Blending concessional funds or grants with commercial capital can be a powerful way for impact investments to take on more risk, or to finance socially valuable investments which are unlikely to provide an attractive commercial return. But providing too much subsidy can deter rather than encourage further private investment, by undercutting commercial sources of finance, and signalling that these investments are unbankable.
So multilateral development banks (MDBs) and Development finance institutions (DFIs) have adopted shared principles (the Enhanced DFI Blended Concessional Finance Principles) to bring discipline to the blending of concessionality with their normal commercial financing. Principle two, for example, calls for minimizing the amount of concessionality in operations, with the aim of encouraging market development and private investment.
MDBs and DFIs have been wrestling with how to set the appropriate level of concessionality to achieve their development objectives, while respecting the principle of minimum concessionality. Four approaches have emerged which could be adopted more widely by impact investors and donors engaged in blended finance: modeling, benchmarking, market mechanisms and performance-based mechanisms.
Modeling
Like other financial institutions, several MDBs (including the Asian Development Bank, Industrial Development Bank of India and International Finance Corp) use models to calculate the risk-adjusted expected financial return on investments.
Similarly, Private Infrastructure Development Group and British International Investment subject their blended finance investments to risk-adjusted return on capital modeling by third parties. These models are used to calculate the breakeven level of concessionality required for an investment to meet the level of financial return required by private investors.
This level of concessionality – often expressed as the share of financing on grant terms (the ‘grant equivalent’) – can be provided through different instruments – guarantees, junior/first loss tranches, concessional loans, grants etc. The modeling approach rests on the availability of data with which to project the financial returns of the investment, and data on the return requirements of investors.
This data can be hard to obtain, or unreliable, especially where investments are in pioneering areas with few precedents, and in places where there is little track record of private investment.
Benchmarking
A second approach, which can be used in combination with modeling, is to benchmark the level of subsidy against previous, similar transactions. ADB, IDBI and IFC are among MDBs using blended finance that incorporate benchmarking information into the investment decision process. This can make sense for heavily invested sectors – such as renewable energy generation – where there are lots of other investments to benchmark against. It is less useful for pioneering transactions in new sectors and countries.
Benchmarking also depends on other investors making investment terms – including use of subsidy – available. This is an area where MDBs, DFIs and other organizations structuring blended finance could collaborate to improve the use of blended finance by all. For example, by providing more financial structuring details to Convergence, a knowledge platform which shares information on blended finance transactions with its members.
Market mechanisms
In some situations, market mechanisms can be used to discover how much subsidy is needed to attract private capital. This can include tender mechanisms where private investors bid to participate in financing investments, based on how much subsidy they require – with the winning bid requesting the lowest subsidy.
This approach has been used by IFC and European Bank for Reconstruction and Development in arranging financing for renewable energy projects. It can also include programmatic approaches – such as funding SME lending by banks – where banks can access subsidized funds or guarantees based on their commitment to increase small and midsize enterprise lending.
Banks which offer more SME lending for a given amount of subsidy are chosen for funding from the program. Market mechanisms take more time and effort to set up and implement, so are best suited to large investments or ongoing programs. And markets may not work well where there are few potential bidders.
Performance-based mechanisms
Lastly, several MDBs and DFIs are increasing their use of performance-based mechanisms which link the payment of subsidy to the achievement of impact outcomes. For example, IDBI now structures more than 90% of its new loans as sustainability-linked loans, where the interest rate is linked to achievement of impact milestones.
This does not ensure that concessionality is entirely minimized, as it is possible another party could have delivered the same outcomes for less subsidy, but it does provide some protection against over subsidizing activities. Again, such mechanisms have higher set-up and implementation costs, so make sense for larger projects and programs, such as projects financed by social impact bonds.
Calibrating concessionality
A common theme of these mechanisms is a tolerance for a wide degree of uncertainty in setting the level of concessionality in truly pioneering investments, accompanied by a discipline which draws on data and previous experiences to push towards minimum concessionality as more financing goes into the same type of investment, and as investments get larger.
As the use of blended finance matures and becomes a regular part of impact investing and development finance activity, there will be greater scope to use these good practices to minimize concessionality and avoid distorting markets with excessive subsidies.
Neil Gregory is a senior research associate at ODI Global
