Analysis by the IMF points out that climate swaps have value to climate-stressed countries, but challenges remain around securing creditor commitments.
Debt-for-Climate swaps follow Debt-for-Nature swaps which have proven ecological value. Debt-for-Climate swaps provide climate resilience programmes and restructure sovereign debt providing cash flow relief on repayments but their conditionality is weaker than conditional grants.
Debt-for-Climate swaps have a strong role in promoting climate finance. Many countries may not pay for needed climate investment, even when it is financed on concessional terms.
Climate policies in Low Income Countries and International Financial Institution support would provide necessary backing for Debt-for-Climate swaps to flourish.
Debt-for-Climate swaps can be beneficial to climate and debt-stressed countries
Recent analysis pointed out deficiencies in the conceptualisation of Debt-for-Climate Swaps but identifies value to climate-stressed countries. Debt for Climate (DFC) swaps are considered by many to be an excellent way of financing climate action on the ground while reliving pressure on international debt service.
In-depth analysis by the International Monetary Fund (IMF), has found that Debt-for-Climate swaps have a qualified economic case. They are more problematic than conditional grants in attracting creditors and have limited sovereign debt relief, but as a form of climate-conditional debt relief, they can be highly beneficial to climate and debt-stressed countries that may not have the fiscal scope to pay for climate investment.
They are considered superior to comprehensive debt restructuring in avoiding the economic dislocations that the latter often involves but should be scaled up for better efficiency.
Instead of an indebted state making payments on international debt (often in an international currency which can add a further financial burden) they can use local currency to fund domestic climate projects on agreed terms. This could be mitigation or adaptation projects, based on the terms agreed and the needs of the debtor state.
One of the reasons that the idea has grown in appeal over time is a combination of factors. Many low and middle-income countries pay large sums annually to service debt instead of focusing on internal development. At the same time, the most climate-vulnerable countries also pay a higher premium for sovereign debt on the international markets.
IMF considers grants more efficient and lower risk than debt-climate swaps
Climate-conditional grants (or grant/loan combinations) are generally a more efficient way of supporting public investment in a recipient country than debt-climate swaps. The IMF explains that “unless the swap is structured to ensure that the expenditure commitments are de facto senior to the remaining debt service,” a donor/creditor who wants to fund a climate investment faces greater (sovereign) risk if the support takes the form of a debt-climate swap than if it takes the form of a conditional grant.
With de facto senior to the remaining debt service, the swap can support a given climate expenditure at lower cost to the creditor/donor, since at least part of the climate expenditures will be indirectly financed by other creditors (who would suffer greater losses in a crisis).
Debt-climate swaps are not trivial and can harness climate finance
There is a strong correlation between country fiscal risk and climate risk reflecting the fact that many developing countries with histories of debt vulnerabilities are also vulnerable to climate change.
Climate change is heightening the debt problem, by harming economic output, creating fiscal costs such as for reconstruction after natural disasters, and making external borrowing more expensive. There is an economic case for debt-climate swaps along other instruments. They would be best promoted, the other purpose of the study, by strengthening climate finance.
How debt for climate swaps work
In simple terms, a third party purchases a country’s debt at a discount, using impact capital, restructures it, and uses it to fund conservation activities for ecosystem-based adaptation to climate change.
Debt is reduced in exchange for spending or policy commitments on the side of a debtor country, at fiscal cost no higher than the debt reduction. This is a bilateral debt swap.
Seychelles and Belize are the key case studies for debt for nature swaps in association with The Nature Conservancy (TNC). The 2015 Seychelles transaction involved the government of Seychelles and TNC to buy back $21.6 million of public bilateral debt, primarily to Paris Club creditors, for $20.2 million (a discount of 6.5%).
A newly established Seychelles Conservation and Climate Adaptation Trust (SeyCCAT) was set up. In return, the government issued two promissory notes amounting to the same $21.6 million, to pay off the TNC loan as well as to endow SeyCCAT.
SeyCCAT became the new owner of the debt, to which the government pays back over a longer tenure. The government committed to protect 30% of its waters, protect 15% of its high- biodiversity areas, and adopt a marine spatial plan to guide the update of coastal zone management, fisheries, and marine policies. Since 2015, in line with its commitment to the debt swap, Seychelles has progressed from protecting 0.04% to 30% of its national waters.
Tripartite swaps are more common that involve donors and/or new lenders usually intermediated by an international nongovernmental organization (NGO). In the most common type of operation, the NGO lends the funds to the debtor country at below-market interest rates, on the condition that:
(1) the debtor uses the funds to buyback commercial debt at a discount, and
(2) a portion of the resulting debt relief (the difference between the cost of the retired commercial debt and the new debt to the NGO) is used to fund climate-related actions or investments.
Debt for climate swaps remain at a small scale
Debt-nature swaps have been successful in their conservation outcomes and as financial arrangements benefitting the country’s debt servicing but their impact in national debt relief has been limited.
Debt swaps are generally not the right tool to address unsustainable debt situations as they are not broad enough for climate resilience outcomes though they have an essential role.
Scaling up of the approach is required to be effective
Debt-for-climate and debt-for-nature swaps have historically been linked to specific projects that needed to be identified, structured, and monitored, all costly governance procedures.
Second, the pool of debt held by creditors that could potentially be interested in debt swaps has been relatively small and further dissuaded by the high transactions and monitoring costs.
The IMF report suggests they would be better directed to spending programmes rather than projects, and scaled up to support countries in building climate resilience but that faces challenges.
Scaling up could be carried out by bundling projects and policy reforms. Policy reforms such as energy sector reform and carbon pricing.
Conditionality agreed with international financial institutions could underpin financing, attracting private and donor financing. Furthermore, budgetary expenditures supporting adaptation and/or mitigation would provide assurance to creditors.