The nine trillion-dollar idea you (probably) didn’t catch at COP
by Theo Talbot, Chief Economist & Associate Director – Sustainable Finance
Photo: md zakirul mazed konok / Alamy
With the hoopla of COP, you would be forgiven for missing a modestly-attended panel discussion on The Case for Climate Resilient Debt Clauses, a superficially simple idea that nonetheless could help pivot hundreds of billions of dollars towards tackling disaster risk.
The topic? Adding an innovative new type of clause to lending contracts, the agreements that set out how much countries like Jamaica or Pakistan want to borrow and the terms they will pay.
It won't set your heart racing—but it could be a quiet financial revolution.
The innovation in play is integrating pre-agreed conditions—we call them triggers —under which borrowing governments could temporarily pause paying back loans. If these triggers were a severe storm, heat wave, or flooding, the holiday from repaying debt could free up serious cash for life-saving response and rebuilding. And if countries don't have this liquidity when they need it, the problem might spiral into insolvency. The theory is debt postponement creates compensating value for lenders by lowering the chance of post-disaster default or restructuring.
The case for pause clauses
Branding has done these clauses no favours. These were variously called hurricane clauses after the storm-linked triggers Barbados and Grenada used when they had to restructure their loans, climate resilient debt clauses at the COP event, climate-resilient debt instruments in earlier discussions, and state-contingent debt instruments in some of the finance literature.
Confused? We like something simple and descriptive. A pause clause does what it says on the tin: it enables countries to temporarily pause repayments when a pre-defined disaster hits. And pause clauses could be a big deal for three reasons: scale, politics, and urgency.
Scale. Low- and middle-income countries collectively owed the rest of the world US$8.7 trillion at the end of 2020 (this is lumpily spread out, with China alone for about a fourth). The net inflows of new borrowing to these countries were about US$913 billion that year alone. The amount countries repay (and so how much could be temporarily pivoted to disaster response) varies. But the scale of these liabilities in countries likely to be affected by disasters shows how much money could be put in play.
Politics. We should expect pause clauses to get a boost from the political moment at the intersection of debt and disaster risk. Governments of vulnerable countries are calling for an urgent solution to the carrying costs of debt. (The Centre’s research shows that most of the money lower-income economies needed in the wake of Covid came from new loans). Attention is coalescing around proposals by Barbados, which negotiated pause clauses as part of a restructuring agreement for its loans. The country's Bridgetown Initiative sets out ways to goose the multilateral system to help countries deal with climate change. It includes pause clauses as a core element.
Urgency. If your government budget is US$100 and you pay US$20 to service debt but can’t borrow more, then a 1-in-100 risk (one that we expect to see on average once every century) that costs US$80 would bankrupt you. That sounds rare. But there's a 50% chance –the flip of a coin—you'll see a 1-in-100 risk over 70 years. If factors like climate change raise this to 1-in-50, your insolvency risk becomes a coin flip in just 17 years. These risks can be managed to avoid the disaster. And these risks need to be planned for, blunting the effects of disasters that do happen.
So, pause clauses could be a public policy unicorn: impactful, saleable, and needed.
Pause clauses at COP
How did the panel do on setting out a vision for making pause clauses a reality? Here's our review of four key aspects: pricing, triggers, money out…and, let us just say, demographics.
Valuable, not free
Much is made of the fact that pause clauses can be designed to leave the underlying loan neutral in present value terms. The reasoning is that borrowers add missed payments into a loan’s outstanding balance, compensating lenders for missing a payment. Avinash Persaud joined the panel as an elder statesman of international finance and now a senior advisor to Mia Mottley, Barbados' Prime Minister. He noted, “[Net Present Value] neutral is the most important aspect of this instrument—creditors are no worse off if the event takes place.”
But as we’ve said before, present value isn’t the only feature in valuing fixed-income securities like debt. Pausing repayments pushes them into the future. That raises the loan's duration, or the exposure of a stream of repayments to changes in interest rates. And pausable debt doesn't eliminate credit risk, the chance of default, or late payment.
How all this shakes out depends on the shape of demand and supply curves for that debt. The market might conclude the lower risk of default is worth the added cost. Or the balance of these factors might lower demand, splitting the cost between lenders and borrowers based on the shape of those curves. But the general point remains true: delaying repayment is a valuable option, and valuable options aren't free.
