Last month, the Environmental, Social, and Governance (ESG) investing movement got a hard reality check about one of its favorite financial tools.
Known as debt-for-nature or climate swaps, the tool played a role in a recent coup in Gabon. The nation’s democratically elected government was overthrown by rival militants just a week after the completion of a $500 million swap agreement, illustrating the problems with these instruments in both theory and practice.
Climate swaps take existing emerging market debt and either refinance it at a lower rate or extend the terms of the loan. The emerging nations then take the money raised and use it for biodiversity protection and climate adaptation.
The swaps, the origins of which date back to the 1980s, have taken on new life as environmentalists encourage developing markets to spend more to conserve their forests and jungles.
An article in Bloomberg estimates that the market for both public and private climate-swap deals is set to exceed $800 billion. In fact, the swaps are more popular than they’ve ever been, as large banks look to make more ESG-related deals and higher interest rates pressure emerging-market countries to, for instance, renegotiate debt.
Take the Nature Conservancy, whose website claims that the environmental NGO enabled a deal that reduced Belize’s debt by 12% of GDP, unlocking $180 million for the impoverished nation’s treasury over the next 20 years. But Barclays has raised concerns that such deals — the Belize swap in particular — are not being adequately scrutinized or are examples of “greenwashing,” when monies are earmarked to promote conservation but never actually amount to much.
Indeed, the greenwashing would not be so terrible if all that swap money was going somewhere useful.
Instead, argues Barclays, much of it is being deployed to pay bank fees and other intermediaries. Also, as the recent Gabon coup illustrates, these swaps can enable corruption and unrest and are often characterized by a lack of transparency.
A group of 31 nonprofits recently criticized the swaps on grounds that the money raised goes to domestic conservation NGOs, some of which run annual budgets suspiciously larger than many government departments or civil-society organizations.
The problems with green debt swaps go deeper than poor implementation or lack of accountability. There is something unseemly about European and American banks imposing their values on poorer countries that usually have more pressing economic demands. Emerging markets often need investment in projects that could alleviate poverty and promote development — while still paying off for investors in both the short and long term.
And local investors typically have a better sense of what a nation’s fiscal priorities should be. Which is why the real danger posed by the swaps is that they create market distortions that favor politically popular Western ideas rather than truly serve economies in need.
There are also the long-term obligations created by these swaps, problematic when much can change in a few years — let alone over a few decades — in countries with corruption and other political risks.
It’s unclear if the new government in Gabon, for instance, will honor the previous government’s climate deal and use the funds as intended. The Gabon contracts are insured for political risk, which will pay out the loan-maker if the country defaults or fails to use the money for conservation.
Perhaps the insurance will make the market viable and bring accountability — but if the swaps also breed corruption, insuring deals will be harder in the future, making investing in emerging markets even riskier.
Debt-for climate-bonds are clearly well intentioned: Markets can be too focused on the short term and under-value cleaner oceans. Still, the arguments made by climate-swap supporters don’t fully add up.
The Nature Conservancy, for example, maintains that rich countries have a moral obligation to bankroll the swaps because they gained their wealth by polluting the planet. But to whatever extent this is true, climate risk is not solved by expecting emerging markets to funnel their scarce capital into conservation simply to please progressive ideologues.
A better solution: Keep explicit ESG goals out of these markets, and let the markets allocate capital to the most productive sectors, enabling developing countries to become richer. When that happy day arrives, these once-poor nations will have the resources to devote to their environmental goals as they see fit.
Allison Schrager is a senior fellow at the Manhattan Institute and is a contributing editor at City Journal, from which this piece has been adapted.