Expert opinion: E/S due diligence in ECA deals – A call for pragmatism

The Environmental and Social (E/S) due diligence procedures in large-scale, ECA-backed infrastructure projects in emerging markets are a very important part of any deal. But when you take an important matter and overdo it unreasonably, you miss the main goal: to provide timely, sustainable and impactful change on the ground.

This picture repeats itself: 60% of my time is now spent on calls and meetings reviewing documents related to the E/S aspects of our projects. When those calls or meetings end, the colleagues in the industry, senior managers in big banks, EPC companies, or representatives from borrowing governments always quietly say to me: “This is insane. This is not logical.” I am sure that you, the people from the industry who are reading this, know exactly what I am talking about. 

But no one wants to speak out. People prefer to accept the situation and continue to attend conferences and show impressive slides about “sustainability”, but the biggest danger to real sustainability is rendering the word hollow. We must not let this happen. We need to speak about the 'elephant in the room' and make the process more realistic and pragmatic, which means being much more effective in the long run.

I am not talking academically, but rather from practical experience. I have been in the ECA finance business for 15 years now. During the last nine years, we (Bluebird Finance & Projects), as financial arrangers who work for international EPCs, have successfully closed financing packages for very large and complex infrastructure social projects. These include water supply, road, agriculture, hospital, and railway deals, with many European ECAs and many large banks, totalling more than €2 billion. This gives me a very wide perspective, from the good moments to the frustrating ones, on these long journeys.

Let’s make it clear from the beginning to avoid any doubt: no one, including me, wants to go back to the days where large infrastructure projects were done without checking if they might harm animals on the ground, or without paying compensation to people who lose their land on the route of a road or railway. Of course not.

But to be effective, everything must be done in the right volumes and proportions. In recent years the picture has turned 180 degrees. The E/S due diligence procedures have become extreme and automatic and are now way out of proportion. In short, this is bad for “sustainability”. 

In brief, the problems (and solutions):

A lack of differentiation - ECA E/S experts need to more accurately distinguish between the different types of risks and projects. For example, hospitals and water supply projects for rural villages – traditionally (and rightfully) considered Category B or C projects, since they contain no elements of harm to biodiversity and don't require the physical resettlement of people, just reasonable compensation to people on specific lands, which is done `by the book` and as per all international standards – are being treated with Category A procedures. 

This is despite formally retaining their Category B status in documentation. When the top level of E/S risk applies, there are huge time and expense implications. It is totally unreasonable that most projects are being considered as Category A regardless of their real risk profile. Are rural hospital and water supply projects equal to an oil/gas project? Or to a railway project with thousands of people being resettled? Or to a project which causes massive pollution? Really? You cannot convince me of that, not even in a hundred years. It misses the whole point. It doesn’t contribute to “sustainability” – it only makes it an empty word, and this is dangerous.

The solution: 

Before applying categorisations, the categories need to be defined.

- ECA committees and managers that receive deals for approval need to pay close attention to the project’s E/S category. Understanding this issue has huge implications for all stakeholders, as well as project costs, timelines and the chance of close. Tougher questions need to be asked and categorisations should not be automatically accepted. It should be an inherent part of the E/S procedure. For example, the IFC’s E/S definitions for each categorisation are too wide and vague and in many cases are subject to interpretation and debate. Therefore, more pragmatic thinking is required and greater discretion from the ECA.

- If the project is presented to them as Category A, they need to request that their E/S teams provide clear and strong justification for this. Even if it is clear cut, they still need to explain why, and equivalently why it could be interpreted as Category B.

- The E/S categorisation of every project needs to be a decision made at the ECA committee/management level, including the commercial teams rather than just the E/S people, since it is a strategic decision – not just a technical-professional decision. 

Break the category into a more enhanced scale.

- Category A should be split into two sub-categories: A and A+. For instance – a highly pollutive gas project cannot have the same requirements as a social road or railway brownfield project being constructed on an existing dirt road.

- "A+" should be triggered by high pollution, extreme PS-5 aspects, or extreme harm to biodiversity, such as a a gas project.

- "A" should apply on railway/road projects which entail normal resettlement and/or biodiversity risks, without any extreme factors.

- Category A does not always apply to the entire project; a 100km railway project is not always Category A throughout the whole route. In some segments it is indeed “A”, but there are segments on the route where the resettlement/biodiversity aspects are much less significant, meaning there could be many Category B segments within a Category A project. It is time to recognise this and to ease requirements in those sections. In short, each component of a project needs to be broken down by category.

- Once the category has been defined, ECAs need to have a clearly written and binding procedure which distinguishes between the requirements of each category. The list of requirements for Category A+ should obviously be very wide, but less so for Category A, even less so for Category B and far less so for Category C. Having a clear procedure with clear requirements will provide all stakeholders, including the EPC and the buyer government, with more confidence, visibility and understanding of the whole process and will minimise the risk.

