Breaking the Deadlock on Climate: The Bridgetown Initiative

“Let us be honest with ourselves”, opined the head of delegation of a wealthy country at a pre-COP meeting I attended on how to mobilise US$4 trillion a year for climate mitigation. “Finance isn’t the problem; if every country had all the finance they need, it would not be the answer to climate mitigation.” At this point, I realised that we live on top of each other, sharing the same Earth and its greenhouse gases, but we also live worlds apart. How could he surmise that finance wasn’t the most significant part of the problem? He sat opposite me, and next to him was the head of delegation from a large developing country who looked at him equally puzzled. I quickly checked the cost of borrowing in the two countries they represented. The Government of the rich country was borrowing ten-year money at 1.4% per annum, while the developing nation was borrowing at 11%. Some of its neighbours were borrowing at 20%. Private sector borrowing rates are the Government rate plus a premium, so the cost of capital of a privately funded renewable energy project in the rich country would have been close to 4%, and in the developing nation, 15%. At 4%, finance isn’t the problem. The regulatory and tax regime may matter more. At 15%, it doesn’t matter what your regulatory and tax regime is. There are few if any profitable projects. Finance is by far your biggest problem.

Today, developing countries represent over 60% of current greenhouse gas emissions (GHGs). Rich countries say, in some tension to Paris’ recognition of common but differentiated responsibilities, that there is no solution to climate mitigation that does not involve developing countries doing more and faster. In the capitals of the developed world there is excited chatter of using new technologies and private finance to transition developing countries out of coal, oil and gas. But the differential cost of capital between countries means that cajoling them to commit to hitting net zero soon doesn’t make sense because most countries would be making unfunded commitments. Elsewhere, government officials could be sacked for doing that.

People who live in countries with a low cost of capital nod sagely when you bring this up. We need risk-mitigation in the developing world they say. This is a sophisticated way of saying that the responsibility lies with high-risk countries (almost all poorer and often smaller) who must make more effort to lower risks. Grants and loans are available to them to pay professionals, often from low-risk countries, to provide technical assistance on the importance of policy certainty and transparency, fiscal discipline, institutional strengthening and a range of other obvious risk-reducers. This reminds me that the fox knows many things, but the tortoise knows one big thing. The US, Italy, Greece and Japan have some of the lowest risk-premia and lowest long-term interest rates in the world; yet some of the highest debt levels. And their politics is not, shall we say, humdrum ¹ . What defines whether a country has a low cost of capital is whether its currency is accepted as a safe asset internationally – not the myriad of things that may be mitigated. The major international safe asset currencies are the dollar, the euro, the yen and the pound. The role of history and convention in making a global safe asset is a discussion for another time ² . The point for now is that risk mitigation is almost always a good thing but almost no amount will bring down the rate differential sufficiently. Any solution to global climate mitigation must involve better directing and leveraging international safe assets for global climate mitigation.

The Global Climate Mitigation Trust

We propose to break the deadlock over climate finance with a $500bn Global Climate Mitigation Trust seeded with IMF Special Drawing Rights. SDRs are the right of one IMF member to borrow a quantified amount of central bank reserves from another, effectively at low overnight interest rates, currently at 2.4%. These reserves, collectively amount to US$12.7 trillion.  There are already two SDR-funded IMF Trusts, the Poverty Reduction and Growth Trust and the recently established Resilience and Sustainability Trust and there are almost USD$1 trillion of SDRs. The vast majority are held by countries who do not need them ³ .

SDRs are the cheapest way to seed this Trust but not the only way. Those unwilling to rechannel their unused SDRs could instead offer pre-commitments by development finance corporations, guarantees or even paid-in capital. The Trust would use $500bn of SDRs and similar instruments as security to borrow overnight at least US$500bn, spread over the SDR constituent currencies to reduce currency risk, and keep rolling over this borrowing ⁴ . The Trust could then break up the borrowed $500bn into tranches of different sizes to be on-lent to qualifying projects that the Trust approves on the basis of how much and fast they reduce global warming per each dollar the Trust invested. The Trust lends directly to projects and not to governments which is a critical difference from the other IMF Trusts. These loans would become an asset of the Trust and a liability of the project, critically taking climate mitigation off government balance sheets.

