Climate factors' impact on a debtor's ability to honor its obligations has been recognized for over 4,000 years. It was the Code of Hammurabi in Mesopotamia that first mandated a deferral of principal repayment and cancellation of interest in a given year if a particular crop failed due to events outside the debtor's control.
In the modern legal systems, a broader notion of force majeure that would permit a non-performance by a debtor in exceptional circumstances became a well-established contract law principle in many jurisdictions, although it has never been included in standard bond terms and conditions. Soaring sovereign debt levels and heightened climate change risks, coupled with inflation and the still vividly felt impact of the COVID-19 pandemic, have pushed market participants to seek new approaches for handling obligations of debtors hit by climate shocks, especially in the sovereign space. One of the latest initiatives is climate resilience debt clauses ("CRDCs") developed and presented by Private Sector Working Group (the "PSWG") (chaired by the UK Treasury and comprised of the IMF, World Bank, G7, borrower countries, academics, as well as major banks and investment firms) in November 2022 during COP 27.
The underlying idea is not new, as "hurricane clauses" have already been included in the terms of bonds issued by both Barbados and Grenada as part of their debt restructurings, and in the most recent Barbados bonds issuance1. However, the scope of application of CRDCs, as envisaged by the PSWG, is much broader both in terms of the type of natural disasters covered and proposed countries which may benefit from CRDC. Given that all of the evidence points to increasing climate events affecting countries in every part of the world, the introduction of CRDCs creates an opportunity to hardwire fiscal relief for future events that are becoming increasingly inevitable.
CRDCs offer an "in-built" standardized sovereign debt deferral mechanism in the event of a pre-defined natural disaster leading to major financial losses. Specifically, the CRDCs provide for the deferral of a country's debt repayments for a pre-agreed period in the event of a severe climate shock or natural disaster with the twin aims of (i) avoiding a chaotic and lengthy debt restructuring process and/or payment default for a country already in crisis and (ii) preserving much needed FX liquidity to support disaster relief. The mechanics of the CRDCs are set out in the ICMA standardized term sheet2 and the published summary of PSWG work and discussions on the CRDCs (the "Summary")3.
CRDCs are designed to future-proof debt rather than provide immediate relief, although with the increasing number of stressed and distressed sovereigns either in the process of restructuring their debt or needing to in the future, it creates an opportunity to hard-wire these provisions in for future circumstances. While the idea of CRDCs is clearly a positive step, some issues may arise upon their application.
Focus on the CRDC Mechanics
The Summary proposes a non-exhaustive list of in-scope countries4 which may include CRDCs in their bond issuance terms. The list includes countries eligible for debt relief under the G-20 Common Framework, as well as some smaller, climate-vulnerable countries. While other countries can seek to include CRDCs in their debt instruments, it remains to be seen whether investors will accept this for those countries which are considered to be more economically resilient to climate shocks and/or less exposed to climate risks.
The CRDCs can be triggered by defined climate shocks and natural disasters, such as tropical cyclones/hurricanes, earthquakes, tsunamis, drought, flood/excess rainfall and epidemics/pandemics. They effectively function as insurance contracts, providing a sovereign with automatic debt relief when the CRDCs are triggered. It remains to be seen whether the list of triggering events could or would over time be expanded to cover other risks such as wars or human-created disasters of a high magnitude.
An objective and independently verifiable trigger mechanism is required to determine when an event of sufficient magnitude takes place to engage the CRDC deferral. The PSWG clearly advocates for parametric based triggers (i.e. triggers backed up by physical measurements or scientific data rather than self-declared by a sovereign, or even an international body). Two options of the parametric trigger mechanisms have been suggested by the PSWG: (i) existing regional risk pools5 and/or (ii) bespoke parametric triggers that will need to be designed and adapted for each country.
The Summary suggests that CRDCs should provide for deferral of both principal and interest payments for a period of one to two years, with one year as standard and two years as the maximum deferral period. The number of possible deferrals during the life of the bond should be between one and three times, subject to negotiation at the issuance of the bond and depending on the maturity of the debt instrument. While both the Summary and the term sheet are flexible on this point, it is proposed that the deferred amounts be capitalized and repaid (i) over a set period of time prior to final maturity of the instrument, (ii) pro rata over the remaining life of the instrument, or (iii) at final maturity. Quite importantly, the PSWG did not advocate for extension of maturity of affected instruments (although recognized, the diminished value of CRDCs if a trigger were to occur towards the end of the life of a particular bond); however, it is likely to be a negotiation point in practice as extension of maturity is a common feature in sovereign restructurings.
