SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS Foreign Direct Investment, Financial Intermediation and Public-Private Partnerships CONTENTS Foreword 03 PART III: PUBLIC-PRIVATE 30 Abbreviations 04 PARTNERSHIPS Blended business models 31 Introduction 05 Consumer preferences and incentives 32 Pay-for-performance models 32 Scaling private finance for the sustainable 05 development goals Payment for ecosystem services 33 Private offsets, public commitment and 33 The role of corporate and financial 07 long-term contracts intermediation Blended finance 34 Calibrating expectations for scaling 35 PART I: FOREIGN DIRECT INVESTMENT 09 blended finance Understanding foreign direct investment 10 Focus on temporary use and mechanisms that can 36 The link between portfolio investments and FDI 11 be replicated commercially FDI as a source of SDG finance 12 Prioritizing use of private concessionary capital 37 in emerging markets for blended finance Maximizing the impact of FDI 15 Governance issues 37 Inherent benefits Subsidized corporate finance 38 15 Considerations for long-term development 16 What is subsidized corporate finance? 38 of local markets Corporate structure as a credible vehicle for 39 Alignment with host country’s sustainable 17 blended finance development plans Linking subsidized corporate finance with FDI 40 Focusing fdi on priority sectors and regions 18 Developing local capital markets 41 Focus on economic and social benefits for 18 The link between FDI and local capital markets 42 emerging markets Moving forward together 42 Leveraging corporate intermediation 20 for impact Internal investment criteria 20 Corporate governance 20 Capital market transactions 20 PART II: FINANCIAL INTERMEDIATION 21 The role of banks and financial institutions 22 Banking services 22 Trade finance 24 Insurance and guarantees 25 Hedging and derivatives 26 Securitization and syndication 26 Leveraging financial intermediation 27 for impact Corporate-level mechanisms 28 Product-level mechanisms 28 Standardization 28 Lower capital requirements for sustainable finance 29 SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 2 Foreword Re-orienting Capital Markets Towards Sustainable Development The urgency of addressing the climate crisis and efforts to a new and comprehensive Sustainable Finance Programme realize the Sustainable Development Goals (SDGs) have set at the UN Global Compact, which aims to empower financial innovation to move at a fast pace. This is welcome, companies as a global voice in the redesign of finance for as it reflects a collective search for solutions that should sustainable development. The Programme includes: lead to the most effective approach. 1. A CFO Taskforce for the SDGs While we are not yet at the consolidation and standard- ization phases of SDG finance, it is nonetheless valuable 2. A set of principles for SDG-aligned corporate finance to review the current range of innovation and highlight a and investment few pathways that have the potential to bridge the gap in 3. A programme of activities to guide CFOs in the financing the 2030 Agenda for Sustainable Development. application of the principles for SDG alignment In our first two publications: SDG Bonds — Leveraging These publications aim to provide practical resources and Capital Markets for the SDGs and Corporate Finance — A insights in your journey towards the SDGs. We look forward Roadmap to Mainstream SDG Investments, we focused on to working with you in pursuit of the 2030 Agenda. optimizing the conditions for SDG impact in mainstream investments (listed bonds and equity) and creating large and diversified portfolios of credible SDG investment opportunities for institutional investors. In this latest publication, Scaling Finance for the Sustain- able Development Goals, we explore financial innovation for SDG investments that do not fit the criteria typically required for direct financing by portfolio or institutional investors. This includes foreign direct investment, financial intermediation and public-private partnerships for SDG finance. Lise Kingo CEO and Executive Director We hope to contribute practical solutions to the rapidly United Nations Global Compact evolving field of sustainable finance and to provide critical insights in the global agenda to leverage private finance for the SDGs. The three publications represent a broad vision from the UN Global Compact on how capital markets can increasingly re-orient towards more sustainable development while still serving investors’ primary mandate, which is to preserve and maximize their investments within acceptable levels of risk. The publications also provide the conceptual framework for SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 3 Abbreviations CFO Chief Financial Officer LDCs Least Developed Countries DFID UK Department for International LICs Lower-income Countries Development M&A Mergers and Acquisitions DFI Development Finance Institution MDB Multilateral Development Bank ECA Export Credit Agency MFI Microfinance Institution FDI Foreign Direct Investment MIGA Multilateral Investment Guarantee FPI Foreign Portfolio Investments Agency GHG Greenhouse Gas MNC Multinational Corporation HLEG High-Level Expert Group on Sustainable NDC Nationally Determined Contribution Finance ODA Official Development Assistance IBD Inter-American Development Bank ODI Overseas Development Institute IBRD International Bank for Reconstruction and Development PES Payment for Ecosystem Services ICMA International Capital Market Authority SDGs Sustainable Development Goals IDA International Development Association SME Small- and Medium-sized Enterprise (World Bank Group) SPV Special Purpose Vehicle IFC International Financial Corporation UNCTAD United Nations Conference on Trade and IIA International Investment Agreement Development IPA Investment Promotion Agency UNDP United Nations Development Program IRR Internal Rate of Return VNRs Voluntary National Reviews LC Letter of Credit Introduction Scaling Finance for the Sustainable Development Goals Scaling Finance for the Sustainable Development In doing so, we take the perspective of companies and Goals explores the role that financial intermediation and examine the capacity of blended business models as a public-private partnerships can play in bridging the gap scalable type of public-private partnership for SDG finance, between global capital markets and SDG investments wherein public resources support existing or new business that are too small or too risky to attract direct portfolio models. We also look at the role of subsidized corporate investments. We first explore specific types of financial finance and how blended finance can be used to support intermediation that have the potential to scale SDG finance companies making direct investments in the SDGs or banks in key areas: providing SDG-related financial services. We suggest that companies and banks can be effective vehicles for ▪▪ Providing access to finance in countries with less scaling the SDG impact of blended finance because of their developed financial markets or for SDG solutions that sophisticated management and governance models, liquid are too small or illiquid to attract portfolio investors investment products, and a track record of innovation and delivering financial returns. ▪▪ Linking global capital markets to companies, projects and individuals that cannot directly access Lastly, we look at the importance of developing strong local these markets capital markets. Strengthening emerging markets ensures a direct path to institutional investors and complements FDI ▪▪ Leveraging the intermediation process to maximize and banking intermediation to localize the benefits of scaled the impact of downstream investments — for SDG finance. example, by ensuring sustainable practices of subsidiary businesses or by focusing on certain geographies, populations, or activities Scaling Private Finance for the Sustainable Development Goals In Part I, we look at foreign direct investment (FDI) and how multinational companies that raise capital on global At a basic level, scaling SDG finance is a quantitative goal financial markets can provide a critical source of SDG to bring more capital to regions or activities that are key for finance in emerging markets and least developed countries the realization of the SDGs. It is often called for in response (LDCs). In Part II, we look at more traditional forms of to the estimated US$ 2.5 billion annual SDG financing gap financial intermediation by banks and financial institutions, in emerging markets — to exponentially increase sources of such as providing financial services to companies and public and private finance. individuals, or creating innovative financial structures that pool investments and use securitization to scale When it comes to leveraging private finance for the SDGs, SDG finance. We then explore the role of public-private however, a more nuanced view of scaling is needed to take partnerships in SDG finance (Part III) to support activities into account existing flows of capital, the role of creating an that cannot be financed on a purely commercial basis and enabling environment, and how to coordinate and maximize therefore require some form of public support to benefit the combination of public and private finance. In Figure 1 from private investments. below, we suggest two approaches to scaling SDG finance. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 5 FIGURE 1: Two Dimensions of Scaling SDG Finance The first approach to scaling is to ‘qualify’ the SDG impact services provided by banks and other financial institutions. of large, traditional investment asset classes such as equity As described in Figure 2 below, one strategy for scaling SDG and bonds. It is well accepted that investments in equity finance is for companies and banks to systematically manage, and corporate bonds have an impact on the SDGs, but the monitor and communicate their SDG impact. Such practices impact is not well understood or measured partly because allow investors to better understand the SDG impact of existing it is realized through internal investments or the services of equity and corporate bonds (Phase 1) and increase the flow of underlying companies. This is also the case with foreign direct capital to those with positive SDG contributions (Phase 2). investments by large multinational companies and financial Figure 2. Qualifying the Impact of Large Asset Classes SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 6 A second — and more traditional — approach to scaling SDG The Role of Corporate and Financial finance is to increase the amount of capital available for Intermediation investments that directly contribute to the SDGs but that are too small, too risky, or do not have sufficient financial Corporate and financial intermediation1 can play a critical returns for corporate or financial investors. Here the strategy role in scaling SDG finance when the financial characteristics for scaling is to leverage financial engineering and blended of SDG investments do not match the risk-return and size finance to create larger investments, thereby lowering the constraints of institutional investors. It can provide a bridge risk and/or increasing the return of the investments. Three when SDG investments are too small, risky, or illiquid to main approaches to scaling these investments are discussed attract institutional investors. in this paper: At the local level, financial intermediation can also bring ▪▪ Standardization and aggregation of smaller about a local transfer of ownership of business and financial investments through securitization or syndication assets and maximize the impact of global investments on (addressed in Part II) local economic and social development. In addition, it can trigger a multiplication effect of money creation that is typical ▪▪ Leveraging public finance for blended capital solutions of a well-functioning economy. that can support both corporate and financial investments (Part III) 1. Financial intermediation occurs when an institutional unit acquires financial ▪▪ Creating the conditions for more sustainable assets and, at the same time, takes on liabilities on its own behalf via financial operations on the market. The assets and liabilities of financial intermediaries investments through an enabling environment, have different characteristics, which assumes that in the financial intermediation including the development of local capital markets process, the funds raised are transformed or grouped together according to their due date, volume and degree of risk. Source: INSEE, https://www.insee.fr/en/ and stock exchanges (Part III) metadonnees/definition/c1873. FIGURE 3: Financial Intermediation Through FDI SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 7 While many types of finance can be understood as financial and equity of large multinationals that themselves invest intermediation, in this publication we focus on specific types of directly in local companies through FDI and bank loans. financial intermediation that can have a significant impact on the SDGs: Figure 4 illustrates the financial intermediation process in financial engineering. Here financial institutions raise capital ▪▪ Foreign direct investment in financial markets to provide SDG-themed loans or other ▪▪ Services of banks and financial institutions financial services to individuals and businesses. These loans ▪▪ Financial engineering are then packaged together in special purpose vehicles (SPVs) and sold to capital markets as liquid securities (securitization). The illustrations provide examples of financial intermediation A similar process of financial intermediation occurs when and how they can work together to scale SDG finance. Figure financial institutions pool together financial assets in a fund 3 shows the interaction between portfolio investments, FDI (bonds, equity and other securities) to increase investment and bank loans when global investors invest in the bonds size and diversify risk. Figure4. Intermediation Through Financial Engineering Note: FI = Financial Institution; ABS = Asset-Backed Securities SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 8 Part I Foreign Direct Investment FDI can be a source of financial intermediation between In this section, we first provide an overview of FDI and its global capital markets and smaller, less liquid investment potential to finance economic and social development in opportunities in emerging markets and LDCs. Foreign emerging and frontier markets. In doing so, we draw an companies (including banks) that make direct investments important link between institutional investors and the in emerging markets are often multinational companies impact of FDI from their portfolio companies in countries with access to deep, global capital markets. They can raise and sectors that are key to the realization of the SDGs capital through equity and bonds and use these funds to We then explore the conditions under which FDI can make direct investments in other countries through FDI. contribute to the SDGs, based on academic literature and By extension, FDI can provide a source of finance for some UN development priorities. Lastly, we look at how corporate of the most difficult sustainable development issues in management and governance practices along with financial emerging and frontier markets, where the interplay of instruments can help actualize the potential benefits of FDI basic economic development needs and lack of basic and communicate