Why Should the Devil Have All the Good Financial Instruments?

A new financial instrument, the Social Impact Bond (SIB) is gaining in popularity.  SIBs are designed to transfer the risk of social programmes from the public sector to the private sector, by paying investors when social targets are achieved.

What Are Social-Impact Bonds?

A Social Impact Bond is a contract between an external organisation and the public sector in which the public body agrees to pay for positive social outcomes achieved by the organisation’s programmes.  The organisation receives upfront funding from investors to operate their social programme, with the investors receiving an attractive return if agreed outcomes are achieved.  The money for the investment return comes from the public body and is funded by the resulting public sector savings.  The public sector benefits through the lower cost of dealing with social issues, as well as reduced programme risk and cost as it does not need to pay for ineffective programmes.

This financial experiment is only a few years old, but is already being used to reduce homelessness, improve the adoption of children and lower recidivism rates among ex-convicts in New York.

An Example

The easiest way to understand this concept is through an example.

In 2010, the British government launched the first SIB pilot scheme.  The scheme is being run by an organisation called Social Finance and aims to reduce the re-offending rate of prisoners leaving Peterborough prison.  The six-year bond will be paid out provided there is a 7.5% reduction in recidivism relative to a group of similar prisoners discharged from other prisons.

Social Finance needs funds to pay for their programme in advance of any payment from the government, so it has raised money from investors. In exchange for paying the upfront costs, these investors receive an agreed upon return if the outcome is achieved.

The British government calculated how much it is willing to pay for the outcome by looking at the savings likely to accrue to government agencies over time as a result of reductions in re-offending.  These benefits include future savings in incarceration costs as well as in court and police time.

The Case for Social Impact Bonds

Interest in SIBs is growing.  About 20 have been issued world-wide, with more than 10 U.S. states considering them.

These bonds provide a genuine way for governments to spend funds on programmes that actually work, without needing to pick the winners themselves.  They allow governments to partner with innovative and effective service providers while assuring the taxpayers that they will not pay for the programmes unless they demonstrate success in achieving the desired outcomes.

Social Impact Bonds can also help overcome the tendency to divide money and information into different “silos,” preventing programmes and agencies from working together effectively.  Think about preventative healthcare.  The government may have multiple programmes and funding streams for health screening, nutrition and diet, and active lifestyle.  With a Social Impact Bond for preventive health care, however, there is a strong incentive for the external organization to coordinate different approaches to achieve the desired outcome and receive their payment.

While government agencies may find it difficult to shift funds away from ineffective programmes because of political pressures, external organisations will be more motivated to focus on approaches that work.  And SIBs will encourage the external organisation to identify and adopt innovative programmes that have already worked elsewhere.

Conclusions

There are criticisms of this approach, and it is still largely untested.  Nevertheless, SIBs present a real opportunity to better solve stubborn social issues through partnerships between the government, not-for-profits and the private sector.  SIBs can improve the quality of public services, save taxpayer money, and offer new approaches to providing social services without requiring government to assume all of the financial risk.

The biggest drawback I can see is that investors may try to protect their investment by demanding more involvement in the organisation that operates the social programme.  I’m all in favour of applying good business principles, but it seems wise to have a clear boundary between the financiers’ involvement and the social work.  What do you think?  Can financial instruments have a social impact?

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