Why the World Needs Innovative Financing: Innovative financing’s “bridge” role in economic, social, and environmental development
As the development agenda comes under the spotlight at this week’s UN General Assembly in New York, one thing will become clear: the future we want – a future that meets the needs of people and the planet – will require investments estimated in the trillions of dollars over the next ten years.
Securing and mobilizing that investment will not be an easy task.
But the concept of innovative financing – which focuses on programs that deliver results and supports collaboration between the public and private sector – may present at least part of the solution.
A new report, titled Innovative Financing for Development: Scalable business models that produce economic, social, and environmental outcomes, was released today by Dalberg Global Development Advisors and the Global Development Incubator. Funded by the Citi Foundation (a NextBillion sponsor) and the Agence Française de Développement, it describes the innovative financing landscape and how expanded use of these mechanisms can promote development outcomes. The report aims to accelerate the growth of innovative financing by creating a common language and vision for leaders in both the public and private sector to use as they explore innovative financing opportunities to drive positive social and environmental impacts.
What is innovative financing?
Innovative financing instruments do not replace, but rather complement, traditional resource flows such as aid, foreign direct investment and remittances. By addressing specific market failures and institutional barriers, innovative financing can mobilize additional resources to eliminate poverty, raise living standards and protect the environment.
Innovative financing encompasses a broad range of financial instruments and assets used for global development. We estimate that innovative financing instruments mobilized nearly $100 billion and grew at 11 percent per year between 2000 and 2013. Innovative financing is unique because it can attract private companies that want to expand into new markets; investors and fund managers who want to create both financial and social returns; and governments that want to achieve more and better development impact in a resource-constrained environment.
Most of these mechanisms combine public and private sector resources and expertise; successful innovative financing creates incen-tives for private companies to invest in projects that benefit people at the base of the pyramid or support the environment.
One example of successful innovative financing is the Pneumococcal Advance Market Commitment (AMC), sponsored by the GAVI Alliance. Pneumococcal vaccines are complex and usually reach low-income countries a decade or more after introduction in industrialized nations. Yet each year pneumococcal disease kills half a million children under the age of five. Through the Advanced Market Commitment, donors, including the Gates Foundation, pledged $1.5 billion to guarantee a low price for two billion doses of pneumococcal conjugate vaccine (PCV) from pharmaceutical manufacturers.
The Advanced Market Commitment reduced market uncertainty, encouraging manufacturers to speed up the development and availability of vaccines. In exchange for the upfront funds from donors, the manufacturers agreed to sell the PCVs to low-income countries at a price no greater than $3.50 for the next ten years – a price that is 90 percent lower than the price of PCV in high-income markets.
In defining innovative financing, it also helps to note that it is different from financial innovation. Established financial instruments, such as guarantees and bonds, constitute nearly 65 percent of the innovative financing market. While new products dominate many conversations about innovative financing, most resources mobilized through it use existing products in new markets, or involve new investors. Our definition of the “innovation” aspect of innovative financing includes the introduction of new products, the extension of existing products to new markets, and the presence of new types of investors.
So how does innovative financing create value?
Innovative financing mechanisms address specific market failures and institutional barriers that hinder global development.
Often, innovative financing instruments reallocate risks from investors to institutions better positioned to bear the risk and, in the process, enable participation from mainstream investors. In the case of the AMC for pneumococcal vaccines, pharmaceutical companies were more motivated to conduct vaccine research and produce vaccines for developing countries because they had the advance guarantee from donors that those vaccines would be purchased.
The AMC for pneumococcal vaccines, while promising, is a single instrument sponsored by donor governments and philanthropies that has not yet been widely replicated. In order to achieve scale and attract private capital, innovative financing instruments need relatively simple financial structures and a proven track record that clearly describes the expected financial and social returns. For example, the World Bank’s issuance of green bonds to finance investments in low-carbon infrastructure has grown quickly because they are evaluated using standard risk models, provide a risk-adjusted return that meets investor expectations, and also offer investors the opportunity to be associated with a positive environmental outcome.
What are the next steps in innovative financing?
The focus of innovative financing is shifting from the mobilization of resources through innovative fundraising approaches – an approach commonly associated with traditional development finance – to the delivery of positive social and environmental outcomes through market-based instruments that are more sustainable.
In our report, we anticipate three primary drivers of growth in the innovative financing sector:
- Increased use of established financial instruments. Established instruments that investors can evaluate through existing risk frameworks, such as green bonds, will attract new participants including pension funds and institutional investors. Channeling the proceeds of these instruments to productive development goals will require new standards that specify how funds can be used most effectively.
- Expansion into new markets through growth of replicable products. Over the past ten years, the international development community has experimented with new instruments such as performance-based contracts. These instruments do not yet have the track record to attract institutional investors, but offer promising opportunities to improve development outcomes in new sectors.
- Creation of new innovative financing products. Finally, we have seen the emergence of new products, such as development impact bonds, that are promising, but are still in their early stages. While these products will remain a small portion of the market in the short-term, we encourage donor governments and other funders to continue experimenting with these products so they can mature into the next important asset class.
Meeting global commitments to eradicate poverty and to respond to climate change will require all possible sources of financing. Through its combination of private sector approaches to achieving risk-adjusted returns and a philanthropic orientation to producing social impact, innovative financing is a critical “bridge” to address the most pressing global economic, social and environmental challenges.
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Editor’s note: This post will be also published, by prior agreement, on Business Fights Poverty and Dalberg’s blog.