A unique way to boost financing for sustainable development in emerging markets

According to the global network Convergence, $231 billion in blended finance capital has been mobilized towards sustainable development in developing countries to-date. Although a drop in the bucket compared to the $139 trillion global private and public equity markets, blended finance’s unique structuring approach offers investable opportunities that address some of the world’s most urgent environmental and social issues.

This article looks at how blended finance operates, its significant impacts and challenges, and strategies to optimize its application in the development landscape.

Understanding blended finance

In essence, blended finance leverages public funds to attract private sector investment towards projects aimed at achieving sustainable development in underfunded and high-risk areas of developing countries. Public and philanthropic funders, often development finance institutions (DFIs), provide the initial capital and risk assurance needed to attract private investors who might otherwise be wary of investing in projects due to perceived risks or uncertain returns.

Through mechanisms like debt and equity cofinancing, risk-sharing instruments and guarantees, blended finance facilitates the flow of substantial private funds into critical sectors such as renewable energy, sustainable agriculture, and infrastructure.

The “State of Blended Finance 2024” report presents a number of examples of how blended finance works across the spectrum, particularly for small and medium-sized businesses. For instance, the Green Guarantee Company (GGC), launched in 2023, is deploying an initial $100 million raised from government and multilateral donors to unlock $1 billion in private sector investor capital for climate mitigation and climate adaptation projects in developing countries.

And Thrive Agric, a Nigeria-based agri-tech company, used a $1.75 million grant from USAID West African Trade and Investment Hub to raise $10 million in private investments, “enabling the company to increase the number of rice, maize and soybean smallholder farmers with access to its agronomy advisory services, harvest logistics support, and credit and insurance products.”

In an interview with The Sustainable Finance Podcast, Paul Hailey, head of impact and ESG at responsAbility Investments AG, talked about how their projects in South America and North Africa are achieving competitive returns while making significant impacts on climate mitigation, health care, education, manufacturing, financial inclusion and quality jobs for the younger generation.

Managing competing concerns is challenging, Hailey said: “We know that if we’re going to address some of the social concerns in a country, that’s going to necessitate a rise in emissions. So, we also have an obligation to try and invest in energy infrastructure, for example, to try and ensure that the transition, when they increase their capacity, is done using renewables and not coal.”

DFIs play a crucial role, he said, by providing guarantees or accepting lower returns to stimulate private investment.

Financial gaps and challenges

The latest findings from Convergence indicate a robust blended finance market recovery in 2023 from a decade-low in 2022, with investment volumes hitting a five-year high of $15 billion, evidenced by an increase in large-scale deals — 40% of which exceed $100 million.

Additionally, climate blended financing surged, more than doubling from $5.6 billion to $11.6 billion in a year. However, this amount still falls significantly short of the $6.9 to $7.6 trillion required annually to meet the Sustainable Development Goals for developing economies by 2030, as marked by UN trade & development.

Multilateral development banks (MDBs) are instrumental in this space, driving 70% of the total private finance mobilization according to OECD. However, in 2020, when the funding gap was estimated at $3.9 trillion, only $52 billion was mobilized by all official development finance providers in private finance.

This gap highlights the ongoing challenge: MDBs and DFIs have been criticized for their conservative risk management, which has often led them to prioritize their own financial stability over mobilizing additional private capital.

Other challenges in adopting blended finance include the small scale of projects and high associated costs such as due diligence and transaction execution. Market complexity and a lack of accessible networks and expertise further impede private investor engagement, diminishing the overall impact and effectiveness of blended finance in addressing development needs.

Strategies for enhancing blended finance adoption

First, MDBs and DFIs need to revamp their strategies to leverage private sector funds more aggressively. By taking bolder steps to refresh their business models and prioritize private sector mobilization, these institutions can significantly enhance their contribution to maximizing the impact of blended finance in the near future.

Second, a specialized tech-driven intermediary platform can enhance the flow of private capital into sustainable projects. This intermediary would act as a central hub, connecting investors with opportunities and aggregating smaller projects into larger investment prospects, particularly those exceeding $500 million.

Key functions include deal structuring to meet diverse needs, due diligence to minimize costs and the development of tax-efficient structures. An open-source impact data repository would also improve transparency and demonstrate investment outcomes.

Standardized principles are also essential for a disciplined, transparent approach to blended finance. For instance, IFC’s Blended Finance practice follows DFI enhanced principles and guidance for how to advocate for “commercially viable solutions using minimum concessionality” and “increased scrutiny of projects proportionate with the underlying risk that concessional resources could lead to market distortion.”

Similarly, OECD Development Assistance Committee also proposed its Blended Finance Principles for Unlocking Commercial Finance, emphasizing evidence-based strategies, best practices and local tailoring.

Finally, recognizing that it is challenging to create a regulatory framework that fits all jurisdictions, regulators must also focus on where the bulk of assets are concentrated. As Hailey pointed out, the primary obligation of regulators is to protect consumers, which directs their attention to the most prevalent products.

“There’s plenty of sustainable listed products out there, but let’s also look at where the need is as well, and let’s try, encourage, and foster the growth of products in that space,” he said.

Overall, blended finance provides a vital pathway to bridging the funding gaps for sustainable development by linking public initiatives with private capital. Successful blended finance investments help create markets and accelerate solutions to climate change and global poverty.

But to fully realize its potential, strategies such as adjustments in MDB and DFI operations, effective capital flow mechanisms and targeted regulatory frameworks are essential.

Read more: How companies are struggling to measure the ‘S’ in ESG