Position Paper: Overcoming obstacles facing blended finance

The following position paper was published in Environmental Finance (subscription required).

Blended finance was highlighted in Environmental Finance in January as one of ‘The 12 themes set to shape 2019’ and the possibility was mentioned of France using the G7 summit it will host in August to “to push for development banks to do more to crowd in the private sector”.

Indeed, there are high hopes globally for blended finance, defined in an OECD report as “the strategic use of development finance for the mobilisation of additional finance towards sustainable development in developing countries”. This is logical, in view of the unanimously accepted assessment that the vast amounts of financial support necessary for sustainable development in developing countries cannot be provided by the public sector alone.

However, blended finance is easier said than done, though successful examples do exist. Strong messages from high-level bodies such as the G7 summit, while helpful, will not be sufficient. It will be vital to develop a common understanding about practical issues blended finance faces and how they may be overcome by concerted efforts among relevant organisations. This article discusses some key factors for its successful implementation.

Importance of realistic expectations

The crucial starting point is to ensure that policy makers and project implementers recognise that, although blended finance works well for certain projects, it cannot be applied to others.

This is because the ‘additional finance’ mentioned in the OECD’s definition will predominantly derive from private sector investors: equity investors and/or debt investors (typically banks). These investors’ interest in a project presupposes its ability to generate revenue – as the basis for profit for equity investors and for debt servicing (payments of the principal and interests) for debt investors. A good example would be renewable energy mini grids for rural electrification. Blended finance will be able to support them only when the villagers have the capacity to pay (at least partially) for the electricity supplied to them. In the absence of revenue, no amount of financial ingenuity will enable the projects to devise a successful blended finance structure, despite their excellent sustainable development value.

For this reason, blended finance is no panacea for funding problems. Nonetheless, it will be useful for a wide variety of sustainable development projects, ranging from energy and waste management to adequate supply of safe water.

Determined efforts by public sector entities

One factor that sometimes receives less attention than it deserves is the strenuous work demanded of public sector entities in promoting blended finance. The hard work is due primarily to two reasons. One stems from the approach’s very nature that, as per the OECD’s definition, involves “the strategic use of development finance for the mobilisation of additional finance”. To perform this function, the public sector needs to take on difficult risks itself, with a view to reducing remaining risks to levels palatable for the private sector. Yet, public sector entities must also attend to their own risk control. The balance between risk taking and risk avoidance (including the development of risk hedging expertise) will be one of the major challenges for public sector entities in promoting blended finance.

Secondly, the appropriate role for the public sector in blended finance structures is constantly evolving. Take, for instance, public/private co-financing of large solar power generation projects in mid-income developing countries. This was an excellent example of the technique a few years ago, when large-scale solar PV was an untested technology with unproven profitability. Co-financing led by a public sector entity would allay the concern of private sector companies and crowd them in.

Today, however, the same project may well be undertaken on a purely private sector basis, at least in some mid-income developing countries, thanks to increased familiarity with the project type. If this is the case, continued adoption of the public/private co-finance structure for this project type will be counterproductive, though it gives the appearance of promoting blended finance. Maintenance of the blended finance structure in this situation would mean that what started as a good example of ‘crowding in’ begins to have the effect of ‘crowding out’, with the public sector playing the role that can now be taken over by the private sector.

To counter this problem, public sector institutions must focus on genuine crowding in, distinguishing it from the gross volume of blended finance that sometimes may not be an accurate gauge of private sector mobilisation. Their mandate will include commitment to continuous innovation and invariable willingness to take on new frontiers. This will undoubtedly be a challenging task for public sector entities. High-level bodies such as the G7 summit can help by providing guidance and encouragement, as well as pressure.

Clear communication with the private sector

Among private sector entities, there are substantial concerns (often without being stated officially) that participating in blended finance will prevent them from making the best business decisions. Dealing with this issue will entail communication with the private sector about two points simultaneously. One is assurance that nothing in the blended finance arrangement will compel private sector entities to deviate from pursuing their best business interests.

The other is clarification that the best course of action from the business point of view is changing rapidly. What seemed like a mere corporate social responsibility activity is, or will be, an essential business element, due to new developments in such areas as government regulations, investor expectations, and supply chain management.

One private sector entity well aware of these new developments is a transportation company which is evaluating the possibility of participating as a principal equity investor in blended finance of a project to collect used cooking oil and produce biodiesel from it. As it uses a waste material as feedstock, this form of biodiesel is free from the criticisms sometimes directed at fresh material biodiesel (derived from soybeans or palm oil, for example), based on the concern that they are produced at the expense of food supply or conservation of virgin forests. The initial analyses indicate that, with some assistance from the public sector, the project will be profitable at current diesel price levels.

As a transportation company that consumes large quantities of fuel, its management believes that supporting biodiesel from used cooking oil through blended finance, and using it for its own vehicles, will be favourable with respect to the company’s reputation among investors, supply chain assessment by its customers and government relationships. This is the way of thinking that warrants encouragement.