A financial institution can manage its exposure to environmental and social (E&S) risks by developing an Environmental and Social Management System (ESMS). This helps a financial institution to decrease its exposure to overall risk.

By developing procedures, E&S assessment tools and internal capacity to identify and manage environmental and social risks as part of the risk appraisal process for financial transactions a Environmental and Social Management System or ESMS a financial institution can manage its exposure to overall risk.

An ESMS consists of several components, including a financial institution's E&S policy, procedures and designated staff with responsibility for implementation. It should be designed to manage the level of environmental and social risk that the financial institution is exposed to through its portfolio.

Developing an ESMS is most effective and efficient if it is supported by senior management and integrated with a financial institution's existing risk management framework. Once approved by senior management, the ESMS can be implemented across the financial institution.

Through the financing of their clients or investments in enterprises, financial institutions play a vital role in the development of economies and are in a unique position to promote socially and environmentally sustainable development outcomes. If clients/investees engage in activities that present a potential environmental and social risk, financial institutions can encourage their clients/investees to identify and mitigate these risks. Understanding the environmental and social challenges the world is facing and capturing the opportunities that can be derived from them can prove to be a defining aspect of the success of today's financial institutions.

E&S Tools and Resources

Environmental & Social Management (ESMS) System Diagnostic Tool for Financial Institutions (FIs)

The ESMS Diagnostic Tool for FIs is designed to enable IFC, FIs, institutional investors, and asset managers to assess or self-assess the quality of an ESMS and benchmark it against IFC's Performance Standard 1 and good market practices. The ESMS Diagnostic Tool assesses nine key elements of a financial institution's ESMS System and classifies them on the basis of their level of advancement.

esms
esms

Risk Categorization Table

Factors such as scale, location, sensitivity and magnitude of impacts of a project need to be considered on a case by case basis. For example, some hotel/tourism developments may be categorized as A, rather than B.

The examples of project categorization provided below are for illustrative purposes only.

Typical Category A Projects

  • Projects affecting indigenous peoples
  • Construction of dams and reservoirs
  • Projects involving resettlement of communities/families
  • Pesticides and herbicides: production or commercial use
  • All projects which pose serious socioeconomic concerns
  • Major irrigation projects or other projects affecting water supply in a given region
  • Projects associated with induced development (e.g. inward migration)
  • Domestic or hazardous waste disposal operations
  • Projects which impact on cultural property (e.g. religious and archeological sites)
  • Hazardous chemicals: manufacture, storage or transportation above a threshold volume
  • Projects which pose serious occupational or health risks
  • Oil and gas developments, including pipeline construction
  • Impacts on protected natural habitats or areas of high biological diversity including wetlands, coral reefs and mangroves
  • Large infrastructure projects, including development of ports and harbors, airports, road, rail and mass transit systems
  • Forestry operations
  • Metal smelting, refining and foundry operations
  • Mining (opencast and pit)
  • Large thermal and hydropower developments

Typical Category B Projects

  • Breweries
  • Hotel/tourism developments
  • Cement manufacture
  • Mining (small scale)
  • Dairy operations
  • Metal plating
  • Food Processing
  • Modernization of existing plants
  • General manufacturing plants
  • Pulp and paper mills
  • Hospitals
  • Textile Plants

Typical Category C Projects

  • Software development
  • Factoring Companies
  • Consulting firms
  • Share registries
  • Service industries
  • Stockbroking
  • Technical assistance

Typical Category FI Projects

  • Bank
  • Microfinance institution
  • Private equity fund
  • Leasing company
  • Insurance company

Training

The IFC and other Development Finance Institutions offer training platforms on E&S risk management and environmental business opportunities.

IFC’s Sustainability Training & E-Learning Program (STEP):Designed for managers and staff of financial institutions (FIs), this e-training, available in English, French and Russian, represents the next generation of products designed to help financial institutions better understand sustainable finance, environmental and social risk management and explore sustainability-related business opportunities.

IFC’s Managing Environmental & Social Performance Training: Designed to help clients and investees of financial institutions to manage their environmental and social risks, thereby having a positive impact on their bottom line, reputation and development impacts.

UNEP-FI Sustainable Finance Training: The primary aim of these services is to raise awareness and to build capacity in sustainable finance amongst UNEP FI Signatories and other financial institutions, as well as relevant stakeholders in governments, NGOs and academia, especially in developing countries and emerging markets.

Available services include the Environmental & Social Risk Analysis Training Programme, which includes the following elements:

  1. Introductory Workshop
  2. Online Course: Upcoming sessions in 2017 are available here
  3. Advanced Workshop

What is an ESMS?

A Environmental and Social Management System is a set of policies, procedures, tools and internal capacity to identify and manage a financial institution's exposure to the environmental and social risks of its clients/investees.

A Environmental and Social Management System states a financial institution’s commitment to environmental and social management, explains its procedures for identifying, assessing and managing environmental and social risk of financial transactions, defines the decision-making process, describes the roles, responsibilities and capacity needs of staff for doing so and states the documentation and recordkeeping requirements. It also provides guidance on how to screen transactions, categorize transactions based on their environmental and social risk, conduct environmental and social due diligence and monitor the client’s/investee’s environmental and social performance.

What is an ESMS?
What is an ESMS?

The scope of financing activities of different types of financial institutions varies greatly, and so do the associated environmental and social risks. The management of these risks should also be tailored to the individual institutional characteristics of each financial institution, which are different for banking institutions, leasing companies, microfinance institutions, and private equity funds.

The supporting policies and procedures of the ESMS should be well documented, made available to all staff with responsibilities for implementation and can be compiled into a stand-alone operations manual to formally document the process. This manual should be updated regularly through a simple but effective revision process.