Lastly, the CRDCs' main principle is that deferrals should be net present value ("NPV") neutral and, therefore, more palatable to investors. While the CRDC does not go into detail on this point, since the deferral is intended to be NPV neutral, it presumably means that interest will accrue at contractual rates on all deferred amounts, both on deferred principal and deferred interest. Again, the Summary does not clarify this; however, presumably the NPV formula should be determined at the issuance rather than at the time of deferral. In any case, ensuring that deferrals are NPV neutral will not be straightforward to assess, particularly where multiple series of CRDC bonds may have their provisions triggered.
Implementation of CRDCs raises a number of legal and commercial considerations for both issuers and investors
Investors' perception: While the CRDCs are beneficial for issuers, investors may have differing views, even amongst themselves. From one perspective, the CRDCs could be viewed as pushing climate shock risks onto investors, introducing an element of uncertainty into bond payment terms and making the bond more difficult to price. In addition, the CRDCs might be seen to be creating different categories or classes of sovereign debt as further discussed below. On the other hand, assuming (i) the NPV-neutral principle is applied and (ii) the CRDCs are proposed to be included universally across all outstanding bonds of the sovereign (and perhaps even loans advanced by private creditors), investors could see the CRDCs as a "win-win" scenario. From this perspective, a deferral of payments in an organized and relatively foreseeable manner will benefit investors by reducing the risks of disorderly default and an unpredictable debt restructuring process - as well as save the time and costs associated with a negotiated debt restructuring.
Pricing implications: The PSWG believes that the CRDCs would likely have no or minimal pricing impact, provided they are structured as NPV neutral. This is primarily because the creditors should be expected to already price the risk of severe climate shocks into the bond at the outset (i.e. knowing what climate shocks a country is prone to, the creditors would factor the relevant risks into the price). Accordingly, given that CRDCs are designed to reduce the likelihood of default when these risks materialize, the inclusion of CRDCs could even have a positive impact on pricing as compared to bonds lacking such clauses.
However, there is currently insufficient evidence to support the PSWG's view, apart from the recent Blue Bond issuance by Barbados, where an embedded "hurricane clause" apparently did not have any noticeable effect on the pricing6. It remains to be seen how CRDCs will be perceived by investors. Indeed, it may even not be surprising if, at least in the early stages of the introduction of CRDCs, there will be investor expectations of a compensatory premium7. Any meaningful pricing impact will need to be carefully considered by issuers as not to outweigh the potential benefits of the CRDCs.
More generally, and as discussed above, the deferral of debt under the CRDCs is supposed to be NPV-neutral and so, whilst it would create fiscal space during the suspension period, it does not relieve the country of the obligation to repay the debt in the future. At the same time (and unlike in the case of the DSSI8 mechanism implemented to address the COVID-19 challenges) there does not appear to be a requirement to use created fiscal space to specifically respond to the climate crisis. Given the lack of any contractual direction related to the fiscal relief or any limit on further borrowing while the suspension provisions are operative, the impact of the disaster could in fact mean deferred bonds are "kicked down the road" and the issuer suffers more immediate fiscal distress at a time when the bonds are already deferred, potentially impacting later recovery rates.
Equality of treatment of pre- and post-CRDCs bondholders: While theoretically possible to introduce the CRDCs into the terms of outstanding "legacy" bonds by way of a consent solicitation, this process would no doubt be complex and costly. In addition, there may be limited investor appetite to include these provisions in existing bonds, or at a price point that is palatable to issuers. Therefore, issuers are likely to introduce the CRDCs only into their new bonds or as outstanding debt matures (as was the case with the introduction of ICMA aggregated collective action clauses). This means there will be a period during which legacy non-CRDCs bonds will co-exist with the new CRDC-bonds. Possibly, more likely, the fact that an issuer's existing bonds do not contain the CRDC provisions will become a significant market impediment to implementing them in any new issuances. However, if issuers do start adopting CRDC provisions, following the occurrence of a triggering event for the CRDCs during this transitional period, two possible scenarios may be envisaged in this case:
- Pre-restructuring: Investors holding the CRDC bonds will see coupon and principal payments deferred, while the issuer might decide to stay current on its payments to the holders of the old non-CRDC bonds. In this scenario, only new CRDC bondholders will be contributing to the preservation of liquidity and financial stability of the issuer. Given the negative cash flow implications for CRDC bondholders, there could well be a material negative impact on pricing of the CRDC bonds in the secondary market compared to non-CRDC bonds, particularly if the impact of the climate event is worse than thought or the country has to borrow more to deal with the impact.
