The Equator Principles Association (EPA) has published a report prepared by consultants ERM on the outcome of the Strategic Review of the Principles. The report sets out key findings and recommendations that will inform the process to update the Principles (the EP III Update) which is due to commence in the second half of 2011, and is intended to ensure that the Principles remain the "gold standard" in environmental and social risk management in financing.

The EPA has also published a summary response to the report indicating that some of the more minor recommendations will be adopted immediately, but that most will be taken forwards for further discussion and agreement by the EPA membership. Both the report and the EPA's response will be of significant interest to financial institutions which have adopted the Principles, or are considering adopting them in future, as well as project sponsors seeking to finance qualifying projects.

The EPA III Update will include public consultation and stakeholder engagement. A draft of the revised Principles will be provided to stakeholders by the EPA for a period of at least 60 days for comment.

The Principles comprise a set of voluntary social and environmental guidelines, adopted by 72 financial institutions to date. They provide a credit risk management framework, and impose a minimum due diligence standard, for determining, assessing and managing environmental and social risk in project finance transactions. Financial institutions that have adopted the Principles apply them where total project capital costs exceed USD$10 million.

The Principles were launched in 2003 by the International Finance Corporation (IFC), and were revised and replaced in February 2006. The Strategic Review was launched in October 2010 to evaluate the challenges and successes of the Principles, identify strengths and weaknesses in the current framework, and prepare for the update of the Principles later in 2011.

The IFC's performance standards, which are incorporated into the Principles by reference, have been reviewed and revised recently. On 12 May 2011, the IFC's board of directors approved the updated standards, which include new measures to enhance energy and water efficiency and target greenhouse gas reduction, and take into account the complexities of supply chain management by requiring clients to assess whether their primary suppliers are contributing to the degradation of natural habitats. The revised IFC performance standards are available here.

The report proposes a widening role for the Principles, beyond project financing and recommends changes to the EPA itself.

Specific recommendations

Regarding the Principles, and how they are applied, the report sets out 26 specific recommendations, including improvements relating to:

  • transparency;
  • the definition of "project finance";
  • implementation of the Principles;
  • membership; and
  • coverage issues.

Transparency

Report findings

Reporting on the implementation of the Principles by financial institutions is inconsistent and limited, data is hard to obtain and cannot be aggregated or verified.

Report recommendations

  • Raise disclosure requirements.
  • Establish an independently managed league table of implementation by financial institutions.
  • Develop a detailed standard for consistent implementation.
  • Eliminate the one year grace period on implementation reporting for new adopting institutions.
  • Develop an assurance standard that can be used to audit implementation processes.
  • Publish an annual report of implementation achievements and challenges.

Project finance

Report findings

The definition of "project finance" in the Principles is broad and, as a consequence, the term has been interpreted inconsistently between institutions. In some cases, projects with challenging environmental and social issues have been disguised as corporate loans such that institutions can avoid applying the the Principles to those transactions. In other cases, the Principles have not been applied because the project in question has been financed on a hybrid basis, or because the financing uses an innovative or atypical limited-recourse structure.

The Principles are increasingly being adapted and applied to other financial products voluntarily. On one hand the extension of application of the Principles is a welcome development, evidencing that institutions are increasingly seeking to uphold environmental and social standards in all aspects of their business. However, the consultants express a concern that inconsistent application of the Principles to other products may confuse the Principle's brand. Conversely, one might think that the application of a gold plated standard to a wider range of finance techniques, on a voluntary basis, is achieving exactly what institutions like the IFC and other stakeholders would like to see.

Report recommendations

  • Extend the scope of the Principles to encompass not only financing of a special purpose vehicle set up to develop an asset on a non or limited recourse basis, but also corporate loans where 50% or more of the funds are being used to finance a "single asset" (this still leaves open the question of whether a corporate loan to finance a portfolio of assets would be captured).
  • Develop guidance notes for other financial products to which the Principles are being applied.

The EPA has emphasised that there will be a full discussion around the feasibility and practicality of extending the Principles to corporate loans and to explore any alternatives.

Implementation

Report findings

Implementation of the Principles by financial institutions is often inconsistent; at the due diligence stage the application of the Principles is front-loaded and, notwithstanding regular reporting obligations required to be included in facility documentation, in practice ongoing monitoring is limited. In some cases Category B projects (medium risk projects with more limited adverse social and environmental impacts) are not given as sufficient treatment as Category A projects (high risk projects with potentially significant adverse social or environmental impacts that are diverse, irreversible or unprecedented) even taking into account the different risk levels.

The EPA is keen to ensure that a deeper understanding of the Principles is embedded within the transactional teams of financial institutions so that those responsible for negotiating the financing terms are not wholly dependent on external consultants for guidance in applying the Principles.

Report recommendations

  • The EPA should make a systematic effort to promote knowledge sharing between members, develop training materials, guidance notes on the use of consultants and set up a Best Practices Working Group as well as regional workshops.
  • Develop an assurance standard that can be used to audit implementation processes and de-list institutions that fail to meet this standard.

Membership

Report findings

Entry criteria for institutions are low and unverified and there is no requirement for executive management to be engaged in the adoption and implementation of the Principles. There is a single-tier membership category which does not distinguish between institutions based on their capacity and ambitions. Attempts to expand the geographic application of the Principles lack focus; banks and clients outside Europe and North America have less awareness of the Principles and in China and India different regional priorities and capacity limits affect the level of desire for institutions to adopt the Principles.

Report recommendations

  • Revise the membership criteria to require demonstration of an institution's capacity to implement the Principles when they are adopted and require executive management to commit to the Principles.
  • Develop an outreach strategy to target India, China and other priority markets.
  • Introduce tiered membership to reflect varying levels of disclosure and/or product application.  

Coverage issues

Report findings

Financial institutions are addressing coverage limits in IFC performance standards on climate change, thermal power and nuclear power in different ways and would benefit from a common approach. Some high income OECD countries, or sectors within these countries, do not necessarily have environmental, social and regulatory standards which are adequate to cover individual project risk.

In addition, some institutions may not be following the Principles when assessing environmental and social risks in high-income OECD countries in the mistaken belief that local law requirements in those countries will always exceed the environmental and social standards set out in the IFC performance standards and World Bank Group's industry guidelines on which the Principles are based.

Report recommendations

  • The EPA should actively consult with the IFC to facilitate the incorporation of the perspective of the Principles on climate change, human rights and biodiversity into the IFC performance standard update.
  • If coverage issues remain a problem in the revised IFC performance standards, incorporate a policy statement into the preface to the Principles which indicates a commitment to addressing these risks.
  • Perform a gap analysis for a number of high-income OECD countries to determine the difference between the standards required by the Principles and national and provincial/state requirements.
  • Develop guidance on the treatment of projects in high-income OECD countries to ensure that environmental and social risks are managed thoroughly.

Next steps: Updating the Principles

The process to update the Principles is expected to start in the second half of 2011. More information on the Strategic Review, and the report published following conclusion of the Review, is available here.

The report and the EPA's response need to be considered alongside a number of new standards that have recently been introduced or will be adopted in coming months including the "Protect, Respect, Remedy" Framework and guidance for negotiators developed by Professor John Ruggie, the United Nations Special Representative to the Secretary General on Business and Human Rights, the new OECD Guidelines on Multinational Enterprises and ISO 26000 Guidance on Social Responsibility.