these benefits to investors. social infrastructure deters other types of foreign capital investment. Financial intermediation through FDI involves a three- The Role of FDI in Sustainable step process: Development 1. Portfolio investment in equity or bonds of a global 2030 Agenda for Sustainable Development company or bank 10.b Encourage official development assistance and financial flows, including foreign direct investment, 2. Investment by a global company or bank in equity to States where the need is greatest, in particular of a local company or bank through acquisition or least developed countries, African countries, small building a subsidiary island developing States and landlocked developing countries, in accordance with their national plans 3. Local provision of products and services by local and programmes. [underline added] companies or banks Addis Ababa Action Agenda on Financing The role of FDI for sustainable development has for Development been recognized in the 2030 Agenda for Sustainable Development and the Addis Ababa Action Agenda on 45. We recognize the important contribution Financing for Development, and it puts multinational that direct investment, including foreign direct companies in developed and developing markets at the investment, can make to sustainable development, forefront of achieving the SDGs. particularly when projects are aligned with national and regional sustainable development strategies. [underline added] SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 9 Understanding Foreign Case Study Direct Investment ENEL’s Acquisition of FDI is a category of cross-border investment where an Eletropaulo in Brazil entity resident in one economy has control over or a significant degree of influence on the management of an Enel Brasil’s acquisition of Eletropaulo (currently enterprise resident in another economy. FDI is measured in Enel Distribución São Paulo) is an example of how stock and flows and includes equity capital, reinvestment FDI, supported by capital market transactions, of earnings and intercompany debt. Ownership of ten can provide a critical source of finance for SDG percent or more of the ordinary shares of voting stock investments in emerging markets. is the criterion for determining the existence of a direct investment relationship.2 In June 2018, Enel Brasil (a subsidiary of Enel S.p.A) acquired Eletropaulo Metropolitana Electicidade de There are multiple types of foreign direct investments. Sao Paulo S.A. (Eletropaulo) and became the largest FDI can be done through the construction of new facilities distributor of electricity in Brazil with 17 million (greenfield) or via mergers and acquisitions (M&A) customers and 20% of the distribution market. The involving local companies (brownfield). Overall M&A investment rationale focused on three main aspects, represents half of all FDI; however, greenfield investments which ultimately reinforce Enel Group contribution are more prevalent in emerging markets.3 to SDGs 7, 9, 11 and 13: FDI can also be categorized in reference to the value chain ▪▪ consolidating Enel Americas footprint in Brazil, of the investing companies.4 growing in low carbon service becoming a leading integrated payer (SDG 13); ▪▪ Horizontal FDI consists of establishing abroad ▪▪ leveraging on Enel Group competences for an affiliate in a firm’s primary industry to serve networks digitization and quality of service customers in the foreign market. providing infrastructure towards sustainable ▪▪ Vertical FDI involves establishing a foreign affiliate cities, while offering RAB and customer base that produces inputs to or provides intermediate growth opportunities (SDG 9 & 11); services associated with a final product. ▪▪ boosting Enel Americas growth in free ▪▪ Complex FDI combines features of both horizontal market and new energy service space through and vertical FDI. innovation and energy efficiency solutions (SDG 9 & 11). Lastly, FDI can be differentiated by type of investment: To finance the acquisition, ENEL used a combination of debt and equity financing in different markets. ▪▪ Real FDI denotes investment by companies in the First, a syndicate of local and international banks ‘real’ economy. provided Enel Brazil a loan in Brazilian Real (BRL) for ▪▪ Financial FDI is investment by banks and financial the acquisition. Then, ENEL S.p.A., through its Dutch institutions setting up branches or subsidiaries to holding company (Enel Finance International N.V. or provide financial services abroad. EFI), issued a bond on the US market and used part of the proceeds to re-finance Enel Brasil’s debt from 2. UNCTAD and World Bank. the acquisition via an intercompany loan. 3. Laura Alfaro and Jasmina Chauvin, Foreign Direct Investment, Finance, and Economic Development, Encyclopedia of International Economics and Global Trade, 2017. In order to disburse directly the intercompany loan to 4. Ibid. Enel Brazil in Brazilian Real, EFI entered into a cross currency swap hedging itself against the EURO-BRL exchange rate and interest rate risk. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 10 The Link Between ▪▪ Understanding the sustainable development benefits of their portfolio companies’ FDI Portfolio Investments ▪▪ Increasing allocation to companies with the most and FDI positive contributions Assessments of sources of private capital for development Equity investors (and to some extent bond and loan often contrast FDI with foreign portfolio investments (FPI), financiers) can be highly influential in making sure but such assessments fail to recognize the role of portfolio multinational corporations (MNCs) participate in sustainable investors as owners of companies doing FDI. Yet, institutional FDI, and they can apply responsible investment practices, investors are often the owners and creditors of global including company engagement. companies that make critical FDI in emerging markets (see Figure 5). In addition, FDI often involves significant financial This suggests that the ultimate owners of MNCs — pension resources, either for an acquisition or to build and operate funds, foundations and insurance companies — can have a new subsidiary. Unless the parent company has excess a voice and leverage their equity voting rights to promote cash or the home financial market is deep enough, FDI will, sustainable development standards among companies and therefore, require significant loans or issuance of corporate banks conducting FDI, thereby making a major contribution bonds, with intermediation by global capital markets.5 to the financing and realization of the SDGs. Transparency around how pensions and insurance companies use their To the extent that they manage and disclose the SDG voting rights and other influence over investee companies to impacts of FDI, global listed companies can provide a promote the SDGs through FDI would be a powerful incentive pathway between portfolio investors and SDG invest- for companies to expand work in this area. ments that are otherwise too small, risky, or illiquid. By extension, institutional investors have an opportunity 5. Poelhekke, Steven, Financial Globalization and Foreign Direct Investment (2016). to scale their SDG investments through FDI of their De Nederlandsche Bank Working Paper No. 527. portfolio companies by: FIGURE 5: Linking Portfolio Investments and FDI Equity Global Local Global Company FDI Company Investor or Bank or Bank Bonds Management FDI Disclosure of SDG impact SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 11 Case Study FDI as a Source of SDG World’s First SDG- Finance in Emerging linked General-purpose Markets Corporate Bonds According to the United Nations Conference on Trade In 2019, ENEL S.p.A., through its Dutch holding and Development (UNCTAD), FDI constituted the most company Enel Finance International N.V., issued two significant external source of financing for developing separate SDG-linked general-purpose corporate economies between 2013 and 2017 (39%), followed bonds to institutional investors based in the US, by portfolio investments (18%) and bank loans (9%).6 Europe and other international markets, raising over In LDCs, the primary sources of external finance were US$ 4 billion. Official Development Assistance (ODA) and remittances. Nonetheless, FDI remained a substantial source of external Proceeds from the bonds will be used to finance the financing at 21%, and the contribution of bank loans reached company’s overall sustainable strategy to transition 14%. For developing economies, FDI is also a more stable toward renewable electricity generation capacity, source of financing compared with portfolio investments energy efficiency and carbon neutrality, improving and bank loans, which experience dramatic fluctuations access to energy and creating the infrastructure for over business cycles (seeFigure 6). electric mobility. The importance of FDI for emerging markets is also evident This will include FDI in key markets in Latin America when compared with capital market transactions. World and Africa where the company will provide critical Bank data indicates that FDI represented a large share of access to clean and affordable energy. private capital for emerging markets, reaching 4.0% of GDP, The bonds were issued at a discounted interest compared with public bonds at 5.5%, private bonds at 1.0%, rate with respect to a comparable issue without and equity portfolio investments at 0.2% (seeTable 4). The sustainability characteristics, reflecting the trend is even more pronounced in low-income countries, commitments by ENEL to make timely progress in where the share of all capital market instruments drops and the implementation of its strategy, as evidenced by FDI becomes the primary source of private capital. clear indicators that will be independently verified: 6. World Investment Report 2018, UNCTAD. ▪▪ Increase renewable generation capacity to 55% of consolidated installed capacity by December 31, 2021 ▪▪ Reduce carbon dioxide emissions to below 125 g/kWh by 2030 The bonds also include a step-up mechanism where interest rates will increase by 25bps if the company fails to meet its targets. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 12 FIGURE 6: The Importance of Foreign Direct Investments Sources of external finance, developing economies Growth rates (%) and LCDs, 2013–2017 (Per cent) 2017 2013–2017 Volatility 14 9 average index 1 18 Developing economies 11 FDI 0 0 20 36 Remittances 95 27 24 ODA and other official flows -1 2 19 Portfolio investment 110 -80 88 28 Other investment 70 -25 90 39 (mainly bank loans) 21 Least deve loped countries LDCs Developing economies FDI -17 6 23 REmittances 4 3 35 FDI Remittance s ODA and other official flows -1 2 17 Portfolio investmen t Official development Portfolio investment 21 -13 237 ass istance and other Other investmen t official flows Other investment -58 6 113 (main ly bank loans ) (mainly bank loans) Developing Economies: Sources of External Finance, 2009-2018 (Billions of Dollars) 800 FDI (directional) 600 Remittances Other investment 400 Portfolio investment 200 Official development 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 -200 -400 Source: UNCTAD. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 13 The importance of FDI for emerging markets is also evident and equity portfolio investments at 0.2% (seeTable 4). The when compared with capital market transactions. World trend is even more pronounced in low-income countries, Bank data indicates that FDI represented a large share of where the share of all capital market instruments drops and private capital for emerging markets, reaching 4.0% of GDP, FDI becomes the primary source of private capital. compared with public bonds at 5.5%, private bonds at 1.0%, FIGURE 7: Source of Capital in Emerging Markets (% of GDP) 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Upper Middle Lower Middle Low Income All Emerging Income Income Markets Public Bonds 7.7% 4.2% 0.7% 5.0% FDI 3.6% 3.3% 3.9% 3.6% Private Bonds 1.3% 0.5% 0.0% 0.8% Portfolio Equity Flow 0.5% 0.0% 0.0% 0.2% Public Bonds. Public and publicly guaranteed debt from bonds that are either publicly issued or privately placed. Total outstanding. Private Bonds. Private nonguaranteed long-term debt of a private debtor not guaranteed for repayment by a public entity. Total outstanding. FDI (foreign direct investment) refers to direct investment equity flows from a resident in one economy owning 10% of ordinary shares of voting stock of an enterprise resident in another economy. It includes equity capital, reinvestment of earnings and other capital. Portfolio equity flows include net inflows from equity securities other than those recorded as direct investment and including shares, stocks, depository receipts (American or global) and direct purchases of shares in local stock markets by foreign investors. Income Levels. Countries’ income level calculated based on 2017 GNI per capita, as follows: low income is US$ 995 or less; lower middle-income between US$ 996 and US$ 3,895 and upper middle- income between US$ 3,896 and US$ 12,055. Source: UN Global Compact analysis; World Bank data for 2017. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 14 Maximizing the Importantly, FDI can raise the corporate governance standards of local companies and elevate their Impact of FDI management of environmental and social impact. As discussed above, FDI is a critical source of financing A related benefit of FDI comes from the ‘direct’ nature of for emerging and frontier markets. It is generally the investment and the relative control over the invested regarded as having a great potential to promote economic entity. Unlike portfolio investments, which are generally development by strengthening productivity, promoting non-controlling and therefore more passive, FDI provides growth and helping diversify the economy. FDI does the investing company with the ability to influence the not, however, automatically contribute to sustainable direction of the investee company, including its contribution development. As with any investment, it must be made with to sustainable development. consideration of its economic, social and environmental impacts — especially at the local level. According to the Indian economist Prabhat Patnaik, “[w]hat is needed … is a nuanced approach to FDI flows, and not one that believes FDI Supporting the African that the more the FDI flows, irrespective of what kind and to Industrial Revolution what destination, the better.”7 FDI is a critical aspect of Africa’s recent industrial A recent publication on FDI sustainability characteristics expansion beyond the traditional extractive sectors defines ‘sustainable FDI’ as to sectors such as food processing and auto manufacturing, thereby substituting imports with commercially viable investment that makes a maximum local manufacturing to meet growing local demand. contribution to the economic, social and environmental Recent examples of FDI in these sectors include development of host countries and takes place in the Nibulon (Ukraine)’s US$ 2 billion project to upgrade framework of fair governance mechanisms.8 Egypt’s grain storage infrastructure and Hyundai’s auto manufacturing plant in Ethiopia, with a planned In this section, we first look at the inherent benefits of FDI, capacity of 10,000 vehicles per year. Africa also focusing on economic development benefits, control and benefits from FDI in export manufacturing as additionality. We then look at how FDI can contribute to industries shift from China to lower-cost regions. the long-term development of local markets, targeting local development gaps and sustainability issues while Industrial capacity is also building through FDI mitigating negative impacts. in sectors that can have long-lasting benefits on sustainable development of local economies, such Inherent Benefits as tourism, agriculture, technology and renewable energy. For example, Microsoft has been creating a The main impetus for FDI is strategic; the parent company talent pool in Africa and recently launched its Africa often finds a synergistic relationship between the target Development Center with initial sites in Nairobi, investment and its existing business. FDI therefore Kenya and Lagos, Nigeria. Other examples include contributes ‘strategic’ value beyond a pure financial Google’s new artificial intelligence center in Ghana investment. This is in contrast with portfolio investments, and, in South Africa, Huawei’s new data centers where the contribution is mostly financial.9 and Mainstream Renewable Energy’s new 110 MW wind farm. In the context of emerging and frontier markets and the SDGs, FDI can provide a range of macro- and micro- economic benefits: 7. Prabhat Patnaik, FDI As A Means Of Financing Development, March 1, 2014. G-24 Policy Brief No. 18. ▪▪ Creation of new economic sectors 8. Towards an Indicative List of FDI Sustainability Characteristics, Karl P. Sauvant and Howard Mann, 2017, published by the International Centre for Trade and ▪▪ Access to new markets Sustainable Development and the World Economic Forum. http://ccsi.columbia. ▪▪ Job creation edu/2017/10/24/towards-an-indicative-list-of-fdi-sustainability-characteristics/. 