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The challenge: How can foreign direct investment fulfil its development potential?

22 July 2016

DCR 2016Today’s post, by Karl P. Sauvant, Resident Senior Fellow, Columbia Center on Sustainable Investment, Columbia University, is published in collaboration with the 2016 OECD Development Co-operation Report: The Sustainable Development Goals as Business Opportunities.

International investment, and in particular foreign direct investment, has an important role to play in helping to achieve the Sustainable Development Goals. It can be a powerful international mechanism for mobilising the tangible and intangible assets (such as capital, technology, skills, access to markets) that are essential for sustainable growth and development.

Yet to fulfil this potential, foreign direct investment must increase substantially; it must be geared as much as possible towards sustainable development; and it must take place within a framework of international investment law and policy that is enabling, yet at the same time respectful of host governments’ own legitimate public policy objectives.

Foreign direct investment flows reached their peak in 2007 at around USD 2 trillion, dropping to USD 1.2 trillion by 2009 as a result of the international financial crisis. While this represents a relatively small share – about 10% – of gross domestic capital formation, in individual countries this share can be even higher than domestic investment.

To help meet the investment needs of the future, these flows have to increase substantially. There is no apparent reason why they could not do so over the longer term, say to a level of USD 4 or 5 trillion annually.

How to get there? Improving the economic determinants, the principal factors governing investment decisions, is fundamental. Official development assistance will continue to be important, especially for the least developed countries, including to leverage higher foreign direct investment flows. This is a long-term challenge.

However, national regulatory frameworks and investment promotion efforts can be improved in the short term, especially in the least developed countries.

The first challenge is to increase foreign direct investment through a concerted international effort to help developing countries, and especially the least developed among them, to improve their foreign direct investment regulatory frameworks and investment promotion capacities. At present, there is no such international effort – along the lines of the Aid-for-Trade Initiative and especially the Trade Facilitation Agreement – in the area of foreign direct investment. But in a world of global value chains, these trade arrangements can help only so much, precisely because they address only one side of the task, namely to increase trade. But a concerted international effort for foreign direct investment, such as an international Aid-for-Investment Initiative or even a Sustainable Investment Facilitation Understanding, could help developing countries, and especially the least developed among them, rapidly to improve their regulatory frameworks as well as their capacity to promote investment – thereby helping to increase investment flows to developing countries.

Encouraging higher foreign direct investment flows is, however, not enough.

The second challenge is to promote foreign direct investment that is geared as closely as possible towards sustainable development: “sustainable foreign direct investment for sustainable development”. This presents the challenge of defining “sustainable foreign direct investment”. A first approximation could be: commercially viable investment that makes a maximum contribution to the economic, social and environmental development of the host country and takes place in the context of fair governance mechanisms, as established by host countries and reflected, for instance, in the incentives they offer. Yet any definition needs to be operationalised. So this challenge would also involve developing an indicative list of sustainability characteristics to be considered by governments seeking to attract sustainable foreign direct investment (and to encourage sustainable domestic investment). Such a list would also be a helpful tool for international arbitrators considering (as they should) the development impact of investments, as well as for identifying the mechanisms – beyond those deployed to attract foreign direct investment in general – that encourage the flow of sustainable investment and increase its benefits for host countries.

The third challenge is to reform the international investment law and policy regime. National foreign direct investment rule making increasingly takes place in the framework of international investment law and policy. For this reason, it is important to ensure that the international investment regime constitutes an enabling framework for encouraging the flow of sustainable foreign direct investment, while at the same time allowing governments to pursue their legitimate public policy objectives. This requires asking several questions, including: How can the objective of sustainable development be made the lodestar of the international law and policy regime? What are the implications of such a concept for the regime’s rights and obligations? How will this affect the mechanism for settling disputes between investors and states? This last function is central to the regime and gives it its strength, yet it is precisely the existing dispute-settlement mechanism that is strongly questioned – especially by non-governmental organisations, but also by a number of governments. Any reform needs to address this challenge adequately to avoid threatening the very legitimacy of the regime.

In conclusion, governments need to find ways and means to increase sustainable foreign direct investment flows within a reformed international investment law and policy regime to realise the sustainable development potential of this investment.

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Regulators – the new Men in Black?

