The Evolution of CRDCs
Climate risk insurance has a long history, including as a potential mechanism to finance adaptation needs. Incorporating climate risk into sovereign debt contracts has only started to take root more recently, but builds on the fundamental premise that channeling scarce financial resources in response to a crisis can improve both human and economic outcomes, particularly in vulnerable countries. Through the work of the Private Sector Working Group (PSWG), and its chair, the UK Treasury, this concept was actualized in 2022 in a model term sheet for Climate Resilient Debt Clauses (CRDCs), which allow for time-bound debt service deferral in response to specific and measurable catastrophic events.
The public sector began to adopt CRDCs based on the PSWG’s work. UK Export Finance announced it would offer CRDCs in direct sovereign loans in November 2022, with the Inter-American Development Bank (IDB) following suit shortly thereafter (e.g., its principal payment option (PPO) was included in loan contracts in February 2023). The World Bank announced an expanded disaster response toolkit in June 2023, which included CRDC options on new loans. That toolkit was eventually expanded to include all loans—both new and existing—to eligible countries in late 2023.
Risks and Opportunities for Private Investors
A growing chorus of countries and stakeholders is now calling on the private sector to expand CRDC adoption in debt contracts, given the frequency and magnitude of global economic shocks since 2020, the deterioration in public finances that those shocks have amplified, and the accelerating need to mitigate climate-related risks.
Can the private sector meet this call?
At first glance, contractual debt deferrals may seem inconsistent with risk/return considerations that define the typical client/manager relationship. But if CRDCs can be designed to mitigate negative total return impacts—or can be shown to clearly exhibit ''risk-reductive'' characteristics—their adoption by private-sector investors would seem to align with fiduciary duties.
To satisfy the total return condition, the PSWG provided a set of indicative terms that attempt to maintain net-present-value (NPV) neutrality under a trigger event. The World Bank's framework, with features like one-time activation per loan life, deferral not cancellation and a maximum two-year deferral period, broadly adheres to PSWG recommendations.
However, preserving NPV neutrality requires the World Bank to limit deferrals relative to loan maturity (deferrals cannot happen within five years of final maturity), and this potentially blunts their impact. When viewed through the lens of traditional bond structures featuring bullet (or soft-bullet) maturities, this challenge becomes more acute.
A second consideration, and a greater potential structural challenge, relates to the deferral of repayments and the risk of default either: (1) before repayment has started or (2) during the repayment period prior to final maturity. NPV neutrality under a default scenario remains broadly intact for an official sector lender—such as the World Bank—given its ''preferred creditor status'' (PCS). But from the perspective of bondholders, who do not benefit from PCS, and therefore incur incremental credit risk (and NPV losses) with any extension of repayment terms, NPV neutrality becomes more difficult. Ultimately, this may lead investors to seek incremental credit spread for CRDC-enhanced bonds, making CRDCs look a bit more like an insurance policy for issuers, rather than a costless option.
There’s a potential countervailing force against higher credit spreads, though, in the form of CRDCs' ''risk-reductive'' properties. Debt deferrals can contribute to ''risk reduction'' by keeping real interest rates low (relative to a non-deferral scenario), increasing fiscal space for countercyclical measures, and helping preserve key external buffers.
CRDCs can contribute to ''risk reduction'' in more indirect ways, as well. For example, the targeted deployment of relief can help underpin social sustainability via the rapid reconstruction of schools, provisions of nutrition support and efficient delivery of clean water. But determining the ex-ante likelihood of material impact requires both debt transparency—a higher percentage of CRDCs in the country’s debt stock will correlate with more capacity for relief—as well as careful assessment of the issuer’s governance context and state capacity. Neither challenge is necessarily easy to surmount; investors will need to make assessments on a case-by-case basis.
Summary and Outlook
Well-designed CRDCs can align debt deferrals with traditional conceptions of an asset manager's fiduciary duty by minimizing potential NPV effects and mitigating key risks. We believe the challenges in CRDC implementation principally relate to instrument design and the quantification of direct and indirect impacts on economic, institutional and social factors. Larger critical questions remain, including how to treat deferred amounts in an eventual restructuring, how to improve debt transparency and how to safeguard against governance shortfalls and the variability of state capacity over time.
While not without challenges, we believe CRDCs offer an avenue for integrating climate resilience into sovereign financing. With refinement, acceptance and adoption, they can play a vital role in enhancing sustainability of public finances and positive human outcomes in eligible economies, within the bounds of fiduciary obligations. Western Asset will continue to work with multilateral development banks and other public sector entities to articulate and advance the types of structural features that can facilitate greater private sector adoption of CRDCs.