Projects would have to pre-qualify using proven technologies and processes and high environmental, social and governance standards like those embedded in Just Energy Transition Partnerships (JET-Ps) ⁵ . The Trust could fill the yawning financing gaps revealed by JET-P planning and consultative processes. For instance, a JET-P project that converts an electricity generator from coal to solar with a US$25bn funding gap, including the social impact costs to the workers and their communities could bid for USD$25bn of nearly 2.4% money on the basis of the climate impact. This would incentivise private savings to find the right technologies and best social impact methodologies to transition the dirtiest processes wherever they may be. This gets us out of a country-by-country squabble. It incentivises the most efficient mix of economic adjustment, climate-impact, technology and private savings, and leverages the impact of each public sector dollar by five to tenfold. This US$500bn Trust of 2.4% money for climate mitigation projects could draw in USD$2.5 to USD$5trn of private savings into climate mitigation and social and economic transformation. This is how we go from billions to trillions without heaping debt onto stressed government balance sheets. There is no other plan with this scale.

More concessional finance to climate-vulnerable countries to build resilience

While it is not always so, much climate mitigation and in particular the all-important energy, transport and agriculture transformation, generates revenues. With the help of our Global Climate Mitigation Trust then, mitigation can be funded primarily by the private sector. However, much  climate resilience and adaptation does not have a revenue stream and can only be financed by the public sector. Given how little fiscal space developing country governments have we would love the private sector to do resilience too. There is much resistance to this conclusion from those who believe in the omnipotence of private capital. I can’t count how many times people outside developing countries have said that ‘resilient seeds’ proves me wrong. The cold reality is that the biggest ticket items in resilience costs are defences against sea-level rising, salinity intrusion and floods, more resilient road and bridge infrastructure and water conservation. Most hard-core climate resilience and adaptation costs cannot be shifted to a private sector or third balance sheet. It rests on government balance sheets where space is limited, cost of capital is high and as a result too little adaptation is being done. Loss and damage are rising exponentially as a consequence.

The solution is concessionary finance to Governments from Multilateral Development Banks (MDBs). Concessional finance means finance on better terms than those available commercially. For developing countries, the most extensive spread is between what a developing country’s Government can borrow at and the rate that a country with an international safe asset for a currency, like the United States or Euro-area, can borrow. The rating agencies give these reserve currency issuers a AAA-credit rating given they have many other options than default and so they enjoy the lowest borrowing rates. For developing countries, concessionary finance could mean borrowing at the overnight borrowing rate for AAA borrowers with ultra-long-term repayment and a minimum spread for administrative costs. Even then, I recognise that there are no free lunches, so the extent to which countries can take advantage of the low borrowing rates of reserve currency issuers is not unlimited. Today, MDBs offer very concessional funds only to the poorest countries, those with a GDP per capita of less than USD$1253 per year, where 900 million people live or 12% of the world’s population. This is a crude cut-off. For a start, 62% percent of the world’s poor live in “middle-income” countries where around 5 billion of the world’s population live ⁶ .

During Covid, some middle-income countries that were particularly badly hit, such as Barbados and Bahamas, were granted temporary access to concessional borrowing to finance Covid-related costs.  Major MDB shareholders have said they would likely repeat this in the wake of a climate disaster ⁷ . But that does not make good economic or investment sense. A number of empirical studies conclude that every dollar spent on better resilience today saves four to seven dollars in a climate disaster. Better to give limited, not temporary, access to concessional borrowing, limited to climate-vulnerable countries and their investments in climate resilience.

Broader eligibility for concessional funding must not mean a fight for resources between the most vulnerable. The cake needs to be expanded. Critically, MDBs can borrow an additional US$1 trillion at AAA rates to on-lend to developing countries without anyone having to write a cheque if only three things happen:

(1) They raise their risk appetite in ways recommended and outlined by the G20’s Independent Review of Capital Adequacy Framework of the Multilateral Development Banks ⁸ .