Because the procedures and decision-making process of the ESMS are systematically incorporated at each stage of transaction appraisal and monitoring, the ESMS cannot function as a stand-alone system. The process for developing a ESMS needs to consider a financial institution’s existing risk management framework and transaction cycle.

Related Documents

ESMS for Banking Institution

A banking institution's exposure to environmental and social risks varies greatly as a function of the clients within its portfolio and the types of financial transactions, which should be reflected in the scope of the ESMS.

The scope of financing activities of banking institutions may encompass transactions that target corporate finance, housing, project finance, retail, short-term finance, and small-medium enterprises.

The environmental and social risks will be more significant for corporate or project finance transactions, which are typically of large size and long duration and usually finance clients whose operations are complex and have potentially high environmental and social impacts. The environmental and social risks will typically be smaller for short-term finance transactions or transactions that support the activities of small-medium enterprises. For transactions that support housing (excluding construction) and retail, the environmental and social risks are generally considered to be non-existent.

As a starting point, a banking institution should review its current portfolio according to transaction types and exposure to the different industry sectors in which its clients/investees operate. The banking institution will apply the environmental and social risk management procedures to each transaction as part of its overall risk management framework. These procedures will be more substantial if transactions carry higher environmental and social risk and will require more in-depth environmental and social analysis on a project-by-project basis. For transactions involving lower environmental and social risk, a more simple procedure for screening transactions will be sufficient.

A banking institution’s ESMS will include the following components:

  • Environmental and social policy. The policy will state the banking institution’s commitment to managing environmental and social risks to which it might be exposed to as a result of transactions and clients in its portfolio. Typically, this will include a commitment not to finance certain types of activities, and requirements for clients/investees to comply with environmental and social regulations and also international standards for certain high risk transactions.
  • Transaction screening and risk categorization. The banking institution will screen all transactions to determine if it will proceed with a given transaction. It may categorize these according to low, medium or high environmental risk to determine the scope of the environmental and social due diligence that will be necessary to identify risks. This will enable the banking institution to prioritize transactions and focus on those clients that represent high environmental and social risks.
  • Environmental and social due diligence. The banking institution will conduct a environmental and social due diligence for each transaction but the level of detail will vary by transaction and will be based on the environmental and social risks identified during screening. For low-risk transactions, such as housing and retail, the extent of the environmental and social assessment will be limited to a simple review of the client’s operations to confirm that financing will be used for its intended purpose. For medium-risk transactions, such as short-term finance and to support small-medium enterprises, the environmental and social assessment will need to include an overview of the client’s operations, which may require a site visit, to identify potential environmental and social impacts due to the client’s industry sector. Environmental and social impacts of this scale are typically regulated under a country’s environmental and social regulatory framework and the banking institution will need to satisfy itself that the client complies with all applicable regulatory requirements. For high-risk transactions, such as corporate or project finance, a more in-depth assessment against environmental and social requirements will be necessary to fully understand potential environmental and social risks associated with the client’s operations. This will require a site visit and depending on the complexity of the client’s operations and industry sector, the banking institution should retain the services of an external expert.
  • Corrective action plan. Based on the findings of the environmental and social due diligence or during subsequent monitoring of the client’s performance, the banking institution may require clients to implement certain mitigation measures within a specified timeframe.
  • Environmental and social covenants. The banking institution may incorporate the corrective action plan and other environmental and social requirements as clauses in the legal agreement with the client. The scope of environmental and social clauses will depend on the transaction and the client’s operations.
  • Monitoring environmental and social performance. The banking institution may monitor the compliance of clients with its environmental and social requirements. The scope of monitoring will depend on the transaction and the client’s operations and can include periodic site visits.

For a banking institution, decision-making may be centralized or delegated at the branch level depending on the transaction size. The ESMS needs to define the roles and responsibilities of staff involved at each stage of the decision-making process and will typically include an ESMS Officer with oversight of the Environmental and Social Management System and an ESMS Coordinator for the day-to-day implementation of the ESMS.

Loan Officers will typically request from the client the necessary environmental and social information, which will be reviewed by Credit Analysts. For corporate or project finance transactions with high environmental and social risks, a banking institution may hire an external environmental and social specialist to conduct the environmental and social due diligence. The environmental and social findings and recommendations should be considered by the Credit Committee during the decision-making process for proceeding with a transaction.

A banking institution will need to ensure that a system is in place for record-keeping on environmental and social issues associated with each transaction as well as ensure that its staff is adequately trained to follow the procedures and identify E&S risks according to their roles.

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ESMS for Leasing Company

The scope of financing activities of leasing companies encompasses transactions that vary in duration and consist of finance leases or operating leases of assets such as office equipment, vehicles, properties, and specialized equipment and machinery.

A leasing company’s exposure to environmental and social risks will vary for finance leases or operating leases and will be more significant for transactions involving specialized equipment and machinery for use in certain industry sectors such as forestry operations, mining, and oil and gas.

The leasing company will apply the environmental and social risk management procedures to each transaction as part of its overall risk management framework. A leasing company’s ESMS will include the following components:

