The Nickel Report

On June 24, 2019, the Equator Principles Association announced the release of the draft text of the fourth revision of the Equator Principles. Known as EP4, this document includes a number of changes intended to address perceived shortcomings regarding the manner in which the current framework is applied to different countries and to enhance the focus on issues such as climate change. These changes reflect the evolving nature of transactional diligence with respect to environment, social and governance (ESG) issues.

ESG Transactional Diligence – The Basics

ESG diligence applies a set of standards, framework or criteria related to environmental issues such as energy efficiency, water usage and impacts on climate change; to social issues such as labor standards and indigenous peoples; and to governance issues such as executive pay, cybersecurity and internal controls. ESG diligence is often described as a mechanism for capital markets and investors to capture non-financial risk assessments or sustainable investment strategies, including potential reputational issues. More recently, it has been seen as a framework to understand potential value and performance of a target.

There are various drivers and goals that may motivate an ESG diligence effort. It may be a result of individual entities’ commitments or a result of membership in sustainability associations. ESG diligence is not static and these commitments may change over time. In addition, the existing frameworks and criteria continue to evolve. Further complicating ESG diligence, commitments to adhere to frameworks or criteria may be buried in loan agreements, limited partner agreements, corporate commitments in sustainability reports or may arise by virtue of membership in associations such as Equator Principles Association or Principles for Responsible Investments (PRI). Many of these commitments will need to be included as enforceable covenants in transaction documents.

Project Finance, Project-related Corporate Loans and Equator Principles

The Equator Principles (EP) are among the most commonly applied ESG criteria for project finance. In 2003, the World Bank Group’s International Finance Corporation (IFC) began to develop the EP to promote sustainable environmental and social performance and investment. EP may apply to member financial institutions in project finance, project-related corporate loans and bridge loans. As described by IFC, EP “is a risk management framework, adopted by many financial institutions, for determining, assessing and managing environmental and social risk in projects and is primarily intended to provide a minimum standard for due diligence and monitoring to support responsible decision making.” EP apply globally, including 96 financial institutions known as Equator Principle Financial Institutions (or EPFI) in 37 countries, covering a large percentage of projects worldwide.

EP distinguish between projects in “non-designated countries” and projects in “designated countries”. Projects covered by EP in “non-designated countries”, generally those with developing or emerging economies, require environmental and social impact assessments in accordance with the EP. An initial risk assessment is performed to categorize the project using the IFC environmental and social screening process. There are three categories:

• Category A are “[p]rojects with potential significant adverse social or environmental impacts that are diverse, irreversible or unprecedented;
• Category B are “[p]rojects with potential limited adverse social or environmental impacts that are few in number, generally site-specific, largely reversible and readily addressed through mitigation measures and
• Category C are “[p]rojects with minimal or no social or environmental impacts.”

Under EP, the EPFI must require its client to perform an Environmental and Social Assessment (Assessment) to the EPFI’s satisfaction. An illustrative list of social and environmental issues to be covered in the Assessment are included in an exhibit to the EP and there are guidance documents that describe in detail what the Assessment should cover.

The client of the EPFI must covenant in the financing documentation to comply with all host country environmental and social legal requirements. In addition, for Category A and (where applicable) Category B projects, the client must covenant in financing documents to: (i) comply with the Environmental and Social Management Plan and Equator Principle Action Plan; (ii) provide periodic compliance reports; and iii) where applicable, agree to a decommissioning plan.

For Category A and applicable Category B projects, the Assessment Documentation must include the following:

• an Environmental and Social Impact Assessment to be made available online
• For projects that will emit more than 100,000 tonnes of CO2 equivalent annually, an alternatives analysis
• an Environmental and Social Management Plan including an Equator Principles Action Plan where applicable standards are not met
• Stakeholder Engagement process
• Grievance Mechanism
• Review by an Independent Environmental and Social Consultant

Projects in “designated countries”—i.e., “those countries deemed to have robust environmental and social governance, legislation systems and institutional capacity designed to protect their people and the natural environment”—are not currently covered by EP. They are subject to review under the laws and regulations of the country where the project is constructed.

This bifurcation of applicability has led to harsh criticism by activists and non-governmental organizations (NGOs), such as Banktrack in particular. In November 2017, the Equator Principle Association announced that it had initiated internal discussion on four areas including: social impact and human rights, climate change, designated countries, and applicable standards and scope of applicability.

On June 24, 2019, the Equator Principles Association announced the release of the draft text of the fourth revision of the EP known as EP4. As revised, the distinction between reviews for projects in designated versus non-designated countries was retained. However, language was added that requires the EPFI to evaluate whether one or more of the IFC Performance Standards should be applied. Language regarding the assessment of human rights and climate change was added to Principle 1 regarding the initial risk assessment. For Category A and as applicable Category B projects globally, language was added to require the EPFI’s ESG diligence to include a review of how the project meets the EP. In addition, a climate change assessment will be required for Category A and applicable Category B projects.

Capital Markets and PRI

Unlike project financings, capital market ESG diligence is typically subject to many different standards or frameworks. For example, many investment banks, institutional investors and investment managers have developed their own programs. These entities may be limited partners in private equity firms and ESG diligence requirements could be included in side letters between the general partner and limited partner or in a limited partner agreement.

An important framework for investors is PRI, which was developed by investors in partnership with the United Nations Environment-Finance Initiative Partnership (UNEP) and the United Nations Global Compact. According to the PRI 2018 annual report, there are over 2000 signatories in 60 countries. PRI issued a due diligence questionnaire in November 2015 which is used often as a basis for ESG diligence. Due to the large variety of issues related to different sectors, industries and supply chains, PRI does not mandate formats or frameworks. Instead, signatories develop their own programs to meet PRI’s six principles.

Corporations and Sustainability

According to a report by Investor Responsible Research Center Institute (IRRC) and Sustainability Investments Institute (Si2) regarding the state of integrated and sustainability reporting in 2018, 78 percent of the S&P 500 issued a sustainability report. However, the actual level of sustainability commitments varies greatly. ESG diligence associated with corporations should take into account any public statements or commitments associated with sustainability as well as any commitments corporations may have made as members of sustainability associations.

Several years ago, diligence associated with corporate sustainability might have been addressed in an environmental assessment report. In many cases, this would suffice as greenhouse gas was the primary focus. More recently, ESG sustainability has evolved to cover social and governance issues as well as an expanded coverage of environmental issues. It is becoming more common for a separate ESG report to be prepared or in some cases several reports or summaries. These documents can take many forms and cover a variety of issues. Since the information in these documents may, in some instances, necessitate disclosure by publically traded companies, the documents should be properly evaluated.

Role of Lawyers

Due to the complexity of the considerations surrounding ESG diligence, legal integration can be an important aspect of the process. Lawyers can facilitate ESG diligence through the coordination of the many goals, evolving frameworks and variety of experts to develop a sound, consistent record that can later be provided to third parties or protected as confidential where appropriate. Lawyers can also ensure that transaction documents contain appropriate provisions to support ESG commitments and provide advice on any reporting or disclosures that may be required as a result of the ESG diligence. The ESG diligence process is in part a risk assessment tool and experienced lawyers can advise clients regarding risk mitigation and potential value creation opportunities. ESG diligence may be considered mainstream, but there are many unsettled considerations. Lawyers can help limit unintended exposure to new risks and liability.