Results-focused Impact Bonds Can Improve Development Outcomes by Involving the Private Sector

December 21, 2015

  • Impact bonds are innovative financing instruments that leverage private sector capital and expertise, with a focus on achieving results.
  • Private investors initially finance a project and are repaid only if agreed-upon social and economic outcomes are achieved.
  • This approach transforms a development challenge into an investible opportunity rather a problem.

Between $3.3 to $4.5 trillion in investments each year will be needed to fund the Sustainable Development Goals, according to UN estimates.

As one way to meet these staggering needs, the international development community is developing new results-focused financing instruments, some of which seek to mobilize untapped private sector capital and knowledge, while repositioning global economic and social challenges into investible opportunities. 

Socially responsible investing, which has been growing globally over the last decade, can bring a welcome and needed entrepreneurial mentality and private sector dynamism to global development challenges.   

Development Impact Bonds (DIBs) and Social Impact Bonds (SIBs) are among the more exciting and potentially promising instruments to recently enter the innovative financing market. 

SIBs are typically used in developed countries where a government pays back investors, while in the DIB model, donors or foundations repay investors, although a combination of a government and donor(s) is possible as well.  

How do impact bonds differ from other more traditional instruments? 

Impact bonds leverage private sector capital and expertise, with a focus on achieving results. 

Rather than a government or a donor financing a project upfront, private investors initially finance the initiative and are repaid only if agreed-upon social and economic outcomes are achieved. 

This approach transforms a development challenge into an investible opportunity rather a problem. 

It also shifts the focus from inputs to performance and results, since private investors will be concerned about recovering their investment and ensuring it is put to most efficient and productive use by private sector service providers who are delivering the project.

Impact bonds aren’t bonds in the traditional sense, i.e. debt securities that pay a fixed interest rate until maturity. Instead, they should be considered more as equity-like instruments that offer repayment to investors on the basis of results achieved. They also carry higher levels of both risk and potential return than traditional bonds do.

The first Social Impact Bond was launched in 2010 in the UK. Since then, more than 40 SIBs have been deployed in seven countries across various sectors. 

Though impact bonds are relatively new instruments that will ultimately need to be tested and measured, evidence is mounting in favor of their effectiveness. 

A recent Brookings’ report examined experiences with SIBs and DIBs to date and found that a number of development claims made about DIBs appear to hold up.

The World Bank’s First Impact Bond for Youth Skills Project in Palestine

The World Bank is establishing its first Development Impact Bond to tackle youth unemployment and skills development in Palestine, a location where some might least expect a DIB. 

Rapidly rising unemployment among Palestinian youth is one of the critical challenges facing the country. 

Palestine is a prime example of an environment where billions of dollars of donor aid have been deployed over the last decade. While some important results have been achieved, sustainable long-term progress seems to be elusive, as is the case in many conflict-affected countries. Progress is also often confounded by complex constraints and vulnerabilities that will require broader long-term political and governance solutions. 

Numerous skills development donor projects – estimated at $140 million since 2001 –  have been implemented in the country over the last decade, but there is little robust evidence that traditional donor approaches have yielded desired outcomes.

However, with a mounting public sector financing gap, declining donor assistance, and rising unemployment, a skills development DIB is a new approach to tackling a long standing developmental challenge.

The skills development DIB as a part of the Finance for Jobs project will catalyze the role of the private sector by crowding in both private sector capital and expertise to better incentivize employment outcomes. 

Because investors are only repaid if the outcome is achieved, the incentive structure focuses on outcomes rather than on program expenditures and inputs. 

DIB investors have a strong incentive to ensure that various service providers involved in delivery remain on track, which is a key advantage compared to traditional donor interventions.

Detailed data analysis and monitoring of the service providers’ performance will allow investors to manage their risk and intervene or modify early on. 

The DIB model also offers a clear management and governance structure, where a DIB Manager has overall responsibility for bringing actors together to deliver the project. 

The hope is that a DIB model would be better suited to addresses these complexities. The true test for DIBs will come as they are implemented – and more importantly measured – in places like Palestine. 

The international development community knows well not to expect "silver bullet" solutions to development challenges. However, experimentation and innovation through instruments like DIBs may offer another way to address these challenges effectively and generate more learning about what works in development.