It’s only a Small Tweak to Reinvent Finance
How Incentives Can Successfully Steer Capital Towards Impact
by Bjoern Struewer, Founder & CEO, Roots of Impact
If there is one single paradigm shift that has the potential for far-reaching impact, it’s changing the rules of finance. No doubt our economic system needs a reset, and what drives it at the core are flows of money. The good news is that transforming the system only requires a small tweak. Humans designed the rules, so humans can change them. But how exactly can we do this tweak? What is the most effective nudge to drive the power of finance towards positive, sustainable impact? Towards impact that is solid and real, and not fleeting or built on half-hearted claims.
Reinventing finance is actually quite simple: Embed rewards for positive impact – into ANY type of finance. At Roots of Impact, we call this „Impact-Linked Finance“ or “better terms for better impact”. It’s a proven model and can be applied by anyone who wants to unlock the full potential of business. The vision is no less than creating a blueprint for a financial system that truly serves people and planet.
So, what is Impact-Linked Finance all about? It incorporates financial incentives (“the tweak”) for enterprises that achieve exceptional positive outcomes. Independently verified, these outcomes can come in many shapes and forms, for example increased incomes for the poor, more gender equality, reduced plastic waste, or improved learning outcomes for children. The more social or environmental value a company creates, the lower its cost of capital will be. This has a powerful effect: The best companies in the world – in terms of positive impact – are suddenly able to raise large amounts of low-cost capital to scale. And even more importantly, they can further optimize their impact. As a result, resources flow to what matters most to society, and this has mutually reinforcing effects:
- Empowering the “impact champions” for even bolder missions: Impact entrepreneurs who can demonstrate the effectiveness of their innovations receive investment at an exceptionally low cost. This enables them to unleash their full impact potential – above and beyond what was previously thought possible. With fresh capital, they are so-to-speak encouraged to be truly “impact-bold”.
- Nudging the do-gooders to become do-betters: Responsible companies that are already doing good receive strong incentives to do better: They will begin to measure, manage, and optimize their impact. For them, creating positive impact will become a business that pays off. Put differently: they will discover a new way to thrive and be successful.
- Transforming the “tankers” towards improved net impact: big corporations in sensitive sectors get the tools and incentives to transform their businesses and advance their net impact. It’s not only about the energy giants. Think of the food, pharma, and fashion industries, or of big tech. The effects of this transformation would be significant, considering the sheer size of these often global “tankers”. It’s high time to start with positive incentives and ramp up low sustainability standards and lax regulations.
You could say that this is too bold of a vision, even for the aforementioned “impact champions”. However, everything is already in place to make it happen:
(1) There are many development finance actors and catalytic capital providers across the globe who seek deep impact and social value for their monies;
(2) There is an increasing number of impact investors and venture capitalists who are keen to get access to high-quality impact deals; and
(3) there are many great, courageous, and inspiring entrepreneurs out there who are ready to scale their proven and impact-heavy solutions.
Many seem to believe that we must accept the system as it is. They have doubts that rewarding verified impact can be done efficiently. But it’s already happening. At Roots of Impact alone, we have structured more than 30 Impact-Linked Finance transactions in 9 countries in the past five years. And there are many others who are with us on this exciting journey. I am the first to admit that I am a bit biased, but initial market reports and independent research studies confirm that the results are convincing. This makes me confident that now is the time to apply Impact-Linked Finance on a large scale. However, with the massive challenges we are facing on this planet, it shouldn’t be Roots of Impact and a few like-minded players alone who implement this practice. Every financial intermediary, advisory firm and professional involved in impact should do so. We need a much bigger push, and this starts with capital. This is why those at the forefront of impact, i.e., the development funders, public agencies, and catalytic funders, are uniquely positioned to push the boundaries. Here’s what everyone needs to know:
Impact-Linked Finance is (more) effective blended finance
It would be unrealistic to expect that today’s investors (the “private sector”) will gladly sacrifice their returns for greater impact. This is not how our financial system functions right now. The vast majority of impact investors are neither able nor willing to do that and this phenomenon hasn’t changed a bit since the rise of the impact investing movement. However, we are in the era of blended finance: Catalytic capital on concessional terms can unlock and mobilize substantial flows of commercial capital. And there are billions in public and catalytic capital waiting to be deployed in partnership with the private sector. So, what could be more effective than using these funds to incentivize impact and embed this “tweak” into investments? There is no need for resource-consuming and complicated structures. Impact-Linked Finance can directly flow to high-performing enterprises and unleash their impact potential at the source. Currently, blended finance is primarily used to take over risk from investors in anticipation of future impact. But most likely it is more effective and transformative to provide it in return for impact – supported by evidence, not by assumptions.
