Principled finance?

The sight of protestors outside of WestLB's New York offices was the most visible sign of the latest meeting of projects and protest ? at least for the lenders. Activists had targeted the landesbank for its arranging role on the OCP project in Ecuador. The pipeline, sponsored by Occidental, Perenco, Repsol, Agip SpA, Pecom, Encana and Techint, enjoys the support of the Ecuadorian government, but not the World Bank, or environmentalists.

Such signs ? that the activist movement has moved behind sponsors to the banks that support them ? have been noted by project lenders. The result is an ambitious step by project finance lenders in using market power to prevent high profile projects from exposing them to reputational risk. Nevertheless, the banks involved are enthusiastic at the possibility of being taken seriously as environmental advocates.

The Equator Principles have been in the works since October 2002, when the International Finance Corporation invited a number of banks, ABN Amro and Citigroup among them, to present case studies on their experience in dealing with environmental risk. The opportunity came at a useful time for the banks, which have struggled, as with many market-wide issues, in creating a united front for action.

The objectionable projects generally fall into two categories ? large oil and gas pipelines through areas of particular environmental sensitivity and hydroelectric dams that cause widespread social disruption. Both require exhaustive consultation and environmental due diligence. Moreover, both usually require heavy support from export credit agencies and multilateral lenders.

There has been a marked decrease in dam activity recently ? Brazil has been the site of the most recent, relatively uncontroversial, projects. However, coming up is the Bujagali dam in Uganda, which is struggling against sponsor AES' financial woes as well as allegations of irregularity in the tender process. China's Three Gorges Dam used the China Development Bank as a financing vehicle, but Morgan Stanley attracted criticism for underwriting the bank's bonds.

Pipeline projects represent the bulk of recent activity, and include the Chad-Cameroon pipeline, the aforementioned OCP, and the Baku-Tblisi-Ceyhan project, which may approach lenders shortly. Chad-Cameroon is often held up by lenders as the high point to date of socially and environmentally aware financing, given that it included solid due diligence as well as a trust account for Chad's share of revenues, to be earmarked for social spending.

The project is still much disliked by activists, who charge that the pipeline will cause considerable disruption along its route. The next project likely to attract attention is the Camisea pipeline in Peru, on which the Inter-American Development Bank and Citigroup had been preparing a financing package. The banks would like to have a common environmental risk assessment framework in place before this and other contentious projects hit the market.

However, the process will be a difficult one, since many banks regard such risk assessments as both proprietary and individually tailored to a banks needs. There are echoes here of the struggle to present a common front in opposition to Basel II's regulations on capital adequacy levels for project finance. Adopting voluntarily rules in what is, after all, a market will be a fraught process.

The first means of mitigating this risk is to adopt a set of guidelines that are well-respected and reasonably neutral. The International Finance Corporation (IFC)/World Bank rules are the nearest thing to a common standard, although arguably not the strongest standards. Some would say that the US Ex-Im rules are unusually strong, while participants in InterGen's Bajio project in Mexico have less-than-fond memories of complying with the IDB's standards.

One complication in adopting the guidelines is that banks cannot formally sign up to them. The IFC treats its own guidelines as proprietary and looks dimly upon projects with which it is not involved claiming adherence to the rules. Therefore, the Equator principles function something like an ideological special purpose vehicle ? banks sign up to Equator, which in turn bases its guidelines on the IFC process.

The document uses unusually strong language ? the preamble states that ?we will not provide loans directly to projects where the borrower will not or is unable to comply with our environmental and social policies and processes.? Indeed the preamble's aspirational language might strike some readers as a little lofty.

The main steps in the creation of the principles have been taken by four banks ? ABN Amro, Citigroup, Barclays and WestLB ? with Chris Beale, Citigroup's global head of project and structured trade finance, and Richard Burrett, ABN Amro's project finance head, being the key players. According to Beale, ?project banks play an important role in development projects around the world, and particularly in the emerging markets. Environmental risk is a credit risk as well as a reputational risk, and we believe that project banks have an opportunity to foster good environmental practice.?

The group also includes Credit Lyonnais, Credit Suisse First Boston, HVB Group, Rabobank, Royal Bank of Scotland and Westpac, and includes banks better known for their advisory and underwriting franchises. But it will eventually need to see whether not only the broader syndication market, but also the export credit agencies, institutional investors and bilateral and multilateral lending arms will sign up.

In the meantime, the core group has also reached out to non-governmental organisations (NGOs), the same groups that have been protesting and lobbying against recent investment decisions at the project banks. The meetings were apparently fruitful, and included groups such as the World Wildlife Fund (WWF), Friends of the Earth, and Environmental Defence. Nevertheless, word, and a draft version of the document, leaked out to the business press in April.

The NGOs' original welcome was cautiously warm ? it was apparent that they had not expected such a forthright proposal from the lenders. The interchange is best understood as the first skirmish in a public relations war that will ultimately shape how corporates and the public view the proposals. The Rainforest Action Network had been running television adverts in New York specifically targeting Citi ? the two have now agreed a ?truce? while they work on projects together. Likewise, one NGO has claimed the end of Citi's advisory mandate on the Camisea project as evidence that Citi is anxious to avoid sabotaging the principles' launch. Beale stresses, however, that the mandate expired in September 2002, before the banks began the Equator process.

