Back to the Equator

In early July, the Equator Principle signatories published Equator II – their response to the International Finance Corporation’s new environmental safeguards. But what do the new principles mean for project finance? Oliver Balch investigates

Three years after their introduction, the world’s leading project finance houses have reached agreement on revisions to the Equator Principles. Published on 6 July, the revised environmental and social guidelines increase the scope and transparency of nonfinancial due diligence for cross-border project finance deals, the signatories say.

The revised Principles are a result of the International Finance Corporation’s (IFC) decision to update its own internal standards. Used as the basis for the Equator Principles, the IFC’s new standards are widely seen as “practical and sensible” by the Equator banks.“The IFC’s new Performance Standards are not seen as too onerous in the market,” says Chris Bray, head of environmental risk at UK bank Barclays in London.

The next stage for Equator – addressing project finance in Asia

Under the terms of the new standards, Equator banks will follow the IFC in requiring

future project finance clients to provide tougher reporting on greenhouse gas emissions, guarantees for community health and safety, and more comprehensive impact assessments. Other additions include stronger safeguards on biodiversity protection and new measures on the use of security services.

Equator participants have taken the IFC revision as an opportunity to undertake a wider appraisal of their own responsible investment code. Since the Equator Principles were launched, the number of its supporting financial institutions has increased from 10 to 41. In 2005, $49 billion in cross-border project finance fell under the umbrella of the Principles.

Two of the most significant changes to the Principles apply to its scope. The first affects project size.The new Principles propose incuding all project financings with total capital costs of $10 million or more across all industry sectors globally. The previous limit was $50 million.

The threshold was initially introduced to quieten fears that participating banks would find themselves facing a potentially unmanageable flood of projects to which the Principles applied.The flood never happened.

“Most infrastructure projects funded through project finance tend to be quite large, so we think that the actual practical impact of the reduction won’t be great,” explains Pam Flaherty, New York-based senior vice-president of global community relations at Citigroup.

The change should certainly please campaign groups, which have consistently argued that smaller projects can pose just as serious environmental and social risks as larger projects. The banks’ clients should also be happy. The consultation process for the new-look Principles proved that many companies are already applying social and environmental evaluations to projects of less than $50 million.

This change is expected to influence regional banks that deal with smaller structured finance deals.Typically, these might apply to hotel, construction or real estate projects. The new $10 million threshold, meanwhile, is designed to give reassurance to regional banks working on even smaller projects. Applying Equator to a real estate project of $3 million, these banks argue, would make the deal uneconomic.

“It was felt that it was an important message externally to stakeholders that we really did intend them to cover anything of significance in this area. Obviously, the goal of the Equator Principles is to establish a set of best practices for all project finance.This was a way of confirming that,” explains Flaherty.

The second extension in scope is the application of the Equator Principles to project advisory work. Under the revised terms, Equator banks commit to make their clients aware of the content and benefits of the Principles even before the financing stage.

“The focus is 99% on banks at the moment. But the banks are in the middle. Below that you have project advisory people, lawyers and management consultants, who are all involved in the project,” explains Martin Hancock, London-based chief operating officer of Australian bank Westpac and chair of the United Nations Environment Programme Finance Initiative.

The shift marks a logical step. Most banks involved in financing projects are also involved in the advisory process. For a bank to advise a client to go ahead with a project and then to withdraw at the financing stage because the project was deemed non-Equator compliant would, to quote one participating bank, be “highly embarrassing”.

Firms other than the participating banks that offer project advisory will be encouraged to endorse the Equator Principles publicly. The arrangement will remain an informal commitment given that the Principles refer only to project finance institutions, but most large project advisors are already citing the Principles, the Equator banks point out.

The remaining revisions do not represent any substantive alterations to the original Principles. Many constitute a clarification of language. Others cover technical considerations or possible eventualities unaccounted for when the Principles were first drawn up.

A notable example relates to the extension of an existing project. When such an extension involves a significant social or environmental risk, then the Equator Principles will now apply. The addition of a new turbine to a power plant would be a typical case in point. A straight refinancing deal, however, when not accompanied by any additional project changes, would not require the Principles to kick in.

The Equator banks have also used the revision process to introduce some efficiencies and safeguards into the project assessment process. It will now be taken as read, for example, that projects in high-income OECD countries which have already passed the planning process are considered Equator compliant.

“Where countries have their own well developed framework to manage social and environmental risk, we shouldn’t put the client through a dual process,” explains John Williams, head of group sustainable development at HSBC in London.

