Equator Principles 4: Redesigned for a more expansive view of responsible investment

The Equator Principles (EP) are a risk management framework to assess and monitor potential adverse effects of large-capital projects on the natural environment and local communities. Based on a combination of standards and guidelines established by the World Bank Group (WBG) and International Finance Corporation (IFC), the EP integrate recognized protocols relating to human rights, climate change, and biodiversity. Today, 116 Equator Principles Financial Institutions (EPFIs) in 37 countries subscribe to the EP to confirm that the energy, infrastructure, and industrial projects they finance are developed in a manner that is socially responsible and reflective of sound environmental management practices. The EP are also a mechanism for the financial industry to see that such risks are mitigated and that compliance is monitored through the life of the debt term. And as lenders and investors increasingly weigh Environmental, Social, and Governance (ESG) metrics in their investment decisions, the EP can provide an indication of potential financial risk due to environmental or other practices.

An updated version of the Principles, EP4, went into effect on October 1, 2020. As with proceeding updates, this new release of the Equator Principles reflects the evolution of societal and environmental best practices on the development, construction, and operation of projects and assets as well as lessons learned from prior versions of the EP. As such, EP4 incorporates some significant differences from its predecessor, EP III, as introduced in the table and discussion below.  

These changes and subtleties call for both rigor and finesse in EP due diligence so that developers can demonstrate their projects meet an EPFI’s expectations when seeking financing. EP diligence evaluates projects against each of 10 Principles and their underlying standards and guidelines, resulting in categorization of a project based on identified social and environmental impacts. Leidos has conducted EP diligence on domestic and international projects for more than 15 years, building on our work as independent engineer conducting technical diligence. 

New requirements, broader applications

The table below presents an overview of the Principles as well as how the EP4 Principles differ from those of its predecessor, the EP III.  

A few of the changes have particular impact on the EP due diligence process.

• Projects in Designated Countries. Prior versions of the EP stated that successful completion of the permitting process in a Designated Country satisfied the requirements of four of the ten Equator Principles (Principles 2, 4, 5, and 6). Principle 3, Applicable Environmental and Social Standards, now requires that loan recipients must demonstrate projects satisfy all of the EP and host country requirements – no matter the project location – as well as applicable portions of the underlying IFC Performance Standards and WBG Environmental, Health, and Safety Guidelines. The reasoning behind this change is that even though Designated Countries are deemed to have robust programs designed to protect their citizens and the natural environment, independent assessment of an individual country’s performance in these areas is not made in relation to the EP. Historically, Leidos performed EP reviews primarily for projects located outside of the 34 Designated Countries. With EP4, attention has turned to all projects, regardless of industry or location.
• Human Rights. Principle 2, Environmental and Social Assessment, places new emphasis on potential human rights impacts of financed projects. Principle 2 refers to the United Nations Guiding Principles on Business and Human Rights as guidance for assessing such impacts and outlines the parameters for human rights due diligence and its essential components. The initial step is to identify and assess actual and potential adverse human rights impacts with the purpose of understanding the specific impacts on specific people, as determined for a specific project. Human rights impacts can result not only from external impacts of a project, such as environmental and social impacts, but also as a result of corporate policies, or the lack thereof, pertaining to the workplace. Subsequently, these policies and programs must now be evaluated as part of the EP diligence.
• Climate Change Risk. Also in Principle 2 is the requirement for a Climate Change Risk Assessment (CCRA) for projects. The CCRA requires consideration of relevant physical risks as defined by the Task Force on Climate-related Financial Disclosures (TCFD). Established to help parties assess climate-related risks and opportunities in relation to their investments, the TCFD has developed recommendations for financial disclosures and identified potential financial impacts of risks and opportunities associated with climate. Risks identified by the TCFD include physical, financial, market, technology, and regulatory. Also included are acute risks, which are event-driven such as those related to severe weather events. The borrower must identify and address these risks to the satisfaction of EPFIs lending to the project.
• Loan Covenants. Specific language regarding EP compliance must now be included in credit agreement loan covenants as outlined in Principle 8. Credit agreements must include loan covenants requiring borrowers to 1) comply with the EP in all material respects; 2) provide periodic reports documenting compliance with the EP, as well as with relevant local, state, and host country environmental and social laws, regulations, and permits; and 3) decommission the facilities, where applicable and appropriate, in accordance with an agreed decommissioning plan.

Implications and ambiguities of project categorization

Different EPFI lenders have occasionally disagreed on a project’s categorization. As with prior EP versions, the categorization criteria outlined in Principle 1 of EP4 are subjective. Some EPFIs have developed specific categorization criteria, while others have not, and still others have developed criteria that are no more specific than the EP themselves. The categorization of projects is implemented on a continuum, with one end of the scale being Category C (projects assessed to present the least impact) and the other being Category A (greatest impact). The exact placement of a project on this scale depends on the views of a given EPFI. In the end, a categorization difference between what some EPFI call an A and others call a B does not really matter much as the projected impacts from the project itself do not change with categorization, and monitoring and reporting requirements are the same for both categories. The real difference is in the perception of financing an A project versus a B project. Financing of “A” projects can be viewed in a negative light, and some EPFI have EP and ESG policies against financing them. EP4 does not resolve the ambiguity around categorization, and associated categorization issues will continue.  

A potentially more significant issue related to categorization is whether an Environmental and Social Impact Assessment (ESIA) is – or isn’t – required for a given Category B project. Principle 2 states that the Assessment Documentation for Category B projects include an ESIA, “as appropriate.” Note 2 to EP4 specifies two different categories within Category B for this requirement. Per Note 2, Category B projects viewed as lower risk can be “treated in a lighter regime,” while Category B projects deemed higher risk “will be treated similarly to Category A” projects. The note directs an EPFI to use its own discretion to “determine the appropriate level of Assessment Documentation, review, and/or monitoring required to address these risks and impacts in accordance with Principles 1-10.” It is not clear exactly what “lower risk” and “higher risk” mean, leaving it up to each EPFI. The potential issue here is if a project proponent, with or without lenders involved, believes its project fits the definition of “lower risk” and moves forward under that assumption. If at a later time the EPFI requires a full ESIA, the project could face significant delays. This is but one potential pitfall that points to the importance of working with due diligence consultants and the EPFI well in advance of financing to confirm project development plans are satisfactory to the EPFI.

The items presented above represent only a few of the recent changes to the EP and issues that could lead to increased review and development time for projects being financed. Proper planning is the key to satisfying the lender’s requirements, preventing schedule impacts, and ensuring projects are developed in accordance with EP requirements, which, in turn, enhances a company’s ESG performance.  You can learn more about the EP4 here https://equator-principles.com/ep4/.  

Since the establishment of the Equator Principles in 2006, Leidos has evaluated the capacity of scores of projects to comply with the EP. This work draws on our experience as independent engineer performing technical diligence to thoroughly evaluate the potential risks and rewards of investments in the energy industry, whether debt or equity. We have gained in-depth understanding of the Equator Principles themselves as well as many of the institutions that have adopted them as part of their policies and procedures.