Equator Principles Large Group Discussion

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Equator Principles Large Group Discussion

• Professor Doug Cerf
• Donald Bren Graduate School of Environmental
  Science and Management
• Environmental Risk Management (ESM 286)
• Winter 2008

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Fundamental questionWhat problems are the
Equator Principles trying to solve?
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• How do you foster economic growth and increase
  the quality of life without
• damaging the environment,
• compromising the human rights of some or
• jeopardize cultural traditions?
• How do you avoid/manage risk (environmental,
  social and political)?

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The Dilemma

• There has been an increase in economic
  development as a result of increase in large
  projects (500 million or more) in recent years
• Large projects in developing nations where
  environmental policies are either in their
  infancy or ignored by government authorities are
  particularly susceptible to causing environmental
  or social harm (creating environmental risk)

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ExampleChad-Cameroon Pipeline Project

• Economic growth to the west coast of Africa
• Threatened the areas fragile ecosystem
• Forced relocation of a number of the areas
  indigenous people
• Case for next time

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Equity in benefits and costs

• There is asymmetric distribution of the benefits
  and costs when environmental and/or social
  degradation occurs form a large project
• Costs accrue to the host country and local
  citizens
• Benefits accrue to the project sponsors and
  financers
• It is difficult to quantify the costs related to
  environmental and social degradation
• Sponsors may pay to minimize the environmental
  and social costs and risks
• Sponsors may benefit from managing the
  disruption

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Which parties should bear the environmental and
social risks?

• Theory risk should be allocated to parties that
  best able to control the risks.
• Possibilities
• Host government
• Project sponsors
• Lenders

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Which parties are best able to control
environmental and social risk?

• The sponsors (e.g. construction contractors) are
  best able to control the risk because they have
  the power to eliminate or remove the risk
• Short term risk
• Example peoples livelihoods as a result of
  being displaced
• Long term risk
• Example air pollution from the project facility

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Sponsors motivation to mitigate the environmental
and social risk

• They are not charged for the degradation
  therefore have little economic incentive to take
  action
• They are particularly concerned if the
  environmental damage will delay successful
  completion or operation of the project
• This is different than for firms that are in it
  for the long term
• Example air pollution for a firm owned refinery
  versus air pollution from a project finance new
  power generation facility where the sponsor
  leaves after the project is on-line

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Are private banks responsible for sustainable
development?

• Banks in question are private banks that
  participate in project finance.
• Do these banks through their lending practices
  contribute to environmental and social
  degradation?
• Analogy Banks have responsibility under the
  superfund law

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Private banks involvement in large projects

• Banks provide
• financial advisory services to project sponsors
• help arrange project financing
• provide portion of project debt
• Unlike the project sponsor banks do not play a
  role in conceiving, promoting or managing the
  large project
• Banks have an incentive for projects to be
  successful because some fees are dependent on
  successful completion
• Banks fees are dependent on timely completion

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Private bank risk

• Banks consider environmental and social risk as
  credit risk because the degradation could lead to
  project interruption which could impact
  collection of interest and fees
• Banks consider environmental and social risk as
  reputation risk because of the risk of being
  involved in harmful project.
• Can impact banks other lines of business such as
  consumer lines

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Private bank responsibility

• Should banks be held accountable for sustainable
  development given sponsors have few incentives to
  promote sustainable development?
• Possibilities.
• Fully responsible (i.e. retroactive, joint and
  several liability similar to superfund law)
• Somewhat responsible because they were party to
  the deal.
• Not responsible
• Students should vote and provide justification

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Non government Organizations

• A non-governmental organization (NGO) is a
  non-profit group or association that acts outside
  of institutionalized political structures and
  pursues matters of interest to its members by
  lobbying, persuasion, or direct action. The term
  is generally restricted to social, cultural,
  legal, and environmental advocacy groups having
  goals that are primarily noncommercial.
• There are 29,000 international NGOs
• The US and India each have approximately 2
  million NGOs

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The World Bank

• The World Bank Group is a group of five
  international organizations responsible for
  providing finance and advice to countries for the
  purposes of economic development and poverty
  reduction, and for encouraging and safeguarding
  international investment.

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The NGO impact on large projects

• The likelihood that projects financed by private
  commercial banks will go bad has increased in
  recent years because of the actions and the
  growing sophistication of NGOs.
• The World Bank has sustainable development
  mandates
• Private banks involved in large projects did not
  have sustainable development guidelines

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Will Equator Principles help solve the problem of
environmental degradation?

