How unmanaged E&S impacts can generate business risk

Case 1: An example of good E&S risk mitigation by a Bank

Background Client - medium sized fertilizer manufacturing company. Location – near a major international watercourse, upstream from a national park Financing request - long term loan facility for $10mn. Bank categorized the Client’s activities as high risk project and engaged an external consultant to assist with the E&S due diligence.

Findings and Outcome of the E&S Due Diligence Lack of management commitment, systems and capacity to address E&S impacts. Actions to control and manage pollution and fix failings in the effluent holding ponds and other site infrastructure had not been implemented. Management appeared to be underestimating the potential risks associated with poor effluent management. Outcome The Bank makes repairs of infrastructure a condition precedent for disbursement of loan facility.

What went wrong ? Shortly after signing - a flood Heavy rains lead to large volumes of effluent spilling into the river as holding ponds fail; Wildlife and livestock deaths over a 15km stretch of river; Tourism activities suspended; Plant closed down by authorities. Fortunately for the bank - first disbursement was on hold pending implementation of condition precedent.

Lessons Learned The type of activity, size and location all have a bearing on likelihood and potential severity of E&S impacts. Assessing a Client‘s commitment, capacity and track record to manage E&S impact is a critical part of the due diligence process. The bank‘s ESMS correctly identified high risks associated with weaknesses in E&S management, in particular failure to address structural failures in effluent ponds. The bank correctly made risk mitigation actions as conditions precedent to disbursement in the loan agreement.

Case 2: Importance of taking local communities into account

Background Client: Medium sized company manufacturing activated carbon from coconut shells. Financing request: long term loan facility for $7mn to expand production facility by 2 ha. Findings: E&S due diligence undertaken by the bank involved a desk top study of information provided by the client. No site visit was made. Terms: A clause was included in the facility agreement requiring the company to comply with relevant local E&S legislation, but Client was not requested to submit documentation to demonstrate compliance with this clause.

What went wrong ? Closure. Shortly after signing the facility, the company is closed down by the local authorities. Bank learns of the news through the newspaper. Why? The trigger for closure was a community protest over expansion and concerns of worsening dust pollution. No good news. Further investigations revealed that the factory had been exceeding national emissions levels by a lot, for a long time. Information that had not been shared with the Bank. Facility is written off by the Bank. It was only after community protests that the local authorities moved in to close the factory.

Lessons Learned Do not rely on the client’s word. Visit the site as often as possible, ideally with the help of a specialist. Talk to other stakeholders, in particular those directly affected such as neighboring communities Consider E&S issues as early in the process as possible to avoid cutting corners with the E&S due diligence. Ask yourself “Would you and your family like to live next to the project you are financing?” If not, you can probably count on community activism.

Case 3: Assess E&S risks beyond your project and financing perimeter

Background Client: A chemical plant producing highly inflammable substances, using state of the art technology with all E&S related licenses of local authorities obtained, operating in the industrial zone. Financing request: multi-million dollar facility.

Finding of Bank’s E&S due diligence The E&SDD noted many overlooked risks that could increase the likelihood and severity of a potential accident, including: Proximity of many informal vendors outside the company walls, preparing food on open fires only metres from petroleum intake; Highly congested neighbourhoods and poor road infrastructure preventing an effective emergency response; Inadequate emergency preparedness and response; no engagement with neighbouring entities or communities whatsoever. The Bank requested the Client to Develop a joint emergency response plan with neighbouring companies and vendors. Move the vendors to a vacant space away from the perimeter wall. Engage local authorities to improve the road infrastructure. It was only after community protests that the local authorities moved in to close the factory.

Lessons Learned A full assessment of potential community health and safety risks should have been undertaken before site selection by the Client’s ESIA. Ventures located in congested urban environments have inherently high community health and safety risks. Banks must look beyond issues that are directly within their Client’s control. If it is difficult for the Client to influence a third party to mitigate risk, it may be better not to proceed with the deal. What do we learn from this case? Be aware when projects/operations with inherently high community health and safety risks are located in a congested environment. Always ask whether the location is even appropriate regardless of approvals from authorities. Are you exposing the Bank unnecessarily? Do not just look at the aspects that are directly within your Client’s control. You also have to understand how your Client’s activities can impact in areas that they may not be able to directly control (e.g. improvement of the road infrastructure). Understand these risks, establish whether the Client has any influence over their management and identify strategies and associated costs to address. In the event that it may be near to impossible for the Client to influence action on behalf of a third party or establish a viable alternative then it may be better not to proceed with the deal. E.g. the Bank deems it highly unlikely that the Sponsor will be able to get movement with the local authorities to improve accessibility for emergency services. Ideally, a full assessment of potential community health and safety risks should have been undertaken before site selection. Had one included the potential costs for rehabilitation of the road into the financial model (worst case scenario in the event that the Client is unable to influence the local authorities to undertake the necessary repairs), then possibly other sites would have been even more attractive.

Lessons learnt from all the cases Implementing E&S Management Systems in FIs pays in terms of avoided financial losses. Banks must always ask Clients for demonstrable evidence of compliance. If in doubt, involve specialists. Banks should always conduct their own site visits. E&S risk research must extend beyond the direct boundaries of the venture being financed. Banks should be alert to poor management commitment and capacity.