  • Environmental and social policy. The policy will state the leasing company’s commitment to managing environmental and social risks to which it might be exposed to as a result of transactions and clients in its portfolio. Typically, this will include a commitment not to finance clients conducting certain types of activities and requirements for clients to comply with environmental and social regulations.
  • Transaction screening. The leasing company will screen all transactions to determine if it will proceed with a given transaction.
  • Environmental and social due diligence. The leasing company will conduct a environmental and social due diligence for each transaction. For most transactions involving office equipment, the extent of the environmental and social assessment will be limited to a simple review of the client’s operations to confirm that financing will be used for its intended purpose. For transactions involving vehicles, specialized equipment and machinery, and properties, the environmental and social assessment will need to include an overview of the client’s operations, which may require a site visit, to identify potential environmental and social impacts due to the client’s industry sector. Environmental and social impacts of this scale are typically regulated under a country’s environmental and social regulatory framework and the leasing company will need to satisfy itself that the client’s use of the leased asset complies with all applicable regulatory requirements. This may require a site visit by the leasing institution.
  • Corrective action plan. Based on the findings of the environmental and social due diligence or during subsequent monitoring of the client’s performance, the leasing company may require clients to implement certain mitigation measures within a specified timeframe.
  • Environmental and social covenants. The leasing company will incorporate the corrective action plan, if necessary, and other standard environmental and social requirements as clauses in the legal agreement with the client.
  • Monitoring environmental and social performance. The leasing company will monitor the compliance of clients with its environmental and social requirements to ensure that leased assets are used for intended purposes and operated and maintained properly. The scope of monitoring will depend on the transaction and the client’s operations and can include periodic site visits.

For a leasing company, decision-making may be centralized or delegated at the branch level depending on the transaction size. The ESMS will need to define the roles and responsibilities of staff involved at each stage of the decision-making process and will typically include an ESMS Officer with oversight of the ESMS and in some cases also an ESMS Coordinator for the day-to-day implementation of the Environmental and Social Management System. Loan Officers will typically request from the client the necessary environmental and social information, which will be reviewed by Credit Analysts. The environmental and social findings and recommendations will be considered by the Credit Committee during the decision-making process for proceeding with a transaction.

A leasing company will need to ensure that a system is in place for record-keeping on environmental and social issues associated with each transaction. This can be integrated with a leasing company’s existing system and will need to be accessible by all branch offices.

Related Documents

ESMS for Microfinance Institution

The scope of financing activities of microfinance institutions encompasses transactions that are of smaller amounts than those of banking institutions, focusing on commercial clients whose operations are generally small.

A microfinance institution’s exposure to environmental and social risks is typically low, requiring in most cases environmental and social risk management procedures to screen transactions only. These will be applied as part of the microfinance institution’s overall risk management framework for each transaction. A microfinance institution’s Environmental and Social Management System will include the following components:

  • Environmental and social policy. The policy will state the microfinance institution’s commitment to managing environmental and social risks to which it might be exposed to as a result of transactions and clients in its portfolio. Typically, this will include a commitment not to finance certain types of activities that clients might be involved with.
  • Transaction screening. The microfinance institution will screen all transactions to determine if it will proceed with a given transaction.
  • Environmental and social due diligence. The microfinance institution may conduct a environmental and social due diligence for certain transactions with clients whose operations are within industry sectors that may have potential environmental and social risks associated with them. This will generally be limited to a simple overview of the client’s operations, which may require a site visit to identify potential environmental and social issues associated with the client’s industry sector.
  • Corrective action plan. In some cases based on the findings of the environmental and social due diligence or during subsequent monitoring of the client’s performance, the microfinance institution may require a client to implement certain mitigation measures within a specified timeframe.
  • Environmental and social covenants. The microfinance institution may incorporate standard environmental and social requirements as clauses in the legal agreement with the client.
  • Monitoring environmental and social performance. The microfinance institution will monitor the compliance of clients with its environmental and social requirements, which may require periodic site visits.

For a microfinance institution, decision-making may be centralized or delegated at the branch level depending on the transaction size. The ESMS will need to define the roles and responsibilities of staff involved at each stage of the decision-making process and will typically include an ESMS Officer with oversight of the ESMS and its day-to-day implementation. Loan Officers will typically screen all transactions and conduct additional environmental and social due diligence if necessary. The environmental and social findings and recommendations can be considered by the Credit Committee during the decision-making process for proceeding with a transaction.

A microfinance institution will need to ensure that a system is in place for record-keeping on environmental and social issues associated with each transaction. This can be integrated with a microfinance institution’s existing system and will need to be accessible by all branch offices.

Related Documents

ESMS for Private Equity Fund

The scope of financing activities of private equity funds encompasses transactions that are direct equity investments in companies, generally for a fixed term, which are later sold in excess of the price initially paid for the investment.

Due to the legal nature of the transaction, which makes the private equity fund a partial or full owner of an investee company, the private equity fund is directly exposed to, and thus also liable for, the environmental and social risks of the investee company.

Through environmental and social risk management, the private equity fund can mitigate potential environmental and social risks that would otherwise reduce an investee company’s financial viability and also identify environmental business opportunities that would enhance an investee company’s financial viability. Also, as a function of the private equity fund’s ownership position in an investee company, it will be in a unique position to advocate for sound environmental and social management of the investee company’s operations.

The private equity fund will apply the environmental and social risk management procedures to each investment as part of its overall risk management framework. The environmental and social risks of investee companies will range by industry sectors. For investments involving investee companies with high environmental and social risk, a more in-depth environmental and social analysis will be required than for those investments involving investee companies with lower environmental and social risk. A private equity fund’s Environmental and Social Management System will include the following components:

