The promise of innovative finance is to unlock billions—if not trillions—of dollars in private sector capital to address the world’s most critical challenges. This big and bold promise is making innovative finance fashionable these days. Policy makers are taking note as they grapple with the sticker shock of the estimated $5 to $7 trillion that it will cost annually for the next 13 years to achieve the UN Sustainable Development Goals (SDGs). Asset owners and investors are also showing increased interest in innovative finance as they seek new opportunities to diversify risk and achieve returns in today’s modest growth economy.
Innovative finance solutions span a broad set of instruments and mechanisms across asset classes, from insurance-linked securities, to pay-for-success debt instruments, to publicly traded equity investment vehicles. Two notable successes include the International Finance Facility for Immunisation (IFFm), which has raised more than $5 billion from investors for immunization programming, and African Risk Capacity, which has to date issued more than $370 million in drought insurance to eight African countries. What these much-celebrated examples of innovative finance mechanisms have demonstrated is that innovative finance does, indeed, offer effective means of engaging private markets at scale.
With the rise in popularity of innovative finance, there has been a flurry of activity to develop a new set of transformative innovative finance solutions to address the world’s critical funding gaps—from financing education and livelihood programs for refugees to investment mechanisms to rebuild and protect our natural ecosystems. On the one hand, this momentum is great news, because it is necessary to meet the staggering annual price tag of achieving the SDGs. On the other hand, this flurry of activity also carries the risk of creating noise that could distract from the solutions that actually have a shot at succeeding. Innovative finance is still in its infancy, so ensuring the credibility and continued success of solutions is paramount to the field’s ability to grow to its full potential.
What are the design principles of a successful innovative finance mechanism with the potential to mobilize the billions of dollars we need?
This distinction raises questions: What makes an innovative finance solution successful? What are the design principles of a successful innovative finance mechanism with the potential to mobilize the billions of dollars we need? Our experience developing The Rockefeller Foundation’s Zero Gap work—a grant portfolio dedicated to incubating new innovative finance solutions—and analyzing past successes points to four design characteristics that are critical for success:
All successful innovative finance solutions need to first be attractive to investors based on their financial merits alone. In the absence of the necessary cash flows to provide investors with a risk-adjusted market return, innovative finance solutions could never achieve the necessary scale. Many social and environmental programs do not—and may never—meet this requirement. Not all programs in need of funding can be turned into investable or insurable propositions, but our focus needs to be on the issue areas and programs that do meet that requirement. While there have been instruments where concessionary capital—from both private donors and philanthropic institutions—has been used to adjust for shortfalls in underlying cash flows and make returns for commercial investors attractive, such “blended finance” products inevitably face a ceiling beyond which they cannot scale. There simply isn’t enough concessional capital available to subsidize returns at scale.
Standardize, standardize, and standardize.
The global challenges the world faces are deeply complex. Take for instance the challenges of tackling climate change, global health epidemics, and extreme poverty, all of which are multi-causal, interrelated, and cut across national borders. They require new and creative solutions and new financing mechanisms that overcome the market failures that have traditionally inhibited investment flows. However, the capital markets do not like bespoke exotic financing mechanisms. They like standardized, easy-to-execute solutions that have low transaction costs. To achieve scale, innovative finance solutions also need to be standardized—keeping complexity hidden from view. This is the beauty of Green Bonds, which channel investment into climate-friendly projects and, in structure, are indistinguishable from ordinary bonds. First launched in 2007, total outstanding issuances of Green Bonds topped $133 billion at the end of 2016. By contrast, Social Impact Bonds (SIBs) may have catalyzed a global pay-for-performance movement and shifted the political dynamic of underinvestment in prevention programs, but have struggled to achieve anywhere near the same scale as Green Bonds since they rely on a more complex, less familiar, and expensive structure. This seems to be poised to change with the next generation of impact bonds, such as Washington, D.C.’s Water Environmental Impact Bond, which is bringing pay-for-success to the mainstream capital markets.
Scale as a requirement, not just a good-to-have.
To access the world’s large pools of capital, innovative financing solutions must have scale. For it to make sense for institutional investors like pension funds and insurance companies to due-diligence—let alone invest—in a particular investment strategy or instrument, the mechanism has to have the capacity to absorb investment in the billions of dollars. The challenge of scale has curtailed, for example, institutional investment into off-grid, renewable energy across the developing world. Despite offering potentially attractive returns, individual investments have been designed with bespoke structures, making it impossible to pool these investments into a larger investment proposition that could bring in larger scale institutional investment.
An investment mindset with on-the-ground capacity
Moving from the traditional, aid-based model for addressing the world’s critical challenges to an investment one requires a fundamental change in mindset. Despite the unpredictability and limited scale of grant funding, many in the development world are happy with the “giving a grant and receiving a grant” mentality. For any innovative finance mechanism to be successful, relevant stakeholders including NGOs, governments, and donors need to take on an investment mindset and have the on-the-ground capacity to deliver with the discipline and rigor that the capital markets require.
The solution to closing development’s precarious funding gap is indeed creativity and a sustained focus on innovation—let’s be smart about how and where we innovate.