Equator Principles Global In 2003, several of the world’s largest and most well-known financial institutions announced their adoption ofthe Equator sustainability ‘Yearbook 2004 Equator - Risk and Principles, a set of guidelines for use by lenders to ensure projec they finance are developed in a manner thats socal responsible ‘and environmentally sound. The possible implications of this development for global projec finance are explored, and guidance is ‘undermining, sutainable development has come ‘under increased scrutiny in recent yeas, prompting borrowers to address the environmental and social ‘impact oftheir activites. From the perspective of bankers, such measures reduce credit risk, protec and ‘enhance firm reputation, and farther busines generation ‘efforts. For there and other reasons several of the worlds Jargest and most well-known financial institutions pledged ro follow the Equator Principles a framework {or use by lenders in financing projects developed in 2 socially responsible manner reflective of sound ‘environmental management pracices.” With the mumber ‘of banks adopting the Equator Principles expected 10 expand, their decision to apply such standards could have significant implications, pacculaly in the context of oil and gas exploration and production, utes, Inydroelectric facilities, timber, ageiculture, and mining projects in the developing world. Thus, the framework ‘may inexorably become the norm. T: role of project finance in enhancing, or “® THE EQUATOR PRINCIPLES, ‘The Equator Principles comprise a biseline framework for implementation of internal envitonmental and social procedures and standards for project financing activities. Adopters ofthe Equator Principles pledge to apply them co dtect project loans with a toral capital cost of US$50m or more, globally, across all industry sectors, Their origins can be traced to 2 2002 meeting ‘of banks on environmental and socal isues in project finance convened by the International Finance Corporation (IFC), which would ultimately play 2 key role in che initiative. Announced in June of 2003, the offered on implementation and strategy. By William L. Thomas of Pillsbury Winthrop LLP [Equator Principles provide a standardised way of assessing projects based upon several IFC and World Bank policies and guidelines. For financiers, adoption cof the Equator Principles likely will entail adoption or refinement of environmental srategies in such areas a5 {interval controls, nancial and credit risk, public relations and marketing. Borrowers secking financing from thete banks should factor these guidelines into the design and execution of thei projects “> COMMITMENTS BY FINANCIERS. ‘The Equator Principles would have banks undertake a carefal review of proposals ffom customers requesting project financing. Asan inital matte, banks would ‘categorise projects in accordance with internal guidelines based on the environmental and social screening criteria of the International Finance Corporation (IFC). (EP 1) Projects are placed into one of three categories (A, indicating high risk B, indicating medium risk, or C, indicating low risk) depending on the type, location, sensitivity, and scale of the proposed project, and the nature and magnitude of its potential environmental and social impacts. (EP 1), ‘Category A is for projects considered likely to have significant adverse environmental and human population impacts that are sensitive, diverse ot tunprecedenced (such asthe relocation of a heavily populated village due to the construction of 2 hydroelectric project)” Projects thought ro pose potential for less adverse environmental impacts on human populations or environmentally important areas ‘would e placed in Category B. Such impacts ate site= specific, tend not to be irreversible, and are more Project Fnance IntemationalEquator Principles Glob: susceptible to mitigation than Category A projects (uch asthe construction of a coal-fired power project with environmentally protective equipment and located at the coal fields in a minimally populated area). By contest, Category C covers projects likely 0 have minimal or no adverse environmental impacts (uch asthe installation of a wind power project in a ‘mountainous region). In the cae of Category A and B projects, the bank is asked to satisfy iself chat the key environmental and social issues identiied during the categorisation process ate properly addressed in an Environmental Assesment (EA) provided by the borrower, including the project’ ‘overall compliance with applicable World Bank and IFC Pollution Prevention and Abatement Guidelines EP 2 and 3) In the case of Category A projects, 2nd "as considered appropriate for Category B projec”, the Equator Principles call for the borrower (or 2 third party expert) to prepare an Environmental Management lan (EMP) responsive tothe conclusions of the EA. (EP 4) Banks would then review the EMP to ensure that it adequately addresses mitigation, action plans, ‘monitoring, and management of risk The preamble t0 the Equator Principles sates that adopting banks “will not provide loans directly to projecss where the borrower will not or is unable to comply with our ‘environmental and social policies and processes” ‘Significantly, in the case ofall Category A projects, and ‘certain Category B projects, the Equator Principles requite that a bank satisfy iself that the borrower (or third party expert) has consulted in a meaningful way ‘with afected groups, inclading indigenous peoples and local NGOs: (EP 5) The FA and the EMP are to tke account of such consultations. In the case of Category A projects, the EA and EMP would also be subject to independent expert review: It remains to be seen, however, who will carry out such a review, what timelines will be adopted forthe review, and what recourse there will be for potentially affected persons. Another question