Finding the right blend

IFR IMF/World Bank Report 2022
11 min read
Nick Herbert

Blended finance is key to mobilising private sector finance into helping developing countries reach their SDG targets.

The topic of blended finance has been high on the G20’s agenda during Indonesia’s presidency in 2022. Blended finance, broadly defined by the OECD as ‘the strategic use of development finance for the mobilisation of additional finance towards sustainable development in developing countries’, is seen as an essential mechanism in scaling the flow of capital into building sustainability into emerging markets.

A United Nations estimate from 2014 pointed to the need for some US$5trn–$7trn of investment per year between 2015 and 2030 to reach a set of sustainable development goals globally, and US$3.3trn–$4.5trn per year for developing countries to pay for basic infrastructure, food security, climate change mitigation and adaptation, health and education.

The magnitude of capital needed to support emerging market countries in reaching their SDG targets cannot be financed by the public purse alone. It requires the participation of private investors to fill the funding gap, but that is yet to happen at the scale required.

“The financing of sustainable infrastructure, particularly in emerging markets, is a high priority policy area for many governments, and there have been calls from the shareholders of MDBs (multilateral development banks) to do more to crowd in additional private investment,” said Christopher Bredholt, senior credit officer at Moody’s. "They recognise that the scale of the investment needed is far beyond what MDBs and the private sector has managed to provide to date."

Through blended finance initiatives, such as concessional finance, grants, credit enhancements, first loss guarantees, liquidity provision and insurance, MDBs can improve the attraction of projects to the private sector. It has the potential to unlock a growing pool of institutional funds looking for green and sustainable assets, directing them to the emerging markets but without negatively impacting on returns.

“Blended finance brings together commercial finance with philanthropic funds or development finance, which can include MDB guarantees, to help projects that would not get off the ground without it, but which can demonstrate to the private sector that perceived risks around technology and around country risk, for example, may be overstated,” said Merli Baroudi, director of economics and sustainability at the Multilateral Investment Guarantee Agency (MIGA).

Uncertainty about the impact of unfavourable government actions and decisions in emerging market countries is one of the major factors hindering the flow of funds into developing geographies. A member of the World Bank Group, MIGA promotes cross-border investment in developing countries by providing guarantees, in the form of political risk insurance and credit enhancement, to investors and lenders.

According to the G20’s Capital Adequacy Framework report, MIGA’s range of insurance products, its strong balance sheet, a geographically diverse portfolio and a well-established presence in the reinsurance markets make it a potentially highly effective MDB partner. Its active use of reinsurance (currently for 62% of its portfolio) drives a highly efficient capital model: operating capital of US$1.8bn supports gross exposure of US$24bn. Its ability to reinsure exposures gives it the capacity to help MDBs manage portfolio risk, says the report, especially for regional development banks with significant concentration risks.

The agency issued US$4.93bn in new guarantees during fiscal year 2022 across 54 projects set to help provide new or improved access to power to some 15 million people, support job creation and enable US$1.9bn in loans to SMEs and for climate-related activities. And as part of the World Bank’s latest five-year Climate Change Action Plan, it has committed to align 85% of its real sector guarantees by July 1 2023, and 100% by July 1 2025.

MIGA screens all real sector projects for climate risks and has also committed to increase climate finance for 2021–2025 to an average of 35% of gross issuance.

New pools

Once negative perceptions are overcome, it is hoped the private sector can follow the example set using blended finance to potentially scale up their own activities in any given sector or country.

“Blending commercial finance with donor financing makes an investment more attractive for the private sector,” said Baroudi. “It can help demonstrate to investors that perceived risks are just that – perceived. It should result in the private sector becoming more comfortable with the risks and potentially scaling up their own activities in the sector or the country.”

Overcoming emerging market risk is important if projects in those countries are to compete favourably for the proportion of funds held in the hands of major asset managers directed towards alternative investments, such as infrastructure.

“The investors we’re after are not emerging market, liquid public market investors,” said Christopher Marks, head of emerging markets, EMEA at MUFG. “It’s the big infrastructure funds, infrastructure departments of pension funds and asset managers, and private credit buyers. Those are the people we're trying to get in. This may be the same people that own Heathrow or Dogger Bank Wind Farm, for example, or similar strategic infrastructure in a developed country.”

