Impact bonds are complex — but they could help us hit the SDGs

Opinion: International development impact bonds are underexplored

This piece was originally written for Apolitical the learning platform for government

It was republished by UNDP

The potential of social impact bonds (SIBs) to contribute to meeting an estimated US$2.5–3 trillion in annual investment needs for the UN’s Sustainable Development Goals (SDGs) has attracted increased attention over recent years from both policymakers and development practitioners.

In an impact bond, which originated in the UK to address the high socio-economic costs of prison recidivism, private investors provide up-front capital to an organisation to deliver certain services and receive back their investment, plus a return only if results are achieved.

Governments reimburse investors in the case of social impact bonds, while third parties such as donor agencies or foundations are the outcome funders in the case of development impact bonds (DIBs). Under the model, risks are shifted from the public to the private sector.

For public sector bodies and aid agencies who want to demonstrate impact for scarce public funds, the appeal is clear; it allows them to pay directly for results, rather than for inputs.

The impact bond market is growing steadily and has spread across many world regions. According to the Brookings Institute, in 2019 there were 135 impact bonds across 28 countries in areas such as employment, social welfare, health, education and criminal justice.

With only 10 of these operational in developing countries, such as India and Peru, there may be a major growth market for these kinds of approaches that draw on elements of impact investing or blended finance, as well as public-private partnerships.

Yet, despite the hype, impact bonds are fewer in number and smaller in deal size than momentum would suggest.

The impact bond market remains small at about US$370 million invested to-date, according to research by Brookings, compared to the US$228 billion in impact investing assets, according to the Global Impact Investing Network (GIIN). They remain highly niche products with a US$3.7 million average upfront capital investment.

The extent to which such models are scalable, represent value-for-money or represent a good idea relative to more traditional financing approaches can be confusing.

What is our work telling us? The United Nations Development Program (UNDP),like many other development actors such as the World Bank and the UK’s Department for International Development (UKAid) and USAID is entering this territory. The tool is still relatively new in the developing country context and remains poorly understood in the countries in which we work.

UNDP support thus far has tended to focus on early stage exploration and financing for impact bond feasibility studies. These include an impact bond to reduce Rhino poaching in Southern Africa, one to support tobacco farmers in Zambia transition to alternative farm and non-farm livelihoods, and another to support dairy farmers in rural Armenia improve productivity. The UN is also working to develop an impact bond to halt cholera transmission in Haiti. Many are still in the design phase, of which only some will come to fruition.

Expertise is certainly on the up. At UNDP, we’re investing in building capacity within our own organisation to identify opportunities for this type of approach, and to design and structure impact bond deals, as well as share experiences, best practices, tools and models across the organisation.

But it’s not easy and there are many moving parts. It takes considerable time to originate and close an impact bond deal — through feasibility, design, due diligence and completion. This can be a significant investment, especially where it is not certain the project will ultimately materialise.

In the developing countries in which we work, investors sometimes do not understand the local market and have concerns related to instability of the economy and political uncertainty. These increase costs.

Impact bonds can be constrained by legal issues, including the ability of donors to use outcomes-based contracting modalities.

On the impact side, there is the attribution challenge; to what extent can positive outcomes (or failures) be isolated to the impact bond? Impact bonds also demand timely high-quality usable data (or a means to collect it in a cost-effective manner). Strong local service providers are also needed who must be able to adjust their programs where delivery is weak.

Realistically, some developing countries have a better “enabling environment” for impact bonds than others; a tradition of active civic engagement, strong local service providers and the availability of good quality data are all helpful but are less present in some developing countries. Technical support for project preparation is needed in most developing countries.

There are thus heavy transaction costs currently associated with designing each impact bond contract, and the market is highly fragmented. Aid organisations are well aware of these challenges and efforts are being made to address them.

UNDP is part of an “International Development Bonds Working Group” which convenes leading players in this field from the public aid sector, philanthropy and multilateral financial institutions. Amongst other initiatives, it has proposed a design grant facility for SIBs/DIBs, a knowledge-sharing platform, building a forum for industry players to engage in forward looking ideas around the strategic direction of the market, and creating a facility for the pooling of funding for outcomes-based initiatives.

These initiatives could help provide important market signals and help accelerate a pipeline of next generation impact bonds. How technology can be better harnessed in support of data collection and to better inform investors’ decisions is underexplored.

Impact bonds provide one way to combine the capital of different actors, especially the private sector, in new and diverse ways to leverage new finance with a focus on sustainable development results. As the market grows, especially in developing countries, it will be critical to observe progress and outcomes closely, so that valuable lessons can be learned on where — and in what circumstances — these financing tools can be most useful.