How governments can shift innovation risk through pay for success
When governments implement and scale innovative social programs, they face two large hurdles: funding the program and managing the risk. Although the pay for success (PFS) model addresses both—while spreading important principles and practices of improved performance management—shifting risk is how PFS adds significant value for governments.
Traditionally, if governments want to implement a new and potentially impactful social program, they bear all the risk of the program’s potential failure. Using evidence to identify successful programs helps defray—but doesn't eliminate—some of this risk. Risk of failure can discourage governments from pursuing the program altogether, particularly in the tight fiscal environments many governments face today.
In a PFS project, governments pay only for outcomes achieved. If a program fails to meet the goals agreed upon at the contract signing and as determined by an independent evaluation, the government is not liable to repay the investor and walks away with no loss. Only if the program meets or exceeds those goals is the government liable to repay the original investment plus a return to the investor, which varies based on the degree of success and the structure of that particular deal.
However, because PFS can be more complicated and even carry more costs than self-financing, governments should assess the risk of potential programs and their own risk tolerance before turning to PFS as a potential financing mechanism.
If the risk is negligible (e.g., the program is similar to a business-as-usual intervention) or irrelevant to the government (e.g., the government acknowledges and is prepared to accept the full risk of project failure on its own books), PFS may not be necessary. The government may wish instead to self-finance the program through its general budget or by issuing special bonds.
But if the risk of potential failure is an important factor—and perhaps the most important factor—in the government’s decision process, PFS may be worth consideration.
Because designing, negotiating, and implementing a PFS project can be complicated, PFS is not risk free. Indeed, there is a “risk” that a program will greatly exceed its targets and that governments will be responsible for large outcome payments. Governments should be aware that investors will typically expect higher potential payouts for programs with higher risk (i.e., less developed evidence bases). However, there are ways to manage and mitigate the risks that come with PFS, and the original risk of program failure is typically a larger and more unavoidable concern for most governments.
From a risk management perspective, PFS may be the best solution for governments because they pay only for outcomes achieved. In other words, through the PFS vehicle, risk for non- or underperformance is shifted to external funders and places governments in the enviable position of paying only for success.