Beyond Risk (2003)

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BEYOND R ISK

In developed markets, the concept that environmental

risk can critically affect the viability of investments is well

understood. But in emerging markets, the appearance of

a new set of global stakeholders presents both risks and

opportunities for financiers.

JAPAN/IFC

COMPREHENSIVE

TECHNICAL ASSISTANCE

TRUST FUND

INTERNATIONAL

FINANCE CORPORATION

A Member of the

World Bank Group

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S US TA INA BI L ITY A ND THE E ME RGING MA RKE TS F INA NCIA L S E CTOR FOREWORD

With support from the Japan/IFC Comprehensive Technical AssistanceTrust Fund, IFC has developed a pioneering program designed to help its financial

sector clients in emerging markets integrate environmental management techniques

into their operating practice.

Drawing on the lessons of experience of these clients, the objective of this

casebook is to examine emerging risks for the financial sector, outlining examples

of strategic responses that have the potential to transform this risk into opportunity

and documenting experience in implementing these initiatives successfully.

Letitia F.Lowe

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ACKNOWLEDGEMENTSThis casebook has been prepared by Leo Johnson, Consultant, on behalf of the Environment and

Social Development Department of the International Finance Corporation (IFC). The project was made

possible by the generous financial support of the Japan/IFC Comprehensive Technical Assistance Trust

Fund. The task manager for the project was Letitia Lowe.

Many people within IFC provided valuable guidance, input and support including: Glen Armstrong,Martyn Riddle, Imoni Akpofure, Dan Siddy, Todd Hanson, Clive Mason, Maria Gallegos, Vanessa

Manuel, Sevaun Palvetzian, Debra Sequeira, James Beck, Zenaida Chavez, Sarah Ruck, Richard Caines,

Bernie Sheahan, Karin Strydom, Batsuren Eenjin and Stuart Turnbull.

Thanks also go to:

Andre Abadie, Charity Agorsor, Vera Assad, Trevor Bowden, Ferdinando Buffoni, Cesare Calari,

Michael Campbell, James Casey, Paul Clements-Hunt, Josefina Doumbia, Roberto Esmeraldi, Warren

Evans, John Ganzi, Maureen Gilbert, Iris Gold, Caroline Goldie, Bregje Hamelynck, Harvey Himberg,

Hilary Hoagland-Grey, Mark Hughes, Madeleine Jacobs, Kaj Jensen, Stanley Johnson, Mark King,

Rachel Kyte, Julian Lampietti, Dana Lane, Arthur Levi, Tina Mack, Jacob Malthouse, Arvind Mathur,

Shawn Miller, Mario Monzoni, Herman Mulder,Taies Nezam, Joe OKeefe, Michael ONeill, Niamh

OSullivan, Harry Pastuzek, Vipul Prakash, Bruce Purdue, Gladis Ribeiro, Helen Sahi, Robin Sandenburgh,

Alke Schmidt, Corrie Shanahan, Mangala Suresh, Felice Tambussi, A.J. Teixeira, Yogesh Vyas, Udayan

Wagle, Flavio Weizenmann, Christina Wood, Prakash Yardi, Caroline Zuniga.

Special thanks go to: Vijay Joshi and the management of IL&FS, Roberto Dumas Damas, and Maria

Estela Ferraz de Campos of BBA, Ziad Oueslati of Tuninvest, Gaspar Millhaiffy, Laszlo Szabo and

Attila Bogdan of Raiffeisen Bank and all of the participants in the CEA workshops.

Table ofContents

1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

2 THE NEW GEOGRAPHY OF RISK . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

3 THE EMERGING MARKET RESPONSE . . . . . . . . . . . . . . . . . . . . . . . .25

4 LESSONS FROM THE FIELD: SUSTAINABILITY IN ACTION . . . . . . . . .45

5 CONCLUSIONS AND RECOMMENDATIONS . . . . . . . . . . . . . . . . . . .57

ANNEXES

A) LIST OF BOXES,FIGURES AND TABLES . . . . . . . . . . . . . . . . . . . . .65

B) SURVEY, METHODOLOGY,QUESTIONNAIRE PRO-FORMA,

UPTAKE OF ENVIRONMENT INITIATIVES . . . . . . . . . . . . . . . . . . . .69

C) LIST OF SITE VISITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79

D) CEA WORKSHOPS AND PARTICIPANTS . . . . . . . . . . . . . . . . . . . .83

E) REFERENCES,LINKS AND FURTHER INFORMATION SOURCES . . . . . . . .93

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4

ISO International Organization for Standardization

MOF Ministry of Finance

NGO Non-Governmental Organization

NPL Non-Performing LoanOECD Organization of Economic Cooperation and Development

SME Small and Medium-sized Enterprise

SRI Socially Responsible Investment

UNEP United Nations Environment Program

USAID United States Agency for International Development

WB World Bank

WBG World Bank Group

WCED World Commission on Environment and Development

WTO World Trade Organizatio n

WWF World Wide Fund for Nature

1.INTRODUCTION

A successful bank can no longer just look a t the

commercial performance of a customer. It has to

consider its broader performance in environmentaland social issues.

Roberto Dumas Damas

Banco BBA Creditanstalt,Brazil

ACRONYMS

ADB Asian Development Bank

AFDB African Development Bank

CEA Competitive Environmental Advantage

CDC Commonwealth Development CorporationEBRD European Bank for Reconstruction and Development

EIB European Investment Bank

EMAS Eco-Management and Audit Scheme

EMS Environmental Management System

ESMG Environment and Social Management Group

EU European Union

FI Financial Intermediary

IFC International Finance Corporation

IFI International Financial Institution

IPO Initial Public Offering

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SINCE 1997,OVER 375 MANAGERS FROM 275 FINANCIAL INSTITUTIONSAND 45 NATIONS HAVE PARTICIPATED IN THE C OMPETITIVE

ENVIRONMENTAL ADVANTAGE WORKSHOP SERIES

7

Since mid-1997, as part of a two-phased programfunded by the Japan/IFC Comprehensive Technical

Assistance Trust Fund, IFC has collaborated with

regional, multilateral and bilateral development

banks in running the Competitive Environmental

Advantage (CEA) workshop program. The workshops,

part of a program designed to build environmental

appraisal capacity in private financial institutions

from developing and transitional economies, aim

to equip participants to complete three tasks:

1. Assess the strategic rationale for environmental

management for their financial institutions

2. Perform cost-effective environmental risk manage-

ment of investments

3. Implement value-adding environmental techniques

institution-wide

Since 1997, over 375 managers from 275 financial

institutions and 45 nations have participated in the

workshops, with institution types including commer-

cial banking, project finance, leasing and private

equity. Annex D provides details of the workshops

held to date, together with a list of the participant

institutions & partner development banks.

Under the second phase of the program IFC set out

to complete three tasks:

s a website on environmental management for the

financial sector

s development of a Trainers Manual

s publication of a casebook on environmental man-

agement in the emerging markets financial sector.

OBJECTIVES

This casebook, the first of its kind to focus exclusively

on the emerging markets financial sector, aims to cap-

ture the lessons of experience of IFCs participating

institutions:

Chapter 1 provides background and summarizes

objectives.

Chapter 2 summarizes major sustainability-related

business drivers for the financial sector.

Chapter 3 provides illustrative examples of leading

financial institutions that have responded

strategically to these business drivers,

including examples from commercial

banking, leasing, private equity and

project financing institutions.

Chapter 4 examines good practice in implementing

a cost-effective management system to

respond to these risks and opportunities.

Chapter 5 presents summary conclusions and a series

of recommendations.

Introduction

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8

2.THE NEWGEOGRAPHY OF RISK

What is the relevance of sustainability to the

emerging markets financial sector?

METHODOLOGY

For this casebook IFC used a three-part approach

designed to capture the experiences and expertise

of the workshop participants:

s IFC conducted a series of in-depth interviews

with senior management participants of the CEA

workshops.

s IFC conducted a detailed questionnaire survey

of a representative sample of 60 institutions from

different regions.

s In addition, IFC reviewed current best practice

among institutions in the international financial

sector.

Annex B presents a more detailed review of the

methodology.

Beyond Risk

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Beyond Risk The New Geography of Risk

THE SIGNIFICANCE OF ENVIRONMENTAL AND SOCIAL ISSUES FORFINANCIAL INSTITUTIONS HAS,IN GENERAL, BEEN CONSIDERED LIMITED

WHAT IS THE RELEVANCEOF ENVIRONMENT TO BANKS?

The emerging markets financial sector

faces a growing number of competitive

pressures; from economic integration to

the rise of technology-enabled banks and

non-bank competition (See Figure 2.1, left).

