Blended finance

What Is Blended Finance?

Blended finance is a strategic approach within sustainable finance that combines public or philanthropic funds with private capital to mobilize additional financing for projects, particularly those aiming to achieve sustainable development objectives in developing countries. This innovative financial mechanism typically uses catalytic public or development finance to mitigate investment risks and improve the risk-return profile of projects, thereby attracting greater amounts of private capital that would not otherwise invest. The goal of blended finance is to bridge significant funding gaps, especially for initiatives related to the United Nations' Sustainable Development Goals (SDGs).³⁶, ³⁷, ³⁸

History and Origin

The concept of blended finance gained significant traction in the mid-2010s, particularly in response to the substantial funding gap identified for achieving the Sustainable Development Goals. While the mixing of public and private funds has long occurred in various forms, the structured and strategic application of blended finance for development purposes became a key focus following the Third International Conference on Financing for Development in Addis Ababa in 2015.³⁵ This conference recognized the potential of new investment vehicles that combine public and private finance, along with expertise from both sectors.³⁴ Organizations like the World Economic Forum and the Organisation for Economic Co-operation and Development (OECD) have been instrumental in defining and promoting blended finance, emphasizing its role in mobilizing commercial finance for development. The OECD officially adopted Blended Finance Principles in 2017 to guide the design and implementation of such initiatives.³³ This approach is a natural evolution from traditional development aid models, seeking to leverage greater financial scale than public or philanthropic grants alone could provide.³¹, ³²

Key Takeaways

• Blended finance strategically combines public/philanthropic funds with private capital to finance projects, primarily in developing countries.
• Its main objective is to mobilize additional private investment by making projects more financially attractive or less risky.
• It is often applied to projects aligned with the United Nations' Sustainable Development Goals (SDGs).
• Blended finance involves various financial instruments, including grants, concessional loans, guarantees, and equity investments, to de-risk projects for commercial investors.
• Despite its potential, blended finance faces criticisms regarding its effectiveness, transparency, and impact on low-income countries.

Interpreting Blended Finance

Blended finance is interpreted as a tool for financial innovation and leveraging, rather than a direct funding source itself. Its effectiveness is measured by its ability to attract "additional" private capital that would not have invested without the catalytic public or philanthropic component.³⁰ Public funds, often provided on concessional terms, are used to improve the risk-return profile of an investment, making it appealing to commercial investors.²⁹ This involves strategic risk mitigation through mechanisms like first-loss tranches, where public funds absorb initial losses, or guarantees that reduce the exposure of private investors.²⁸ The interpretation also extends to the development impact, ensuring that the blended finance initiatives genuinely contribute to sustainable development outcomes.²⁷

Hypothetical Example

Consider a scenario where a developing country needs to build a large-scale renewable energy project, such as a solar farm, to provide clean electricity to rural communities. The project requires $100 million in total investment, but commercial lenders perceive it as too risky due to regulatory uncertainties and the nascent nature of the local energy market.

A development finance institution (DFI), acting as the public partner, steps in with a blended finance structure. The DFI provides a $10 million grant to cover initial feasibility studies and project development costs, reducing the upfront burden. Additionally, the DFI offers a $20 million subordinated debt facility, meaning its loan would be repaid after other lenders in case of default. It also provides a $15 million guarantee to senior lenders, covering a portion of their principal in case of default.

With these de-risking elements, commercial banks and equity investors, seeing a reduced risk exposure and an improved return outlook, commit the remaining $55 million through senior debt and direct equity investments. This allows the solar farm to be built, providing sustainable energy and contributing to the country's development goals, a project that otherwise might not have attracted sufficient private funding.

