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The increasing frequency, intensity, and unpredictability of climate crises have significant implications for the sustainability of sovereign debt due to the impacts on debtors’ repayment abilities. 

As these effects on trade activity intensify, disruptions will increasingly expose countries to the conflicting imperatives of debt service repayments and necessary spending to respond to and recover from said disasters. In recognition of this new operating environment, Climate Resilient Debt Clauses (CRDCs) are a novel financial instrument proposed to mitigate these challenges. 

Overview: Climate Resilient Debt Clauses (CRDCs) 

CRDCs have been formulated by a group led by the UK Export Finance (UKEF) and Treasury-chaired Private Sector Working Group (PSWG). They seek to incorporate considerations of force majeure climate risk into sovereign debt contracts to insulate trade finance from new liquidity concerns presented by the increasing prevalence of negative climate events. 

Offered in direct sovereign lending operations, CRDCs assist borrowers’ abilities to respond to environmental crises through the suspension of debt obligations on a cost-neutral basis for up to two years, providing the fiscal space necessary to respond to environmental crises whilst decreasing default risk exposure. 

The clauses allow least developed countries (LDCs) and small island developing states (SIDS) to defer debt repayments following predefined climate shocks or natural disasters, including cyclones, droughts, earthquakes, flooding, pandemics, or tsunamis. 

Such measures acknowledge the increasing prevalence of environmental crises whilst bolstering the financial resilience of vulnerable countries, allowing them to prioritise responses to shocks over debt servicing. This reflects increasing attempts to embed the effects of climate change into trade finance. 

CRDCs can be seen as an extension of similar concepts such as “hurricane/pause clauses” which have previously been incorporated into the terms of bonds issued by Barbados. However, CRDCs constitute a broader scope of application in terms of the environmental crises covered, as well as the eligible countries. 

Due to the increasing frequency and scope of disruptive climate events, CRDCs represent a welcome introduction of hardcoded fiscal relief mechanisms into trade finance instruments. 

The PSWG proposes CRDCs as contractual provisions included in sovereign debt instruments to mitigate climate-related risks faced by both borrowers and lenders. Similar to insurance contracts, they would provide sovereigns with automatic debt relief/deferral mechanisms in the wake of such events. 

This would allow the borrower reasonable scope to recover from the events to a position where it is able to honour the contract, incorporating climate risk considerations into traditional processes of debt issuance and liquidity management. 

Impact on sovereign debt, international trade and trade finance 

The implications of CRDCs for sovereign debt are significant. Two principal effects of such measures include the introduction of mechanisms that prevent lengthy debt restructuring processes and potential default for countries already distressed by climate disasters, as well as retaining critical foreign exchange liquidity to be directed towards relief efforts. 

Further, CRDCs could see credit rating agencies adjusting sovereign ratings according to countries’ exposure and ability to manage climate risks.

Implications of CRDCs for lenders include the introduction of less certain time frames regarding debt repayment, as borrowers are protected from originally agreed repayment schedules in the event of negative climate events. This could, as a result, lead to heightened due diligence and risk assessment accompanying sovereign debt instruments. 

The foremost impact of CRDCs on international trade is the inclusion of climate risk assessments and premiums accompanying trade finance decisions made by institutions. This could affect both the costs of financing and insurance for traders. 

CRDCs also signify the emergence of novel financial products incorporating climate risk into trade finance and risk insurance. These new considerations demonstrate efforts to increase trade resilience through the reduction of climate-related financial constraints, as well as incentivising the establishment of more secure supply chains to ensure trade facilitation. 

Challenges and outlook 

Whilst the development and formulation of CRDCs is a welcome recognition of the new operating environment for trade due to climate risks, several challenges are evident. 

The foremost concern is the issue of both defining and quantifying climate risks into contracts in a manner palatable for both lenders and borrowers. 

The complexity of determining and agreeing upon appropriate “trigger points” for debt repayment suspension is likely to diverge between lenders and borrowers. 

This entails a balancing act between incentivising climate resilience and adaptation practices, whilst preventing excessive financial burdens falling on poorer countries or reducing lenders’ willingness to provide trade finance. 

Whilst CRDCs appear most beneficial for issuers, the effects for lenders are less clear. As CRDCs are likely to increase financing costs, as discussed above, climate risk appears to be shifted to lenders. 

Moreover, when coupled with the increased uncertainty of bond payment terms, pricing may become more complex. Another related effect may be the establishment of different categories of sovereign debt according to countries’ potential climate risk exposure. 

However, the PSWG stresses that deferrals should be net present value (NPV) neutral, to the benefit of lenders. It is argued that this ensures the aforementioned potential price impacts are mitigated, as lenders are likely to price in climate risks to bonds. 

This additionally reduces the likelihood of default when borrowers experience these climate shocks, meaning there is potential for a positive effect on prices relative to bond issuances without similar clauses. 

Nevertheless, the evidence from “hurricane clauses” that could be used to inform such determinations remains unclear, and there is a strong case to expect creditors to demand initial compensatory premiums for the inclusion of CRDCs, potentially decreasing financing availability and trade activity. 

However, lenders, and by extension trade activity, stand to benefit from the reduced likelihood of chaotic defaults associated with unpredictable climate-related debt restructuring processes. 

This presents a rationale for expanded operations of CRDCs. If increasingly available in both the private and multilateral space, having CRDCs in a wide array of external financing instruments would likely afford more comparable treatment to a wider group of sovereigns, increasing liquidity and introducing greater certainty into trade activity. 

CRDCs mark a necessary movement towards the incorporation of climate risk into sovereign debt management and trade finance practices. They have the potential to increase climate resilience and provide the scope to affected countries to prioritise responses to climate disasters. 

If executed effectively, CRDCs could play a vital role in promoting financial stability, sustainable economic development, facilitating international trade, and strengthening global resilience in the face of climate change.