The Equator Principles bring shareholder value, but the limits of the approach must also be recognised

October 24, 2006

With campaign groups putting increasing pressure on Equator Principle (EP) banks to take responsibility for the environmental and social risks of the projects they finance, there is a need to recognise the limitations that financial institutions (FI’s) face when implementing due diligence approaches.

In general it is certainly not a lack of commitment on the part of EP banks to managing these risks that causes the difficulties, and the vast majority have made an impressive effort in this area. A key factor is the limited ability of FI’ to influence project sponsors, and as the project progresses, to influence other parties such as construction contractors and workers. The main ways FI’s can exert their influence is either by refusing to finance the project, or by writing covenants in to the loan agreement that must be met prior to each draw down of the loan.

This is not to say that project sponsors are the weak link in the environmental and social risk management process, but there is a need to recognise that the maturity of sponsors varies considerably, with some demonstrating a far better understanding of the potential risks and recognition of the need for robust management approaches than others.

While FI’s and their advisors can help project sponsors to understand how to manage risks effectively, the onus remains on the sponsor to follow the guidelines and implement the recommended measures at the appropriate time.

Extracts from The Banker

Equator Principles
Oliver Balch reports on how environmental activists and bankers are entering a new era of understanding through the Equator Principles.

Shareholder value
Banks are increasingly conforming to the view that social and environmental risks pose a threat to long-term shareholder value. “Protecting our assets in a traditional sense is risk management and protecting shareholder returns,” explains Andre Abadie, head of sustainable business advisory at ABN AMRO. “So if we are financing potentially socially and environmentally egregious projects in far flung corners of the world, then we also have the commitment to ensure that the social and environmental footprint of those projects is well managed.”

Limits of Environmental and Social Due Diligence

But the scope of non-financial due diligence has its natural limits. The financier needs to know the end purpose of the loan if it is to assess the environmental impact of its lending activities.

“If you’re advancing a corporate loan to a large company that is not being used specifically for a project, it is not going to be reasonable or practical to get that [environmental] information across all the projects that the company might be working on,” says Jon Williams, head of group sustainable development at HSBC in London.

Naturally, for some corporate or government loans, banks will be aware of a loan’s end use. The same is true for certain debt securities placements and underwritings, equity transactions and letters of credit. But one area where banks certainly have prior knowledge is, by definition, project finance. Consequently, this is where the banking industry has channelled the bulk of its efforts to date.

Extraneous limitations on due diligence
External, not internal, reasons limit banks’ environmental due-diligence efforts, many risk specialists argue. Short of calling in its loan, a bank’s influence over a project sponsor depends largely on delicate client management. The revised Equator Principles aim to add an extra safeguard by covenanting certain environmental commitments up front. They also require all high-risk projects to be assessed independently throughout the lifetime of a loan. Experience has shown that a bank’s ability to influence other actors can be even more limited than with their clients.

Chris Bray, head of environmental risk at Barclays, believes the Principles have sent a clear message that social and environmental issues represent mainstream business risks. More than that, the principles have shown banks their main environmental impacts derive from how they use their money. As Mr Bray puts it: “Equator has fairly and squarely put lending centre-stage.

HSBC’s approach
In the past three years, the UK-based bank has adopted a raft of environment-related policies and procedures. The list includes specific guidelines on dangerous chemicals, freshwater infrastructure and forest products. In May 2005, HSBC became the first major private bank to put its name to the World Commission on Dams. Within the next 12 months, it plans to add an extractive industry policy to its growing catalogue of green tape. Underpinning what HSBC terms its “restricted appetite” for environmentally sensitive transactions lies its environmental risk standard. Launched in 2002, the standard is designed to minimise the environmental, credit and reputational risk associated with the bank’s investments. Most of the procedural steps are straightforward. HSBC’s due-diligence register, for example, now features environmental impact assessments and reviews by external auditors.