What is the relevance of environmental

and social factors to the performance of

a financial institution?

The significance of environmental and

social issues for financial institutions has,

in general, been considered limited. In

a number of developed countries, wherebanks have been held directly liable for

the clean up of contaminated collateral,

environmental due diligence has begun

to form a routine part of the due dili-

gence process.

Direct Legal Liabilities

Between 1986 and 1996, a number of

court rulings and well-publicized cases

on environmental damage widened the

focus of lenders: not only towards con-

cern for pre-existing conditions on

properties on which they foreclosed,

but also onto their capacity to exercise

influence on the daily operations of the

company concerned. Box 2.1, left, sum-

marizes a range of direct liabilities for

financial institutions.

11

BOX 2.1

SUMMARY OF FORMS OF DIRECT LIABILITY FOR FINANCIAL INSTITUTIONS

FIGURE 2.1

COMPETITIVE THREATS TO THE FINANCIAL SECTOR

TECHNOLOGICAL

CHANGE

s Internet

s Electronic Banking

s ATM

s Virtual Banks

ECONOMIC

INTEGRATION

s GATT/NAFTA/WTO

s Reduced Tariffs

s Currencies linked

s Global Capital flows

s Diversification

MATURATION

OF DEVELOPED

COUNTRY

MARKETS

s Slower Growth

s Aggressive Exporters

s Deregulation

DECLINE OF

COMMUNISM

s Privatization

s Corporate Growth

s Global Private

Capital Flows

FINANCIAL SECTOR COMPETITIVE THREAT

Source:Furrer,Increasing a Companys Value Through Environmental Management

s Liability for the clean up of any contaminated collateral

(for example,asbestos,heavy metals, polychlorinated bi-phenols).

s Liability for misrepresentation of environmental risks

(e.g.to co-financiers).

s Liability for negligence in any failure to assess actual and potential envi-

ronmental risks.

s Direct liability if the financial institution is a principal,general partner

or owner.

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Primary sources of risk were found to

vary according to the type of financial

institution surveyed. Figures 2.32.7,pgs.

1214, present the results for institutions

that are financing sectors which sub-

divided into the following categories: a)

export-oriented industries, b) infrastructure,

c) domestic general manufacturing, d) high-

tech industries and e) extractive industries.

Summary of findings: A Range of

Risk Drivers

Overall, the enforcement of national

and export market regulations was the

most frequently identified source of envi-

ronmental and social risk for client orga-

nizations. Risk drivers were found to vary

significantly according to the client base.

For those institutions financing export-

oriented industries the key risk driver

to clients was identified as the loss of

markets. Other major risks identified

included the following: shutdown/fines,

reputational risk, protests over critical

resources and, loss of financing.

Risk of shutdown/fines was also identified

as a key risk for infrastructure clients and

domestic general manufacturingalong with

reputational risk, protests over critical

resources and loss of market.

13

The Emergence of Indirect Liabilities

Are these legal liabilities also the prime

risk drivers for emerging markets? To

address the topic, IFCs survey requested

60 emerging market institutions to iden-

tity what they considered to be the most

significant sources of environmental risk,

both for their clients and for their own

institutions directly. The results suggest

evidence of a significantly different risk

profile for emerging markets.

Survey Results: New Stakeholders

Figure 2.2, right, summarizes the most sig-

nificant sources of environmental risk

that institutions identified for their clients

The survey showed that all the respon-

dents in the four groups identified the

existence of significant risk drivers for

their emerging market clients. While

government is identified still as the

key risk driver, new stakeholders have

emerged. In particular, 58% of respon-

dents cited the influence of export market

regulators as a key risk driver for their

customer base1.

12 FIGURE 2.4

INFRASTRUCTURE

FIGURE 2.5

DOMESTIC GENERAL MANUFACTURING

FIGURE 2.2

SIGNIFICANT SOURCES OF ENVIRONMENTAL RISKS for clients identified by all financing institutions

FIGURE 2.3

EXPORT-ORIENTED IND USTRIES

The most significant long-term sources of environmentalsocial risks as identified by infrastructure institutions

The most significant long-term sources of environmentalsocial risks as identified by domestic general manufacturers

1As an example, in the past 5 years, the impositionof environmental standards requirements has been

widely perceived as the major driver in a numberof Asian export-dependent markets, particularly

consumer electronic related. This appears to have

been one of the main reasons for the rapid uptakeof industry environmental management systemscertified to the internationally recognized

ISO14001 standard.

0% 10% 20% 30% 40% 50% 60% 70%

Government (e.g.shutdown,fines)

Export market regulators

Media (reputational risk,negative publicity)

Community

Financiers

Customers

Supply and distribution chain partners

Insurers

International NGOs

Employees

Other

60%

56%

40%

38%

36%

28%

12%

12%

10%

8%

20%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Government

Exportm

arket

regu

lators

Media

Comm

unity

Fina

nciers

Customers

Supply&

distr.

chainpartners

Insurers

International

NGOs

Employees

Other

4%4%

17%13%

25%29%

46%46%50%

75%

67%

0%

10%

20%

30%

40%

50%

60%

70%

80%68%

53%

63%

53% 58%

37%

11%

32%

16%

5%

16%

Other

Employees

International

NGOs

Insurers

Supply&distr.

chainpartners

Customers

Financiers

Community

Media

Exportmarket

regulators

Government

0%

10%

20%

30%

40%

50%

60%

70%

80%

Govern

ment

Exportm

arket

Media

Comm

unity

Financiers

Custo

mers

Sup

ply&

distr.chain

Ins

urers

International

N

GOs

Employees

Other

5%8%

16%

11%

24%32%32%

35%41%

68%

59%

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Forgeneral manufacturing, the primary

risk driver was identified as export market

regulation. After government and export

market regulators: the risk of community

action, the potential for adverse publicity

in the media and possible action from

financiers ranged among the top five

overall risk drivers.

THE CHANGING

GEOGRAPHY OF RISK

Several conclusions can be drawn from

these results. Conventional wisdom sug-

gests that environmental risk derives from

the enforcement of national legislation

with resultant civil and criminal penal-

ties. Government, therefore, is held to

be the key risk driver and where local or

national government does not have the

resources to enforce environmental regu-

lation, there is thought to be no risk.

BEYOND COMPLIANCE

A more complex reality appears to be

emerging. A decade ago, information was

accessible by only parts of the interna-

tional community. Distance separated a

company with a poor environmental track

record, or a proposed project with poten-

tially significant environmental impacts,

from key national and international stake-

holders. But changes in information

technology, including the growth in

internet and fixed and cell phone usage

appear to have lessened that distance.

The two Figures 2.8 and 2.9, left, show

changes in international connectivity

between 19911997

Connectivity

New technology has enabled the rapid

international flow of communications,

and in the process has begun to empower

previously disenfranchised individuals and

their spokespersons. In particular three

changes have occurred:

s Stakeholders can readily acquire infor-

mation about the impact on environ-

mental resources.

s Stakeholders have a low-risk means of

preparing a coordinated international

response to these impacts.

s Finally, they have a cost-effective

means to implement these campaigns.

Driven by this reduction of distance, a

trend is emerging. A networked economy

is developing in which governmental and

non-government regulators can pose risks

to a companys operations at a number

of stages in the business cycle, translating

value reduction at the individual level into

value reduction at the level of the firm.

14 15FIGURE 2.8

PRESENTS CONNECTIVITY IN 1991

FIGURE 2.6

HIGH-TECH INDUSTRIES

FIGURE 2.7

EXTRACTIVE INDUSTRIES

0%

10%

20%

30%

40%

50%

60%

70%

80%67%

33%

78%

56%

33%

22%

11%

0%

33%

11%

0%

Other

Employees

International

NGOs

Insurers

Supply&

distr.chain

Customers

Financiers

Community

Media

E

xportmarket

Government

The most significant long-term sources of environmentalsocial risks as identified by high-tech industries

0%

10%

20%

30%

40%

50%

60%

70%

80%

Government

Exportmarket

regulators

M

edia

Community

Finan

ciers

Customers

Supply&distr.

chainpartners

Insurers

International

N

GOs

Employees

O

ther

0%0%

50%

0%

25%25%

0%

25%25%

75%

25%

The most significant long-term sources of environmental

social risks as identified by extractive industries

IBRD 32423

IBRD 32424

FIGURE 2.9


INTERNATIONAL CONNECTIVITYVersion2- 9/91

Internet

Bitnet but not Internet

EMail Only (UUCP,Fido Net)

No Connectivity

No Data

Source: Larry Landweber and the Internet Society.

