Earlier this week, Members of the European Parliament had the opportunity to hear the Commissioner-designate for ‘International Partnerships’, a crucial step before she can be formally appointed by the Council later this month. In her statement to MEPs, former Finnish finance minister Jutta Urpilainen committed to focus on meeting the SDGs, reducing inequalities and eradicating poverty. To achieve these ambitious objectives, Urpilainen stressed the need to put a stronger focus on ‘leveraging private capital’ as ‘traditional measures of aid delivery are not enough’. The EU has been using various instruments to crowd in private finance in its development efforts for a number of years now even though there is no established evidence of their positive development impact. The more surprising, that these instruments and the many concerns associated with them received very little attention during the commissioner-designates’ hearing. This blog sets out a number of key concerns on the current agenda to finance the EU’s development priorities through private sector engagement.
Blended finance – a combination of official development assistance with other public or private resources – is portrayed as a key tool to leverage private finance for development. This is not a new phenomenon but the idea has gained traction in recent years due to an increasingly dominant narrative that places private finance, and the role of the private sector, at the center of donor policies. Blended finance is transforming the development architecture and a growing amount of resources are being channelled through Development Finance Institutions (DFIs) to support private-sector operations, carving out a more central presence in the development discourse and implementation. The key question, however, is to what extent this transformation is actually bringing the world closer to the Commissioner-designates ambition of meeting the SDGs. Recent evidence casts doubt on the contribution of blended finance on two key dimensions.
Tilting the balance of risk and reward for commercial investors?
A first dimension is centred around the promise of blended finance to tilt the balance of risk and reward for commercial investors in a way that allows private flows to be massively oriented towards development purposes. The rationale behind this promise is that a relatively small injection of concessional, public finance allows those investors to move into markets they would otherwise consider too risky. This effect is often referred to as the ‘additionality’ or ‘leverage effect’ of blended finance. While additionality refers to the value added through the use of ODA that would not have been there if the market would have its way both in financial terms and in terms of development impacts, ‘leverage ratios’ look at the relationship between the amount of finance mobilized and the amount of public finance initially injected into a project. The use of some of these leverage ratios often involves bold and unsubstantiated assumptions about the impact of the public element in blended finance projects. For example, the European Commission has been reported to claim ratios in the order of 1 to 9 or higher, meaning 1 euro of ODA has been able to attract 9 euro of additional private money. Even if such high ratios reflect reality, they raise questions about additionality. The easiest way, in theory, to hit high leverage ratios is to attach a very small sum of ODA to a large and already viable investment project, which calls the financial additionality into question.
Despite the fact measuring leverage effects is very challenging, current independent efforts to do this provide a sobering reality check for the proponents of blended finance. Recent reports clearly show that the towering expectations for blended finance to close the SDG financing gap are unrealistic. Those expectations build on the assumption that DFIs and MDBs are playing a key role in sparking an investment boom in many developing countries while they are only just one, and an apparently marginal, factor in determining the investment fundamentals. Furthermore, blended finance is clearly biased towards investments in ‘hard’ sectors, such as energy and transport infrastructure. Moreover, recent evidence suggests leverage ratios plummet to 1 to 0,37 in Low Income Countries, compared to 1 to 1,06 in the Lower Middle-Income Countries. A strong focus on blended finance risks skewing public concessional financing away from those countries most in need and from social sectors such as education and health.
Undermining development effectiveness
A second dimension focuses on the quality or development additionality of blended finance projects. There is a growing body of evidence on the adverse impacts of certain blended finance projects for whole communities of people living in poverty. These include the alleged grabbing of indigenous communities’ agricultural land in Mexico; the imposition of unaffordable user fees at a hospital in Zimbabwe, forced evictions to make way for a highway in Kenya and renewable energy projects tailor-made for the extractive industries in Chile.
If Commissioner-designate Urpilainen is serious about her commitment to achieve the SDGs, a more cautious approach towards blended finance would be appropriate. A growing body of evidence is clearly demonstrating that donors are over-promising on the contributions blended finance can make to reaching the SDGs, both in terms of additional resources flowing to development purposes as the quality of those flows for effective development. Especially, in fragile contexts with prohibitive barriers to sustainable investment, blended finance risks to divert scarce resources away from public investment in social and economic infrastructure projects. When Commissioner-designate Urpilainen starts her term, she will have the opportunity to direct the EU’s aid efforts towards achieving the SDGs. This will require the audacity to revive well-known development instruments, as an alternative to blended finance – especially in poorest countries where investments constraints are particularly challenging. Closing the ongoing negotiations of the EU’s multi-annual financing frameworks and the upcoming initiatives of a Comprehensive Strategy for Africa and a European Green Deal provide excellent opportunities to do this.