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You’ve probably heard about the massive global funding gaps for climate and biodiversity action.

While climate finance has grown rapidly in recent years, reaching an estimated USD 146 trillion in 2022, we still need about USD 7.4 trillion a year to meet global climate goals.

When it comes to reversing biodiversity loss and protecting nature, the annual funding gap is about USD 700 billion. Meanwhile, almost USD 7 trillion is invested each year in activities that directly harm nature.

This imbalance is especially worrying for low- and middle-income countries (LIMCs), many of which are highly vulnerable to the impacts of the climate, biodiversity and land degradation crises.

Yet it’s proving difficult to increase investment in positive solutions. Public budgets are already stretched thin, especially as Global North governments slash aid, while private investors often see faster and/or higher returns elsewhere.

To change this, the public and private sectors need to work together, leveraging each of their particular strengths against the other’s limitations. One way to do this is through blended finance.

In this explainer, we break down what blended finance is, how it works, who’s involved, the challenges it faces, and what can be done to scale it up – so that more money flows into protecting nature rather than destroying it.

What is blended finance?

Blended finance is a way to encourage private investment in sustainable development projects by ‘blending’ public or philanthropic funds with private capital.

These funds are willing to accept lower returns and take on the bulk of the risk. If an investment fails, they’re the first to take the hit – thus making these projects less risky and more attractive to private investors.

Why is blended finance important?

Simply put, public funding alone isn’t enough to meet global climate, biodiversity, and development goals – especially in LMICs.

Private investment could fill much of that gap, but investors often see these projects and regions as too risky.

These risks can be financial (like inflation or credit risks), political (such as weak investor protections), or technical (for example, a lack of infrastructure or experience).

That’s where public and philanthropic funds come in, offering a ‘cushion’ to absorb these risks.

For instance, as we cover in our sustainable finance explainer, these funds can take on the role of ‘junior equity’ – meaning they’re the last to receive a payout if a company they’ve invested in goes into liquidation. That means private investors get paid first and are more likely to get their money back.

By making these projects and regions less risky, they aim to attract private capital that would not otherwise have been willing to invest in them.

Who provides blended finance?

There are a wide range of development actors involved in providing blended finance.

Public funds are contributed by governments through official development assistance (ODA), multilateral development banks like the World Bank, and other international financial institutions like the International Monetary Fund (IMF).

Many philanthropic organizations also chip in with their own philanthropic funds.

These public and philanthropic funds are then mixed with regular private investment to create blended finance.

How does blended finance work?

Blended finance improves the risk–return balance of investments by helping create markets, demonstrating financial viability and pooling resources.

It involves a range of tools, including:

Equity: Investors take partial ownership of a project or company and share in its profits after debts are paid off.

Debt: Loans or bonds are offered at better-than-market terms to make projects more viable.

Guarantees: Public or philanthropic funds provide insurance against risks like non-payment.

Grants: Non-repayable or interest-free funds help projects reach the ‘investment-ready’ stage.

First-loss capital: Public or philanthropic funds absorb early losses, protecting private investors.

Technical assistance: Support such as training, equipment, infrastructure and feasibility studies is offered to strengthen project quality and reduce risks.

For blended finance to succeed in the long term, experts say it must focus on providing additionality – mobilizing new private capital and delivering meaningful development impacts – while minimizing concessionality, meaning public funds should stay as close to market conditions as possible.

What are some challenges facing blended finance?

Despite its promise, blended finance has not grown as quickly as proponents have hoped.

A recent report from the OECD Development Assistance Committee (DAC) describes the field as “a cottage industry with largely bespoke and fragmented interventions, as well as lack of standardization and transparency.”

One key challenge it notes is that blended finance is meant to be temporary – it helps build markets under imperfect conditions. But for lasting impact, governments and partners must also improve the broader investment environment by reforming institutions, policies and regulations.

As the climate crisis deepens, the financial sector is also exposed to greater risks, making investors more conservative – particularly in areas where those impacts hit hard.

In the light of numerous damning exposés of purportedly climate- and biodiversity-friendly projects in LMICs in recent years, greenwashing is also an ongoing concern – inflicting reputational damage on those who invest in maligned projects.

How can we scale up blended finance?

Action will be needed in several arenas to scale up blended finance to the levels we need.

For one thing, it requires larger projects to be developed with trustworthy vehicles to attract big investors. That requires building effective alliances and partnerships at the international, regional, national and local levels.

Education and advocacy is also needed to ensure that all actors and potential investors understand the long-term value of nature-positive investment – and, in turn, the reputational and profit risks of investing in ecologically damaging activities.

LMICs and their partners also need to lay the groundwork for ongoing investment. This includes clarifying and securing land tenure, earmarking national funds for nature-positive initiatives, developing safe and supportive physical and technical infrastructure, passing enabling policies and regulations, and implementing these with effective monitoring and enforcement.

For instance, in the Amazon, the true ‘bottleneck’ for investment is not financial tools like subsidies and tax breaks but rather governance and law and order, said Leonardo Letelier, CEO of Brazilian impact investment firm SITAWI Finanças do Bem, in an interview with #ThinkLandscape.

Each landscape, political economy and sociocultural context is different and requires its own specific blended finance approach. Yet, it’s also important to find enough commonalities to attract private sector investment under diverse conditions.

As former Global Environment Facility (GEF) program director Gustavo Fonseca explained at a previous GLF investment case symposium, uncertainty is anathema to markets: if blended finance can give investors confidence that the basics have been covered, critical and scalable projects across the Global South may finally get the backing they deserve.

After all, there’s plenty of demand for environmentally and socially ethical investment options: according to a report by Morgan Stanley from earlier this year, nearly 90 percent of global individual investors are interested in sustainable investing, and 59 percent intend to increase their sustainable investments over the coming year.

Whether that’s because people see these investments as a safer bet in the long term, or simply because they prefer to invest their money in ways that match their values, it’s a promising sign.

Now, it’s simply a question of providing green investment opportunities at the scale that investors – and the planet – are demanding.