(2) They include the nearly US$1 trillion of callable capital (capital promised in the event of trouble but not paid-in) in their risk frameworks to determine their borrowing room.

(3) They should be allowed to hold rechanneled SDRs to provide the liquidity to expand their borrowing and on-lending. 

An excellent place to kick start this three-pronged programme of additional lending would be for five countries or more to work with the IMF to rechannel their SDRs to the African Development Bank to expand its lending capacity. Who will be part of the first five?

Two critical changes to the international financial architecture

If we shift climate mitigation off the balance sheets of governments through the Climate Mitigation Trust and lower the cost of climate adaptation through increasing lending by MDBs and widening windows for concessional finance, we would achieve much. But climate-vulnerable countries would still experience a debt crisis before they can adapt and the rest of the world mitigates. To avert that, we critically need two more pieces of the climate finance architecture.

However much of the new debt is concessional and the private savings are in the form of equity; the world will still be adding more public and private debt to fund climate mitigation and adaptation. And the whole world starts off this debt-laden journey with excessive debt levels because of Covid ⁹ . Moreover, debt levels are only half the story. The other half is the level of interest rates, which are rising rapidly as developed economies tighten monetary policy in the face of inflationary pressures. Even when the inflation fight is won we are witnessing a normalising of interest rates that will leave them significantly higher over the next decisive decade for climate than during the last decade ¹⁰ . To this worsening financing environment, we must add the increased frequency and size of climate-related disasters. In a few hours, a climate disaster can wipe out 200% of the GDP for small states, as with Dominica in 2017, or 10% for large states like Pakistan in 2022. Disasters on this scale require Governments to divert substantial resources to relief and recovery. There is a way to address this, but it is not through even more debt arranged in an emergency when debt repayment is compromised. Nor is it through insurance-like instruments like cat-bonds, parametric insurance or the insurance elements of the recently proposed ‘Global Shield’. This is because climate change is an uninsurable event.

Commercial insurance works by pooling and spreading losses. This works well where the incidence of loss is uncertain and those who think they are vulnerable but are not experiencing a loss still want to be part of the pool; where the losses are uncorrelated with other losses; where the risk of loss is reasonably steady over time so an insurer can spread the risk through time; and where those who are causing the risk pay more than those who are victims; incentivising a reduction in risk. Climate change is none of those things. The incidence of loss and damage from the climate crisis is increasingly known, and so many will choose not to be part of those risk pools. As we crash through critical cascading points of temperature increases, climate-related losses exponentially increase in size and correlation with previously uncorrelated losses. Anyone selling climate change insurance will give up or go bust. Anyone buying it will face intolerable and rising premiums until the insurer goes bust or withdraws just as they need the coverage. And because those who contribute the most greenhouse gasses in the atmosphere are not bearing the greatest losses, it will mean the innocent victims of climate change will pay for the loss and damage caused by others: it is victim pays, just in instalments.

(i) Natural Disaster and Pandemic Clauses

The first part of a solution is Barbados-style natural disaster and pandemic clauses in all debt instruments, from those held by multilateral or official agencies to those held by private creditors or even Chinese state-owned enterprises ¹¹ . These are not insurance instruments; the lender is no worse off if a natural disaster occurs. They are net-present-value neutral in the terminology. The clause suspends debt service for two years when an independent agency declares a natural disaster of a certain threshold has hit and extends the instrument’s maturity for two years at the initial interest rate. This automatically provides enormous liquidity when countries most need it without having to pay the cost of crisis liquidity, negotiate conditional arrangements and increase debt levels. If all developing countries had these instruments in their sovereign debts during the pandemic, it would have released one trillion dollars of liquidity ¹² to devote to whatever they needed to spend it on, from healthcare to employment-protection schemes. At the time, excluding China, they could only spend half of that. In the case of Barbados, the current largest issuer of these instruments, it releases liquidity of around 17% of GDP in a crisis. No other instrument comes close. Contingent credit lines from MDBs, often conditional in eligibility and expenditure, are usually capped at 2.0% of GDP and are additional debt.

