Equator Principles: Do they make business sense? by Abhijeet Deshpande

Equator Principles (EPs) seem poised to make a key contribution towards sustainable project finance lending and ultimately, safeguard investors’ interests.

In the late 1990s, ABN Amro was the target of a campaign by Friends of the Earth (FoE) for financing a mining project in Papua New Guinea that severely contaminated local water supplies. Realizing that there were no established principles to guide lending decisions for social and environmental risks, the bank approached the International Finance Corporation (IFC) with these concerns. Later, other major players in project finance joined the discussion and, on June 4, 2003, 10 banks announced the adoption of the Equator Principles.

EPs are a voluntary set of standards for determining, assessing and managing social and environmental risk in project financing. They are based on the IFC performance standards on social and environmental sustainability, and on the World Bank Group’s Environmental, Health and Safety general guidelines. The EPs apply to all new project financings globally with total project capital costs of US$ 10 million or more, and across all industry sectors.

In addition, while EPs are not intended to be applied retroactively, institutions will apply them to expansions or upgrades of existing projects in which changes may significantly alter the nature or degree of an existing environmental or social impact.

EPs also extend to project finance advisory activities. In these cases, institutions commit to informing the client of the content, application and benefits of applying the Principles to the anticipated project, and request that the client communicate its intention to adhere to the requirements of the EPs when seeking subsequent financing.

Banks and institutions adopting these principles are referred to as Equator Principles Financial Institutions (EPFIs). To date, 70 financial institutions, covering about 85% of the project finance market globally, have adopted the EPs.

Many events and factors drive the establishment of this standard and growth in its adoption rate. Through the 1990s governance efforts focused on promoting foreign direct investments (FDI) in the infrastructure sector, especially in the emerging markets. Following this, the project-finance industry itself grew many folds. This trend was accompanied by awareness in the realm of sustainability and a changing regulatory landscape for social and environmental issues in developing countries. Then, the two major economic crises of the 21st century (2001-2 and 2007-8) appear to have renewed industry’s focus on ethical business practices. Lastly and importantly, the campaigns by civil society organizations (FoE, BankTrack, etc.) spurred financial institutions to adopt the EPs in order to mitigate their reputational risk.

EPs are not without their share of criticisms. They have been targeted for improper governance and lack of transparency. The EPFI Secretariat was established in London as part of efforts to improve governance. The Principles were reviewed, updated, and re-released as EP II in 2006.

EPs have also been dubbed as a marketing ploy. However, in one empirical research report, Banking on the Equator, 2007, authors Bert Scholtens and Lammertjan Dam at the University of Groningen observe: “We do not find support for the view that adoption of the Equator Principles is merely window dressing, since there are at least some costs involved, and there are many project finance banks that do not adopt the Principles.”

One of the principal findings of the paper Banking on the Equator is that “shareholders did not react negatively to the announcement of the adoption of the Equator Principles.” It also notes that a key characteristic of participating banks is their large size. Further, a quick glance at the list of participating banks reveals that many of them are from the developed world. Perhaps it is safe to infer here that shareholders may not react negatively if the EP-adopting bank happens to be a large entity and from a developed country.

The response from emerging markets and countries-in-transition has not been so warm. In 2008, Dr. Nachiket Mor, Presidentof the ICICI Foundation for Inclusive Growth, while addressing an IFC seminar in Mumbai noted the market perception about EPs: none will adopt if all fail to adopt, as early movers risk losing business. However, Dr. Mor also noted that banks face the risk of project suspension or even closure if environmental risks are not managed. He recommended regulatory direction from the central banks.

Therefore, it is vital to address the loss-of-business concerns (as noted above) and adopt an industry standard to manage social and environmental risks at an early stage of project financing. In fact, adopting a benchmark may prevent government and regulatory interventions at later stages of projects and mitigate the risk to projects’ revenue streams. The mitigation of reputational risk is perhaps a positive externality of adoption. A concerted initiative using industry associations that encourage all players in a particular geography to adopt the Principles might help. In addition, early movers could offer value-added EP-centric advisory services. And again, it is important to note that EPs apply only to projects that top the $10 million mark in value.

Finally, many banks have adopted EPs under Corporate Social Responsibility (CSR) initiatives. This may be due to a firm’s preference to separate the costs of adopting the principles from its core operating costs.

However, defining EPs as CSR assumes that their adoption is not for the sake of the immediate interests of the firm or shareholders, but rather for a broader social good. It is worthwhile to note here that the large infrastructure undertakings to which EPs tend to apply inherently carry social and environmental risks which, if left unattended, could translate into reputational risks to the lender. Furthermore, the nature of project finance is such that the lender typically has little or no recourse to the assets of the borrower, and it is critical for the lender to ensure that nothing (including social and environmental risks) threatens the project’s revenue stream. Clearly, a firm’s reputation and the projects’ revenue stream do not fall within the category of a broader social good: their protection is a direct and immediate concern for investors. It follows then that an action to safeguard these cannot be classified as CSR.

Irrespective of the accounting practice (CSR vs. non-CSR) used to adopt them; EPs are fulfilling an important role in protecting both investors and the communities affected by the projects.

The author, Abhijeet Deshpande, is an independent researcher and analyst focusing on the areas of policy and finance in the energy sector. He holds an MBA from The Energy and Resources Institute in New Delhi. E-mail him at abhijeet48@yahoo.com.

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