Under the hood of debt-for-nature swaps

The sovereign debt restructuring facility seems capable of solving numerous challenges simultaneously but has some way to go before it becomes an easily replicable way of protecting natural capital.

Debt-for-nature swaps are an intriguing addition to the financial toolkit that is available for catalyzing investments into nature.

The nascent sovereign debt restructuring facility made a splash earlier in May when Ecuador exchanged $1.6 billion in government bonds for a $656 million impact loan to be invested in the conservation and enhancement of the Galapagos Islands’ marine ecosystem. Climate Fund Managers structured the deal.

Although only a handful of debt-for-nature swaps have been closed to date, the growth in their size has been rapid. The 2017 Seychelles DFN swap was the first of its kind and restructured approximately $22 million of national debt to free up roughly $9 million over 20 years for the nation’s marine ecosystem. Belize followed in 2021, restructuring approximately $550 million of sovereign debt to allow $180 million in debt service savings to be funneled to marine conservation, while Barbados restructured $150 million of national debt to free up approximately $50 million for conservation in 2022.

In terms of how savings are generated in the Ecuador DFN swap, CFM regional head Latin America Juan Paez told Agri Investor: “The involvement of the US DFC provides the arbitrage opportunity because their involvement allows us to exploit the differential in the credit risk between the Ecuadorian sovereign and the US government sovereign. So that allows for amplitude of space, and then we can translate some of those savings to the government and some of those savings go to conservation.”

The US International Development Finance Corporation provided $656 million in political risk insurance, while Inter-American Development Bank provided an $85 million guarantee. Credit Suisse acted as offeror for the international bonds and a group of 11 private insurers provided more than 50 percent reinsurance to facilitate the project.

“Early-stage risk capital was provided by Dutch Fund for Climate and Development and the European Commission via the development fund of Climate Fund Manager’s Climate Investor II fund,” said a statement from CFM provided to Agri Investor.

Original debt holders must also accept a concession on the value of their notes to facilitate the deal – for the Barbados DFN, original note holders took $92.25 for every $100.

The long list of backers and participants required to structure a DFN – all of whom have not been listed here – is one of the facility’s shortcomings, acknowledges CFM chief executive Andrew Johnstone.

“The process is still inefficient,” says Johnstone. “There are multiple parties involved with multiple interfaces. The consequence is that it takes quite a long time to actually curate and to bring the transaction to fruition and over this period there could be political cycles and elections, financial market changes, and changes in actors along the way. So that brings inefficiency, longer timelines, higher transaction costs than in a  more mature market and in the context of climate change, every day lost comes at a huge cost to the environment.”

Analysis published by the London School of Economics suggests the Belize DFN swap may have cost as much as $85 million to structure on a whole-life basis, but the publicly disclosed transaction cost was $10 million.

Johnstone cites the now “standardised and commoditized” transaction costs of wind farms as being “far lower” than a DFN swap, for example, while providing a positive environmental impact, but this would ignore the fact nature swaps are currently being used by countries where the national balance sheet is already under stress and has limited room to add natural conservation investments.

Use of funds generated by DFN swaps are prescribed within the covenants of the loan agreement and include outcomes such as sustainable and alternative livelihoods, enhanced ecosystem protection, women’s economic empowerment and improved access to sanitation and waste management infrastructure.

If Johnstone’s belief comes to pass that, with time, structuring costs can be reduced as DFN swaps become more commonplace, and commercial LPs are indeed willing to provide the liquidity for such loans, we may well see such structures continuing to grow in number and size.