Blended finance: can the new rules avoid market distortion?

29th November 2017 Jack Aldane

Development finance institutions have finally come together to lay out the principles of blended finance with the aim of taking public and private investment in the poorest countries from billions to trillions. The challenge now is to keep the market stable.

The week in development finance many will remember this year is that which set the agenda for blended investment.

At the World Bank’s Paris office on 7 September, officials from development finance institutions and multilateral development banks began the last of three meetings to lay the foundations for policy on this financing mechanism. Present were members of the European Development Finance Institutions (EDFI), who nine months earlier had drawn up guidance for how to deal with the risks involved in using soft money from donors to mobilise both public and private capital for sustainable development.

Under the orchestration of International Finance Corporation (IFC), the meeting ended with a fresh permutation of these principles. Days later, the DFI officials were joined by a much broader group of stakeholders in a senior advisory group of the Organisation for Economic Co- operation and Development (OECD). The advisory group has since brought a new set of high-level policy principles for blended finance to its member states through the Development Assistance Committee.

Soren Andreasen, the general manager of EDFI, who sat through all three sessions, told Development Finance shortly afterwards that he felt confident EDFI had achieved its goal of elevating blended finance on to the agenda of international policymakers.

“My expectation is that we more or less have an agreement there. The meetings build on what EDFI proposed at the end of last year, but now we have a very wide range of institutions supporting this,” Andreasen said. “We had a lot of discussions and shared a lot of experiences. The IFC has been the secretariat for the exercise and has done a really good job.”

Multilateral banks convened again on 15 October to endorse the consensus. Two weeks later, the Development Assistance Committee approved new guidance measures for blended finance, cementing its place in the development finance architecture.

Blending, as we know it

Blended finance combines concessional funding from public entities and governments with private capital at attractive risk-return rates to scale projects for sustainable impact. The motivation for institutions to seek clearer terms for blended finance emanates from their mandate to achieve the United Nations’ 17 sustainable development goals (or SDGs). The goals include the eradication of extreme hunger, universal healthcare and access to education, and gender equity. The UN stipulates a deadline of 2030 for the fulfilment of the objectives, leaving little time for preparation. Even more worrying, each goal is riven with its own financing gap of what amounts to billions in investment per year.

Soren Andreasen, general manager of EDFI

The exact amount needed to fund the SDGs amounts to around US$3.9 trillion every year for the next 12 years. Public finance alone cannot plug the shortfall and governments in developed countries are eager to appease public scepticism towards aid by ensuring every taxpayer dollar represents value-for-money. The best of all possible solutions lies in untapped volumes of private capital. Blending can harness this resource, allowing private investors to fill the public funding deficit while guaranteeing them a risk-rated return comparable (if not identical) to other types of investment.

This year has seen several examples of successfully closed blended financing deals. In June, the first climate financing facility launched by fund group Climate Fund Managers, named Climate Investor One, closed at US$412 million. The IFC meanwhile has a proven track record for mobilising and intermediating concessional finance from the Global Environment Facility, the Climate Investment Funds and the IFC-Canada Climate Change Program. Around 80 percent of blended finance deals are generated through development finance institutions.

Source: The 2017 survey by the Blended Finance Breakthrough Taskforce

Among these, the IFC and Dutch development bank FMO rank first and second in the list of top public investors, according to data compiled by investor network firm Convergence and the Business and Sustainable Development Commission.

Convergence’s database includes more than 187 blended finance deals totalling around US$51.2 billion of capital mobilised towards the SDGs. Around 74 percent of the database has been generated from funds and facilities and account for more than 60 percent of total mobilisation. The other 26 percent of deals collected are projects and businesses, which according to the survey tend to contribute a larger share of capital due to large-scale infrastructure projects.

An early discussion of the concept of blending emerged in a 2011 study supported by the German Federal Ministry for Economic Cooperation and Development (BMZ). Blended finance is described in the study as linking “EU budget grants, member state grants and loans by international, regional and European bilateral financial institutions”.

This was a decade before the SDGs when institutions worked towards fulfilling eight similar targets known as the Millennium Development Goals. The study cautions however that blending mechanisms have limited application in financing development, and that “although generally well-functioning, they are still in an early phase and should be treated as ‘work in progress’.”

