The global COVID-19 pandemic has caused millions of deaths and the greatest global economic downturn in nearly a century.At the same time, unprecedented levels of investment will be needed to fund COVID-19 stimulus and relief packages, as well as to address the challenges posed by climate change and the degradation of ecosystems that regulate the air, water and soil on which we all depend.
In this context, policy makers, the private sector, and investors are asking whether the solutions to these challenges can be linked. These connections are, in fact, already being made in the financial markets. In 2019, sustainability-linked loans (SSL) tying the interest rate to a company’s performance reducing its impact on climate and the environment, increased by over 168% from a year earlier, with major agricultural firms including Bunge, Louis Dreyfus and Wilmer among the issuers. The growth in these loans is expected to continue. The market for sovereign bonds that finance sustainable development is also developing fast. Governments issued over $13 billion in sustainable-labeled bonds during the first half of 2020, according to the Climate Bonds Initiative.
Linking financial instruments to NDCs and other targets
Sustainability-linked bonds promise to use their proceeds to finance sustainable development. The question is whether the sovereign debt markets are now ready to complement these “use of proceeds” instruments with “performance-linked” instruments which tie interest rates or refinancing mechanisms to the achievement of sustainable goals. Targets could include countries' Nationally Determined Contributions (NDCs) to the Paris Agreement. The NDCs are currently being updated under the “ambition mechanism” of the Paris Agreement to reflect 2030 targets at the forthcoming UN Climate Change Conference (COP26) in November. Nature-related targets will also be set this year as a new Global Biodiversity Framework is agreed upon through the Convention on Biological Diversity (CBD COP 15).
These bonds would be issued for general budget spending like any other government debt, but with a link to a refinancing mechanism if NDC or other targets are met.
Sustainability-linked bonds could complement the Sustainable Development Goals (SDG)-bond market and other labeled-bond markets by linking them directly to outcomes rather than to expenditures. This change would make the bonds more scalable and tradable as traditional benchmark securities and help avoid fragmentation of general government bond markets – a situation in which bond markets become less liquid and trading and pricing more challenging, which is already an issue in smaller economies and more fledgling markets. Difficulties around budget tagging and project identification would also be avoided, as these measures can be costly and require resources. In addition, these instruments would allow countries to raise debt to deal with immediate COVID-response needs while signaling commitments to medium-term goals that both contribute to sustainable development and reduce potential financial risks.
<h3>"One way to link sustainable sovereign financing with national climate and biodiversity commitments could be through sovereign sustainability-linked bonds."</h3>
Reducing risk and raising targets
What role could the World Bank and other development finance institutions play in creating a market for financial instruments linked to sustainability results, climate and biodiversity commitments? Multilateral development banks (MDBs) have a long history of providing finance linked to the design and implementation of policy actions. Access to this type of financing helps mitigate government debt funding pressures by reducing the cost and risk of the overall debt portfolio. Rollover financing could be secured for targeted government debt after a specific period, rewarding countries for meeting robust, measurable climate, nature or other sustainable policy commitments. MDBs would also play a key role in setting credible, measurable targets.
What is new about this instrument is that for the first time it links private finance mobilization (through traditional sovereign bonds) to MDB financing in ways that align incentives for the achievement of sustainable development goals and reduce debt rollover risks. Institutional investors—not just the so-called “impact” investors, but mainstream capital owners such as pension funds—would be able to purchase a financial instrument directly tied to measurable sustainable impacts. MDBs would amplify their limited funding resources by facilitating mobilization of larger sums of private capital from a broader investor base. Over time, as the achievement of development goals can be more measurably tied to sustainable growth, fiscal stability and financial performance, it is hoped that the market would start to “reward” countries meeting ambitious targets with lower-cost debt.
Ten Billion Tree Tsunami Programme, a national reforestation effort and the largest public safety-net program to be implemented nationally during the current downturn, is not only contributing to climate resilience and biodiversity improvement but has also created more than 63,600 jobs.Stimulus packages currently being crafted provide examples of how short-term economic recovery can be linked to long-term goals, including the protection of biodiversity and climate adaptation and resilience. For example, Pakistan’s
Ultimately, by linking lower debt rollover risks to key biodiversity and climate change targets, sustainability-linked sovereign bonds could help prevent debt defaults, reduce the risk of future debt distress, enhance climate resilience and conserve biodiversity—promoting economic resilience and the sustainable recovery that’s needed in the world today.