  • Environmental and social policy. The policy will state the private equity fund’s commitment to managing environmental and social risks to which it might be exposed to as a result of its shareholding position in investee companies. Typically, this will include a commitment not to finance certain types of activities, and requirements for investee companies to comply with environmental and social regulations and also international standards for certain high-risk investments.
  • Investment screening and risk categorization. The private equity fund will screen a proposed investment to determine if it will proceed with it. The private equity fund will assign a category according to low, medium or high environmental risk to determine the scope of the environmental and social due diligence that will be necessary to identify risks. This will enable the private equity fund to determine early on if a potential investee company represents environmental and social risks that are too significant to be exposed to.
  • Environmental and social due diligence. The private equity fund will conduct a environmental and social due diligence for each proposed investment but the level of detail will vary and will be based on the environmental and social risk. For low-risk investments, the extent of the environmental and social assessment will be limited to a simple review of the company’s operations to confirm that there are no concerns with the operations. For medium-risk investments, the environmental and social assessment will need to include an overview of a company’s operations, which may require a site visit, to identify potential environmental and social impacts due to the company’s industry sector. Environmental and social impacts of this scale are typically regulated under a country’s environmental and social regulatory framework and the private equity fund will need to satisfy itself that the company complies with all applicable regulatory requirements. For high-risk investments, a more in-depth assessment against environmental and social requirements will be necessary to fully understand potential environmental and social risks associated with the company’s operations. This will require a site visit and depending on the complexity of the company’s operations and industry sector, the private equity fund should retain the services of an external expert.
  • Corrective action plan. Based on the findings of the environmental and social due diligence or during subsequent monitoring of the investee company’s performance, the private equity fund will require investee companies to implement certain mitigation measures within a specified timeframe.
  • Environmental and social covenants. The private equity fund will incorporate the corrective action plan and other environmental and social requirements as clauses in the legal agreement with the investee company.
  • Monitoring environmental and social performance. The private equity fund will monitor the compliance of investee companies with its environmental and social requirements. The scope of monitoring will depend on the company’s operations and can include periodic site visits.

Although the staff of a private equity fund is generally limited in number, the ESMS will need to define their specific roles and responsibilities with respect to environmental and social risk management. An Investment Officer typically takes on the responsibilities of the ESMS Officer and has oversight for the day-to-day implementation of the ESMS.

In some cases, Investment Officers will conduct the environmental and social due diligence for low or some medium-risk investments. Generally for investments that potentially represent high environmental and social risks, a private equity fund will hire an external environmental and social specialist to conduct the environmental and social due diligence and provide the necessary recommendations for mitigation measures. The environmental and social findings and recommendations will be considered by the Investment Committee when determining to proceed with an investment. A private equity fund will need to ensure that a system is in place for record-keeping on environmental and social issues associated with each investment.

Related Documents

Developing an ESMS

Developing a ESMS requires senior management support and needs to be integrated with the financial institution's existing risk management framework.

Developing a ESMS is most effective and efficient if it is supported by senior management and integrated with the financial institution’s existing risk management framework. A financial institution can initiate the process for developing a ESMS by establishing a Working Group.

An ESMS includes a policy, a set of procedures to identify, assess and manage environmental and social risks in financial transactions and internal capacity of staff responsible for environmental and social management and investments.

Developing an ESMS
Developing an ESMS

It should be designed to manage the level of environmental and social risk that the financial institution is exposed to through its portfolio, both in terms of the industry sector of its clients/investees and the type of financial transactions. The management of these risks should be tailored to the organizational needs of each financial institution, which are different for banking institutions, leasing companies, microfinance institutions, and private equity funds.

Related Documents

Tips from Lessons Learned

Here are ten lessons for effective integration of sustainability into the policies, practices, products, and services of financial institutions.

Based on the experiences of financial institutions taking concrete steps to integrate sustainability into their policies, practices, products, and services, IFC’s report on Banking on Sustainability reveals the following 10 lessons for effective integration:

  1. Design a Environmental and Social Management System (ESMS) that goes beyond written policies into action, such as allocating human and financial resources for implementation, and training employees. The policy is a necessary but not sufficient step for implementing a strong management system. Other elements should reflect institutional structures and operations.
  2. Bring on board and support dedicated managers and/or environmental and social departments, staffed by experts with appropriate academic background and experience, and responsible for implementing environmental and social controls.
  3. Adopt an organization-wide approach to capacity building, and reinforce it with training and the support of senior management.
  4. Systematically integrate environmental and social procedures for risk management into overall risk management systems for all projects. Sustainability risks vary by project size and industry, but are potentially present in any project.
  5. Transform the assessment of sustainability risks into the creation of business benefits. Work with clients to improve their environmental and social performance rather than simply rejecting potentially risky investments.
  6. Make environmental and social considerations part of overall market assessment and project appraisal. In choosing their approach, financial institutions should define priority areas and focus on them. Avenues for engagement can include: market research into sustainability-driven sectors; partnerships with communities, NGOs, and related organizations; and identifying demand among existing customers for products with environmental and social components, such as affinity credit cards and “green” or social trusts.
  7. Cooperate with international financial organizations, tapping both financial resources and technical assistance.
  8. Join voluntary industry frameworks, such as the Equator Principles, to benefit from shared knowledge and expertise.
  9. Communicate improvements to stakeholders in a clear and transparent manner. Improved reputation and relationships with stakeholders is one of the immediate benefits of adopting sustainability as a business approach. Getting the message out can be done through a variety of channels, such as sustainability reports, Web sites, and the media.
  10. Undertake continual improvements to ensure that the financial institution’s commitment to sustainability goes beyond compliance with legal requirements and remains effective as a tool for gaining competitive advantage.

Download full report Banking on Sustainability from Related Documents section

Related Documents

Initiate ESMS Development Process

A financial institution's internal process for developing a ESMS may vary based on its organizational characteristics. The process can be initiated by establishing an ESMS Working Group, which is responsible for developing the ESMS.

The ESMS Working Group’s core members should include a representative from the Executive Board, the ESMS Officer and/or ESMS Coordinator, operational staff and, if needed, an external consultant. Core members are encouraged to complete the Sustainability Training and E-learning Program (STEP), designed for managers and staff of financial institutions. This free, online training provides an understanding of sustainable finance and outlines how financial institutions can identify and manage environmental and social risks and opportunities.

The financial institution should allocate sufficient time to staff to develop the ESMS. Operational staff, who will be responsible for implementing the ESMS on a daily basis, should also be involved in the process. Their input on the operational aspects of the ESMS will help ensure that the management system is practical. Involving operational staff early on in the process will also help build ownership and commitment to the ESMS when it is implemented.

