Equator Principles: An Attempt Towards Sustainable Financing

Overview

Large-scale development projects pose devastating impacts on the environment and local communities. To address the risks of these projects, the World Bank and several financial institutions adopted the Equator Principles, which serve as a "financial industry benchmark for determining, assessing, and managing environmental and social risks in projects.” They provide the standards that investors and banks must comply with to ensure that the projects financed are developed in a socially responsible manner and reflect sound environmental management practices.

The Equator Principles were introduced in June 2003, but have been periodically updated, with the latest iteration—Equator Principles 4 (“EP4”)—released in October 2020. Since its introduction, the Equator Principles have been officially adopted by 134 financial institutions (“EPFI”) in 38 countries. This represents approximately 70 percent of international Project Finance debt in emerging markets.

EPFIs commit to implement the principles when financing a project. They do so by incorporating the standards in their internal processes and procedures as well as including compliance with the requirements as covenants in the financing documents. Failure by project proponents to adhere to the standards and requirements is a ground to deny funding of a project.

Equator Principles apply globally and to all industry sectors. However, it only covers the following financial products: project finance and advisory services with total project capital costs of US$10 million or more, project-related corporate loans with a total aggregate loan amount of at least US$50 million; and associated bridge loans and project-related refinance or acquisition finance.

Project Classification and Requirements

The Equator Principles classify projects into three categories based on their potential environmental risks and social impacts. These categories dictate the project’s requirements. Category A projects are those with potentially significant and irreversible environmental and social concerns and require the highest level of assessment and mitigation processes, while Category C projects are those with minimal or no adverse impact and have the least requirements.

The Equator Principles obligates project proponents to assess the relevant environmental and social risks of the proposed projects, including potential adverse human rights issues and climate change problems, and to develop a plan to address these concerns. It also mandates that project sponsors consult affected communities and implement effective grievance mechanisms to resolve concerns about the project’s environmental and social performance.

Compliance with the environmental and social standards must be monitored and reported by both the EPFI and project sponsor. EPFIs are required to publicly report, at least annually, the transactions which have reached financial close and how these transactions complied with the Equator Principles, while the borrowers must make publicly available online a summary of its environmental and social impact assessments and how the risks are addressed.

Implementation Issues and Concerns

The Equator Principles embody the commitment of financial institutions to responsible financing and sustainable development. Its objectives are laudable and reinforces the social and environmental responsibilities of the financial sector. However, despite being in force for almost two decades, critics argue that it has little impact and fail to address the social and environmental harm caused by financed projects.

A recurring criticism of the Equator Principles is its lack of proper enforcement mechanisms to ensure compliance. Equator Principles are voluntarily imposed standards, and there are currently no penalty or sanctions for non-compliance. Critics claim that it lacks “appropriate accountability, monitoring and auditing systems” and is ineffective since credible deterrents and formal sanctions are absent. Both borrowers and lender-signatories are allegedly committing breaches due to inconsistent implementation and the absence of monitoring and verifiable metrics to measure compliance.

Indeed, only reputational pressure compels financial institutions to properly implement its commitment. However, this does not seem to be a complete deterrent. BankTrack, a commercial banking sector watchdog, claimed that EPFI continue to finance projects that “violate indigenous rights, exacerbate climate change and adversely impact on local communities”. It also reported that seven out of the nine projects financed under the Equator Principles that it investigated failed to conduct proper community consultation and lacked effective project-level grievance mechanisms contrary to the requirements of the Equator Principles.

Moreover, despite the recent release of EP4 which incorporated in its preamble a commitment to “support the objectives of the Paris Climate Agreement”, EPFIs reportedly have been involved in financing of at least 200 fossil fuel projects between 2016 and 2020 directly endangering the goals of the Paris Climate Agreement.

Working with the Equator Principles

Although Equator Principles are highly criticized for failing to meaningfully protect human rights and the environment, some scholars believe that it significantly improved the banking industry by developing an industry standard that created “uniform public expectation” which compels banks to take a more proactive role in protecting the environment and upholding human rights. While there are no legal sanctions for failure to comply with the Equator Principles, it is argued that it compels financial institutions to act because they can be made accountable “in the court of public opinion” for their violations. To illustrate, some EPFIs financing the Dakota Access Pipeline—a controversial project due to its perceived E&S risks to sacred Native American land—withdrew from the project because of public outcry.

Notably, an empirical study focused on exploring the economic impact of the Equator Principles suggested that “reputation management” is one of the main incentives for its adoption and that it is linked with improved financial performance in terms of liquidity and total shareholder return.

It may be difficult to measure how effective the Equator Principles are. There are undoubtedly gaps in its implementation, but by creating a uniform standard of conduct and a common set of expectations that pressure banks to act responsibly, the adoption of the Equator Principles is a step in the right direction. They reinforce private sector participation in assessing and managing project risks and create positive ripple effects towards environmental, social, and economic sustainability.

Ma. Carla Mapalo serves as a Graduate Editor of the NYU Journal of Law & Business. She earned her L.L.M. Degree in Corporation Law from the New York University School of Law as a Dean’s Graduate Scholar. Prior to attending NYU, she worked as a senior associate of the corporate and commercial department of a top tier law firm in the Philippines, where she specializes in mergers and acquisitions, antitrust, and project finance.