Innovative Finance, a new discipline that investors, companies and government should know about
Innovative financing is a combination of something new and a new framing of activities that have existed for a long time. Perhaps the most important and surprising thing about Innovative Finance is that it is not financial innovation. The «innovation» aspect of innovative financing lies in the introduction of new products, the extension of existing products to new markets, and the presence of new types of investors.
For more than a decade, microfinance has been the poster child of finance in developing countries. In the decade to come, we believe that innovative financing, which identifies ways to achieve social, environmental, and financial returns; will be the most important new source of development finance. In Spain this is a significant opportunity both for companies and investors to engage in emerging markets. The emergence of this asset class will trigger a new domestic dialogue between the private sector and Government in Spain about how to invest in better public services and new growth engines in the economy. By paying more attention to the innovations that occur in newer economies, we in Europe can provide better returns for our businesses and better lives for our citizens.
This article first presents the background for innovation finance and its definition. We then offer some perspectives on the size and future of innovative finance. Finally, we will suggest different avenues on how Spanish companies can engage in the arena.
Why Innovative Finance?
Imagine not having access to essential livesaving health products. Severe pneumococcal disease – primarily pneumonia and meningitis – is the leading vaccinepreventable cause of death in children under five. The most effective way to prevent these deaths is to ensure that all children have access to a safe, affordable vaccine. Despite the widespread availability of the vaccine in North American and Europe, appropriate vaccines were not available in developing countries prior to the introduction of the Pneumococcal Advanced Market Commitment.
In June 2009, the governments of Italy, the United Kingdom, Canada, the Russia Federation, Norway and the Bill & Melinda Gates Foundation launched a new innovative financing product, the Pneumococcal Advanced Market Commitment, to increase supply and reduce the price for pneumococcal vaccines. As a result, it is estimated that the pilot can prevent more than 1.5 million childhood deaths by 2020 1.
The growth in innovative finance has been born out of both demand and supply side needs. On the demand side, particularly three streams have been important: a) Fighting poverty and climate change requires additional massive investments; b) Meeting the demands of growing middle class families that want reliable energy supply and quality health and education now and not in years to come; and c) Finding new ways to supplement government budgets that have been shrinking after the financial crisis. If we take a look upon the first item, then it is estimated that dealing with climate change and meeting the Millennium Development Goals and its successor will require additional one trillion dollars a year 2. The public sector does not have the resources to support all of these needs alone.
Figure 1: A successful transition to sustainable development will require substantial resources
Estimates of annual investment needs for selected sustainable development sectors $ billions
On the supply side, it has particularly been two drivers behind the interest in innovative finance. The first and most important one has been the continued low interest rates in OECD countries. Large pension funds and other institutional investors with large holdings in bonds are increasingly on the lookout for alternative investment options that have a longterm, secure, yield. The second driver has been the growing recognition by the private sector of the rewards of promoting economic and social prosperity and environmental sustainability through their operations. For example, the 1200 signatories of the United Nationssupported Principles for Responsible Investment Initiative – including asset owners, investment managers, and service providers – have today $34 trillion dollars in assets under management 3.
What is innovative finance and what benefits does it bring?
Like most other advances, innovative financing is a combination of something new and a new framing of activities that have existed for a long time. Perhaps the most important and surprising thing about Innovative Finance is that it is not financial innovation. The «innovation» aspect of innovative financing lies in the introduction of new products, the extension of existing products to new markets, and the presence of new types of investors. The term refers to a broad range of financial instruments and assets including securities and derivatives, resultsbased financing, and voluntary or compulsory contributions that by design and in a combination both serves public and private goals.
Case Study: Green Bonds
Green bonds provide an instrument through which investors who are concerned with the effects of climate change can make a difference by specifically supporting climate change related projects.