still to be clatified involves the circumstances that should lead 2 bank to appoint 2n independent environmental expert to provide additional monitoring and reporting services. (EP 7) ‘The Equator Principles sate only that such steps should be taken when necessary. Finally. in the area of financial and credit risk, the Eqoator Principles anticipate that borrowers will enter into covenants to comply with the EMP during construction and operation of the project, provide regular reports on compliance with the EME, and decommission facilities in accordance with an agreed Decommissioning Plan, EP 6). In circumstances where a borrower isnot in compliance with such covenants, and cherefore in potential default, che bank most Yearbook 2004 ‘engage the borrower in is effors to achieve compliance. (EP 8) The Equator Principles do not sate ‘that such covenants should be disclosed. + IMPLICATIONS FOR PROJECT SPONSORS In order to ensute acces to project Snancing fom banks tha have adopted the Equator Principles, borrowers and project sponsors shoulé anticipate the need to comply with the bank’ pplication of those principles. This analysis would ental in the ee of. Category A snd B project, the competion of an appropriate EA addresing,to the bank’ stsfaction, ey eovionmental and social sues dented in the project categorisation proces. (EP 2) An EA fora Category A project will examine potential cwironmental impact, compare chem with those of feasible alternatives, and recommend preventive, mitigating or compensatory measures. An EA fora Category B project is relatively narrower in scope Hostever it ako will examine potenal negative and positive envizonmental impacts and recommend measures needed to prevent, minimise, mitigate, oF compensate for adverse impacts and improve ‘environmental performance Matters to be covered by EAs for Category A and Category B projects include: 4 An asesment of baseline environmental and socal conditions, ‘¢ Requizements under host country ws and regulations, as well as apliable international conventions ‘Sustainable development and use of renewable natural reoure ‘ Protection of human heath cultural properies, and biodiversity. inchuding endangered species and (Use of dangerous substances ‘Occupational health and safer; (Fire prevention and lie afer + Socioeconomic impact 4 Land acquisition and ws: 4 Involuntary sewement; ¢# Impact on indigenous peoples: ‘Cumulative impace of exsing projects, the proposed project, and anticipated future projects « Pariipation of affected paris in the design review, and implementation ofthe project: ‘ Consideration of feasible environmentally and socially preferable alternatives + Bficient production, delivery and wse of energy «# Pollution prevention and contrl;and 1 Waste minimisation and management. (EP 3). The Equator Principles aso require the BA to address compliance with applicable hose couritry laws, regulations anal permits required by the project, 3s well as adherence tothe svininntm standards applicable Project Finance international‘under the World Bank and IFC Pollution Prevention and Abatement Guidelines. For projec in low and ‘medium income countries, IFC Safeguard Policies also apply. (EP 3) The Equator Principles sate that an adopting bank must satisfy itself that the BA adequately addresses the projects overall compliance with, or {usted deviation() from, such guidelines and policies (EP 3) While borrowers already may be obligated t0 perform clements of such an assessments under local Jaws or the policies of international financial institutions, the Equator Principles exceed most ‘requirements in requiring the consideration of such ‘matters 38 social standard, international conventions, and consultation. ‘The borrower aso can anticipate being asked to “undertake environmental management planning, consult with affected groups,and agree to enter into certain covenants in is financing documents. In Category A projects and as appropriate for Category B projects the borrower (ora third parey expert) will be asked to prepare an EMP that responds to the conclusions of the EA, and that addresses mitigation ‘measures, action plans, monitoring protocols, and risk ‘management. (EP 4) Similarly in connection with all Category A projects and certain Category B projects,a borrower will ind it necessary to establish to the bank's satisfaction that it (ora chind party expert) has consulted in a meaningful way with affected groups ‘This consultation process includes making the EA, or 3 summary thereof, available to the public for a reasonable period of time, in the local language, and in 4 culturally appropriate manner. Ie may also require publication of notice thereof in one or more local language newspapers. The EA and the EMP must account for such consultations and, in the case of Category A projects, will be subject to independent expert review: (EP 5) Lastly, borrowers should anticipate being asked to enter into covenants in the financing documents to comply with the EMP during construction and operation of the projec, to provide regular reports on compliance with the EMP, and ‘where applicable, decommision facilities in accordance ‘with an agreed Decommissioning Plan. (EP 6) ‘Sponsors that fil to anticipate such lender expectations ‘ould lter find themselves confionted with delays and additional costs ‘Asa result ofthe Equator Principles, borrowers and sponsors will need to be informed, prepared, and flexible regarding their responses to environmental and social project impacts. This means planning carefily 3t the design, development, and term sheet stage, and building i fexibiliy so that if more rigorous standards than expected are ultimately applied, the project will not founder. Obsaining accurate and timely market knowledge ftom advisors concerning the expectations pda thomsonibcom cof projec financiers wil he critical. Success could