The ESMS Working Group should develop an Action Plan, which states the necessary steps, timetable, responsibilities and resources needed to complete the Environmental and Social Management System. The effort required to complete each of the tasks will vary by financial institution. It is estimated that it takes 4-8 months to develop a ESMS.

Tasks of ESMS Working Group

The ESMS Working Group should review the financial institution's exposure to environmental and social risk through its portfolio and develop the necessary procedures for evaluating and managing environmental and social risk.

To start the process of developing a ESMS, the ESMS Working Group should analyze the financial institution’s portfolio to gain an understanding of the financial institution’s exposure to environmental and social risk, including the industry sectors of clients/investees and transaction type.

The ESMS Working Group should then review the financial institution’s existing procedures for assessing environmental and social risk to determine if these are adequate for managing the identified level of environmental and social risk. In particular, the ESMS Working Group should review existing procedures for screening transactions, categorizing transactions based on their environmental and social risk, conducting environmental and social due diligence and monitoring the client’s/investee’s environmental and social performance. The ESMS Working Group should also review the process for formally documenting each transaction’s environmental and social risk, considering environmental and social findings in the decision-making process, and incorporating environmental and social requirements as covenants in legal agreements.

The ESMS Working Group should then identify any potential gaps to determine what additional procedures need to be developed and/or revised to ensure that the ESMS will meet the needs of the financial institution. Next, the ESMS Working Group should develop the structure of the ESMS such that procedures for environmental and social risk assessment are incorporated into the financial institution’s existing risk management framework. This will also require a revision of existing forms or the development of new forms and tools, which are used as part of the financial institution’s risk management framework. These typically include loan applications, risk appraisal forms, due diligence report templates, site visit checklists, transaction monitoring forms, legal agreements and external reporting templates. The ESMS Working Group should share internally early drafts of the procedures and forms to obtain feedback from staff to ensure that the proposed enhancements to the risk management framework are practical and can be implemented.

Finally, the ESMS Working Group should compile the policy and all the procedures for managing environmental and social risk into an operational manual to formally document the financial institution’s ESMS. Once the ESMS and the supporting material have been developed in detail, the ESMS Working Group should present it to the financial institution’s Senior Management for formal approval and to request the necessary resources for implementation. The ESMS Working Group can then develop an implementation plan to institutionalize and roll out the Environmental and Social Management System across the financial institution, which should include training of all staff that will be involved in E&S risk screening and management.

If needed, the ESMS Working Group can hire an external consultant to help the financial institution throughout the process of developing and implementing the ESMS.

Related Documents

Institutional Commitment

An ESMS can only function effectively and properly if its development and implementation is supported by the financial institution itself.

As with any other internal management system, an ESMS can only function effectively and properly if its development and implementation is supported by the financial institution itself. This requires ownership, dedication and commitment by the financial institution to allocate the necessary resources for the successful development of an ESMS.

Even though support from an external consultant may be useful or needed to provide expertise on planning and managing environmental and social risks, the process of developing the ESMS should be led by the financial institution itself. This ensures that the ESMS is tailored to the existing internal processes and procedures and is relevant for the local market.

The financial institution should designate a representative from the Executive Board, who is responsible for the overall commitment to environmental and social risk management and oversees the development and implementation of the ESMS. Typically, a financial institution also designates an ESMS Officer, who is responsible for the development of the ESMS and in some cases also an ESMS Coordinator, who is responsible for the day-to-day implementation of the procedures by operational staff.

Related Documents

Integrate with Existing Risk Procedures

To be effective and cost-efficient, a financial institution's ESMS needs to be fully integrated into its existing risk management framework and it will be necessary to revise the existing procedures.

The procedures for managing environmental and social risk need to be applied in tandem with other risk management procedures already in place at each stage of the transaction cycle. To ensure this, a financial institution may need to revise the procedures that support its existing risk management framework by incorporating considerations for environmental and social risk throughout the transaction cycle or developing a stand-alone ESMS operations manual to formally document the environmental and social risk management process.

Integrate with Existing Risk Procedures
Integrate with Existing Risk Procedures

The financial institution’s documentation associated with each stage of the transaction cycle should be revised to incorporate environmental and social risk considerations or new forms should be developed, if necessary. A financial institution’s transaction cycle typically includes:

  • Identification. The Loan Officers/Relationship Managers at a financial institution identify a potential transaction or are approached by a potential client/investee. The scope of potential transactions that a financial institution will consider will be based on its own financing objectives, and may include a focus on certain transaction types, industry sectors, or environmental business opportunities.
  • Screening. At an initial stage, the Loan Officers/Relationship Managers will determine if a proposed transaction complies with the financial institution’s requirements for financing, such as client/investee reputation and integrity. A financial institution’s requirements may also include a list of activities and industry sectors that it will not finance.
  • Appraisal. The Credit Analysts/Investment Analysts will appraise the financial viability and credit risk of a proposed transaction, which generally entails a site visit. The appraisal process should also incorporate an evaluation of potential environmental and social risk associated with the transaction, based on product type and industry sector. The Credit Analysts/Investment Analysts can assign a environmental and social risk category, which will determine the level of environmental and social due diligence that will need to be conducted.
  • Formal Approval. The Credit Committee/Investment Committee evaluates the overall risk of a potential transaction to determine if the financial institution should proceed with the transaction, and if so, under what conditions. The decision-making process should also factor in the environmental and social risk category, the findings of the environmental and social due diligence and any recommendations for corrective actions to mitigate potential environmental and social risk.
  • Negotiation. After a financial institution decides to proceed with a transaction, the Loan Officers/Relationship Managers discuss and negotiate the terms and conditions with the client/investee. This may include requirements to comply with environmental and social parameters, such as implementing corrective actions to mitigate environmental and social risks.
  • Disbursement. The Legal Department will develop the loan/investment agreement, which will stipulate the client’s/investee’s obligations for proceeding with a transaction to mitigate the financial institution’s exposure to potential risk. Additional stipulations in the legal agreement will include the client’s/investee’s obligations to comply with environmental and social parameters to minimize the financial institution’s exposure to environmental and social risk and liability.
  • Monitoring. The financial institution monitors each transaction on a regular basis to ensure that the client/investee continues to comply with the conditions stipulated in the legal agreement. Any non-compliance, which increases the transaction’s overall risk, can be identified early on and followed up with the client/investee. Monitoring should also include a review of the client’s/investee’s ongoing environmental and social performance as well as implementation of corrective actions, as necessary, to identify early on a potential environmental and social risk to the financial institution.
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Documentation and Recordkeeping

