Making sovereign debt markets work for sustainable development

Improving the financial health of sovereigns and reducing the need for ex-post debt structuring

The increased sensitivity to climate risk principally penalises the world’s poorest countries that are climate vulnerable through no fault of their own. Making matters worse, sovereign risk pricing rarely rewards countries that invest in low carbon transitions and climate resilience.

The integration of nature-related risks into financial decision-making is reinforcing this damaging asymmetry – those most in need are being charged the most for capital. This polarisation has an impact on all of us.  

Recent research commissioned by NatureFinance predicts the transmission of nature-related risk into sovereign risk assessment will affect the cost of capital flowing into the most nature-dependent sector – food.  This will increase the cost of nutrition, globally. 

Almost 60% of the world’s lowest-income countries were already in debt distress, or at high risk of it, before the start of Russia’s war in Ukraine, according to the World Bank. When you then layer into this the growing incidence of exogenous climate shocks and the risks of eroding biodiversity, you have the vicious cycle of sovereign debt defaults and restructuring, and massive vulnerability. 

Debt crisis is part of the climate and nature problem. Failing to address the underlying development crisis will undermine any hope of an effective, international response to climate change. The risks of nature, climate, debt and capital market exclusion demands, as Mia Mottley, Barbardos’s prime minister so aptly stated – “a new financial architecture”. 

The good news is that economic thinking is catching up with this interconnected nature-climate-debt reality. There have been multilateral efforts of temporary suspensions of debt servicing, alongside country-by country debt restructuring deals.

What we need, however, are ways to channel adequate finance towards investments yielding long-term economic rewards based on the fundamentals of sustainability development. Simply said, sovereign debt markets need to reward sustainable development outcomes and share the burden of exogenous shocks. 

This is what sustainability performance-linked sovereign bonds are designed to achieve. The ambition is to invert the vicious cycle of sovereign indebtedness and climate risk into the virtuous circle of fortifying nature and sovereign finances. We can reshape financial possibilities by directly rewarding positive nature and climate outcomes through reducing the costs of capital. This can incentivise investments that reduce sovereign risk through improving resilience and economic productivity, thereby reducing the costs of capital. This creates fiscal space to support broader sustainable development outcomes. All of which will improve the financial health of sovereigns and reduce the need for ex-post debt structuring. 

There are early examples of the success of this approach: Chile’s renewables-linked sovereign bond and the nature-linked restructuring of Belize’s and Barbados’s sovereign debt. But to develop this market requires embedding nature and climate risk into practice, regulation and other rules, and this will take all the players in the sovereign debt universe to work together to mainstream the market.  

It is through working together that we can introduce approaches that will catalyse systemic transformation without needing widespread consensus and coordinated policy action. We can reshape the sovereign debt market and create a just transition to a low carbon, climate resilient, nature-positive world.