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Finding principles that fit

The leading Equator Principles banks face huge challenges in reaching consensus on the latest reforms to the financing standards.  Their proposals have much to commend them – but there is room to go further, says Suellen Lazarus

Oil sands exploitation: posing challenges for the Equator banks

The steering committee guiding the redrafting of the Equator Principles (EPs) has faced a daunting task. With limited resources, under conflicting pressure from both inside and outside the group, and dealing with some of the world’s most complex environmental challenges, the EP Association has demonstrated finesse in negotiating the third iteration of the principles.

With the public comment period having ended in October 2012, the Equator Principles Financial Institutions (EPFIs) are now reviewing comments and finalising the draft. It seems timely to identify the strengths of the draft and urge the EP Association, which manages, administers and develops the Eps, to push harder in some areas.

Globally, 76 financial institutions are adopters of the Eps, a framework that they apply to assessing and managing environmental and social (E&S) risk in their project finance business. The EP standards are based on the International Finance Corporation (IFC) Performance Standards, which were updated in January 2012. In anticipation of that revision, and with the accumulation of experience since the Eps’ last revision in 2006, the EP Association embarked upon an update process in 2010, referred to as EP III.

The landscape in which the EPFIs are operating has become more complicated since 2006. Some of the major players in project finance are gone and others have left the market. They have been replaced by EPFIs in geographies as diverse as Morocco, Mauritius, and Mexico. While this diversity illustrates the success of the principles, with it comes more complexity. Communication, varied implementation capacity, access to skilled advisers and consistent application are just a few of the challenges.

In the energy sector, new technologies have emerged that require increased scrutiny and raise climate change issues, particularly extraction of oil from tar sands and hydraulic fracturing. Meanwhile, the emergence of new powerhouses of project finance in India and China raises issues of coverage. In 2011, India represented about one quarter of the project finance market, with two Indian banks among the top ten loan arrangers. To date, no Indian bank has adopted the Eps. China’s Industrial Bank remains the only Chinese adopter. Better coverage of these fast-growing markets must be an EP priority.

Against this backdrop, it is not a surprise that it took considerable time for the EPFIs to agree on the draft that was released this past August. The EPFIs and their 13-member steering committee are a collegial group with longstanding relationships, many of which were forged when the Eps were first developed in 2002. Its members take pride in the professional bonds provided by this group and the opportunity for competitors to cooperate for the benefit of the planet.

Nonetheless, the one-year drafting period suggests that these were tough negotiations. Prime credit for the heavy lifting must go to the two steering committee chairs who managed the process. Shawn Miller at Citi began the strategic review and oversaw much of the EP III drafting process, while Leonie Shreve at ING, who assumed the chair in May during the final drafting, will engineer its rewrite following the comment period, and its adoption.

If it looks like a duck … A breakthrough in the draft is the first time inclusion of project-related corporate loans under the Eps. This is a welcome progression beyond the current definition of project finance. To paraphrase: if it looks like a project, and acts like a project, then it must be a project. With this addition, individual project-like assets financed by different financial products will at last be treated in the same way.

The proposed coverage limits for project-related corporate loans are complicated and high, with a minimum loan amount of $100 million, a minimum individual bank exposure of $50 million, and a loan tenor at least two years (see box 1). This minimum level is in contrast to the minimum capital cost for project finance of $10 million.

At the $100 million limit, will banks capture most of their high impact project-related corporate loans? The case needs to be made. Project-related corporate loans do present complexities in assessment, covenants and monitoring. And a large volume of small, fast-disbursing assets would quickly swamp a risk management team. But the exclusions create room for manipulation and should be monitored carefully.

You can’t manage what you don’t measure

The draft represents substantial progress in EPFI reporting. Growing from a brief footnote in EP II, Annex B of EP III now sets out reporting requirements in detail. This more robust approach specifies more complete data reporting, as well as project-specific reporting, including the release of project names at the time of financial close. The disclosure of project names has long been requested by NGOs and is an important component in building trust and transparency. Clear requirements should improve the quality and consistency of EPFI reporting. An EP Association annual report would be helpful, too.

Client reporting requirements are also strengthened. In addition to public disclosure of their environmental assessments, clients are expected to release their environmental and social management plans, “except in cases where the borrower does not have a company website.” My advice to the banks: These clients are borrowing millions of dollars from you. Ask them to build a website. I would also encourage the disclosure of annual project monitoring reports. This would promote both compliance and careful attention by EPFIs to these reports.

