Blended Finance For Water
By Dr. Alex Money 17 January, 2019
Oxford University's Dr. Money on blended finance, a new way to attract finance for water infrastructure projects
Read more from Dr. Alex Money →
At World Water Week this year, China Water Risk attended a session co-convened by the World Water Council (WWC) on the topic of financing water infrastructure and Dr Alex Money, an academic based at Oxford University and a consultant to WWC, presented their new publication ‘Hybridity and Blended Finance’. After the event, CWR had the opportunity to sit down with Dr Money to find out more about this topic – what is blended finance and why is it important in investments for water infrastructure?
China Water Risk (CWR): Congratulations on publishing the new report ‘Hybridity and Blended Finance’. One of the premises in this report is that water infrastructure projects struggle to raise finance. So what is blended finance and how can it help?
Dr Alex Money (AM): We have tried to stay close to the OECD definition of blended finance, which is the “strategic use of development finance for the mobilisation of additional finance towards sustainable development in developing countries”. We believe that using blended finance for water infrastructure can help narrow the investment gap that needs to be filled if the SDG 6 targets are realistic.
Projects which would not normally attract commercial investment could be ‘blended’ with projects that offer higher financial returns
Our premise is that blended finance can support the diversification of infrastructure projects in order to both reduce risks and enhance returns. Applied to water infrastructure, this could mean that projects with relatively low financial returns but high environmental or social returns, which would not normally attract commercial investment, could potentially be ‘blended’ with projects that offer higher financial returns. In effect, a form of cross subsidy is being proposed where the overall project risks are reduced, and the total returns – financial, economic, social and environmental – are enhanced.
This model of diversification takes its inspiration from modern portfolio theory
This model of diversification to capture multiple returns takes its inspiration from modern portfolio theory, which proposes that the risks associated from holding a single stock can be reduced by holding multiple stocks, whose performance are not closely correlated to each other.
CWR: This seems to be a rather novel approach to financing water infrastructure. Can you briefly run us through the proposed framework from the report?
AM: The framework consists of 5 layers (see below):
- Collaboration – Different stakeholders have comparative advantage in accessing types of financial, manufactured, social and human capital. As no single actor occupies monopolistic access to the capitals described, it can make sense to collaborate, where such collaboration leads to a better outcome than any actor could achieve acting unilaterally. In this case, the better outcome is improved water infrastructure, which benefits each stakeholder, albeit in different ways. In particular, corporations – accounting for the majority of private sector investment in infrastructure – are fundamentally important actors in the financing landscape.
- Investment – We see impact investors as a bridge between concessionary finance and commercial finance. Impact investors, we propose, will consider accepting lower financial returns on investment for projects that deliver enhanced impact, as measured by economic, social or environmental return. Impact investment is a fast-growing asset class and we believe there is the potential here for disrupting some of the financing silos that currently render many potentially impactful projects as unbankable.
- Impact – For impact to be managed, it first needs to be measured. From a research perspective, we’re focused on better understanding economic, social and environmental returns. Specifically, how these can be identified and compared across different projects, and over time, within a consistent, verifiable and replicable process. This is still a work in progress, and is the focus of our research efforts in 2019.
- Management – To implement this framework in practice, a portfolio management layer is necessary. An infrastructure portfolio manager performs four key roles: 1) select projects and optimize them against their risk & return attributes; 2) measure project performance against benchmarks of return; 3) ensure that projects maintain compliance; and 4) intermediate the performance information from the range of projects into a consolidated format that is meaningful and relevant to investors, and then report this information on a regular basis.
- Income – To generate return sustainably over a multi-year investment timeframe, the portfolio must generate income, both to meet the operating and maintenance expenditures required, as well as to contribute to overall financial performance. The OECD defines three basic sources of revenue available to water supply and sanitation: tariffs, taxes and transfers. To this we add the element of transactions income, derived from the divestment of assets in the portfolio, over time.
“We are not trying to reinvent the wheel with this framework”
It is important to point out that we are not trying to reinvent the wheel with this framework. The functional attributes of the underlying components are already well developed and applied in various contexts. For example, collaborations involving public-private partnerships are a staple of infrastructure finance, as are instruments that reallocate risk and return to suit investor preferences.
CWR: Of the USD2.5-3 trillion invested in water infrastructure each year, the private sector accounts for USD1-1.5 trillion. How can water projects be tailored to best attract commercial finance? Which water sub-sectors are most attractive at the moment?
AM: That is literally the “trillion-dollar” question isn’t it. However, we have to remember here that this is not a zero-sum game. We don’t think that it’s possible to achieve the targets in SDG 6 without public investment, and we don’t think that every investment will deliver a financial return.
It is important to ensure the ‘right’ money is being deployed for the appropriate project…
… the context is what matters here
What is important is to ensure the ‘right’ money is being deployed for the appropriate project. For example, it doesn’t make sense for concessionary capital to crowd out commercial capital. Equally, there are many projects which will never attract commercial finance. We think that the framework we’re developing could improve capital allocations, And we’re agnostic about sectors – opportunities and challenges abound everyone. The context is what matters here.
CWR: With that in mind, can you share some of the successful case studies?
AM: We’re early in the process but are optimistic about a pilot that we’re getting underway in Mexico. We completed a lot of the groundwork in the past year and have brought on board a number of outstanding partners to work with. A new government will shortly take office in Mexico, and we look to build momentum with this work next year.
We will be looking to expand our project scope to other regions such as Latin America, Sub-Saharan Africa & even Asia
Going forward, we will also be looking to expand our project scope to other regions such as Latin America, Sub-Saharan Africa and even Asia. After all, project selection has to be optimised to factor in the political, regulatory, macroeconomic or business environment of specific regions, countries or cities.
CWR: And currently, what are the challenges in mainstreaming and scaling blended finance for water infrastructure projects?
Well – the fact is that we are proposing a hypothesis. We think it’s possible to attract impact investment into water infrastructure projects, in ways that lower overall risk and enhance total returns.
The next step is to test the hypothesis, and that is the work we’re prosecuting now. The pilots will flag up these challenges of mainstreaming and blending that you raise. And whatever the outcomes there will, we hope, be valuable learning from the process. I look forward to telling you more about these, the next time we get to talk!
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