The story remains much the same six years on. Blended finance can be undeniably effective in the right conditions, particularly where timelines, regions and sectors are aligned. This has been shown most notably in global energy and climate-related projects – the sector takes in a 30 percent majority of all capital mobilised for blended finance deals. Yet, blending has also proven immensely tricky to pin down Blended Finance in terms of nomenclature, data and what is known as additionality. This ultimately makes it harder to crowd in private investment and turn billions into trillions.

Source: The 2017 survey by the Blended Finance Breakthrough Taskforce

The definition problem

The term ‘blended finance’ often confounds private investors with its myriad meanings. By understanding the market, development finance institutions have made some projects successful using blending techniques. However, just as someone with a healthy taste for alcohol can mix a pleasant cocktail using all the right ingredients, consistency of approach is paramount to sustainably scaling the task.

Nanno Kleiterp, chairman of EDFI’s board of directors, says focus should fall on the apportioning of risk as opposed to the specific source of funding. “Blending is a confusing term because it sounds like you’re blending or mixing different types of money, when its much more about distributing risks in a different way.”

Joan Larrea, CEO of investor networking initiative Convergence, argues that a binding definition of blended finance among institutions is essential to meaningful discussions about risk, execution and impact. At present, she says, “Where you stand is where you sit.”

Peter Stoute-King, managing director the investment network at Convergence

“Definitions change depending on whether you’re a DFI or a non-profit ecosystem-building world that we’re in. For us, blended finance needs to be using catalytic capital either from public institutions or philanthropic and the motivation has to be private sector investment, not just blending public and private sector investment. It has to be in an emerging market and it has to be aimed at attaining the SDGs in some manner,” she adds.

An examination of blended finance published in February by civil society group network Eurodad–titled Blended Finance: What it is, How it works and How it is used, claims the definition of blended finance varies widely depending on the deal. Andreasen explains the two ways in which blended finance can currently be defined, based on the recent Paris meetings.

There is investment of donor funding – grants or guarantees from public aid donors or private philanthropies – alongside commercial funding from institutional investors or private companies. DFIs usually participate in these investments with their own funds. Then there is what the OECD calls ‘development finance’ alongside commercial finance, the wording of which is designed to include both donor funds and DFIs.

That means that not all future blended finance deals will be traditional in the sense of using strictly concessional finance, but rather will take capital from DFIs and blend it with capital from institutional investors. This is an important distinction to make, Andreasen adds, because DFI deal volume significantly outweighs that of donor funds and so creates a risk of blurring or misattributing data to one or the other.

Crowding-in and additionality

To put the definition problem to one side, institutions face a bigger challenge in crowding in private investors to the market. The challenge is to ensure blended finance not crowd investors out. Jeremy Oppenheim, programme director for the Business and Sustainable Development Commission, says private investors’ concerns about blended finance typically have two features to them.

“Just doing the deals is transactionally high cost. They are slow and costly, which doesn’t tend to go down easily. The second thing is that the product itself is illiquid, because it’s so complicated and one- of-a-kind. It’s not something you can easily get out of, so you have to be really sure this is something you want to be in for the next ten to fifteen years.”

Oppenheim says the commission aims to “shift the needle” on the first problem by reducing transaction costs and structuring financing vehicles with better exit and liquidity features to attract private actors.

Crowding in private capital requires institutions to educate the market on the risks involved in investing in developing countries as well as in specific assets. Before DFIs even think about filling Africa’s financing gap for infrastructure, they must first fill the gaps in investors’ knowledge about such projects. Oppenheim says more data on successful blended finance deals would certainly help, along with Nanno Kleiterp, chairman for the EDFI board of directors more consistency across all forms of blending methods.

“More information is going to lead overall to more mobilisation of private capital, as will more market mechanisms that establish an efficient price and lead to product standardisation and securitisation,” he says.

Jeremy Oppenheim, programme director for the Business and Sustainable Development Commission

Kleiterp says DFIs are having steady success reaching out to investors to explain how blended finance can form a category of risk-return that meets their needs. However, as blended finance institutions continue to strike for clarity and equilibrium, there remains a risk of scaring away new initiates. One way in which this can happen is if governments or DFIs encroach in places where the private sector sees an opportunity to act independently.

“If you are going to subsidise things that the market can do, the private sector will pull out. We all want to get from billions to trillions, but if it goes wrong, you go from billions to millions,” Kleiterp says.

So goes the problem of additionality. In an ideal world, a government or DFI’s role is to make possible investments that would not otherwise have happened. Additionality also has the function of augmenting deals to increase their developmental impact. Kleiterp says the problem is that losing investors after having crowded them in makes chances of winning them back miniscule.