One question raised is if everyone has these, will it create a systemic risk for creditors? This is where the net-present-value characteristic of the instrument is essential. A holder of these instruments could at any time swap or strip the clause with a life-insurer who could reverse the effect of the clause at only an administrative cost because they would be giving up liquidity they do not need, in return for long-term income which they do.

(ii) Reconstruction Grants

The liquidity offered by the natural disaster clauses helps them to respond appropriately at the time. Still, ultimately there is an underlying cost to reconstruct what has been lost in a disaster, be it homes, infrastructure and livelihoods to institutions, communities and intangibles. The remaining missing instrument in our climate finance architecture is loss and damage financing. The moment of an enormous disaster is not one for increased debt. Over fifty per cent of the increased debt of many climate-vulnerable countries is a result of the loss and damage associated with natural disasters ¹³ . If this goes unaddressed, it will sink them before they can adapt. Climate-vulnerable countries passionately believe that wealthy nations broke a promise on loss and damage financing offered to gain their support for the Paris Agreement. The Warsaw Mechanism for loss and damage lies empty nine years later. Many feel fobbed off by the offer instead of a Santiago Network of technical assistance offered to countries that could teach the world a thing or two about managing disasters. A precipitous walk-out by climate-vulnerable countries is possible if there is no movement on loss and damage.

Grants are even more scarce than concessionary finance. Still, I believe that within the climate finance architecture proposed here, where we have addressed mitigation, adaptation and liquidity with appropriate instruments, if we focus on the most significant losses in the most vulnerable countries, we can define loss and damage in a tight enough way to be financed by grants.

We propose that when an independent agency declares that a climate event has taken place and loss and damage are over 5% of GDP, an automatic payment is made to the Government to pay for reconstruction. Global budgets have little room for fiscal transfers and there is little scope today to increase the cost of living. So we propose a funding mechanism with similarities to the Oil Pollution Compensation Fund managed by the International Maritime Organisation ¹⁴ .

Producers of fossil fuels would pay a levy linked to the carbon content of fuels that will start at zero. The levy would rise automatically as the fuel crisis subsides. For every ten percentage point decline in oil and gas prices, the levy will increase by one percentage point. If oil and gas prices return to their pre-covid levels, this will generate over $200bn per year. The markets expect oil and gas prices to fall back, partly because of the increasing switch to renewables and the declining energy intensity of the economy. And while the market is prone to short-term manipulation and events, these unwind.

Conclusion

We are hurtling to 1.5 degrees of global warming. Inadequate mitigation requires increasing adaptation. Insufficient adaptation is leading to substantial loss and damage. We are at a critical conjunction. There is no longer any space for delay. But action will not be delivered through the trapdoor of history. We must make it happen. The scale of the investment required to mitigate global warming is beyond the capacity of rich governments, far less developing countries. The private sector will have to play a major role – maybe three-quarters of climate financing must be done with private savings. The main obstacle, especially in developing countries where some of the most significant opportunities for mitigation now lie, is the cost of capital. This has prevented progress and caused multilateral efforts to descend into a dangerous dispute over who should be doing more. Our US$500bn, SDR-backed Global Climate Mitigation Trust sidesteps the squabble. By offering 2.4% money to any project wherever it is as long as it reduces global warming much and fast, we incentivise private savings to match the right technologies to the places where the most and fastest mitigation can occur. The US$500bn Trust should mobilise US$2.5 to US$5trn of private savings, mostly in developing countries where the current cost of capital is a high multiple of this funding and off governments’ balance sheets.

