Mixed finance struggles to take off
ANDREW JOHNSTONE manages a fund that goes “where people haven’t gone before”. Launched in 2015, Climate Investor One finances renewable energy projects deemed too risky by the market, such as wind farms in Vietnam or hydroelectric installations in Uganda. It uses grants from development agencies to attract capital from pension funds. This allows him to raise more money. For every dollar in grants, he got 12 dollars from the private sector.
The fund is an example of blended finance, where public or philanthropic money reduces the risk of investments for the private sector, using financial instruments such as default insurance or loan guarantees. The mixed money directly finances projects, often infrastructure in poor countries, or goes into a fund supporting many businesses. The idea took root in development circles in the late 2000s. Many still see it as a way for markets to close the gap in financing for goal achievement. UNsustainable development goals, estimated at $ 2.5 billion per year.
Institutional investors are thought to be exposed to lower risk emerging markets. Development institutions, such as the financing arm of the World Bank, are raising more capital. Ideally, blended finance would open up new markets. Once the viability of water treatment plants in Kenya is demonstrated, for example, the private sector should fund similar projects itself.
However, mixed finance has struggled to develop. Since 2014, the flow of public and private capital into projects and mixed funds has remained stable at around $ 20 billion per year, according to data from Convergence, a nonprofit. This is a far cry from the $ 100 billion target set by the UN in 2015, which targeted spending related to climate change and was to be met this year. Even some advocates admit that the approach is stagnating.
What’s wrong ? On the one hand, institutional investors are reluctant to get involved. The asset class is unknown. Projects are often tailor-made and too small to be worth the effort; the median value was $ 50 million in 2018. This raises another issue, says Jay Collins of Citigroup, a bank. The creation of a mixed structure requires financial expertise. But wizards tend to work for large financial firms with little interest in delicate transactions. Getting a good mix also requires the trust of the public and private sides, says Johnstone. A culture shock can prevent it. One portfolio manager describes working with heavy bureaucracies as “tortuous”.
Another stumbling block lies in public institutions. On average, multilateral development banks mobilize less than a dollar of private capital for every public dollar, says Katherine Stodulka of the Blended Finance Taskforce, a global body. Part of the reason is that their inner workings encourage grants above the mix.
Viable projects are also hard to find. In poor countries, governments find it difficult to prepare projects for investors, for example lacking the expertise to carry out feasibility studies. Private investors want to maximize returns, for a given risk; funders want the most impact. A blended finance project must balance the two, and there is little, says Christoph Kuhn of the European Investment Bank (EIB).
To help blended finance flourish, some development banks are working with poor governments to show projects are viable. This costs 2 to 5% of the project expenses (in consulting fees, etc.), but reassures investors. Mr. Kuhn advises using familiar mixing techniques to investors. The EIB focuses on capital stratification, where the government tranche takes the first loss if a project goes wrong, and guarantees against losses for banks.
Greater transparency could also attract investors. Transaction data is often confidential, so it’s hard to tell which returns are normal and how many projects fail. Development banks promise more disclosure (but investors doubt that will happen).
These small fixes will encourage growth. But merging public and private money will always be difficult, and early hopes may have simply been too bright. A trillion dollar market seems well out of reach. Even reaching the hundreds of billions a year can be a stretch. ■
This article appeared in the Finance & Economics section of the print edition under the title “Looking for Scale”