“If you look at all the plans governments have and their philosophy of leveraging as much private sector investment as possible, that is going to be a significant amount, and significant amounts can have a significant positive as well as negative effect, which something we have to avoid.”

Peter Stoute-King, managing director of Convergence’s investment network, understands this challenge from the DFIs’ perspective. He says the days when these institutions could claim additionality on the basis of loan tenor have all but passed. Now, it is about coming up with ways to test markets in order to see if subsidies can be minimised or done away with.

“I think the additionality argument depends on the source of finance. If you’re getting funding from a development financial institution that has a mandate to help people diversify their economy, I can understand why you wouldn’t want to have that type of institution in a transaction where it ought not to be,” he says.

Joan Larrea, CEO of Convergence

“When the source of financing is coming from the private or philanthropic sector I think there’s less of a interest in having additionality, and rather recognising that this is a transaction that should get done.”

Market distortion

Blending public and private capital for development is an exercise in efficiency, which, if done poorly, can have distorting effects on the market. Market distortion is, in many respects, the dark side of additionality. An institution runs the risk of causing distortion when it misjudges its capacity to add value to a facility or project, and in so doing mobilises millions of dollars in concessional finance only to dilute investors’ returns, chase investors out and, waste public funds. As Kleiterp explains:

“More information is going to lead overall to more mobilisation of private capital, as will more market mechanisms that establish an efficient price and lead to product standardisation and securitisation “There are certain countries in Africa currently where renewable energy is financed through concessional and commercial money. The commercial financing has a cost of 5 percent, the soft money goes at zero, and then it is sold at 2.5 percent. That’s when private sector investors pull out because this is not a market they can be in.”

Oppenheim shares Kleiterp’s concern, though says the right strategy is needed to ensure blended finance weans private investment off concessional support before investors get hooked on a hidden set of subsidies.

“Within reasonable, improving second-best markets and policy environments, where there is a coherent strategy for the use of blended finance that would allow for it to taper over time, this is what I think you could describe as good for infant industry development,” he says.

Pereira’s paper for Eurodad addresses each of the issues explored thus far, yet none are as recurrent throughout as the
overwhelming lack of data available on blended finance. Information on individual projects is scarce and limited in detail, he argues, which makes judging market distortion hard to begin with.

“While blending can have development benefits, I think there is a risk of distorting ODA flows and distribution, but it is difficult to assess whether it is happening right now,” he says.

This runs into the question of how transparently institutions have dealt with blending until now. A maturing market arguably takes time to generate enough data for others to assess how it is justifying its activity. The recent meetings involving the OECD are an attempt to set collective sights on developing a better record of blending and allowing for comparison of performance based on the mean definition and approach.

“At the project level, DFIs that usually lead blending projects often release very limited information on individual projects for different reasons. Disclosure also changes from one DFI to another. I think additional efforts could be made on this front as well,” Pereira says.

Nanno Kleiterp, chairman for the EDFI board of directors

Common reporting standards for blended finance among institutions could be the next sticking point, as Pereira himself suggests.

There are however considerable efforts being made to generate more data. The OECD is in the process of deploying a new metric that will include blended finance in development aid flows. The Blended Finance Breakthrough Taskforce, an amalgamated effort by Convergence and the Business and Sustainable Development Commission, aims to use its combined industry intelligence to disambiguate the system and allow more mainstream capital to flow in.

Larrea agrees that a greater quantity of data is needed, though says the public sector needs to start using what is already available to identify potential problems and use evidence of success to lure the private sector.

She says: “There are multiple project preparation facilities where they don’t really look left or right to determine if anyone else is doing the same thing. I think having the public sector get more mindful about duplication and also finding what’s working and scaling up would do a lot to reassure the private sector.”

What now for blended finance?

It is easy to misconstrue the argument for blended finance as advocating a straightforward solution to the problem of how to achieve the SDGs. The argument is in fact twofold: by de-risking private investment in developing nations, investors have no less reason to invest into those nations than in developed ones, which makes markets stronger and, ultimately, less dependent on support from public funding. The point of blended finance is to increase confidence about private capital entering emerging economies. This is an ambitious proposition that requires fast work from everyone, not least governments in developing countries that lack the necessary legal frameworks to regulate the private sector. The past six years constitute a slow start, which is why each of the next twelve must count.

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