9. Private equity is an exception, as it typically involves a strategic investment. ▪▪ Technology transfer ▪▪ Enhanced productivity levels ▪▪ Improved management and governance ▪▪ Re-allocation of capital towards productive sectors SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 15 Additionality is a third benefit of FDI given the scarcity Considerations for Long-Term of capital in emerging and frontier markets. Additional- Development of Local Markets ity — a key concept of impact investing — is the “extent to which a new input (action or item) adds to the existing The benefits of FDI depend on the host country’s level inputs (instead of replacing any of them) and results in a of economic development and whether the investment greater aggregate.”10 In the context of financing, addition- is complementary to or competitive with local real and ality means that the capital invested would not otherwise financial resources. Economic research shows that FDI be available. can genuinely aid development financing when it brings in real resources and does not contribute to contraction FDI by companies in the financial sector (Financial FDI) in domestic output and employment.12 Specifically, the provides many of the same macro- and micro-economic following factors affect the development impact of FDI: benefits as FDI conducted by real-economy companies. There are, however, specific benefits that financial FDI ▪▪ Changes in the allocation of local resources, brings, mainly linked to the role that affiliates of global including employment and finance. FDI is banks can play in facilitating FDI in other industry sectors.11 most beneficial in economies that are short of real resources such as industrial capacity, foreign Financial FDI provides critical financial intermediation for exchange reserves, or commodities. In economies real-economy FDI (and by extension for foreign portfolio with export surpluses, FDI can still be helpful investments) by vetting and monitoring local investments because it can bring technology transfers and access and potentially increasing the size and quality of the pool to international markets. A possible downside of FDI, of target firms. The presence of local affiliates of global however, is that when global companies complement banks also helps address information asymmetries their FDI with local financing, it can restrict access to that are inherent in international investments, through finance for local actors. independent investment and credit research. This is particularly important in countries with lower standards of ▪▪ Development of local capital markets. FDI is governance, transparency and investor protection. The role most attractive as a source of capital in markets that affiliates of global banks play in improving conditions where capital is scarce (additionality). However, in local financial markets is addressed in Part III in The Link the degree to which FDI can provide additional Between FDI and Capital Market Development. sources of capital also positively correlates with the development of local financial markets. Good local 10. Impact Management Project financial conditions allow for increased FDI because 11. See footnote 5. 12. See footnote 3. companies can secure complementary financing 13. See footnote 8. locally and hedge local currency risk. The existence of local capital markets can also mitigate the potential usurpation of local financial resources when foreign affiliates raise capital locally (see also The Link Between FDI and Capital Market Development in Part III). ▪▪ Local resources and assets. According to some economic analyses, FDI through M&A (brownfield) contributes less to finance for development, as it brings financial resources but not real resources. In addition, M&A has the effect of “de-nationalizing” economies by shifting control over productive assets from domestic nationals to foreigners.13 SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 16 Alignment with Host Country’s Sustainable Development Plans An Example of FDI Criteria for Country Investments As part of their implementation of the 2030 Agenda for Sustainable Development, countries develop a series of FDI in the Democratic Republic of the Congo national, regional, and local strategies and programmes increased by 11 per cent in 2018, to US$ 1.5 billion. that are documented in their Voluntary National Reviews Continued investments in mineral exploration (VNRs) and Nationally Determined Contribution (NDCs) (especially for cobalt, of which the country holds 60 and translated in national development plans. These percent of the world’s known reserves) underpinned national plans can provide roadmaps for the private sector flows to the country. International mining companies to invest in the SDGs, focusing on the unique needs and including Glencore (Switzerland) and Molybdenum challenges in specific countries. They provide a baseline (China) expanded their presence in the country in indication of where countries stand in their implementation 2018. Extractive-industry investors will now operate of the SDGs and gaps that can be filled by private sector under an amended mining code, with new provisions solutions and private capital. They also provide a sense of that increase royalties, remove the 10-year amnesty how Governments prioritize among the SDGs based on the on new rules for existing miners, and impose a unique situation in each country. super-profits tax. Aligning FDI with a country’s SDG plans can increase the overall scale and intensity of impact by contributing to a broader SDG-enabling effort. For example, if a country has The alignment of FDI with national development plans is committed to climate mitigation through a meaningful also a key consideration in the promotion of FDI in the 2030 deployment of a specific type of renewable energy capacity, Agenda for Sustainable Development and the Addis Ababa impact is enhanced when foreign businesses invest in Action Agenda on Financing for Development. Paragraph 45 building similar or complementary energy capacity in of the Addis Ababa Action Agenda states: that country. We recognize the important contribution that direct Lastly, investing alongside a country’s SDG plans can lead to investment, including foreign direct investment, can make better risk-adjusted financial returns since these activities to sustainable development, particularly when projects may receive direct or indirect support from the Government are aligned with national and regional sustainable in the form of incentives, subsidies, or favorable policies and development strategies. … We will prioritize projects with regulatory regimes. In turn, this can lead to more stable and the greatest potential for promoting full and productive longer-term private-sector contribution to the SDGs. employment and decent work for all, sustainable patterns of production and consumption, structural These benefits are highlighted in academic research on the transformation and sustainable industrialization, characteristics of sustainable FDI: productive diversification and agriculture. [M]any governments consider that some types of 14. See Footnote 8. investment, especially when supported by national and international policies, can make a particular contribution to the development objectives of their economies. … At a minimum, … they consider that investment with certain characteristics is particularly desirable and, therefore, might benefit from various policy measures to encourage it.14 Accordingly, the need to align FDI with local development priorities is often reflected in international investment agreements (IIAs), where recipient countries specify their expectations for the contribution of private international investments. It is also reflected in the policies of investment promotion agencies (IPAs) in developed and developing countries, which often prioritize projects and FDI that they consider as contributing most to their own development priorities. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 17 Focusing FDI on Priority Sectors Focus on Economic and Social and Regions Benefits for Emerging Markets Scaling the impact of FDI also requires reallocation of In their recent publication on FDI Sustainability Characteris- capital towards countries and sectors most in need. Quoting tics, Sauvant and Mann identify emerging FDI sustainability again from the Addis Ababa Action Agenda on Financing characteristics based on a variety of instruments linking for Development: sustainability to investments in emerging markets (e.g. international investment agreements, company codes, Private international capital flows, particularly foreign etc.).16 The authors observe that economic and social direct investment, along with a stable international benefits (versus environmental benefits) figure more financial system, are vital complements to national prominently among these characteristics than with typical development efforts. Nonetheless, we note that there corporate sustainability issues, which they explain through are investment gaps in key sectors for sustainable a focus on emerging markets. development. Foreign direct investment is concentrated in a few sectors in many developing countries and often What is noticeable is that none of the FDI sustainability bypasses countries most in need and international capital characteristics in the economic sustainability dimension flows are often short-term oriented. make it into the group of common sustainability characteristics, though they figure more prominently According to the United Nations Development Program among the emerging common FDI sustainability (UNDP), the sustainable development benefits of FDI are characteristics. This may reflect the fact that the not uniform. Investments are increasingly being made in real sustainable development discussion was previously estate versus manufacturing or research and development. particularly driven by developed countries and their FDI is also heavily concentrated in middle-income countries civil societies, which have a particular interest in and in resource-rich low-income countries, leaving least environmental sustainability and governance, and, in developed countries with less than 2 percent of total world the case of social sustainability, by trade unions. On the FDI flows.15 other hand, a great number of IIAs, most of which involve developing countries, make general references to the furtherance of economic development.”17 FIGURE 8: IFC Performance Standards In addition, they found that emerging FDI sustainability characteristics in the social dimension focused more on the well-being of local societies, including issues such as indigenous rights, resettlement and cultural heritage. This is consistent with the Performance Standards of the International Financial Corporation (IFC), which define IFC clients’ responsibilities for managing environmental and social risks. Four of the eight standards focus on the well-being of local populations: community, resettlement, indigenous people and cultural heritage (seeFigure 8). Source: IFC. According to the Economist Prabhat Patnaik, “FDI flows into the developing world must fulfill two criteria: they must be economically justifiable; and they must not go against certain overriding social considerations.”18 15. FINANCING THE 2030 AGENDA: An Introductory Guidebook for UNDP Country Offices. UNDP 2018. 16. See Footnote 8. 17. Ibid. 18. See Footnote 7. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 18 FIGURE 9: Matrix of Sustainability Characteristics of FDI a. Economic dimension of sustainable FDI b. Environmental dimension of sustainable FDI IIntergov. organisation standards Intergov. organisation standards Voluntary intergov. instruments Voluntary intergov. instruments Voluntary global business codes Voluntary global business codes Private institutional investors Private institutional investors & industry codes & industry codes Company codes Company codes Home country Home country Host country Host country IIAs IIAs General reference only General reference only Employment Resource management Local linkages Pollution controls Technology transfer Low carbon footprint Infrastructure Waste reduction Community development Biodiversity protection Equitable distrib. of wealth Climate change Tax accountability Water Promote R&D Renewable energy General and specific indicator General and specific indicator General or specific indicator General or specific indicator c. Social dimension of sustainable FDI d. Governance dimension of sustainable FDI Intergov. organisation standards Voluntary intergov. instruments Voluntary global business codes Voluntary global business Private institutional investors codes & industry codes Intergov. organisation Private institutional Voluntary intergov. Company codes Home country Host country instruments & industry codes Company codes standards Home country investors Host country IIAs General reference only IIAs Transparency General reference only Local management Labour rights Supply chain standards Skills enhancement Consumer protection Public health Stakeholder engagement Workplace safety Anti-corruption Non-discrimination Legal compliance Fair wages Risk-management systems Benefits Environmental management Human rights systems Indigenous rights Environ./social assessment Gender Human rights diligence Resettlement Corporate governance Cultural heritage protection General and specific indicator General and specific indicator General or specific indicator General or specific indicator Source: Towards an Indicative List of FDI Sustainability Characteristics, Karl P. Sauvant and Howard Mann, 2017. Note: Bolded characteristics are common characteristics and italicized characteristics are emerging common characteristics, as defined in the text. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 19 Leveraging Corporate Capital Market Transactions Intermediation for Consideration of SDG impacts in the internal investment Impact process and governance of FDI can be an important source of credibility when companies raise capital in support of SDG activities, whether through bonds, equity, or loans. The intermediation process of FDI is an opportunity to For example, sustainable FDI can serve as the underlying maximize the impact of downstream investments by investment behind SDG bonds, with mechanisms to integrating considerations of SDG impact into the strategy measure, monitor and report SDG impacts. and governance mechanisms of the parent company and its subsidiary, including: To the extent that companies can commit to certain sustainable practices or even sustainable outcomes from ▪▪ The internal investment process of the parent company their activities, contractual commitments can be included ▪▪ Governance of the parent and subsidiary in bond or loan transactions to give investors assurance that ▪▪ Capital market transactions of the parent company their investments promote sustainable development. ▪▪ Reporting by the parent and subsidiary Internal Investment Criteria The Enel SDG Bond Programme is designed Parent companies can adopt internal investment criteria to fund implementation of a company transition for FDI that are based on their overall sustainability towards renewables, within an Enel Group strategy strategy and risk management but adapted to operations that is fully aligned with the SDGs. A significant in emerging markets and least developed countries. Over portion of the bond proceeds will be used to fund time, these criteria could become another ‘hurdle’ rate for investments in emerging markets, mostly in Latin FDI alongside the traditional internal rate of return (IRR), America, following high governance standards in line focusing on positive SDG impact and management of with the Ten Principles of the UN Global Compact. downside ESG risks. Some companies have started to incorporate SDG On-going investor communications should address a considerations into internal investment decisions. For company’s FDI footprint in emerging markets and LDCs example, energy company Enel requires the incorporation and focus on elements that maximize benefits of FDI. of SDG/ESG considerations into corporate business plans Both positive contributions and management of downside before approving any specific investments. impact should be considered, with emphasis on localization of benefits and sophistication of local financial markets. Corporate Governance Companies should also track and regularly report on the SDG benefits of FDI, differentiating sustainability issues Parent companies can leverage their corporate governance in their home countries from those prevalent in the foreign structures and practices to maximize the sustainability markets where the companies are directly investing. benefits of FDI.19 This includes the adoption of strategic and business development guidelines, codes of conduct 19. This is one of the key benefits of subsidized corporate finance vs. blended finance or ethics, oversight by the board of directors, risk in scaling SDG finance. See Part III. management, and internal controls and reporting. Parent companies can also transpose important governance standards and practices at the subsidiary level, including oversight of SDG impact. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 20 Part II Financial Intermediation Private banks and financial institutions provide a critical In both cases, financial intermediation has a multiplication link between the global capital markets and SDG effect wherein the original investment is leveraged investment opportunities. Their capital furnishes deeper into several more investments or financing, increasing access to finance in private markets, transferring risk and the potential for SDG impact. If done at the local level, transforming the duration of financial liabilities. financial intermediation can also result in a local transfer of ownership of real and financial assets, driving further Banks and insurance companies raise financing on global or economic and social development. local capital markets (equity, bond and repository markets) or from depositors. In turn, they use these funds to provide In this section, we explore different types of financial loans or other financial services in support of SDG-relevant intermediation and how they can help scale SDG finance. activities such as developing and implementing new We also look at the process of intermediation as an instru- technologies and business models, bolstering underbanked ment to maximize impacts on the SDGs. markets (including emerging markets and LDCs), and providing consumer finance to expand access to essential products and services. Financial engineering by banks and insurance companies can change the financial characteristics of investments to make them more attractive to institutional investors. In this intermediation process, funds raised are transformed or grouped together according to their due date, volume and degree of risk. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 21 The Role of Banks and Examples of Financial Financial Institutions Intermediation for Micro and Banking Services SME Finance ▪▪ Credit Suisse has been committed to Financial intermediation by banks is critical because it creates a link between global capital and private financial microfinance since 2002, managing over US$ solutions that are necessary for the realization of the SDGs, 2 billion of assets that are used to fund including the following: microfinance institutions (MFIs). ▪▪ UBS’ Loans for Growth Fund provides debt ▪▪ Mortgages, loans and other credit solutions to support capital to specialized SMEs Financing financial inclusion Institutions in frontier & emerging markets — ▪▪ Loans and other credit solutions to finance fostering economic development, creating jobs consumption of SDG-related products and solutions and contributing to poverty alleviation. (such as energy efficiency and renewable energy) ▪▪ TIAA-CREF invested US$ 32 million in two ▪▪ Leases to support circular economy models global private equity funds focusing on inclusive finance. These funds in turn invest Facilitating inclusive access to finance can provide banks in financial institutions in developing countries with a compelling impact theory when raising capital on the that provide financial services and products to global capital markets. Financial inclusion is featured as an underserved consumers, micro-entrepreneurs enabler of sustainable development in eight of the seventeen and SMEs. SDGs, and there is growing evidence that it contributes to more stable financial systems and economies, increasing domestic resources through national savings and helping to increase Government revenue.20 20. Source: UN Capital Development Fund (UNCDF). 21. The Importance of Financial Sector Development for Growth and Poverty Reduction. 2004. DFID. According to the UK Department for International 22. Source: Climate Bond Initiative. Development (DFID), “access to financial services can reduce poverty through the same channels that affect overall growth: by increasing investment and productivity resulting in greater income generation, and by facilitating risk management thus reducing vulnerability to shocks.”21 On the environmental side, private loans and bank credit facilities are critical for both listed and non-listed companies transitioning to clean energy or other environmentally sound practices. In 2018, the green loans market was one of the fastest-growing segments in sustainable finance. The market grew from US$ 3.1 billion in 2017 to US$ 5.1 billion in 2018, mostly in real estate (32% of the market) and energy (24%).22 Figures 10 and 11 are excerpts of the use-of-proceeds of ANZ and HSBC’s SDG bonds. They illustrate the wide range of SDG benefits that banks can support through the financial services they provide, including: ▪▪ Access to education and healthcare ▪▪ Clean water and clean energy ▪▪ Sustainable infrastructure (transportation, communication) ▪▪ Affordable housing and public transit ▪▪ Climate adaptation and disaster prevention SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 22 FIGURE 10: Use-of-Proceeds of ANZ SDG Bond Eligibility Criteria: Activities that provide Eligibility Criteria: Activities that provide access to essential health-care services, access to safe and affordable drinking water, promote mental health and wellbeing and improve water quality and/or increase water achieve universal health coverage use efficiency Examples: Public hospitals, private Examples: Water treatment facilities, hospitals that are non-for-profit or provide water supply and distribution, water social benefit programs to disadvantaged recycling facilities communities, aged care services Eligibility Criteria: Activities that promote Eligibility Criteria: Activities that increase equal access for all men and women to the share of renewable energy in the global affordable and quality education mix, and expand infrastructure and upgrade technology for supplying modern, reliable and Examples: Technical, vocational and tertiary sustainable energy services for all education providers, construction of facilities such as tertiary campuses, universities, Examples: Wind, solar, hydro power, student housing or training infrastructure biomass, or geothermal generation, as well as energy efficient technologies in new and refurbished buildings, energy storage, district heating or smart grids Source: ANZ. FIGURE 11: Use-of-Proceeds of HSBC SDG Bond Eligibility Criteria: Develop quality, reliable, sustainable infrastructure, to support affordable and equitable access for all that will also benefit economic development and human well-being; Upgrade and retrofit infrastructure to make them sustainable, with increased resource-use efficiency and greater adoption of clean and environmentally sound technologies and industrial processes Examples: Rail transportation projects for public use; Development of roads in areas that lack connectivity, or in areas lacking infrastructure; Communication projects including internet coverage and mobile phone usage Eligibility Criteria: Activities that expand or maintain the supply of affordable housing; Activities that expand or maintain access to sustainable transport systems Examples: Rail transportation projects for public use; Development of roads in areas that lack connectivity, or in areas lacking infrastructure; Construction of Social Housing; Right to Buy schemes Eligibility Criteria: Adaptation projects that demonstrably contribute to reducing vulnerability to climate change identified in the project area and do not increase carbon emissions Examples: Natural disaster prevention infrastructure; Education programmes to increase awareness and knowledge on climate related issues Source: HSBC. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 23 Trade Finance Trade finance is also a strategic area for export credit agencies (ECAs) and development finance institutions (DFIs) Banks can play an important role as providers of trade to promote trade and sustainable development in emerging finance to support international trade with emerging and frontier markets. ECAs and DFIs can play a critical role in markets, linking local companies to the value chain and promoting sustainable trade finance by providing guarantees helping them become more competitive. According to and other benefits for banks that promote sustainability research by the Asian Development Bank, trade finance standards in international trade. can contribute to employment and productivity growth by helping create export opportunities for local companies For example, IFC’s US$ 5 billion Global Trade Finance “which would otherwise be considered too risky, to link into Program (GTFP) provides banks with risk mitigation solutions expanding global value chains.”23 Unfortunately, research (price incentives or longer tenors) for new or challenging also finds that while trade finance is “robust for the main trade routes when defined climate change benefits can be routes of trade and for large trading companies […] access to demonstrated. trade finance remains costly and scarce in countries which have the strongest potential for trade expansion.”24 Figure 12: IFC’s Global Trade Finance Program Trade finance can also be an instrument to promote more sustainable international trade. In a recent publication,25 the Banking Environment Initiative (BEI) explored how documentary trade finance can be leveraged to enforce sustainable practices in international trade. This is particularly important in emerging markets, where a significant proportion of international trade is financed through documentary trade. In a standard trade finance transaction, a bank issues a letter of credit to guarantee payments for shipments that meet certain conditions, based on documents presented to the bank. “By removing the risk faced by suppliers, i.e., that buyers will not pay for their goods, trade finance banks play a critical role in facilitating world trade.”26 (seeFigure 12). According to BEI, the concept of a Sustainable Shipment Letter of Credit (LC) is very simple: a sustainability standard Source: Banking Environment Initiative. can be included in a letter of credit’s conditions and documentary evidence. 23. Auboin, M. and A. DiCaprio. 2017. Why Do Trade Finance Gaps Persist: And Does If the buyer requires of its supplier commodities produced It Matter for Trade and Development. ADBI Working Paper 702. Tokyo: Asian Development Bank Institute. to a particular, pre-existing and internationally recognised 24. Ibid. sustainability standard, it can instruct its bank (the issuing 25. The BEI’s Sustainable Shipment LC: A financing innovation to incentivise sustainable commodity trade (CPSL, 2014). bank) to issue an LC in favour of the supplier including 26. Ibid. this condition. If such a request does not add materially 27. Ibid. to the complexity of the documentary trade process and if buyers, suppliers and banks can be incentivised to prioritise these Sustainable Shipments, then the trade finance industry can play a material role in increasing the visibility of sustainability standards in supply chains and rewarding their greater use, thereby helping to drive new market norms.”27 SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 24 Insurance and Guarantees Examples of Private Insurance Insurance plays a crucial role in scaling SDG finance for and Guarantees solutions and markets that are too risky for commercial finance alone. Insurance and guarantees are often used by Swiss Re is collaborating with The Nature DFIs as highly effective mechanisms to leverage scarce Conservancy to incorporate nature-based coastal public funds to bring in private capital. adaptation measures into open source risk models and maps, informed by assessment of the cost Traditionally, de-risking solutions for development finance effectiveness of green (e.g. mangroves) and grey (e.g. have been provided as public-private partnerships, where a seawalls) infrastructure solutions. public institution (sovereign state or development bank) or a philanthropic organization uses concessionary capital to guarantee the risks of a project or an investment and attract A Solar Revenue Put developed by kWh with private investors. Guarantees are also provided by ECAs to backing by Swiss Re drives down investment risk promote export of national technologies and solutions in and encourages the development of clean, low-cost markets that are too risky for the private sector alone. solar energy. The Solar Revenue Put is structured as an insurance policy on solar production and revenues and provides credit enhancement for financial investors. The put provides comprehensive coverage The African Energy Guarantee Facility (AEGF), that banks rely upon, enabling financial institutions created by the European Investment Bank (EIB), to more easily finance solar projects on terms more Munich Re and the African Trade Insurance Agency favorable to the sponsor. (ATI), offers protection against political risks to facilitate private investment in the use of renewable Performance guarantees for solar panels are energy. The AEGF is structured in different risk an innovation of Munich Re, which provides a transfer tranches, which can be assumed by insurers 25-year performance guarantee to manufacturers and private financial institutions. The facility offers of photovoltaic modules, lowering the risk an insurance capacity of US$ 1.4 billion for political and increasing the financial attractiveness of risks for a total of 25 African countries. investments in renewable energy. Wind Energy Yield Cover is another Munich Re However, such insurance solutions need to be scaled expo- offering. It provides risk insurance for wind energy, nentially to lower the risk of the enormous pool of private covering risks associated with turbine performance investments needed to realize the SDGs. The financial need and wind output. extends well beyond the concessionary capital of develop- ment banks, foundations and export agencies. One solution is presented by financial innovation in the insurance industry to develop new business models for private insurance products and guarantees that can reduce the risk of SDG investments. For example, advances in climate science, technology and data collection help actuaries better forecast climate-related risks and create innovative insurance products that can reduce the risk of SDG investments in climate adaptation, renewable energy, agriculture and consumer finance. