The Hindu Business Line : Can banks ensure eco-friendly economic development?

The Sardar Sarovar Project has been in the news, not as a symbol of economic development as it was intended to be, but as that of environmental and social degradation.

The reason is evident. Very large projects, by virtue of their size, implementation and investment objectives, coupled with weak or compromised government policies, can create environmental and social risks.

The Sardar Sarovar project is no exception. It is highly likely that more environmental and social issues would arise in future infrastructure projects too.

In the last few years, two powerful forces have joined hands with the government in realising India's infrastructure dream — the private sector with its managerial and financial resources and keen commercial sense, and the financial system, consisting primarily of banks and, to a lesser extent, the capital market. This brings us to the pertinent issue — who is to manage environmental risks?

Prudent risk management demands that risks be allocated to parties that can best bear them at least cost.

Can environmental and social risks of infrastructure projects be allocated to stakeholders? If not, who should bear these risks — the government, the private sponsors or the lenders?

TARGETING LENDERS

It seems only logical that the government and the private sponsors, who conceive, promote and manage large infrastructure projects, also bear the environmental risks. Lenders are mere facilitators.

Yet, in many countries, environmental activists have begun targeting banks in such deals. In one such case in 2001, the Rainforest Action Network (RAN) targeted a banking major for allegedly financing environmentally and socially harmful projects.

It launched a campaign encouraging students and others to boycott the bank's credit cards and other loan facilities. There have been several such actions against banks in other countries as well.

Banks in India have begun to play a key role in infrastructure financing through the project-financing route — the most preferred alternative for project sponsors.

Sponsors create a legally independent project company with a single purpose capital asset — a power plant, an airport or an oil pipeline. The asset is financed by the project company through equity from multiple sponsors and large doses of debt, primarily from banks.

The project financing structure enables optimum risk allocation through contracts. Therefore, the debt is non-recourse to project sponsors — that is, lenders typically look solely to the project cash flows for debt service, and not to the sponsors' other assets in case of default.

In 2005 alone, the volume of project financed transactions in India more than trebled, taking India's market share in such transactions in the Asia-Pacific region from a mere 2.8 per cent to 12.5 per cent.

For the first time ever, at end 2005, State Bank of India grabbed the top slot in the Asia-Pacific Project finance league tables.

As mandated lead arranger, SBI helped some 16 Indian infrastructure deals worth $ 2.1 billion during 2005. What makes the achievement noteworthy is that SBI had occupied the 15th place in the region only a year ago (Thomson Financial).

With banks' growing role in financing infrastructure, possible action by activists against them for financing environmentally harmful projects cannot be ruled out.

Thrusting responsibility

Environmentalists believe that banks need to take legal and moral responsibility for the economic and social consequences of their business practices.

That apart, lenders have economic incentives to ensure that environmental risks are mitigated. Banks typically earn upfront fees for advising on project deals and tying up the financing. They earn income from the funds lent.

Banks would, therefore, want the project to achieve early financial closure, and generate cash flows to service the debt once the project is on stream.

If environmental risks hamper the project's progress, lenders face substantial credit risk, which could translate into reputation risk. In contrast, private sponsors have the real option of abandoning projects with possibly less economic and reputation losses.

Forty-one top international banks have subscribed to the Equator Principles formulated by the IFC in the late 1990s (last revision in February 2006) to ensure that infrastructure projects being financed by these banks reflect socially responsible and environmentally sound practices.

In adopting these principles, banks undertake to (a) review carefully all project financing proposals from sponsors, and (b) not provide loans to projects where the borrower is unable to comply with prescribed environmental and social policies and processes.

What must India do?

It is imperative that the Reserve Bank of India and banks put in place appropriate measures on the lines of international best practices to ensure that they do not finance environmentally or socially harmful projects. Some of the immediate measures to be initiated are:

The RBI should devise stringent criteria for environmental assessment of infrastructure projects,

Oversight mechanisms should ensure that banks and institutional lenders involved as advisors or lenders in infrastructure projects, uncompromisingly, adopt these criteria,

Make strict compliance with stipulated environmental and social standards a precondition for financial closure,

These criteria could be on the lines of the Equator principles and customised for Indian projects,

Leading project financing banks in India, to gain international and IFC acceptance, should be encouraged to join the select band of banks following the Equator principles.

The government faces the challenge of striking a balance between economic development and environmental or social degradation.

The onus is, therefore, on the banking system to ensure that the need for economic development does not outweigh the need for environmental protection.

(The author is a finance consultant and visiting faculty at IIMs. Feedback may be sent to )

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