21 July 2016
by Guest author

MIBFaisal Naru, Bill Below, Filippo Cavassini, and Anna Pietikainen, OECD Directorate for Public Governance and Territorial Development

The “Men in Black” are a special unit charged with regulating Alien activity on planet Earth (at least so it is in the film with Will Smith and Tommy Lee Jones). Their job is to operate incognito, working behind the scenes to avoid an intergalactic apocalypse. When uncovered, special technology allows them to eradicate all knowledge of themselves and their function.

At least to most of us, regulators are a lot like the “Men in Black,” ensuring that trains will run on time, there is clean water in the tap, lights switch on, the broadband is working and there is cash in the ATM machines, largely going unnoticed, that is, until something goes wrong, stops working or crashes.

Unlike the “Men in Black,” regulatory agencies do not operate incognito—at least they shouldn’t. They must be part of a well-functioning and transparent governance ecosystem that provides these important public services and is held accountable for the performance of its different actors. Being part of this ecosystem, however, carries a number of risks.

Different stakeholders—whether the regulated industry, government, politicians, consumers or other interest groups—have powerful incentives to influence, or capture, regulatory policies. The danger of capture is all the more present because of the proximity of regulator and the regulated. We need regulators to be independent, just as we need our judges and referees to be independent. Independence cannot come at the price of accountability or engagement, and regulators need to keep their fingers on the pulse of the market through interaction with industry and consumers. Autonomy should still be compatible with maintaining helpful feedback loops between the regulator and its governmental executive overseers.

The challenge for regulators is this: they must be engaged but not enmeshed, insulated but not insular.

Not easy to achieve when you consider that the life of a regulatory agency is fraught with potential entry points for undue influence. These “pinch points” are specific to the regulator’s environment and are amplified when two or more events occur at the same time. An example might be a political election coinciding with a rise in crude oil prices and a change in the head of the agency. Successfully navigating these powerful forces can be accomplished with good governance and clear regulatory policies addressing such issues as agency finances, staff behaviour, the appointment and removal of leadership, the way in which agency intersects with political cycles, and the interaction with the various actors in the regulatory sphere.

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Given the challenging context within which regulators operate, the question is how to limit undue influence in practice and create a strong culture of independence. Independence is not a static state achieved once and for all by statute, but an active objective that the regulatory agency must be prepared to approach proactively and continuously. While institutional design is one part of optimizing independence, it is not sufficient. A regulator can be part of a ministry and yet be more “independent” than a regulator in a separate body.

The OECD has set out to understand how regulatory agencies around the world are structured to be protected from undue influence. The OECD has developed a unique dataset of the formal arrangements for independence of regulators across 33 OECD countries, complemented by detailed case studies showing what holds regulators accountable for their performance.

A follow-up study, recently published as ‘Being an Independent Regulator,’ has filled in many of the gaps in our understanding of how de facto independence plays out in the daily life of regulators, differing from other research on independence, which tends to focus only on formal (de jure) institutional arrangements. Forty-eight regulators from around the world participated, representing institutional arrangements including formally independent regulatory institutions, ministerial regulators, and single- and multi-sector regulators.

A key conclusion of this work is that regulatory independence is not an end in itself, and that it should be seen as a means of ensuring effective and efficient public service delivery by the different market players. Developing a culture of independence is just another way of saying nurturing better performance.

Being an independent regulator cannot mean adopting the cloak of invisibility and working behind the scenes like the Tommy Lee Jones and Will Smith characters. Regulators must fully engage with all stakeholders. Maintaining independence in the midst of significant pressure from all sides requires governance structures aimed at cultivating and maintaining a culture of independence.

It may not keep the galaxy safe, but it will ensure that regulatory agencies better meet their mandates to serve the public good.

Useful links

For more information, follow this link.

OECD (2016), Being an Independent Regulator, The Governance of Regulators, OECD Publishing, Paris

OECD.  (2016), Governance of Regulators’ Practices: Accountability, Transparency and Co-ordination, The Governance of Regulators, OECD Publishing, Paris.
Koske,I., Naru.F, et al.  (2016), “Regulatory management practices in OECD countries“, OECD Economics Department Working Papers, No. 1296, OECD Publishing, Paris.

The challenge: Can social impact investment serve the “bottom of the pyramid”?

20 July 2016

DCR 2016Today’s post, by Julie Sunderland, Director of Program-Related Investments, Bill & Melinda Gates Foundation is published in collaboration with the 2016 OECD Development Co-operation Report: The Sustainable Development Goals as Business Opportunities.

