On 18 November 2019, the Equator Principles Association published version four of the Equator Principles (EP4), updating the international baseline for the identification, assessment and management of environmental and social risks in international project finance debt markets. The changes, which take effect on 1 July 2020, include the application of the Equator Principles to a broader range of financial products, a greater degree of consistency between high income OECD countries and other jurisdictions and substantive new requirements in relation to human rights, climate change and impacts on Indigenous Peoples.
Specifically, the introduction of EP4 will require the majority of sponsors to prepare:
These key changes, each of which has been clarified since publication of the consultation draft of EP4, will have the most significant impact on project financings in jurisdictions which do not require UNGP-aligned social impact assessments, TCFD-aligned climate change assessments or mandate FPIC-aligned Indigenous engagement outcomes. In these jurisdictions, which will include a number of high-income OECD countries, there will be a material divergence between what is required to obtain host country project permits and what is required to satisfy EP4.
Sponsors will need to familiarise themselves with the requirements of EP4 and ensure that their approach to environmental and social impact assessment adequately meets the updated requirements. In particular, sponsors in high income OECD countries should ensure that they understand the extent of any divergence between the domestic requirements and EP4 in order to avoid delays in project financing.
Lenders, in familiarising themselves with EP4, should consider their position in relation to a number of discretionary elements (including the application of EP4 to financial products below the thresholds or otherwise outside of the scope of EP4, the level of assessment documentation required for the wide range of projects with limited adverse environmental and social impacts and their approach in circumstances where a sponsor is not able to demonstrate FPIC) and prepare to communicate their policy positions ahead of the commencement of EP4. Lenders should also consider whether they may wish to start applying EP4 ahead of the 1 July 2020 start date, as some have already begun to do.
Application to a broader range of financial products
- Removal of aggregate loan amount threshold for project-related corporate loans: EP4 eliminates the US$100m aggregate loan amount threshold for project-related corporate loans, resulting in its application to any project-related corporate loan where a lender makes an individual commitment of at least US$50m (before syndication or sell-down).
- Application to project-related refinancing and acquisition financing: EP4 applies to project-related financing and acquisition financing for projects previously financed in accordance with the Equator Principles that remain both incomplete and unchanged in scope.
- Lifting of exemption for project-related corporate loans to sovereign borrowers: EP4 removes the exemption for project-related corporate loans to national, regional or local governments, governmental ministries and agencies for a project with adverse environmental and social impacts, aligning the requirements for sovereign borrowers with the existing requirements for government-owned corporations and State-owned enterprises.
- Inclusion of expansions and upgrades: While EP4 is not intended to be applied retroactively to existing projects, it will apply to the financing of expansions and upgrades of such projects.
- Voluntary application to other financial products: EP4 acknowledges that lenders have broader responsibilities for identifying and managing environmental and social impacts for financial products that fall outside the scope of EP4 and that lenders may, at their discretion, apply the EP4 framework to products that fall outside that scope.
Greater consistency between high income OECD countries and other jurisdictions
- No deemed compliance in Designated Countries: While EP4 retains the concept of ‘Designated Countries’ (i.e. high income OECD countries) and requires projects in those countries to be evaluated for compliance against host country laws, it no longer assumes that those laws will necessarily meet relevant requirements in relation to environmental and social assessments, management systems and plans, stakeholder engagement or grievance mechanisms. EP4 retains the language of its predecessor, making clear that host country laws represent the minimum standard, and require lenders to evaluate specific risks of the project to determine whether the IFC PS could be used as guidance to address those risks, in addition to host country laws.
New requirement for Human Rights Impact Assessment
- UNGP-aligned assessment of human rights impacts: EP4 introduces a new requirement for a UNGP-aligned assessment of potential adverse impacts on human rights.
- Application to workers: EP4 makes clear that assessment of social impact must include risks and impacts on workers (including employees and contractors), in addition to affected communities.
New requirement for Climate Change Risk Assessment
- TCFD-aligned assessment of climate change risks: EP4 introduces a new requirement for a TCFD-aligned climate change risk assessment, taking into account physical risks (i.e. effects of acute and chronic risks on assets, operations and markets) of climate change, for all projects with material environmental or social impacts. EP4 also retains the existing requirement for an alternatives analysis for all projects with Scope 1 (direct) and Scope 2 (indirect) emissions in excess of 100,000 tonnes of CO2 annually, while adding a requirement for consideration of relevant transition risks (i.e. risks associated with policy, regulatory, technological and commercial responses to climate change).
Global standard for Indigenous engagement
- FPIC as global standard for Indigenous engagement: EP4 applies a global standard for engagement with Indigenous Peoples affected by projects with impacts on lands or resources subject to traditional or customary use, requiring relocation or resettlement, or impacting or deploying Indigenous cultural heritage, including in ‘Designated Countries’, by requiring evaluation against IFC PS 7 and the requirement for FPIC. However, recognising the challenges that can sometimes arise either in obtaining FPIC or substantiation that FPIC has been obtained, EP4 permits that a lender may determine whether this qualifies as a justified deviation from the requirements of IFC PS 7 and whether additional corrective actions should be pursued to meet those requirements.