Costs – Category B and C projects used to require E/S checks which could cost around €40,000 to €60,000 prior to financial close. This was a reasonable amount for a minor-risk project. But now, such projects are accumulating huge E/S costs from international firms who are hired by the ECAs to write the reports, check those reports, and then to monitor construction. Today, all this comes down to unrealistic sums of €400,000 to €500,000 prior to financial close, plus additional amounts during construction. In total this can reach millions of euros. I am not inflating anything. 

These amounts need to be included in the project’s budget, meaning eventual deductions from the planned scope of the project. In order to accommodate those costs EPCs need to reduce the amount of medical equipment in the project, or to deduct a few kilometers from a new road, or to remove a few villages from the list that will benefit from clean drinking water. To put it simply: the huge E/S costs, which in these cases have no real professional reason, cause significant deductions to the scope and impact of projects. Does this help sustainability or harm it? Does anyone really think about this?

The solution:

- See the solution mentioned for point one: the decision for categorisation should take into account E/S costs, as the procedure of requirements which distinguishes each category must reflect a very different level of costs between Categories A+, A, B and C. 

- The total costs of all E/S reports for a Category B project should not exceed a fixed amount of €60,000 in total, all inclusive.

- The E/S monitoring costs for the lenders’ consultants during construction should not exceed €30,000 per year and this should also be part of the ECA’s written procedure.

- For Category C projects these costs should be half at most.

- Putting an expenses cap will calm and limit the industry of E/S firms, and will signal to them that they cannot charge unlimited amounts, which today grow significantly from month to month.

Time – a reasonable E/S due diligence (for Category B/C projects) which once took three to four months prior to financial close, now – due to the harsh requirements – takes easily nine to twelve months and sometimes even more. A normal compensation process for project-affected people without any physical resettlement, which once took three to four months after financial close, can now take easily twelve to eighteen months or more (!) I am talking about real facts from the ground. This means that extensive E/S processes cause people in the project area to wait longer, sometimes even additional years, for the benefits of new crucial infrastructure. Does this help sustainability or harm it? 

The solution:

- See the solution mentioned for point one – the decision on the categorisation should take into account the E/S due diligence time. The procedure which distinguishes between categories must reflect a very different level of time required for the due diligence between them.

- For Category B/C there should be a formal time cap of up to four months to conclude the E/S due diligence.

The people on the ground lose track – with all due respect to the European lenders, the entities which eventually execute the project and operate it are the EPC contractor (for the construction) and the borrowing government (for the long-term ownership & operation). What we’ve seen in recent years is unbelievable: the E/S process is becoming a closed European game. 

ECAs and banks sit together in Teams calls, commission endless reports to be done, hire large European firms to execute them and then define what the EPC and the government should do before the project can start. They forget throughout this whole process to speak with the people on the ground. They need to sit together seriously with the EPC and the government and listen to the difficulties on the ground in Africa, which are very different to those in Stockholm or Zurich or Frankfurt.

Of course, it is good to raise standards and requirements, but this has to be done in a pragmatic way and only after a genuine and extensive dialogue. After all, not all the requirements Europeans have in mind can be implemented in Africa. The process needs to include inherent compromises, it cannot target a perfect world, which does not exist. Targeting an illusion of a perfect project, in which all risks can be mitigated to zero is not “sustainable”.

What happens now in many projects is that the EPC and the host government just lose track and understanding of the project. They don’t understand the need for hundreds of pages of ESIA-ESMF-RAP and they don’t read them. They don’t understand the logic of the requirements for projects which should be Category B or C. They don’t understand why they need to spend millions of euros on due diligence.

Worst of all, when they come to implement the paperwork, they do what it demands to fulfil E/S conditions, without really understanding them. This means that E/S has become a game of papers. “Sustainability” becomes an empty word for conferences, but not on the ground, and this is exactly the danger.

The solution:

- Before deciding on the project’s E/S category, the ECA needs to have a formal dialogue in advance on the E/S requirements with the EPC and with the buyer/borrower, in order to hear their views and inputs. This should not be done just to “check the box”, but to really listen to the EPC and the buyer government. Their say should have weight in the decision making on categorisation.

- Before defining the E/S Action Plan (ESAP), the ECA should meet the EPC and the government, to discuss with them what they think is feasible and what is not. If the EPC or the government say that certain elements of the envisaged ESAP are not reasonable, then this should be brought to wider attention at the ECA, which includes commercial people in addition to E/S experts.

Massive impact on the construction period of projects – this is a known secret in the industry. E/S requirements are much bigger, and since the EPC cannot start construction before fulfilling those requirements, the first twelve to eighteen months post financial close are spent only on satisfying them, and not on construction.

This causes delays for the project timeline. It sounds like something technical, but it’s not – those projects are planned to be constructed always within a maximum of three to four years. Every month within this period is critical and delays have many implications for expenses, the drawdown period of the loan, the commitment fees and the interest which the borrower pays.

The EPC pays more money to keep big teams on the ground and the borrower government starts repayments later than expected. All these additional costs are eventually included in (and deducted from) the project budget, meaning they reduce the project’s impact for the population.

