Written by Tomas Zbynovsky and Celso Roberto Pereira Filho.
1. The project finance industry and the challenges in implementing the Equator Principles
The project finance industry comprises the banks, multilateral financial agencies, and other financial institutions in the business of providing financial resources to the execution of large infrastructure, industrial or commodities projects. The main products of the industry are (a) financial advisory services; (b) project financing (non-recourse loans); and (c) corporate and bridge loans associated with the project.
The project finance industry has set goals in the Equator Principles, which is a risk management framework, adopted by financial institutions, for determining, assessing and managing environmental and social risks in projects. 90 financial entities from 37 countries have adopted the Equator Principles, which now cover 70% of international project finance debt in emerging markets.
The compliance with the Equator Principles depends on the monitoring activities and advice of external consultants or experts, who independently assess the compliance of a project and may recommend corrective measures for compliance (Principle 7: Independent Review).
One big challenge for the effectiveness of the Equator Principle is that, as such consultants and experts are hired locally by the financial providers or their clients, there is a large variability in the output of such professionals, which makes difficult the evaluation and comparison of compliance in different projects. Moreover, the local hiring of consultants raises potential trust issues to the financial institutions and others users of Equator Principles certification (investors, shareholders, NGOs etc).
We believe that an important sustainability goal for the project finance industry is overcoming such variability in assessment reports of projects and the trust issues in the selection of consultants and experts to certify projects.
The achievement of this goal would make the Equator Principles significantly more useful in orienting capital allocation decisions in the global financial markets. Banks, agencies and other investors would have a clear comparison framework to decide in which project to invest on the basis of sustainability criteria. In addition, the achievement of such goal would help local communities, governments and NGOs have better information and arguments to fight against negative impacts of projects.
2. Business Model Innovations applied to the Equator Principles Chain
Business models innovations could help the Equator Principles adopters to achieve such goal in a sustainable and financially viable path. Such new business model would involve the use of standardization, re-sequencing and marketplaces.
Standardization in this context means reducing or eliminating the variability in the reports issued by independent consultants or experts. This result can be achieved by the adoption by the Equator Principles Association of (a) guidelines and directives to the process of collecting, analyzing and reporting the data relevant to the projects and (b) mandatory training and certification for the consultants and experts issuing valid reports.
Another business innovation tool is re-sequencing the selection of consultants and experts. Currently, these agents are recruited from a local pool of environmental consulting agencies and then trained about evaluating compliance with Equator Principles. However, such consultants and experts shall rather first be trained and certified by a commonly recognized entity and afterward be hired by financial firms to evaluate projects. This re-sequencing logic is particularly important in emerging markets where the availability of local experts is reduced (Africa and Latin America).
Finally, the use of a marketplace is also a powerful tool applicable to this context. The Equator Principle entities shall be able to use that marketplace to shop for consulting services previously approved and certified for performing the analysis and reports required in the principles. Therefore, a global market for such consulting services would be possible, reducing transaction costs, solving trust issues and reducing opportunism of agents (a rating system could be provided).
3. The Impact of the Business Model Innovations
The combined use of such business model tools could be a game changer for the market for consultants and experts (rising quantities due to smaller transaction costs) and for the market for investments.
The consulting markets will benefit from an increased match between demand and supply, allowing for larger quantities of services and, at least, a split of the transaction costs between supply and demand market agents.
A standardized evaluation of social and environmental risks will help in the allocation of financial resources by lenders and shareholders, and help communities, governments and NGOs to assess impacts of projects and intervene as necessary (Principle 6 requires a grievance mechanism to allow local players communicate and solve concerns related to the project).
The impact in capital allocation may operate as a dramatic incentive mechanism as it reduces the cost of capital for socially and environmentally responsible projects. In a world of low yields, investors are searching worldwide for returns, but, ideally, such returns shall come from sustainable projects and not others.
In the same way, the impact of the solution will provide local communities with arguments to question projects in their locations, by pointing out comparisons with projects adopted elsewhere in the world. For example, the standardization validates the claim that one project in the forests of Africa shall adopt at least the risk management measures adopted in a Latin American project financed by one same international bank.
The presented business model is becoming each day more urgent as new large projects have been setting in frontier emerging markets such as Sub-Saharan, South American and East Asian countries. In these countries, where the environmental and social regulations applicable to large projects are not yet established, the Equator Principles have a crucial impact. Equator Principles has the power to stop the vicious loop in that the higher the potential economic growth associated with a project, the higher the damages of the project, and vice-versa.
4. Drawbacks of the Business Model Innovations
Notwithstanding the many benefits, the use of the new business models tools presents some challenges. One challenge is that financial firms may be reluctant to adopt the marketplace or standardization, fearing they will lose control of the process of analyzing and reporting the data from the projects. As country specific differences exist, firms may be wary of adopting a centralized validation of the consulting and experts qualifications.
Another challenge is the cost of training such consulting and experts: who will bear them? The financial firms or the service providers? Instead of diminishing the barriers, the third party validation process can work as a potential barrier to consultants and experts not capitalized enough to go through the process of validation.
5. Current comparable applications
If we look at the global financial markets, the most similar business model to the one we suggested is the one of the credit rating agencies.
The rating agencies, the likes of Moody’s, Fitch or Standard & Poor’s, perform all the due diligence necessary to produce an easy to understand and standardized measure of the credibility of the issuer. The standardized ratings allow the comparability investors and other users of financial information need to take investment allocation decisions or other actions (other users are for example employers, who change their jobs when a firm`s grade worsens).
The suggested re-sequencing exists for rating agencies because rating agencies shall be first recognized as qualified entities before their credit ratings have meaning to investors. The securities regulator have first to recognize the capabilities of the rating agency (e.g. in the US, the SEC shall grant the title of NRSRO for rating agencies to become relevant).
As regards the marketplace technique, as far as we know, there is no experience in practice addressing the situation or a similar one (though marketplaces for service providers have become popular lately, from markets for drivers to physicians, physiologists, veterinarians etc. ).
6. Summary
In summary, Equator Principles need to reinvent themselves to become more effective. The reducing of variability, re-sequencing and marketplaces are business models innovations applicable to the markets of consultants and experts responsible for assessing and certifying compliance with such principles. Such innovations would facilitate investor allocation in alternative projects according to sustainability criteria and a better understanding and contesting arguments for affected communities, governments and NGOs in relation to the projects affecting their regions.
I’m not sure resequencing the hiring of local consultants (or training them under one certified body) would reduce the variability in the sustainability of project finance endeavors. Consultants will always have the temptation to “meet their KPIs” through nefarious ways to justify why they are being paid in the first place by the project sponsor. I’m not sure changing this element will result in more environmentally sustainable project finance projects.