Documentation and record-keeping on environmental and social issues associated with each transaction are a key aspect of an effective ESMS.

This enables a financial institution to track the environmental and social performance of each transaction and to assess the financial institution’ s overall exposure to risk. As part of a financial institution’s existing recordkeeping process, the following documentation and records should be kept for each transaction:

  • Preliminary Environmental and Social Screening Form. At an early stage of a proposed transaction, Loan Officers/Relationship Managers identify potential environmental and social issues and history of significant environmental and social incidents and accidents associated with a client’s/investee’s activities. Based on these initial findings, a environmental and social risk category may be assigned and the need for additional environmental and social information is identified.
  • Environmental and Social Due Diligence Form. During the environmental and social due diligence process, the financial institution should record any environmental and social issues associated with the proposed transaction. This form should include the key environmental and social risks identified during the desk top review and site visit, including any non-compliance with applicable environmental and social regulations and international standards.
  • Summary/Recommendations on Environmental and Social Findings Form. Typically, financial institution staff prepares a summary of findings on environmental and social issues which should be used in the decision-making process to approve or reject a transaction. This form should also include recommendations for a corrective action plan, if necessary, and any other environmental and social conditions to be incorporated by the Legal Department into the legal agreement with the client/investee if the transaction is approved.
  • Environmental and Social Monitoring Form. Record all findings from reviewing the client’s/investee’s environmental and social performance, based on a desktop review or a site visit. Depending on the complexity of the environmental and social issues associated with a transaction, a financial institution may require a client/investee to submit a environmental and social monitoring report on an annual basis. In cases of non-compliance, this form should be used by the financial institution to record the action to be undertaken by the client/investee and timeframe for doing so.

Guidance for Managing E&S Risk

To help ensure that the ESMS is effective, a financial institution may need to prepare additional guidance documents for staff to have a better understanding of environmental and social issues and how to manage them.

As necessary or as identified during the review and continuous improvement process of the ESMS, a financial institution may decide to prepare guidance documents on the following:

  • Risk categorization. Guidance should explain what factors such as a client’s/investee’s business activities, scale and location, sensitivity of surroundings and magnitude of potential environmental and social impacts are considered in assigning a environmental and social risk category for a proposed transaction. Guidance for Credit/Investment Analysts will ensure that the risk categorization for all transactions is systematic and consistent across the financial institution.
  • Industry sector guidelines. Industry sector guidelines provide a brief overview of the key environmental and social risks associated with a specific industry sector, issues to identify during the due diligence process, proposed mitigation measures, as well as environmental business opportunities. A financial institution can develop industry sector guidelines for Credit/Investment Analysts for those industry sectors to which it has the largest exposure.
  • Decision-making on environmental and social risk. Guidance should explain how environmental and social risk is factored into the decision-making process of a financial institution to approve or reject a transaction. This will help ensure that there is a consistent approach by the Credit/Investment Committee for all transactions.
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Roles, Responsibilities and Decision-Making

For a ESMS to function properly, it is essential that roles and responsibilities for carrying out the necessary procedures and making decisions are clearly defined.

Roles, Responsibilities and Decision-Making
Roles, Responsibilities and Decision-Making

Typically, the following staff of a financial institution are involved with implementing different aspects of the ESMS, although each financial institution should assign responsibilities in the manner that makes most sense according to its own structure:

  • Senior Management, for example one or more representatives from upper management (for example a member of the Executive Board or the Fund Manager) should be responsible for the financial institution’s overall commitment to environmental and social objectives. Senior Management establishes the financial institution’s environmental and social requirements and conditions for clients/investees. In cases of unresolved environmental and social issues or non-compliance associated with a transaction that cannot be resolved by the Loan Officers/Relationship Managers, Senior Management determines the appropriate course of action to follow to reduce the financial institution’s potential exposure to environmental and social risk, which may include taking legal action against the client/investee.
  • ESMS Officer is responsible for leading the financial institution’s effort to develop the ESMS as well as for communicating with senior management on environmental and social issues and concerns.
  • ESMS Coordinator is responsible for developing and updating the procedures and documents that are part of the financial institution’s ESMS. This person also evaluates the environmental and social risks at the portfolio level and provides assistance to Loan Officers/Relationship Managers and Credit/Investment Analysts in evaluating and monitoring the environmental and social performance of clients/investees.
  • Loan Officers/Relationship Managers are responsible for following the procedures of the ESMS at the transaction level. They discuss and negotiate possible environmental and social mitigation measures with the client/investee.
  • Credit/Investment Analysts are responsible for evaluating the environmental and social risks at the level of individual transactions and make a recommendation to the Credit/Investment Committee on whether to proceed with a transaction.
  • Credit/Investment Committee is responsible for deciding if E&S risks are acceptable to the financial institution’s overall exposure to risk before proceeding with a transaction.
  • Legal Department ensures that the financial institution’s environmental and social requirements are incorporated in legal agreements for each transaction. The Legal Department may advise if a client’s/investee’s non-compliance with environmental and social clauses constitutes a breach of contract and is considered an Event of Default under the terms of the legal agreement that requires follow up by Senior Management.

