Alchemy vs Chemistry: Does Innovative Finance Really Bring in New Money?

April 04, 2014

Innovative finance schemes are most likely to fail if the main aim is to bring in more money, and most likely to succeed if the aim is to create new ways of working.

Take for example Development Impact Bonds. We don’t think of DIBs primarily as a way to bring in ‘new money’ even though they involve private investors (we explain why not below): we think of them as a new business model which helps create an effective partnership between the private and public sector.  But we also know that ‘new money’ is sexy, so we are prepared to lift the veil a little: yes, Development Impact Bonds will bring in additional money, but perhaps not in the way you think.  We list six ways below – none of which is the naive claim that private investment means additional funding. Maybe you can suggest others? If so, please add them in the comments.

During a coffee break at the UK’s Social Impact Investment Forum on 6 June 2013, a small group of former UK Treasury officials compared notes over conference biscuits. In our twenties, we had all been involved in the UK Private Finance Initiative (PFI), which had aimed to bring private sector expertise into public services. As we listened to the speeches at the 2013 conference, we had all been struck by the same thought: we had heard it all before twenty years earlier. (Some of us had even written the speeches.)  And it hadn’t ended well.

I still believe the PFI was a good idea in theory, but it was quickly hijacked by Ministers and civil servants who saw it as a way around government spending limits. They were keen on PFI not because it would bring better management to public services, but because they wanted ‘new money’. The PFI enabled them to build new schools and hospitals immediately and leave the bill for future taxpayers.   Instead of better public services, we ended up with expensive borrowing; and the chickens are now coming home to roost. Development advocates who promote innovative finance as a source of new money should take note: be careful not to bankrupt your successors.

That is why we get nervous when people portray Social Impact Bonds or Development Impact Bonds as a way to bring new money into development. If the thought of additional funding is mainly what attracts you to this kind of innovative finance, then it probably isn’t for you. Investors expect to get their money back eventually; so in the long run the private investment does not add to the total amount of money going into the service.  DIBs are about chemistry, not alchemy.  If you are looking for a way of creating money from nothing, you might be better off trying to mine Bitcoins.

What we like about the financial innovation of Development Impact Bonds is that it enables a new business model to be put in place: if private investors rather than public agencies provide the initial finance this may enable more flexibility and better management of innovation and risk, so offering the chance of producing better outcomes. DIBs may be a way for public and private actors to work together with more efficiency, flexibility to adapt programs to changing circumstances, and data and evidence to shape decisions.  That is why we think DIBs should be tried; and we want people who implement them to be focused on making that partnership work effectively.

Nonetheless, it is possible that DIBs can result in increased spending in a particular sector or can increase total development finance.  Though we don’t think this is the main reason to test DIBs, we have thought of six ways in which they can bring ‘new money’ to particular problems or to development as a whole.   

  1. First, DIBs may allow donors to spend money on something that they could not otherwise engage with, so increasing their willingness to put money into a sector which might otherwise be too risky. In the DIB case studies in the Working Group report – for example, proposed DIBs to reduce Sleeping Sickness in Uganda or HIV in Swaziland – there is some evidence that proposed interventions will lead to results, but donors would just not have enough confidence that results would be achieved to enable them to finance the interventions in advance. They may be happy to be the outcomes payer if someone else is taking the risk of failure.  This means that additional money would be brought into projects or programs that couldn’t attract it otherwise. 
  1. Second, some DIBs may release other fiscal benefits which increase financing to a particular sector or development finance overall. The most intuitive example is an investment to increase domestic revenue collection, which could pay for itself and raise extra tax money for development finance. The main role of external outcome funders (e.g., donors) in this case might be to guarantee the investors against political risk.  Although generating medium or long-term cash savings for governments is less likely for most applications of DIBs than for developed country SIBs, there might be cases where there are fiscal benefits from an investment (e.g., job creation which leads to more income tax, or improving courts so fewer prisoners are on remand) so that the external outcome funders only have to contribute part of the outcome payments to the DIB, with additional fiscal benefits paying the rest, leading to a net increase in development finance.
  1. Third, some DIBS could leverage aid budgets by complementing other revenues. For example, a DIB could part-finance a new private school, or improve collection of user fees on utilities like water, sewage or electricity.  In such cases, the outcome payment from donors might focus mainly on subsidising an externality or paying for the outcome only for the part of the community that is too poor or marginalised to pay; but by doing so, enable a service provider to scale up a partly-commercial, revenue-generating enterprise that wouldn’t be able to reach scale on its own. Too often with conventional development finance, donors tend to conclude that if there is a market failure preventing private provision, then the state or donors have to step in to provide the entire service instead.  DIBs are a way in which an outcome funder can focus an aid budget on providing a marginal supplement which makes a service profitable and sustainable, rather than spending the aid budget on providing the entire service when markets do not work.
  1. Fourth, the structure of DIBs could open development finance to new outcome funders who are excluded today. For example, you could imagine that members of the public might not be willing to give money ex ante to NGOs on the promise of results that might be achieved (and probably will never be rigorously measured) but might be willing to crowd-fund ex post a successful project to get girls into school or provide people with clean water.  So DIBs could expand development finance by offering opportunities to a whole new class of outcome funders who want to pay for proven results.
  1. Fifth, some investors may be willing to accept sub-commercial rates of return (because they are getting a double bottom line of some financial return plus some good karma).  We expect this to be the case with early DIB investors. If those investors would be willing to make concessional investments in DIBs but wouldn’t have been willing to give the grant equivalent in some other way, then this increases total development finance by making the program less costly for the donor outcome payer.
  2. Sixth, more broadly if over time DIBs enable outcome funders to achieve more results more cost-effectively, and to be able to prove that they are doing so, and because they are only paying on success, this might increase public (and congressional and parliamentary) appetite for foreign assistance, so increasing overall development finance.

The value of private sector involvement in DIBs is not “additional money” but the efficiency gains that come from aligned incentives to achieve results, and shared expertise in areas like program management.  In the long run, we believe these new business models will in turn increase the total amount of money coming in to particular projects or programs, into some sectors, and possibly into development finance overall, in the ways we have described.  But if we want DIBs to succeed, the focus should be on new ways of working, not on new money.


CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.