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 25 Hedging and Derivatives Securitization and Syndication Hedging can be used to manage currency risks in frontier Securitization transforms financial assets or a pool of markets. For example, cross-currency and interest swaps assets into securities, which can be traded on capital have been used for many years to de-risk investments markets. For creditors — companies or banks providing in emerging markets, focusing on political and currency credit — selling off existing financial assets frees up capital risks, including the risk of having debt and revenues in two and increases cash flows to develop or finance more different currencies. Hedging can also be used to protect SDG-enabling projects. For borrowers, it expands the pool against the risk of loans with variable rates (prevalent in of capital available to global investors and leads to a more emerging markets where there is a higher risk of inflation). stable source of capital at a lower cost. While the practice of securitization more generally has come under increased scrutiny following the financial crisis World’s First SDG-linked of 2008, it can provide important benefits to the financing of Cross-currency Swap sustainable development. For example, loans for renewable energy — both residential and commercial — have been Enel S.p.A. and Société Générale entered into a pooled into securities (bonds) that can be sold to large cross-currency swap in connection with Enel’s institutional investors, improving the cost and availability General-Purpose SDG-linked bond, issued in of funds for a transition to clean energy. Securitization September 2019. The goal of the derivative can also pool together and finance loans to small- and transaction was to hedge against the exchange medium-sized enterprises (SMEs) in emerging markets rate and interest rate risk created by the different or SDG-themed assets that can be easily standardized denomination of the bond repayments (US dollars) (e.g. residential solar equipment). and the source of repayments (Euros). Other examples include: As part of the transaction, Enel received a discounted rate based on its commitment to ▪▪ Bonds backed by consumer loans or leases for sustainability performance. Société Générale electric cars (e.g. Toyota) provided the discount as part of its commitment to the Positive Impact Principles and based on ▪▪ Bonds backed by renewable energy projects (e.g. Enel’s positive contribution to one or the pillars of JRE Mega Solar Project Bond Trust 1) sustainable development (economic, environmental and social) and mitigation of any potential negative ▪▪ Green receivables bonds that raise capital for green impacts to any of the pillars. projects by securitizing receivables (e.g. agribusiness receivables credits in Brazil) As part of the transaction, Enel obtained a price adjustment based on its commitment to ▪▪ YieldCos: publicly listed companies holding multiple sustainability performance in line with the Bond renewable energy assets features. This SDG-linked cross-currency swap is an example of sustainability-linked derivatives Securitization has also been used to scale micro- and it is offered by Société Générale as part of its finance, insurance, and loans to SMEs in developing Sustainable & Positive Impact Finance commitment, and frontier markets. to support positive contribution to one or more of the three pillars of sustainable development (economic, environmental and social) and mitigation of any The Women’s Livelihood Bond (WLB) potential negative impacts. is a US$ 8 million bond intended to help impact enterprises and microfinance institutions to grow their businesses and scale social impact. WLB Similarly, derivative products can be used to transfer the is the world’s first listed bond with dual focus on risk associated with an SDG investment to a financial financial and social returns, empowering the lives intermediary in exchange for a fixed, recurring payment. For of over 385,000 women in Southeast Asia. WLB example, synthetic green asset-backed securities allow the is structured to create a ‘basket’ (Special Purpose credit risk of green loans to be transferred from a lender Vehicle) of impact enterprises and raises funds from to an investor, helping banks meet risk-weighted capital investors seeking financial and social returns. requirements and freeing up funds to originate new loans. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 26 Syndication is a form of financial intermediation that con- sists of combining a pool of smaller investments to diversify Leveraging Financial risk and increase investment size to attract institutional Intermediation for investors. In turn, access to larger pools of capital lowers the cost of financing the underlying investments. Impact As with real-economy FDI, the intermediation process of In the context of SDG finance, syndication can be used to banks and financial institutions presents an opportunity increase the quantity and lower the cost of financing for to maximize the impact of downstream investments. The investments that are too small or too risky for commercial bargaining power of financial intermediaries can provide banks or institutional investors. It can also reduce the costs leverage to ensure a focus on key geographies, populations, of fund management, administration and impact measure- or activities for the SDGs, or to impose strong covenants for ment, which can be prohibitive for single investments. sustainable practices. Examples of funds pooling together SDG investments include: Because the secondary (or downstream) investment processes in financial intermediation are internal and ▪▪ Funds of green, social or sustainability bonds typically not publicly disclosed, financial intermediaries ▪▪ Funds of companies contributing to the SDGs must have strong governance mechanisms to generate (equity or bonds) credibility and ensure that the potential SDG benefits ▪▪ Private equity funds focused on SDG solutions of financial intermediation are actualized. The form ▪▪ Funds of microloans for farmers (microfinance) of a credibility mechanism will depend on the type of financial intermediation, the impact theory, and whether intermediation is done through active management or standardization. Figure 13 below shows examples of credibility mechanisms based on different types of financial intermediation, from more actively managed investments, where more delegation of judgement is warranted, to less actively managed investments, where standardization is critical. Figure 13: Maximizing Impact Through Financial Intermediation — Mechanisms to Ensure Credibility Types of Financial Impact Theory Mechanisms to Ensure Credible Impact Intermediation Actively Banks / Financial SDG focus of financial services Corporate commitment Managed Institutions Management of E&S downside Criteria for investments (use-of-proceeds Performance-based products Asset Management / SDG focus of investments Criteria for investments Private equity Management of E&S downside Active investment management (engagement, reporting) Securitization of Proven SDG contribution of Standard underlying assets (e.g. renewable energy Standardized Financial Assets (e.g. EV underlying asset (e.g. taxonomy) project) loans) Standard underlying financial contract (e.g. loan or leases) Pooling (funds) of Real SDG contribution of underlying Standard underlying assets (e.g. renewable energy project) Assets (e.g. YieldCos) asset SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 27 Corporate-level Mechanisms Use-of-proceeds mechanisms can also be applied to bank loans to ensure that funds will be used for activities that Financial institutions are separate legal entities (often positively contribute to the SDGs. Recently, International corporations), and mechanisms to ensure credibility of Capital Market Authority (ICMA) issued a set of principles impact are, therefore, similar to those recommended for for Green Loans based on the credibility mechanisms of the FDI in Part I. The SDG impact of financial institutions is Green Bond Principles. These principles focus on defining considered in various aspects of corporate strategy and and auditing the use of bond proceeds. governance, including: Standardization ▪▪ Internal investment process ▪▪ Governance Standardization plays a critical role in scaling SDG finance. ▪▪ Capital market transactions First, standardization of financial products and services ▪▪ Reporting and investor communication can help to scale SDG finance by facilitating the replication of smaller investments, either by pooling them together Consideration of SDG impacts in internal processes and with similar investments or by lowering the incremental governance can be an important source of credibility transaction cost of issuing each product. This is particularly when banks and financial institutions raise capital for SDG important for securitization and syndication, which are activities. General-purpose corporate bonds can be linked premised upon pooling together smaller investments whose to the company’s overall SDG strategy, or use-of-proceeds underlying financial and sustainability characteristics are bonds can be issued if SDG investments fall into established similar and well understood by investors. green or sustainability taxonomies. Furthermore, standardization can help maximize the SDG Product-level Mechanisms contribution of financial products and services by ensuring a minimum level of impact. For example, sustainability When providing loans and other financial products, banks standards for underlying investments can be used as can use their leverage to get strong commitments from criteria in the selection and management of assets in clients to maximize the SDG impact of their activities. funds and other pools of assets. They can also be used This can take the form of SDG-linked covenants in loans, in the methodology for constructing index funds — in mortgages, letters of credit, and other financial products. considerations for the selection of the underlying assets For example, a number of financial institutions have issued and how the index is weighted. Sustainability standards corporate loans with interest rate that are tied to the increase the transparency of SDG investments and provide borrower’s key performance indicators related to the SDGs. a credible and scalable pathway for sustainable finance. Taxonomies represent an important source of standardization of financial products and services for the Examples of Performance- SDGs. They can provide an initial and illustrative set of assets based Loan Pricing and activities that qualify as sustainable investments for banks and financial institutions. They can also serve as an Iberdrola (Electricity, Spain): € 1.5 billion loan with organizational tool — an industry classification system — for favorable interest rates contingent on company analyzing, comparing and bundling assets together into performance on SDG 7 and indicators 7.1 on universal investments with similar SDG focus. energy access and 7.2 on the share of electricity produced from renewables. For example, the European Union is developing a taxonomy of economic activities that can make a substantial Colonial (Real Estate, Spain): € 75.7 million contribution to climate change mitigation or adaptation sustainable improvement loan to finance a LEED- while avoiding significant harm to its other environmental certified building, with variable interest based on ESG objectives. Similarly, ICMA produces a taxonomy of and LEED performance. eligible activities as part of its Green and Social Bond Principles. The organization has created a linkage document Royal DSM (Healthcare, Netherlands): € 1 billion (US$ illustrating the relationship between eligible categories for 1.2 billion) revolving credit facility with variable interest Green and Social Bonds and the SDGs (seeFigure 14). rate based on greenhouse gas (GHG) emissions, energy efficiency and electricity sourced from renewables. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 28 Figure 14: Mapping Green and Social Bonds Eligible Projects to the SDGs SbP Project GbP Project SDG Example Indicators Categories Categories Access to Essential Pollution 3.1 Number of people reached with improved health care Services (3.1, 3.2, Prevention and 3.3, 3.4, 3.5, 3.7, 3.8, Control (3.9) 3.2 Cost reduction for standard treatments and medicines 3B, 3C) Renewable 3.3 Amount of waste water treated, reused or avoided before and after Affordable Basic Energy (3.9) the project Infrastructure (3.6) 3.4 Amount of raw/untreated sewage sludge that is treated and disposed of Access to Essential 4.1 Number of people receiving education services Services (4.1, 4.2, 4.3, 4.4, 4.5, 4.6, 4.7, 4.2 Number of students attaining standard for education level 4A, 4C) 4.3 Education facilities for inclusive and effective learning environments Socioeconomic Advancement and Empowerment (4.4, 4.5) Access to Essential 5.1 Number of equal paying jobs created for women another under- Services (5.4) represented gender groups Socio Economic 5B Number of women using technology products Advancement and Empowerment (5.1, 5.4, 5.5, 5B) Affordable Basic Sustainable 6.1 Number of people provided was safe and affordable drinking water Infrastructure water and wastewater 6.2 Number of people provided with adequate an equitable sanitation management (6.1, 6.2, 6.3, 6.4, 6.3 Volume of water saved 6.5, 6A, 6B) 6.4 Volume of waste water treated for reuse Terrestrial and aquatic 6.6 Area covered by sustainable land of water resources biodiversity management practices conservation (6.6) Source: The International Capital Market Association (ICMA). Lower Capital Requirements for Such incentives are being contemplated in the European Sustainable Finance Union under the concept of a ‘green supporting factor’ and the European Commission is “looking positively” at lowering Maintaining a portfolio of sustainable loans can improve capital requirements for banks and an “efficient way to the financial position of banks by lowering the risk of default direct investment into new technologies such as electric that could result from negative sustainability impacts. cars and mortgage loans for energy-efficient homes”.28 Reducing risk could, in turn, result in lowering the capital reserve requirements of banks, enabling them to increase Separately, the High-Level Expert Group on Sustainable the amount of capital for lending. Finance (HLEG), as part of its recommendations for Financing a Sustainable European Economy, suggested Lower capital requirements could result naturally from the that lowering capital requirements for lending to the green management of sustainability risks in banks’ portfolios. It sector should only be implemented if there is an actual could also result from regulatory incentives provided by risk-differential justifying such a discount.29 central banks to encourage more lending or better pricing for sustainable businesses or practices. 28. Brussels looks at easing bank capital rules to spur green investment, Financial Times, January 1, 2018. 29. Financing a Sustainable European Economy: Final Report 2018 by the High-Level Expert Group on Sustainable Finance. European Commission. 2018. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 29 Part III Public-Private Partnerships In this section, we look at the role of public-private Second, blended business models and subsidized partnerships in supporting SDG-related activities that corporate finance can leverage the corporate structure cannot be financed on a purely commercial basis (often the as a scalable and credible investment vehicle for the social aspects of the SDGs) and, therefore, require some SDGs. As discussed in Parts I and II above, real-economy form of public support to attract private investments. In companies and banks can provide critical access to doing so, we take the perspective of companies, looking finance for more risky SDG investments and leverage their at different ways they can benefit from public funds or bargaining power as corporate and financial intermediaries commitments to support their SDG contributions. We focus to impose SDG considerations as part of their investments on markets that present greater economic or political risks or financial services. or that offer new solutions that are not fully tested and, consequently, have a high risk-return profile. We explore the We also suggest strategic use of blended finance in areas value of public support at different links of the investment where it can be most optimal, focusing on temporary needs value chain, including: in the early development stage of solutions or after a market failure. Lastly, we recommend maximizing private sources ▪▪ Consumer incentives and pay-for-performance of blended finance. schemes that can form the basis of new business models (blended business models) Our goal is to outline an order of preference among methods for leveraging public funds for private finance, favoring ▪▪ Capital, guarantees, or insurance that can help solutions that generate the highest ratio of private-to-public companies make their business model work in difficult capital and that maximize the impact of SDG finance. This situations (subsidized corporate finance) approach is consistent with the World Bank’s cascade approach to maximize financing for development by ▪▪ Quasi-private financing schemes that are leveraging the private sector and optimizing the use of demonstrated with public finance but can be scarce public resources (seeFigure 15 below). According to replicated by commercial banks or insurance the World Bank Group Development Committee, companies (blended finance) The Cascade first seeks to mobilize commercial finance, We propose that blended business models and subsidized enabled by upstream reforms where necessary to corporate finance should be prioritized over blended address market failures and other constraints to private financial structures, for two reasons. sector investment at the country and sector level. Where risks remain high, the priority will be to apply guarantees First, blended business models focus public funds on and risk-sharing instruments. Only where market solutions that are almost commercial or that can eventually solutions are not possible through sector reform and risk become commercial after an initial demonstration effect, mitigation would official and public resources be applied.”31 improving the leverage ratio of private-to-public capital. Similarly, subsidized corporate finance can be an efficient use of public funds, as companies generally look for 30. There is currently a debate in the development community on the best way to leverage public capital for private investment, and to improve the ratio of solutions that are commercially viable after a period private-to-public capital in blended finance solutions. of experimentation.30 31. Forward look: a vision for the world bank group in 2030 — progress and challenges. Joint Ministerial Committee of the Boards of Governors of the Bank and the Fund on the Transfer of Real Resources to Developing Countries, World Bank and IMF, March 24, 2017. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 30 Figure 15: World Bank’s Cascade Approach Source: World Bank. Blended Business Models demand and guarantees, improving the risk and return profile (akin to a public contract for a private company) and helping to attract more investment. This is the model behind We introduce the concept of blended business models in social impact bonds, where private actors fund and execute contrast with blended finance. Instead of using public funds social projects and are paid by Governments if and when or guarantees to make investments more attractive for investors (blended finance), blended business models direct they meet agreed-upon measures of success. public resources towards reducing the risk or boosting returns of enterprises that provide SDG solutions, thereby In this section, we explore several types of blended helping to create robust business models that can be business models wherein consumers, the public, or public financed on commercial terms. organizations make direct payments to the private sector in exchange for SDG benefits: The opportunity lies in identifying consumer preferences or incentives for the underlying products or services that ▪▪ Consumer preference and incentives companies provide (e.g. for ecosystem services, social ▪▪ Pay-for-performance models benefits, or vaccines for rare diseases). These incentives can ▪▪ Payment for ecosystem services be integrated into a company’s business model as locked-in ▪▪ Private offsets and public commitment SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 31 Consumer Preferences and Pay-for-Performance Models Incentives These solutions involve conditional payments by A new kind of business model, variously described as “circu- Governments, development banks and foundations based lar economy,” “sharing economy,” or “inclusive economy,” is upon the successful implementation of sustainability seen as a scalable solution to increase efficiency and make solutions by the private sector. They are mostly used in business more inclusive and less resource-intensive, in line the social and economic development sectors and can be with many of the SDGs. Examples include: financed through innovative financial products, including social impact bonds and development impact bonds. ▪▪ Renewable energy and energy efficiency ▪▪ Closed-loop manufacturing Social impact bonds are three-way financial arrangements ▪▪ Extending the lifetime of products where private actors finance and execute a social project ▪▪ Product-as-a-service and are paid by Governments upon meeting agreed-upon ▪▪ Leasing measures of success. They are typically used where early- ▪▪ Sharing products and assets with low use rates stage intervention can direct outsized economic benefits to a public institution (e.g. a municipality, health authority, While these models and technologies can succeed in large NGO, or development finance institution). part on their own merit due to their inherent efficiency or the benefits they provide, their success also carries social value Similarly, development impact bonds are issued to private and, therefore, engenders public support. investors to fund development programmes and are repaid by donor countries or host-country Governments based on This is evident, for example, with renewable energy and pre-agreed outcomes. The Center for Global Development electric vehicles, where the value proposition for the con- and Social Finance suggests the use of development impact sumer is often based on perceived sustainable development bonds for applications such as: benefits and Government incentives. Another example is how Governments’ commitments to climate change ▪▪ Education. Provide loans to low-cost private mitigation factor prominently in projections for the growth schools, with the loans repaid by Governments of renewable energy. Public commitments and incentives or donors upon demonstration of improved such as the US investment tax credit for solar or Germany’s educational outcomes. Energiewende policies can influence business’ decisions about what technologies to deploy and what products and ▪▪ HIV prevention. Programme costs are repaid from services to offer. a Government’s savings on healthcare costs. ▪▪ Energy efficiency. Repayments derive from Here the public contribution is somewhat indirect. It energy savings. happens because business models leverage the social value that is created, gaining public support through consumer Development impact bonds can also be used to support preferences or incentives for consumers. For example, contributions to climate change mitigation and emission consumer preferences for sustainable products can lead to reduction as well as resiliency improvement. more stable demand or Government incentives, subsidies, or guarantees, which can lower the cost or risk of doing business. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 32 Payment for Ecosystem Services Examples of Innovative Financing Payment for ecosystem services (PES) work with semi- for Ecosystem Services externalities where environmentally damaging activities specifically impact commercial or public beneficiaries of a ▪▪ Credit Suisse’s Nature Conservation Notes preserved natural ecosystem and these beneficiaries agree to fund sustainable agroforestry and eco- to pay for the preservation of said ecosystem. The most system conservation, based on revenue from recognized examples of PES schemes include (i) payments the sale of sustainably certified commodities by users of the Panama Canal to preserve the surrounding and payments for ecosystem services. ecosystem and improve navigability, (ii) payments by the City of New York to improve upstream farming practices to ▪▪ European Investment Banks’ Althelia reduce the cost of water treatment, and (iii) payments by Climate Fund to finance forest protection the large food company Danone to preserve the quality of and sustainable land use based on revenue Evian’s water source. streams from tradable carbon assets. Another example of a PES scheme is the UN-sponsored ▪▪ Cloud Forest Blue Energy Mechanism REDD+ mechanism, where tradable carbon credits are to fund restoration and conservation of cloud issued upon measurement and verification of avoided forests in Latin America, based on revenue from deforestation.32 These credits can then be monetized based improved productivity of hydroelectric plants.34 on a collective interest in climate stability and mandatory and voluntary offsets by companies and Governments. ▪▪ Rimba Raya, the largest REDD+ project in the world, to support the conservation of Revenue streams from payment for ecosystem services can a nearly 65,000-hectare natural reserve in be capitalized and can generate innovative private financing Indonesia to avoid more than 130 million tons schemes. For example, while public finance accounts for of CO2 emissions. The project was financed a large proportion of investment in REDD+ projects, the by Allianz, Microsoft and other private invest- private sector is becoming an increasingly important source ors in exchange for verified avoided CO2 of funding, contributing over US$ 400 million between 2009 emissions (carbon credits) to meet carbon and 2014.33 neutrality goals.35 Private Offsets, Public Commitment and Long-Term Contracts Example of Long-term Contract — Power Purchase Offsets consist of payments by companies or other entities Agreements to offset their GHG emissions or other impact on the environment. This practice is typically seen in regulated Power purchase agreements are long-term con- cap-and-trade markets for GHG emissions, but it also works tracts that can provide energy companies with a on a voluntary basis when there is sufficient pressure on stable revenue sources to invest in renewable energy. companies (from consumers, investors, employees, etc.) to offset an environmental footprint that they cannot mitigate For example, the Enel Group is planning for a 34% (e.g. voluntary carbon credit markets). increase in total renewable capacity between 2019 and 2021 — a growth of about 9 GW of capacity in 3 Advance market commitments consist of capitalizing years. This aggressive growth plan is made possible, on multi-year financial commitments of countries (e.g. in part, by long-term contracts (power-purchase international aid or commitments to buy vaccines) to agreements) with electric utilities and commercial finance upfront investments that will deliver broad and and industrial customers, covering a majority (55%) long-term economic and social impact. For example, GAVI of its energy production. (the Vaccine Alliance) pools the demand from developing countries for new vaccines and provides long-term, predictable financing to attract new (private) vaccine 32. Reducing Emissions from Deforestation and Forest Degradation, as well as conservation, sustainable management of forests and enhancement of forest manufacturers. Long-term contracts on preferential terms carbon stocks can provide companies with stable input and a reliable 33. Financing the Low-Carbon Future: A Private-Sector View on Mobilizing Climate Finance. The Climate Finance Leadership Initiative. 2019. supply chain. 34. Source: Climate Policy Initiative. 35. Ibid. