Introduction
When oil prices were high, top companies in the Oil and Gas sector dedicated funds and efforts to managing sustainability and Environment and Social Governance (ESG). Then, all of a sudden, oil prices decreased and so, too, did this focused effort and funding across the sector. Now that oil prices are incrementally escalating and the pressure on clean energy sources is increasing, there are companies that have traversed the desert of low oil prices with their funds dried up. Does anyone want to allot funds to a poorly-managed ESG company? Will investment funds go to the poorly-managed or the appropriately-managed company? Where do you think the money will go?
This paper is not about ticking the ESG box to get funds at a lower cost. Instead, it is intended as a guide, nudging the reader to honestly assess your company’s ability to translate your ESG policy, and to think about changing the way you do business in order to deliver promise and value to your stockholders.
Background
How can you be sure that a project is managed according to ESG standards? The simplest answer to this question is making sure that your project is bankable, which ensures alignment with ESG standards. Here’s why: investors are often convinced to place their funds in lenders’ accounts because lenders say they will invest in activities that protect or benefit society and its environment.
So how or when is a project considered bankable? A project is considered bankable if lenders are willing to finance it. This is the clear position of the European Investment Bank. Yet, before we arrive at bankability, we have to understand the context from which some of the direct benefits will be extracted by the companies taking this approach, which may also affect the lenders’ criteria to finance a project.
Project Financing
In the current context, large and small-scale projects face a range of challenges including government regulations, construction schedule and budget, and profitability during operation. Obtaining project financing is almost always the greatest challenge for the developer.
It’s not a new one. Long ago, Roman and Greek merchants used project financing techniques to share the risks inherent to maritime trading. A loan would be advanced to a shipping merchant on the agreement that such loan would be repaid only through the sale of cargo brought back by the voyage. Sound familiar? In modern finance terminology, this means that project financing would be repaid by the internally generated cash flow of the project. This technique was widely adopted during the 1970s in the development of the North Sea oil fields, and in the US power market following the 1978 Public Utility Regulatory Policy Act (PURPA) (Gardner&Wright).
The increasing tendency for companies to use project finance mechanisms has necessitated the involvement of lenders, usually in a syndicated manner, to distribute the risk of project development. Additionally, there are three main motivators for sponsors to seek project finance:
1. Limited Recourse. In case of investment failure, a Lender’s only recourse may be the assets of the Project Company.
2. High leverage. It is not uncommon for projects to be 90% debt financed, which carries additional benefits:
• Lower initial equity injection requirements, decreasing the project investment risk;
• Enhanced shareholder equity returns; and
• Deductible debt finance interest from profit before tax (PBT), reducing the (post-tax) weighted average cost of capital of the Project Company.
3. Balance Sheet Treatment. This allows the shareholders to book debt off from the balance sheet. Having established the current context and trends related to project development financing, we can return to the original, definitive question: “Is this project Bankable?” To answer this question, we must review the criteria that drive a lenders decision to financially support a project.
Essentially, there are four key drivers:
1. Economic sustainability, which encompasses cash flow to support repayment of the loan under different stress scenarios, assessed through technical reviews of the operability and reliability of the project as well as the product or service market;
2. Loan Interest Rate, which should be balanced against the risks;
3. Policy Compliance, particularly those that are public such as Equator Principles and IFC Standards and Guidelines; and
4. Operational Risk, which can be translated into risks affecting the Repayment of the loan and/or the bank/lender reputation.
For the purposes of this paper, we are going to focus on Policy Compliance and Operational Risk.
Most banks or lenders have embraced the Equator Principles as part of their policies. When conducting bankability assessments, lenders look for compliance with Equator Principles and IFC Standards and Guidelines, as well as Good International Industry Practices (GIIP). Consultants are usually engaged to prepare the documents from the developer side, whereas the lenders engage with other consultants to review the business structure against those standards. Time, effort and potential changes to the initial design are involved in assessing compliance with these standards, which are also related to operational risk, which is perhaps the most crucial element of the bankability assessment.
As mentioned previously, the lender takes on risks related to repayment and reputation. The due diligence of a project identifies existing or potential liabilities that may disrupt the cash flow or the project balance sheet, and policy compliance (against Equator Principles, IFC Standards, and GIIP) is an effective and expedient way to identify them. If the developer fails in the cash flow forecast due to improperly addressed risks, the likelihood of repaying the loan decreases. Furthermore, if any of these risks have links to social or environmental mismanagement, the lender’s reputation will likely be affected, which is particularly detrimental to those who sell a social, environmental, and ethical portfolio (Green Funds or Socially Responsible Investors).
Risk Assessment and Project Bankability
According to the World Bank , the following key risks need to be allocated and managed to ensure successful financing of a project:
- Construction and Completion Risk
- Operating Risks
- Demand Risk
- Force Majeure
- Political and Regulatory Risk and Expropriation and Nationalization Risk
- Environmental Risk
- Social Risk
- Tenor and Refinancing Risk
- Currency Exchange Risk
- Interest Rate Risk
The perception that risk has changed in the last 10 years has affected the context of project bankability. Based on analysis by the World Economic Forum (WEF), risks between 2007 and 2010 were primarily geopolitical, economic, and social (health). Since 2011, environmental and societal issues have been in the top five . The WEF's Global Risk Landscape 2017 shows the impact and likelihood of global risks.
The Risk Radar update from the CRO Forum, a group of professional, insurance industry risk managers that focus on developing and promoting industry best practices, identified environmental and societal-related issues as risks likely to result in a claim in the next 10 years.
Additionally, according to Goldman Sachs (2010), Non-Technical Risks account for up to 70-75% of cost and schedule failures in projects in the form of schedule delays and cost overruns, local deal opportunities, and a host of stakeholder-related issues. An example of this might be a company in the extractive industry that suffers $6.5bil value erosion over 24 months due to non-technical risks, including community opposition and delays in regulatory approval - exactly the situation that lenders try to avoid.
Until relatively recently, compliance with local regulations was almost the only requirement for a project to proceed. Environmental and social issues were seldom included in the project conceptualization, visualization, or design. However, in recent years, there has been a dramatic shift in both risk perception and lender requirements to provide financing.
