Urban Institute
Policy Program Manager

Expanding the potential of pay for success: financing physical social infrastructure

June 7, 2018 - 10:55am

Though pay for success (PFS) projects traditionally deliver social services, there’s no reason that the financing model should be so limited. Environmental stakeholders have already recognized the potential to use PFS to improve public spaces through environmental impact bonds (EIBs). In recent years, increasing evidence has shown the effects that certain design choices might have on social outcomes. Innovative designs for schools, hospitals, prisons, and housing—all types of physical infrastructure with high up-front costs and the potential to significantly shape people’s lives—offer a chance to rethink the way we apply PFS.

Take schools as an example.

Some existing studies suggest that school design choices such as increased natural light, improved air circulation, and better acoustics may help enhance student learning and achievement. This presents an ideal PFS scenario: an upstream intervention requiring upfront investment but with delayed, downstream, measurable potential impacts. Yet the existing evidence base might be insufficient to convince a school district to depart from traditional design choices and potentially spend more on new or retrofitted schools with no guarantee of improved outcomes. This is another scenario suited to PFS: high upfront costs coupled with innovation risk, which can create a disincentive to try something new.

Imagine that a school district is considering a new school design that incorporates more natural light, provides opportunities to engage with nature, and offers spaces for collaboration among students. Evidence suggests that this design could lead to significantly higher knowledge retention and graduation rates—but it’ll cost 20 percent more than typical projects. PFS could enable the district to fund the school while shifting some of the risk to private investors, who would only be repaid if the new design achieved the desired outcomes. For example, the school district could measure improvement in average test scores within five years of the school opening, compared against a matched population in a neighboring school district.

In existing PFS projects that deliver social services, most or all of the repayments are outcomes-based: if the project fails to meet outcome targets, not only will investors fail to receive the potential return, but they may lose their principal as well. PFS projects for physical infrastructure could be especially risky for investors due to the steep up-front construction costs (building most schools, hospitals, or prisons costs much more than even the largest existing social service PFS project) and the time period to realize outcomes (construction alone can take multiple years). Investors might then either shun these risky projects or expect very high returns.

To mitigate this, physical infrastructure PFS projects could tie just a portion of the funding repayments to outcomes.

The DC Water EIB demonstrates this concept in practice. This project uses a “two-way contingent payment,” meaning that if the project meets its target outcome (in this case, reduced storm water runoff), the stated interest rate is paid in addition to the investors’ principal, and if the project underperforms, investors are repaid their principal and DC Water essentially gets an interest-free loan. Meanwhile, if the project outperforms expectations, investors will not only receive the stated interest rate and their principal, but also a bonus “outcome payment.” This approach decreases the investors’ risk while maintaining an element of shared risk (and benefits).

New PFS projects that fund physical infrastructure could follow DC Water’s approach of integrating the principle of outcomes-based payments into their contracts. Though there will likely be resistance to disrupting established funding models and it’s uncertain how many investors would be willing to pilot the idea, there is a potential role for PFS here, and, as EIBs have demonstrated, there is appetite.

Have a Pay for Success question? Ask our experts here!

As an organization, the Urban Institute does not take positions on issues. Scholars are independent and empowered to share their evidence-based views and recommendations shaped by research. Photo via Shutterstock.