• Theoretically, if the principles promote
  sustainable development, the NGOs will cease
  their attacks
• Concerns about Equator Principles include, scope,
  implementation, enforcement
• Student vote Do you think equator principles
  will help promote sustainable development?
• If not, why not.

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Equator principle issues

• Narrow scope
• Impact a small percentage of the projects
• Principles apply only to project finance loans
  5-10 of total capital expenditures
• Remainder uses corporate finance
• Does not apply to project bonds 10-20 of
  projects
• Only applies to projects of 50 million or
  more14 between 1997 and 2002 were below 50
  million
• NGOs do not approve of the coverage of human
  rights
• There arent any no-go zones (location where
  projects are forbidden)

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Equator principle issues

• Inconsistent implementation
• No industry wide implementation guidelines so
  banks must develop their own internal guidelines
• Limited enforcement mechanisms
• Voluntary compliance program
• Have voluntary compliance programs worked in the
  past?
• Degree of transparency is limited
• Without explicit reporting requirements
  stakeholders will not know if banks are
  implementing the principles or how effective they
  are
• Free rider problem of banks that adopt the
  principles but do not implement them (fully)

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Equator principle issues

• Equator banks claim that principles would not
  dramatically change the approach to environmental
  and socially risky projects
• They already have internal policies for this
  purpose
• Are these best practices principles or a least
  common denominator principles?

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Reasons why Equator Principles will work

• Represents a major step in the right direction
• Adequate scope
• Increase in the use of project finance
• About half of all projects over 500 million used
  project finance
• Project finance investments have reached 132
  billion in 2002
• The 10 original equator banks arranged 31 of all
  the project finance loans in 2002
• Principles will affect 100 billion in global
  investment over the next 10 years

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Reasons why Equator Principles will work

• Implementation flexibility
• Principle establish a common baseline
• Banks can implement internal policies that are
  superior to the equator principles
• Banks can determine the policies that work in
  their organization
• Flexibility should benefit implementation

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Reasons why Equator Principles will work

• Adequate enforcement
• Free riders will not impact the benefits of
  participating banks
• Risk reduction measures will be part of the loan
  covenants and therefore will be enforceable on
  the sponsors

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What should the banks do next?

• Marketing--Existing equator banks recruit non
  equator banks
• At some point if there are enough banks involved
  the principles become an industry standard (one
  the original objectives)
• Should they target lead arranging banks
• Four of the top lead arranging banks have not
  adopted
• Should they target banks in other areas of the
  world besides US, Europe and Australia where the
  originating banks reside?

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If you were a project finance banker and received
a call would you adopt the principles?

• Reasons to adopt the principles
• Prevent project interruptions and derailments due
  to NGO opposition
• Minimizing environmental risk leads to
  minimization of credit risk
• Cooperation minimizes reputation risk
• Even if the bank already has internal principles
  equivalent or superior to equator principles
  there may be reputation benefits by being
  associated with Equator Principles
• Required by some development banks that require
  similar principles

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If you were a project finance banker and received
a call would you adopt the principles?

• Reasons not to adopt the principles
• If you are not a bank that is being scrutinized
  by the NGOs adopting the equator principles may
  bring attention to you and result in a negative
  reputation impact
• Original banks suffered from negative reputation
  impact from the NGO spotlight
• Competitive advantage because non participating
  banks will put less requirements on the project
  sponsors (borrowers)
• Why adopt the policies if they are flawed.
• Difficult to compete with regional banks in parts
  of the world where lenders are not equator banks
  (Asia, Latin America, Middle East)

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Should equator banks work on implementation?

• This strategy will buy the banks some time from
  NGO criticism
• Engage NGO during the implementation process
• This comes with the risk that the NGOs will want
  too much
• NGOs will have difficulty being critical of a
  implementation process they are involved in
• How do they select the NGO(s) to engage?

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Case Questions

• What problems are banks trying to solve by
  adopting the Equator Principles? How do banks
  contribute to this problem? Will the Principles
  solve the problem?
• Why are the NGOs criticizing the Equator
  Principles? Is their criticism valid?
• What should the Equator banks do now marketing
  (encouraging other banks and ECAs to adopt the
  principles), implementation (develop policies and
  procedures), or damage control (respond to the
  NGO criticism)?

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Case Questions

• If you were a banker would you adopt the Equator
  principles?
• How will history judge the actions taken by the
  Equator bankers? Will the Equator Principles be
  seen as a bold step towards achieving sustainable
  development, a negligible step with long term
  impact, or simply a public relations stunt?