce Common Principles to Track Nature-Related Finance. Available here.