The past failure to mitigate climate change has baked-in 1.2 degrees of warming and created enormous climate adaptation needs between the Tropics of Cancer and Capricorn. This is where temperatures will rise to the most intolerable levels, and sea levels will increase the most through thermal expansion and the Earth’s spin. Climate related loss and damage in this band around the equator is three or four times greater than elsewhere ¹⁵ . Because of the absence of revenue streams, most climate adaptation needs to be funded by governments. Climate vulnerable countries must be offered concessional lending to invest in climate resilience. To ensure this does not crimp lending to the poorest countries and the pursuit of other sustainable development goals, MDBs must expand their overall lending by at least US$1 trillion. They can do this without anyone writing a big cheque, through just three things: increased risk appetite, recognition of existing callable capital in risk frameworks and using SDRs to back additional borrowing from the capital markets. The African Development Bank’s capital replenishment is the right opportunity to expand capital and lending through rechanneling unused SDRs.

Without these changes to eligibility and lending at the MDBs, adaptation has been scarce and so  loss and damage are rising exponentially. Over the next decade climate-vulnerable countries need a mechanism of direct and quick grants when a climate disaster hits. With climate mitigation funded by the Trust and adaptation by expanded MDB lending, these grants can be focused on reconstruction costs. A reverse levy, which rises by one per cent for every ten per cent decline in fossil fuel prices, could fund over $200bn per annum ¹⁶ of reconstruction grants annually without adding to the current cost of living.

There is a universal recognition that announcing burgeoning producer profits in gleaming corporate headquarters while losses and damage pile up in vulnerable countries that burn the least fossil fuels, is untenable. For too long have climate-vulnerable countries waited for a mechanism to address the loss and damage of climate change. Without it, there will be a debt crisis. And a debt crisis will inevitably lead to reduced spending on public health, housing, education, and welfare, quickly spawning a development crisis, increasing pressures for regional and international conflict and migration. And that frontline will come to you if it has not already. We live worlds apart; but also on top of each other.

1. To have such high debt levels and such low interest rates is quite a feat of fiscal indiscipline as the other countries with high debt levels partly got there by the compounding of high interest rates.
2. See, Anna Gelpern and Erik F. Gerding, Inside Safe Assets, 33 Yale J. on Reg. 363 (2016), available at https://scholar.law.colorado.edu/faculty-articles/8.
3. SDRs are allocated in proportion to IMF quotas which are related to GDP so that the largest economies have the largest quota.
4. The SDR constituent currencies are the same safe assets plus the Chinese yen. Because of its diversity, the basket provides a reasonable currency hedge.
5. See on JET-Ps, https://ec.europa.eu/commission/presscorner/detail/en/IP_21_5768
6. See https://www.worldbank.org/en/country/mic/overview
7. See https://www.worldbank.org/en/news/press-release/2019/06/19/42-trillion-can-be-saved-by-investing-in-more-resilient-infrastructure-new-world-bank-report-finds
8. See, https://g20.org/wp-content/uploads/2022/07/CAF-Review-Report.pdf
9. https://www.reuters.com/markets/europe/emerging-markets-drive-global-debt-record-303-trillion-iif-2022-02-23/
10. For why, see, ‘The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival’ by Charles Goodhart and Manoj Pradhan.
11. The developers of these instruments are Sebastian Espinosa and David Nagoski of White Oak.
12. This estimate is based on data presented in, “Born Out of Necessity: A Debt Standstill for COVID-19”, Center for Economic Policy Research; Policy Insight No. 103 (2020), by Bolton, P., et al.
13. See, Munevar, D (2018), “Climate change and debt sustainability in the Caribbean: Trouble in paradise?”, background paper, Intergovernmental Group of Experts on Financing Development 2nd session, 7-9 November, Geneva: UNCTAD.
14. See, https://iopcfunds.org.
15. See, Baarsch, F., Granadillos, J. R., Hare, W., Knaus, M., Krapp, M., Schaeffer, M., & Lotze-Campen, H. (2020). The impact of climate change on incomes and convergence in Africa. World Development, 126. https://doi.org/10.1016/ j.worlddev.2019.104699
16. Author’s estimated based on recent average prices and production of oil, gas and coal, for the underlying data see, https://www.eia.gov/outlooks/steo/report/global_oil.php