The new European Commission (EC) policy of ‘differentiation’ aims to recalibrate its development cooperation with middle-income countries (MICs), and introduces two significant changes: (1) new aid allocation criteria; and (2) differentiated development partnerships for different categories of countries. Differentiation will be applied in two stages of aid allocation: firstly, in terms of eligibility to bilateral development aid (this is new), and secondly, in terms of aid allocation at the programming stage.

Under current proposals, grant-based bilateral aid administered through geographic programmes will be cut from 19 countries from 2014 onwards. Countries will graduate if classified as upper-middle-income countries or if they have a share of global GDP greater than 1%. Other factors will be considered, including the Human Development Index, the Economic Vulnerability Index, aid dependency, economic growth levels and foreign direct investment.

Differentiation will currently be applied to just one EC development instrument – the Development Cooperation Instrument (DCI) which funds 46 countries from Latin America, Asia, Central Asia and the Middle East, as well as South Africa. Under current proposals, around €3.1 billion could be potentially be freed up from 2014 to 2020 through this policy. The funds saved through differentiation will be reallocated to the remaining 27 countries in the DCI. 15 of these countries are categorised as least-developed countries (LDCs), other low-income countries (OLICs) or fragile states.

This ODI working paper explains the EC’s new policy and looks at its implications for developing countries. The first section defines the features of the new policy, while the second section shows how it impacts on what countries receive in grant-based aid from the EC. The third section analyses six key challenges that the EC should consider in the design and implementation of the new policy:

1. Poverty focus. The DCI instrument has a low poverty focus according to country poverty analysis. In 2010, 31 of the 46 DCI countries were classified as MICs, while 15 were LDCs or OLICs. 57% of the geographic funds in 2010 were disbursed to MICs, compared to 43% disbursed to LDCs or OLICs. Differentiation should improve the country poverty focus of the DCI, depending on where the funds are reallocated to. However, as more OLICs graduate to MIC status, all donors face a potential decline in country poverty focus.
2. Poverty focus is affected by how it is measured. The EC’s new policy relies on country poverty analysis and therefore does not address the people poverty debate. According to people poverty analysis, the DCI has a high poverty focus – an estimated 71% (954 million) of the world’s poor lived in the 46 DCI countries in 2009. The 19 countries that will receive less aid after 2014 had an estimated 79% (751 million) of the DCI’s poor in 2009.
3. Transparency. There is currently no explanation of how the different measures included in the criteria are to be weighted. So, although the aid allocation criteria are outlined, the formula for country selection is not clear.
4. Predictability of flows. The potential scope of differentiation is currently unclear, as there is little information explaining when and how this policy could be extended to other countries in the DCI and to other EC development instruments (in particular the European Development Fund).
5. Reallocation of funds. It is unclear where the potential €3.1 billion funds saved will be reallocated to. The absorptive capacity of the countries likely to receive more funds should be evaluated.
6. Aid darlings and orphans. Many donors are now cutting aid to MICs and prioritising OLICs, LDCs and fragile states. If these decisions are made without an evaluation of other donors’ policies, there is an increased risk of creating aid darlings and orphans.