Debt-for-nature swaps

Background

The concept of debt-for-nature swaps was first launched in 1984 by the then vice president of the World Wildlife Fund, Thomas Lovejoy, in response to the deteriorating tropical rain forests and mounting debt obligations in developing countries, especially in Latin America. The first debt-for-nature agreement was signed in 1987 between Bolivia and Conservation International, a US non-profit environmental organization. In that agreement, Conservation International purchased US$650,000 of Bolivia’s foreign debt in the secondary market at a discount. In exchange, the Bolivian government agreed to set aside 3.7 million acres in three conservation areas as buffer zones. According to
the United Nations Development Programme (UNDP)¹, since the inception of debt-for-nature swaps, the total value of debt restructured under their auspices amounted to US$2.6 billion from 1985-2015, of which US$1.2 billion was used to fund development or nature-related projects.

Definition and structures

Debt-for-nature swaps are typically structured as a voluntary transaction in which an amount of debt owed by a debtor (often a country) is cancelled or reduced by a creditor in exchange for a commitment to certain nature- or climate-related actions by or on behalf of the debtor. The goal of a debt-for-nature swap is to provide a debtor with additional fiscal headroom (through savings from the reduced debt service) to address nature and climate issues. Depending on the financial terms of the arrangement, debt-for-nature swaps can achieve large-scale funding for nature, or climate-related, conservation initiatives and are, therefore, considered by the UNDP² and the United Nations Secretary-General³ as one of the tools that can be used to contribute to the United Nation’s Sustainable Development Goals.

Debt-for-nature swaps can be structured in different ways:

• Multi-party debt-for-nature swaps: In a multiparty debt-for-nature swap, one or more third parties (such as non-governmental entities or other donor institutions) purchase outstanding debt from the creditor through the secondary market at a significant discount, and then renegotiate the debt obligation with the debtor (most often a country, but this could also be private or commercial entities) in exchange for the debtor’s commitment to undertake natureor climate-related policy actions and/or investments. Rather than renegotiating the debt obligation, the third party may also opt to (i) sell the debt back to the debtor at a discount (but still at a higher price than what it has paid for the debt in the secondary market) in exchange for such nature- or climate-related policy actions and/or investments; or (ii) lend funds to the debtor at below-market interest rates on the condition that the debtor uses the funds to buy back outstanding debt at a discount and use a portion of the resulting debt relief (the difference between the cost of the retired debt and the new debt to the third party) to fund nature- or climate-related actions and investments.
• Bilateral debt-for-nature swaps: With this type of debt-for-nature swap, a bilateral creditor usually restructures a portion of a debtor’s obligations or sells the debt to the debtor at a discount. Funds for nature, or climate-related, conservation projects are raised through reduced debt service payments on restructured debt or from the debtor’s leftover reserves after purchasing debt at a discounted price. This results in a redirection of previously committed debt service to the financing of mutually agreed projects or investments in areas such as nature conservation and climate.

Dynamics

Debt-for-nature swaps have been part of the restructuring professional’s toolkit since the 1980s when they played a prominent role in the Latin American sovereign debt crisis. However, since the early 2000s and until recently these arrangements have steadily been on the decline amid a shift towards more comprehensive debt relief under the HIPC/MDRI initiatives, coupled with stronger economic growth (at least, pre-pandemic). Since the Earth Summit (Rio de Janeiro) in 2012, there has been renewed interest in debt-for-nature swaps from both debtors and creditors. COP26 in 2021, and the surrounding international movement for a “green recovery”, have prompted policymakers and stakeholders to seek innovative ways to finance nature, or climate-related, change mitigation in debt-burdened countries. Moreover, a recent surge in emergency spending to weather the consequences of the Covid-19 crisis, inflationary pressures and the ensuing monetary tightening have endangered developing countries’ ability to repay their debts, creating further opportunity for the use of debt-for-nature swaps.

The latest round of deals closed by Barbados, Belize and Seychelles are a testament to the rekindled interest for this approach to debt restructurings. Similarly, Ecuador, in May 2023, successfully reprofiled US$1.6 billion of its debt through a bond-to-loan conversion that will result in over US$300 million being channelled to independently managed marine conservation around the Galápagos Islands over the next 18 years.

Debt-for-nature swaps and conditional grants: a comparison

Conditional grants are grants to countries which are only disbursed when a particular nature-related investment occurs. They are targeted at one particular purpose, namely, the nature-related investment. In contrast to conditional grants, debt-for-nature swaps are customarily considered to be more efficient in supporting public investments in a recipient country in two ways: (i) the nature-related expenditure comes at a lower cost for the creditor as it is usually shared with other creditors; and (ii) debt-for-nature swaps generally produce some net debt relief and, therefore, they generate higher net fiscal transfer to be earmarked to nature-related projects. However, to maximise the efficiency of the
arrangement, it should be structured to ensure that the expenditure commitments are senior to the remaining debt service, otherwise the creditor wishing to fund a nature-related investment faces greater sovereign risk (or insolvency risk for commercial debtors) if the support takes the form of a debt-for-nature swap as opposed to a conditional grant.

