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Social Impact Bonds: Aligning Incentives and Social Impact

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You have probably been approached on the street to donate to a social or environmental cause by an enthusiastic spruiker. If you are like me, you are torn between two impulses: one to protect yourself from being ripped off, but the other to help. Because I can’t verify if my donation will actually make a difference, I usually don’t donate. This is an example of what economists call ‘asymmetric information’; the potential donor has little or no information on how their donation may help, whereas the charity organisation holds this information. Because of asymmetric information, people who may want to help do not help because they cannot verify (without incurring high costs) whether or not their donation had an impact. Social Impact Bonds (SIBs) are a way of overcoming this asymmetric information problem.

SIBs overcome asymmetric information by basing returns to the investor on performance relative to an agreed metric. The metric and performance is transparent between the three key parties: government, investors and intermediaries. The government benefits from improved social outcomes through lower expenditure and is responsible for repaying the principal and the investors’ returns. The investor provides the up-front capital for the service deliverer. The intermediary manages the day-to-day delivering of the services. Note, the intermediary manages the service deliverer but is not the party actually delivers the service. The metric is jointly designed and agreed by these three key parties as part of designing the SIB.

The metric is outcome-focused in design so it is designed to capture the impact of service delivery on improving performance against the metric. For example, in New South Wales, the Newpin Social Benefit Bond is designed to finance the expansion of a program to restore children living out-of-home to their families. The return for the investor depends on the actual restoration rate achieved – if 60% restoration rate is achieved, the investors’ return is 7.5%, if 65% restoration then 12% return and if 70% restoration then 15% return is paid. Clearly, the investor has an incentive for improving social outcomes under this SIB design.

Risk transfer is also an important element of SIBs. Risk of delivery is shifted from the service deliverer to investors. The intermediary receives the upfront capital for the length of the SIB (e.g. 7 years for Newpin) from the investor who allocates it to the service deliverer to enable implementation to proceed. This allows the intermediary and the service deliverer to concentrate on the technical aspects of implementation rather than diverting scarce personnel and resources to administration and fund-raising activities. The investor bears the risk of delivery because their capital and income being at risk of the service deliverer’s performance.

The returns are paid for by government. Government is ultimately responsible for the social outcomes. A SIB allows government to shift the risk of achieving social outcomes to the private sector. Potentially, the government may save on expenditure if the SIB is successful in reducing social problems. Furthermore, the government is not directly involved in delivery which allows the intermediary and service deliverer to implement innovative solutions to social problems.

The development of the metric may have useful cultural impacts on how governments implement social policy. It could encourage greater use of evidence in policy and investment in data collection and management systems. The greater use of data in social policy would also allow governments to focus more on outcomes rather than output or input measures evaluating the performance of the public service. Ideally, this would help drive improvement in the performance of governments in reducing social problems.

The other critical feature of SIBs is the allocation of incentives within a SIB framework. For a SIB to be truly credible, sufficient monitoring and enforcement mechanisms needs to be built in to prevent moral hazard. An independent assessor is commissioned to determine the extent of performance. This prevents the possibility of manipulation of performance results for the benefit of either parties.

Until now, I’ve been telling you why SIBs are a great idea. SIBs do require significant investment of time and resources to develop. Securing agreement on the metric may be a long-term project because of the clashing incentives between government, investors and the intermediary. Furthermore, the design of the metric needs to ensure that it is targeting the intended social outcomes and does not inadvertently create perverse incentives. For example, ‘cream skimming’ is often cited as a problem in the literature; cream skimming is where the service deliverers focuses on the easiest cases rather than on cases where service delivery may have made a difference.

SIBs are useful for providing ‘venture capital’ to innovative new approaches to social policy but may be less useful for established, proven measures. SIBs may provide governments the space to try out promising new approaches whilst transferring the risk of the social outcome to the private sector.

While SIBs are by no means perfect, they are a promising approach to financing long-term, innovative social programs to generate desired social outcomes. If well designed, a SIB could deliver meaningful social outcomes. Also, as our experience with SIBs increase, the up-front transaction cost may be reduced and time required shortened to make SIBs a common financial product as shares or bonds. Who knows? Maybe SIBs could help overcome the perennial funding scarcity that all charities face. As long as they can demonstrate results through evidence, charities could become as well-resourced as successful businesses. Watch this space.

What do you think? Would you invest in one? Or, if you are from a non-profit, would you like to be financed by one? Feel free to leave a comment below!