The role of governments in social innovation

The 2008-2009 financial crisis left us with, among many others, two relevant sequels.

The first is government budget constraints. Traditionally, governments were geared to supply the needs of the population. For many, that has been their role and their justification for existence. The financial crisis has turned this paradigm upside down because governments’ new tight budgets have significantly limited their ability to be the continued supplier for needs such as health, housing, credit, education, food, etc.

The second is that the crisis provided us with clear, unequivocal evidence that we need to change. For the required change to happen, we need to find new models. And finding new models means one thing: we need to innovate.

Social innovation tackles these twin issues simultaneously. Social innovation’s “mission”, if you want to call it that, is to explore market solutions and eventually to create new business models that address social needs and problems. Let’s take low-income housing as an example. Instead of the traditional approach of government writing a check, social innovation is the process of creating new business models that facilitate access to housing for low-income families. This approach lowers the demands on government budgets thanks to the creativity and innovation of entrepreneurs seeking to solve a social problem in a sustainable way.

At the centre of this approach you need innovation. And with innovation you have risk. This creates a big challenge in the post-financial crisis world, which has become much more risk averse. To break this obstacle, governments have a vital role to play. Government needs to create the right incentives for private investors, philanthropic foundations and civil society actors to be willing to take those risks.

I do not believe that government should lower risks for investors – such structures create perverse incentives. But what governments can do is improve investors’ potential returns. What is off balance from investors’ perspective is the risk-adjusted return – when the perceived risk is high, investors will only be willing to invest if and when the potential returns are high. The issue is that since these innovative business models are serving lower-income communities, investors do not believe the potential returns can be high.

A government could take an approach similar to what the Israeli government did to motivate investors to invest in venture capital, which at the time was perceived to be very high risk with no proven financial returns. Under the Yozma investment scheme, the government invested alongside private investors, and the investors had the benefit of the upside of the funds invested by the government. This added incentive pushed investors’ potential returns and therefore balanced their risk-adjusted returns. With this new equation, investors were then willing to invest.

Every investor is looking for a project that can tap into a large market where there is a great need. That is precisely what the bottom of the pyramid is: an enormous population with huge, unmet nets in education, health, housing, sanitation – you name it. The need for innovative approaches is critical and the potential for returns is there. What we don’t have are investors willing to bear the risk of developing such innovations under the current risk-return framework. But if we can open investors’ eyes by increasing their potential returns, we will open the floodgates for capital markets to fund social innovation at scale.

Author: Álvaro Rodríguez Arregui is Co-Founder and Managing Partner of IGNIA Partners, Mexico and a member of the World Economic Forum’s Global Agenda Council on Social Innovation and Co-Chair of yesterday’s Social Innovation Summit

Image: People crowd a street in Ciudad del Este, Argentina REUTERS/Jorge Adorno