Banking and sustainable development

Annex 4.1: Banking and sustainable development

Corporate responsibility and sustainable development have become key aspects of good business practice in the financial sector. Responding to increasing pressure from customers, shareholders, non-governmental organisations and the media, financial institutions have realised that it is important for their good reputation to address environmental and social issues.  They have also recognised that borrowers non-compliance with national regulations and standards can translate into real financial risk for banks. This has prompted many to integrate environmental and social considerations into their credit assessment processes. In addition, many banks have come to recognise the business potential of sustainable development in areas such as energy efficiency and carbon finance. Over 65 per cent of respondents to a recent survey by the International Finance Corporation (IFC) indicated that following training, they experienced tangible benefits from developing new business in these areas.

To what extent the concepts of corporate responsibility and sustainable development have become key considerations in the financial sector in the transition region is examined below.

First, we examine the participation of banks in three major international initiatives that aim to promote environmental and social standards in the financial sector the Equator Principles, the United Nations Environment Programme Finance Initiative (UNEP FI) and the United Nations Global Compact. Secondly, we examine the degree to which environmental and social issues are reported in the official publications of leading banks.

The analysis shows that banks in the transition region consistently lag behind in terms of adopting environmental and social policies, compared with three benchmark countries Greece, Spain and Portugal.

Participation in international initiatives

Equator Principles

The Equator Principles were agreed by a group of leading commercial banks in 2003. Based on environmental, health and safety guidelines and the IFCs environmental and social safeguard policies, the principles set out a framework for socially responsible and environmentally sound lending practices. They focus exclusively on project finance bank lending against the cash flow of a specific investment project without recourse to the sponsors of the project. Originally, they only applied to loans of more than US$ 50 million but in 2006 this threshold was lowered to US$ 10 million. At the same time, the principles were updated to include new IFC Performance Standards on Social and Environmental Sustainability, and their scope was expanded to include advisory services. Signatories are also required to report publicly on their performance in meeting the principles. As at September 2006, 40 banks had signed up to the revised principles.

The Equator Principles are relatively stringent and require a serious institutional commitment in terms of environmental and social assessment and performance standards for borrowers. However, by focusing on project finance they are also quite narrow.

Project finance is rather specialised and usually reserved for large and complex transactions like extractive industries or big infrastructure investments. As such, it is not a typical banking activity in the transition region and made up only 9 per cent of total lending (or about US$ 8.5 billion)[3] between January 2005 and July 2006. About two-thirds of the projects (accounting for more than 90 per cent of this amount) were for loans above US$ 50 million. (Had the US$ 10 million threshold been in place for the whole of this period, practically all projects would have fallen within the scope of the Equator Principles)

Although there are no banks from the transition region among the 40 signatories of the Equator Principles (see Table 4.1.1), most project finance activities in transition countries are covered. This is because most project finance transactions are processed by specialised teams in international banks, whose central office has signed up to the principles. Many deals also involve international financial institutions, such as the EBRD and IFC, which have stringent environmental and social requirements. The only commercial banks involved in project financing in the region that are not signatories of the Equator Principles are BNP Paribas, Raiffeisen Zentralbank (RZB) and BayernLB. However, all of these banks have some level of commitment to environmental and social assessment in lending, and BayernLB also requires its projects to meet World Bank environmental and social standards.[4]

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UNEP Finance Initiative

The UNEP FI is a partnership arrangement between the public and private sector, which offers training and best practice advice to its members. Unlike the Equator Principles, it has very general objectives. Participating banks must embrace sustainable development as a fundamental aspect of sound business management in both lending and internal operations. They are also encouraged to report publicly on the implementation of their environmental policies although they are not obliged to apply any measurable performance standards to either themselves or their borrowers. The only membership obligation is the submission of an annual report outlining the steps taken to comply with UNEP FI principles. These reports are for internal UNEP FI use only and are not made public.

As at September 2006, the UNEP FI had 161 members worldwide, with some 75 per cent based in western Europe or North America. The number of signatories has dropped from 289 members in 2002, when a compulsory membership fee was introduced. Those leaving included banks from the transition countries, which are now represented by only four signatories the American Bank of Albania (a commercial bank), HBOR (the state development bank of Croatia), , Banca Commerciala Romana (the leading Romanian bank) and Econatsbank (a Russian niche bank).