Also, debtors may prefer debt-for-nature swaps over conditional grants when the debt-for-nature swaps offer debt relief in excess of what is needed to finance the nature-related projects. While grants are normally set to cover at most the cost of an investment, debt-for-nature swaps typically produce debt relief that exceeds the cost of the investment resulting in a higher net fiscal transfer.

Debt-for-nature swaps and the relationship with conventional debt restructurings

Debt-for-nature swaps are generally not the first tool to address debt distress at material levels or default situations. Debt-for-nature swaps are best deployed pre-emptively, when the debt of debtor governments is approaching unsustainable levels, but before a concrete risk of default materializes. The debt-for-nature swap would either (i) bring back the debt burden to sustainable levels and avoid the costs of a comprehensive restructuring involving many classes of creditors and varied debt instruments; or (ii) signal to the official sector and private parties a willingness to steer fiscal resources in accordance with institutional guidelines. Otherwise, debt-for-nature swaps have been used as substitutes, although sub-optimally, when a full restructuring was unavailable. In the latter case, the reputational and economic costs of a sovereign debt default out-weigh the consequences of a less-than optimal use of the swap arrangement.

The pragmatic case for debt-for-nature swaps

There is a pragmatic case for debt-for-nature swaps, and more generally for linking debt relief and nature, or climate-related, action. Even when the best way to help developing countries with debt and/or nature/climate problems is a combination of plain debt relief with conditional grants or grant-loan combinations, unconditional debt relief may not readily be on offer, and conditional grants will rarely be so generous as to create fiscal space beyond what is needed to fund the nature/climate action. Also, there may be cases when nature/climate conditionality enhances the willingness of creditors to provide debt relief.

In this light, debt-for-nature swaps have also been used to create fiscal space in middle-income countries – countries with a moderate debt-to-GDP ratio – and which are less likely to receive grants but have, however, benefitted greatly from additional fiscal headroom to address nature, or climate-related, challenges.

Commercial and transaction issues

Despite the many positive features, and there being an economic case for the existence of debt-fornature swaps along with other restructuring arrangements, the implementation of debt-fornature swaps has certain challenges:

High transaction cost

Debt-for-nature swaps, unlike conditional grants, involve transactions among several stakeholder groups and their preparation, negotiation, and implementation result in a complex and lengthy process, sometimes taking from 2 to 4 years.

Design and implementation of nature, or climate-related, projects

Debt-for-nature swaps often channel resources to nature, or climate-related, programs that conflict with existing programs. Debt-for-nature swaps have historically been linked to specific projects that needed to be identified, structured, and monitored. Creating those projects and the associated governance structures has been costly as many projects (such as conservation programs) are resource-intensive and usually entail a steady supply of equipment, fuel and trained staff.

High monitoring costs & lack of uniform performance indicators

The fragmented nature of debt-for-nature swaps has so far resulted in project-specific performance measures. This creates (i) an obstacle to scale since prospective investors need to become familiar with each specific project resulting in higher monitoring costs; and (ii) a constraint to the participation of financial institutions that could potentially mobilize significant financing for debt swaps if there were uniform performance indicators and monitoring standards (across a spectrum of projects) and a liquid secondary market.

It has been argued that debt-for-nature swaps could and should be linked to key performance indicators (KPIs) measuring nature- or climate-related outcomes rather than to expenditures or projects. Such an exercise could be part of the ongoing work on the design and standardization of KPIs for sustainability-linked bonds and loans. If such outcome-related KPIs would be used, similar to sustainability-linked bonds and loans, debt-fornature swaps may become increasingly vulnerable to ‘greenwashing’ claims (especially if KPIs are not set at the correct levels or ambitious enough or when debt-for-nature swaps are funded through an ESG-labelled bond).

Time-inconsistency problem

The success of debt-for-nature swaps is often contingent on the ability of debtor governments to be willing and fiscally able to deliver on the nature, or climate-related, commitments. However, such commitments can be frustrated amid fiscal or liquidity changes arising at a later stage, climate-related events or governance issues, such as mismanagement and corruption. Also, the debtor may also be reluctant to undertake regulatory policies that lead to permanent and costly reallocations of capital and resources.

Size of transactions

Despite the benefits of debt-for-nature swaps, the total volume of debt relief they have generated has been modest. The main reason has been the small size of the transactions. According to the 2022 IMF Working Paper, most debt swaps have been in the two-digit US million-dollar range. It is hoped that Ecuador’s arrangement – representing the largest debt conversion for marine conservation – will encourage other stakeholders to consider the benefits of such arrangements.

Conclusions

Considering the current environment of a high debt burden in emerging markets, access to market issues for certain countries and a climate crisis that is steadily more imminent, debt-for-nature swaps, in the right circumstances, can direct much needed resources to environmental, or climate-related, projects while, at the same time, providing debt relief for sovereign borrowers. We, at Norton Rose Fulbright, believe that these arrangements will become increasingly more popular and, as market practice deepens, debt-for-nature swaps can be used by sovereign borrowers to actively manage their debt while, at the same time, earmarking funds for environmental causes and bolstering broader sustainability credentials.