Sustainability-linked sovereign debt-related (SLSD) bond issuances can grow 100-fold this decade to help address the crises trio of debt, climate, and nature, a report released Friday found, with linkages to nature markets seen as one of several steps that could help scale the instrument.

Chile’s and Uruguay’s inaugural issuances of sustainability-linked bonds last year, following on from Belize’s debt-for-nature swap the year before, has helped create a lot of interest in developing tools that seek to ease the fast-growing sovereign debt crises in many emerging economies, global nature and biodiversity loss, and climate change in one fell swoop.

But at the end of 2022, the value of sovereign sustainability-linked bonds issued by emerging and developing economies (EMDE) only stood at $3.5 billion, according to a report released by the Sustainability-linked Sovereign Debt Hub, a group of companies and organisations hosted by Geneva-based non-profit NatureFinance.

That could grow to as much as $250-400 bln by the end of the decade, the report found, if the market takes necessary steps to scale up.

“Scaling this innovative debt instrument can advance climate and nature goals while avoiding the vicious cycle of unsustainable debt, deteriorating creditworthiness, and diminishing economic health that is currently threatening emerging markets and developing countries,” said Arend Kulenkampff, the hub’s director.

CONSCIOUS EFFORT

Broadly speaking, SLSD arrangements involve debt-stricken nations being able to refinance their debt by taking on key performance indicators (KPIs) related to sustainability issues, such as reducing greenhouse gas emissions or protecting natural environments.

With one in five countries experiencing fiscal and financial stress and the external debt of lower income countries almost tripling to $1 trillion over the past decade while climate change and consequences of nature loss loom large, according to the report, there is ample opportunity to develop the SLSD instrument.

The Chilean and Uruguayan bonds related in part to commitments the two nations had made under the Paris Agreement, but future arrangements can take a wide range of approaches.

“Conceivably, any policy objective or issue area can be accommodated within this structure, such as fostering the development of biodiversity credit markets, while KPIs can link to practically any relevant metric, such as the issuance of such credits,” the report said.

It listed a number of ways biodiversity credits, nature-based carbon credits, or other units related to nature could link to SLSD structures as part of efforts to scale the mechanism.

One way would be to integrate the revenue stream from the issuance and sale of nature credits into SLSD as a form of collateralisation via a sinking fund, it said, referring to Gabon’s plans to earmark a third of the revenue from sales of its REDD+ sovereign carbon credits for servicing its debt.

Further, if revenue from such credit sales help enhancing the risk profile of the sovereign nation in question, that could improve the uptake of SLSD instruments among a wider pool of investors, according to the report.

The issuance of credits itself could also be a KPI, it said, referring to an emissions reduction-linked bond issued by the World Bank in February, where coupon payments are linked to the number of Verra-issued carbon credits generated by a water purification project in Vietnam.

Such a structure could be used for scaling sovereign debt instruments as well, according to the report, and could involve projects that reduce the potential loss and damage from floods as well as create carbon and biodiversity credits from sequestration, conservation, and restoration.

MANY SCALING PATHWAYS

To achieve a 100-fold increase in SLSD by the end of the decade, despite starting from a low base, would require a lot more than just linking to nature-based crediting markets, however.

The report outlined six other pathways that would boost sustainability-linked sovereign debt instruments, including credit enhancement arrangements, climate/nature/disaster risk finance initiatives, standardisation efforts, capacity building, enabling regulation and market development, and developing fiscal rules and frameworks.

If such efforts gain momentum globally, we might see a fast rise in the development of debt instruments that also address climate change and biodiversity loss.

“Under a baseline scenario, every sovereign with market access presently can be expected to issue at least two bonds during the seven-year forecast horizon,” said the report.

“This performance would mirror the trajectory of the sovereign ESG debt issuance more broadly, which grew from under $1 billion in 2016 to over $120 billion of green, social, sustainable, and sustainability-linked (GSSS) bonds five years later.”

There are barriers to the growth, though, such as multinational development banks applying restrictive accounting rules, rating agencies using outdated methodologies, data and technology constraints, coordination failures, and market fragmentation.

The Sustainability-linked Sovereign Debt Hub formulated the scaling pathways to overcome those barriers.

“Fortunately, surmounting these barriers does not require far-reaching political consensus among major creditor and debtor groups. Rather, they are amenable to several technical fixes and collective efforts on certain key fronts,” the report concluded.

It was released ahead of the upcoming IMF Spring meetings, which will run from Apr. 10 through Apr. 16, where the authors expect debt and climate will feature prominently.

By Stian Reklev – stian@carbon-pulse.com

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