As we enter 2023, the world continues to face economic volatility and compounding crises, from high interest rates to a growing energy crisis and extreme climate conditions that continue to pummel every continent. As we contend with these mounting global challenges, the importance of blended finance has never been clearer. In light of this, Convergence highlights four blended finance trends to watch in 2023:
Blended finance will help mitigate the consequences presented by the current macroeconomic uncertainty.
Like the second half of 2022, the global economic outlook for 2023 revolves around uncertainty and instability. As stated in our State of Blended Finance 2022 report (SOBF22), interest rates have skyrocketed across developed markets to curb runaway inflation, impacting foreign exchange risk for borrowers in developing economies and elevating liquidity concerns as foreign lenders pull out of riskier markets to seek more secure returns in stable investment environments. Rising rates have tied up the balance sheets of many international financial institutions, a critical source of debt capital in blended finance. Unable to offload existing loans without risk of significant loss, banks are forced to restrict lending and have tightened risk appetites to avoid further losses, ultimately reducing the supply of affordable capital in emerging markets.
Highly indebted developing countries will be most impacted by a global economic recession. According to UNCTAD, 70-85% of low-income countries’ debt is in hard currency, driving the proportion of countries in debt distress higher. Tightened monetary policy in the world’s leading economies has reduced the prospect of significant forthcoming debt relief for over-leveraged countries, instead exacerbating concerns of a debt crisis as many become increasingly at risk of defaulting.
Blended finance is expressly intended to overcome these market risks. It mitigates credit and FX risk through the strategic use of concessional funds to boost liquidity and investment appeal in less favourable investment environments. First-loss capital or concessional guarantees can backstop commercial lending from banks to reduce capital costs for borrowers. The urgent need to scale climate finance means we cannot wait for market conditions to improve to expand financing to emerging markets. Indeed, influential climate proponent and special presidential envoy for climate, John Kerry, foreshadowed the trajectory of blended finance structures into the mainstream investment industry in his call to immediately ramp up the use of blended finance. Accordingly, blended finance will continue to be a structuring tool stakeholders reach for to de-risk climate projects in the face of increasing macroeconomic uncertainty.
Multilateral Development Banks (MDBs) and Development Finance Institutions (DFIs) will continue to take steps to refresh their business models to prioritize private sector mobilization.
Longstanding calls for MDBs to increase their investment and mobilization levels from across the international development finance ecosystem – including from Convergence, Overseas Development Institute (ODI), and others – are finally being heard.
MDBs have historically faced criticism for their relatively conservative risk appetite and low mobilization numbers. The objections are largely fuelled by their desire to maintain prudent capital adequacy and their conservative credit ratings (mostly AAA), which allow them to borrow at low interest rates from global capital markets and, in turn, drives them to use concessional financing to mitigate their own risks, rather than to mobilize third party financing from private investors. Earlier analysis by Convergence finds that most commercial financing mobilized through blended finance comes from Development Finance Institutions (DFIs) and MDBs, with only a fraction provided by private investors. This makes sense to a certain extent, given that their business models were designed when private sector mobilization was a tertiary priority. However, given the scale of financing needed to achieve the Sustainable Development Goals (SDGs), and the share of capital held by the private sector, MDBs and DFIs must more efficiently work with the private sector.
While MDB’s adherence to investment-grade ratings is unlikely to change, there appears to be some progress. Last year, Convergence and USAID released the Action Plan for Climate and SDG Investment Mobilization, which identified the most efficient and effective approaches for MDBs and DFIs to deploy more catalytic financing. Specifically, Convergence and USAID recommended that MDB and DFI shareholders create a set of key performance indicators to govern development banks that are intentionally designed to align these institutions with the 2030 Agenda and make the mobilization of private investors a core activity.
Similarly, ODI recently published a report analyzing the business models of six DFIs– BII, DEG, DFC, FMO, Norfund, Proparco, BDMG, PIDG, and TBD – in an effort to understand how DFIs can increase their risk appetite, scale investment volumes, and mobilization models. ODI found that all DFIs have room to increase the level of risk in their investment portfolios without recourse or increased use of donor external concessional resources.
Then in October 2022, US Secretary of Treasury Janet Yellen spoke of the need for MDBs to consider expanded options, including adopting stronger targets for mobilizing private finance, deploying a larger range of instruments, including guarantees and insurance products, and exploring financial innovations to stretch existing balance sheets. Yellen also called on the World Bank to develop an evolution roadmap in December and spoke of deeper work beginning in the Spring of 2023.
