The SDGs in emerging markets are underfinanced — and even more so after COVID-19. That is why we need to mobilize private capital at scale. So how do we incentivize private investors to move into areas they didn't go to before? Blended finance could be a solution. But while it sounds simple, in practice it’s far less straightforward-especially when it involves tree-based projects.
The potential of sustainable forestry Forests are an incredibly valuable and renewable resource. But despite the vital importance of forests, they are under threat. So how can we develop sustainable forestry projects that curb that threat as part of their business model at scale. Characterized by often long investment horizons and back-ended cashflows, it can take a decade before trees generate an income.
Too risky? Only a few private investors dare to invest in these forestry projects, especially if we look at developing economies. Why? Mainly, it is due to risk: whether real or perceived, political, social and environmental, or reputational. But because of the large climate impact of forestry projects, more and more investors are willing to sacrifice risk for (climate) impact. Hence, more projects are coming to the market looking for innovative, blended finance products.
Proof of concept Forests provide one of the more cost-effective climate mitigation strategies, with benefits for biodiversity, conservation and support to local communities. Donors (often governments) aim to prove the viability of new markets and business models for sustainable forestry to crowd in other investors which multiplies impact outcomes. While donors can take on more risk and venture early into projects, they also want to ensure that taxpayers' money flows to the right forestry projects — projects that can create impact and new markets, while also having the potential for scale. Above all, however, they must benefit the environment and local communities.
“Blended finance creates investable opportunities in developing economies that are aligned with the SDG agenda.”
Making the right match A blended solution brings and melts public and private parties together. DFIs are in a unique position to connect the two sides. They know how to invest in private sector projects in developing economies with tailor-made instruments in their toolbox to develop, manage and monitor environmental and social issues, while also using technical assistance for implementation. All are essential in blended finance solutions to get projects off the ground and to a bankable state. Designing a blended finance solution for a sustainable forestry project means bringing together a wide range of experts and institutions—from donors and financiers, to local organizations and NGOs and forestry experts. This approach requires strong structuring skills. However, designing a project right from the beginning is key to its success and the impact to be achieved. A blended finance solution appropriately allocates the risks to the various parties in a project according to their risk appetite. For financing a sustainable forestry project, this could consist of any financial instrument (i.e. first-loss equity from the donor/investor or even guarantees) that de-escalates the various risks in a project. In cash-flow terms, it regulates the waterfall to investors in a certain way to allow private sector some priority on the back-ended cash flows.
Capital and technical assistance at work for the SDGs Most blended finance solutions include technical assistance funds. Why? For one, these funds enable building a pipeline of investment-ready projects often with the support of local organizations and NGOs and address any potential risks early on. In the case of a forestry project, the technical assistance and grant funding can be provided to expand ESG capabilities and improve performance. In the end, the right blend, including E&S management and technical assistance, minimizes potential investments’ risks in such a way that private investors will feel comfortable to tread a path otherwise deemed too risky.
All about scale
Blended finance can create investable opportunities in developing economies that are aligned with the SDG agenda. Projects and businesses that would otherwise become stuck at the pilot stage are thereby able to flourish. Private investors can step in as their key risks are minimized. To plug the SDG financing gap we need to increase the capital flows to these projects and markets. Blended finance can do just that.
Once the viability of projects and business is shown, the private sector could fund similar projects by itself…all while doing it better, so we can all profit.