The principles call for all banks to categorise the projects that they consider into three levels, A,B, and C. C represents a project with no or minimal potential environmental and social impact, while B and A represent much more serious potential impacts. C projects would presumably be those that stirred up little controversy, and banks would not require an environmental assessment (EA) from the borrower. B projects would need an EA, while A projects, and some Bs, would also require an environmental management plan, and evidence of a serious consultative effort with affected groups. Banks would list the numbers of projects in each category that they supported, ideally in a bank-wide corporate governance and social responsibility report.

The final significant aspect of the proposals is that loan documents would have reference to environmental responsibility, and would be covenanted so that borrowers would need to remain in compliance with any management plan described in the documentation. The banks' ultimate aim is that borrowers and sponsors would have done much of the relevant work before even going out to award a mandate.

However, NGOs and others have noticed a few loopholes, some of which were addressed in the periods between drafts. The most significant of these is that the guidelines, while originally covering emerging markets, are now global in scope. The second is that the guidelines only cover projects greater than $50 million in size. The Equator banks' argument is that such projects represent only around 3% of the project market and that, as one banker put it to the NGOs, ?you have to spend a lot of money to pollute the environment? (their response was not recorded).

Nevertheless, such deals represent a large number of, often contentious, small ticket resources deals, in particular mining. The IFC itself has received a large amount of negative coverage for its support of smaller mining operations. More recently, Barrick's Bulyanhulu project attracted strong levels of criticism from human rights campaigners. This last would have been covered by the guidelines, but smaller mining deals are often those that are less likely to need multilateral support because their tenor and size mean that they can secure political risk insurance in the private market.

A more serious paradox is on offer, however, one that explains the cautious stance of NGOs. The guidelines need to be tight enough to present a meaningful advance and draw the protestors' ire, but loose enough to encourage adoption and keep the corporates on side. Sponsors, remember, have been forced to confront criticism for much longer than banks, and have not only their own environmental guidelines, but their own means of rebutting adverse comment.

While the guidelines will not add appreciably to transaction costs, if only because the majority of deals already use many of the risk mitigation steps outlined there, they may alter project economics. The temptation for banks to break in front of powerful sponsors will be strong, or, as one banker put it, ?will they take on ExxonMobil over QatarGas 2? I doubt it.? It will be possible for projects to shop around where environmental scrutiny is most to their liking, although almost all public sector institutions will have fairly stringent guidelines.

Another point made by supporters is that the larger sponsors already have some form of environmental monitoring in place, although opinions differ as to its effectiveness. Corporates such as BP have been effective in persuading consumers and some stakeholders that they are serious in monitoring their compliance ? shareholder activism has forced still others to take steps in this direction. As Richard Burrett at ABN Amro puts it, ?the principles should create standards that sponsors can live with, since most of the more sophisticated firms are doing this already.? It is likely to be the smaller, privately-held sponsors with less in the way of clout with banks and less form in being environmentally conscious, that will have to take Equator to heart.

Those at the less enthusiastic end of the spectrum of Equator supporters note that the deal will not cover bonds, and also that, given the nature of many commercial and investment banks, some projects will slip through the cracks ? ?it's not a panacea?, as one put it. Given the declining importance of project finance at some banks, and the fact that non-recourse debt will be offered on a one-off basis, mean that project finance heads will occasionally be unable to enforced the principles within their own institutions.

And it is in implementation that the banks will face the most serious challenges and criticisms. Michelle Chan, a US spokesman for Friends of the Earth in the US, cautiously welcomes the proposals but has doubts about the effectiveness of implementation. ?The IFC safeguard policies are a good place to start,? she says, ?but the IFC has around 30 people working on this. I'm not sure that banks have the people to look into this effectively.? Chan believes that an independent auditor or ombudsman, a neutral arbiter of adherence would be a good place to start, but banks will be wary of policing mechanisms that infringe on their independence. As such, the NGOs would be wary of offering the banks a strings-free public relations boost.

Likewise, the IFC has to carefully circumscribe its relationship with the Equator Banks. According to Suellen Lazarus, head of syndications at the IFC, it does not envisage its role as enforcement, but more in terms of educating the banks on how to apply the safeguards. Nevertheless, she is gratified by the enthusiasm of the banks, saying ?it's a recognition that the IFC has guidelines that have worked over time, so the principles are an affirmation of what we've been doing.?

The arrangers make a strong case for the positive effect that a few banks can have on the business ? the core group of 4 alone corner about 17% of the bank debt market, and the full group holds 30%. Their effect on projects on which they either do advisory work or are part of a club syndicate is probably higher. As Burrett at ABN Amro puts it, ?any bank joining a loan syndication by an Equator bank will be buying into due diligence done according to the principles. We can't force banks to adopt them, but think that the principles are a useful way of ensuring that institutions go through the necessary steps.? There is no question that banks would refuse to do business with an institution that did not sign up, and the essential sanction at work is that not signing up will make a lender look bad.

Nevertheless, as both Beale and Burrett say, the guidelines will have a public place where banks will be able to state their willingness to adhere to the principles. Moreover, they will be a useful way for activists and stakeholders to call lenders to account. Disclosure of details will be patchy, but will offer affected communities a way to voice concerns knowing that some of the larger institutions will be wary of lending to contentious projects. The principles may even become the de facto standard for all international project lending ? an embarrassment to ECAs that have so far been unable to come up with meaningful common standards.

As this article went to press, the banks and the IFC were set to hold a press conference to announce the launch of the principles (for more details as they emerge, see Deals and Developments this issue). From then on starts the slog of carrying banks and NGOs in opposite directions ? that the principles are meaningful, but adaptable enough to fit lenders and sponsors.