Is Blended Finance the Future for Development Finance Institutions?

In this interview, Paul Horrocks, one of the expert contributors for the Blending4Ag event, expresses his personal opinion on the status quo and challenges of blended finance, and the involvement of development finance institutions (DFIs).

Is blended finance becoming a mainstream approach for DFIs?

Many DFIs are increasing their ability to deliver blended finance. At the same time, DFIs do not always consider that they are operating in the blended finance space: many offer finance at non-concessional market rates and consider blending to be based on concessionality and therefore do not consider that their activities are actually blending. They may be taking more risks than the private sector but their capital is not priced at a concessional rate, which is what participants typically understand as blending.

 Aid agencies are increasingly moving away from a purely grant focus to combining public and private sector funding as a ‘blended finance instrument’. This in turn is contributing to the mainstreaming of blended finance. DFIs are important in this process in terms of sharing capabilities and providing aid agencies with the necessary risk frameworks for working with the private sector in market environments.

Does this mean that DFIs are operating in the ‘blended finance space’ but don’t realise that they are, or that they would rather not be operating in this space?

That depends on how you define blending. Many bilateral DFIs do not consider that they are blending – i.e. pooling concessional public resources with non-concessional private capital – as this would not be in line with their definitions of financing activities undertaken. However, we do not want to lose these DFIs from the blended finance debate as they are often the largest private-sector players in this funding space. In addition, blending is typically considered the use of concessional and non-concessional finance. The OECD typically defines blended finance as the strategic use of official funds including concessional tools to mobilise additional capital flows (public and/or private) to emerging and frontier markets.

What are the bottlenecks or challenges to growth for blended finance?

The key challenges facing blended finance is the lack of a common understanding of what blended finance is, and in clarifying the different perspectives on concessional and non-concessional funding. In particular, aid agencies tend to use concessional finance to deliver projects whereas DFIs tend to focus more on non-concessional finance instruments to catalyse the private sector, however, to be effective a common understanding should be built. Without this, blended finance will not achieve the necessary scale and desired impact.

 Another issue around blended finance is the need to ensure an adequate pipeline of bankable projects. This requires sufficient capacity to handle blended finance in target countries, but also demands that the private sector has a clear understanding of what instruments are available, and how to incorporate them into financial structures. Bringing institutional investors into blended finance projects is a significant challenge, as the necessary blended finance mechanisms or capital market depth do not currently exist. For example, the pension and insurance funds that are looking to invest in emerging and frontier markets are still concerned about the risk of exposure to these economies.

 Blended finance growth is currently constrained by a lack of budgetary and institutional capacity in aid agencies, where there is still risk aversion around partnering with the private sector – and a lack of adequate risk frameworks to deal with working with private companies. Donors need to increase their capacity to deliver blended finance projects and the amount of funds they allocate to these projects. They also need to be willing to take more risks in order to spur innovation in the sector and also reduce overall risks by combining projects across sectors and regions.

DFIs and aid agencies need to work together more effectively in a coordinated fashion, whether nationally, bilaterally or multilaterally, in order to make sure that enough blended public- and private-sector finances are invested in those geographical regions and sectors that are critical to delivering the United Nations’ Sustainable Development Goals.

In your experience, what has worked well and what hasn’t worked as expected in blended finance deals?

We are currently looking at a number of blended finance case studies. One of the things that has surprised me is the ability of blended finance projects to create a market, for example giving farmers the opportunity to purchase seedlings. Blended finance can be directed not just to a single project but also to much wider issues, thereby bringing about significant economic benefits.

However, blending does need to be correctly priced and calibrated: giving the market too much cheap finance could crowd out and discourage the private sector from continuing to invest in projects (that depends on market returns). For maximum impact in the development sector, both forms of investment have a role to play.

How does blending for agriculture differ from blending for infrastructure, energy or health?

Blending for agriculture has some similarities to blending in the health sector but less so with infrastructure and energy. We have seen some of the experience of working with the private sector in other sectors being transferred to agricultural initiatives.

 Like projects in the health sector, agricultural projects often need considerable support and wide community participation in order to be successful. Depending on the agricultural sector or crop, it can also require considerable patience before a significant harvest and financial returns are seen. Again, this is akin to the impact of some community health interventions.

What do you think will be the main driver for scaling up blending for agriculture?

A main driver will be lessons learned from successful case studies. These need to be articulated and mainstreamed across regions and where possible to other sectors of agriculture. Ex post assessment of lessons learned should be used to inform how effective structures can deliver development outcomes through agriculture.

There also needs to be further innovation in order to deliver more effective projects and scale. This can be achieved through donors and multilateral development banks (MBDs), targeting the agricultural sector more effectively and allowing increased risk-taking on projects.

Will blended finance make a significant dent in the agricultural financing gap if it does become mainstream? Or will it be a somewhat marginal tool?

Compared to other parts of the economy – in Africa in particular – agriculture can often have a strong revenue stream and access to export markets. This means that there are considerable opportunities to engage the private sector. Blended finance approaches that are successful in developing nascent agricultural sectors and allowing markets to emerge will be critical in driving these sectors and demonstrating to private companies that agricultural projects can benefit from blended finance tools. For blended finance to have a significant effect on the market it may need to target large-scale and more commercial projects where large institutional funds will see significant potential. However, small-scale farmers are often where future markets exist and where further patience and increased concessionality may need to prevail.

Areas where difficulties may occur and which should be addressed in order to allow blended finance projects to succeed include the infrastructure that allows agricultural produce to reach its markets, be it internal or external. Infrastructure needs must be taken into consideration when developing blended finance projects.

A joined-up and coherent strategy by donors and MDBs on blended finance for agriculture across a number of African countries could, if effectively implemented, create the scale and scope necessary to ensure the mainstreaming of blended finance in agriculture.