Developing countries need ways to achieve fair and sustainable climate financing

An independent Group of 20 (G20) expert group estimates that emerging market and developing economies (excluding China) need to mobilise around three trillion US dollars annually to achieve the Paris Climate Agreement and the United Nations’ 2030 Agenda for Sustainable Development. One trillion US dollars of this is expected to come from external sources. While these figures are intimidating, they represent only about two percent of global economic output in 2022—less than what the world spends annually on education.

This financial challenge sets the stage for the 29th United Nations Climate Change Conference (COP29), where leaders aim to renegotiate climate finance targets for the period after 2025. Past negotiations have revealed stark differences between developed and developing countries, both in the scale and nature of climate financing. But ambition has proven difficult to raise, not only at climate summits. In October, the International Monetary Fund (IMF) and World Bank Group Annual Meetings in Washington concluded with limited progress on expanding funding, despite a pressing need for reform. This need is especially urgent as many countries bear the burden of high debt levels, with interest payments consuming more of their budgets than spending on health or education.

As COP29 approaches, there is cautious hope that these talks will yield a more ambitious and effective framework for global climate finance.

The funding gap and its consequences

Economies have been weakening as a result of the pandemic, food and energy price shocks due to the war in Ukraine, rising interest rates and the associated strengthening of the US dollar, making it more expensive for developing countries to service their sovereign debt and borrow on financial markets. Raising trillions of dollars in new external funding would be difficult even in the best of times. It is even more difficult when the world is faced with an escalating debt crisis.

Rising debt threatens development and climate protection

A recent study by the Debt Relief for a Green and Inclusive Recovery (DRGR) Project shows that 47 developing countries, home to over one billion people, would exceed the IMF’s critical debt sustainability thresholds if they were to borrow the financial resources for the urgently needed investments in climate protection and the achievement of the Sustainable Development Goals (SDGs). A further 19 countries lack the financial flexbility to make the necessary investments. Over-indebtedness is a particular challenge in Africa and the Caribbean, where conditions have recently worsened.

Since 2008, African governments’ debt to foreign lenders has surged by 240 percent, and today, half of African nations spend more on interest payments than on their public health budgets. The latest IMF economic outlook paints a bleak picture, with low growth prevailing and public debt expected to rise further. As a result, many of these countries face limited development prospects, which increases the risk of being unable to service their debt in the long term, also known as their debt sustainability.

How climate impacts debt – and vice versa

At the same time the international community lacks appropriate tools to assess which countries need debt relief and to what extent. While the IMF conducts its own debt sustainability analyses, these are inadequate in many respects, including distorted projections, unrealistic climate investment needs and underestimation of the impact of climate shocks. The DRGR Project study, published jointly by the Heinrich Böll Foundation, the Boston University Global Development Policy Center and the Centre for Sustainable Finance at SOAS, University of London, illustrates the extent to which vulnerability to climate change impacts and environmental damage can affect debt sustainability. The authors find that climate change thus increases a country’s risk of default and increases the cost of capital i.e., the costs incurred in raising capital for government investments.

According to an independent expert commission convened by the Indian G20 presidency and its chairmen Lawrence Summers and N.K. Sing, developing countries face yet another challenge: in 2023, less capital flowed into developing countries than flowed out of them. Rising interest rates and repayments of bonds and loans resulted in almost 200 billion dollars flowing out of the poorest countries to private creditors – without public funds even remotely being able to compensate for.

Countries that are vulnerable to climate risks are also exposed to higher borrowing costs on the capital market. A vicious cycle of debt and climate change ensues, with countries having little ability to implement robust climate action that increases their resilience to extreme weather events and economic shocks. The longer the international community delays meeting all climate investment needs, the higher the cost of mitigating global temperature rise and dealing with its consequences will be.

Need for comprehensive reform and recommendations for action

To break the cycle of environmental and economic crises and usher in an era of sustainable growth, countries need to invest now. Therefore, any strategy to tackle climate change and realise the SDGs must lower the barriers to new financing. This includes targeted debt relief and credit enhancement for developing countries.

An ambitious debt relief initiative is essential in order to grant meaningful debt relief to countries facing a full-blown sovereign debt crisis. This initiative should be modelled on the successful Highly-Indebted Poor Countries (HIPC) Initiative created by the IMF and the World Bank in 1996.

For such an initiative to be implemented effectively, the active participation of all creditors is required. This includes multilateral financial institutions such as the World Bank, as at least half of the total external debt of 27 debt-ridden countries ­– many of them low-income countries or small island states – is owed to multilateral creditors. Even if all bilateral and private debts were cancelled, some of the world’s weakest countries would still be burdened with excessive debt. There is therefore no way around the involvement of multilateral financial institutions. However, this must be done in such a way that these institutions are compensated for losses and that preserves their high creditworthiness and their ability to provide loans at low interest rates.

A first step in the right direction would be to reform the Common Framework for Debt Treatment adopted by the G20. This framework has so far proven to be too slow and inefficient, in particular because it does not offer sufficient incentives for private creditors to participate and only applies to low-income countries, excluding highly indebted middle-income countries. 

The First Global Stocktake, adopted at the COP28, for the first time recognized the positive connection between sufficient fiscal space and climate action, referring to the Common Framework as one of the existing mechanisms. The document also noted that „scaling up new and additional grant-bsaed, highly concessional finance and non-debt instruments remains critical to support developing countries“. 

Making climate investments affordable for countries with limited financial leeway

For countries with limited financial flexibility for essential investments, such as those in climate change mitigation and adaptation, reducing the cost of capital is crucial. . Numerous proposals have already been made to this end. Credit enhancement through guarantees on bonds would be conceivable, as would additional financial injections through the distribution of special drawing rights (SDRs), a type of reserve credit for IMF member countries. SDRs are meant to provide additional financial resources for countries in need, as was the case during the Covid-19 pandemic in 2021. Debt servicing could also be suspended – for example through a revitalised and expanded Debt Service Suspension Initiative, which also provided valuable support for over-indebted countries during the pandemic. The latter should be coupled with new financing where the weighted cost of capital is lower than the projected growth rate of the participating countries.

The prolongation of the debt crisis will exacerbate the climate crisis, especially for the countries that have contributed the least. COP29 must demonstrate that, despite these challenges, the global community remains committed to action by providing vulnerable countries with the necessary climate finance. A reformed sovereign debt architecture will be a crucial building block to ensuring all countries can achieve their emissions reduction and climate adaptation targets and thus lay the foundation for a prosperous and sustainable future.