WASHINGTON — Finance for development is rapidly evolving. Along with those changes have come not only a host of new instruments, but also a new lexicon.
As development is increasingly funded in partnership with the private sector, finance-based instruments are becoming part of the mix, bringing with them terms that are adapted to the new context.
These new mechanisms, often called innovative finance, encompass a range of new or nontraditional mechanisms to fund development projects. The World Bank breaks innovative finance down into three categories: raising additional funds, improving efficiency of funding, and linking financing to results.
One of the challenges in the innovative finance space is that the same or similar mechanisms can have different names based on the industry or region. Results-based financing, for example, is also called performance-based financing or pay-for-success.
It can be easy to get bogged down in the new vocabulary, especially with duplicative terms and words that take on different meanings in the development context than in the financial industry. Devex has compiled a development finance glossary to help reduce some of the confusion. Given that the industry is constantly evolving, this list will undoubtedly grow and change.
Results- or performance-based financing, or pay-for-success
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This type of financing ties funding to specific performance or results that are typically agreed upon in advance. In many cases, funding — or incentives — is contingent on meeting those goals.
Results-based financing can take the form of contracts or deals, including social and development impact bonds. Traditionally, contracts or grants are based either on the inputs (the number of services delivered) or on short-term outputs. But these mechanisms require clear, measurable results and outcomes, thus pushing those involved to build robust data systems and closely monitor their work.
In health, this type of financing is typically referred to as results-based financing, while governments often use the pay-for-success terminology.
Social impact bonds
Social impact bonds are partnerships or contracts between governments, NGOs and investors to fund interventions that address pressing challenges. They are designed to bring in new funding for programs, typically to address social issues with preventative interventions that could save government dollars.
In SIBs, an investor provides the upfront capital to support a specific intervention and is repaid by the government based on the success of the program, which is implemented by a service provider, usually a nongovernmental organization.
SIBs have primarily been developed in the United Kingdom and the United States, although several middle-income countries, including South Africa, are considering launching SIBs. For many developing countries, SIBs may not be an option due to weak investor confidence or government credit ratings, which gave rise to the development impact bond, in which a third party — a donor agency or foundation, rather than the government — is the outcome payor.
Development impact bonds
Development impact bonds are results-based contracts in which private investors pay up front for the costs of a proven intervention, which is implemented, typically by an NGO, and measured by clear, predetermined metrics. If the intervention succeeds in achieving the goals, the outcome payor — typically a donor agency, foundation or perhaps a company — will pay the investor back based on the performance or success of the interventions.
The attraction of DIBs is their potential to leverage private capital to new situations, for example to battle sleeping sickness in Uganda or reduce malaria in Mozambique. Still, these are fairly complex financial instruments that work best under particular circumstances and can take years to get off the ground.
DIBs are not bonds in the typical finance use of the term and have only been tested in limited cases. Today there are two DIBs being implemented, with several more expected to come online in the next year.
Blended finance or blended capital
Blended finance occurs when development finance in the form of grants, loan guarantees or philanthropic funds are used to attract or leverage private capital into developing countries. The term derives its name from the mix of types of capital. Blended finance is typically used to de-risk investments or bring returns in line with what investors are seeking.
Blended finance may have the potential to bring in new sources of funding to development challenges. But development finance institutions warn that blended finance deals have to be put together carefully, with the different types of financing used at the appropriate stages to ensure that any concessional financing doesn’t distort markets.
Concessional loans offer better than market-rate terms, either through longer repayment times, low interest rates, or both. Development finance institutions often use these loans to de-risk or encourage certain investments.
A loan guarantee is a promise by the guarantor, often a development finance institution, to pay back a borrower’s debt if a borrower defaults on a loan. Guarantees can cover all or part of the debt and are often used to de-risk investments for conventional or commercial investors.
Impact investments are made in companies, organizations or funds that intend to generate social and environmental impact along with a financial return. Impact investing includes a spectrum of investment types, including those seeking market rate returns and those that are looking to just recoup capital.
The field continues to grow, and there is a push to track some investments to the Sustainable Development Goals, though this still represents a small fraction of total investments.
Impact investing is sometimes equated with socially responsible investing or investing based on environmental, social and governance standards, but the two differ. Impact investments don’t merely screen out investments that have a negative impact or consider potential impacts; rather, they have the express purpose of creating impact.
Green bonds, climate bonds and more
As impact investing has gained some traction, investors are looking for ways to support socially or environmentally impactful programs, which has given rise to a new field of bonds that primarily tackle environmental challenges.
A green bond, for example, is a debt security (a legal contract for money that is owed and can be bought and sold) designed to raise funds to support climate-related or environmental projects. Green bonds typically fund large-scale projects — green infrastructure, energy efficiency, transit, or renewable power, among others — that can be repaid over the long term.
Climate bonds are a subset of green bonds and are issued to raise funds for projects or programs that address climate change mitigation or adaptation. Climate and green bonds, like other bonds, can be issued by governments, multinational banks or corporations.
Ethical debt instruments could be the innovation we need to fund the Sustainable Development Goals.
Climate risk bonds are also a variation on the same idea and can be used by national, state or local governments to protect against the risks associated with climate change. Governments can issue a bond when a new project that will increase climate risk is approved to ensure they have the funds necessary to undertake the needed adaptation and climate disaster response work.
Blue bonds are similar to climate bonds, but they target conservation and climate mitigation as it applies to oceans. The Nature Conservancy has tested the model in the Seychelles where NatureVest, the Nature Conservancy’s conservation investing unit, brought down the country’s debt and then helped set up a local trust to carry out conservation programs as the government repays the debt. They are looking to expand the model to other small island developing states.
Domestic resource mobilization
Domestic resource mobilization is the way in which countries raise and spend their own funds to address the needs of their citizens. Increasing taxes and other income into government treasuries, improving tax policy and cracking down on the misuse of funds can all be part of domestic resource mobilization. Domestic resource mobilization is seen as critical to funding the SDGs. It was a key focus of the 2015 Financing for Development conference in Addis Ababa, Ethiopia, and continues to be a part of global conversations about funding the goals.
Venture capital is one source of financing that might contribute to the $2.5 trillion of funding that will be needed to achieve the United Nations Sustainable Development Goals by 2030.
Venture capital is financing that investors give to startups. It is typically a high-risk investment that has high potential payoffs, and is most prevalent in Silicon Valley. While there are still many countries where venture capital is hard to come by, some venture capitalists are expressing interest in investing in emerging markets. India is a good example.
Remittances are funds sent by people living and working abroad back to their home countries. In many developing countries remittances are the largest external source of finance, greater than official development assistance and foreign direct investment. The World Bank estimated that remittances to developing countries stood at $429 billion in 2016, down 2.4 percent from 2015, the second year they dropped in about 30 years.
Diaspora bonds are bonds issued by governments to get citizens or members of its diaspora to help support the country’s economic growth. Members of the diaspora are often willing to overlook certain risks, including political stability, which might restrain other investors. The bonds typically have low yields and mature over a long period of time. Earlier this year Nigeria sold its first ever diaspora bond, which raised $300 million, and India has raised billions of dollars through three diaspora bonds in the past 20 to 30 years, though not all efforts have been successful.
This list will be updated as the industry continues to change and develop. If there are other development finance terms you want defined, or any we left out, let us know by emailing email@example.com.