Outcome-Based Funding for Social Development: A Theoretical Critique
Part I

By V Santhakumar

Given the enormous need for financial resources to achieve social development (as outlined in Sustainable Development Goals) in relatively less developed societies, and the limited resources available for this purpose with their governments and philanthropic organizations, innovative experiments to fund development projects are being tried out. There are efforts to use such funding strategies in India too. A major philanthropic organization, namely Tata Trusts, has employed these in their work.¹ Their Quality Education Development Impact Bond (QE DIB) is one such funding program. This education bond is an Outcome-based Funding (OBF) program wherein education projects (say, to improve the learning achievements of a sizable number of children in specific subjects in a specific locality) that are carried out by different `service providers’ (and these could be non-governmental organizations) are funded upfront by financial investors.²

If projects that run on OBF achieve their expected outcomes (as per the evaluation of a third party), then a philanthropic organization (like Tata Trusts) pays back the money to investors with a reasonable rate of return (which could be somewhere in the range of 10-15%). This model may encourage financial investors who are interested in a decent return and are willing to take some risk by committing a part of their resources to social development projects. This is seen as a strategy to divert a part of these resources (which seek normal returns) towards the social sector. There are other experiments of this kind in India and elsewhere. Tata Trusts also provides such grants to Social Finance India (SFI) and plans `to collaborate with governments, non-profits, for-profit social enterprises, philanthropic foundations and impact investors to create innovative financing solutions to improve social outcomes’ (read more). The SFI has established the India Education Outcomes Fund (IEOF), which is another OBF instrument in the domain of education in India. It is still early to make an assessment of the effectiveness of such programs.

Since the funding is based on outcomes (as evident from third-party assessments), some of these funded projects may be able to achieve effectiveness in their specific contexts but whether such an approach can address the major challenges in financing social development, needs to be assessed. There are comparisons of OBF with other social impact funds, especially in the context of developed countries, such as the UK (Edmiston and Nicholls, 2017). One write-up on education bonds in India argues that this instrument may be useful for certain kinds of projects (we discuss some of their findings in a following section). Their findings are based on the experience of several such funding programs from different parts of the world, including India. However, a systematic assessment of the effectiveness of OBF requires comparing the cost of it, say, for a philanthropic organization, with that of achieving similar outcomes through direct funding, and based on our knowledge, such an assessment has not been carried out so far.

This article assesses theoretically, the prospects and challenges in the use of OBF. It is an ex-ante assessment of the possible effectiveness of such funding which is based on an analysis of the incentives of different actors. It is informed by an understanding of the challenges in financing social development, in general, and the specific challenges faced by philanthropic organizations in countries like India.³ It is also based on an understanding of different motivations behind investments in social development projects.⁴ Some of these motivations are those which are explained within the framework of conventional microeconomics, but there are others which are evident from the experiments in behavioural economics. Hence, this article is an `internal’ (within the discipline of economics) critique of OBF.⁵

Core challenges in financing social development

There are several factors which persuade different actors to think about innovative instruments for financing social development. When we consider countries like India, there are inadequate investments in services such as education and healthcare. The low per-capita incomes further reduce the financial resources available in the hands of individuals and the government for investing in such services (which does not imply that the underinvestment of financial resources is the only reason for the challenges faced by, for example, India in education services where there may be demand factors and a need for behavioural changes⁶). Political economy factors (like those which work against the willingness of governments to extract a higher share of the GDP as taxes) can also reduce the investible resources in the hands of a government for this purpose.

It is somewhat obvious that the for-profit companies may not invest adequately in social sectors, such as education and healthcare. There are aspects of education and healthcare in which the social return could be higher than the private return to the providers of these services. In cases where the private gain is greater than the private cost, one can expect for-profit organizations to invest, even in education and healthcare. This is evident from the functioning of fee-paying private schools or self-financing colleges. However, education and healthcare may require other actions too wherein social gains are more than private gains, and private gains are less than the private costs. For-profit organizations are less likely to engage with such activities.

Hence, there is a need for philanthropic funding (including that from international development organizations), which is provided by not-for-profit organizations (NPOs) expected to invest in social services in which social gains are greater than the social and private cost, and private gains are lesser than private costs. However, these organizations face a different set of challenges in the two activities of funding and service-provision. If these two activities are carried out by two entities, there is a principal-agent problem, the possible non-alignment of the objective of the agent with that of the principal, and the need for costly monitoring. This is aggravated by the fact that all outcomes of services in education and healthcare (or other social sectors) are not so tangible, and even if some of these are tangible, these may take a longer time to be reflected. Even if a philanthropic funder carries out both, the funding and the service-provision, there are challenges in the relationship between these two arms of the organization, requiring costly monitoring.