INTERNATIONAL CONNECTIVITYVersion2- 9/91

Internet

Bitnet but not Internet

EMail Only (UUCP,Fido Net)

No Connectivity

No Data

Source: Larry Landweber and the Internet Society.

FIGURE 2.9


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Beyond Risk

These risks are presented in Figure

2.10, right.

In this networked economy, corporate

performance depends not solely on reg-

ulatory compliance, but on the ability

to understand and satisfy the expecta-

tions of a wide range of stakeholder

interest groups.

RISKS FOR THE EMERGING

MARKETS fiNANCIAL SECTOR

Having explored the changing demands

on companies, drivers for these changes

and the potential for company operationsto be affected by the scrutiny from stake-

holders, the survey asked participants to

identify major sources of environmental

risk for their financial institution. Figure

2.11,pg. 17, presents an overview of the

responses.

Overall, the prime risk was identified as

non-performing assets. A number of

otherissues were also identified as

significant, again varying by institutional

type. Key risks identified include the fol-

lowing: devalued collateral, reputational

risk and loss of international financial

institution funding.

CONCLUSIONS: EMERGING

MARKETS ENVIRONMENTAL RISK

The survey results suggest that the same

change in the geography of risk that has

affected their industrial client base is also

beginning to affect the financial sector.

Stakeholders that have the potential to

affect the performance of financial insti-

tutions are beginning to emerge, adding

environmental risk to the range of

identified business risks, from interest

rate risk, currency risk, and legal risk

to operational risk.

Traditionally, where the primary environ-mental risk drivers for financial institu-

tions have been restricted to the threat

of direct legal risks, these new stakehold-

ers, active in developed and emerging

markets alike, are posing a wider range of

indirect risks. If a bank borrower violates

labor laws, that borrower can be penalized

in ways that cause it to close down its

operations. The borrower then goes into

default and the bank is left with a non-

performing loan. If an industry faces a

sector-wide boycott or regulation, multiple

companies in that industry can default

on their loans, creating large losses for

individual banks and the banking system.

Allegations of poor corporate governance

can undermine the reputational assets of

the institution.

16 17FIGURE 2.11

ENVIRONMENTAL RISKS FOR FINANCIAL INSTITUTIONS

The New Geography of RiskFIGURE 2.10

DRIVERS OF ENVIRONMENTAL RISK ACROSS THE CORPORATE VALUE CHAIN

CONSUMER BOYCOTT

s Entry of substitute product

s Product liabilities

s Product replacement

LABOR RECRUITMENT,

RETENTION

s Productivity

s Strikes or sabotage

s Shut-down

s Fines,penalties

s Compensation for health

s Operating liabilities

AVAILABILITY OF

WATER SUPPLY

s Raw materials access

s Raw materials price

s Permit rejection

PERMITTING DELAY

OR REJECTION

s Insurance access or cost

s Construction delay

s Contract lost

s Labor supply

s Contract terms

s Infrastructure obligation

s Cost of capital,access

SALES AND DISTRIBUTION

MANUFACTURING

MATERIALS ACQUISITION

START-UP

0% 10% 20% 30% 40% 50% 60% 70%

Non-performing loans/leases/investments

Devalued collateral

Reputational risk/Negative publicity

Loss of IFI funding

Reduced access to private/international capital

Liability for cleanup of contaminated collateral

Civil or criminal liability for negligence

Increased central bank/MOF regulation

Loss of depositors

Other

58%

46%

46%

42%

35%

23%

10%

4%

6%

13%

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Indirect environmental and social risks,

then, can affect a financial institutions

performance at three levels: at the level

of the single non-performing loan, at the

level of multiple non-performing loans,

and at the level of operating license,

driven by reputational risk.

LEVEL 1: SINGLE

NON-PERFORMING LOAN (NPL)

At the level of the single non-perform-

ing loan, the operations of these diverse

stakeholders have the potential to cause

loan defaults across the manufacturing

cycle of portfolio companies. Clearly,

these impacts on portfolio companies

may pose a risk of increased costs for a

financial institution. However, the prob-

ability of these risks occurring during the

lifetime of a short-term loan is relatively

small. In addition a number of factors

may lower the risk of default:

s The company may have insurance.

s Debt service coverage ratios may be

unaffected and payments may proceed

on time.

s The financial institution may have

collateral that is unaffected by envi-

ronmental stigma.

More significant for the financial institu-

tion though is the potential for multiple

non-performing loans.

LEVEL 2: MULTIPLE

NON-PERFORMING LOANS

New stakeholders have the potential to

cause not just single NPLs but multiple

NPLs within a banks portfolio. A growing

trend is for an industry sector to become

the target of a coordinated campaign

involving NGOs, consumers and the

media. When these stakeholders act, they

can affect numerous companies within

the sector at once. These campaigns have

the potential to result in a pattern of

defaults, horizontally across the portfolio.

Key drivers of multiple NPL include the

following:

s Government regulators may respond

by invoking a change to regulations

that can lead to a virtual closure of

the sector, or the alternative of incur-

ring prohibitive switching costs

s Export market regulators may impose

restrictions.

s NGOs may lead national or interna-

tional product boycotts.

s Consumers may lead product or cor-

porate boycotts, or enter into sector-

focused class action lawsuits.

s In addition, NGOs, local communities

and employees may adopt a project by

project strategy that has the same effect

of reducing the operating viability of

multiple projects within a sector

18 19

FIGURE 2.13

THE RISK MANAGEMENT GAP

BOX 2.2

FINANCIAL COSTS OF ENVIRONMENTAL NON-PERFORMANCE

The New Geography of RiskBeyond Risk

s Decreased quality of assets

s Increased need for provisioning

s Reduced capital adequacy

s Increased cost of funds

s Reduced liquidity

s Reduced profitability

s Reduced rating

Unmanaged Risk

Single NPL

Multiple Sector NPL

Multiple Regional NPL

Reputational Risk

COVERED

Current RiskAssessmentCapacity

High

Low

Potential Losses

FIGURE 2.12

RISK TO THE EMERGING MARKETS FINANCIAL SECTOR

LEVEL 3: Reputational risk

LEVEL 2: Multiple non-performing loan

LEVEL 1: Single non-performing loan

Low High

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BOX 2.3

PERFORMANCE SIGNALS

HIGH QUALITY

BRAND SIGNAL

s System indicator

s Quality metrics and management

s Positioning for long-term

s Trustworthy

LOW QUALITY

BRAND SIGNAL

s Perception

s Manipulation of market perception

s Lack of management capacity

s Lack of resources

s Short cut/quick-fix

s Untrustworthy

Beyond Risk

s Resource-based conflict can cause

multiple defaults within multiple sec-

tors, impacting wholesale, retail and

individual accounts.

LEVEL 3: REPUTATIONAL RISK

For deposit-taking financial institutions,

reputation and brand image are of critical

importance. In particular, a deposit-taking

commercial banks operations are built

on a borrow-short, lend-long strategy

that depends on three elements:

s Depositor belief that the bank has

a critical mass of deposits to smoothover potential asset-liability mismatches

s Mass trust among consumer base

s Mass branding as trustable

Core to the operation of a bank then is the

establishment and maintenance of trust.

The cost of environmental and social

campaigns waged against the financial

sector are heaviest when they erode the

trustworthiness branding that underpins

the depositary base. Adverse campaigns

can transform the organizations brand

assets into liabilities, turning big into

brutal, dominant into dominating,

profitable into predatory. An additional

impact of these campaigns is the signal-

ing of inadequate management systems

and capacity.

Reputational risk as a whole was ranked

the third most important risk after non-

performing loans/investments and deval-

ued collateral.

Significantly, the survey showed that

reputational risk did not just affect insti-

tutions with major depositor bases.

Additional reputation-driven costs that

were highlighted included: the potential

loss of depositors, reduced access to capi-

tal from private financial institutions and

international bond market, increased

central bank/finance ministry regulation,

and loss of IFI funding (see Figure 2.11,pg. 17). The financial costs of these

campaigns are hard to quantify, but the

combination of these multiple NPLs may

begin to affect the financial performance

of a bank directly.

Key financial impacts (see Box 2.2,pg. 18)

In summary, an emerging trend is for the

rapid transmission of risk: from the risk

of adverse environmental impacts caused

by a companys operations, through risk

to the company, through to risk for the

financial institution backing the venture.