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 33 Blended Finance Blended finance is defined by the OECD as “the strategic use ▪▪ Policy makers need a better understanding of the of development finance for the mobilization of additional poverty and development impact of blended finance, finance towards sustainable development in developing as well as its true costs, to ensure value for money countries.” In contrast with blended business models and effective policymaking and allocation of aid. or subsidized corporate finance, blended finance brings together public and private financial resources as part of the ▪▪ Multilateral development banks and development capital structure to finance projects or activities that cannot finance institutions need to collectively adopt a more be financed on a commercial basis. distinct and tailored approach to blended finance in low-income countries.36 Blended finance has become a very popular area of This has led to a debate over how to improve the ratio of sustainable finance, and it is seen by many as a critical tool private-to-public capital in blended finance solutions and, to scale finance for the SDGs. Yet, the growth of blended more generally, how best to leverage public funds to attract finance has tapered off in recent years (see Figure 16), as private investment. In the same report, ODI suggests the have projections on how much private capital it can attract need for a better approach: to finance the SDGs. Donors need to think carefully about the allocation Recent research from the Overseas Development Institute of ODA and the risks and trade-offs of investing ODA (ODI) provides a mixed review of blended finance, stating that: in blended finance. There may be other public policy interventions that are more transparent and effective in ▪▪ Expectations that blended finance can bridge the SDG achieving development objectives than providing a direct financing gap are unrealistic: ‘billions-to-billions’ is subsidy to the private sector.37 more plausible than ‘billions to trillions.’ 36. Overseas Development Institute, Blended Finance in the Poorest Countries — ▪▪ The big push on blended finance risks undermining the The Need for a Better Approach, Samantha Attridge and Lars Engen, April 2019. poverty eradication agendas in the poorest countries. 37. Ibid. Figure 16: Growth of Annual Blended Finance Activities (2007­­–2018) $20 $15 $10 $5 16 16 26 30 35 45 42 51 44 56 55 48 $0 2007 2008 2009 2 010 2 011 2 012 2 013 2 014 2 015 2 016 2 017 2 018 Total capital committed Number of (USD billions) transactions closed to be formally added to the Convergence database at this time Source: Convergence. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 34 Calibrating Expectations for age ratios increase exponentially, scaling blended finance Scaling Blended Finance would require a step increase in sources of concessionary finance, while the scarcity of that capital is the very reason Recent research suggests that ambitions for scaling why blended finance was invented in the first place. Another blended finance — from billions to trillions — should be difficulty is that scaling finance where it is needed most, recalibrated in the context of lower leverage ratios in least including in LDCs, would require DFIs to take on more risk. developed countries and limited public funds for ODA and According to ODI: development finance.38 Low leverage ratios suggest ODF will have to play a major In its latest report The State of Blended Finance, Conver- role in blended-finance investment. Our estimates suggest gence, a global network for blended finance, notes that: that the public sector (the MDBs and DFIs) has on average picked up 57% of the cost of blended-finance investments Indeed, blended finance transactions to date have to date and as much as 73% of the cost in LICs... represented a drop in the bucket compared to the promise of the potential resources available from global financial If blended finance is to be scaled up, … MDBs and DFIs markets. … we need to walk before we can run — and will need to make fundamental changes to their business setting reasonable and right-sized expectations are key.39 models and take on riskier projects … Conservative MDB and DFI financing models and the returns required on Figure 17 below shows that this situation is worst in least blended concessional finance are dampening risk appetite developed countries, where the need for financing is greatest, and the ability to engage in LICs.40 but where blended finance only brings US$ 0.37 of private finance for every dollar of public finance. As we contemplate scaling blended finance, we should also consider that there may be an optimal level of leverage At this level of leverage, scaling blended finance solutions between public and private capital beyond which governance to trillions of U.S. dollars would require DFIs and other market participants to also originate trillions of U.S. dollars 38. Ibid. in investment opportunities, necessitating a step change in 39. The State of Blended Finance. Convergence. 2019 their capital and capacity from today’s levels. Unless lever- 40. See footnote 36. Figure 17: Leverage Ratio of Blended Finance in Least Developed Countries Source: Overseas Development Institute. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 35 issues for DFIs start to arise, including potential conflict Focus on Temporary Use and with national agendas, as well as governance and legitimacy Mechanisms That Can Be Replicated concerns. Traditionally, the work of DFIs has been funded Commercially by public sources, mostly Governments. As we increase the participation of private investors in the work of DFIs, there is a Strategic use of blended finance should focus on solutions question of whether the DFIs would retain sufficient indepen- that can ultimately be mimicked by the private sector, so dence and legitimacy to deliver on their mission and mandate. they can become self-sustaining and potentially end up un-blended over time (seeFigure 18). In this paradigm, One solution could be to scale the blended finance market on candidates for blended finance would have a strong the model of the US municipal bond market, where private commercial element, and barriers to full commercial investors fund public projects and administration. To some financing would be temporary. Given the strengths and extent, DFIs are already doing that by issuing bonds based on limitations of blended finance, and the scarcity of public their AAA credit ratings to support their core activities. capital for development, we suggest focusing on temporary support for early-stage, high-impact SDG solutions or Potential conflict of interest and legitimacy issues can rectification of a systemic market failure. be addressed by ring-fencing private investment through use-of-proceeds mechanisms, as is now standard in green, According to the Overseas Development Institute: social and sustainability bonds. Here the primary reason for use-of-proceeds clauses is not the protection of investors Using concessional finance to blend can help pioneer and (although that is a secondary benefit), but rather protection create new markets, foster innovation and invest at the of the DFI-issuers from potentially conflicting interests of earliest stages of projects, when risk levels are at their private investors. highest and when private investors need a greater degree of risk mitigation.41 Here there is parallel with venture capital, which funds critical life-stages of businesses. Like venture capital, blended finance could focus on investments with higher risk but also higher rewards if the solution it supports succeeds and scales to deliver meaningful impact. 41. Ibid. Figure 18: Strategic Use of Blended Finance Optimal use of Blended Finance Amount of Financing Private Capital Public Finance Blended Finance No Commercial Commercial Element Standalone Element Potential Mimicking Commercially Order of preference to scale SDG Finance SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 36 Prioritizing Use of Private Concessionary Capital for Examples of Subsidized Blended Finance Corporate Finance Consistent with the model of some development finance US$ 700 million Guarantee for the Sankofa Gas institutions,42 one way to scale blended finance is to Project by the World Bank Group, to help mobilize up leverage private sources of concessionary capital, with to US$ 7.7 billion from private sponsors and finance a scarce capital from public finance or ODA reserved for project that could potentially generate 1,000 MW of core development work. These private sources can include power in Ghana. See case study below. philanthropic foundations, impact investors and high-net- worth individuals, as these investors have a strong appetite Global Index Insurance Facility (GIIF). The World for impact and an ability to absorb higher risk. Bank Group and African Reinsurance Corporation (Africa Re) have entered into an agreement to According to IFC, “[b]lending funds from private investors carry out a risk-sharing facility, in the form of an with concessional funds from donors and philanthropic experience account, to decrease premium levels for sources has a strong potential to scale up investment insured farmers and encourage local companies to in lower-income countries and thereby accelerate create affordable insurance products. development.”43 Because there is a risk that the agenda of foundations, impact investors and wealthy individuals IDB/GCF Energy Savings Insurance in El may not always align with country and international Salvador guarantees the financial savings of energy Government plans for sustainable development, the efficiency projects, helping small- and medium- continued involvement of DFIs is critical, focusing less on sized businesses make investments in more providing concessionary capital for blending and more efficient practices. on providing expertise and capability to source attractive investment opportunities and commercial capital. Bangladesh Investment Promotion and Financing Facility (IPFF) is a US$ 356 million World Governance Issues Bank credit line to Bangladesh Bank (the central bank) to on-lend to commercial banks for large Blended finance mechanisms are often intermediated by infrastructure financing. public or non-profit organizations who either originate or select investments and source the concessional capital. These intermediaries have governance models and criteria for making investments that are neither standard nor 42. For example, see IFC, the private-sector arm of the World Bank, and IDB Invest, transparent. Similarly, the investment vehicles used for the private-sector development arm of the Inter-American Development Bank (IBD). blended finance have varied governance and accountability 43. EM Compass, Blended Concessional Finance: Scaling Up Private Investment in mechanisms. According to ODI’s recent report on Blended Lower-Income Countries. November 2018. IFC. 44. Ibid. Finance in the Poorest Countries: Effective policy-making has been thwarted by the lack of a common official blended finance framework and poor data availability, hindering transparency and accountability, and undermining public trust in this approach. … This is at odds with the blended-finance principles agreed by the international community.44 SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 37 Subsidized Corporate In the development finance space, insurance and guarantees are highly effective mechanisms to leverage Finance scarce public funds to incentivize the private sector. They can mobilize and leverage commercial financing by The concept of subsidized corporate finance is a partial mitigating and/or protecting risks, notably commercial answer to the challenges associated with traditional default or political risks. blended finance. It harnesses the benefits of corporate and financial intermediation by real-economy companies The World Bank Group, through its Multilateral Investment and banks to maximize the use of public funds as leverage Guarantee Agency (MIGA), has an entire practice dedicated to for private capital, to maximize impact, and to ensure promoting cross-border investment in developing countries replicability and credibility of public-private partnerships. by providing guarantees (political risk insurance and credit enhancement) to investors and lenders. While MIGA works What Is Subsidized Corporate primarily with Governments, private companies often benefit from the guarantees and de-risking solutions it provides to Finance? improve emerging market investments. For example, the agency’s risk insurance arm recently supported the world’s Subsidized corporate finance refers to mechanisms largest solar power plant in Egypt by offering US$ 210 million where a public entity or development institution provides in financial guarantees for the international companies guarantees or other financial benefits to a company or bank contracted to build the solar fields. to support business solutions for sustainable development. It involves the use of public finance (e.g. catalytic capital, Guarantees are also used by export credit agencies to insurance, guarantees) to support corporations operating in promote export of national technologies and solutions in difficult but important markets for the SDGs, or proposing markets that are too risky for the private sector alone. solutions where private finance is not available. This is complementary to but different from blended business models, where public funds or commitments are leveraged 45. Ghana Sankofa Gas Project, World Bank Group Financial Solutions Brief, to create new business models. January 2018. Case Study cial banks (HSBC and Standard Chartered) and export Ghana Sankofa Gas Project credit agencies (UKEF), and political risk guarantees from MIGA. The Sankofa Gas Project in Ghana is an example of how public-private partnerships can help finance critical SDG According to the World Bank,45 the project is expected to investments in emerging markets despite great market bring a combination of economic, social and environmen- uncertainty, using a combination of the tools described in tal benefits for Ghana: this paper — long-term off-take agreements, guarantees from DFIs and ECAs, FDI by multinational companies, “The gas from the project will fuel up to 1,000 MW and banking intermediation. of domestic power generation, or about 40 percent of Ghana’s currently-installed generation capacity. The Sankofa Gas Project is part of the Offshore Cape This will help improve the reliability of power services Three Points (OCTP) project that includes two major in Ghana, replacing the current use of expensive, oil fields holding an estimated 131 million barrels and polluting fuels (imported light crude oil) with cleaner Ghana’s first non-associated gas fields (Sankofa and and more affordable gas resources. Gye Nyame) with a potential production of up to 1 trillion cubic feet (Tcf) of non-associated gas. Close to 90 percent of the net economic benefits of The project was made possible by a long-term natural the project are expected to be captured directly or gas sale agreement with the downstream power sector indirectly by Ghana through revenues for the govern- in Ghana, overseen by the Ghana National Petroleum ment and GNPC (US$ 2.3 billion) and through fuel cost Company (GNPC). In addition, US$ 700 million in World savings (US$ 1.2 billion). Additional indirect economic Bank Guarantees (IDA and IBRD) helped mobilize US$ benefits of the Sankofa gas field include economic 7.7 billion in financing including FDI by a multinational growth—as energy services improve due to increased company (ENI), credit facilities by international commer- stability of gas supply and reduced carbon emissions.” SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 38 Corporate Structure as a Credible institutions (seePart II, Insurance and Guarantees). For an Vehicle for Blended Finance example of a successful transition from public to private finance, see the excerpt “The successful transition from DFI Subsidized corporate finance can leverage the corporate funding to private