also epend on the borrowers capability, and resources, to analyse such issues under dynamic conditions “® IMPLICATIONS FOR LOAN SYNDICATION Ik remains to be seen precisely how, and to what extent, the Equator Principles will impact loan syndication and space does not allow for 2 nuanced evaluation of such prospects here. General ifthe broader syndication market embraces the initiative, it ‘would prove substantially more significant, However, before the Equator Principles are widely adopted, oan syndications are likely to be affected by the dynamics berween banks who have adopted the principles and those that have not. Challenges alo may le ia coordinating the potentially divergent internal guidelines developed by adopting banks to implement the principles. ‘When acting as agents in loan syndications, Equator Principles banks are well positioned to apply their internal environmental and social guidelines in due diligence and negotiations with a borrower, lead the rafting of financing documents to include covenants of the borrower to comply with such guidelines, monitor compliance by the borrower inform the other banks in the syndicate of any noncompliance and, if appropriate, join with the majority of banks in the syndicate to declare a borrower in default due to noncompliance. Banks ating as agents have in the past ‘employed some degree of social and environmental risk assessment in their evaluation of projects and incorporated covenants in financing documents regarding compliance with laws. However, the Equator Principles ae a comprehensive and visible initiative that adopting banks must adjust to and incorporate into thet existing practices. Thus, early in a projects term sheet stage, Equator Principles adopters acting 8 agent banks must inform project participant, including Dorreners and banks that are potential participants in a syndication, ofthe agent bank's adoption of the [Equator Principles and the proposed guidelines for implementing those principles multiple Equator Principles banks are involved in a syndication, they must coordinate and resolve conflicts in the application of internal guidelines developed to implement the principles. Ie could be important, for ‘example, whose implementation guidelines contol. If it ehe lead bank, what happens to those in the syndicate that have adopted arguably more rigorous procedures? Its posible that more rigorous standards ‘would prevail, since chs ensures compliance with ‘guidelines forall banks. Its also possible, however, that 2 sponsor might opportunistically exploit a divergence in standards, depending on the complexion of the Yearook 2004 13Equator Principles Global syndicate and the relative power of the banks exacting higher standards. Transpatency could become important, s Equator Principles and non-Equator Principles banks strive to develop implementation standards appropriate to individual projects yet responsive to markesplace demand, ‘The complexity ofthe loan syndication increases when potential syndication participants are non- adopters Equator Principles banks wil likely inss that any bank {ining 3 lom syndication involving an adopting bank ‘must conduct due diligence according to the terms of the principles, whether or not that bank had adopted the Equator Principles. Ifso,some banks could choose not to participate in a syndication led by or cherwite involving Equator Principles banks. It remains tobe seen whether non-adopting banks and other project participants opt ‘out of projects applying Equator Principles-based guidelines toa greater extent than they otherwise would had diferent ot leser social and environmental guidelines been followed. Its shown that application of uch standards will ental additional costs, Equator Principles adopters may come under pressure fom non-adopting banks to beara greater share of this burden Undoubtedly, there will continue to be a market for banks which do not adopt the Equator Principles However, banks that are adept at communicating with project participants regarding the implementation of the Equator Principles and encouraging non-adoprers {o participate in syndications for projec implementing those principles will be critical to che success ofthe Equator Principles. Similarly, such banks will reduce the size ofthe market for non-adopters, “9 MAKING GOOD ON A PLEDGE The efficacy of the Equator Principles ulkimately and largely will depend on the manner in which they are implemented by the banks - a process now beginning Financiers long have had ample incentive ro account for their customers environmental performance by taking proactive measures in the aeas of personne) Joan analysis and monitoring, lan documentation, customer relations, and transparency, among other areas" Implementation of the Equator Principles will involve the application of environmental, social, and risk management tools and techniques to complex and ‘often highly-contested projects in remote parts ofthe lobe. Even the mos sophisticated banks will find changes and refinements necessiry. “® ASTEP IN THE GREEN DIRECTIOI Thus fa, Sily positive. The number of Equator Banks nearly has doubled since the launch of the initiative in June of action to the Equator Principles has been ‘eabook 2004 2003. However, some of the major players remain in the wait and see camp, Similarly, adoption ofthe Equator Principles has not ended the criticism by some NGOs of project financiers performance visi-vis sustainable development, 25 the tensions over Camisea served to illustrateTo the extent that concerns have ‘been levelled ¢ the subsaance ofthe Equator Principles, the debate has tended to centre on whether the initiative will achieve projects thae are more ‘environmentally and socially sound. While some stakeholders have expressed reservations, most ‘embraced the announcement as a noteworthy accomplishment. sampling ofthis debate