It’s not surprising that the private sector faces challenges in serving bottom-of-the-pyramid customers: the largest and poorest population groups. By definition, bottom-of-the-pyramid populations don’t have much income, making margins slim. In addition, the often weak infrastructure and distribution channels in developing countries make the transaction costs of reaching these customers high. Much of the procurement of basic goods and services for the poorest populations goes through government-managed development co-operation channels, which are often bureaucratic and opaque to companies.

Nonetheless, there is still great potential for the private sector to serve bottom-of-the-pyramid populations. Capital flows into the private sector, both via investment and revenue, dwarf flows from philanthropy and development co-operation combined. The private sector’s commercialisation and manufacturing capabilities can allow for scaled production and delivery of affordable, life-saving products. The private sector can bring critical knowledge, capabilities and resources to solving social sector problems, and its capacity for research, development, innovation and entrepreneurship can be applied to generate transformative technologies and new business models.

Social impact investment can help to realise this potential. When done well, it can address market failures that keep the private sector from investing in social sectors. At the Bill & Melinda Gates Foundation, we’ve seen in practice how patient, flexible risk capital can support innovative models that provide affordable, accessible, quality products and services to bottom-of-the-pyramid populations. When done badly, however, social impact investment can distort markets and prop up unsustainable businesses.

For social impact investment to become a credible bridge to a private sector focus on bottom-of-the-pyramid populations, it needs to address three challenges.

Align incentives for social and financial goals. Except for the limited resources allocated to corporate social responsibility, private companies and investors are driven by financial goals. While a new class of impact investors may be willing to sacrifice some financial returns to generate social impact, investment capital at the very least needs to be repaid out of the cash flows generated by the business activity. One of the current challenges for making social impact investment work effectively, therefore, is identifying (and working creatively to expand) the opportunities for aligning revenue/profit generation with the achievement of social goals.

A great historical example of such alignment is the proliferation of cellular technology. Mobile phones have had significant social impact in fields as diverse as disease response, financial inclusion and technical assistance. Mobile phone companies have also provided excellent returns for their investors. Yet most social goals will lack the natural alignment with scale and profit evidenced by mobile telecommunications. Social impact investment has the potential to bridge this gap through risk reduction mechanisms, such as guarantees; through the application of low-cost scaling capital to validate nascent distribution models; and through company-building equity investment in technologies that hold promise similar to that of mobile phone technology.

Change the economics of reaching bottom-of-the-pyramid populations. Capital-intensive, complicated or transaction-heavy business models that might work elsewhere will not be sustainable in bottom-of-the-pyramid markets. The private sector can develop new technologies, products and business models that are adapted to the needs of bottom-of-the-pyramid populations, allowing for rapid uptake and producing high sales volumes, even if margins remain slim. For example, there are innovations that have the potential to cut delivery costs, ranging from sachet-sized consumer products to agent-based distribution models and pay-as-you-go financing. Social impact investment can support the further development and demonstration of these new business models by leveraging and, ultimately, crowding in private sector investment.

Cultivate top-tier, on-the-ground investment and entrepreneurial talent. Access to capital is often cited as a primary limitation to the growth of small and medium enterprises, and to social sector businesses. Yet access to talent may be a bigger and more persistent constraint as promising models replicate and grow. Social impact investment needs to develop two levels of talent: strong intermediaries and fund managers who are good at allocating capital and building companies; and strong entrepreneurs and managers to lead social sector businesses.

Over time, improving secondary and post-secondary enrolment and education, and increasing entrepreneurial expertise in local markets and among diaspora, will allow talent to flourish. Social impact investors can speed up this process by taking the risks and investing in emerging intermediaries and entrepreneurs, recognising that while they are learning they will be developing experience and networks. A handful of successful cases can encourage others in the private sector to seek out and further develop untapped human capital.

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Doing good business, for profits, people and the planet

18 July 2016
by Guest author

DCR 2016Erik Solheim, Former Chair of the OECD Development Assistance Committee (DAC), based on the editorial of the 2016 OECD Development Co-operation Report: The Sustainable Development Goals as Business Opportunities.

In 2015, when world leaders adopted the Sustainable Development Goals, we committed to the most inclusive, diverse and comprehensive and ambitious development agenda ever. By doing so, we acknowledged that development challenges are global challenges. The new global goals represent a universal agenda, applying equally to all countries in the world.

