Business.view

Social financial engineering

Britain's government tries a new way to finance social spending

Mar 23rd 2010 | From The Economist online

IN THE 1980s Britain pioneered a new approach to public finance that soon spread around the world. Championed in the face of considerable public opposition by Margaret Thatcher, the British government privatised those bits of the public sector it could get rid of. And it put out to competitive tender those services it felt it must continue to provide but believed would benefit from a dose of competition. These policies are now standard practice almost everywhere—supported by a multi-billion-dollar industry.

Britain’s current, Labour government hopes that history will repeat itself with a new approach to public finance, for which it launched a pilot scheme on March 18th. Its big idea, which the opposition Conservatives are also keen on, is that the state issues “social-impact bonds” whose proceeds are applied to schemes to solve social problems. If they succeed they will save the taxpayer large amounts of money, a slice of which will be shared with the bond’s investors. Doing something like this has long been a holy grail for financially-literate social engineers and socially-minded financial engineers, but this is thought to be the first time it has been piloted in national government.

In the pilot scheme the bond will raise up to £5m ($7.5m) to finance various private-sector organisations to work closely for six years with 3,000 short-term prisoners jailed in Peterborough, both inside prison and after their release, to help them resettle into the community. At present, prisoners like these have a tendency to reoffend and end up back in jail, costing government and society a fortune.

The bond gives its investors a powerful incentive to finance organisations that will turn these ex-jailbirds into upright citizens. If they can reduce the rate of reoffending by at least 10%, the investors will be paid, the amount rising as the recidivism rate falls. If the payout is triggered—a 10% decline representing proof that the improvement is due to more than chance—the investors will earn a minimum internal rate of return of 7.5%, rising to a maximum of 13%, with payments made during years six and eight.

Social-impact bond is actually a misnomer: “social-impact special-purpose vehicle” would be more accurate, though also less marketable, given the current widespread suspicion of financial engineering, especially by governments engaging in off-balance-sheet financing. A special-purpose body will raise the money from investors, select the organisations that will do the work, and contract with the government. It will be overseen by an advisory board, not least to ensure that nothing too controversial is attempted to meet the targets. The right to a payout will be determined by an independent assessor. If the minimum performance target is not achieved, the investors get no money back—making the bond more equity-like than bond-like.

The social-impact bond is said to have two advantages over traditional outsourcing and public-private-finance programmes. One is that it transfers the risk of achieving social change from the government to private investors. If the desired impact is achieved, both the government and the investors win. If it isn’t achieved, only the investor pays. This is the sort of deal that politicians love—and thus it may help overcome governments' risk-aversion, especially toward policies of prevention. Preventive policies such as stopping prisoners reoffending make politicians look great if they work, and reduce budgets in the long-term, but can make them look fiscally irresponsible if they don’t.

The social-impact bond would also shift the focus of contract negotiations toward the impact on society, rather than the less risky output-based measurements that are typical in existing outsourcing contracts. The current model of private finance for public services tends to focus chiefly on reducing the cost of the current activity (ie, housing prisoners). Sometimes there are performance elements (eg, penalties for letting prisoners escape), but what is new about the government's scheme is that it incorporates incentives for radically improving outcomes (ie, helping them stay out of jail) into the financing model.

The aim is to attract innovative social problem-solvers in both the for-profit and non-profit sectors, although the pilot scheme only uses non-profits. The frustrations of the non-profit sector with the inadequate funding of preventive policies under the present system, and the prospect that the current economic mess will only make things worse, prompted the bond’s creation. David Robinson, the founder of Community Links, a non-profit in East London, felt that the government was “running an ambulance service at the bottom of a cliff rather than building a fence at the top”. He outlined his thinking at a meeting in 2007 of the new Council on Social Action established by Gordon Brown, the prime minister. As a result, Social Finance, a new British “social-investment bank” focused on developing markets for giving and social investing, eventually took up the idea.

On paper, the potential looks huge. In the pilot scheme, one of the non-profits will be the St Giles Trust. A study by a group of volunteering professional economists called ProBono Economics calculates that if the pilot repeats the 40% decline in reoffending that the trust has already achieved with its “meet at the gate” programme, each pound invested in St Giles would eventually save the state more than £10. (The “eventually” seems to be the reason why the government does not do the obvious, and fund the project in the old fashioned way through public spending.)

Developing a significant market in social-impact bonds will be a challenge, to say the least. It is likely to be hard to persuade mainstream investors to put money into something so new and with such uncertain returns. Perhaps the most likely buyers of the bonds are charitable trusts, since they have a longer investment horizon than many other investors and, of course, because their fundamental objectives are often to solve the sort of social problems that the bonds' proceeds will be applied to. However, trusts may be discouraged from participating by uncertainty about whether the law allows them to invest in such schemes.

Potential investors, besides looking carefully at whether the promised returns compensate adequately for the risks, will also be worried that in seeking to innovate in solving deep-rooted social problems such as crime, drug abuse and so on, the organisations carrying out the schemes may do things that are controversial or reckless—and that some of the blame will rebound on them. Another worry is that not all social impacts are as easy to measure as reconviction rates, so investors may tend to back schemes whose success is easy to measure (and easy to achieve) rather than ones that tackle the most challenging problems. Social Finance hopes that the launch of the bonds will be a catalyst for lots of new work on how better to measure social impact.

Social Finance is already looking at other areas of social policy in which the bonds might work, such as schemes to reduce the numbers of elderly people and vulnerable children going into care homes. David Hutchison, its chief executive, believes the idea has the “potential to unlock an unprecedented flow of finance for social-sector organisations.” However, even if the pilot schemes for the bonds do well, it will be a formidable challenge to scale them up to account for a significant portion of state spending on social services. In the long run, much will depend on whether mainstream private investors can be persuaded that it is worth the risk of trying to do well by doing good.