Practical Applications

Blended finance is primarily applied in emerging and developing economies to address significant funding gaps for public goods and sustainable development. It is widely used in sectors such as:

• Infrastructure: Financing critical infrastructure like renewable energy projects, transportation networks, and water and sanitation systems.²⁵, ²⁶
• Climate Action: Mobilizing capital for climate change mitigation and adaptation projects, including green bonds and sustainable infrastructure.²³, ²⁴
• Social Impact: Supporting initiatives in areas like health, education, and affordable housing, which may not offer purely market-rate returns but generate significant social benefits.²²
• Market Development: Helping to create viable markets in sectors or regions where private investment is traditionally scarce by demonstrating commercial viability and building investor confidence.²¹

For example, the Global Environment Facility (GEF) utilizes blended finance to attract private capital for biodiversity conservation and climate change mitigation, showcasing how public funds can catalyze investments in environmental initiatives.²⁰ The aim is often to attract large-scale institutional investors to projects that align with the Sustainable Development Goals, providing a pathway for private capital to contribute to global development challenges.¹⁸, ¹⁹

Limitations and Criticisms

While blended finance is championed as a solution to mobilize significant private capital for development, it also faces notable limitations and criticisms. One concern is that it often disproportionately benefits middle-income countries or those with more established markets, with a smaller fraction of funds reaching least developed countries where financial needs are most acute.¹⁶, ¹⁷ Critics also argue that blended finance may shift financial risk to public entities or recipient governments, potentially leading to increased public debt and higher costs for public services if projects underperform.¹⁵

Furthermore, there are concerns about the lack of transparency and democratic accountability in some blended finance arrangements, as commercial confidentiality can limit public scrutiny of contracts and financial flows.¹⁴ Some research suggests that blended finance has yet to consistently demonstrate significant "additionality"—meaning it doesn't always attract truly new private capital but rather funds projects that might have proceeded anyway, or at a higher cost to the public. A¹², ¹³s such, the effectiveness of blended finance in maximizing development impact and efficiently deploying public funds remains a subject of ongoing debate and evaluation.

Blended Finance vs. Public-Private Partnership

Blended finance and public-private partnerships (PPPs) are related but distinct concepts. A PPP is a long-term contract between a public entity and a private company for the provision of a public asset or service, where the private sector takes on significant financial, technical, and operational risks. PPPs are primarily a contractual arrangement for project delivery and risk sharing.

¹¹Blended finance, on the other hand, is a specific financing approach or structuring technique that can be applied within a PPP framework or other investment schemes. Its core function is to leverage catalytic public or philanthropic capital to mobilize additional private investment by de-risking projects. W¹⁰hile PPPs define the operational and risk-sharing relationship for a project, blended finance addresses the capital structure, specifically how various sources of funding (public, private, philanthropic) are combined to achieve financial viability and development objectives. A project structured as a PPP might utilize blended finance to attract the necessary private capital, but not all blended finance initiatives are PPPs, and not all PPPs use blended finance.

FAQs

What is the primary purpose of blended finance?

The primary purpose of blended finance is to use limited public or philanthropic funds strategically to attract larger amounts of private capital for projects that contribute to sustainable development, especially those aligned with the Sustainable Development Goals.

⁸, ⁹### How does blended finance attract private investors?
Blended finance attracts private investors by improving the financial attractiveness of projects through risk mitigation and enhanced returns. This is often achieved by public or philanthropic funds taking on a higher degree of risk, offering concessional loans, or providing guarantees, thereby making the investment more palatable for commercial capital markets players.

⁶, ⁷### Is blended finance a form of aid?
While blended finance often uses official development assistance (ODA) or other public funds, it is distinct from traditional aid. Traditional aid primarily consists of grants or highly concessional loans directly from donor governments or multilateral organizations. Blended finance, conversely, uses a catalytic portion of public funds to leverage significant additional impact investing from the private sector, rather than solely providing direct funding.

⁴, ⁵### What are common instruments used in blended finance?
Common instruments in blended finance include various forms of concessional finance, such as first-loss tranches, subordinated debt, technical assistance grants, equity investments from public development banks, and various types of guarantees. These tools are designed to absorb risks or provide favorable terms that encourage private sector participation.¹, ², ³