by Matthew Gouett and Aniket Bhushan
Published: October 16, 2017
Additionality remains one of the most confusing concepts in development finance. Its original usage is rooted in climate finance, i.e. financing for climate change being ‘additional’ to traditional ODA. The term has a slightly different meaning in the context of development finance institutions (DFIs). The need for a common understanding of additionality in the context of DFIs is highlighted by the increasing interest, for instance, from the OECD-DAC in capturing private finance mobilized by official development finance in its reporting and accounting. Moreover, many DFIs now face the requirement to report not only financial return on investments, but how their investments satisfy or create additionality.
What is Additionality?
Additionality can be broken down into two: financial additionality and development additionality. In the case of financial additionality, we borrow from the Dutch DFI FMO’s definition that it is a DFI providing financial services only where the market can’t or does not do the same, or otherwise does not provide financing on an adequate scale or on reasonable terms. In essence, DFI investments lower the gap between what private investors may consider economically viable and unviable, or lowers the premium required to compensate for excess risk (or perceived risk). Financial additionality occurs when a DFI investment catalyzes private investment that would not have occurred otherwise.
Development additionality is the additional complement of some development outcome or objective that the presence of the DFI helps realize, which the private investment otherwise may not aim for (or price in). The International Financial Corporation (IFC) further disaggregates development additionality into operational and institutional additionality. Operational additionality occurs when the DFI offers specialized advice and or bridges skills gaps that may exist between the recipient of the financing and the private investors, whereas institutional additionality may occur as the financing may require improved standards of environmental, social and corporate governance (ESG), sustainability, regulation, and better public/private risk allocation.
Empirical Evidence on Additionality
In its literature review of studies on additionality, the UK Aid Network (UKAN) found that among the different organizations purporting to measure additionality, the definitions of additionality varied. Of the nine reports that UKAN identified as having similar conceptions of financial additionality, the results were mixed.
Three of the nine reports found that over 50% of projects were additional, whereas two of the nine reports observed that the projects studied demonstrated little or no financial additionality. UKAN reviewed studies on operational and institutional additionality, but placed them under the heading of development additionality. In their review, UKAN noted eight of eleven reports stated some form of development additionality had occurred. The other three reports noted no additionality effects.
The challenge with studies on additionality is related to the complexity of measurement and attribution.
Financial additionality is based on the counterfactual that the private investor would not have made the desired investment. But can that be known? It may be more accurate that private investors will not undertake the investment at a rate of return that those supporting the investment may see as tenable.
If two or three private investors would have co-invested but at a higher rate, has additionality been created when a DFI pairs with one of the private investors (to change the risk-return profile), or has the DFI crowded out the other one or two private investors? This possibility is troubling given that DFIs fund themselves with the implicit or explicit backing of their governments and, thus, their cost of capital is certainly cheaper than that of local private players. DFIs have an inherent advantage in this regard and would be wise to employ this advantage carefully to avoid discouraging private investors from competing for deals in developing countries.
In cases where DFIs invest alongside private investors to ensure that development outcomes are included as part of the return calculation, thus ensuring development additionality, the key question that arises is whether the same outcomes may not be more efficiently achieved via traditional bilateral aid?
To garner a full understanding, evaluators need to gather information regarding projects prior to DFI involvement. Only upon knowing what the private market was willing to accept as a return ex-ante, could comparisons be conducted and a proper accounting of additionality may be possible.
However, in most cases, additionality is calculated ex-post under the assumption that there were no willing private investors. It is more likely that there may have been willing private investors that were only willing to enter upon the possibility of higher returns or unwilling to commit to delivering associated development outcomes.
The differences between the informational requirements for estimating ex-ante and ex-post additionality, between additionality from a financial and of developmental perspective, and the potential costs associated with such evaluation, are areas the new Canadian DFIs must keep in view.
Although the UKAN literature review noted the difficulties in attributing additionality, various reports they reviewed point to some factors that influence where additionality is achieved:
- Investments that support small medium enterprises (SMEs).
- Investments in countries with underdeveloped financial systems.
- Involvement in early stages of a given project or objective.
Additionality for the new Canadian DFI
As the Government of Canada operationalizes the new Canadian DFI by January 2018, it has an opportunity to set the terms of reference with regard to measuring the additionality of its investments.
Some of the questions of interest include:
- To what extent should the success of the DFI be measured in terms of the type and amount of additionality it achieves?
- What steps should be taken to set the groundwork to assess financial and development additionality, and should these focus at the investment specific or wider portfolio level?
- To what extent should traditional concessional ODA be coupled with DFI financing in pursuit of additionality, and what are the trade-offs?
These are questions that should be reflected on seriously before the first dollar is disbursed. Short of the same, all development financiers, Canadian or otherwise, need to be mindful that they do not overclaim the additionality impact of their work and its impact on development outcomes on the margin.
In the coming weeks, we will publish a series of articles that will elaborate on this and other issues facing the new DFI and how we think they can be resolved.