capital in Chile” below. structure as a scalable and credible investment vehicle for Traditionally, de-risking solutions have been provided the SDGs, drawing on the benefits of corporate and financial through public-private partnerships where a public in- intermediation discussed in the first two parts of this paper: stitution (sovereign state or development bank) provides ▪▪ Sophisticated management and governance guarantees or concessionary capital to reduce the risks of ▪▪ The ability to issue liquid investment products a project and attract private investors. More recently, de- ▪▪ A track record of providing innovative solutions risking solutions have also been provided as blended capital, ▪▪ Proven delivery of financial returns with contributions from either philanthropic foundations, ▪▪ Documented positive environmental and social impacts through first-loss guarantees or concessionary capital, or via impact investors who are willing to accept lower risk- In addition, profit motivations ensure that companies and adjusted return in exchange for impact. In comparison with private banks favor solutions that will become commercially private financial institutions, however, states, development viable after a period of experimentation. Support from the banks and foundations, and impact investors are limited in public sector is, therefore, temporary by design and focuses the amount of capital they can deploy to guarantee or other- on mechanisms that can be replicated and scaled.46 wise de-risk a project, preventing the replication of their SDG investments at scale. Accordingly, over time, insurance and guarantees that 46. There is currently a debate in the development community on the best way support subsidized corporate investments can be replicated to leverage public capital for private investment, and to improve the ratio of privately and scaled through commercial banks or financial private-to-public capital in blended finance solutions. See Note 27. Excerpt: The successful transition from DFI funding to private capital in Chile Chile’s power sector, which has been deregulated since the 1980s, is considered one of the most sophisticated power markets in Latin America; private investment is encouraged across the sector, including in generation, transmission, and distribution. However, the country’s power sector transition to clean energy began only recently. In 2013, when less than 5% of Chile’s electricity came from renewables, the government imposed a 20% renewable portfolio mandate on utilities for 2025.1 By 2018, the share of renewables had already more than tripled to reach 18% of generation.2 DFIs played a critical role in nurturing the growth of Chile’s renewable energy sector after its renewable mandate was introduced. The first project to break the $100 million mark was the $260 million 101MW Amanecer Solar PV project, in which the IFC and the U.S. Overseas Private Investment Corporation (OPIC) provided $212.5 million in debt.3 Since 2013, DFIs have paved the way for commercial lenders, with OPIC, the World Bank, and the Inter-American Development Bank having cumulatively deployed more than $1 billion in project lending.4 DFIs’ presence in the market has gradually been phased out, supplanted by interest from commercial banks, which provided over $900 million of clean energy funding in 2017 alone.5 International utilities like Enel and AES have also since entered the market, providing more of the finance by tapping their own balance sheets. Lending from DFIs has played an important role in stimulating solar and wind production in Chile’s electricity market by helping clean energy developers secure attractive financing. In the Chilean auction system, renewables compete with fossil fuel generators. In the first tender, solar and wind projects won contracts to deliver just 7% of the auctioned generation volume.6 In the tenders held since 2018, however, renewables outcompeted fossil fuels to win 100% of the contracts on offer. In emerging markets where local financing is often limited or comes at a premium, concessional finance provided by DFIs can reduce the time needed for solar and wind to become more cost-competitive than fossil fuels by four to seven years on average.7 1. BNEF, Climatescope 2018: Chile country profile, 2018. 4. BNEF, Climatescope 2018: Chile country profile, 2018. 2. Martin Libra; PVTech, accessed [31 July 2019], “Chile: Land of 5. BNEF, Investment & Valuation — Financing Deals database. Opportunity for Renewable Energy,” 31 October 2018. 6. BNEF, Clean Technology Fund (CTF), “Clean Technology Fund and 3. Overseas Private Investment Corporation. “SunEdison, IFC and OPIC Concessional Finance: Lessons Learned and Strategies Moving Forward,” Close $212.5m Project Financing Arrangement for a 100 MW Solar Power February 2019. Plant in Chile,” [Press release], September 2013. 7. Ibid. Source: Financing the Low-Carbon Future: A Private-Sector View on Mobilizing Climate Finance, Climate Finance Leadership Initiative, 2019, p. 56. SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 39 Linking Subsidized Corporate Internationally, we will support these efforts through Finance with FDI financial and technical support and capacity-building and closer collaboration between home and host Blending public and private finance reinforces the role of country agencies. We will consider the use of insurance, companies and banks as critical sources of financing for investment guarantees, including through the the SDGs in emerging markets, as described in Part I. Multilateral Investment Guarantee Agency, and new The link between blended or subsidized finance and financial instruments to incentivize foreign direct FDI is highlighted in the 2030 Agenda for Sustainable investment to developing countries, particularly least Development and the Addis Ababa Action Agenda on developed countries, landlocked developing countries, Financing for Development. Paragraph 45 of the Addis small island developing States and countries in conflict Ababa Action Agenda continues: and post-conflict situations. Case Study the financing gap for SDG investments in developing Ngonye 34 MW Solar Photovoltaic countries. Under the arrangement, the Ngonye PV (PV) Plant in Zambia plant, which is owned by a special purpose vehicle 80% held by Enel Green Power and 20% by Zambia’s This project is an example of how companies can use Industrial Development Corporation (IDC), will sell its blended finance solution from development finance In- energy to the country’s state-owned utility ZESCO stitutions (DFIs) to subsidize foreign direct investments through a 25-year power purchase agreement. (FDI) for critical infrastructure in emerging markets. The Enel Group and IDC signed a financing package of In 2018, Enel Green Power started construction of around US$ 34 million for the construction of the solar the Ngonye 34 MW solar photovoltaic (PV) facility in plant, including: Lusaka South Multi-Facility Economic Zone in southern Zambia. Once completed, the facility is expected to ▪▪ Senior loans of up to US$ 10 million from the produce around 70 GWh of electricity per year, while International Financing Corporation (IFC); avoiding the annual emission of over 25,600 tons of ▪▪ Up to US$ 12 million from the IFC-Canada CO2 into the atmosphere. Climate Change Program; and The project, which is part of the World Bank Group’s ▪▪ Up to US$ 11.75 million from the European “Scaling Solar” programme, is designed to boost “the Investment Bank (EIB). government’s ambitious push to improve access to electricity throughout the country, while diversifying its The financing was also made possible by allocating EUR generation mix, currently dominated by hydro, to hedge 10 million from the proceeds of a Green Bond issued by against severe drought and climate change effects.” Enel Finance International N.V.in 2018. The project leveraged a long-term power-purchase agreement and funding from diverse sources to tackle SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 40 Developing Local Building local capital markets has a number of other benefits, including limiting reliance on foreign debt and Capital Markets lower currency and interest rate risks as domestic finance is mostly done in local currencies. Also, as discussed in Part I, Scaling SDG finance in emerging markets and LDCs strong local financial markets are a resource for FDI. will involve the creation or improvement of local capital markets. As is often stated, the scale of the financing gap Paragraph 45 of the Addis Ababa Action Agenda on Financ- we face is only matched by the scale of global investment. ing for Development addresses local market development: The gap will only be closed with strong local capital markets and financial intermediation, such that both global Government policies can strengthen positive spillovers and local investors can make direct portfolio investments in from foreign direct investment, such as know-how and these key markets for the SDGs. technology, including through establishing linkages with domestic suppliers, as well as encouraging the As discussed earlier, financial intermediation can trigger integration of local enterprises, in particular micro, small a local transfer of ownership of business and financial and medium-sized enterprises in developing countries, assets, heightening the impact of global investment on into regional and global value chains. We will encourage local economic and social development. It can also trigger investment promotion and other relevant agencies to a multiplication effect leading to local capital growth. focus on project preparation. According to the UK development agency DFID: 47. The Importance of Financial Sector Development for Growth and Poverty Reduction. 2004. DFID. 48. See IFC’s Strategic Alignment with the SDGs, https://www.ifc.org/wps/ [a] large body of evidence now exists which shows that wcm/connect/Topics_Ext_Content/IFC_External_Corporate_Site/ financial sector development can make an important Development+Impact/Development+Goals/SDGs 49. DFID’s Economic Development Strategy 2017. contribution to economic growth and poverty reduction. This is especially likely to be true in developing countries, whose financial sectors are likely to be particularly underdeveloped, and without it economic development may be constrained, even if other necessary conditions are met. By increasing the savings rate and the availability of savings for investment, facilitating and encouraging inflows of foreign capital, and optimising the allocation of capital between competing uses, financial sector development can boost long-run growth through its impact on capital accumulation and on the rate of technological progress. 47 While not a new priority for DFIs, building local markets and strengthening the enabling environment for private SDG investments is becoming more central. Indeed, IFC’s new corporate strategy (IFC 3.0) focuses on creating markets and mobilizing private capital, with increased support to countries where private capital flows are inadequate to address major development gaps.48 Similarly, one of the priorities in DFID’s Economic Development Strategy is to support countries to “mobilise their own domestic resources by tackling corruption, improving tax systems, and enhancing the wider enabling environment for business.”49 SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 41 The Link Between FDI and Local Moving Forward Together Capital Markets Realizing the dream of the SDGs of improving all lives and As discussed in Part I, FDI as a source of capital in emerging transforming our world for the better requires universal markets positively correlates with the development of local and transformative steps.53 This includes modernizing financial markets. In turn, good local financial conditions the global economic and financial system to factor allow for increased FDI because companies can secure sustainable development and introducing financial complementary financing locally and hedge local currency innovation to increase the flow of capital towards the risk. This is what some academics call the two-way SDGs. However, financial innovation at the global level causal relationship between FDI and local capital market will only be beneficial in the long-term if it is translated at development; they reinforce one another.50 the country-level and intermediated through robust local capital markets, especially in emerging markets and least Foreign investment also helps develop local stock markets developed countries. as affiliates of multinational companies often list their shares on local stock markets. In addition, FDI inflow 50. Causality and Externalities: Causality between FDI and Financial Market encourages market-friendly regulations, which promotes Development: Evidence from Emerging Markets. Issouf Soumare and Fulbert Tchana Tchana. The World Bank Economic Review. 2015. the development of the stock market. The existence of 51. See footnote 5. local capital markets can also mitigate the potential 52. Linda Goldberg. Financial-Sector FDI and Host Countries: New and Old Lessons (2004). NBER Working Paper No. 10441. for usurpation of local financial resources when foreign 53. Transforming our world: the 2030 Agenda for Sustainable Development. affiliates raise capital locally. Preamble. 2015. Conversely, a relatively well-developed stock market helps attract foreign investors, as a sign of vitality and openness, and of a market-friendly environment. In addition, the strength and success of foreign portfolio investments can be a positive sign for multinationals considering FDI, as FDI is a longer-term and less liquid investment. Financial FDI is also linked to local market development (seealso Part I on Financial FDI). Academic studies51 have found that financial-sector FDI leads to improvements in and diversification of the local banking sector and better prudential regulation: The institutional effects are clearer. Financial FDI from well-regulated and supervised source countries can support emerging market institutional development and governance, improve the mix of financial services and risk management tools of a host country, and potentially reduce the sharp crises associated with financial underdevelopment in emerging markets.52 SCALING FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS | 42 THE TEN PRINCIPLES OF THE UNITED NATIONS GLOBAL COMPACT HUMAN RIGHTS ENVIRONMENT 1. 7. Businesses should support Businesses should support and respect the protection of a precautionary approach to internationally proclaimed environmental challenges; human rights; and 8. 2. undertake initiatives to make sure that they are not promote greater environmental complicit in human rights abuses. responsibility; and 9. encourage the development and diffusion of environmentally friendly technologies. LABOUR 3. Businesses should uphold the freedom of association and the effective recognition of the right ANTI-CORRUPTION to collective bargaining; 10. 4. Businesses should work against the elimination of all forms of corruption in all its forms, forced and compulsory labour including extortion and bribery. 5. the effective abolition of child labour; and 6. the elimination of discrimination in respect of employment and occupation. The Ten Principles of the United Nations Global Compact are derived from: the Universal Declaration of Human Rights, the International Labour Organization’s Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development, and the United Nations Convention Against Corruption.