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Risk, Market Failure and Government: Case for a Social Impact Bank?

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Last week, I attended the All-Energy Australia Conference because of my interest in renewable technologies and energy efficiency. A couple of speakers from the Clean Energy Finance Corporation (CEFC) were highlights for me. The CEFC is an Australian Government-owned financial corporation that was established to address financial impediments to private financing of renewable energy, energy efficiency and low emissions projects and emissions – i.e. it addresses a market failure in clean energy financing. It does this by developing innovative financial products and working with private financiers, principally aimed at reducing risk which in turns reduces the risk premium charged to clean energy projects and companies. Furthermore, it does so by actually generating a profit for the Australian Government; it provides loans and equity on a commercial basis and doesn’t provide grants. It seemed to me that basic model of the CEFC would be useful in catalysing private capital in other policy areas, such as reducing social disadvantage. This blog post will go through my thinking on how a ‘Social Impact Bank’ could work along CEFC lines.

For a Social Impact Bank to make economic sense, there must exist an economic rationale for establishing such an agency. We know that governments around the world are already intervening in reducing social disadvantage – the OECD average of public expenditure is 22.1% of GDP compared to 2.7% private expenditure in 2009. The impact of this expenditure has been mixed. On average in OECD countries, poverty rates have been increasing 1% per year from the mid-1980s to the late-2000s. So, the question is, will a Social Impact Bank be more successful in reducing social disadvantage than current modes?

There are two ways that a Social Impact Bank designed along CEFC lines could improve the social impact of public expenditure: co-investment and efficiency. The CEFC model was designed to catalyse private financing by reducing risk through financial innovation and risk-sharing. An example of this are Environmental Upgrade Agreements (EUAs). Briefly, EUAs are designed to overcome commercial landlord’s disincentives to invest in environmental upgrades (because the tenant receives most of the benefits) by offering a financing product that is lower cost than a conventional loan. Local government is a party to this transaction as a guarantor and collector of the debt repayments through council rates. Using council rates to collateralise the loan enables commercial lenders to provide more favourable terms for specific environmental retrofits. Finally, local governments benefit because they achieve sustainability outcomes without providing the upfront capital. Similarly innovative financial products could increase the proportion of private expenditure in social policy from the OECD’s average of 2.7% of GDP. As the EUA example shows, there are creative and beneficial ways that financial engineering could be used to achieve broader social goals. Also, by co-investing with commercial financiers, the Social Impact Bank could ‘crowd in’ rather than ‘crowd out’ private capital.

A Social Impact Bank could improve the efficiency by removing impediments to mainstream financiers funding social impact projects. Developing innovative financial products that reduces the credit risk of funding social impact and risk-sharing with commercial lenders would help mainstream financiers develop expertise in social impact, and eventually take the lead in social impact investment. In addition, a Social Impact Bank could develop metrics and standards for measuring and reporting social impact (e.g. Social Returns on Investment). Setting standards for reporting social impact could further reduce risk perceptions amongst financiers by ensuring credible reporting. Reducing risk perceptions would further reduce the cost of capital for social impact projects. Using metrics that can attribute investment to outcomes would be expected to improve the social returns on social expenditure.

A Social Impact Bank would be an independent statutory authority. An independent statutory authority would have more scope to focus on achieving its specific mission. This would allow the Social Impact Bank to build and develop specific social impact financing, monitoring and analysis capacity that would enable it to effectively catalyse private investment into social impact projects.

There are significant differences between clean energy policy and social policy that would affect differences in the design of a Social Impact Bank. First, the impact of expenditure on clean energy technologies is much better known than investment in social impact projects. When we invest in solar and wind farms, we can reliably predict the energy generated, carbon abated and the revenue earned. With a social impact project, such as reducing Indigenous disadvantage in remote Australian communities, there are no clear options that are known to reliably produce social impact. A Social Impact Bank could play a crucial role in developing tools that can be used to rigorously measure the impact of social impact projects.

Second, the CEFC invests a minimum of $20 million per project. If a Social Impact Bank adopted this minimum, this could exclude some worthwhile social impact projects. However, the CEFC has developed an aggregation technique that allows it and its co-investors to invest is small loans through third party finance providers with better distribution channels. A Social Impact Bank could use aggregation to finance small projects.

Third, social service organisations generally don’t have reliable cash flow to repay debt. Several financial instruments have been developed to overcome this liquidity issue such as social impact bonds (SIBs). However, there are substantial transaction costs in using SIBs at the moment because of the lack of standardisation and doubts on attribution to the funded activity. A Social Impact Bank that has a mandate to develop standards and rigorous metrics could reduce the transaction costs of using SIBs and other financial instruments that can overcome the liquidity problem.

Some banks are already investing in social impact projects, some of them the largest names in the sector such as Goldman Sachs, why don’t we let the market deal with it instead of establishing another government agency? That’s true but as I’ve pointed out before, risk is key deterrent to most banks lending to social impact projects. Social impact is also usually outside the core competencies of most banks. Furthermore, as the example of the EUA shows, there may be a role for a CEFC-like organisation to lead the development of innovative financial solutions to address a social problem. Currently, most banks restrict their involvement in social impact projects to a community development foundation and grant-giving. While laudable, these investments are too small to make a significant impact and lack the long-term intensive effort to substantially reduce social disadvantage. On the other hand, Social Impact Bank could provide the leadership, support and expertise that could enable private capital to move into social impact investing in a significant way.

A Social Impact Bank modelled on the CEFC could play a critical role in providing solutions to entrenched social problems. The design of such a Social Impact Bank should be cognisant of the key differences between clean energy and social policy. A Social Impact Bank could be an improvement on business as usual in two ways. First, it could help ‘crowd-in’ private capital. Secondly, it could develop metrics that promote an outcome-focused approach to social impact. Improving the quantity and quality of social impact would seem to be a good use for both public and private social expenditure.