These direct, portfolio and reputational

risks combined have the potential to

20 21FIGURE 2.14

SUSTAINABILITY OPPORTUNITIES

FIGURE 2.15

OPPORTUNITIES FOR COMMERCIAL BANKS

The New Geography of Risk

BOX 2.4

OPPORTUNITIES FOR FINANCIAL INSTITUTIONS

s Accessing international funding: Securing longer term capital available from IFIs with environmental and

social performance criteria

s Providing loans for environmental projects: Gaining market share in the growing environmental products

and services sector

s Providing eco-efficiency and cleaner production advisory services: Gaining market share in the

mid and small cap client base, offering advisory services that boost client business including energy efficiency

audits,cleaner production assistance,and exporter market opportunity identification

s Accessing SRI/Ethical investment funds: Gaining access to the long term institutional investors and SRI

investors with positive and negative environmental and social screens

s Providing risk management services to high risk industries: Gaining market share in environmentally

and socially complex sectors by providing high value consulting services that enable clients to manage complex

social and environmental issues such as resettlement,supply chain management,and community relations

s Attracting improved terms of insurance: Using reduced social and environmental risk as a means

of attracting lower insurance premiums at the portfolio and project level

s Attracting depositors: Positioning the bank as a dependable institution,with ethically sound corporate

governancein its dealings with depositors and other stakeholders

0% 10% 20% 30% 40% 50% 60% 70% 80%

Accessing international funding

Providing loans for environmental projects

Providing eco-efficiency and cleaner productionadvisory services to small and mid-sized clients

Accessing ethical investment funds

Providing risk-management servicesto high-risk industries

Attracting improved terms of insurance

Attracting new depositors

Other

70%

47%

26%

26%

9%

15%

9%

21%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Accessing

international

funding

Providingloansfor

environmentalprojects

Providingeco-efficiency

andcleanerproduction

advisoryservicestoSME

Accessingethical

investmentfunds

Providing

risk-management

servicesto

high

-riskindustries

Attractingimproved

term

sofinsurance

Attractingnew

depositors

Other

13%

6%

13%13%13%19%

50%

69%

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The New Geography of Risk

produce a range of costs for the institu-

tionfrom direct liability to single NPLs

to multiple NPLs and reputational risk

(see Figure 2.13,pg. 19).

Significantly, from the credit risk per-

spective, as these losses escalate conven-

tional risk assessment and management

techniques provide less guidance.

CURRENT TRENDS

Is this risk likely to grow? A number of

emerging trends for the financial sector

suggest that the relevance of sustainability

issues will continue to increase:

s The growth of socially responsible invest-

ment (SRI): A growing number of

investors are now conducting negative

or positive screens to ensure the social

responsibility of their investments.

Assets in socially screened investment

portfolios rose by more than one-third

from 1999 to 2001 to top the $2 trillion

mark for the first time ever. This rep-

resents just over 10% of the $19.9

trillion in professionally managed

investment assets in the U.S. SRI

analysis now evaluates financial insti-

tutions on their environmental and

social performance, potentially impact-

ing on the access to capital for these

institutions as well as their portfolio

companies (see Figure 2.19,pg. 23).

s The emergence of the sustainability ana-

lyst industry: A growing number of

institutions now offer an analysis of

corporate and financial sector practice

in terms of sustainability. In 2002,

Friends, Ivory & Sime released a

benchmark report evaluating the sus-

tainability performance of leading

international banks. Additional lead-

ers in the field include Innovest, and

Bank Sarasin.

s Sustainable indices: Both the Dow

Jones Group (Dow Jones Sustainability

Index)and the Financial Times

(FTSE4Good index) have introduced

sustainable indices to enable SRI

investors to invest in corporations

having a superior performance on

environmental and social issues.

s Financial sector standards and codes of

conduct: In parallel with the develop-

ment of more robust methodologies

to evaluate corporate performance, a

number of codes of conduct for banks

are emerging that set out good practice

on sustainability. While there is still

no widely acknowledged template,

current codes include ISO 14000,

FORGE and the UNEP Statement

on Banking and the Environment.

22 23FIGURE 2.16

OPPORTUNITIES FOR LEASING INSTITUTIONS

FIGURE 2.17

OPPORTUNITIES FOR PROJECT FINANCE INSTITUTIONS

Beyond Risk FIGURE 2.18

OPPORTUNITIES FOR PRIVATE EQUITY INSTITUTIONS

0%

10%

20%

30%

40%

50%

60%

70%

80%

Accessing

international

funding

Providingloansfor



and

cleanerproduction


Accessingethical

investmentfunds

Providing

risk-management

servicestohigh-risk

industries

Attractingimproved

termsofinsurance

Attracting

newdepositors

Other

80%

40%

27%

33%

27%

33%

27%

13%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Accessing

international

funding

Providingloansfor

environm

entalprojects

Providing

eco-efficiency

andclean

erproduction

advisoryse

rvicestoSME

Accessingethical

investmentfunds

Providing

risk-management

servicestohigh-risk

industries

Attrac

tingimproved

term

sofinsurance

Attracting

newdepositors

Other

64% 64%

50%

36% 36%

21%

7%

21%

0%

10%

20%

30%

40%

50%

60%

Accessing

international

funding

Providingloansfor



and

cleanerproduction


Accessingethical

investmentfunds

Providing

risk-management

s

ervicestohigh-risk

industries

A

ttractingimproved

termsofinsurance

Attracting

newdepositors

Other

56%

25% 25%

44%

25%

13%

0%

6%

FIGURE 2.19

SOCIALLY RESPONSIBLE INVESTMENTGROWTH MARKET

SOCIALLY RESPONSIBLE INVESTMENT (SRI)

Worth over US$2 trillion in

US and US$25 billion in UK

Numerous environmental,socialand ethical ranking,rating and

screening methodologies

One of the fastest growing

areas of equity investment

Growing importance in Europe

8/14/2019 Beyond Risk (2003)

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Beyond Risk

Figure 2.14,pg. 21, summarizes the results

for all respondents. Overall, the results

indicate that access to international

funding, providing loans for environmen-

tal projects, providing advisory services

to SMEs and accessing ethical invest-

ment funds are considered the main

opportunities.

These opportunities varied significantly

by institution type. Figures 2.152.18,

pgs. 2123,present the results from com-

mercial banks, leasing, project finance,

and private equity institutions.

Key conclusions include the following:

s Overall, the main opportunity ident-

ified by all institutions was access

to IFI funding. Providing loans for

environmental projects was seen as

a key opportunity for project finance

institutions and commercial banks.

s For project finance institutions,providing

risk management services to high-risk

industries also featured highly along

with provision of eco-efficiency and

cleaner production services.

s Forprivate equity, accessing ethical

investment was rated highly.

24

s NGO and media campaigns: A number

of NGOs are now directing coordinated

campaigns towards the financial sec-

tor. Key drivers of recent campaigns

include Friends of the Earth, the

National Wildlife Federation, and

Milieu Defensie.

s International Financing Institution (IFI)

conditions: Finally there is increasing

demand from IFIs for the financial

institutions they invest in to imple-

ment management systems that ensure

the environmental performance of

their portfolio. The procedures of

these IFIs prohibit investment in

institutions without adequate envi-

ronmental management systems. IFIs

actively addressing this through train-

ing and capacity building include IFC,

IIC, Proparco, Coface, EBRD, DEG,

FMO, ADB, AfDB and CDC.

At the same time, a number of leading

financial institutions are beginning to

translate these risks into opportunity, by

transforming these stakeholders from dri-

vers of risk to drivers of reward. In the

survey, the financial institutions were

asked to identify what they consider to

be the major environment-related oppor-

tunities for their business. Key opportu-

nities identified are highlighted below.

3.THE EMERGINGMARKET RESPONSE

In practice, how have leading financial institutions

started to capitalize on these opportunities?

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PERFORMANCE BASELINETo measure participants progress in imple-

mentingenvironmental change, IFCs

survey sought first of all to create a base-

line of environmental management before

the workshops.

Institutions were asked whether, prior to

the CEA workshop, they had a formal

management system in place to address

the issue of environmental risk when

considering investments/lending. Figure

3.1, left, summarizes the results.

Overall, 22% of institutions surveyed

reported that they had a formal procedure

for environmental management before

IFCs workshop, with results varying

slightly between commercial banks, pri-

vate equity groups, leasing companies

and project finance institutions.

POST-WORKSHOP: RESULTS

IFCs survey also asked institutions to

identify enhancements they had made to

their environmental and social manage-

ment capability after the workshop. Figure

3.2, left, presents the overall findings of

the survey.

100% of respondents reported that they

had implemented measures to enhance

their environmental and social manage-

ment capability after the workshop.

