Michael Iveson, Overseas Development Institute (ODI) Fellow (Economist) based in Sri Lanka, assesses the opportunities Sri Lanka needs to avail of in climate financing, with regards to negotiating debt in the future. He posed the question, “What is Sri Lanka’s Galapagos?” referencing the recent successful debt-for-nature swap of Ecuador, which leveraged the Galapagos Islands, known for its rich biodiversity and ecotourism, in its negotiations with its lenders.
Sri Lanka, which defaulted on its external debt in 2022, requires $11.26 billion dollars in investment to meet its renewable energy targets by 2030. Sri Lanka faces the challenge of mobilizing resources needed to fulfil its ambitious climate targets, as the country’s fiscal constraints, exacerbated by its debt burden and limited tax revenue, may pose obstacles to financing climate-resilient initiatives. As a significant portion of the government budget is allocated to servicing debt, Sri Lanka needs to navigate a constrained fiscal space in its bid to invest in climate action and other priority areas.
Debt Sustainability is the Priority
Ensuring Sri Lanka’s economic stability is paramount before delving into complex yet crucial endeavours such as climate financing and debt-for-nature swaps. Debt restructuring is already underway and it will dictate the economic landscape for sustainable economic growth. Previous debt-for-nature swaps have typically emerged when countries faced debt distress – not default – so it’s important Sri Lanka achieves sustainability as part of their strategic approach.
However, timing is critical, and now presents an opportune moment for consideration and planning for the future. The intricacies of debt restructuring outline just how complex it can be to introduce new elements such as climate conditionalities. Even incorporating governance-linked bonds and the proposed macro-linked bonds created so much additional work. Sri Lanka has agreed to restructure its debt in the traditional way so it must see that through.
While acknowledging the grievances with the global financial system’s treatment of debt, Sri Lanka is still operating within it. The IMF deal is restoring investor confidence and this additional capital will pave the way for sustainable economic recovery, but the imposed reforms have posed immeasurable challenges for ordinary people and these cannot be ignored. The economic recovery must focus on distribution as well as growth.
Reflecting on historical precedents, developed nations underwent industrial revolutions at the expense of environmental degradation, disproportionately impacting developing countries. The call for cleaner growth trajectories from nations with historical carbon footprints must be met with equitable solutions, acknowledging past injustices and facilitating sustainable development pathways. Developed countries must mobilize more resources for countries like Sri Lanka, whose development pathways are constrained by their need to fulfil debt obligations and climate targets with limited fiscal space.
While radical solutions like debt cancellation remain elusive, advocating for increased concessional finance is both practical and realistic. Climate financing mechanisms, including Article 6 of the Paris Agreement, hold promise in incentivizing developed nations to invest in climate initiatives in developing countries, fostering global solidarity in combating climate change.
Climate Credibility
Fulfilling climate commitments isn’t just about ticking boxes; it’s about credibility. If a country like Sri Lanka falls short of its promises, it risks damaging its reputation in the eyes of international financiers. When it comes time to seek climate finance or additional debt for future projects, lenders may hesitate and question whether the country will follow through on its commitments this time around.
But the consequences of failing to meet climate goals extend far beyond financial credibility. Take renewable energy, for example. If the country neglects to invest in renewable energy and domestic energy capacity, it’ll continue to rely heavily on imported fuel. As a small open economy, Sri Lanka does not dictate the price it pays for its own energy, making it vulnerable to market fluctuations and global shocks such as the Russia-Ukraine conflict.
Suddenly, energy costs soar, and the country, unable to influence prices, must deplete its foreign exchange reserves to keep the lights on. This isn’t sustainable. The government cannot maintain such exhaustive spending on fossil fuels denominated in foreign currencies and continue to impose costs on themselves, businesses, households and individuals. Failure to diversify the energy sector – and, ultimately, to fulfil its climate commitment – has ripple effects across the entire economy and will continue to undermine stability and development.
So, when we talk about missing climate targets, it’s not just about falling short on environmental promises; it’s about jeopardizing economic sustainability and the standard of living of ordinary people. The energy sector is just one example – think about the tourism sector, fisheries, and agriculture, these are some of the most important sectors in the economy. Each missed target adds to the economic strain, making it harder to address pressing issues and build a resilient future.
Climate First, Debt Second
While the benefits of climate investments may not always translate directly into immediate revenue generation, they contribute significantly to the long-term resilience and prosperity of the nation. Firstly – and most obvious – investments in climate-friendly initiatives such as renewable energy and marine conservation can create job opportunities. Climate investments help build the capacity of the economy and, if done right, can empower local communities and support locally-led initiatives.
When we discuss the impact of servicing debt on low-income countries, it’s crucial to recognize the multifaceted nature of the issue. It’s not merely about the financial burden of paying off loans; it’s also about the opportunity cost and the ripple effects it creates across critical sectors such as education, healthcare, and infrastructure. Debt repayment isn’t just about where you’re spending money, it’s also about where you’re not spending your money. Funds that could be invested in essential areas like education and healthcare are instead directed towards debt repayment. The result? Resource-constrained sectors that limit the welfare, development and potential of the workforce, hindering long-term economic growth. The opportunity costs of debt are extremely high.
