An Economic Analysis of Debt-for-Climate Swaps

This paper examines the economic case for debt-for-climate swaps: partial debt relief in return for climate investment/policies by the debtor country. As a form of fiscal support for climate investments, debt swaps are generally dominated by conditional grants. As a way to fund climate investment and reduce debt, they are generally dominated either by a combination of conditional grants and standard comprehensive debt restructuring, or by climate-conditional comprehensive debt restructuring. This said, debt-climate swaps could be efficient when they noticeably reduce debt risks while avoiding the costs of a full-blown debt restructuring. Beyond this narrow efficiency case, there is a pragmatic argument for debt swaps when conditional grants are unavailable in sufficient amounts and a comprehensive debt restructuring is not on the table. The design of debt swaps should focus on minimizing free riding by non-participating creditors. This can be achieved by structuring the swap such that the investment commitment is de facto senior to debt service and by avoiding the use of debt buybacks at market prices (relying instead on negotiated exchange offers backed by Collective Action Clauses). To the extent that debt swaps are implemented through market-based debt buybacks, these should be conducted by the donor rather than by the debtor.