Staff responsible for environmental and social risk management are encouraged to complete the Sustainability Training and E-learning Program (STEP), designed for managers and staff of financial institutions. This free, online training provides an understanding of sustainable finance and outlines how financial institutions can identify and manage environmental and social risks and environmental business opportunities.

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Components of an ESMS

An ESMS is anchored in a financial institution's environmental and social policy and depends on the environmental and social management capacity of its staff and, as applicable, external experts.

The ESMS includes the financial institution’s environmental and social policy and designated roles and responsibilities of its staff.

It is implemented through a set of procedures for:

Components of an ESMS
Components of an ESMS

The procedures outlined in the ESMS should be applied to each transaction as part of a financial institution’s overall risk management framework. For each transaction, this also requires a financial institution to formally document its environmental and social review as part of its record-keeping process, consider environmental and social findings during the decision-making process, and incorporate environmental and social requirements such as a corrective action plan as clauses in legal agreements with clients/investee.

To ensure the effective implementation of the ESMS across operations, the financial institution needs to allocate the necessary resources for internal communication and training.

As part of its commitment to good corporate practices, a financial institution can periodically report on the environmental and social performance of transactions and measures taken to reduce overall exposure to environmental and social risk.

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E&S Policy

A environmental and social (E&S) policy states a financial institution's vision and mission with respect to the environment, society and contributions to sustainable development.

It is a short, written statement that articulates the financial institution’s commitment to integrating environmental and social considerations into its business activities as well as contributions to sustainable development. It serves as the financial institution’s foundation within which the objectives and procedures of the ESMS are anchored.

The environmental and social policy should be approved and supported by senior management. It may include the following statements and commitments:

There is no standard content for a environmental and social policy. The content should be tailored to the specific objectives of the financial institution, reflecting key environmental and social priorities and concerns as well as the environmental and social standards that clients/investees are required to comply with. The ESMS Officer can start developing an E&S policy by reviewing the financial institution’s portfolio to gain an understanding of the environmental and social risks associated with its financing activities.

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E&S Standards

Commensurate with the environmental and social risk associated with clients/investees in its portfolio, a financial institution should define environmental and social standards that establish the E&S requirements for transactions.

Environmental and social standards establish criteria for the financial institution in terms of activities that it will not finance and also establish requirements for clients/investees to comply with, such as national environmental and social regulations and international standards.

In general, environmental and social standards can include:

  • Exclusion List: A financial institution can develop a list of excluded activities that it will not finance because of environmental and social implications or other concerns of the organization or its shareholders. In some cases, excluded activities are specified in national laws or regulated under international agreements, international bans and international best practices. Excluded activities may also be specified in the terms of an agreement with an international development finance institution.
  • Environmental and Social Regulations: The activities of any client/investee are subject to the environmental and social regulatory framework of the country in which the activities are being conducted. The financial institution needs to be familiar with the national environmental and social regulations that clients/investees are required to comply with as well as the requirements, if any, of the international conventions, agreements and international bans of which a country might be a signatory.
  • International Standards: The activities of a client/investee may also be subject to the requirements of international standards established by international development finance institutions as specified in the terms of an agreement with the international development finance institution. The activities of a client/investee may also be subject to the sustainability standards established under internationally recognized industry certifications.

Providing financing to a client/investee whose activities fall on the exclusion list or whose activities do not comply with applicable national environmental and social laws and international standards presents a potential risk to the financial institution. The financial institution should verify as part of its environmental and social due diligence process that the activities of a client/investee are not on the exclusion list and comply with applicable national environmental and social laws and international standards.

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Risk Categorization and Managing Portfolio Risk

To help a financial institution to determine the extent of environmental and social due diligence that will be required for a particular transaction, a environmental and social risk category should be assigned to each transaction.

The level of environmental and social risk will vary greatly for different types of financial transactions and by industry sectors. It can also be determined by factors such as scale and location and magnitude of potential environmental and social impacts.

To help a financial institution to determine the extent of environmental and social due diligence that will be required for a particular transaction, financial institution staff should assign a environmental and social risk category to each transaction. This provides an initial assessment of the environmental and social risk associated with the transaction. Together with the findings of the environmental and social due diligence, this environmental and social risk category can be incorporated into the overall risk assessment of a transaction and factored into the decision-making process.

The financial institution should develop a environmental and social risk categorization system to assign a environmental and social risk category to every transaction in a systematic and consistent manner. A typical system includes three environmental and social risk categories, designated as high, medium and low risk (or other similar terms such as A, B and C or 1, 2 and 3) representing different risk levels:

  • High Risk: Transactions typically involve clients/investees with business activities with significant adverse environmental and social impacts that are sensitive, diverse, or unprecedented. A potential impact is considered sensitive if it may be irreversible (such as loss of a major natural habitat), affect vulnerable groups or ethnic minorities, involve involuntary displacement and resettlement, or affect significant cultural heritage sites.
  • Medium Risk: Transactions typically involve clients/investees with business activities with specific environmental and social impacts that are few in number, generally site-specific, largely reversible and readily addressed through mitigation measures and international best practice. Potential adverse environmental impacts on human populations or environmentally important areas are less adverse than those of High Risk transactions.
  • Low Risk: Transactions typically involve clients/investees with business activities with minimal or no adverse environmental and social impacts.

The financial institution can also assign Financial Intermediary (FI) as a risk category to those transactions involving clients such as banks, microfinance institutions, private equity funds, and leasing and insurance companies, which act as financial intermediaries in making financing available to other clients. By assigning the FI Category, the environmental and social risks related to these types of transactions can be managed accordingly.

