Can Blended Finance Plug the Adaptation Funding Gap?

It’s the one weird trick for making private institutions spend on high-risk, low-return investments: blended finance.

The label applies to an array of innovative financing structures, in which public or philanthropic dollars are used to make impact investments more palatable for commercial money managers. Typically these investments align in some way with one or more of the United Nations Sustainable Development Goals (SDG), which serve as a popular yardstick for sustainable investors. The idea is that by having public capital take the first-risk-of-loss on these bets, or guarantee some level of performance, private banks, pension funds, and asset managers can be tempted to put more of their own money toward these goals.

The approach is particularly well-suited for climate adaptation investments. Many climate-proofing projects in developing countries have little to offer big money managers by way of financial returns, meaning they need a little extra encouragement to bust their wallets open.

However, in the past adaptation projects have received little love from the blended finance world. An adaptation finance report published by the Climate Policy Initiative (CPI) found that adaptation obtained US$7.5bn through blended finance over the past decade, a fraction of the US$64.2bn given to mitigation projects. “Hybrid” transactions that address adaptation and mitigation goals together attracted US$18.5bn in flows.

Moreover, Convergence — a global network for blended finance supported by government funders — calculated that in 2022 there were only $US0.2bn of blended adaptation deals, compared to US$3.6bn of mitigation transactions. 

Aggregate annual financing flows to mitigation blended finance, adaptation blended finance, and hybrid blended finance deals, 2013-October 2023

“Adaptation is still seen certainly as riskier than mitigation,” says Robin Ivory, senior associate at Convergence. “Commercial investors are looking for higher levels of concessional financing just because of that perception, whether it actually is based in reality or just on preconceived notions that adaptation is riskier and will lead to longer term losses.”

Still, the future looks bright. Ivory helped author Convergence’s State of Blended Finance 2024, the latest in a series of papers on the evolving public-private deal space. This shows that climate blended finance had a banner year in 2023, and suggests adaptation in particular is on an upward trajectory.

Tailwinds For Adaptation Blended Finance

The topline numbers are impressive. Climate-related transactions accounted for 60 of the 99 deals Convergence tracked last year, amounting to US$11.6bn in volume, up from US$5.6bn the year before. Almost half of last year’s transactions came in monster sizes too, meaning US$100mn or larger.

Though the latest report doesn’t break down financing by adaptation or mitigation for the full year — a dedicated paper on climate blended finance is coming soon — an earlier analysis found that over the first ten months of 2023 US$0.9bn had been invested in adaptation deals, more than quadruple the full-year 2022 total.

What sectors are driving adaptation flows? The Convergence report says 2023 saw increased focus on “climate resilient and sustainable agriculture blended transactions” and noted that most new blended finance investment funds launched in the last three years “have had a climate-centric focus, with an emphasis on climate resilient infrastructure.”

Ivory provides additional color: “I was looking recently at transactions, and in agriculture there are some really innovative technology adaptation products going on that are mapping out different weather patterns and how different crops will grow and trying to suit different crops to different regions. That actually has adaptation benefits because it’s helping the local communities adapt to changing weather patterns, but that's also going to have huge productivity gains down the line, because by adapting to the various weather patterns, they're also going to have more productive crops,” she says.

Proportion of adaptation & hybrid blended finance transactions by sub-sector

The big engines of blended finance, development finance institutions and multilateral development banks, are also providing favorable tailwinds to adaptation. The World Bank, for instance, has established climate-smart agriculture as an investment focus, helping drive public and private capital to support resilient agri-food systems. Meanwhile, USAID’s West Africa Trade and Investment Hub, a program started in 2019, unlocked capital for public-private investment funds focused on Burkina Faso, Cape Verde, Côte d’Ivoire, Ghana, and neighboring countries. Convergence says the surge in deal count for agriculture-focused blended finance transactions in 2021 and 2022 can be attributed to deals financed by this Hub.

Breaking Barriers

Still, there are plenty of obstacles preventing blended finance from plugging the US$387bn per year adaptation financing gap. Breaking down these barriers is high on Convergence’s to-do list.

