Impact Voices | March 23, 2022

How incentives can successfully steer capital toward impact

Bjoern Struewer
Guest Author

Bjoern Struewer

ImpactAlpha, March 23 – Our economic system needs a reset. What drives it at the core are flows of money. Therefore, changing the rules of finance has the potential for far-reaching impact.

The good news is that transforming the system only requires a small tweak: embedding rewards for positive impact – into any type of finance. 

At Roots of Impact, we call this “impact-linked finance” or “better terms for better impact”. It’s a proven model, and it can be applied by anyone who wants to unlock the full potential of business. The vision behind is to create a blueprint for a financial system that truly serves people and the planet.

So, what is impact-linked finance all about? It incorporates financial incentives (the tweak) for enterprises that achieve exceptional positive outcomes. These outcomes can come in many shapes and forms – for example increased incomes for the poor, more gender equality, reduced plastic waste, or improved learning outcomes for children. The more social or environmental value a company creates, the lower its cost of capital will be. 

This value-creation could have a powerful effect. The best companies in the world – in terms of positive impact – would suddenly be able to raise large amounts of low-cost capital to scale. And even more importantly, they could further optimize their impact. As a result, resources would flow to what matters most to society, and this has mutually reinforcing effects:

  • Empowering “impact champions” for even bolder missions. Impact entrepreneurs who can demonstrate the effectiveness of their innovations would receive investment at an exceptionally low cost. This would enable them to unleash their full impact potential. With fresh capital, they could become truly “impact-bold”. Enterprises such as ATEC, Ilumexico, Root Capital, or Clínicas del Azúcar already are able to scale their impact faster with impact-linked finance.
  • Nudging the do-gooders to become do-betters. Responsible companies that are already doing good would receive strong incentives to do better. They would begin to manage and optimize their impact. Creating positive impact would become a business that pays off. Imagine how companies like Danone or Patagonia could push the boundaries if they were directly rewarded for impact.
  • Transforming the “tankers” towards improved net impact. Big corporations in sensitive sectors would get the tools and incentives to transform their businesses and advance their net impact. And not just energy giants. Also: food, pharma, fashion and big tech.  The impact of transforming huge global players such as Nestlé, Coca-Cola, or Amazon would be substantial, considering the market position and influence that these “tankers” have. 

Leading by example

If this sounds like too bold of a vision, consider that everything is already in place to make it happen.

  • There are many development finance actors and catalytic capital providers across the globe that seek deep impact and social value for their monies. Pioneers such as SDC, IDB Lab, Aqua for All, KfW/DEG, GIZ and the Jacobs Foundation are already using impact-linked finance. Others are preparing to do so.
  • There is an increasing number of impact investors and venture capitalists who are keen to get access to high-quality impact deals. Dozens have already invested in companies that have been “impact-boosted” with incentives. Among them are impact investors like Acumen and SunFunder, VCs like Active Capital and Mucker Capital, and DFIs like IDB and IFC.
  • There are many great, courageous, and inspiring entrepreneurs out there who are ready to scale their proven and impact-heavy solutions. High-performing impact enterprises such as Frontier Markets, African Clean Energy or could create even more value for their customers with rewards for their impact. 

Many seem to believe that we must accept the system as it is. They have doubts that rewarding verified impact can be done efficiently. But it’s already happening. 

Roots of Impact has alone structured more than 30 impact-linked finance transactions in the past five years for companies in nine countries to date. And there are many others who are with us on this exciting journey. 

I am the first to admit that I am a bit biased, but initial market reports and independent research studies confirm that the results are convincing. This makes me confident that now is the time to apply impact-linked finance on a large scale. 

With the massive challenges we are facing on this planet, it shouldn’t be Roots of Impact and a few like-minded players alone who implement this practice. Every financial intermediary, advisory firm and professional involved in impact should do so. We need a much bigger push, and this starts with capital. This is why those at the forefront of impact are uniquely positioned to push the boundaries. 

Impact Incentives 101

Here’s what everyone needs to know:

Impact-linked finance is (more) effective blended finance. It would be unrealistic to expect that today’s investors will gladly sacrifice their returns for greater impact. This is not how our financial system functions right now. The vast majority of impact investors are neither able nor willing to do that, and this phenomenon hasn’t changed a bit since the rise of the impact investing movement. 

