Compounding these overlapping development strains is mounting vulnerability to weather-related extreme events. Uruguay, for example, faced this year its worst drought for almost a century.
The global climate emergency demands immediate action and long term solutions. There is no room for small fixes and incremental solutions — the truth is we need transformative change. In that spirit, as co-chair of the Bank-Fund Development Committee, Uruguay first advanced the idea, in October 2021, that new international financing instruments should be developed to embed incentives for countries to contribute to global public goods, such as mitigating greenhouse gas emissions and nature conservation.
In particular, we proposed to link countries’ cost of borrowing from debt markets and multilateral loans with their success in reaching their environmental targets under the Paris Agreement. Countries that live up to their commitments and show good environmental performance should pay lower interest rates.
Transparency and accountability is vital
Countries, asset managers and financial institutions also need to be held accountable for their environmental pledges and actions.
This has at least three dimensions. First, countries need to implement their Paris Nationally Determined Contributions.
Second, the financing burden of achieving environmental goals should be fairly distributed between developed and developing countries, guided by the principle of “common but differentiated responsibilities”.
And third, investors and banks should fulfil a greater responsibility than simply optimising financial returns, by acting as stewards of the entire financial ecosystem.
In short, the provision of global public goods requires that all financial actors ‘walk the walk’. Announcements and commitments without credible action, transparency and accountability are only lofty words.
In October 2022, Uruguay took the leap on these tenets by issuing a sovereign sustainability-linked bond (SSLB) that directly linked its financing strategy and cost of capital to two key performance indicators: reducing the intensity of greenhouse gas emissions in the economy and preserving the area of native forests. The sustainability performance targets for these KPIs were goals Uruguay has set for 2025 in its first NDC.
This bond also included a breakthrough step-up and step-down mechanism, the first of its kind. Investors will reward the country with a lower interest rate if it overperforms on its environmental targets, while Uruguay will compensate investors if it fails to meet its environmental commitments, with a coupon step-up.
As part of the design of the SSLB, Uruguay has accelerated reporting of GHG emissions from biennial to annual frequency.
Uruguay is one of the world’s leading countries in sustainable electricity generation. It is now embarking on its second energy transition, to accelerate decarbonisation in hard-to-abate sectors, such as heavy transport — by promoting electric mobility, developing green hydrogen production and harnessing its abundant renewable energy sources, such as water, wind, and biomass.
As a food supplier to the growing world population, Uruguay intends to meet the challenge of boosting agricultural and livestock production, while reducing the intensity of methane emissions and preserving its unique grassland ecosystem and native forests.
By turning its NDC commitments into financially binding targets, Uruguay has enhanced its transparency and accountability on climate action and walked the walk.
New model for MDB loans
Building on the SSLB, during 2023 Uruguay has worked closely with the World Bank and the Inter-American Development Bank to develop a similar financial mechanism for multilateral development bank loans.
These loans will have step-down interest rates or reductions in principal to reward countries for achieving environmental targets. They will not include financial penalties if KPI targets are not met.
This week, we announced agreement with the World Bank on an innovative loan with these features. The interest rate will be reduced if Uruguay can lower the intensity of methane emissions from its livestock sector (which is an integral part of our economic fabric), beyond its Paris Agreement commitments.
This could result in saving up to $12.5m of interest during the life of the loan, which would be channelled to climate-smart agricultural projects in Uruguay. We are convinced that this is a clear and concrete incentive. The design of this loan involved strong coordination between the Ministry of Finance, the Ministry of Agriculture and Livestock and Ministry of the Environment.
The United Nations Development Programme will independently verify the environmental performance indicators, further ensuring robust reporting.
Uruguay would be the first country to benefit from this feature and the World Bank will seek to replicate and scale this approach to incentivise countries to provide global public goods.
Embedding these financial incentives could prove a significant way to improve the current paradigm at some MDBs, where middle and high-income countries have faced negative financial incentives, since their borrowing rates are increased as their GDP per capita rises.
In Uruguay’s view, it is not only MDBs’ balance sheets that should bear the cost of reducing interest for environmental overperformance — it should be shared by the wealthier advanced economies, which bear the responsibility for their past, emissions-intensive growth, which has led to the current climate crisis.
This would be a fair way in which developed countries could fulfil their pledges to deploy resources to support developing countries in meeting their climate goals.
In addressing climate change, financial innovation in sovereign funding is a critical ally. In particular, the power of positive financial incentives can be used to reward countries that pursue sustainable policies, empowering them to forge a greener recovery as part of their development strategy.