The Impact of Credit on Credit Quality in Emerging Markets

While many countries are gearing up to combat climate change, financing these large projects may pose a challenge. 

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Simon Waever: Welcome to Thoughts on the Market. I'm Simon Waever, Morgan Stanley's Global Head of EM Sovereign Credit Strategy. 

Carolyn Campbell: And I'm Carolyn Campbell, Head of Morgan Stanley's ESG Fixed-Income Research. 

Simon Waever: On this special episode of the podcast, we'll discuss the credit impact of climate finance in emerging markets. 

Carolyn Campbell: It's Monday, June 26, at 10 a.m. in New York. 

Simon Waever: We believe that the ramp up in climate mitigation and adaptation financing from developed markets can be a key credit positive for emerging market countries, if executed correctly. The amounts of financing required in low and middle income countries to adapt to and mitigate the effects of climate change is likely to be over 1 trillion per year by 2030. Carolyn, let's start with that 1 trillion figure and the scale of the challenge. How are low and middle income countries positioned for climate change? 

Carolyn Campbell: So when we think about climate change, there's two sides of the coin. There's climate change mitigation, which is everything that will slow or prevent the temperature from rising more than a degree and a half above pre-industrial levels, which is the goal of the Paris Agreement. And on the other side, we've got adaptation, which is financing projects that will build resiliency to physical risks, for example, or to help transform the economy away from dependency on industries that are likely to be harmed by climate change. So on the mitigation side, we've seen energy consumption in emerging markets steadily rise over the past couple of decades as their economies continue to develop and their populations grow often at faster rates than we see in developed countries. Now, while we've seen absolute levels of renewable energy usage tick up in these countries, on a proportional basis we're not seeing a material change, and that's because of this absolute rise in energy usage overall. So that leaves a lot of scope for the expansion of low carbon technologies such as wind and solar and so on, and that's obviously very expensive. On the adaptation side, a lot of the emerging markets are located in areas that will bear the brunt of climate change, whether that's through worsening storms or increased droughts, rising sea levels and so on, and they don't have the same infrastructure or economic diversity to deal with these climate impacts. So it's an immense amount of capital required for both types of projects, as you said, likely to be greater than a trillion dollars per year by 2030. And so far, developed markets have actually come up short on their promise to deliver $100 billion annually in climate finance. So all this being said, I think it begs the question how will they pay for it without incurring an unsustainable debt load? 

Simon Waever: Yep, that is the question. And I would say the good news so far is that more and more sources are being made available with some being more targeted than others. The first main source is loans. So these generally come from either bilateral agreements, so from other sovereigns, or from multilateral institutions such as the World Bank. An example of a new facility being made available just in the past year is the resilience and sustainability trust from the IMF, which has now already made disbursements to six countries with more on the way. And the advantage of this facility, compared to others from the IMF, is that it comes at a lower cost and a longer maturity. The second main source is the capital markets. The instruments people will be most familiar with here are the labeled bonds, such as green, sustainable or even sustainability linked bonds that see their coupons change depending on various targets being met. But today, there's also an increasing use of the debt for nature swaps such as used in Belize and Ecuador recently and the introduction of climate resilient debt clauses. What this means is that if an adverse event happens like a hurricane, etc., there can be an automatic pause or delay in payments, which in theory should help both the country and creditors because you avoid going into any distress situation on the bonds. But another interesting avenue that's opened up in the last decade or so has been to raise financing by turning carbon into a commodity, whether as a voluntary carbon offset or through direct carbon pricing. Carolyn, how would those be used? 

Carolyn Campbell: Yeah. So on the voluntary carbon side, a credit represents one tonne of carbon reduced, removed or avoided, and a lot of emerging markets are able to sell these credits, not necessarily at the sovereign level directly, but in some cases, yes, to developed markets, either to the sovereigns or to corporates who are willing to buy those emissions to offset against their own. And so those projects can be anything related to forest preservation or other natural capital projects or linked to renewable energy deployment and so on, and that can help raise the financing to get those projects off the ground. On the other side, there's direct carbon pricing, which is compulsory and includes things like Europe's emissions trading scheme or commonly thought of as cap and trade programs. There's also carbon taxes which raise revenue from businesses that emit and tax every tonne of carbon emitted. And direct carbon pricing is really important because the revenues raised from these schemes don't actually have to be applied to green projects so they can further other local development priorities. Lots of interesting avenues, but not every avenue will be suitable for every country, there's a wide range of emerging markets out there. But let's assume for a moment that all the financing will actually be deployed at a sufficient scale over the near and medium term. What does that mean for the credit quality of these recipient nations? 

Simon Waever: Yes. So as we've actually covered before on this podcast, developing countries are facing significant financing challenges. And by that I mean they've been used to getting a lot of cheap financing over the last ten years, that's no longer available. So if the result is that more financing is being made available, that is credit positive, especially if it then also comes at lower financing costs and with longer maturities. I would of course say that the magnitude of the impact is going to differ by country, and overall, I would highlight the lower rates of countries as benefiting the most. And just to give two examples of countries that have benefited recently, one is Kenya. They've been under pressure in the markets because they have a 2 billion maturity next year that people were questioning where they were going to get the funds to repay it. Now, through the help of the IMF and their new Resilience Sustainability Trust facility, they've seen larger disbursements and the markets have traded much better. The other example is Ecuador that was able to complete a debt for nature swap that in the end resulted in lower debt burden, fewer bonds outstanding, and at the same time helping conserve the Marine area in Ecuador. But actually, all this is a lot about just a near-term impact. The longer term impacts will eventually turn out to be even more important, I would think. Carolyn, could you give some examples of this? 

Carolyn Campbell: So on the one side, we've got climate resiliency improvements that can materialize in ways like reduced costs in the face of acute weather events or economic resiliency to slow onset adverse climate events, we mentioned droughts earlier. Another very important avenue is fundamental improvements via the renewable energy transition. So deployment of renewable energy might increase overall levels of electrification in the country, which can boost productivity and so on. If we think about South Africa as an example, South Africa has struggled with lower productivity because of its dependency on aging coal power plants. So there's a real case to be made about the benefits of renewable energy deployment there in terms of economic productivity. So all this sounds great, but there are some real execution risks for this quantity of financing and getting these projects off the ground. Simon can you tell us what that might mean for these countries? 

Simon Waever: Right. That's a key topic, and it may be that there's actually insufficient climate financing, and that would at best mean that you have other suboptimal financing sources used. But at worst, that we see scaled back, delayed or even canceled climate projects. And actually the risk of this happening isn't low, so it's something we do need to watch. And then another risk is that the debt dispersed but used in the wrong places or used inefficiently, because then you end up with the countries with higher leverage that doesn't actually see the benefits. 

Simon Waever: But with that, Thanks, Carolyn. Thanks for taking the time to talk. 

Carolyn Campbell: Great speaking with you, Simon. 

Simon Waever: And thanks to everyone for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.