Debt-for-Climate Swaps: Analysis, Design, and Implementation

Abstract

INTERNATIONAL MONETARY FUND debt relief and fiscal adjustment on the one hand, and climate finance (loans, conditional grants, or grant/loan combinations) on the other hand. Using several instruments has the advantage of providing extra degrees of freedom. For example, debt relief can be used to restore debt sustainability where it is lacking, while subsidized finance can be calibrated to address climate externalities (when such finance supports emission mitigation) or to a moral argument (namely, that countries that historically generated, or are currently generating, most emissions should support adaptation investments in developing countries suffering from those emissions). The purpose of this paper is to establish whether there is an economic case for debt-climate swaps along other instruments, and if so, whether and how they should be promoted. The answer to the first question is a qualified yes. But as explained below, getting to this answer is less straightforward than might be expected, and understanding why this is the case helps avoid some pitfalls. The answer to the second question is that debt-climate swaps should be promoted ("scaled") so long as this strengthens climate finance more generally. Many actions that can be undertaken to support debt-climate swaps arguably meet this requirement because (1) policies that support debt swaps involving commercial debt involve much of the same monitoring and verification structures that also support climate-conditional lending instruments, and (2) the link to climate actions is likely to incentivize both bilateral official and commercial creditors to provide debt relief. The economic case for debt-climate swaps turns out to be sensitive to how such swaps are defined. If they are understood as any form of climate-conditional debt relief-including comprehensive debt restructurings in which the debtor commits to specific climate actions-then debt-climate swaps have an efficiency advantage over the "unbundled" alternatives (i.e., separately providing debt relief and subsidizing climate action) when climate actions have a significant impact on the solvency of the borrower. However, debt-climate swaps are generally understood more narrowly, as a type of conditional debt relief involving just one creditor or creditor class. Historically, debt-nature swaps-the predecessor of debt-climate swaps-have aimed to promote both specific investments and policy actions on the one hand and to provide some debt relief on the other, but not to provide comprehensive debt relief or restore debt sustainability in unsustainable debt cases. As shown in this paper, the economic case for debt-climate swaps defined as a conditional debt relief operation involving a limited set of creditors is narrow. When debt is sustainable, debt-climate swaps are generally a less efficient form of supporting climate action than conditional grants, because some of the debt relief generated by debt swaps will end up subsidizing non-participating creditors. When debt is unsustainable, debt swaps will generally be dominated by comprehensive debt restructuring operations (which could include climate conditionality). However, debt-climate swaps could make economic sense when (1) climate adaptation is efficient; and (2) fiscal risks are high, but debt is not necessarily unsustainable. In such cases, debtors could be better off with debt-climate swaps than with climate conditional grants because the former, but not the latter, can create fiscal space beyond what is needed to finance the climate investment. At the same time, debt swaps might be preferable to a comprehensive debt restructuring if the latter involves reputational costs or economic dislocations that debt swaps can avoid. In addition, there could be a pragmatic case for debt-climate swaps. Even when debtor countries are in principle be better off with concessional climate finance, deep debt relief, or some combination of both, these alternatives might not be available (or not in sufficient amounts). If debt-climate swaps can expand fiscal support for needed climate actions in such cases, they would be worth pursuing. The paper proceeds as follows. In the section that follows, we describe the basic structure of bilateral and tripartite debt-for-nature swaps and summarize their history. While well over 100 transactions of this type have occurred since the late 1980s, their average size and total volume has been relatively small. This is followed by an analysis of the economics of debt-climate swaps. The two final sections explain why debt/nature swaps have historically remained small and discuss policy options to meaningfully increase their scale.