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The paper offers an independent contribution to the European Union’s (EU) internal discussions on its future mechanisms for the complementary use of grants and loans (blending).  Although led primarily by a team of researchers at the Overseas Development Institute, comments and written inputs were provided by the European Think-Tanks Group.

The study reviews the existing EU blending mechanisms, comparing their different governance arrangements, drawing lessons from each, and considers the pros and cons of possible future governance options for blending operations.  However, whilst blending has emerged rapidly and is now common practice in development finance, there is currently a limited evidence base on the effects of blending. Whilst a sizeable literature exists about the theoretical use of loans and grants, there is little on how it works in practice, which methodology or procedure works best and whether a certain governance model is more effective in reaching its objectives. 

Blending mechanisms, when adding grants to loans, aim to achieve a number of objectives, including the need to increase the volume of development finance in a context of constrained resources.  Compared to pure loans, blending mechanisms allow for:

1. making transfers to heavily indebted countries without exacerbating debt overhang problems (although in practice in the EU blending mechanisms, the grant share in total loans and grants is often below 5-10);
2. addressing positive externalities to bring the financial rate of return closer to the economic rate of return for projects with a high socio-economic and/or positive environmental impact; and 
3. improving the quality of funded projects.

The study shows that all of the EU’s blending facilities have similar structures.  They all have a strategic body providing policy direction, a decision-making body deciding which projects should receive grants and a group of financiers screening proposals and providing technical analysis before forwarding select proposals to the decision-making body.  The researchers were unable to pinpoint any large differences in operational outcomes as a result of a different internal governance arrangements. There is, however, a discussion possible on the principles which may help to inform the best possible governance option for EU blending mechanisms, for example: 

• The need for a fair arbiter in order to avoid potential conflicts of interest between eligible Finance Institutions;
• The need to ensure a “policy driven” screening of grant requests based on development policy objectives;
• The need to keep a separation between the policy and technical aspects of the grant award process (donors vs. Development finance institutions);
• The need for transparent and formal checks and balances on the proposals of project financiers at early stages.