UN Global Compact[6]

Launched in 1999, the UN Global Compact brings together companies, UN agencies and others, such as NGOs, to support ten universal environmental and social principles. These principles cover human rights, labour standards, the environment and fighting corruption. The operational phase was launched in 2000. Participants are asked to report on their progress in following the principles but do not assume any more detailed commitments. The compact is open to participants from all areas of the economy, with only one in eight members coming from the financial sector. The 282 participants from transition countries account for about 8 per cent of all members. In the financial sector, transition country participants number 29 (out of 284) or about 10 per cent of signatories (see Table 4.1.1).

Reporting on social and environmental policy

Transparency and accountability are considered important elements of corporate responsibility. Therefore, an important way to gauge commitment to sustainable development is to examine how leading banks cover this commitment in their official reports. Publications from the three largest banks (by assets) in 19 transition countries were screened for information about the banks external and internal policies on the environment and social issues and their sponsorship activities in local communities.[7]

External policies cover the integration of environmental and social considerations in the credit appraisal process and the standards expected from borrowers. . Internal policies concern a banks own rules and procedures covering, for example, energy efficiency, recycling or human resource management. Development initiatives aimed purely at improving the financial performance of the bank are not considered. Local sponsorship activities are of interest because in western Europe they were often the first steps that companies took to demonstrate good corporate citizenship. Their adoption in transition countries might therefore imply a similar advance.

Such a survey may not describe accurately the efforts made by a bank in its actual operations. The subsidiaries of Western banks, for instance, typically apply the environmental and social policies of their parent companies, which are reported on a group-wide basis.[8] In some cases, policy statements may not be fully implemented. Moreover, the efforts of the three largest banks are not necessarily representative of a countrys financial sector as a whole. Nevertheless, scrutiny of public reports can give a good indication of the importance of environmental and social policies.

The results of the survey are shown in Chart 4.1.1 along with the results from the benchmark countries (Greece, Portugal and Spain).

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Banks in the transition region show a far lower level of environmental and social awareness than those in the benchmark countries. Only one-sixth of the banks surveyed took environmental factors into account in their lending decisions, and even fewer were concerned about social factors. Internal measures to improve the environment were also rare. Regarding internal social policies, only one in four banks in the transition countries reported programmes to improve working conditions and staff welfare. More positively, three out of four had a local community sponsorship or charity programme. It is the only area where the level of activity approaches that of the benchmark countries.

Chart 4.1.1 shows banks in central eastern Europe and the Baltic states (CEB) outperforming their counterparts in south-eastern Europe (SEE) and the Commonwealth of Independent States (CIS) regarding environmental criteria. Social indicators are similar for SEE and CEB, with the CIS again recording a lower score. Sponsorship and philanthropy is the only area where CIS banks have not lagged behind. This could be because company engagement in activities benefiting the community was already a well-established practice during the Soviet era.

Conclusion

Environmental and social awareness has not yet become a significant feature of the financial sector in the transition region. Transition countries are clearly under-represented in international initiatives such as the Equator Principles, UNEP FI and the UN Global Compact. For all three initiatives, the number of participants is lower than the combined total from Portugal and Spain. Compliance with the Equator Principles is highest, helped by the fact that most transactions covered under this initiative are undertaken by institutions outside the region. The low level of environmental and social reporting by leading banks reinforces this conclusion, particularly in the CIS.

There may be several reasons for this comparatively poor performance. Only when environmental, health and safety, and labour regulations are effective and properly enforced will non-compliance by borrowers become a potential credit risk for financial institutions. As long as non-compliance has no financial implications for borrowers, it is unlikely that banks will integrate environmental and social considerations into their risk management processes. In this respect, the eastern expansion of the European Union has given indirect impetus to sustainable development in finance through the promotion of harmonised and comparatively stringent environmental regulations.

The risk of liability for soil and groundwater contamination has played a significant role in advancing the business case for environmental risk management in banking. For example, when taking possession of a secured asset, a bank might find itself with something worthless or, worse, with an environmental liability (see Box 4.1.1). How to address past environmental contamination was a key issue during the 1990s in many CEB and some SEE countries, although less so in the CIS. Legal uncertainties over asset ownership, regulatory changes related to clean-up liability and standards, and investor concerns about future responsibilities are all incentives for borrowers and banks to conduct environmental due diligence (although less so where enforcement is weak).

