$354 billion USD in project finance transactions were signed globally in 2010, surpassing the previous record of $320 billion USD that was set in 2008.  To a large extent, the increasing volume of project finance deals reflects the overall expansion of the global economy as companies and governments in both the developing and the developed world proceed with large infrastructure, energy, mining, oil and gas, and other industrial projects.

Risk management in project finance

With increased investment comes increased risk.  Financial risk has been (and remains) of primary importance for such deals.  Understandably, lenders want to ensure that they will receive an adequate return on their investments, whether they are in the form of loans, bonds, or equity transactions.

Increasingly, however, there is a growing awareness amongst lenders that social and environmental risks associated with large projects can also pose financial risks.  If the concerns and grievances of local communities are not appropriately managed, operations associated with a large project can be disrupted or shut down.  Similarly, environmental degradation resulting from project activities can result in major liabilities for project operators.

A number of high profile projects were highly criticized by nongovernmental organizations in the 1980s and 1990s because of their social and environmental impacts, and international lenders associated with these projects found themselves in the uncomfortable position of having to justify their financial support of these activities.  Increasingly aware that social and environmental risks also posed reputational risks, a number of large financial institutions were compelled to establish more rigorous internal policies that acted as safeguards against such risks.

Towards responsible lending

Two major frameworks for responsible lending that have emerged in the last ten years are The Equator Principles and the IFC Performance Standards for Social and Environmental Responsibility.  The Equator Principles are a set of voluntary standards that many private banks and several export credit agencies have chosen to adhere to for project finance transactions worth more than $10 million.

A notable recent adopter of the Equator Principles is the Export-Import Bank of the United States, which provided approximately $3 billion in financing to the Papua New Guinea Liquified Natural Gas Project and $900 million in financing to the mining sector in fiscal year 2010 (source).  The Equator Principles make a distinction between projects in high-income OECD countries and other countries in the developing world, acknowledging that the strength of environmental laws and central governance institutions tends to be markedly higher in the former.

Similarly, the International Finance Corporation’s Performance Standards for Social and Environmental Responsibility contain detailed guidance to companies on subjects such as social and environmental assessment and management systems, labor and working conditions, pollution prevention and abatement, community health and safety, land acquisition and involuntary resettlement, biodiversity conservation, indigenous peoples and cultural heritage.

They have undergone an extensive review and will be updated this year, with the changes coming into effect for transactions the IFC makes in 2012.  The IFC also has industry-specific Environmental Health and Safety (EHS) guidelines that provide companies with detailed information about industry best practices for the purpose of fulfilling their obligations under Performance Standard 3 (Pollution Prevention and Abatement).

A transparent audit trail

These initiatives have greatly raised the bar for companies operating in the developing world, since high standards must be met before loans are disbursed.  Loan covenants usually specify that companies need to follow detailed Action Plans if social and environmental gaps have been identified in the project review process.  Companies must be able to demonstrate transparency with lenders and provide them with reports and an audit trail.

Andrew Sanford, Environmental Analyst, Boréalis