The Future of Cities Depends on Innovative Financing (Harvard Business Review)

By John D. Macomber

Today’s mega-cities have a footprint problem. They are developing horizontally, not vertically, with vast areas of low sprawl reaching out for miles from Sao Paolo, Lagos, New Delhi, Guangzhou, Jakarta, and many others. A central question our civilization must address is how we can avoid becoming a planet of informal slums.

Every year, hundreds of millions of people across the globe move from rural to urban environments in search of opportunity.  In a perfect world, governments would have the cash and the consensus to fund and coordinate the construction of the infrastructure required to sustainably accommodate a rapidly urbanizing world. But few governments appear to have the money or the political will to foot the up-front costs to prevent or fight fragmentation.

As I travel to urban development conferences, I often hear people bemoan an infrastructure funding gap, but the hard truth is there is no funding gap. The world is not short on capital — a startling $43 trillion of assets is currently under management in the United States alone. Investors from hedge funds to insurance companies are operating in an environment of low yields, near-zero interest rates, and a glut of savings. Rather than a funding gap, there is a bankable projects gap: the projects themselves are not attractive to investors.

There are a variety of reasons why infrastructure investments in developing cities so often frighten investors. These range from uncertain revenues to disagreements over guarantees to concerns about political risk. The main challenge is that investors are very good at understanding a single asset with standalone cash flows — a toll road, for example, or a power plant, or an apartment building. But to tackle sprawl, multisector coordination is required: roads, rail, land-use, zoning, power, water, and sanitation must work together. In traditional financing models, it’s just not possible for investors to see their way to a financial return based on some abstract added value of the integrated whole. The benefits are diffuse, including economic growth, city competitiveness, more jobs for more people, and more efficient use of scarce resources such as energy (which leads to less pollution).

This is where a new financial product, social impact bonds (also known as pay-for-successcontracts), can play a role. These financial products create a risk-bearing financial arrangement between public, private, and nonprofit organizations. In 2014, for example, the state of Massachusetts, the nonprofit Roca, the financial intermediary Third Sector Capital Partners, and a group of investors entered into a contract under which Roca was paid by the investors to operate a program aimed at reducing criminal recidivism. If Roca meets certain goals related to preventing released prisoners from ending up back in jail, the state will repay the investors their principal, with a sliding scale of profit tied to degree of success. (The state is willing to do this because keeping people out of prison saves the state money.) If Roca is unsuccessful, the investors could lose some or all of their money. (The investors have to believe that the developers can deliver the results, and that the state can fulfill its agreements.)

Social impact bonds were conceived to tackle social problems that can be objectively measured, such as recidivism. That makes them a great candidate for sustainable urban development, an environment rich with reliable and objective data. For example, bonds could be designed so that real estate developers and infrastructure promoters are paid bonuses based on various measures of coordinated progress achieved beyond the minimum expectation; multisector outcomes might include less time in commuting, or reductions in the rate of urban pollution per unit of GDP.

Pay-for-success could be an appropriate generator of enthusiasm, too. Rather than attracting mostly single-project debt investors who pander to timid underwriters obsessively guarding against downside risk, social impact bonds would reframe negotiations to spotlight upside potential. Investors and entrepreneurs interested in pay-for-success financing would be more interested in questions such as, “On a sliding scale of social impact, what do we get in addition to tariff revenue if together we reduce road congestion by 10% or increase uptime for electricity in an urban area by 50%?” A social impact bond arrangement focused on these metrics would enable independent developers of road, rail, water, and high-rise building projects to share a bonus for creating the aggregate benefits of higher density and a shrunken footprint — a clear incentive to coordinate with a shared goal in mind.

As with other pay-for-success programs, the ability to attract pure return-seeking capital may be limited for social impact bonds. However, social impact and pay-for-success securities could unlock substantial foundation, philanthropic, and NGO assets to buffer the risk for return-seeking capital. Corporations might even get involved. For example, earlier this year, the Indian government passed legislation requiring large companies to spend at least 2% of their annual profits on corporate social responsibility. In the case of a large company such as Tata, for example, that equates to about $100 million per year, a hefty store of dry powder that could be invested into social impact bonds targeted at reducing sprawl and fragmentation.

Of course, this approach might cost the issuer (the city) more money if it has to make good on an incentive fee — but it’s only due if the incentive is earned. If the pricing is anywhere close to right, issuing social impact bonds and making the success payments would be net cheaper for governments and other issuers than having no fix at all. A dense, slum-free city where low-income workers don’t need to travel for hours to find employment and where clean water and electricity is ubiquitous will be a much more prosperous city in the long run.

Pay-for-success may not be a universal panacea to address the footprint problem and its underlying causes. But it’s a potentially powerful way to mobilize vast pools of global capital toward multisector thinking, working toward a common good that none of the parties currently seems able to finance. The vibrant, sustainable cities of the future will be funded and delivered by creative financing arrangements that encourage collaboration. Social impact bonds could be one of the most innovative and effective.

John D. Macomber is a senior lecturer in the finance unit at Harvard Business School. He teaches in HBS’s Business and Environment and Social Enterprise Initiatives.