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Awareness of environmental and social issues in local communities and the media is another important factor. The environmental and social performance of companies is scrutinised increasingly by NGOs and the public. Moreover, campaigners may trace the funds received by companies with a bad sustainability record back to their lenders. Pressure on banks to consider the environmental and social impact of their core business consequently rises. However, this type of public scrutiny, primarily targeting international financial institutions (IFIs) and foreign-owned banks, is relatively new in the transition region and the risk to domestic banks is still comparatively low.

Similarly, the pressure on banks in the transition countries to disclose environmental and social information remains much lower than in western Europe. Foreign-owned banks in the region will probably rely on group-wide reports published by the foreign owner. However, what is often lacking in this case is a reference in the subsidiarys report to sustainabilityinformation provided by the group. Conversely, only few international banks provide disaggregated data for their Eastern European subsidiaries in their sustainability reports, or information on how they ensure effective implementation of their policies in subsidiaries.

In addition to environmental law enforcement and public scrutiny, the desire to access funding from IFIs is one of the main incentives for adopting environmental and social risk management practices. For example, the EBRD and the IFC have extended finance to almost 80 per cent of the leading banks surveyed above and the two institutions have, between them, an equity stake in over 50 per cent of these.

Modern environmental and social practices are being adopted at a slow rate, however. Typically they are introduced initially for products (such as credit lines) supported by an IFI. With adequate technical, they may be extended subsequently to cover other lines of business and incorporated into the companys general business practices (see Box 4.1.2).

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Only a few banks in the transition region have reached this stage. However, rising awareness, improvements in the application of environmental, health and safety standards and the continuing influence of IFIs should encourage further change. The banks themselves are anticipating the change. A small UNEP FI survey conducted in 2004 in 12 transition countries found that more than 75 per cent of the responding banks expected that sustainable development issues, particularly environmental risk management, would increase in importance in the financial sector in the coming years.[9]

References

IFC (2006), Choices matter. 2005 Sustainability Report, International Finance Corperation, World Bank Group, Washington   D.C. Available at: https://www.ifc.org/ifcext/enviro.nsf/AttachmentsByTitle/p_2005SustReport_full/$FILE/2005SustReport_full.pdf

PFS Program (2006), Survey of reporting on corporate social responsibility (CSR) by the largest listed companies in eleven central and eastern European (CEE) countries, Budapest, Hungary. Available at: https://www.pfsprogram.org/capitalmarkets_research.php

UNEP FI (2004), Finance and sustainability in central & eastern Europe, UNEP Finance Initiative, Central and Eastern European Task Force. Available at: www.unepfi.org/fileadmin/documents/ceetf_finance_sustainability_2004.pdf

Table 4.1.1

Box 4.1.1: Environmental risk management

Some examples of the business case for environmental risk management are outlined below.

Poland

A bank lends US$ 2 million to a food processing plant to upgrade technology.

The customer offers the plant as security.

The customer defaults and the bank takes possession of the security.

The bank learns that the full value of the security cannot be realised without a US$ 1 million capital investment required for environmental compliance.

The plant does not operate while the bank, as legal owner, negotiates with the local authorities on the extent of its financial liability.

Czech Republic

A bank lends US$ 1 million to a property developer.

The bank takes apartment buildings as security.

The customer defaults and the bank takes possession of the security.

The bank learns that the buildings are contaminated, making them unfit for occupation and rendering the property worthless.

The bank writes off almost all of the loan but remains the owner of the site and has liability for the clean-up costs.

Romania

A bank makes a five-year loan to a lignite producer with an exemplary environmental compliance record.

The producers main customer (generating 70 per cent of its revenues) is a nearby power plant.

This customer subsequently informs the producer that, because compliance with air emission regulations will require power plants to convert from coal to natural gas or to invest in expensive emissions control equipment, it is opting for conversion to gas.

The bank works with the producer to assist it in finding new markets for its coal, with some success, but is nevertheless forced to write off a large portion of the loan.