The Global South’s vicious cycle of climate debt

It has been said that opportunity and risk come in pairs, with development challenges spurring entrepreneurs and investors to find income-generating solutions to crises. But today, in our anthropogenic world, where people are increasingly feeling the effects of climate change, the correlation between risk and reward is becoming much more tangible.

Consider, too, that many investors (both sovereigns and corporates) that are positioned to capitalise on opportunities in combating climate risk are the same ones that contributed the most to the climate crisis, polluting their way to prosperity. Indeed, by turning climate finance provision for developing countries into a business opportunity, the parties most to blame for the climate catastrophe are (again) reaping the profits.

That is the disheartening truth of the matter; efforts to tackle the escalating climate crisis exacerbate long-running macroeconomic management and debt sustainability challenges in the Global South, especially in Africa. Emerging and developing market economies have been pushed into a nefarious debt trap, taking on financing to combat the effects of climate change at prohibitively high interest rates, which sharply increase debt servicing costs. More will fall into debt distress.

More must be done at the global level to promote the principles of climate justice enshrined almost a decade ago in the 2015 Paris Agreement and equalise access to affordable long-term climate financing. In the absence of such reforms, the additional costs associated with combating climate change will further exacerbate the debt-climate trade-off and undermine the transition toward a carbon-neutral economy in the Global South.

Nearly 60% of the developing economies most vulnerable to climate change are also at considerable risk of fiscal crisis. This growing and daunting intersection of climate and debt crisis includes several African countries, some of which have already defaulted on their external debt.

A recent analysis of UN and OECD climate finance data has found that programmes funded by advanced economies – those that, historically, are most responsible for the world’s high levels of pollution, accounting for more than three-quarters of cumulative greenhouse gas emissions – are funnelling billions of dollars back to these rich countries.

More than two-thirds of climate financing extended by these wealthy, industrialised countries to middle-income countries between 2015 and 2020 – the most recent years for which data are available – was loaned at market rates to secure high returns, despite the latter already contending with shrinking fiscal space as a result of default-driven borrowing rates which dramatically inflate their debt-servicing costs.

In that five-year period, France – which disbursed 90% of its bilateral climate financing support to developing countries through loans, while grants comprised only 4.9% of its climate finance contributions – received some of the highest returns. Japan disbursed 79% of its climate-financing support as loans, against just 6% through grants. Taken together, the top four climate finance contributors – France, Japan, Germany and the United States – have extended more than 70% of their climate-financing support to developing countries in the form of loans at market-rate interest.

Growth-crushing conditionalities

The analysis also highlighted how the growth-crushing, fiscally-constraining features of the current model of climate finance provision have long undermined sustainable development in recipient countries and could undercut their transition toward carbon neutrality. The stringent, conditional nature of the climate financing extended by wealthy countries in the Global North applies to loans at market rates as well as to grants. In both cases, recipient countries are required to hire or purchase materials from companies in the lending countries and rely primarily on consultants and contractors from these countries.

US entities received at least 80% of the US conditional climate grants, or around $2.4bn. Similarly, the 2022 annual report of the Agence Française de Développement – France’s development agency – stated that more than 71% of all projects it funded that year involved “at least one French economic actor”, and generated €2bn in “economic benefits” for these parties.

Aid that is tied to the exports of a particular country is more expensive and tends to drain the scarce foreign reserves of recipient countries. It is generally agreed that recipient countries will incur additional costs of up to 30% if aid is tied. For low-income countries which are more exposed to the “original sin” of having to borrow in foreign currency, exchange risks could further increase the fiscal incidence of these additional costs – their impact on society.

For these reasons, the OECD had recommended moving away from tied aid to allow recipient countries to draw on international competitive bidding to defray the costs. The current model of climate finance provision perpetuates the income gap between developed and developing economies. Instead of building capacity for sustainable development and prioritising technology transfer to enhance resilience, aid has been designed to advance the geopolitical and economic interests of donor countries.

Bane of economic development

The combination of tied aid and default-driven borrowing rates pushes recipient countries into a debt trap that sustains their unhealthy commodity dependence. Across Africa, which remains the most commodity-dependent region of the world – with a median value of commodity exports of 90% of all merchandise exports – that model has been the bane of economic development for decades, exacerbating external and internal imbalances at the root of recurrent balance of payment crises.

That asymmetric relationship greatly benefits donor countries and foreign investors. Moreover, it clearly defies the lessons that the international community has learned from decades of development assistance. One study published by the IMF has shown that tied aid has been used to alleviate the balance of payments pressure of aid transfer and expand employment opportunities in donor countries, especially in export-heavy industries, at the expense of low-income recipient countries.

Over the last several decades, aid with stringent hiring conditions has stifled the growth of local companies. In today’s climate change era, conditional funding will undermine prospects for technology transfer, which is critical for nurturing green industries and local expertise, fostering recipient countries’ transition toward carbon neutrality and bolstering sustainable development.

Without reforms to the international financial system that equalise access to affordable, patient capital and move away from tied aid, the transition toward a globally-synchronised, net-zero transition and progress toward the sustainable development goals (SDGs) will remain elusive.

High returns on climate investments in the Global South incentivise investors to channel more resources to emerging economies – but climate finance shouldn’t be allowed to trigger new instances of debt distress.

The financing model, as currently constituted, clearly perpetuates the flow of scarce resources from the Global South to the Global North, exacerbating the short-term challenges of mitigating the debt-climate trade-off in the former and undermining convergence between the two parties in the medium and long term.

Fortunately, the principles of “climate justice” and “equity and common but differentiated responsibilities and capabilities” between nations enshrined in the Paris Agreement provide a framework to grapple with climate change without widening the global prosperity gap or heightening the risk of debt crisis in the Global South.

Until these principles are applied to the global distribution of capital, the current model of climate finance provision will continue to be seen as one that is designed – to paraphrase Andrés Mogro, the former climate negotiator for the G77 bloc of developing countries and China – by arsonists who “set a building on fire and then sell fire extinguishers outside”.

The path we are presently treading will only exacerbate the debt-climate trade-off and undermine progress towards the SDGs in the most vulnerable countries, creating a rift between the Global South and the Global North. It is a risk factor that we cannot afford to ignore any further. If we do, there’ll soon be far too few fire extinguishers to save us.