27FIGURE 3.1

PROCEDURE FOR ENVIRONMENT RISK MANAGEMENT

FIGURE 3.2

ENHANCEMENTS UNDERTAKEN TO ENVIRONMENTAL AND SOCIAL ISSUES fol lowing the CEA workshop

The Emerging Market Response

Yes,a formal procedure

22%

43%

35%

Yes,an informal procedure

No

Before the IFC workshop,did your institution have a procedure for

environmental risk management?

5 10 15 20 25 0 35 40

Training of internal staff

Update operating policy

Development ofenvironmental/social procedures

Rejecting projects withenvironmental issues

Working with clients

Report to Directoron opportunities

Communications to clients

External reporting of EMS

Providing environmental loans

Hiring of internalenvironmental consultants/staff

Media events

Other

36%

35%

33%

30%

12%

21%

11%

29%

32%

5%

5%

5%

MOVING BEYOND COMPLIANCE

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Despite the possibility of selection and

reporting bias, the results show significant

uptake at the institutional level. The

critical question, however, is the business

value of the initiatives implemented. To

explore the link between sustainability

initiatives and business value, IFC carried

out four more detailed case studies, aiming

for representation across financial institu-

tiontypes and geographical region. Table

3.1, right, presents the four case studies by

institutiontype and location.

These case studies addressthe following

questions:

s What is the institutional background?

s What initiatives did the institution

implement?

s What are the business benefits?

s What are the lessons learned?

CASE 1

PROJECT fiNANCE:

LESSONS LEARNED

The IL&FS case reveals a number of

lessons for project finance institutions:

s For project finance clients, there is a

critical need for assistance in manag-

ing these issues.

s The local consultant market does not

fulfill this need.

s Banks can use their cross-sectoral risk

management expertise to help clients

address these needs.

s Financial institutions, and theirclients, can have a range of national

and international stakeholders. These

various stakeholders can have different

and sometimes conflicting performance

standards that require extensive nego-

tiation to resolve.

s The presence of a full time manager

can have a major impact on institu-

tional uptake.

28 29TABLE 3.1

CASE EXAMPLES FOR PROJECT FINANCE,COMMERCIAL BA NKING, PRIVATE EQUITY AND LEASING

The Emerging Market ResponseBeyond Risk

TYPE OF FINANCING ORGANIZATION COUNTRY

INSTITUTION

Project Finance Infrastructure Leasing and Financial Services Ltd (IL&FS) India

Commercial Banking Banco BBA Creditanstalt Brazil

Private Equity Tuninvest Tunisia

Leasing Raiffeisen Bank Hungary

The key issue now is moving beyond compliance towards the management of real social

and environmental risks

Background

Infrastructure Leasing and Financial Services Limited (IL&FS) was incorporated in India in 1987 and is one

of the countrys top five non-banking financial companies.Initial shareholders were the Central Bank of

India,Unit Trust of India,and Housing Development Finance Corporation Ltd.IL&FS has offices in Bombay,

Bangalore,Delhi and Calcutta, where the organization provides asset management and retail operations

services in the areas of commercialization of infrastructure projects and financial services.

Key risk drivers for IL&FS clients

Operating in the environmentally and socially complex Indian market,IL&FS identifies a number of potential

sustainability driven risks for its client base. Key risk drivers for clients include the following:

s Export market regulators:Loss of markets,particularly the US and EU,for example, an industrial water

supply project supplying export industries.Should these industries lose export market potential,this inturn would have a negative impact on the water supply project

s Media:reputational risk

s International NGOs:issue-based campaigns

s Customers:loss of market share

s Government:shutdown,fines

s Community:protest over impacts on critical resources

Key risk drivers for IL&FS

At the same time,infrastructure finance institutions in India face a number of sustainability-related risks:

s Non-performing loans/investments/leases from environmental/social risks

s Liability for clean up of contaminated property/collateral

s Civil or criminal liability for negligence

s Reduced access to capital from private financial institutions/international bond market

s Increased central bank/MOF regulation

s Loss of IFI funding

s Devalued collateral

s Reputational risk/Negative publicity

s Loss of reputation with the concessionaires (state and central governments)

s Reduced ability to raise money in the international markets

Implementation

In response to these emerging risks and opportunities for the institution and its clients, IL&FS sought to

attain world-class expertise in environmental management.

Continued on page 30

CASE 1: PROJECT FINANCE

CASE EXAMPLE: INFRASTRUCTURE LEASING AND FINANCIAL SERVICES LIMITED ( IL&FS)

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s Consulting services represent a cost-

effective way of establishing ability to

handle complex projects.

s The presence of a full time manager

can have a major positive impact on

institutional uptake.

s For project finance institutions, this

can be a significant selling point,

enabling the institution to win man-

dates for more complex transactions.

The environmental management capacity

that IL&FS has acquired has the potential

to generate significant business benefits

for the institution (see Box 3.1,pg. 31)

30 31

BOX 3.1

PROJECT FINANCE OPPORTUNITIES

CASE 1 Continued The Emerging Market ResponseBeyond Risk

Environmental risk management services

From 1988 to 1994,environment and social issues were the responsibility of a part-time finance/project

executive, helped by external consultants.In 1994 IFC provided introductory environmental risk management

training in Bombay,followed by a workshop on environmental risk management in 1997. During 1995,IL&FS

drew on a WBG line of credit to fund private sector infrastructure projects.As part of the WBG requirements

an environment and social report (ESR) was developed and then adopted.The ESR defined the environment

and social policy framework for project development and implementation.In early 1996, an in-house envi-

ronment and social management group (ESMG) was constituted to implement ESR requirements for all

projects and investments.After operating successfully for 6 years as a dedicated group responsible for ESR

and WBG requirements,in 2001,IL&FS floated a fully-owned companyEcosmart India Ltd (Ecosmart).

The expertise built-up by the ESMG is domiciled in the new company.Apart from providing environmental

and social management services to IL&FS investments,Ecosmart provides strategic services to various

external businesses including infrastructure projects. IL&FS has also undertaken a range of additional initiatives

as part of its environmental management activities.

Additional IL&FS Initiatives following the ESR

s Communications to clients and media events

s

Rejecting projects with adverse environmental issuess Working with clients to manage environmental impacts

s Hiring of internal environmental consultant/staff

s Development of environmental and social procedures

s External reporting of EMS

s Experience sharing with other financial institutions

Barriers for IL&FS

IL&FS faced two key challenges in implementing its management system.Initially the lack of consulting

expertise proved a major obstacle,but Ecosmart capitalized on this lack of skills and then entered the wider

market.Furthermore,the varying policies and standards of different national and international stakeholders

when handling the complex environmental and social issues of India,presented an additional hurdle. IL&FS

stresses that case studies are needed to highlight the typical differences in IFC/WB policies compared with

those of some developing countries,and to provide guidance on how to handle this conflict.

On the issue of barriers to implementation, IL&FSs Vijay Joshi comments, I strongly feel that we have overcome

all the above barriers over the past 6 years. But the major constraint is that recognition of value of environ-

mental and social risk mitigation by implementing an EMS is not,by-and-large, recognized by various

stakeholders,including government agencies.

SUSTAINABILITY DRIVEN OPPORTUNITIES

s Win new project finance business

s Lead and manage new complex transactions

s Gain access to high asset quality clients

s Develop fee-generating advisory services

s Successfully complete complex deals as a result of social and environ-

mental due diligence

Results for ILFS

Sustainability also provides a number of potential opportunities:

s Accessing IFI funding

s Providing loans for environmental projects

s Providing risk management services through Ecosmart to high-risk industrial sectors,

s Cross-promoting IL&FS financing for Ecosmart clients

s Providing eco-efficiency and cleaner production advisory services to small and mid-sized clients

s Attracting improved terms of insurance

s Accessing ethical investment funds

s Identifying funding/financing opportunities in environmental improvement projects

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32 33The Emerging Market ResponseBeyond Risk

Over the last few years,it has become increasingly clear that environmental perfor-

mance has significant implications for financial institutions.The key issues for banks and

other financial institutions include credit, reputation and political risks associated with

the environmental status and impact of their portfolios.For commercial and investment

banks,environmental risk management is now a critical part of the credit risk manage-

ment process

Roberto Dumas Damas

BBA Creditanstalt

Background

Banco BBA Creditanstalt is the thirteenth largest Brazilian bank in terms of assets,with US$6.63 billion

in December 2001.It is positioned as the fifth largest private bank having local control and the largest

Brazilian wholesale institution and is among the five major banks on-lending funds from the Brazilian

development bank BNDES.