Investors are ready to engage – in smartly designed solutions
Investors who engage in Impact-Linked Finance do not have to forego financial returns. Sounds impossible? Well, this is where the providers of blended finance and catalytic capital come in. They are willing to pay for additional impact and compensate investors for lower returns, it’s just a matter of intelligent design. Impact-Linked Finance, for example, successfully works with impact-aligned but return-seeking investors on one side and impact-focused funders on the other. One instrument called Social Impact Incentives (SIINC) uses time-limited premium payments that enterprises receive for achieving social impact. In parallel, these companies raise investments to scale, without investors needing to change anything in their typical risk-return-impact mindsets. In addition, if these investors want to bake even more impact into finance, they can easily build direct rewards into any financial instrument they provide – for example with Impact-Linked Loans or Impact-Linked Revenue-Share Agreements.
Impact measurement is key – and has multiple benefits
An old piece of wisdom says that you cannot manage and optimize what you do not measure. This is particularly true for Impact-Linked Finance: Solid impact measurement and management (IMM) are key. A good understanding of the value that an enterprise creates for its customers and stakeholders is an investment into the future. IMM provides important insights that feed directly into the enterprise’s business model. Done right, this creates multiple and huge dividends. For example, if you take a high-performing enterprise on an impact journey, measurement is just the start. Once the enterprise can quantify and predict the positive impact of its operations, it can begin to manage and optimize it. Then, a growing number of Impact-Linked Finance practitioners can provide rewards to unlock its full potential. You could say that solid IMM is just the ticket, but it opens many more doors: In the future, technology such as digital tools that collect, verify, and analyze impact data, can help to do it more efficiently and also effectively. Eventually, companies will be well prepared once social and environmental impact becomes an equal measure of performance. Then, and only then, will we be able to arrive at a true impact economy.
Impact-Linked Finance goes beyond commoditization of externalities
You could say that financial incentives for positive impact are quite similar to carbon credits. And yes, there are many promising attempts to implement reward systems that monetize positive social outcomes (“externalities”). However, there are some fundamental differences between Impact-Linked Finance and carbon finance. One difference is that social impact is not a commodity. To improve outcomes beyond carbon emissions, the focus must shift from demand to supply by considering a company’s specific impact potential and context. Also, by combining impact incentives with investment it is possible to leverage these incentives and nudge companies to scale towards the greatest needs of society. Creating appropriate incentives, – and pricing them accordingly -, means finding the right balance between maximum additionality and maximum alignment with a company’s business strategy. Incentives should enable and encourage a company to push harder. Defining these incentives is an art, supported by science.
So much for the arguments – but what’s next?
The simple idea of better terms for better impact (“the tweak”) has the potential to change the way we finance impact. It may even change the way we use finance in general. In any case, I’m excited to see many practitioners starting to embed impact into finance in meaningful ways. If you just look back at the past few years since SIINC was introduced, there are many signs that the idea of rewards for impact is gaining significant traction. At Roots of Impact, we are one of many pioneers, and in the spirit of systems change, we are happy to invite others to join the community of practice. There are many opportunities to fully realize this potential together. Below are just a few of them. Nothing revolutionary, just a small tweak. But it’s high time to get started together, now.
Some bold ideas, to be realized soon:
- Every impact fund needs an impact incentive facility attached, so that it can provide better terms for better impact.
- Impact incentives become an integral part of any future TA (technical assistance): funding for activities needs to be complemented by funding for results.
- The time has come for Impact-Linked Funds in the areas of gender equality, healthcare, climate resilience, and biodiversity.