Rethinking private capital for development

The ‘Fourth International Conference on Financing for Development’ (FfD4) will open next June while two main global donors, the UK and the US, are radically reducing their international development budget. Reconsidering the role of private finance, and blended finance, in driving development has thus never been more important. Blended finance (i.e. the use of concessional capital, provided at below-market risk-return rates, to attract more commercially priced capital into impactful projects) was a main focus of the Third Conference in Addis Ababa in 2015. Blended finance can take many shapes but, in a nutshell, it encourages private investors’ participation by reducing risk or boosting returns for projects that commercially minded investors would not normally support due to less attractive conditions compared to the ones they can get in more developed markets.

Has blended finance been successful in mobilising private finance towards developing countries?

Private finance investments into developing countries have increased but not to the scale needed to bring transformative change and blended finance still plays a modest role in incentivising investments. Foreign direct investment flows to developing countries modestly increased to USD 700 billion in 2023, up from 500 billion in 2013. However, private capital mobilised by Multilateral Development Banks (MDBs) and Development finance institutions (DFIs) has remained essentially flat at around USD 160 billion per year since 2016. Only a fraction of this capital is crowded in by blending concessional capital with non-concessional capital. The aggregate amount of financing made possible by blending has remained at around USD 15 billion per year for the last decade. Overall, these figures are well below the investment needed in developing countries and show that private capital has a limited appetite for emerging economies. To simplify, it is just easier and much more profitable to buy into the US stock market.

Public or private finance, who should lead the way?

A key criticism of blended finance is that it is fragmented, not sufficiently led by country priorities, and, as argued for example by Marianna Mazzucato, “it allows private priorities to shape the direction of public financing”. There is ample room for investors and donors to improve how capital is deployed, pool concessional sources of capital, and standardise blended finance products.

However, blended finance was never intended as a substitute for government spending or a panacea for financing the Sustainable Development Goals. The 2015 Addis Ababa Action Agenda and the 2017 Hamburg G20 initiative outlined a comprehensive framework for channelling private capital toward development. Blended finance was just one element among many, including Integrated National Financing Frameworks to meet country-owned priorities, upstream project development, improved risk and performance data, and addressing regulatory constraints that limit institutional investment in emerging markets. These complementary elements are equally vital in unlocking capital at scale.

Most importantly, development really hinges on effective government spending and better using domestic resources. The largest share of MDBs lending goes to emerging market governments and it is provided at below market rates. Only 1% of Overseas Development Aid is spent on blended finance to mobilise private capital. If governments’ investments are not yielding the desired outcomes, this is not due to donors’ resources being diverted to subsidise commercial investors.

Where should blended finance go?

Blended finance can be used to support projects that are either far from attracting private capital, typically in difficult sectors or least developed countries, or projects that are closer to being commercially attractive, often in higher-income countries or more mature sectors.

Blended finance can support ‘pioneering strategies’, innovative and high-risk sectors, or new business models. These are typically projects that involve nascent technologies, unproven markets or sector like adaptation finance, or supporting underserved groups (SMEs, smallholders farms, agri-insurance). While blended finance has helped to broaden the spectrum of interested investors, these projects require outsized subsidies to become attractive to private investors at scale and for this reason these projects tend to be funded mainly by public investors.

Alternatively, blended finance can be ‘mobilisation driven’, focusing on attracting private capital at scale (i.e. multiple billions) into projects that are closer to being commercially viable. These are often in more predictable sectors like renewable energy or infrastructure. Microfinance institutions or climate-focused funds have demonstrated that initial concessional investments can pave the way for greater commercial participation. Instruments like partial risk guarantees or fist loss capital, which make investing in developing countries not much riskier than investing in mature economies, can unlock significant private capital at minimal concessional cost. As institutional investors gain confidence, the need for concessional support will naturally decline.

Mobilisation is where a little concessionality can go a long way in attracting private finance into projects like renewable energy, clean transport, waste management, and industrial decarbonization. Given that concessional capital is scarce, there is a strong argument that if any subsidy is to be given to private finance, it should go where the smallest subsidy can achieve the largest impact.

Are we forgetting impact by focusing on volumes?

As rightly pointed out in the recently published FfD4 zero draft, success in development finance should always be measured by impact, not volumes. But impact means different things depending on whether we are aiming to pioneer or mobilise the private sector.

In pioneering deals, success is about reach or innovation. It is about reaching underserved populations and proving that it is possible to create some revenue streams from frontier projects like climate adaptation.

In mobilisation-driven deals, success is about the scale of impact and additionality—demonstrating that near-bankable projects can attract commercial capital with as little concessional capital as possible and that the subsidy was absolutely needed. Success measures should include the scale of impact achieved (e.g. the tonnes of CO2 avoided) but also how these investments have changed market behaviours and investors’ appetite, for example by bringing new entrants in the same market. There are success stories of public investors opening the way for private capital. For instance, consider how quickly the telecommunication sector has matured some of Africa’s most difficult markets like Ethiopia, or utility scale renewable energy generation and the electric vehicle markets in India.

Both ‘pioneering’ and ‘mobilising’ impact are valuable, but they are different and cannot be achieved in every context at the same time.

Let’s refocus on the big picture

Taking a step back from deal structuring and impact measurement, the biggest challenge today is moving from isolated transactions to systemic, sector-level change. Over the past few years, we have seen more than fifty blended finance funds come to market with increasing levels of sophistication. There are many important technical aspects that need improvement, such as securitisation regulation, mobilisation reporting, standardisation of legal structures, and availability of performance data. However, these technical issues should not distract us from the big picture.

Effective development is domestically driven. Scaling up requires a sector-driven focus, more effective country platforms, and productive government spending. This calls for governments and public financial institutions to develop explicit strategies for sectoral evolution. It calls for a better understanding of unmet development needs, competitiveness gaps, as well as where we can have sustainable revenue models, and were not. It requires a transparent discussion on where public resources should take the lead and where private finance can be crowded in.

This is the real conversation we should be having at the Finance for Development Conference.

Tags: Finance, Development, Development Policy, Private sector