Key risks for clients

BBA identifies a number of sustainability-driven risks for its client base:

s Media:reputational risk

s Customers:loss of market share

s Government:shutdown,fines

s Financiers:Loss offinancing

Key risks for commercial and investment banks

In addition,BBA identifies potential sustainability-driven risks for commercial investment banks

operating in Brazil:

s Non-performing loans/investments/leases from environmental/social risks

s Loss of IFI funding

s Reputational risk/negative publicity

s Liability for clean up of contaminated property/collateral

s Devalued collateral

Implementation

In response to these risks, two BBA staff attended the CEA workshop in Washington.BBA has since

established a comprehensive environmental management system,the primary objective of which is to

focus on economic development that is environmentally sustainable,minimizing exposure to companies

with poor environmental practices and facilitating access to multilateral and bilateral capital.

Key initiatives:

Following the CEA workshop,BBA has undertaken a number of initiatives. Key initiatives include the following:

s Report to director/board on environmental risks/opportunities

s Communications to clients and media events

s Updating the operating policy of the institution

s Working with clients to manage environmental impacts

s Development of environmental/social procedure

s External reporting of EMS

s Training of internal staff

s Providing environmental loans

Business benefits of EMS to BBA

s In the last 2 years BBA was involved in 27 Projects totalling R$ 7 billion in BNDES financing.

s BBAs environmental management system has enabled the bank to access the BNDES environment

credit line,ensuring improved loan rates and loan terms not otherwise commercially available.

s BBA has met IFCs environmental conditions for environmental management and as a result was able to

access US$40 million additional IFC funding.

s BBA was also able to access more than US$100 million of additional funding from other multilateral

agencies with environmental screening (including DEG,EIB,and FMO).

s Lower credit risks.BBA has identified as unacceptable and rejected a number of projects with

unacceptable environmental credit risks.

s BBA has also been recognized as the first domestic Brazilian bank to adopt an EMS.The bank was

highlighted in the Friends of the Earth eco-finances bulletin.BBAs Roberto Dumas Damas was invited

by UNEP to make a presentation at the Rio+10 UNEP Conference.

Barriers

Key lessons in terms of implementation include the following:

DO

1. Involve the key staff of the bank within the process.

2. Stress how environmental issues can lead to credit risks.

3. Establish clearly the roles and responsibilities of relevant staff members within the process.

4. Identify some projects that went wrong environmentally and the impacts suffered by the funding

providers.

5. Bring environmental issues to the credit committee.

6. Follow environmental issues within approved projects through external consultancy.

CASE 2: COMMERCIAL INVESTMENT BANKING

CASE EXAMPLE: BANCO BBA CREDITANSTALT (BBA) BRAZIL

CASE 2

COMMERCIAL INVESTMENT

BANKING: LESSONS LEARNED

The BBA case reveals a number of lessons:

s IFIs provide a strong incentive for

environmental performance.

s Negatively, IFIs can withhold fund-

ing, and the removal of one IFIs

funding for environmental and

social reasons may cause other IFIs

to withdraw funds.

s Positively, financial institutions

with environmental management

systems can access IFI financingthat is available for development

purposes. This funding is generally

lower cost, as in the case of BBAs

funding from BNDESs environ-

mental credit line. Most significantly

IFI financing provides long term

lending at tenors critical to whole-

sale finance that are not commer-

cially available elsewhere.

s BBAs strategy as a bank is one of

cost-effective risk management. BBA

works with clients to transform border-

line deals. Unlike IL&FS (case 1,pgs.

2930), though, BBA is not aiming

specifically to acquire a critical mass of

environmental and social expertise,

and position itself to manage environ-

mentally complex transactions. BBAs

strategy involves a low cost operation

for screening out rapidly the potential

problem project and adhering to donor

performance standards.

s The main business benefits of the

approach are listed in Box 3.2,pg.34.

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BOX 3 4 37Th E i M k t R p36 B d Ri k CASE 3 Continued

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BOX 3.4

UPSIDE OPPORTUNITIES FOR PORTFOLIO COMPANIES

s Access to SRI funding

s Access to IFI funding

s Increased margins through process efficiency

s Access to new markets

s Enhanced branding

s Enhanced sales

37

BOX 3.5

UPSIDE OPPORTUNITIES FOR PRIVATE EQUITY GROUPS

The Emerging Market Response36 Beyond Risk

s Tuninvest has minimized the environmental risk of its portfolio

s Portfolio companies are focused on exporting and becoming leaders in the Tunisian and Maghreb markets.

Sustainability has a role in helping to make these portfolio companies more attractive for an IPO or a

sale to potential strategic investors

s Sustainability has an additional role in helping portfolio companies achieve sustainable growth and

improve international competitiveness,as well as helping them achieve an Investment Grade rating

in order to tap the bond market

s Tuninvests environmental management system forms part of its presentation to potential IFI and institutional

investors.In the first half of 1998,Tuninvest raised an international fund with investors having environ-

mental and social criteria including EIB,IFC,FMO and Proparco.Their success in applying these criteria was

a factor in the selection of Tuninvest as a technical partner in a new regional fund covering Morocco,

Tunisia,and Algeria raised in 2000 with the same investors and European private institutional investors.

CASE 3 Continued

BOX 3.3

DOWNSIDE RISKS FOR PRIVATE EQUITY

s Reduced valuation through environmental stigma

s IPO brand impacts

s Trade sale stigma

s Incomplete warranties concerning contingent liabilities

s Liability for misrepresentation

s Liability for negligence

s Reputational risk for limited partners

s Directors liability

s Criminal liability

s Introduce environmental covenants

within shareholder agreements.

s Following investment, instigate a

program with company management

to deal with any major corrective

actions, and review regularly (one

internal review every six months and

once a year by an external expert for

verification).

s Inform all members of the fund man-

agement team of any significant envi-

ronment issues.

s Seek any available financial subsidies,

as there are many subsidized credit

lines available, for example for watertreatment units.

s Even though it is necessary for the

investment officers to be knowledgeable

of EMS and environmental issues, it

proved beneficial having an external

expert to follow and review the inter-

nally prepared EMS.

s Schedule training for both internal

staff and the management of portfolio

companies.

SUSTAINABILITY DRIVEN OPPORTUNITIES

s Access to SRI funding

s Access to IFI funding

s Reflecting environmental risk in reduced portfolio company

purchase price

s Reflecting superior environmental and social performance

in enhanced liquidity and pricing of portfolio companies

CONCLUSIONS FOR

PRIVATE EQUITY

Sustainability-driven risks can impact

private equity groups directly. Key risks

for private equity (see Box 3.3,pg. 36).

At the same time, sustainability provides

a number of opportunities to add value at

the level of the portfolio company. Value-

added opportunities (see Box 3.4,pg. 37).

Additionally, sustainability may add value

at the level of the fund itself. Core oppor-

tunities for the fund (see Box 3.5,pg. 37)

39The Emerging Market Response38 Beyond Risk CA SE 4 : L EA S ING

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CASE 4

LEASING: LESSONS LEARNED

Key lessons of experience from Raiffeisen

Bank include the following:

s Smaller cap clients face strong

competitive pressures, with limited

financial and management resources.

At the same time, small cap clients

represent an under-banked segment

compared to large cap top tier clients.

s For these undercapitalized small cap

clients energy efficiency enhance-

ments can boost operating margins

significantly as well as reducing oper-ating risks resulting from fire, health

and safety issues and legislation driven

product obsolescence.

s In addition, management willingness

to engage in longer-term process

enhancement may correspond with

long-term management commitment

to the growth of the company

s As a result of these factors, the delivery

of energy-efficiency services may pro-

vide both a critical means of accessing

the strategically important smaller cap

market, and a means of reducing the

credit risk associated with the segment.

39The Emerging Market Response38 Beyond Risk

Background

In 1993,Hungary adopted a national energy policy making energy efficiency an integral part of government

energy and environmental policies.While energy efficiency has improved significantly since the late 80s,

these improvements have taken place mainly in the private sector.Energy efficiency in Hungary is still

lower than the EU/OECD countries,with opportunities existing across a range of sectors, ranging from

the communal household sector to the publicly owned sector including central government and local

municipalities.

Raiffeisen Bank was established as Unicbank in December 1986, concurrently with the establishment of

the two-tier banking system in Hungary.It was voted, Best International Bank in Hungary 1999.The bank

was interested in exploring the strategically important Small and Medium Scale Enterprise (SME) sector;

a sector that was under-served by the major commercial banks, and where the margins reflected reduced

competition compared to large cap corporate clients.

