Wanted: mechanism for additionality

By Paddy Carter, Research Fellow, Overseas Development Institute

development-financeAdditionality is the thorn in the side of Development Finance Institutions (DFIs). It means: making an investment happen that would not have otherwise. Of course, everybody in development wants to make things happen that would not otherwise, and the possibility that aid substitutes for domestic efforts is a concern in other contexts. But additionality torments DFIs because of the constant suspicion that they crowd out private financiers by investing in products that would have been viable without public support.

DFIs are regularly called upon to provide rigorous evidence that their investments are additional. Rigorous quantitative evidence, in the eyes of academics, requires some credible method of estimating the counterfactual (what would have happened otherwise). And that requires something like a randomised control trial or a natural experiment or a valid instrumental variable. Yet, none of these is feasible in the world of DFIs. And without that, we are unable to distinguish correlation from causation.

Nevertheless, DFIs have no shortage of anecdotal evidence. They can all talk convincingly about projects where their support was vital. But correlations and anecdotes are not admitted as “rigorous evidence” by academics, who then report that evidence does not really exist, leading some in civil society to conclude that there is very little evidence of additionality. Thus, DFIs are continually haunted by their inability to prove they actually do what they say they do.

DFIs can hope their critics will become more realistic about what counts as evidence, but there is another possibility. Rather than trying to demonstrate additionality after the fact, DFIs could adopt procedures to ensure additionality before the deals are done.

One of the fundamental reasons why DFIs struggle to convince sceptics is that when they negotiate, project sponsors (entrepreneurs) will not show their hand. In other words, whether they have willing private backers is private information. The project sponsor has an incentive to pretend that the project will not be viable without the help of the DFI to the extent that – in cases where – DFIs offer terms and conditions that are more favourable than private investors. If you add to the mix the possibility that DFI investment officers have an incentive to play along with this pretence, because they get rewarded for deal flow, it is easy to see where worries about crowding out come from.

This is a policy problem. Donors are pouring money into their DFIs, and the degree of concessionality is widely expected to rise. For example, industry insiders are watching nervously to see how the World Bank’s IFC will use the new USD 2.5 billion private sector window in IDA18.

The good news is that a whole field of economics – known as mechanism design – deals with problems of private information and how to overcome them. The bad news is that it is not obvious how these insights could be applied by DFIs. Work with leading mechanism scholar Professor Francesco Decarolis is exploring how to apply mechanism design to the problems faced by DFIs. Preliminary results reveal two basic problems.

First, the investment business is dominated by decentralised bilateral bargaining, not formal competition between financiers. That limits the leverage of mechanism design to induce project sponsors to reveal their private information – whether they genuinely need public support. Some sort of auction is the typical mechanism for inducing economic actors to compete against each other and, in so doing, reveal private information. In principle, we could ask DFIs to run something like a subsidy minimisation auction. If the auction reveals that the project could be financed at market rates (and we assume that DFIs are more onerous to deal with because of their higher environmental, social and governance standards), then we can expect entrepreneurs with access to private finance to choose it, thus ensuring DFIs do not crowd out private finance. If the auction reveals that some form of concessional finance is required, it will be minimised, thus ensuring DFIs do not needlessly subsidise private profits. But no entrepreneur is going to voluntarily enter an auction for project finance designed to give them financing on the least favourable possible terms. So DFIs would need to force project sponsors to participate, which would not be easy.

This leads to a second problem. If a formal competitive process is not feasible, DFIs may still be able to set their terms and conditions so that projects that do not genuinely require public support voluntarily go elsewhere. This is known as screening. Screening, however, would probably require DFIs to offer less attractive terms than commercial banks and other private investors, and that is hard to reconcile with the mandates of most DFIs. It would also require DFIs to know what market rates look like, which may be impossible when every project is unique and capital markets are undeveloped.

But we haven’t given up hope. Mechanism design is one of the most active areas of research – and it could possibly generate ideas that DFIs could use to solve the additionality problem. Perhaps, for example, DFI investments could be structured to bring expected returns up to market thresholds when returns are genuinely too low to be commercially viable, and hence crowd in private investors, but also cap returns so that those project sponsors who secretly know the pay-off is likely to be larger than they are letting on will voluntarily go elsewhere.

So, now is the time for mechanism designers to heed the call, put on their thinking caps and offer innovative solutions to remove the thorn of additionality from the side of DFIs. And unlocking the full potential of DFIs is one key way to advance development’s sustainable and inclusive impact.