However, we are in the era of blended finance. Catalytic capital on concessional terms can unlock and mobilize substantial flows of commercial capital. And there are billions in public and catalytic capital waiting to be deployed in partnership with the private sector.

Currently, blended finance is primarily used to take over risk from investors in anticipation of future impact.  What could be more effective than using these funds to incentivize impact and embed this “tweak” into investments? There is no need for resource-consuming and complicated structures. Impact-linked finance can directly flow to high-performing enterprises and unleash their impact potential at the source. 

Investors are ready to engage in smartly designed solutions. Investors who engage in impact-linked finance do not have to forego financial returns. When providers of blended finance and catalytic capital come in, they are willing to pay for additional impact and compensate investors for lower returns. It’s just a matter of intelligent design.

One instrument called social impact incentives, or SIINC, uses time-limited premium payments that enterprises receive for achieving social impact. In parallel, these enterprises raise investments to scale, without investors needing to change anything in their typical risk-return-impact mindsets. 

In addition, if investors want to directly bake impact into finance, they can easily build rewards into any instrument they provide, such as impact-linked loans or impact-linked revenue-share agreements. Investors such as IDB Invest, Beneficial Returns, KfW/DEG, VIWALA and UBS Optimus Foundation are already incorporating impact incentives in their transactions. Venture capital firms such as ICA are experimenting with impact-linked SAFE notes

Impact measurement is key and has multiple benefits. An old piece of wisdom says that you cannot manage and optimize what you do not measure. This is particularly true for impact-linked finance: solid impact measurement and management (IMM) are key. 

A good understanding of the value that an enterprise creates for its customers and stakeholders is an investment into the future. IMM provides important insights that feed directly into the enterprise’s business model. Done right, this creates multiple and huge dividends. 

For example, if you take a high-performing enterprise on an impact journey, measurement is just the start. Once it can quantify and predict the positive impact of its operations, it can begin to manage and optimize it. Then, a growing number of impact-linked finance practitioners can provide rewards to unlock its full potential. 

Digital tools that collect, verify and analyze impact data are helping make IMM more efficient and effective. 

Impact-linked finance goes beyond commoditization of externalities. You could say that financial incentives for positive impact are quite similar to carbon credits. And yes, there are many promising attempts to implement reward systems that monetize positive social outcomes or externalities. However, there are some fundamental differences between impact-linked finance and carbon finance. 

One difference is that social impact is not a commodity. To improve outcomes beyond carbon emissions, the focus must shift from demand to supply by considering a company’s specific impact potential and context. 

Also, by combining impact incentives with investment, it is possible to leverage these incentives and nudge companies to scale towards the greatest needs of society. 

Creating appropriate incentives – and pricing them accordingly – means finding the right balance between maximum additionality and maximum alignment with the company’s business strategy. Incentives should enable and encourage a company to push harder. Defining these incentives is an art, supported by science.

What’s next?

The simple idea of better terms for better impact (the tweak) has the potential to change the way we finance impact. It may even change the way we use finance in general. I’m excited to see many practitioners already embedding impact into finance in meaningful ways. Already since SIINC was introduced, there are many signs that the idea of rewards for impact is gaining traction. There are many opportunities to fully realize this potential together. 

First, every impact fund should have an impact-incentive facility attached, so that it can provide better terms for better impact. Today, it is common that an impact fund has a technical assistance facility. Like TA facilities, impact-incentive facilities could be funded by public and catalytic funders looking to generate “impact leverage” in partnership with investors. 

Second, impact incentives should become an integral part of future TA funding for activities, complemented by funding for results. TA funding is intended to improve the impact of promising enterprises. What could be more obvious than, for example, providing incentives for enhancing gender outcomes after conducting a gender analysis and action plan funded by TA money? It closes the loop and encourages the enterprises to actually be accountable for generating results.

Thirs, the time has come for Impact-Linked Funds in the areas of gender equality, healthcare, climate resilience, and biodiversity. There are Impact-Linked Funds in the pipeline and in place for education, gender-inclusive fintech, and WASH. But there are many more important sectors and topics just waiting for the right incentives. 

It’s not just about trying harder, but doing things differently – with a small tweak that has a big impact.

Bjoern Struewer is the founder and CEO of Roots of Impact.