Evidence of grappling with a changing climate

The EP Association made a commitment to grapple with climate change in EP III. But climate change is a tough issue for a global organisation with members in more than 32 countries. While making progress, the difficulties are apparent in EP III, Annex A.

The draft states that projects emitting in excess of 100,000 tonnes of carbon dioxide annually would be required to conduct an alternatives analysis of options to reduce greenhouse gas emissions. Upon completion of the analysis, “the borrower will provide evidence [my emphasis] of technically and financially feasible and cost-effective options” to reduce emissions.

The language is unusual in that it draws from the text of the IFC’s Performance Standard 3, but alters it. The IFC asks the client to consider alternatives, and to “implement [my emphasis] technically and financially feasible and cost-effective options to reduce … emissions.” For EPFIs, what happens to this “evidence” of options once provided? The word “implement” is assiduously avoided.

Projects producing carbon emissions above 100,000 tonnes annually would also be required to publicly disclose their emissions, which is good. The IFC provides for reporting at the 25,000 tonne level, although such reporting is not public. Is it judicious to follow the principle of incorporating IFC’s Performance Standards, but retrench from the standards in the climate change area? Moreover, EP III would benefit from an explicit commitment to address the challenges of climate change.

May we or Should we?

One of the objectives of the revision was to provide more clarity on issues where there has been confusion or inconsistent application. The treatment of projects in high-income OECD countries, where national standards may be substituted for EP standards, was an area that needed clarification, and care has been taken in EP III to provide this. The draft emphasises that projects in high-income OECD countries require application of the EP framework, and delineates the areas in which national law may be substituted (box 2).

But, where national standards are below international standards, the draft states that individual EPFIs “may, at their sole discretion” apply additional requirements. Substitution of national standards is not intended to replace prudent E&S risk management. If an EPFI finds that national law does not provide adequate risk management, then it should benchmark the project against an internationally recognised standard.

Paying for value

Beyond the complexities of managing a large group, the length of this revision process probably has something to do with insufficient resources. The EP Association employs an effective secretariat, but otherwise has no dedicated resources. The members of the steering committee and working groups are E&S managers with full-time day jobs. This hands-on experience is a strength of the EP Association, but resourcing has reached a tipping point. EP dues are stubbornly low for reasons that are not clear, considering the value for money they represent.

At two years and counting, the update process is far from complete. Once adopted, a series of work products will be needed to implement the changes and achieve the objectives of the revision. They include:

  • Preparing guidance notes on climate change and EP reporting requirements;
  • Revising the EP governance rules to update adoption requirements for new members and delisting standards for existing members;
  • Introducing an assurance standard to guide independent audits of EPFI internal implementation processes; and
  • Developing training materials and online toolkits to support a global network.

A modest increase in EP dues, raising the level to the cost of joining comparable associations, would allow the EP Association to deploy professional expertise to facilitate its agenda.

Does one size still fit all?

EP membership includes global banking conglomerates and small, emerging market national banks, export credit and development agencies, insurance companies and investment banks, and spans from Canada to South Africa.  The breadth of its membership makes me wonder about the one-size fits all approach.  In the store, I always give a wide berth to those clothes tagged, “one size fits all”, knowing that it usually means “one size fits no one very well.”

With Equator’s overarching objective of leveling the playing field among financial institutions on E&S issues, the EP Association has worked hard to maintain one standard. But vastly different capacities, ambitions, operating environments and national requirements mean that uniformity may have resulted in the bar being set lower for all.

A tiered membership approach, with a good base entry standard, would allow those banks that are able to achieve higher E&S objectives to do so under an agreed framework at a higher tier. In an area such as climate change, having an agreed EP standard would be a great service to the industry. As it is now, individual EPFIs do push further, but each in their own way, and this does not help in levelling the playing field.

To conclude, there is much to commend in this draft. The EP Association has achieved many of its objectives in clarifying and streamlining the Eps, in making a commitment to respect human rights, in incorporating corporate loans, in strengthening reporting requirements, and in starting to address climate change. They have negotiated hard and long and respectfully.

The Eps remain the shining example of financial institutions taking collective responsibility for improved environmental outcomes. But because they have set the standard in this field, expectations are high that signatories continue to innovate and push the envelope. As they undertake the final redraft of EP III, I encourage them to push a little harder.

Suellen Lazarus is a Washington, DC-based independent consultant who, together with Alan Feldbaum of ERM, conducted the recent strategic review for the EP Association. She was the director of syndications at the IFC and a senior adviser to ABN Amro.

Environmental Finance

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