Equator principles 4 enter into force: What will this mean in practice?

What are the equator principles?

The Equator Principles were created in 2003 to be used as a global risk management framework providing a common baseline and framework for financial institutions to identify, assess and manage environmental and social risks when financing projects.  The Equator Principles have, however, expanded and developed over the years with the release of updated versions. The latest update (EP4) was released on November 18, 2019, and will come into effect on October 1, 2020.

The Equator Principles are intended to serve as. The Principles provide a minimum standard for due diligence, monitoring, and reporting to support responsible risk decision-making by the project lenders.

Financial institutions that adopt the Equator Principles commit to implementing them in their internal environmental and social policies, procedures and standards for financing projects, and agree to withhold financing where clients will not, or are unable to, comply with the Equator Principles.

There are currently 110 Equator Principles Financial Institutions (or EPFIs) in 38 countries that have officially adopted the Equator Principles according to The Equator Principles Association’s website and this number has been steadily growing since their creation in 2003.

While the Equator Principles may not be black letter law, they are internationally recognized guidance which are considered by many stakeholders as the benchmark for analysing, monitoring and mitigating environmental and social risk.

When do equator principles 4 apply?

The Equator Principles apply globally to all industry sectors and to the financial products described below:

1. Project finance advisory services (where total project capital costs are US$10 million or more).
2. Project finance transactions (with total project capital costs of US$10 million or more).
3. Project-related corporate loans where all of the following three criteria are met:
   i. The majority of the loan is related to a project over which the client has effective operational control (either direct or indirect).
   ii. The total aggregate loan amount and the EPFI’s individual commitment are each at least US$50 million (reduced from US$100 million in EP3).
   iii. The loan tenor is at least two years.
4. Bridge loans with a tenor of less than two years that are intended to be refinanced by project finance or a project-related corporate loan that is anticipated to meet the relevant criteria described in 2 and 3 above.
5. Project-related refinance and project-related acquisition finance where the following criteria are met:
   i. The underlying project was financed in accordance with the Equator Principles framework.
   ii. There has been no material change in the scale or scope of the project.
   iii. Project completion has not yet occurred at the time of signing of the facility or the loan agreement.

Requirements depend on project category

The nature of the studies, assessments, and reporting required vary with the category of project being financed:

1. Category A: projects with potentially significant and irreversible environmental and social impacts which require the highest level of assessment and mitigation processes.
2. Category B projects with less severe, but still potentially significant environmental and social impacts.
3. Category C: projects with minimal expected potential.

Key changes introduced by ep4

The Equator Principles are well known to project finance lawyers, developers and bankers involved in EPFI-funded projects in “Non-Designated Countries” – i.e. countries in the developing world.

When the Equator Principles were first created, they were based on another set of well-known international sustainability standards: the International Finance Corporation, or ‘IFC’, Performance Standards.

The IFC Performance Standards are an established and well-respected framework for ensuring sustainable development in developing countries.  The Equator Principles have always been aligned with the IFC Performance Standards and have made compliance with those standards mandatory for projects in all Non-Designated Countries.

However, for Designated Countries, which consist of the high-income, OECD countries around the world, the comparatively robust environmental, social and regulatory laws and protections present in those countries are considered to provide sufficient risk management and sustainability standards, such that compliance with domestic jurisdiction laws in Designated Countries was considered sufficient to be aligned with the Equator Principles.

Under EP4, compliance with domestic laws is still required for projects in Designated Countries. However, at the same time, EP4 moves beyond the clear distinction that existed between Designated and Non-Designated Countries under the previous versions of the Equator Principles.

In recognition of concerns that domestic laws and regulations in Designated Countries may in some cases fall short of international standards, EP4 will now make projects in Designated Countries equally subject to evaluation against IFC Performance Standards, where the specific risks associated with the project warrant it.

This means that, under EP4, compliance with local laws and regulatory processes may not be the only assessment required of a project in a Designated Country; as of October 1, 2020, the project may now also require evaluation against relevant IFC Performance Standards.

EP4 also brings some other notable changes from EP3, such as:

• A requirement for stakeholder engagement with affected communities and other potential stakeholders. For example, EP4 now requires that all “Workers” (defined as workers engaged directly or indirectly on a project, including contractors and sub-contractors) are provided with appropriate grievance mechanisms. In addition, there are now requirements with respect to the free, prior and informed consent (FPIC) of affected communities, with a requirement to either demonstrate that the consent of affected communities has been obtained, or where consent has not been obtained, appropriate plans have been put in place to mitigate and remedy potential adverse impacts for such communities. This means that a qualified independent consultant, which could be a law firm, needs to evaluate the consultation process. This is in addition to ensuring that host country laws are also complied with, both in Designated and Non-Designated Countries.
• There is an overall strengthening of the EPFI’s commitments to avoiding or addressing environmental and social impacts of projects being financed throughout EP4: for example, in the preamble to EP4 there is an express acknowledgement that “the Equator Principles can contribute to delivering on the objectives and outcomes of the United Nations Sustainable Development Goals.”
• As highlighted above, EP4 also expands the types of financial products to which the Equator Principles apply beyond those to which EP3 applied. In general, EP4 applies to more financial products, and more project financings globally.
• EP4 expands the potential due diligence required to address risks of projects in Designated Countries: now it is necessary to evaluate specific project-related risks against the IFC Performance Standards, not simply by assessing compliance with domestic laws.
• EP4 strengthens and enhances the assessment of Human Rights impacts of projects from previous versions of the Equator Principles by mandating that a Human Rights Risk Assessment be done, commensurate with the risk categorization of the given project, based on the United Nations Guiding Principles on Business and Human Rights.
• EP4 includes enhanced commitments and reporting requirements for addressing the risks posed by Climate Change.
• Finally, for the first time, EP4 now includes a requirement for EPFIs to encourage their clients to share non-commercially sensitive Biodiversity Data with the Global Biodiversity Information Facility.

Practical considerations

The Equator Principles are not intended to be a one size fits all checklist. They are intended as a risk management tool to assist financial institutions and industry to determine, assess and manage environmental and social risk in projects. As much as there may be a desire to eliminate these risks entirely, it is not always possible and there are practical matters to take into account.

In the projects space, discussion around the requirements of the Equator Principles and other environmental and social guidance is common, and can be a source of lengthy discussions between financial institutions and project sponsors as they work to find an agreed path to manage environmental and social risks. These conversations are not necessarily contentious, however they can highlight the importance that stakeholders place on these issues.

To meet the standards that will be imposed when EP4 comes into effect, EPFIs and their borrowers will need to consider such things as:

1. Their existing compliance procedures.
2. How, and when, they are conducting due diligence on affected projects.
3. Their own standard reporting processes, metrics, and documentation on those matters covered by EP4.

It is telling that 110 of the world’s financial institutions have signed up to EP4, and there are many high-profile stakeholders who have publicly announced their focus on, and commitment to, sustainability.

There is ever-increasing attention being paid by project lenders to how projects may contribute to Climate Change and its associated risks, to social harms, and how the rights and interests of Indigenous Communities are being addressed when it comes to major projects around the world.

EP4, when it comes into effect, promises to be another significant step in this progression – where financial institutions and their borrowers recognize a shared responsibility for reducing environmental and social risks and impacts of projects.

Norton Rose Fulbright is one of the very few international law firms in the Middle East which can advise clients on ESG issues in this region.

If you have any questions, feel free to get in touch with our team.