Much depends on bringing more private capital onboard. Convergence calculates that around US$3.7bn of blended finance last year came from the private sector. That compares to US$6bn provided by public institutions.

“There's a lot of private investors who are just kind of dipping their toe in the water and it's taking a while for them to structure and close these deals,” says Ivory.

One way to tempt more private capital into the space is by ramping up the amount of concessional finance available for these deals. These are funds from states or philanthropies that are provided at below market rates to borrowers, which can be used to “crowd in” public and private money. The more concessional capital in a deal, the better chance it has of attracting additional public and private investment. Last year, only US$42mn of concessional finance was provided by institutions not aligned with official development assistance entities.

Priming deals in this way has another benefit too — increasing the size of blended finance transactions. This is important for building commercial interest, says Ivory. “When you’re trying to attract large, private investors, a lot of them will have a few requirements in their investment strategy. So that’ll look like having minimum investment spends, but also reducing their risk exposure within a particular transaction. So some commercial investors will say, we can’t actually be more than 20% of the total financing of a deal, but we have to invest a minimum of $20mn. So if you look at those two, then the only way you’re going to attract those large investors is by actually growing the size of the deal itself.”

Another major issue is how financial regulators treat blended finance transactions. Banks and insurers are bound by regulator-set capital rules that force them to set aside equity against investments to absorb potential losses. The riskier the asset, the larger the amount of equity that has to be kept in reserve, and therefore the higher the returns have to be to justify the opportunity cost.

Pension funds, meanwhile, often have mandates that bar them from investing in assets below a certain credit rating. These requirements make much of the blended finance market a no-go area for these entities.

Fortunately, efforts are underway to change this. Last year, the Network for Greening the Financial System (NGFS), a club of climate-focused financial supervisors, set up a blended finance initiative and released a paper analyzing the barriers to private investment in emerging markets. The initiative plans to use its “convening power” to push blended finance up the agenda and propose new policy recommendations. 

Key barriers to scaling up blended finance

Since the NGFS boasts heavyweights like the European Central Bank, Federal Reserve, and Bank of England among its membership, its advocacy certainly has heft. Still, the group has no formal power to reshape the regulatory architecture constraining blended finance — for banking, that’s in the gift of the Basel Committee on Banking Supervision, and the individual jurisdictions that subscribe to their rulemaking.

Europe looks to be the place where a breakthrough could happen, though. An expert group mandated by the European Commission recently issued a bundle of recommendations on scaling sustainable finance in poor countries, one of which calls for the setting up of a “dedicated EU legal framework” to govern public-private investment funds, a framework that will make sure capital requirements “accurately reflect the associated risks, taking into account the de-risking mechanism of the structure and the quality of the underlying assets.” 

While the Commission is not bound to the expert group’s recommendations, their very existence points to an understanding among European policymakers that things have to change.

Still, changing the capital requirements or credit ratings of blended finance deals isn’t a silver bullet. “It's a good thing that there’s a move to account for de-risking mechanisms in the structure, but there’s certainly more that needs to be done to stimulate this investment,” says Ivory.

Take it to the Bank

Perhaps surprisingly, given all the talk about the adaptation financing gap, a big problem remains the lack of “bankable” projects — investments that have been properly scoped, analyzed, and packaged, ready for commercial investors to consider. It’s often the case that while the adaptation needs of a country, region, or sector are obvious, it’s far less clear what financial mechanisms are appropriate for meeting those needs.

To turn the current trickle of bankable projects into a flood, greater emphasis must be placed on “design funding”, Convergence says. This means money used to conduct feasibility studies and proof-of-concepts for blended finance solutions. Convergence offers design funding grants to help with this.

“Nothing’s going to come of just throwing out a pool of concessional money somewhere,” says Nick Zelenczuk, content manager at Convergence. “There’ll be blended funds that are raised that are sizable, and they’ve attracted a lot of institutional investor appetite, but they may struggle in actually finding things to invest in. And as the macroeconomic scenario is what it is right now, that adds further challenges to more long-term pipeline development.”