Urban Institute
Policy Program Manager

Helping smaller communities benefit from PFS through a pooled approach

August 2, 2018 - 12:54pm

Many small, rural communities could benefit from using the pay for success (PFS) model to help them address significant social challenges - like battling opioid use - because it provides a useful way to frame problems, fund potential solutions, evaluate impact, and scale what works. Yet of the twenty existing PFS projects, not one includes a small locality as the government partner. All either involve large counties or cities or are state led.

So, is population size an obstacle to engaging with PFS? If so, is there a way for smaller communities to overcome it to launch their own PFS projects?

The answers to both questions lie in economies of scale.

Why size matters in a PFS project

PFS projects require a sufficiently large population size to be evaluation-ready, and they are resource-intensive with high transaction costs.

  • Strong evaluations are key to PFS and need a minimum sample size. Impact evaluations estimate the effectiveness of an intervention, which is necessary in PFS to determine outcome payments and inform stakeholders on what works. For an evaluation to be statistically valid, it must have a sufficiently large sample size. For small jurisdictions with a small target population, it may therefore be difficult to conduct a rigorous evaluation and have confidence that the public is truly paying only for results.
  • PFS projects are time- and resource-intensive endeavors, requiring sufficient capacity. While PFS can bring tremendous benefits to governments and other partners. They also typically take more than a year to structure and launch, require extensive multi-stakeholder communication and collaboration, and come with transaction costs for intermediaries, evaluators, and legal counsels - not to mention staff time from governments and providers.
  • Investors look for government partners with acceptable levels of risk. All parties encounter risk as part of a PFS project. For investors, programmatic risk and implementation risk, or the risks that outcomes won’t be achieved, feature front and center. Also important for investors is endpayor risk: the risk that even if those outcomes are achieved, the government endpayor will fail to honor its end of the deal to make the agreed payments. For small jurisdictions, with limited credit history and capacity to repay, this risk may be heightened. Although some investors are willing to accept additional risk for an additional return, many investors will seek ways to mitigate it, such asthrough guarantees from a philanthropy or simply find other projects with different – and likely larger - endpayors.

Pooling as a solution to scale

For smaller communities with limited capacities and smaller service populations to benefit from PFS, they must achieve scale. Unless states can provide that scale by including that jurisdiction in a larger, planned PFS project, small jurisdictions can only achieve the needed scale by pooling with other small neighbors.

Using a pooled approach for public finance is not wholly new. The basic premise of insurance is to pool risk. For example, regional risk pools allow small island countries in the Caribbean and Pacific to access financial resources in times of need. A number of bond banks in the United States also exist to help local and municipal governments share the burden of transaction costs and access financing for infrastructure projects.

Sharing the cost burden is especially useful in PFS where there are large fixed costs (e.g. feasibility studies, legal costs, evaluations) that don’t necessarily increase in proportion to the project’s scale. Projects that serve a larger population, therefore, can potentially achieve lower per capita transaction and evaluation costs.

How pooling could work in PFS

There are two potential ways that pooling could work for small communities interested in PFS. The first is simply to create a fund that pools risk and access to capital. Although this may also reduce some transaction costs through streamlining, it would leave other challenges of scale unaddressed.

The second option may be trickier to get off the ground but would ultimately lead to greater efficiencies and address more of the challenges of scale. Multiple jurisdictions interested in addressing the same issue could be linked together into a larger PFS project. In this way, a project can increase in size, allowing it to conduct a strong evaluation, reduce costs, boost capacity, and share risk. The project could set up an executive-level body to coordinate the project, potentially with a third party like the state serving as chair.

Challenges that may accompany pooling

Pooled funds, however, wouldn’t come without their hurdles. Pooled funds could take aspects of PFS that are already challenging and make them even more so:

  • PFS projects can be extremely complicated endeavors, with a number of key stakeholders that have different perspectives, needs, and priorities. Adding an additional jurisdiction (or several) only further complicates PFS, including making decisions on topics like evaluation design, repayment terms, etc.
  • Governance mechanisms would need to be addressed. For example, if one jurisdiction fails to appropriate funds for the end payment, are the other jurisdictions responsible for making up the shortfall? Agreements would need to be carefully negotiated and third parties, like philanthropy or the state government. might need to provide a guarantee as a backstop to mitigate the risk for investors and the partnered jurisdictions.
  • For this pooled approach to work, communities would need to find several similar jurisdictions with a comparable challenge, population, and identified solution and strong and committed leadership. Jurisdictions with past histories of collaboration and aligned efforts are the strongest contenders.

Despite these challenges, small communities may wish to explore a pooled approach to tap into the benefits of PFS to help address pressing social challenges.

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