The recent refinancing on the Scatec Egyptian solar power plant is an example of the importance played by MDBs overall and the value of political risk insurance and credit enhancement to attracting private investors into supporting a deal.

“The Scatec structure mutes the political or institutional risks that could affect the jurisdiction,” said Marks. “It effectively mitigates the Egyptian country risk, something that's essential in jurisdictions without well-established track records for international PPP-style financing. And something that needs to be in place before we even have conversations with the big investors that might never have put their foot in Africa, let alone Egypt.”

In April 2022, Norway-listed Scatec, a leading renewable energy solutions provider with projects throughout the emerging markets, refinanced the non-recourse project debt for six operating solar power plants in Egypt’s Benban Solar Park through the issuance of a US$334.5m 19-year non-recourse green project bond.

The transaction was the first of its kind in Africa, although it followed an earlier example in Turkey that saw the EBRD and MIGA provide a joint credit enhancement scheme to enable the issuance of the first greenfield infrastructure project bond in that country. In 2016, ELZ Finance issued €288m of privately placed senior secured bonds, with proceeds on-lent to the project company. The notes were rated Baa2 by Moody’s, a rating that was affirmed in 2018 despite the sovereign being downgraded to Ba3.

In its announcement at the time, Moody’s said the sizeable liquidity provided by the EBRD complements the political risk insurance from MIGA. That reduces lender exposure to sovereign risk in the context of the project's structure.

The two agencies teamed up again for the Scatec deal to attract private global institutional investors alongside development finance institutions including US Development Finance Corp, the Dutch FMO and German Investment Corp DEG – as well as EBRD, which made a US$100m investment in the bonds. The European development bank also provided a US$30m unfunded liquidity support standby facility to support the US$120m MIGA insurance cover against the risks of breach of contract, expropriation, transfer restriction, and war and civil disturbance.

Scope assigned a BBB+ rating to the US$84.5m Class A1 guaranteed securities, issued by Virtuo Finance, maturing in March 2041. The sovereign is rated B2 (negative) by Moody’s, B (developing) by S&P and B+ (stable) by Fitch.

“MIGA and EBRD risk mitigation instruments were incorporated into the structure to facilitate distribution to private sector investors, including major institutions for whom these are first ever investments in Egypt,” said Scatec about the deal. MUFG was arranger for the bond issue.

The credit enhancement structure, benefiting from a Climate Bond Initiative accreditation and extensive work with rating agencies, could set a precedent for future similar transactions.

“We are trying eagerly to replicate the structure but, as well as the credit enhancement and political risk insurance, you really need a government with the degree of flexibility and comfort with innovation shown by Egypt in the Scatec deal to accommodate new structures,” said Marks.

“There needs to be a bit of give and take with the authorities to get to a point where traditional infrastructure investors, which tend to have a broader perception of the risks that exist, are attracted into a deal.”

MUFG was also keen to stress that the private investors brought into the Scatec deal were focused on the risk mitigation structure rather than rating agency outcomes. They just needed to get to the point where they were comfortable with the attributes and resilience of the structure. “The rating was not integral to the placement of the bond in the Scatec transaction,” said Marks. “But it does represent an outcome that Egypt and MUFG could benefit from in later transactions.”

Capital report

The close attention on blended finance coincides with an independent review of multilateral development banks’ capital adequacy frameworks commissioned by the G20. The review looked at whether MDBs could make better use of the balance sheet to lend more with existing capital or whether they need additional capital in their efforts to build back economies more resiliently and sustainably after the Covid crisis.

This is where insurance products and political risk insurers, such as MIGA, could end up playing a more prominent role alongside the World Bank family and other agencies in the effort to attract more private sector finance into achieving SDG targets.

“The traditional business model for multilaterals is to issue Triple A rated bonds and on-lend that liquidity. That model has its limitations, particularly given the challenges we’re facing,” said Marks.

MIGA’s different business model, one that uses an insurance-style template and one that spreads risk through the reinsurance market, could see multilaterals focusing greater effort on guarantees and credit enhancements in the future, in addition to their existing lending operations.

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