The year 2015 was the best in history for many people. We are taller, and better nourished and educated than ever. We live longer. There is less violence than at any other point in history. Over the past decades many countries, spearheaded by the Asian “miracles” – such as in Korea, the People’s Republic of China and Singapore – have had enormous development success. By believing in the market and the private sector, these nations have experienced strong economic growth and several hundred million people have been brought out of poverty. The debate within the development community on the importance of markets and the private sector is a thing of the past. The debate is won.

But based on astonishing success, we need to bring everyone on board. The 2030 aim is to eradicate extreme poverty, but to do it in an environmentally sustainable way. Luckily – for the first time in history – humanity has the capacity, knowledge and resources needed to achieve this. Never before was this the case. The leaders of the past have never set such goals, nor did they have at their disposal the policies and the resources to reach them. The Sustainable Development Goals cover the economic, social and environmental dimensions of life. And they emphasise that increased co-operation between the public and the private sector is vital to reach them.

Implementing the new Sustainable Development Goals will require all hands on deck, working in concert to build on each other’s strengths. In this report we look at the opportunities for businesses both to make money and do good for people and the environment. We must go beyond traditional thinking that business revenues depend on destroying the environment. Smart investment in sustainable development is not charity – it is good business and it opens up opportunities.

In developing countries, small and medium enterprises are considered the engine of growth. In Asia, they make up to 98% of all enterprises and employ 66% of the workforce. Especially for green growth, small and medium businesses can play an important role by acting as suppliers of and investors in affordable and local green technologies. For instance, in Africa several businesses offer “pay-as-you-go” solar energy to low-income households that do not have access to central resources.

Over the next 15 years, billions will be invested annually by the public and private sectors. We need to make sure that this money creates jobs, boosts productive capacity and enables local firms to access new international markets in a sustainable way. What’s more, these flows are often coupled with transfer of technology that has positive and long-term effects.

This report cites the results of interviews with executives from 40 companies that had performed above the industry average in terms of both financial and sustainability-performance metrics in various sectors – including oil and mining, gym shoes, soup, cosmetics and telecommunications. The research demonstrates that sustainable action can contribute to increased efficiency and profits, gains above and beyond their social and environmental benefits. The returns on capital include reduced risk, market and portfolio diversification, increased revenue, reduced costs, and improved products.

We need to take these experiences further. The 17 Sustainable Development Goals represent a pipeline of sustainable investment opportunities for responsible business. But fulfilling that potential will mean ensuring that business does good – for people and the planet – while doing well economically.

Although some countries are making progress, no country has achieved environmental sustainability. The worse things get, the more difficult it will be to find solutions. We need to take action now. There is more bang for every buck when profits are combined with bringing people out of poverty, improving environmental sustainability and ensuring gender equality. For example:

  • Ethiopia’s growth has benefited the poor and the country aims to become a middle-income country without increasing its carbon emissions.
  • Brazil has reduced poverty and equality while cutting deforestation by 80%.
  • Costa Rica has revolutionised conservation by providing cash payments for people who maintain natural resources. Forests now cover more than 50% of the country’s land, compared to 21% in the 1980s.
  • The Indonesian rainforests, the largest in Asia, are doing much better than recently. Deforestation decreased for the first time in 2013 and the positive trend is continuing. The main palm oil companies have made a no new deforestation pledge.

Poverty reduction can be green and fair. But we need to remember that neither developing nor developed countries will sacrifice development for the environment. But development comes to a stop if natural resources are exhausted, water continues to be polluted and soils are degraded beyond manageable levels.

For those who do not benefit from all the success stories, it is necessary to identify and replicate good policies that actually improve lives. Official development assistance is important for the least developed nations and countries in conflict. Aid remains at a record high at USD 132 billion in 2015, but private investments are more than 100 times greater than aid and more important for poverty reduction and economic growth.

In order to make the most of private investments for sustainable development, it is fundamental to know more about how much is being mobilised from the private sector as a result of public sector interventions. In this report the OECD describes how it monitors and measures the amounts being invested. The European Union found in 2014 that by blending public and private investments, EU countries used EUR 2 billion in public finance grants to mobilise around EUR 40 billion for things like constructing electricity networks, financing major road projects, and building water and sanitation infrastructure in recipient countries. We should be inspired by this example to do more. Business prospers when society prospers.

Each and every decision we take today related to private investment will have historic implications. We must learn that more and better investment is possible. Balancing economic growth with environmental sustainability is not only feasible – it is fundamental.

