Water-related investments are key for sustainable development and inclusive growth. Sustainable Development Goal (SDG) 6, the dedicated goal on the sustainable management of water and sanitation for all, has spill over effects across the SDG Agenda, including the goals on food security, healthy lives, energy, sustainable cities, sustainable consumption and production, and marine and terrestrial ecosystems.

Yet, according to WHO and UNICEF, as recently as 2015, 2.1 billion people lack access to safely managed drinking water services and 4.5 billion people lack access to sanitation compatible with the SDG 6 objectives (WHO/UNICEF, 2017[1]). Further, growing pressures on water resources degrade water quality and increase scarcity, as competition for the resource among various uses (cities, industries, farms and the environment) intensifies. The economic benefits of investing in water security could exceed hundreds of billions of dollars annually (Sadoff et al., 2015[2]). Yet, despite a strong economic case for such investment, financing persistently falls well short of needs.

Investments in water and sanitation services and water resources management have historically been financed by the public sector, with concessional finance playing an important role in developing countries. The mobilisation of private finance for the water sector has been limited to date. Risk-return considerations and structural issues related to profitability of operating business models often undermine commercial investment. While finance from domestic public budgets and development finance, particularly concessional finance, will continue to have an important role to play in the sector, these flows are not sufficient to address total financing needs.

Blended finance can play a critical role in mobilising commercial finance as well as strengthening the financing systems upon which water–related investments rely. The OECD defines blended finance as the strategic use of development finance for the mobilisation of additional finance towards sustainable development in developing countries (OECD, 2018[3]). Blended finance can add value by shifting funds that are currently not directed to sustainable development in countries and sectors that have significant investment needs in order to deliver on the SDGs.

The OECD, with the support of the Swedish International Development Agency (Sida), has undertaken research to better understand the current and potential role of blended finance models for water-related investments. Considering the wide variety of potential types of water-related investments, this research takes a broad approach to water-related investment and covers blended finance models that contribute to the SDGs including, but not limited to, SDG 6. Specifically, the report focuses on three subsectors: (1) water and sanitation utilities, (2) off-grid sanitation and (3) multi-purpose water infrastructure (MPWI), including emerging landscape-based approaches1.

Based on findings from case studies, interviews, workshops and extensive desk research, this publication builds a robust evidence base on how blended finance can play a role in attracting commercial finance. It provides examples of current good practices and trends, distil lessons learned and emerging guidance to scale such approaches in order to exploit the full potential of blended finance.

Blended finance models are emerging but have not reached scale. Blended financing models across the three subsectors reflect different stages of financial market building. Blended models to finance utilities have proven to be an appropriate tool for creditworthy or near creditworthy utilities to move away from purely concessional donor finance towards market financing. For off-grid sanitation, however, grants and concessional financing are predominant, whereas blended finance models that mobilise commercial financing are largely absent. In contrast, MPWI is a subsector where blended finance models are an established financing instrument mobilising commercial finance at scale. For landscape-based approaches, blended finance can potentially operate as a fit-for-purpose financing instrument as it brings together different stakeholders responding to their individual investment preferences, but developments in practice remain at a very early stage.

Effective blended finance instruments include guarantees and technical assistance. Guarantees, including credit risk and political risk guarantees, are an effective tool to mobilise commercial investment in the utilities and the MPWI subsectors. Development actors can use guarantees to limit the risk exposure and reduce the cost of capital from commercial lenders. Beyond guarantees, technical assistance at the transaction level plays a major role in water and sanitation. Technical assistance can have different entry points in blended finance transactions, including for project development, for investees such as utilities, or for financiers such as banks to set up new lending programmes tailored to the distinct needs of the sector. Technical assistance has a particularly crucial role to play in tailoring existing blended finance structures to local contexts.

The success of blended finance is dependent on the ability to mobilise domestic commercial investment tailored to the local context. Blended finance for water-related investments reinforces the need for, and benefits from, tailoring blended finance to the local context. In general, blended finance should aim to build local capital markets by working with and mobilising local financiers, as highlighted in the OECD DAC Blended Finance Principles. Water and sanitation services are, by definition, locally sourced and provided; water resources are best managed at the basin scale. At the same time, the sector requires strong public regulation due to the public good dimension of water and sanitation services and the common pool nature of water resources. These characteristics emphasise the need to work closely with local actors and align with local development needs.

There is a need to link blended finance approaches to the underlying value chain. To effectively tailor blended finance models for water-related investments, an understanding of the underlying business models and value chains is needed. Blended finance models can enter the sector at different points along the value chain, for example at the water provision or treatment level, downstream at the end-user level or at the investor level. Effective blended finance approaches take into account the underlying business models and respective revenue streams, and incorporate different stakeholder perspectives.

Pooling projects could be an effective way forward to address selected unfavourable project attributes. Providing commercial investors access to a variety of different transactions in the water and sanitation sector can mitigate concerns around small ticket size, risk exposure, limited sector or regional knowledge as well as high transaction costs. Pooling mechanisms such as blended finance funds tailor different risk and return profiles for individual investors, with development financiers often taking first loss and junior traches buffering the risk for commercial investors in the senior tranches. Guarantees, moreover, can strategically mitigate portfolio risk.

Design blended finance to build markets - and incorporate its subsequent exit. Blended finance is not about fixing issues in underlying business models. Beyond addressing a financing gap, it is a transitory market building tool that is designed to enable stand-alone commercial investment in the long-run, by providing confidence, capacities and track record in markets where commercial investors are not yet present. Blended finance, starting with concessional elements, should phase out over time and ultimately exit in order to prevent market distortion. An analysis of the exit strategy should be integrated in any programme design.

Beyond transaction-related insights into potential pathways to scale blended finance for water and sanitation, this publication derives policy level implications that aim to facilitate an uptake of blended solutions for sustainable development in the sector.

• Design blended finance in conjunction with efforts to improve the enabling environment. Blended finance cannot compensate for an unfavourable enabling environment, but rather needs to be accompanied by efforts to promote a stable and conducive policy environment. A weak enabling environment characterised by poorly designed or absent regulation, policies settings (e.g. water prices and tariffs), or institutional arrangements, compounded by political interference in the management of (often public) utilities, constrains commercial investment.

• Increase transparency to make a valid business case for commercial investment. Commercial investors are cautious about uncertainty regarding any of the risks related to an investment opportunity. With adequate contractual arrangement or blended instruments and mechanisms, it is possible to mitigate a variety of risks, share the remainder with the public sector or commercial co-investors, or take a certain level of risk on the financier’s own book. However, in order to make such an assessment, risks associated with an investment should be transparent and quantifiable.

• Establish policy-level co-ordination and co-operation processes for blended finance. An excessive reliance on concessional finance can inadvertently crowd out commercial finance, creating market distortions that impede greater accountability and financial sustainability of the sector. Co-ordination and co-operation among development finance actors on their blended finance engagements is a key for the market building aspect of blended finance, particularly when a concessional element is involved. Development financiers should co-ordinate more structurally beyond single transactions. While there is general agreement about the need for improved co-operation, actions on the ground may remain fragmented.