Meanwhile, social and environmental evaluations of all ‘Category A’ (high risk) and some ‘Category B’ (medium risk) projects must now be undertaken by independent consultants. Previously, company-led impact assessments were deemed permissible.There is also a new requirement that the obligatory community consultation process for higher risk transactions be subject to independent review.

“We’re bankers at the end of the day, and we need good consultants to advise us on those very difficult issues,” admits Williams, who concedes that the IFC’s capacity to undertake such assessments in-house exceeds that of private banks.

Pam Flaherty, Citigroup: "The goal of the Equator Principles is to establish a set of best practices for all project finance."

The Equator banks argue that the revisions represent an incremental step for the project finance industry. While some leading banks have already incorporated many of the changes into their existing internal policies, the Principles are premised on building an industry standard.That, the banks argue, means enabling the slowest to keep pace.

Some civil society groups, however, are already calling the revision process a “missed opportunity”. Transparency and accountability have traditionally occupied the top spot in their list of complaints. A recent report by campaign organisations BankTrack and WWF alleged that, on average, the Equator banks had worse disclosure records than their non- Equator peers.

One specific request that campaign groups have consistently made is for the inclusion of an independent ombudsman or some other form of complaints procedure. Previously, the Principles allowed no mechanism for affected communities to take their concerns to the financing banks directly. Under the revised terms, they still don’t.

Instead, the newly drafted Principles follow the IFC’s lead in proposing a “grievance mechanism”. The onus falls on the borrowing company to establish procedures to field project related community complaints. It is the project operator, according to the banks, which has the capacity and responsibility to deal with local concerns.

Critics say the measure does not go far enough. In response, the Equator banks argue that they are not public banks and therefore not subject to the same political considerations as public lenders, such as the World Bank or national export credit agencies. Furthermore, they say that a single ombudsman would be impossible to manage given that Equator now represents 41 independent financial institutions.

Johan Frijns, coordinator of Dutch nonprofit BankTrack, argues that the Equator banks are missing a trick:“From a risk perspective, it makes sense as an ombudsman would provide unfiltered, direct information from affected communities about what’s happening on the ground.”

In the absence of a complaints procedure, BankTrack and others have set about inventing one. The past few months have seen three Equator banks – ING, BBVA and Calyon – served with ‘Equator Principles compliance complaints’. Although the complaints have no official standing, ING subsequently withdrew from the contentious project in question (see Environmental Finance, May 2006, page 13).

The end of the revision process marks the second stage for the Equator Principles. Many banks report that they have been waiting to see how the long-awaited IFC changes impacted on Equator. Now that issue is settled, participating banks hope that more will join the Equator fold. A working group of Equator banks plans a structured outreach to non-participants for the second half of the year.

Particular emphasis will be put on international banks that have yet to sign up. Attention will also be focused on the emerging markets of China, Russia and India, where as yet no financial institutions have formally endorsed Equator.

Also on the table are discussions about the governance of the Equator Principles. At present, Equator is administered and managed on a voluntary basis by participants. Decisions are made on a consensus basis, with specific projects falling to working groups. Participants admit that steps to formalise Equator are necessary, but argue that this raises difficult anti-trust issues given that its advocates now oversee nearly 90% of all cross-border project finance.

Project finance, however, remains a small piece of the overall banking pie. Taking the lessons from Equator and applying them to other facets of private banking still represents the real quantum leap for the future, say NGOs.

Equator Principles: www.equator-principles.com IFC’s Performance Standards: www.ifc.org/ policyreview

Signing back up   One recurrent question during the Equator revision process was whether all 41 signatories would be prepared to sign up to revisions that would extend the scope of the principles. Activist groups that were critical of the International Finance Corporation’s Performance Standards argue that the new standards are unlikely to prove challenging to those that are already signed up to Equator – which is a sentiment shared by most leading project finance houses. As it happened, 33 of the 41 existing Equator signatories were in a position to affirm their commitment to the revised principles at the 6 July launch. Bankers closely involved with the revisions expect most current signatories to re-commit to Equator, although one or two that have pulled back from project finance may decide they are no longer relevant. For some of the others, they say, it is likely to be simply a question of time, in that they will have to pass the revised principles through internal approval processes. Jon Sohn, a senior associate at the World Resources Institute, an environmental thinktank based in Washington,DC, is unsurprised that so many signatories committed to Equator II: “It shows that banks believe that the Equator Principles are a good baseline for standards in project finance.These are real [social and environmental] risk issues, and banks not signing up to the principles aren’t taking these risks seriously enough. “And there’s a number of banks that we need to get on board – such as Chinese banks. If you’re not complying with Equator, you’re so far below the bar of minimum international standards,” he adds.