In this report we look at the opportunities the new Sustainable Development Goals offer for doing good business, for profits, people and the planet. It offers guidelines and practical examples of how all sectors of society can work together to deliver the 2030 Agenda. Investing in sustainable development is not charity, it is smart. We just need to go ahead and do it.

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Living beyond our means: the nitrogen edition

15 July 2016
Fritz_Haber_1891_Prom

The catalyst

Grace Hanley, OECD Environment Directorate

How did a recently-promoted German janitor use uranium to change the course of history and prove the President of British Association for the Advancement of Science right? In his 1898 presidential address, Sir William Crookes told the Association that: “England and all civilised nations stand in deadly peril of not having enough to eat … the land that will grow wheat is absolutely dependent on difficult and capricious natural phenomena … It is through the laboratory that starvation may ultimately be turned into plenty… The fixation of atmospheric nitrogen is one of the great discoveries, awaiting the genius of chemists.” The genius was Fritz Haber, who has renounced his Judaism in the hope of getting a university job. He got one as a janitor at Karlsruhe University, but by 1898 had worked his way up to a professorship. He used uranium as a catalyst to produce ammonia from atmospheric nitrogen in 1909, a process that BASF engineer Carl Bosch helped him to scale up to commercial viability by 1912.

The Haber-Bosch process enabled artificial fertilizer to be manufactured massively and cheaply, and we still use a modified Haber-Bosch process today. Chemical factories now produce more nitrogen than the microbes in the soil do, but while this has boosted agricultural productivity and allowed world population to continue expanding, it has also caused devastating pollution.

The main problem is that nitrogen is used inefficiently by the agricultural industry, which triggers enormous nitrogen losses to the environment, resulting in ecosystem degradation and biodiversity losses as well damaging the land and water. The ammonium nitrates contained in fertilizers are easily soluble, which allows rainfall to carry them into run-off water and seep into water supplies, causing algal blooms and oxygen depletion in the water. Such effects devastate ecosystems and create ocean dead zones.

Research has also implicated nitrogen’s role in climate change, and it is critical that we take collective action to reduce it. There’s a lot of talk about carbon footprints, but we are only beginning to hear about the realities of our nitrogen footprint. As assistant professor at New York University, and recent visitor to the OECD David R. Kanter suggests, there is a need to better integrate nitrogen concerns in domestic policies and room in international law to include nitrogen. In fact, there really is no room to exclude nitrogen because we cannot afford the costs of reparation if we continue business as usual.

Kanter argues that nitrogen could be included in one of the most successful treaties in international law: The Montreal Protocol, where there was universal ratification by all 197 parties to protect against substances that deplete the ozone layer. The Protocol is a landmark of sustainable development and the principle of common but differentiated responsibilities. As nitrogen in the atmosphere contributes to ozone depletion, it is important that it is explicitly included.

Chemists often talk about balances, as so do bankers, and the financial world could provide us with some useful lessons, or stark warnings, about what happens when you get the balance wrong. Take the 2007-08 crisis in the United States for example. The big banks supported unrealistic subprime housing loans to people who would likely never be able to pay them off. This allowed people to purchase impressive homes and spend money they didn’t have for a time—until it all came crashing down. Long story short, reality set in and it put the entire US economy in turmoil, which escalated into a global financial and economic crisis.

What does this have to do with nitrogen? The first lesson is that the crisis was avoidable. Had realistic standards and regulations been put into place, the financial climate of 2007-08 would have looked drastically different.  The same is true for nitrogen: if we co-operatively manage nitrogen efficiency and minimise the amount of excess nitrogen emitted into the environment, we will drastically improve our social, economic and environmental conditions in the coming years. Policymakers must create regional specific strategies and policy instruments to implement these in international and domestic legislation.

Let’s not follow the example of the 2007-08 global financial crisis. Fiscally, we have seen how living beyond our means has serious consequences. However, government bailouts have enabled us to tolerate the idea that living beyond our means isn’t fatal. There has always been an eventual—although not always ideal—solution to our fiscal woes. However, the environment is less forgiving. We don’t have the luxury of requesting bailout replenishment from Mother Nature. Rather, let’s take the example of the Montreal Protocol which attests to the importance of co-operation and regulation to ensure environmental and economic stability and get things back into balance.

Useful links

Nitrogen oxides (NOx ) emissions and intensities in Environment at a Glance 2013: OECD Indicators

Nitrogen balance versus agricultural output in Towards Green Growth: Monitoring Progress: OECD Indicators

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