The World Bank first issued green bonds in 2008 to finance investments in lowcarbon infrastructure, such as renewable energy infrastructure and energy efficiency improvements. In the past five years, green bonds have grown considerably. According to Standard & Poor, government and corporations issued $10.4 billion in green bonds in 2013. A recent report by Bloomberg New Energy Finance points out that the market is growing fast; at its current pace, total volume of green bonds will surpass $40 billion by the end of 2014.
What is intriguing about innovative financing is that it can close some very important market gaps. Successful innovative financing instruments address a specific market failure, catalyze political momentum to increase and coordinate the resources of multiple governments, and offer contractual certainty to investors. Often, innovative financing instruments reallocate risks from investors to institutions better positioned to bear the risk and, in the process, enable participation from mainstream investors. Instruments that have mobilized significant resources benefit from relatively simple financial structures and a proven track record that clearly describes the financial and social returns for investors.
How does innovative financing create value?
• Deploys significant, new private sector capital that would otherwise not par-ticipate in social investments.
• Transforms financial assets through financial structuring and intermediation to meet the needs of development programs by distributing risk, enhancing liquidity, reducing volatility, and avoiding timing mismatches.
• Supports a cooperative public-private sector approach to scale socially benefi-cial operations that require significant capital outlays and traditionally sit squarely in the realm of the public sector.
Figure 2: Bonds and guarantees are the largest innovative financing mechanisms
Amount mobilized by innovative financing mechanisms, 200-2013
Dalberg Global Development Advisors conducted a survey of nearly 350 financing mechanisms that have been recognized as innovative financing. We estimate that innovative financing instruments have mobilized nearly USD 100 bn since 2000 and grown at 11% per year between 2000 and 2013. More than 80% of this total comes from securities and derivatives such as bonds, guarantees [Figure 2]. The proceeds of these investment support increased access to finance, investments in sustainable energy, and improvements to agriculture productivity [Figure 3].
Figure 3: Innovative financing mechanisms have focused on a range of development challenges
Innovative financing mechanism by sector
What is the implication of this in Spain?
We believe that there are at least two important lessons that can be used in a Spanish context. First, companies and institutional investors that target returns in emerging markets must be capable of applying innovative financing approaches to their activities. Spanish companies that are involved in infrastructure projects or desire to serve mass markets must be able to design value propositions that resolves the issue that few public or private customers can pay for major services and investments up front, but have an ability to pay overtime in smaller pieces. Moreover, Spanish providers will also need to find ways to unlock additional value by providing goods and services that there is a public interest (domestic or overseas) to subsidize because it also has large society benefits. For investors that are interested in a different posture and exposure, then innovative finance has the attraction of providing a flow of alternative investments that can combine solid underlying assets with often strong risk adjusted returns because they involve services in great demand as they are centered on basic human needs.
The second lesson is that the Government of Spain with its stress on the public finances should take a hard look at innovative finance and the publicprivate projects that today are being developed in emerging markets. To create new growth opportunities and jobs in the private sector, the public sector needs to play a new role. It needs to move away from being the key driver of new growth activities to facilitating and incentivizes new investments through private sector partnerships. An inspiring example is Estruturadora Brasileira de Projetos (ESP) in Brazil that is coowned by 5 commercial banks. They have successfully set up a publicprivate partnership entity to develop new airports, harbors, roads and other critical infrastructures. This entity has become a factory of large scale infrastructure projects that rests on strong commercial business cases and clear society needs and benefits.
What makes innovative finance different from other initiatives and tools in social and economic development is its scalability. While many efforts are bound by governments or philanthropists’ pockets or conflicting incentives for businesses, this method enables players to bring their core competences and assets to the table and engage in activities that often are close to limitless in their scale or replication.
Written by Sam Lambert and Henrik Skovby, DALBERG.
1. See more at: http://www.gavi.org/funding/pneumococcal-amc/about/
2. These estimates are based on the literature review found in «Financing for sustainable development: Review of global investment requirement estimates», UNTT Working Group on Sustainable Develo¬pment Financing, 2013.
3. See http://www.unpri.org/about-pri/about-pri/ for more information (accessed June 2014).