Trigger warning
Benigno Benítez of the Inter-American Development Bank, and Alexi Chan of HSBC, focussed strongly on this issue, with Chan agreeing that “clarity on the trigger points is absolutely critical.”
This was a marginal point in the discussion but is the crux of the issue. As we’ve written before, adding pause clauses to loans makes them effectively insurance contracts. A trigger is the critical design choice. It determines who gets paid and when.
Countries need triggers that are matched to the risks they face. Barbados’ pause clause, for example, is triggered based on payouts from the Caribbean Catastrophe Risk Insurance Facility (CCRIF), a development insurer that offers governments policies that pay out quickly in response to events like severe tropical storms.
Piggybacking on existing payouts can be useful because triggers aren’t trivial to design. This meaty 400-page prospectus gives a flavour of the detail and rigor involved. Barbados’ solution may have been a clever compromise between the costs of designing a trigger from scratch, what the government actually wanted, and what lenders could live with.
In other cases, triggering based on these kinds of payouts would be a non-starter. The African Risk Capacity (ARC) Group, like CCRIF, is a development insurer owned and operated by African governments. Though a flood policy is in the works, ARC currently only sells cover for drought. If you're an African government whose expected costs are tied to flooding—or if you wanted to activate your pause clause for less or more severe events or another kind of risk entirely – triggering on ARC payouts won’t help.
Even where triggers are a good match for the risk in question, there is a chance that they won't be activated when countries or lenders expect them to – sometimes for opaque reasons. Mexico covered itself against disaster risk using catastrophe bonds. When Hurricane Odile made landfall in 2014, those bonds seemed sure to unleash US$50 million in rapid liquidity. But the money was never paid out. The storm's classification was downgraded after the fact, so the trigger condition wasn't met. (Incredibly, the downgrade was based on data from a hobbyist storm chaser at a Holiday Inn Express holding a pressure meter in a bathtub).
How to spend it
Benítez touched on this point, observing that when a disaster hits a country, “you don't know where to go; you don't know what to do.” He was speaking about getting financing—not directly, at least, what to do with it.
If you can address a large share of your lending with a pause clause, and if it works when you need it to, then well done! Now you have liquidity. But liquidity doesn't save lives, money, or time. Whatever the costs of pausable debt are, they must be measured against the benefits. Those depend on what we call money out: the simple idea that how you use the fiscal space freed up dictates the effectiveness of the response.
It’s obvious but bears repeating that for pause clauses to have an impact, mobilising finance isn’t enough in many settings. We have many examples of moments when liquidity isn’t tied to an effective plan to get that money out the door and situations where response doesn’t include people who don't have political access or clout. (They are, after all, more likely to be poor and vulnerable families). We need to think through how money is spent and who gets protected. Practically, this means making sure that ministries like health and education know what they will do when a disaster strikes and can spend money usefully and well if one does.
The manel
Benítez, Persaud, Chan, and Tim Reid of the UK's export finance outfit, brought a combination of public and private sector heft to the event. They’re also all men. We can critique the organisers for this choice and the participants for agreeing to it. But the point is serious because public policy can’t be a private club. It’s 2022, fellas! It’s on everyone who organises or participates in these events to point out exclusion and push us all to do better.
One thing the group didn't discuss is a tantalising agenda lurking below the surface. The conversation on pause clauses is about external debt. As we recently discussed, Pakistan, beset by terrible flooding, could badly use the US$16.9 billion that the IMF estimates the country will send to overseas lenders. But for many countries, large shares of lending are held locally. A pause on the US$66.9 billion Pakistan will pay to domestic lenders sure would be helpful, too.
A government’s liabilities are liabilities, whether they’re owed to a local bank or a foreign institution. So why the emphasis on external borrowing and the hopeful assumption of no impact on borrowing costs?
I think this is a clever way to stealthily socialise, or spread, the costs of disaster risk from vulnerable countries to richer lenders that can carry more of it by virtue of wealth and diversification. If the full price of flexibility isn't passed on to borrowers, then pause clauses could help forge a path—one of several we will need – for wealthier countries and institutions to help vulnerable countries better manage the costs and impacts of climate change. That won’t substitute for Loss and Damage payments now being discussed as the third pillar of climate change policy alongside adaptation and mitigation. But, like what this flexibility could have done for Pakistan, it sure would be helpful, too.