The solution:

- ECAs should only require a few crucial actions as conditions prior to construction. These should be selected very carefully. All the rest of the ESAP actions should be done in parallel to construction, including the compensation payments. This should be emphasised of course for Category B/C projects, but also for Category B segments which are within Category A projects – as mentioned in point one. That’s why breaking the category inside an A project to sub-sections is important.

- If the EPC or the government requests that some actions be carried out in parallel to construction this should be brought to a wider decision forum at the ECA even if the E/S team disagrees.

Unrealistic burdens on the EPCs – in most cases the huge set of E/S requirements cannot be handled properly by the borrowing government, so the ECAs often choose the easy solution: putting it on the EPC. Here’s one example which we see in many projects now – the land acquisition and compensation process (named PS-5 as per the IFC standards), which is always formally the responsibility of the host government.

Yet, in most cases the government cannot implement it, and certainly not in reasonable timelines. What we see is that to enable proper progress on the project, the EPC contractor hires big teams of sociologists and PS-5 experts, implements the land acquisition surveys and pays the compensation to the project-affected people. This also eventually has to be deducted from the project’s budget, creating huge costs and a burden on the shoulders of the EPC. ECAs need to remember again their original role, which is to take risks. They cannot put everything on the EPC or make endless responsibility-matrix tables which practically remove from themselves any risk.

The solution:

- All steps and solutions mentioned in the former clauses will minimise dramatically the burden on the EPC.

ECAs are not DFIs – some ECAs seem to think today that they are DFIs. They deliver extreme requirements and attempt to dictate to the host government how to operate their projects post construction. I can understand their concerns here, but the current situation is damaging. Trying to dictate to an African country how to run and manage the O&M for their water project is antagonistic and ineffective.

These are very delicate matters which – again – require a much more intimate dialogue between the E/S experts at the ECA and the host government, which doesn’t exist today. If we take this example, a better solution would be to insert into the financed contract a few years of O&M in advance. This would certainly be perceived much more positively by the host government.

The solution:

- A real face to face dialogue between the ECA and the government, before defining the E/S requirements, will eliminate most of this problem.

The E/S process looks only at the risks – in many cases, the E/S process of ECAs only looks at the risks and disregards what happens if the project doesn’t get done. In short, we see water supply projects in Africa where ECAs spend several months analysing minor risks while forgetting that in the present villages are drinking dirty river water.

If they don’t agree to the project then another party will – perhaps a Chinese contractor with Chinese financing, who will carry out less than 5% of the E/S due diligence that Europe demands. This does not justify skipping important E/S checks, but you cannot look only at the risks without also looking at the advantages of a project. This should be an integral part of the E/S process. If we delay a deal for years and villages continue to drink dirty water, is this good for sustainability?

The solution:

- As part of the formal ECA procedure for approving each deal, ECA management should receive a detailed screening on the advantages of the project, how it will improve the current situation, and what would be the implications of failing to complete the project or advancing with significant delays.

- In the decision-making matrix of the ECA, this positive impact screening should be equal to the risk screening.

Endless power is bad – E/S managers in ECAs are more important than board members. Their say can easily kill a project. The big E/S consultancy firms are the kings of the market. They are in high demand and they raise their prices accordingly. All this creates one clear trend: an autonomous industry which has its own interests. This is not sustainable.

The solution:

- All the various points mentioned above will certainly limit this power.

- In addition, as part of the official policy. the lead arranger banks should have veto right on the E/S decisions of the ECAs. Banks are usually more business-oriented than governmental ECAs and greater balance between them will be good for the industry and for projects. If the ECA thinks that a project is Category A, and the lead arranger thinks that it is Category B, then the ECA should not decide alone. They will have to reach a balanced compromise.

Final thoughts

E/S requirements were historically 0% but today those requirements have increased by 150%, and they continue to grow. So, we’ve moved from one bad extreme to another.

We need to strike a balance. This will be achieved firstly, by loudly saying what many people in the industry say quietly, secondly, by understanding that ‘perfect solutions’ are both bad and false; and lastly and mainly, by adapting formal procedures and limitations which will put things into proportion. 

I am a great believer in competition. The managements at ECAs and banks started to understand this recently too. It is a very competitive market out there, unlike any other time in history. ECAs and lenders that exaggerate the E/S process without any real basis simply lose business. Today, EPCs, banks and governments can take a deal and go to any ECA across the globe. This competition will only grow and this will help to create the desired balance.

“Sustainability” is not only E/S. Sustainability needs to account for all of which I’ve mentioned above – the timeline of a project, the various costs, the involvement and motivation of the entities which will run the project for years, the alternatives of not doing the project, the advantages of doing the project. Not only the risks – but everything.

The E/S aspect should be one piece of the sustainability cake, and it should be equal to all the other pieces – but not 60% of it. 

I respect sustainability, that’s why it deserves to be real. It must be reflected on the ground in Africa and other emerging markets in the long term, using a more pragmatic and effective methodology, through a real dialogue with all stakeholders – not by looking for a perfect world, which doesn’t exist. Only then the E/S process will become truly “sustainable”.