Debt-for-nature swaps: virtues shine through thicket of complexity
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Emerging Markets

Debt-for-nature swaps: virtues shine through thicket of complexity


Critics are poking holes in debt-for-nature swaps, and they may need improving, but the technique has power

Debt-for-nature swaps are a hot topic at this week’s World Bank and IMF annual meetings, as they offer a compelling prospect: a new way for countries to finance conservation projects without having to incur debt. But not everyone is convinced.

The International Monetary Fund is suggesting swaps with key performance indicators linked to a country’s National Determined Contribution. The Commonwealth is designing guidelines for debt-for-nature swaps for small nations. Fiji and others have hinted that they are looking into them. Sri Lanka and the Bahamas have previously expressed interest.

So far there have been four deals in two years, along essentially the same principles. Belize in 2021, Barbados in 2022 and Ecuador and Gabon this year have all raised new funding — so far dubbed ‘blue bonds’ because they relate to marine environments — at far lower interest rates than they could otherwise achieve, thanks to credit enhancement from a higher-rated entity. This entity is motivated by a wish to promote conservation.

The governments use proceeds to buy back some of their older international bonds at a discount. The savings generated from that discount and the low interest cost of the new bonds are channelled to marine conservation projects. There is optimism that more transactions are to come.

“Over $800m of conservation funding through four transactions in two years is no mean feat, and we are enthusiastic about the prospects for more debt-for-nature swaps or — as we prefer to call them — debt conversions,” says Slav Gatchev, managing director for sustainable debt at The Nature Conservancy, which has been the sponsor of all the deals so far except Ecuador, where the Pew Charitable Trusts led.

There would appear to be little not to love. Gatchev argues that combining “conservation, climate funding and implementation assistance” with a debt deal makes “truly sustainable capital markets issues”.

And the opportunity is huge. TNC estimates that at least a third of the roughly $2.2tr of commercial debt to the developing world is in some form of distress. Many of those countries are in the tropics, with high biodiversity and real climate challenges. The organisation wants to do more, and sees high interest.

Lingering doubts

Yet sceptics abound. Criticisms range from the peripheral — like how these deals are labelled — to more prickly topics such as the fees counterparties make for arranging the deals.

Some are suspicious because they struggle to grasp how the savings are made and how exactly the funding is channelled.

“Initially there was a lot of excitement,” says Nathalie Marshik, managing director, Latin America fixed income research at BNP Paribas. “However, stakeholders are asking questions. Is this product really what it was intended to be? How much really goes towards nature conservation, when the biggest component of a deal is a debt buyback?”

Several bankers who have worked on the deals insist that these deals are being criticised for failing to live up to claims they never made. For example, is it right to allege that the use of the term “blue bond” is wrong, when no marketing materials have ever claimed that they are traditional use of proceeds style ESG-labelled debt like green bonds?

TNC is moving to describe its strategy as “nature bonds”, rather than blue bonds, as future deals are likely to encompass terrestrial conservation, freshwater and climate. Gatchev hopes this will “eliminate any concerns over the labelling”.

Other lines of questioning give more room for pause. One sovereign debt adviser says he has seen government officials enthused by promising proposals from inexperienced NGOs to carry out debt-for-nature swaps, only for a quick revision of the numbers to show that the economics did not make sense.

Even Gabon’s transaction, issued in August to arguably even more scrutiny than others, as the new financing was — unlike the first three deals — syndicated in traditional bond market fashion, left some observers wondering about the extent of the savings.

Where Belize and Ecuador had repurchased their debt at such deep discounts that the financial benefits were obvious even at a superficial glance, Gabon bought back bonds at between 85 and 96.75 cents on the dollar.

“Some criticised Gabon for the lack of nominal savings, but that comes from misunderstanding a complex product,” says Gatchev. “The deal produced roughly 7% money for a sovereign that had bond yields of 12%, plus $125m of conservation funding that will stay within the country. It’s not just about the discount on the tender offer.”

Those close to the deal say there is little point comparing one country with another. And though bankers see plenty of potential in countries with debt distress on the scale of Ecuador or Belize, enthusiasts hope the product will gain traction beyond distressed exchanges.

“To some extent Gabon was a refinancing and I think there will be more like that,” said a banker who has worked on previous deals. “In those cases, I see it as being about the opportunity cost dynamics. It’s not just a financial decision, it’s a public policy analysis and working out how you want to maximise the benefit of the credit enhancement.”

Broader acknowledgment that these conversions do not only apply when a country is in debt crisis might help the product gain a wider audience.