Meanwhile, the philanthropic community is also finding creative ways to support MDBs and DFIs to increase their mobilization targets. During the 2022 Annual Meetings of the IMF and World Bank, the Bill and Melinda Gates Foundation, Open Society Foundation, and Rockefeller Foundation announced they are collaborating on a New Challenge Fund aimed at unlocking more financing by MDBs to low- and middle income countries. The group is making an initial commitment of $5.25 million.
Early-stage use of blended finance will help increase the pipeline of bankable investments in emerging markets.
As indicated above, unlocking more risk-bearing concessional capital is essential to mobilize private sector financing. But this is only one side of the equation; the need for a robust pipeline of readily bankable deals in many developing economies continues to be a bottleneck to higher levels of private investment, due to many factors, including limited local developer expertise and capacity, unfavourable policy and regulatory environments, and little market building support from large international investors like DFIs and MDBs.
The phenomenon is persistent across sectors, including markets with the most blended finance activity, like energy or financial services. Even in the climate space, where the urgency for action is clear, more financially viable opportunities are required to reach the market at the pace needed. Many stakeholders interviewed in SOBF22 noted the issue as a central challenge to scale in climate blended finance. Aarish Shariff and Johnathan Thurling from Climate Fund Managers stated: “For climate-based projects, both for mitigation and more so for adaptation, there is not an abundance of commercially viable projects.” Speaking about the carbon market, Lauren Ferstandig and Kevin Bender from TNC remarked: “there is a supply-demand imbalance with a lack of investment-ready projects despite high demand.”
However, the application of blended finance in the early stages of project development is helping to reverse this longstanding trend. Low interest financing during project structuring, when risk is highest, can enhance economic feasibility and move projects forward more efficiently. This is especially important to deliver the climate outcomes we need in the near term. Rethinking how we classify certain asset classes or impact themes can also stoke demand for more projects in key sectors and increase project supply. For example, embedding broader objectives of resilience building, food security, or infrastructure development into adaptation blended finance, can help overcome the common narrative that adaptation projects still lack the business case to attract capital at scale. In the longer term, design stage funding, such as through Convergence’s Design Funding Windows, can build a deeper pipeline of ready-to-invest opportunities. This is particularly relevant for innovative and pioneering projects that require longer lead times to launch. For example, Convergence, together with the Climate Policy Initiative, will be launching the Catalytic Climate Finance Facility in 2023, which will provide grant funding to early-stage and market-ready solutions to develop the climate finance ecosystem and mainstream climate action.
Blended finance for climate adaptation, particularly debt for nature swaps, will continue to gain momentum in 2023.
Data from SOBF22 demonstrates that while adaptation continues to be an underdeveloped area for climate blended finance – representing only 14% of transactions –there has been an uptick in financing towards adaptation outcomes, indicating growing momentum around the sector. Indeed, SOBF22 reported that investments into adaptation were 72% higher between 2019-2021, compared to 2016-2018. Adaptation finance has historically faced a number of challenges when attracting commercial investors, namely: i) the common perspective that adaptation projects have less viable business models, and ii) the fact that most mobilization mandates are geared towards private sector mitigation projects rather than adaptation transactions.
Nevertheless, the need for greater financing towards adaptation objectives has fostered some creative and scalable solutions. One example of financial innovation in this space is the rise of debt for nature swaps, where a portion of a country's foreign debt is refinanced at a discount in exchange for local investments in environmental conservation. These swaps are typically structured as follows: First, a developing nation commits to protecting nature or achieving climate-friendly outcomes, for example by investing in climate-resilience infrastructure or protecting biodiverse forest. In support of that commitment, creditor governments and private partners agree to repurchase the debt at a discount, with more favourable interest rates and repayment terms. Investment from the private sector is key here, whereby private investors in addition to governments can participate in repurchasing sovereign debt.
This activity has been most notably led by The Nature Conservancy; the organization has structured three debt conversion transactions under its “Blue Bonds for Ocean Conservation” Strategy to date. Most recently, Barbados became the third party to partner with TNC, after the Seychelles (Convergence provided a design grant to TNC to structure this deal) and Belize. These transactions are innovative in that they both address climate adaptation goals while supporting countries national commitments to reduce their sovereign debt burdens.
We expect to see more debt for nature models come to fruition in the coming year.