There is a greater uncertainty in whether social sector interventions can lead to expected outcomes. This is so since these outcomes are influenced by several factors, and most of these may not be under the control of the interventionist. By using the conventional framework of microeconomics, the providers of social services and foundations may have an incentive structure⁷ and culture which could be similar to public organizations, which may work against the achievement of effectiveness and efficiency. (Of course, this perception may have to be revised if we consider certain insights from behavioural economics, such as the presence of intrinsic motivation, which we will discuss in a later section). Given this expectation of the difficulty to achieve effectiveness and efficiency, there is a tendency to use for-profit organizations for investments in the social sector. This is visible in the case of OBF too.

How does outcome-based funding attempt to address these challenges?

There are three major players in an OBF program. There is an investor (individual or organization) willing to put money up front in a social sector project but is expecting a monetary return from it. This is like a venture capital (VC) investor. The ‘riskiness’ in new ventures may lead to loss or less than average return from certain investments and above-average return from others and hence, a VC is expected to get the normal return in aggregate. Investors in an OBF program are also of this kind and may be like other private investors. (This assumption is important for the theoretical clarity of OBF because if these investors are also philanthropists, then, there cannot be any distinction between their direct funding and OBF of social projects.)

The second player is the organization which is paying back the investment with a return to the investor after the successful outcome of a project has been achieved. In most cases, this player is a philanthropic foundation but in certain cases, governments can also take on this role. However, the governments in developing countries are yet to assume this role of the funder in an OBF (Gustafsson-Wright and Boggild-Jones, 2019). As noted earlier, these `funders’ should have certain features which are different from those of `investors’ mentioned in the previous paragraph, otherwise, the rationality of using the latter as intermediaries would not be clear.

Then, there are `service providers’. In the social sector, these can be private, governmental or non-governmental. Theoretically, there is no problem in using any one of these service providers in an OBF program. The conventional strategy is for the funders to provide resources directly to service providers. The crucial change in OBF is the role of the `investor’ between the funder and the service provider. How does the intermediation of the `investor’ address the challenges in the relationship between the funder and the service provider? Is it because funders are risk-averse that the risk-taking ability of the investor is helpful? Are the processes followed by the funders inadequate to address the principal-agent problem in their relationship with the service providers, and do investors have better processes? Answers to these questions are important for an assessment of the possible effectiveness of OBF as opposed to conventional funding strategies.

Theoretical literature on outcome-based funding

There is some theoretical discussion on the possible benefits of Results-Based Funding (RBF) and OBF is one such funding. Perakis and Savedoff (2015) provide a brief review of the literature.

One argument for the possible success of OBF could be the pecuniary interest of the service-providers. Since these organizations want money, they would channelize their efforts towards the achievement of outcomes (Clist and Verschoor, 2014). This is based on the principal-agent problem discussed in neoclassical economics and to some extent, the OBF program can be seen as an incentive-compatible payment system through which a greater alignment between the objective of the principal (here the funder) and the agent (service provider) is achieved. The conventional funding (which is not linked to outcomes) may not encourage these organizations to have an adequate orientation towards the achievement of outcomes.

The focus on outcomes by the funder or investor can be expected to draw the attention of the service provider to the need to achieve such outcomes or to narrow down its objectives. In that sense, OBF can be viewed as an instrument using which the decision-making of service providers is influenced to achieve a greater focus on outcomes. This may be needed due to various factors –incomplete information, assimilation of available information according to one’s pre-judgements (Baron, 2000), inertia (implied in discussions in Benartzi, S. & Thaler, R. H. 2004) and such factors which may make human choices to deviate from a goal determined by rationality (in the way it is understood in conventional microeconomics). Such tendencies are brought out by experiments in behavioural economics. In that sense, the outcome orientation of OBF could be part of an effort to bring about behavioural changes in service providers.

One can also expect OBF to enhance the accountability of service providers. Using OBF, there could be a higher level of transparency on what these organizations are expected to achieve and whether these goals are reached or not, and these may enhance the social accountability of the actions of both funders and service providers. On the other hand, there could be a certain lack of clarity in conventional funding mechanisms.  It is also argued that the RBF, in theory, can enhance the discretionary space of fund recipients (and in this case, service providers) to decide how to achieve the outcomes since the funders are interested only in outcomes (and not in the ways of achieving these).

Author
V Santhakumar, Professor, Azim Premji University, Bangalore

Outcome-Based Funding for Social Development: A Theoretical Critique Part II
A Discussion between Shantanu Ghosh and V Santhakumar

Featured image by Markus Winkler on Unsplash

References
Baron, J. (2000). Thinking and Deciding.  New York: Cambridge University Press

Benartzi, S., & Thaler, R. H. (2004). Save More Tomorrow: Using Behavioural Economics to Increase Employee Saving. Journal of Political Economy, 112, 164-187

Clist, Paul, and Arjan Verschoor. 2014. The Conceptual Basis of Payment by Results. School of International Development, University of East Anglia

Edmiston, D. & Nicholls, A. (2017). Social impact bonds: The role of private capital in outcome-based commissioning. Journal of Social Policy, 47(1), 57-76

Perakis, R. & Savedoff, W. (2015). Does results-based aid change anything? Pecuniary interests, attention, accountability and discretion in four case studies. CGD Policy Paper 053. Washington DC, Centre for Global Development