follows. ‘Sope ~ Some observers contend the application of the Equator Principles to projects of US850m o greater is too limited. The framers ofthe principles counter that the threshold is justified given the types of projects that are most likely o eause environmental and social adverse impacts Accountability ~ Multilateral financial insiutions (MEI), such as the World Bank, have begun to establish accountability mechanisms, no such formal mechanism exists under the Equator Principles. Defenders of the [Equator Principles atert its unrealistic to expect they will have the me resources devoted to project preparation, monitoring and evaluation. Pechaps this limitation can be overcome by enhanced coordination and partnership on project finance with MFIs and bilateral financial institutions (BF), such a export credit agencies, or by new cost-effective tools developed by MFls and BFIs and shared with private Financiers. Short of such mechanisms, banks may find it productive ro explore with affected groups and stakeholders whether there are appropriate vehicles for disclosure regarding implementation of the Equator principles. Consistency - While the Board members of the MFIs and BFls come ffom roughly the same governments, ‘making coordination and harmonisation of policies ‘more feasible, the leadership and managers of Equator Principle banks nacurally wll diffe. This fact could present challenges for borrowers and arrangers alike. ‘This concern should diminish over time with experience, provided financiers consciously seek to coordinate with one another and with project sponsors and borrowers, and consistently apply the Equator Principles. Monitoring and enforcement ~The ability to monitor and enforce compliance may be a challenge for banks that lack the personnel, expertise, and resources to work effectively with local governments and communities. Afierall,some have contended, even the arguably bewer-staffed MPls and BFls occasionally nd it dificule to effectively monitor and enforce ‘environmental and social standards, Equator Principle ‘banks, and other financiers incerested in playing a role Project Finance tnterrationalEquator Principles Global 16 Yearbook 2004 in projects in environmentally sensitive areas, likely will confront such issues, The IFC could prove a crtical factor in helping train private financiers i the necessary precepts and techniques. Further, the entire Gnancing community could colaborate to develop new procedures, eg, guidelines for the use of independent, qualified auditors and experts (Cast - Proponents of the Equator Principles argue that application ofthe standards will reduce risk and enhance, or at leas protect, frm brand and reputation If the Equator Principles are widely adopted, these benefits may well accrue, but compliance could entail additional costs, eg, for studies, mitigation and ‘monitoring, etc, for both bank and borrower. In the short run, there may be some forum shopping by sponsors and borrowers secking to avoid paying 3 premium for the added incremental transaction costs associated with Equator Principles compliance. Proponents can reduce such prospects by developing lear, efficient implementation procedures. ‘Banks adopting the Equator Principles, and their stakeholders, can be expected to continue to reflect on these and other concerns in search of solutions and a better path forward. Ifthe Equator Principles differ ffom other initiatives, such asthe Collevecchio Declatation on Financial Institutions and Sustainability’ the UNEP Statement on the Environment and Sustainable Development,’ ot ‘the London Principles of Sustainable Finance? ‘theic inherent value remains. In fac, the Equator Principles are superior in moving beyond aspiration language to concrete implementation steps for banks to follow in addressing social and environmental project risks. If adopted and implemented in an effective, eficient manner, the Equator Principles ‘could provide a consistent mechanism to enhance ‘consideration of sustainable development in private project finance. This fact per se represents a material change in mind-set which, given the volume of activities to which it applies, could have a major impact in such decisions. ‘One of the strengths ofthe initiative i its Gexibiliy. As such, i leaves financiers room to employ a range of techniques depending on such variables as che rype/term of financing, geographic location, prior efforts, types of impacts, and the ike, With that Aexibilty however, comes added uncertainty and Increased transaction cost. These factors could keep some bank from adopting the Equator Principles until clearer standards emerge. Unless and until a patern of practice emerges at an applied level, financiers adopeing. the Equator Principles, and those wishing to transact busines: with them, will eich need to be as open, rect, and consistent as possible, “@ CONCLUSION A borrower’ ability co manage environmental and social considerations can determine the viability and profitability of a wide range of projects. Banks that fail to weigh and address such factors could be overlooking significant credit and reputation risk, let alone the potential costly project liability that might arise from an environmental mishap or miscalculation which then adversely affects the lender. These risks may be reduced by obtaining better disclosure of environmental performance fiom borrowers and sponsors, and by taking a closer look at the environmental and social footprint of projects. The nexus between financial services, investment, nd sustainable development is steadily becoming evident. The Equator Principles reflect a growing awareness ofthis nexus and could lead to projets that are better not only fo the financial sector, but aio forthe environment and human health and welfare “> FOOTNOTES ‘The sthr thks Michi! 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