IFC,through the Global Environment Facility (GEF), offered guarantee funding as a pilot project for

Hungarian Banks to finance energy efficiency projects,opening up a potential opportunity for Raiffeisen

to explore the smaller-cap market.IFC also worked with Raiffeisen to structure the project to mitigate

the risks associated with energy efficiency financing for SMEs,in particular the lower credit worthiness

of small-cap clients,operating risks as a result of technological obsolescence and outdated operating

practices,and the low collateral value of energy-efficient equipment.

Implementation

s IFC,through GEF,offered guarantee funding to Raiffeisen to reduce the risk of their loans to the

SME sector.

s A project officers salary was subsidized by 50% for the first year,until a real business line was demon-

strated which justified the banks investment in staff resources.

s Working through the IFCs technical assistance facility,created to support program participants in devel-

oping the energy efficiency finance business,Raiffeisen forged partnerships with potential business

developers,matching its financial structuring expertise with the technical energy efficiency expertise

of project developers.In particular,a business incubator service helped potential project developers

across the range of energy efficiency innovations to develop viable business plans that could be financed.

s A technical assistance project helped Raiffeisen in credit risk assessment for these loans to SME Energy

Service Companies (ESCOs).As part of this credit risk assessment,three officers from Raiffeisen

attended the CEA workshop.The workshop examined potential environmental risks to target Eastern

European clients,ranging from major hazards,fire,occupational health and safety,regulatory shut down

and EU legislation driven product obsolescence,identifying potential opportunities for energy efficient

products with lower risk profiles.

Results

s Raiffeisens participation in the pilot program resulted in the immediate identification of deal flow

potential.Core business products included cogeneration development, and boiler/heating center recon-

struction for public sector clients with inefficient and unsafe boiler technology.

s The bank established an energy efficiency business team and continued to year two on a stand alone

commercial basis after the 50% staff subsidy ended

s Raiffeisen invested equity in a project development company Sinesco,whose revenues come from

shared energy savings from industrial clients,with a specialization in the hospital sector.

s In year 3,the bank began financing a number of projects without IFCs guarantee,judging that it had

acquired enough technical expertise in certain proven energy efficiency market sectors and could avoid

paying the guarantee fee for these projects.

s Raiffeisen expanded further into the retail market,offering $800 loans for homeowners to convert to

gas and upgrade boilers,as well as developing new products to serve the untapped cooperativeblock-

house housing sector.

s As a result of this initiative,Raiffeisen has established a leadership role in serving the strategically

important mid and small cap positions,enhancing market share at the retail level as well as undertaking

pioneer loans for the previously unserved cooperative housing sector for energy efficiency improve-

ment investments.

s The projects commercial success resulted in a number of banks following Raiffeisen into the sector,

as well as IFC investing an additional $12million from its own account into the Hungarian Guarantee

Facility.Banks currently involved include OTP,K & H Bank and HVB Bank.

Table 3.2, pg.40, presents a summary of current Raiffaisen portfolio projects and transaction size across

a range of client segments

CA SE 4 : L EA S ING

RAIFFEISEN BANK

s Typical clients with energy efficiency

opportunities include public sector

service providers (e.g. hospitals, trans-

port, utilities) and sectors where energy

prices have traditionally been subsi-

dized but are presently increasing.

s Opportunities also exist for projects

with short pay back periods in the

retail market

s Conducting low cost up front energy

efficiency audits is a key method of

establishing client demand for energy

efficiency products.

s Meeting market demand for these

services depends on the banks expand-ing in-house delivery capability. Bank

staff training on deal identification

andstructuring is currently under

preparation at K&H Bank, HVB

Bank and OTP Bank, followed by

banking client workshops in various

locations of the country.

41The Emerging Market Response40 Beyond Risk TABLE 3 2 FIGURE 3 4

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Although they may appear to be the least

likely to have the time or money to focus

on business performance, the reality is

that this group is likely to gain the most

from environmental performance enhance-

ment, as many SMEs use outdated and

resource-inefficient technologies.

These SMEs, therefore, present opportuni-

ties to increase efficiency and reduce costs

through cleaner production, productivity

improvements, access to premium export

markets and management system design.

41The Emerging Market Response

THE SME MARKET

SME clients form a key market segment.

As Figure 3.3, right, presents, a number

of factors are increasing the strategic

importance of the SME market for com-

mercial banks and leasing companies.

To what extent can sustainability enable

a financial institution to boost market

share in this strategically important seg-

ment? Conventional wisdom assumes

that SMEs have no time or money to

concern themselves with environmental

issues. Typical SME characteristics include

the following: that they are undercapital-ized, facing global competitive threats,

using antiquated, resource inefficient

technologies, and operating in areas

with lower enforcement levels of envi-

ronmental regulations.

40 Beyond Risk TABLE 3.2

HUNGARIAN ENERGY EFFICIENCY PROJECT EXAMPLES

PROJECT TYPE TRANSACTION SIZE (US$)

Hospital gas-fired heating system 115,707

Hospital heating project 518,369

Block housing gas heating system 68,435

Meat packing plant gas boiler system 115,340

Railroad station gas heating system 825,902

Street lighting projects (21) 396,388

Block house window changing 114,078

TOTAL 2,154,219

FIGURE 3.3

DRIVERS FOR SME BUSINESS

s Growth of Bond Market

s Increased IPOs

s Internet Banking

s Loss of second tier markets

s Margin reductions

s Global financial markets

s Retail market size

s Growth rate of market

s Local knowledge

s Under-served segmentsRETAIL SEGMENT

PUSH FACTORS PULL FACTORS

Retail Banking Competition

FIGURE 3.4

EVOLUTION OF BEST PRACTICE

FinancialComplianceProcedures

EnvironmentalValue-Added

EnvironmentalComplianceProcedures

COMPETITIVE ADVANTAGE

RISK

MANAGEMENT

FAILURE

RISK

ASSESSMENT

FAILURE

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The Emerging Market Response

Providing these services can generate

business benefits for the leasing company.

Key business drivers include the following:

s Develop new SME business

s Cross-sell existing products to supply

and distribution chain

s Deliver environmental product

extensions

s Reduce client marketing costs

s Increase inter-client referrals

s Increase intra-client referrals

s Build low cost word of mouth

marketing addressing corporate

and individual accountss Build media campaigns

CASE STUDY CONCLUSIONS:

FROM COMPLIANCE TO

VALUE-ADDED

The four cases above provide examples

of financial institutions not only per-

forming comprehensive financial and

environmental due diligence, but com-

plementing it by offering their clients a

range of sustainability-based products

and services that address the clients

business needs.

These cases, then, suggest an evolution

in approach: from financial compliance

where client creditworthiness is assessed

Beyond Risk

primarily as a function of the balance

sheet, through environmental compli-

ancewhere the institution imposes

environmental conditions to secure client

compliance and, to sustainability

where the financial institution ensures

compliance as a core part of risk man-

agement.This approach also delivers

environmental value-added to clients

in a way that enhances its competitive

position (see Figure 3.4,pg. 41).

To what extent is the market capitalizing

on these opportunities? Table 3.3, left,

provides examples of current good practicein terms of sustainability initiatives that

can increase business volume, increase

business margins or enhance the long-

term franchise of the institution.

SUSTAINABILITY

AS A BUSINESS DRIVER

While this list is not exhaustive, it

exemplifies the potential for sustainability

strategies to enhance the core drivers of

institutional performance as Figure 3.5,

pg. 44, suggests.

BOX 3.6

PROVIDING ENVIRONMENTAL VALUE-ADDED TO SME CLIENTS

SME BUSINESS NEEDS

Revenue growth

s Decreased operating costs

(labor,inputs,waste disposal etc)

s Increased productivity

s Enhanced quality control

s Enhanced customer security

s Access to financing

Risk reduction

s Long term local operating license

s Long term international operatinglicense

s Avoided loss of contracts,strikes,

government shut down,penalties etc.

s Access to insurance

SUSTAINABILITY

PRODUCTS

s Environmental management systems

s Cleaner production audits

s Energy efficiency audits

s Energy efficiency products

TABLE 3.3

SUSTAINABILITY AS A BUSINESS DRIVERILLUSTRATIVE EXAMPLES

Sustainability as a Business Driver: Good Practice Review

GOOD PRACTICE

BUSINESS OBJECTIVE BUSINESS DRIVER EXAMPLE

s Winning mandates for complex

projects

s Providing loans to SME clients

s Winning microfinance market share

s Winning ethically conscious

depositors and credit card holders

s Winning SME market share through

offering energy efficiency products

s Offering finance to sustainable

businesses

s Reducing environmental credit

risk provisioning through quality

processes

s Providing fee-based advisory services

s Gaining access to IFI finance

s Gaining access to SRI finance

community

s Maximizing employee performance

s

Corporate governance premium

s IL & FSs IDFCs ABN AMRO

s Banco Cuscatlans Rant Leasings Banco Real

s Banco Reals African Bank

s Garanti Banks Cooperative Bank

s Raiffeisen Banks OTP Banks HVB Bank

s Terra Capitals Trioduss ASN Bank

s Indasias Vilniaus Banks Bioventuress Fleet Boston

s Unibancos Tuninvests IL & FS

s BBAs Banco Cuscatlan

s Capital International

Partnerss Citigroup

s Cooperative Banks Standard Chartered Bank

s

Bank of Shanghai

Increasing business volume

Increasing margins

Building long-term

competitive position

44 Beyond Risk FIGURE 3.5

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4.LESSONS FROM THE FIELD:SUSTAINABILITY IN ACTION

What are the main lessons learned in terms

of implementation?

