The Equator Principles: Soft Law in International Project Finance

By Willi Künzli, Assistant Contributor

A group of ten financial institutions agreed in 2003 on a set of principles to guide their lending policies on international project financing. They named this set of rules the Equator Principles (“EPs”) which reached its third version ten years later, in June 2013. Another sixty-eight financial institutions worldwide have joined the Equator Principles since its initial adoption. Even though the number of financial institutions is not high compared to the overall number of lenders in project finance worldwide, financial institutions that adopted the EPs represent a significant portion of financed amounts, among which are Citibank, Credit Suisse and HSBC.

EPs’ overall purpose is to prevent its members (identified as Equator Principles Financial Institutions – “EPFIs”) from financing any project that does not meet the outlined social and environmental standards. EPs are based on the International Finance Corporation’s performance standards on social and environmental sustainability as well as the World Bank’s environmental, health and safety guidelines. EPs became the industry standard to assess social and environmental risk.

EP originated in response to an increasing demand from Non-Governmental Organizations (“NGOs”) for the adoption of specific standards and policies in international project financing with the aim of increasing social and environmental standards primarily because financial Institutions are key players in any project finance structures. They have the power to impose certain standards that other players involved may not have (e.g., local communities, employees, indigenous people affected by the respective project, environment protection NGOs etc.), or even may not be willing to impose for fear of losing investments, such as local governments. Any project that depends upon lenders to obtain the necessary resources for its development has to comply with the EPs if it intends to obtain the funds from any EPFI.

EPs standards and requirements increased during the last decade. As the World Bank and the International Finance Corporation’s standard for assessing social and environmental risks increased, the EPs also developed to achieve this new level of requirements and standards. EPFIs are now going through a transition period from the second version (“EP II”) to the third (“EP III”). EP III is the result of a draft presented in July 2011, which after a consultation process was implemented in June 2013. It will have to be applied to all new products as of January 1st, 2014. This new version of the EP III addresses major critics from NGOs and incorporates significant changes.

EP III adopted a broader scope of application and higher standards for transparency. Although the minimum amount involved in the project capital cost continues to be US$10 million, in addition to project finance loans and project finance related advisory services included in the EP II scope, EP III is also applicable to Project-Related-Corporate loans (subject to other specific requirements, among which is the total aggregate loan amount that shall be of at least US$100 million) and bridge loans with a loan tenor of at least two years. In respect of transparency, EP III elevated the minimum requirements of information that has to be reported to the public as compared to EP II, where only high level information was publicly disclosed.

EP distinguishes between countries with stringent laws on environmental and social welfare and others with less stringent ones. The countries that fall within the first category are defined as “Designated Countries” in EP III (EP II identified them as “high income OECD”).  Projects’ compliance with laws of Designated Countries automatically fulfill the EPs’ requirements related to environmental and social assessments , environmental and social management systems and plans, stakeholder engagement and grievance mechanisms. However, project developers must still present evidence of meeting other EP principles. In addition, EP III expressly states that the EPs contains minimum requirement that EPFIs need to adopt additional requirements at their sole discretion. This is important to leave space to address certain concerns related to specific industries, where the EPs may not be sufficient.

EPFIs are required to conduct a preliminary assessment of environmental and social risks to categorize the project. After this preliminary risk assessment, the relevant project is classified either under category A (significant risk), category B (limited risk) or category C (minimal risk). The project category of the project will dictate which minimum standards are required and which risk mitigation actions the involved parties have to adopt. EP II required certain covenants for compliance with environmental and social laws, regulations and permits in financing documents for project under category A and B, which are now applicable to all projects. Under EP III, all projects’  financing documents (irrespective of its category) must contain a borrower covenant that  comply with all relevant host country environmental and social laws, regulations and permits in all material respects. This change is in line with the flaws of EP II regarding projects with lower risk choosing to waive these covenants.

Another important facet introduced in EP III is a specific human rights due diligence. In limited high risk circumstances EP III suggest it may be appropriate for a borrower to complement its environmental and social assessment with a specific human rights due diligence. The human rights standards that this due diligence addresses are the UN “Protect, Respect and Remedy Framework for Business and Human Rights” and the associated “Guiding Principles on Business and Human Rights”. Notwithstanding the fact that the EP III does not provide a specific framework for this human rights due diligence (which are left for lenders and borrowers to identify and work on a specific framework based on the project’s specificities), it inarguably represents an advance that must be highlighted. This may be the first step in addressing flaws relating to the EPs’ lack of provisions related to human rights.

It is worth mentioning that criticism continues to be drawn to the EPs. The attacks by critics are mainly based on difficulties that EP imposed on finance of projects in developing countries, where projects are undertook to generate income and employment opportunities. In addition, there is criticism relating to increased transaction costs and EPs’ non-binding nature that makes it difficult to hold an EPFI liable in cases where EPs are not complied with. However, such criticism is highly debatable since economic development cannot override environmental and social concerns and further increased transaction costs is an inherent fact where attention to other factors in addition to the capital must be given; however, the invaluable cost of adverse social and environmental impacts may certainly offset transaction costs. In respect of the non-binding nature of the EP, one must agree that in a world where capital flows almost without boundaries and where governments share distinct visions on how to balance economic development with social and environmental concerns (i.e., how to achieve sustainable development), working on a binding international law over project financing is a hard task, a task for which public international law is not yet ready.

EP is an important tool to promote sustainable development in international project finance.  The increasing number of EPFI (among which are financial institutions from developed as well as developing countries), is evidence of the higher attention that the need of promoting sustainable development in international project finance receives. Moreover, latest developments in EP III demonstrate that standards are being raised to address international concern and that the work is still in progress. The next few months are appropriate/crucial for financial institutions all over the world to review their internal project finance compliance standards and educate themselves about the new standards.