Recent global trends related to corporate governance include increased emphasis on the social and environmental responsibilities of businesses. As a result, the environmental and social affairs of a corporation are now a topic of great interest to all stakeholders of the corporation, including its lenders and shareholders.
Due to growing interest in the environmental and social impacts of business, the Equator Principles were formulated in June 2003 to establish a framework for managing these risks and impacts when financing projects. The Equator Principles have been periodically updated, with the most recent version—EP4—taking effect as of October 1, 2020. Under EP4, borrowers could potentially be subject to more stringent requirements with respect to environmental and social risk management compared to what is typically required under applicable laws.
The Equator Principles: What are they?
The Equator Principles apply globally to all industry sectors and are a risk management framework for identifying, assessing and managing environmental and social risks in development projects. Their primary purpose is to provide a minimum standard for due diligence and monitoring, and to support responsible risk decision-making.
Financial institutions (EPFIs) voluntarily adopt the Equator Principles and commit to implementing them through their internal policies, procedures and standards. By adopting this regime, adhering EPFIs agree they will not finance projects that do not comply with its requirements. Each EPFI is responsible for developing and implementing its own environmental and social policies and approach to implementing the Equator Principles.
The EPFIs will categorize projects based on the project’s potential environmental and social risks and impacts. Different requirements will apply depending on a project’s category. The most stringent are applied to Category A projects, which are projects typically with potential significant adverse environmental and social risks and/or impacts that are diverse, irreversible, or unprecedented. At the other end of the range, less stringent requirements are applied to Category C projects, which are projects with minimal or no adverse environmental and social risks and/or impacts. For instance, EPFIs may require borrowers to: (a) develop and maintain an environmental and social management system to identify, assess and manage risks related to the project on an ongoing basis, (b) create an action plan to minimize or offset any potential risks of a project, or (c) demonstrate ongoing engagement with local communities affected by the project.
EP4 includes significant changes from its predecessor, including new requirements related to assessing human rights and climate change impacts of a project, and enhanced requirements for projects affecting Indigenous Peoples. For instance, Free, Prior and Informed Consent from Indigenous Peoples—a specific right recognized in the United Nations Declaration on the Rights of Indigenous Peoples—may be required in certain projects, which goes beyond current United States and Canadian legal requirements to consult.
As mentioned, EP4 introduces new requirements related to climate change risks. As part of Principle 2 of EP4, EPFIs will require borrowers to conduct an assessment on the potential environmental and social risks and impacts of a proposed project in its area of influence. EP4 makes specific reference to the 2015 Paris Climate Change Agreement, so the assessment documentation for a project may now include requirements derived from the agreement. Some borrowers may be further required to conduct a climate change risk assessment, with the depth and nature of such assessment depending on the type of project and the nature of risks. This assessment is required for two sets of projects:
- All Category A and, as appropriate, Category B projects. The assessment will include consideration of relevant physical risks resulting from climate change, which involve event-driven risks (e.g., hurricanes, floods) or longer-term (e.g., sustained higher temperatures) shifts in climate patterns.
- All projects where greenhouse gas emissions from both (i) the facilities within the project boundary and (ii) the offsite production from the project combined are expected to be more than 100,000 tonnes of CO2 annually. Consideration must be given to transition risks, which arise from the process of adjusting to a lower-carbon economy (e.g., imposition of carbon tax). An alternatives analysis evaluating lower greenhouse gas intensive alternatives must be completed. EPFIs must also require borrowers to report publicly, on an annual basis, on greenhouse gas emission levels and provide a greenhouse gas efficiency ratio where appropriate.
Another significant change in EP4 is the possible requirement for EPFIs to assess projects located in “Designated Countries”—countries deemed to have robust environmental and social governance and legislation systems in place, which includes, among others, the United States, Canada, the U.K., and Australia. Prior to EP4, projects in Designated Countries were deemed to be in automatic compliance with certain Equator Principles and were not subject to any evaluation separate from that of the relevant host country laws. With the development of EP4, that is no longer the case. EPFIs will evaluate specific risks of certain projects in Designated Countries to determine whether one or more of the International Financial Corporation Performance Standards should be used as guidance to address those risks in addition to the host country’s laws.
A survey of the loan documents for projects that have been financed by EPFIs since EP4 came into effect on October 1, 2020, reveals that the Equator Principles are typically referenced and form part of the environmental and social laws and standards governing the project. There may be reporting requirements in connection with EP4 and covenants for borrowers to comply with such standards. Non-compliance with EP4 could constitute as a material adverse effect or event of default under the loan agreement.
What should you do as a company?
As a consequence of the new requirements in EP4, the Equator Principles will play a larger role in domestic project finance transactions for projects in the United States and Canada and for American and Canadian borrowers and sponsors than previously. Borrowers should become familiar with EP4, and the standards and requirements that may apply to them when seeking financing. In some circumstances, EPFIs will decline to finance projects if they believe that risks cannot be adequately addressed.
As EP4 brings considerable new changes to project financings, there are several steps that borrowers can take to prepare themselves for upcoming projects that may be subject to the Equator Principles, such as:
- Borrowers should start the conversation with EPFIs early and ask important questions to ensure that expectations are clear at the outset.
- Borrowers should review and, if necessary, update their environmental and social governance regimes and proactively manage environmental and social risks and impacts in light of the revised standards under EP4.
- Borrowers should review and ensure that they are aligned with the UN Guiding Principles on Business and Human Rights.
- Borrowers should become familiar with the requirements under EP4 and review policies, procedures and standards of EPFIs that may act as lenders for their projects.
- Borrowers lacking internal expertise in these matters should consider seeking guidance from external experts with experience with the requirements under EP4.
EP4 reflects a global trend towards increased focus on environmental and social governance and interest in sustainable development. Ultimately, compliance with the Equator Principles in connection with project finance and updated environmental and social governance regimes will not only assist borrowers in securing financing with EPFIs but will also have a positive impact on the overall reputation of the borrower in today’s market toward sustainable economic growth.