Credit guarantees have been described as “mechanisms in which a third party—the guarantor—pledges to repay some or the entire loan amount to the lender in case of borrower defaults” (Gozzi & Schmukler, 2016). This reduces the lender’s expected credit losses, even if the probability of default remains unchanged, acting as a form of insurance against default. In other words, guarantees seek to augment the risk/return calculations of lenders to make project loans more attractive.
Guarantees in developing countries are most popular in structuring financing in which a multilateral development bank, bilateral development partner, or government entity will guarantee the repayment of a loan taken by a project developer. In essence, the guarantor indicates to the lender, usually a financial institution, that it will pay on behalf of the developer if the developer is unable to repay the loan. Multilateral development banks, bilateral development partners, and government entities undertake this risk to incentivize more lending and investment in sectors and countries in which lending from financial institutions is constrained and/or less common. In some instances, guarantees will be paired with technical assistance to further enhance the chances of repayment.
Guarantees could be especially crucial for adaptation projects that have less of a track record and are unfamiliar to investors, or adaptation projects that are predicted to have lower or more volatile returns on investment. In addition, credit guarantee schemes that make investment financing available and affordable for small and medium enterprises can be used to encourage investment in adaptation actions that help these enterprises prepare for weather disasters, drought, and rising sea levels. They can also provide emergency finance for small and medium enterprises impacted by climate-related disasters.
Current or potential adaptation-relevant sector applications:
- crop and food production – crop production (including agroforestry); livestock production; fisheries (marine, freshwater, and aquaculture); irrigation;
- ecological services and management – forest management (including afforestation and reforestation); wetlands; ecosystem and biodiversity protection, conservation, and enhancement;
- water supply (infrastructure) – water storage; water harvesting; water management;
- coastal and riverine protection and management – coastal defences or flood protection barriers; river flood protection measures;
- disaster risk reduction – early warning and observation systems;
- energy infrastructure – energy generation (including renewables);
- transport infrastructure;
- other built environment and infrastructure – urban development;
- social infrastructure – education; health facilities; and
- industry and manufacturing.
Additional insights:
- This is a mature instrument that first emerged in the 19th and early 20th centuries. It is widely used in over 100 countries.
Considerations for using credit guarantees:
- The project/initiative should be close to being “fundable” without the guarantee, to avoid situations in which the amount of the required guarantee is so large that no third party (e.g., a multilateral development bank) will offer it.
- Guarantees are normally held on guarantor balance sheets for the full amount and thus, from the perspective of the guarantor, are less popular than other instruments (i.e., loans) because they generate fewer fees and offer less collateral.
Adapted from the following sources:
Gozzi, J. C., & Schmukler, S. (2015, October 23). Public credit guarantees and access to finance. European Economy. https://european-economy.eu/leading-articles/public-credit-guarantees-and-access-to-finance/
International Institute for Sustainable Development & MAVA Fondation pour la Nature. (2020). Credit enhancement instruments for infrastructure. https://www.iisd.org/credit-enhancement-instruments/
Organisation for Economic Co-operation and Development. (n.d.). Facilitating access to finance: Discussion paper on credit guarantee schemes. https://www.oecd.org/global-relations/45324327.pdf
World Bank. (2022). Guidelines for integrating climate change mitigation and adaptation in public credit guarantee schemes for small and medium enterprises. World Bank Group. https://documents.worldbank.org/en/publication/documents-reports/documentdetail/099512111082215393/idu0ef1c33d00fa6c04e180991a0e47a751befcb