- Collaboration with government: EP4 clarifies that where engagement with Indigenous Peoples is the responsibility of host governments lenders must require sponsors, to the extent possible, to collaborate with government to achieve outcomes consistent with IFC PS 7. This will have the result that sponsors will be required to actively encourage governments to meet that standard and that engagement will be assessed by lenders against that standard, even where host country laws provide that engagement is the role of government.
Enhanced grievance mechanism
- UNGP-aligned grievance mechanisms: EP4 modifies the existing requirement for grievance mechanisms to require that they be ‘effective’ (i.e. legitimate, accessible, predictable, equitable, transparent, rights-compatible and incorporating mechanisms for continuous improvement, based on the effectiveness criteria in the UNGP) and that they be designed for use by both affected communities and workers.
Collaborative approach to non-compliance
- Mandated grace period for remedial actions: EP4 expressly mandates that, where sponsors are not in compliance with their environmental and social covenants, lenders will work with sponsors on remedial actions to bring the project into compliance, resorting to other remedies (including event of default) only if the sponsor fails to re-establish compliance within an agreed grace period.
Human rights and climate change risk disclosure
- Human rights and climate change risk summary to be public: In addition to introducing new requirements in relation to the assessment of human rights and climate changes risks, EP4 requires that a summary of those risks is accessible and available online, together with, or included in, the summary of the balance of the environmental and social impact assessment.
What are the implications for project sponsors?
Sponsors of applicable projects will need to ensure that human rights impacts, climate change risks and effects on Indigenous Peoples are adequately identified and assessed during the project development phase and that appropriate management and mitigation measures are incorporated into their environmental and social management systems. Sponsors, particularly in high income OECD countries, should familiarise themselves with any divergence between host country laws and the requirements of EP4, particularly in relation to human rights, climate change and impacts on Indigenous Peoples, in recognition that compliance with domestic laws is less likely to satisfy the requirements of EP4 than its predecessor. Sponsors should also bear in mind the application of EP4 when planning expansions or upgrades, particularly where those projects have a history of claimed adverse impacts on human rights, climate change or Indigenous Peoples.
In relation to human rights impacts, sponsors will need to adopt practices for Human Rights Impact Assessment consistent with the scope of the human rights defined in the EPs, which is aligned with the concept of ‘internationally recognised human rights’ in the UNGP (which includes, at a minimum, the rights contained in the International Bill of Rights, together with the principles concerning fundamental rights identified in the ILO Declaration on Fundamental Principles and Rights at Work). Sponsors should consider drawing on existing guidance, including the Human Rights Impact Assessment Guidance and Toolbox published by the Danish Institute for Human Rights, to inform their approach.
On climate change, the identification of climate change risks should be consistent with TCFD, from which the dichotomy between physical risks and transition risks is drawn. In particular, sponsors should consider the application of Scenario Analysis to the assessment of transition risks.
Sponsors of projects with specified effects on Indigenous Peoples will need to ensure that their engagement with those people is framed with reference to the requirements of IFC PS 7 and FPIC. It is critical that sponsors appreciate that compliance with host country laws or reliance on government action where those laws or actions fall short of the requirements of IFC PS7 and FPIC, is unlikely to be bankable. This will require a material change to approach in some jurisdictions, particularly some high income OECD jurisdictions where host country laws, while providing the means to obtain FPIC, do not necessarily require that it to be obtained in order to grant a concession or any applicable project permits.
Sponsors will also need to seek to engage with workers and may need to adopt an iterative approach to engagement and development of grievance mechanisms. Grievance mechanisms, particularly where worker-facing, will need to be aligned with employment laws, contracts, policies and procedures, with an eye to minimising duplication.
What are the implications for lenders?
Lenders will need to refresh their internal procedures to reflect the broader scope, and new requirements, of EP4. In doing so, lenders should consider their approach to the several new discretionary elements of EP4, including in the context of other sustainability and ESG commitments:
- whether they intend to apply EP4 to financial products that fall outside of its scope;
- their approach to assessment of projects (in particular, ‘Category B’ projects with discrete environmental or social impacts, which EP4 acknowledges may be ‘higher risk’ or ‘lower risk’); and
- their requirements in relation to FPIC, including where FPIC is not able to be clearly demonstrated or where engagement with Indigenous Peoples is the domain of the host country government.
As with project sponsors, lenders should consider drawing on existing industry guidance to implement processes for assessment of human right impacts, climate change risks and adverse effects on Indigenous Peoples. In particular, in relation to climate change risks, the outcome of the United Nations Environment Programme Finance Initiative pilot project on implementing the TFCD Recommendations, as recorded in the Expanding our Horizons report on transition risks and the Navigating a New Climate report on physical risks.
For projects in Designated Countries, lenders – like sponsors – will need to form a view in relation to the extent of any divergence between host country laws and the requirements of the IFC Performance Standards and be prepared to articulate their requirements to clients. Lenders should, armed with a full understanding of the extent of that divergence, be prepared to communicate their expectations to sponsors as early as possible in their engagement in order to avoid any delays to project financing.
DLA Piper’s global project finance practice includes expertise in relation to human rights, climate change and Indigenous Peoples, and regularly advises sponsors and lenders in relation to the implementation of the Equator Principles in project development and financing. Our experts have experience conducting Human Rights Impact Assessment, Climate Change Risk Assessment and reporting on FPIC compliance and can assist sponsors to meet lenders’ requirements and lenders to assess sponsors’ environmental and social performance.
For further information and advice, please contact Rhys Davies.