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April 20, 2022

Why blended finance risks being bad for SDGs

Combining state financial aid with private sector funding is widely touted as key to helping achieve the UN Sustainable Development Goals. But the current blended finance model risks exacerbating inequality in emerging markets. Development finance institutions must do more, say experts and investors.

By john crabb

SDGs blended finance
Bypassing the SDGs: Development finance institutions are being urged to take more risk to help fund the UN Sustainable Development Goals. (Photo by Stanislav Kogiku/SOPA Images/LightRocket via Getty Images)
  • Blended finance has many supporters, but there is evidence that it may be doing more harm than good for developing countries.
  • Some experts argue that blended finance is exploitative of developing countries’ governments and leaves them more vulnerable to debt crises…
  • …and that development finance institutions should take on more risk to protect governments better from the sometimes ruthless profit-seeking of the private sector.

Blended finance – the strategic use of development funds to mobilise private investment in emerging countries – has many advocates. Given that the volume of private development funding is falling well short of what is needed to achieve the UN’s Sustainable Development Goals (SDGs), it is increasingly argued that blended finance should be utilised on a far greater scale.

On the face of it, this makes sense. Since the UN development committee agreed in 2015 to mobilise the private sector to plug the estimated annual $2.5trn gap in funding needed to achieve the SDGs by 2030, there has been a broad consensus that more blended finance – the flows of which totalled around $9bn last year, according to blended finance network Convergence – could only be a good thing.

Financing more projects with private money has obvious appeal, but those pushing the agenda have arguably failed to consider its limitations. Blended finance and public-private partnerships have been proven problematic from a development perspective.

Undermining policy objectives?

“Instead of offering a long-lasting solution, [attempts at] catalysing private investment at scale may be undermining public policy objectives aimed at sustainable development in the Global South, further eroding the role and capacity of the state to provide public infrastructure and services vital to ensuring human rights, development and climate resilience, and leaving countries more vulnerable to debt crises,” says María José Romero, policy and advocacy manager at the Brussels-based European Network on Debt and Development. “The evidence that [such efforts have] a positive impact on sustainable development is very limited.”

In fact, she continues, there is a risk that aid money ends up subsidising private companies for investments they would have made in any case, while doing little to help the urgent need for aid resources to support countries in crisis situations.

A report commissioned by the European Parliament and published in May 2020 compounds this concern. Private shareholders, it found, may receive funds at the expense of sectors and regions where they are most needed (see also chart above). It concludes that funds are insufficient to plug the SDG funding gap.

According to the economic principles of Milton Friedman, investments must always be attractive and profitable for investors. In international development this is not always plausible.

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Aid versus private finance

“There are many cases where straight-up aid should remain straight-up aid, and there are also many cases where private sector investors don't need any encouragement to do something because it already is lucrative enough to roll the dice and take the risk on whatever they're staring at,” says Joan Larrea, chief executive of Convergence. She also cites the fact that some of the SDGs attract a lot of blended finance activity, while others see very little.

“We are advocating for those in control of donor resources, like USAID [the United States Agency for International Development] and the UK FCD [Foreign, Commonwealth & Development Office] to figure out their strategy,” she adds. “It needs to be more standardised so you can tee up transactions that are big enough, regular-looking enough and familiar enough for plain-Jane institutional investors.”

For its part, USAID is optimistic about the potential of blended finance but also understands the need to tread carefully, a spokeswoman for the organisation tells Capital Monitor.

“USAID is judicious about the amount of public funds used to catalyse private financing,” she says. “We are also optimistic about playing a key role in enabling a financial transaction that supports international development, which would not be possible without USAID funding. It is also important to ensure we operate on the margins in terms of shaping a private sector financial decision, to avoid distorting markets.”

Risk mitigation

To encourage private finance flows into emerging economies, the World Bank has advocated increasing use of risk mitigation techniques that transfer these risks from the investor – the typical holder of risk in corporate finance – to either a development agent or the local government. De-risking can come in the form of revenue support, credit enhancement, insurance or direct investments, but not all financial instruments work for every project.

Blended finance is widely viewed as a good thing because it takes risk off the table for private investors. But managing the private sector’s risks should not necessarily mean transferring it to the governments of emerging countries.

More of this risk should be taken on by traditional development institutions, argues Conor Savoy, senior fellow at the Center for Strategic and International Studies in Washington, DC.

Experts also suggest that multilateral development banks (MDBs) should do more to help facilitate the private sector’s role in development finance.

“The MDBs have not taken the aggressive approach that many of us hoped they would to help leverage private sector finance, so the progress we could have made in addressing income inequality and infrastructure issues has been limited,” says Robert Mosbacher, chair of Houston-based Mosbacher Energy Company and one-time president and CEO of the US government’s Overseas Private Investment Corporation.

“Corporates should not be expected to take the lead on development,” he adds. “MDBs and development finance institutions [DFIs] should.”

For instance, DFIs could ramp up the use of first-loss instruments in loans and deals to encourage private finance to take on riskier projects, without leaving it to governments. The International Finance Corporation (IFC), the World Bank’s private sector arm, uses first-loss to ensure private finance is appropriately deployed into development, but this is an exception rather than the norm.

Introducing first-loss into blended finance allows for lower interest rates, with sufficient capital to work within, making the project more viable.

“But if it is fundamentally too risky, no one will do it, especially if you have a poor investment model,” says Kruskaia Sierra-Escalante, senior manager for blended finance at the IFC. “There is always the criticism that DFIs should be taking more risk, but [the] IFC has many commitments in the most difficult, lowest-income and fragile countries. The more you do, the more support you need.”

One example was a five-year financing package of up to $55m from the IFC and $20m from the Dutch Entrepreneurial Development Bank to finance domestic food production in Yemen. The IFC felt it was important to secure concessional support from its partner, the International Development Association, to de-risk the transaction. The first-loss guarantee of up to 50% enabled the IFC to invest in Yemen for the first time in more than ten years.

Slow progress on climate finance

The difficulty of finding appropriate ways to deploy private finance into development is arguably one of the reasons for the slow development of international climate finance in recent years.

“Channeling private capital towards the SDGs is extremely tricky to do properly. It is hard to not to get a whole bunch of adverse outcomes included in your pot of good ones, which sours the soup completely,” says Gavin Smith, director of Clean Energy Advisors and a private sector observer of climate finance.

It is not that private finance being deployed to development is inherently bad. More appropriate use of DFIs and MDBs can ensure that funding is deployed in a way that does not transfer risk to those that cannot afford it. Otherwise, the additional funds required to finance the SDGs are never going to materialise.

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