Core opportunities in terms of increasing

business volume include the following:

s Increasing business volume: to trans-

form undoable deals into doable ones,

and increase the bankable portfolio,

to provide additional sustainability-

driven financing that supplements

existing loan products, to finance new

sustainable sectors, to reduce attrition,

increase client loyalty, and enhance

loan renewal rates


business margins include the following:

s

Increasing business margins: toreducecritical costs (losses, workout

time, insurance costs, capital costs,

legal liabilities and provisions), to

retain feesfrom advisory services,

syndications/underwriting services,

to reflect value-added in premium

loan pricing


business longevity include the following:

s Increasing business longevity: To

leverage sustainable portfolio perfor-

mance to access expansion capital

(key sources include IFIs, long term

institutional investors, bond markets,

pension funds, depositors and SRI

investors)

y

SUSTAINABILITY AS A STRATEGIC TOOL FOR THE FINANCIAL SECTOR

VOLUME P/A

LONG-TERM PROFIT

MARGIN DURATION

MORE DEALS BIGGER MA RGINS LONG-TERM OPERATION

47BOX 4.1 Sustainability in Action

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PERFORMANCE-BASEDMANAGEMENT SYSTEMS

Chapter 3 has identified a range of

potential sustainability-driven benefits

for financial institutions. What are the

key lessons of experience in terms of

implementing sustainability initiatives?

For an institution to achieve these

sustainability business goals reliably,

it needs a systematic approach. Priority

business goals are identified and the

institutions formal and informal structure

is then aligned to achieve them. Although

these core components are integrated

within the organizations operating sys-tems,a common term used to refer to

these elements is an environmental

management system (EMS). Where the

management systems of the ISO14000

series focus on process conformance, the

EMS outlined in this chapter focuses on

business performance.

There is considerable literature available

on the design and implementation of

environmental management systems

designed to secure process conformance,

in particular the ISO14000 series, see

Box 4.1, left.

ISO14000 SERIES

FOR AN INSTITUTION TO ACHIEVE THESE SUSTAINABILITYBUSINESS GOALS RELIABLY, IT NEEDS A SYSTEMATIC APPROACH.

The International Organization for Standardization (ISO) has published a standard

on guidance for establishing an EMSISO14001.This standard is one in a series of

voluntary standards (the ISO14000 series) concerning environmental management,

environmental performance,product life cycle assessment and product environment

labeling.Many organizations globally have undergone third party verification of their

EMS and have attained certification to the standard.Others have opted for the EUs

EMAS scheme which sets out more demanding requirements. ISO14001 focuses

on implementation of the EMS,while EMAS concentrates on actual environmental

performance.Both standards are voluntary.Some of the largest banks,for example,

Deutsche Bank,UBS,Credit Suisse,Sakura Bank,were among the first in the financial

sector to achieve certification to ISO14001.For financing institutions,the most

important advantage of certification is likely to be a wider public recognition that

the banks position on environmental and social issues is sound.

49BOX 4.2 Sustainability in Action48 FIGURE 4.1Beyond Risk

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While the strategic choice will vary with

the institutions context, there are never-

theless a number of key elements that

are consistent across EMS types. This

chapter focuses on five central elements

of the environmental management sys-

tem, see Box 4.2, left.

A) OBJECTIVES AND TARGETS

An EMS has value for the institution

only in so far as it achieves specific busi-

ness objectives. For the EMS to provide

business value it must define a number of

priority business objectives, set specific

measurable targets for achieving themand then align key elements of the orga-

nizations formal and informal structure

to achieve them.

The choice of these priority objectives

will depend on the business lines, com-

petitive positioning and strategy of the

institution. For commercial banks that are

focused on risk management, as the case

of BBA (see chapter 3) illustrates, a core

goal may be risk reduction. Box 4.3, left

For project finance-focused institutions,

core goals may focus not only on risk

reduction, but also on managing the

environmental and social issues associated

with complex projects, and making those

projects work effectively. Box 4.4,pg. 50

ELEMENTS OF AN ENVIRONMENTAL MANAGEMENT SYSTEM (EMS)

BOX 4.3

POTENTIAL OBJECTIVES FOR RISK MANAGEMENT FOCUSED COMMERCIAL BANKS

The objective of this chapter is to examine

experience based on creating an EMS

that has three aims:

s To boost the business of core clients

s To generate a clear return for the

financial institution

s To work with available resources and

minimize the cost of implementation

Customizing the System

The scope and structure of an EMS,

therefore, varies according to a number

of factors, including institution type,

client base, and strategic focus. Figure 4.1,right, presents four types of EMS catego-

rized according to strategic focus.

Type One focuses on the management of

key environmental and social risks with

a minimum of resources.

Type Two addresses comprehensive envi-

ronmental and social due diligence to

present the financial institution as world

class in terms of credit risk management.

Type Three manages risk comprehensively

but identifies specific value-added oppor-

tunities.

Type Four orients its business line towards

sustainability.

EMS TYPES ACCORDING TO STRATEGIC FOCUS

TYPE ONE:DEFENSIVECore Elements of EMS in Place

Management of key environmental and social risks

s Operational procedures Top management support

TYPE TWO:PROTECTIVEFully Operational EMS

Systematic management of environmental and social risk

s Operational procedures

Application to all relevant sub-projects

TYPE THREE:OFFENSIVEFully Operational EMS


Limited environmental and social value-added

s Operational targets and objectives of EMS (enhanced portfolio quality,

reduced provisions,r educed workout time)

TYPE FOUR:SUSTAINABLEStrategic Focus on Environmental & Social Opportunities


Systematic environmental and social value-added

s Environmental and social opportunities prioritized within existing sectorss New sectors

a) Objectives and targets: setting the key business goals for the institution

b) Applicable standards: identifying the standards acceptable to key stakeholders

c) Procedures: identifying cost-effective processes to achieve those standards

at the project level

d) Roles and responsibilities: allocating roles internally and externally implement

the procedure

e) Communications and reporting: periodic monitoring of the system and internal

and external reporting against targets and objectives

RISK REDUCTION

s Reduced management workout time

s Reduced risk of project rejection at a late stage

s Reduced risk to reputation

s Reduced risk of defaults, and lower loss provisioning

s Reduced liability for any environmental clean-up of collateral

s Reduced legal liability for misrepresentation/negligence

s Continued access to IFI capital

51FIGURE 4.2 Sustainability in Action50 BOX 4.4Beyond Risk

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Identifying applicable standards, and

ensuring compliance with them poses a

number of challenges. Relevant stakehold-

ersmay be hard to identify. Stakeholders

may claim the right to involvement in a

project without any legal basis for juris-

diction. In addition, the standards of

these stakeholders can conflict. Finally,

they can evolve over time, leaving the

financial institution with outdated criteria

to judge acceptability.

In 2001, to address these issues, a number

of banks based in the Netherlands began

to implement corporate-wide forestry poli-

cies.A core step in the policy rollout was

to identify key stakeholders, including

NGOsand industry clients. Policy for-

mulations were then forged in consultation

with these stakeholders and have achieved

broad consensus.

What are the elements of current good

practice for financial institutions in setting

applicable standards? Key lessons include

the following:

s Identify local, national and interna-

tional stakeholders whose support is

critical.

s Identify the standards that they judge

to be acceptable (for example, national

regulations, EU standards, WBG

industry guidelines).

COMPLIANCE APPROACH

FIGURE 4.3

FROM COMPLIANCE TO VALUE-ADDED

For private equity groups, core goals may

focus on both downside risk management

and on creating business value for the

investee company. Box 4.5, right

Key lessons include the following:

s The choice of objectives will depend

on the competitive positioning and

strategy of the institution.

s The organization should prioritize,

resisting the temptation to set too many

goals and diffuse the institutionsfocus.

s Go for qui

Documents

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