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Mr. Marcos d Chamon, Erik Klok, Mr. Vimal V Thakoor, and Mr. Jeromin Zettelmeyer

(20) unless the climate expenditure is senior. If climate expenditure ranks below debt service, then expected payments to creditors are 0.5 * 80 + 0.5 * 80 = 80, and expected debt relief 95 – 80 = 15. If debt service ranks pro rata with the climate expenditure, then expected payments to creditors are 0.5 * 80 + 0.5 * 72 = 76 and the expected debt relief debt swap of face value 20 is 95 – 76 = 19 If the climate expenditure ranks above debt service, however, then expected payments to creditors are 0.5 * 80 + 0.5 * 70 = 75 and expected debt relief is 95 – 75 = 20

Mr. Marcos d Chamon, Erik Klok, Mr. Vimal V Thakoor, and Mr. Jeromin Zettelmeyer
This paper compares debt-for-climate swaps—partial debt relief operations conditional on debtor commitments to undertake climate-related investments—to alternative fiscal support instruments. Because some of the benefits of debt-climate swaps accrue to non-participating creditors, they are generally less efficient forms of support than conditional grants and/or broad debt restructuring (which could be linked to climate adaptation when the latter significantly reduces credit risk). This said, debt-climate swaps could be superior to conditional grants when they can be structured in a way that makes the climate commitment de facto senior to debt service; and they could be superior to comprehensive debt restructuring in narrow settings, when the latter is expected to produce large economic dislocations and the debt-climate swap is expected to materially reduce debt risks (and achieve debt sustainability). Furthermore, debt-climate swaps could be useful to expand fiscal space for climate investment when grants or more comprehensive debt relief are just not on the table. The paper explores policy actions that would benefit both debt-climate swaps and other forms of climate finance, including developing markets for debt instruments linked to climate performance.