To achieve sustainability in natural resources management and to achieve climate goals, vast amounts of financing is required. Currently most of the finance flowing for sustainability is through bilateral cooperation, multilateral grants and intergovernmental mechanisms like the Green Climate Fund (GCF) that are sourced from public money (i.e. government sourced). However, the amount of money flowing from these sources is tiny compared to the capital required to change the status quo and infuse sustainable practices. The funding gap to achieve the SDGs by 2030 is estimated at USD 2.5 – 3 trillion every year, according to the United Nations. The gap can be filled by capital from the private sector. Unfortunately, the private sector is notorious for being risk-averse and profit-hungry; two things that sustainability investments do not favor. As a consequence, little private capital has flown towards such measures.
Market mechanisms that involve the private sector has been touted as the key to changing our development trajectory. So how do you involve the private sector?
Blended finance is a promising tool.
What is blended finance and how does it work?
Blended finance is a term used for a pool of resources that combines public and private capital to “de-risk” investments.
“Risk” comprises of anything that could affect the sustainability of a business and its ability to generate positive returns. For example, an investment in a chain of organic products would involve the risk of lower productivity during the conversion period of up to 4 years. An investment in electric mobility has a risk of lack of sufficient charging infrastructure, which could prevent the business from taking off. “De-risking” by the public capital is done by financing these additional features required to sustain the business. In the examples above, the public capital could be used to provide the newly convered organic farmers with a loss guarantee, that would help them pay their investors if yield reduces. Similarly, this capital can be used to build the requisite charging infrastructure to make electric vehicles viable.
When risk is reduced, the financial viability of the investment improves leading to market-rate (if not higher) returns. The public part of the blend works to reduce the gap between perceived risk and actual risk of the investment by providing interest-free capital; this leverages private part of the blend and scales this investment.
The Land Degradation Neutrality (LDN) Fund is one such Fund that blends finance. Touted as an “impact investment” fund, it puts equal importance on social returns and environmental returns just as much as financial returns. The fund, managed by investment management firm Mirova, was launched in the United Nations Convention to Combat Desertification and Land Degradation (UNCCD) COP 13 in China to promote sustainable business in sustainable agriculture, sustainable forestry and other land-use related sectors like ecotourism.
How does this Fund blend finance?
The LDN Fund is structured in two layers. The “Junior Investors” are the de-risking partners that act as a first-loss facility for the senior investors. When the Fund was launched, Government of Luxembourg, IDB Invest and the Global Environment Facility were the de-risking partners. Others who could take such a position in the Fund include Development Finance Institutions and Bilateral/Multilateral agencies. Their primary goal is social/environmental returns.
The “Senior Investors” are the institutional investors like pension funds, insurance companies and banks that are attracted to these investments after it has been de-risked by the junior investors. Their motivation to join the Fund could be to diversify their portfolios and/or, in keeping up with the times, want to join the “responsible investing” bandwagon. They are, however, most concerned about the financial returns from the investment. The anchoring senior investors included the European Investment Bank, French Development Agency, Fondaction, the Fondation de France foundation and insurance companies BNP Paribas Cardif and Garance.
With these investors, the Fund has raised commitments of USD 100 million out of a target of USD 300 million.
The Fund is focused on providing long-term debt or equity financing to proven sustainable business models. What if there is potential for a model but requires fine-tuning? In that case, grants from Donor agencies are provided to potential project proponents in the form of Technical Assistance, who should demonstrate viability of the model within 24 months. This assistance is managed by the IDH.
What has the Fund achieved and what is in store for the future?
The Fund successfully invested in Peru to support agroforestry models for small coffee growers, and are exploring opportunities in the timber, and hazelnut value chains in Africa and South Asia respectively. The Fund is expected to function up to 15 years, leaving huge potential for sustainable business models to combat land degradation in the world.
With the blending of finance with a long-term focus, the LDN Fund has created a potential for sustainable business models in natural resources management; something that is severely lagging behind other sectors like sustainable energy, sustainable transportation and water technologies.