When Colombia’s President Gustavo Petro spoke in July of a debt “swap” to fund climate change mitigation and adaptation, finance minister Ricardo Bonilla felt he had to speak out quickly to insist Colombia was not planning a debt swap, because that is what countries like Ecuador, which don’t have market access, do.

Respect the product

None of these concerns, however, show that the essential concept does not work. If there is some confusion, this may be an inevitable result of the complexity of the structure and how recently it has appeared.

Greater definition, education, and transparency about debt-for-nature swaps may be needed.

So far, and for the foreseeable future, each deal is unique, and none is easy to put together. Deals must align with the objectives of multiple parties. There needs to be a committed and credible government with suitable conservation projects and an experienced, sophisticated sponsor, and the maths must work for a particular borrower’s debt stack and policy.

“Today we are seeing that this product is not as easy as some people perhaps expected, and all banks looking at getting into this space need to give the product the respect it deserves,” says Jake Harper, investment manager at LGIM Real Assets, which bought $250m of Ecuador’s $656m blue bond. “We like these deals, but they do require a lot of work. For us, it’s key to be involved early on in the process, to enable us to be familiar with the ESG story, the sovereign itself and the structure.”

Some of those closest to the evolution of this market are anxious that its build-out should not be too cavalier. The deals done so far have been notable for strict environmental KPIs with consequences for failure that go way beyond anything in the larger sustainability-linked bond market.

“The incentives for the borrowers to behave correctly are well thought-out,” says Harper. “There are occasions where not meeting targets could trigger a default, and sometimes the financial penalties target the budget of the relevant ministry, which should be more effective [than just a slightly increased interest rate for the issuer].”

Harper hopes that TNC’s Belize Blue Bonds progress report, published in March, “sets the standard” for other transactions, as it was prepared by the people on the ground managing the projects, and clearly details how funds are traced.

“We must avoid a dilution in the strength of the commitments and the consequences of breaches, in the interest of getting deals over the line more quickly,” said a banker.

More parties involved, more deals

Yet excessive caution can also be dangerous: there is an urgent need for more financing. TNC estimates that global biodiversity requires around $700bn of funding a year.

It thinks it could manage two or three deals a year. It is aiming for $10bn of new debt issues by 2030, and for at least 25% of this to be channelled to conservation. Though this is “not a small number”, says Gatchev, it’s “not going to solve all the world’s problems”.

“It will certainly help directly and by example,” he said. “We need others to be doing the same, as we saw in the Galapagos with Pew. The biggest challenge is to make sure more investors and multilaterals get involved.”

Undoubtedly, expanding the list of NGOs that sponsor projects and entities that provide credit enhancement would increase the pace of issuance.

So far, the US International Development Finance Corp has provided an insurance policy to deals in Belize, Ecuador and Gabon, while the Inter-American Development Bank complemented Ecuador’s credit enhancement with a smaller guarantee. The IADB also guaranteed $100m of the $150m Barbados blue bond, with TNC itself guaranteeing the rest.

More counterparties are understood to be getting on board with the idea.

“Getting an institution like the IMF or the World Bank involved would make sense, so everyone’s on the same page,” says Marshik at BNP Paribas. “I think a proper framework, one that addresses some of the issues, would benefit everybody too.”

Growth in the market will require growth in the options for credit enhancement.

“DFC and IADB have leant into this, above and beyond their traditional mandates, and have appetite to do more,” says Gatchev. “Their pioneering efforts are spurring the other multilaterals to take this seriously, and we’ve had productive conversations with institutions like the African Development Bank, Asian Development Bank, World Bank and EIB.”

The presence of multilateral lenders would be particularly welcome, as the IADB guarantee used by Barbados is understood to have carried lower transaction costs than the DFC-led insurance models.

The IADB’s $85m guarantee on Ecuador’s blue bond, though paling in size compared with the DFC’s $656m of political risk insurance, acted like a liquidity reserve for the deal — and was vital for its success.

Ecuador’s debt-for-nature swap was estimated to have generated financial savings of over $1.125bn and savings for conservation funding of $323m — by far the largest of any of the deals.

“When it comes to keeping costs low, sovereigns get the most bang for their buck when they don’t have to prefund reserves, with reserves covered by other means or external parties,” says Harper. “As these structures become more common, hopefully fees for these transactions fall and the overall economics continue to improve for the sovereign.”

Practitioners and observers continue to learn lessons from the deals that have happened. There is no short term prospect of an International Capital Market Association framework, nor a consensus on whether one would be helpful.

Debt-for-nature swaps are clearly not a silver bullet, for either conservation funding or a country’s debt woes — nor do they claim to be.

But when they are done well, they have an edge over the vast majority of conventional ESG-themed bond financings: they offer a genuine solution to funding something that otherwise would not be financed.