This is where the concept of debt-for-climate swaps comes into play. It is about using the debt for the climate. Framing debt swaps as purely debt relief falls short of the point. It is instead about reallocating debt repayments towards climate investments and reducing the opportunity costs of debt. It’s about unlocking finance to address pressing environmental challenges while simultaneously reducing the debt burden. In most cases, the actual scale of the debt relief isn’t that high, relative to the total debt burden, but the value of the resources mobilized for environmental benefit can be huge. By reallocating funds from debt servicing to climate action, countries can invest in renewable energy, sustainable infrastructure, marine conservation, and resilience-building measures.
Countries have made commitments to climate change mitigation and adaptation; they have developed strategies, committed resources, and outlined the need to meet their targets. This is a much more convincing approach to raising climate finance; countries have much more leverage by highlighting established plans that they cannot afford to finance, rather than just hoping that newly generated climate policies might be able to rescue them from debt distress. This brings us back to the point of credibility – countries must fulfil their climate obligations but are facing greater and greater constraints, how can they maintain these investments in the presence of ballooning debt burdens? The answer has to come from addressing the opportunity costs of debt.
Emerging Markets and Developing Economies (EMDEs) and Debt-for-Nature Swaps
Belize, in 2021, faced an economic slowdown and a high debt burden. The Nature Conservancy facilitated a deal where they lent Belize $364 million to repurchase their “Superbond” at a 45% discount, which reduced Belize’s debt by 12% of GDP. This reduced the principal outstanding by $189 million, which enabled Belize to mobilize approximately $180 million for marine conservation over the next 20 years. The agreement was also guaranteed by the U.S. Development Finance Corporation, which provided further assurance to creditors.
The Seychelles also showcased a significant initiative, albeit on a smaller scale, using $25 million to finance marine conservation and the development of a marine spatial plan. While small in value, this signalled serious commitments to marine conservation and reassured prospective investors that Seychelles had sustainability at the heart of its economic strategy. This catalysed the establishment of a blue bond framework, which in turn mobilized even more resources for conservation efforts in Seychelles.
Ecuador’s recent debt-for-nature swap, exceeding a billion dollars, underscores the scalability of such initiatives. Ecuador leveraged its iconic Galapagos Islands, globally renowned for biodiversity and eco-tourism, and emphasized the need to free up funds for marine conservation. The importance of the Galapagos Islands – and their status as a hub for biodiversity, eco-tourism, and conservation research – attracted many investors who saw it as a financially viable option with huge environmental benefits.
Sri Lanka, for instance, could explore opportunities in renewable energy or heritage conservation, identifying its own “Galapagos” to attract investments and address climate challenges. So, what is Sri Lanka’s Galapagos? Personally, I see immense potential in the renewable energy sector. There are early-stage discussions around integrating Sri Lanka and India’s energy sectors, which signals vast opportunities. If done efficiently and competitively, Sri Lanka fulfils its domestic renewable energy targets and has potential to export the excess to one of the fastest-growing regions in the world just 20 miles off the north coast. There are naturally many challenges to this that go far beyond economics but we need ambitious proposals – this could be one of them.
Could Sri Lanka’s Galapagos be its coastal regions, and its marine conservation efforts? Even something seemingly small like the Kandy-Ella train ride, beloved by tourists, could be another opportunity. As the effects of climate change reshape the hill country and land erosion disrupts the train routes, could we raise sustainable finance to protect this iconic route? It might not be on a grand scale, but every little effort counts. Perhaps Sri Lanka doesn’t have one massive Galapagos-scale opportunity, but a series of smaller ones, each with its own potential to be leveraged. When we look at countries like Belize, Seychelles, and Ecuador, they all had something unique, something they were known for and needed to protect. What is Sri Lanka’s equivalent? That’s the question we must answer if we want to learn from their successes.
However, navigating such negotiations requires careful consideration. While debt-for-nature swaps can alleviate immediate financial burdens, it’s essential to ensure that investments align with long-term climate goals. Effective communication is crucial, framing these initiatives not merely as debt relief but as targeted financing for climate action. Moreover, targeting productive sectors, like renewable energy, can generate sustainable revenues, reducing the long-term debt burden.
Yet, it’s imperative to recognize the broader systemic challenges. Structural reforms within international financial institutions, like the IMF, are necessary to address the root causes of debt distress in developing countries and better reach underserved borrowers. Improved access to concessional finance and more generous loan structures for long-term climate and social investments offer feasible solutions within the current framework, but this also requires flexibility from creditors.
Debt-for-climate swaps present promising opportunities for EMDEs to maintain their climate investments while also alleviating some of the debt burden. By leveraging their unique assets and engaging in strategic negotiations, countries can chart a path towards sustainable development while navigating the complexities of global finance.