- During restructuring: If the majority of the issuer's debt stock does not have CRDCs, it is unlikely that the debt deferral achieved pursuant to the new bonds with CRDCs will save the issuer from the need for a broader debt restructuring, depending of course on the severity of the climate event. In this case, payment or other defaults on non-CRDC bonds will likely cross-default the bonds with the CRDCs, thereby bringing both non-CRDC and CRCD bond creditors to negotiation table despite deferral. In addition, if the debt restructuring happens after the CRDCs have been triggered, but before the end of the deferral period, the holders of CRDC bonds might argue for special treatment in restructuring, given their existing support of the issuer. On this point, the PSWG supports the view that the debt with a CRDC should not benefit from any contractual seniority over non-CRDC debt and that it is a matter of negotiation between the sovereign and its creditors to decide on the treatment of such debt on case-by-case basis. In practice, in the context of a broader restructuring, it most likely means that the CRDC bondholders will end up being treated in the same way as other bondholders.9
These two scenarios suggest that investors will likely be cautious about accepting CRDCs in the bonds of issuers with significant non-CRDCs bond stock outstanding. This is why, arguably, the best moment to integrate the CRDCs could be a restructuring itself, where all legacy bonds can be replaced with new bonds with the CRDCs.10
Unintended default consequences: There is often a lack of consistency in terminology of sovereign's bonds and other financial arrangements. In particular, there are examples of sovereign financial agreements which make it an event of default if the relevant country discontinues its payments to creditors or seeks a debt deferral. The sovereigns that look to integrate the CRDCs in their bonds should carefully examine their legacy debt instruments to make sure that activation of the CRDC would not unintentionally trigger an event of default under any of its debt instruments (both bonds and loans). Otherwise, activation of CRDC in the bonds may lead to a default under another financial agreement and, therefore, provoke a "domino effect" of potential cross-defaults across multiple agreements. This is especially important if the CRDC trigger is drafted as automatic rather than an option to defer on the part of the issuer.
CRDCs beyond bonds: While the CRDCs are designed for private bond and loan creditors, there is nothing in principle that would prevent using the CRDCs in financing contracts with official and even multilateral creditors. Indeed, introducing CRDCs into a broader array of external financing instruments would be beneficial as it would magnify the benefit of debt deferrals following a triggering event and ensure comparable treatment of a broader array of sovereign creditors. The reaction of the broader official sector is yet to be seen, but it is encouraging that UK Export Finance11 and the Inter-American Development Bank12 have already announced their willingness to integrate these clauses into their loans.
When applied universally across a country's debt stock, the CRDCs can be a powerful tool in sovereign debt management. However, it will be some time before they become a material part of any countries debt portfolio until existing bonds mature, are refinanced or restructured. At the same time, as with all such developments, they do create an opportunity for issuers to proactively look to manage future shocks and, given the direction of travel of climate change, anything can happen! As we saw in the Ukraine restructuring, during the 2015 restructuring Ukraine included collective action clauses ("CACs") across all restructured bonds and then subsequent issues. Later on the CACs were also included in the guaranteed deals for two state-owned entities – Ukrnergo and Ukravtodor. No one could have thought that Ukraine would have been invaded and would put to use the collective action clause provisions in 2022 to obtain fiscal relief across all bond debt, including guaranteed debt. Future proofing can be put to great effect.
It remains to be seen whether private and official sector creditors will support inclusion of the CRDCs in practice. However, the current dynamics in the emerging markets sovereign debt space, and looming climate shock risks, seem to be making a good case for inclusion of CRDCs.
1 Barbados Issues 1st Pandemic-Protected Bond, Which Also Covers Natural Disasters (insurancejournal.com)
2 Indicative Voluntary Heads Of Terms - Climate Resilient Debt Instruments
3 Private Sector Working Group –Climate Resilient Debt Clauses (CRDCs) Chair's Summary
4 Annex B of the Summary
5 These are joint reserve funds that provide their member countries with affordable parametric insurance solutions against disasters and climate shocks and that retain first losses and transfer excess losses to the international reinsurance markets on competitive terms. A list of pre-existing triggers from the regional risk pools/other organisations is set out in Annex A of the Summary
6 Introducing Hurricane Clauses: Lessons from Grenada's recent experience, pp. 16-17 Climate disaster relief clauses could go mainstream in EM bonds
7 Introducing Hurricane Clauses.PDF
8 Debt service suspension initiative ("DSSI") announced by the G20 in April 2020 in response to the COVID-19 pandemic.
9 While unlikely, it might also work in the opposite direction during the restructuring negotiations: CRDCs terms on some existing bonds may show a direction of travel for restructuring terms across the rest of the bond instruments of the country
10 The Role of State-Contingent Debt Instruments in Sovereign Debt Restructurings by the IMF, p.6
11 UK Export Finance launches new debt solution to help developing countries with climate shocks - GOV.UK
12 IADB to roll out hurricane clauses as small state pleas gain traction
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