A environmental and social risk categorization system enables a financial institution to monitor and evaluate its exposure to environmental and social risk aggregated at the portfolio level. A financial institution can set internal threshold levels for its overall exposure as a function of environmental and social risk category or by exposure to industry sector or transaction type as a function of environmental and social risk category. This allows the financial institution to better manage and track changes in the overall risk profile of its portfolio and the associated environmental and social impacts of its clients/investees. This information can also be used by the financial institution to report internally to Senior Management and externally to stakeholders on overall environmental and social performance.

Transaction Screening

At the initial stage of evaluating a potential financial transaction, financial institution staff should screen the activities of the potential client/investee to determine if it is an excluded activity or if there is a history of severe incidents.

If the activity falls on the financial institution’s list of excluded activities, the financial transaction should not be considered.

Financial institution staff should also review the client’s/investee’s past record for a history of severe accidents and environmental and social issues associated with business activities. If the client/investee has experienced significant incidents, the financial transaction should not be considered to reduce the financial institution’s exposure to potential risk in the future.

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E&S Due Diligence

Conducting environmental and social (E&S) due diligence on transactions is a critical component of a financial institution's ESMS and its outcome should be factored in to the decision-making process for proceeding with a transaction.

The purpose of the environmental and social due diligence is to review any potential environmental and social risks associated with the business activities of a potential client/investee (not non-commercial/individual borrower) ensure that the transaction does not carry environmental and social risks, which could present a potential liability/risk to the financial institution.

Environmental and social due diligence involves the systematic identification, quantification and assessment/evaluation of environmental and social risks associated with a proposed transaction. This process also helps identify the mitigation measures that are necessary to reduce any environmental and social risks that are identified. The extent of the environmental and social due diligence and level of detail is based on the transaction’s environmental and social risk category and will vary by transaction type:

The environmental and social due diligence can involve a simple desktop review or require a site visit with the use of technical experts, if necessary, to understand potential environmental and social risks associated with business activities and review a client’s/investee’s compliance with the financial institution’s environmental and social requirements.

Environmental and Social Due Diligence
Environmental and Social Due Diligence

The financial institution will need to develop the necessary guidance documents and checklists for use by financial institution staff in conducting the environmental and social due diligence. This should reflect the social and environmental issues that will be reviewed and other factors that will be considered to review compliance with the financial institution’s environmental and social requirements. A good starting point is a review of the environmental and social issues associated with those industry sectors that the financial institution is the most exposed to and the environmental and social laws as well as the specific context of the country in which clients/investees are located.

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Desktop Review

Financial institution staff can conduct a desktop review, which involves reviewing documentation concerning environmental and social matters as they relate to a proposed transaction and the technical aspects of a client's/investee's operations.

This includes verifying compliance of the business activities of a proposed client/investee against the relevant environmental and social regulations as well as international standards, as necessary.

The purpose of conducting a environmental and social desktop review is to obtain an understanding of the risks that are potentially associated with the business activities of a proposed client/investee. To help collect this information, the financial institution staff should develop a questionnaire on environmental and social issues, which a proposed client/investee completes as part of the transaction process.

The environmental and social risks vary by industry sector but typically the following issues should be considered and evaluated:

  • Geographic location: surrounding land use and proximity to natural habitats and rivers and lakes.
  • Site condition: condition of facilities and potential ground contamination.
  • Access to utilities such as electrical power, natural gas and water.
  • Social issues on: labor, occupational health and safety, community health and safety, community engagement, land acquisition and resettlement, indigenous and vulnerable people and cultural/archaeological heritage.
  • Environmental issues on: water use and quality, wastewater, material use (hazardous and nonhazardous), wastes (hazardous and nonhazardous), land use, biodiversity, energy use and air emissions and quality.
  • Performance and reputation of client/investee on environmental and social issues, including any fines and penalties as well as severe accidents related to environmental and social issues.

Depending on the nature of the activities and the industry sector of the client/investee of a financial institution, the environmental and social laws that may apply regulate issues such as:

Compliance with some regulations can be verified by checking for the presence or absence of valid permits and licenses. In other cases, compliance must be verified by reviewing the most recent inspection report by a government authority or the Environmental Impact Assessment required under national regulation to understand what environmental and social issues, if any, need to be addressed by the client/investee to ensure compliance.

Other documentation that can provide useful insight into a client’s/investee’s environmental and social performance and reputation include:

  • Monitoring reports on air emissions and water discharges.
  • Waste management plans.
  • Environmental management policies and plans.
  • Stakeholder engagement activities.
  • Health and safety policies.
  • Land acquisition proposals.
  • National, local or trade press relevant to industry sector or geographic area with potential references to the client/investee.
  • Government reports such as Environmental Impact Assessment.
Related Documents

Due Diligence for Corporate Finance

The environmental and social risks associated with a corporate finance transaction will vary and can be significant depending on the operation's industry sector, size, location, and company commitment and capacity to managing environmental and social risks.

The procedures and tools for conducting environmental and social due diligence for a corporate finance transaction are described in a financial institution’s Environmental and Social Management System and should include the following steps as part of a desktop review and a site visit:

  • Screen client’s/investee’s activities against a list of excluded activities adopted by the financial institution;
  • Review of industry sector and environmental and social issues that are typically associated with this type of operation;
  • Review of national environmental and social regulations that apply to the client’s/investee’s operations;
  • Review of the client’s/investee’s track record on environmental and social issues, in terms of potential non-compliance with national regulations or negative publicity;
  • Review of the client’s/investee’s performance against international standards or industry best practice regarding environmental and social issues; and
  • Review of the client’s/investee’s actions (if any) to mitigate potential environmental and social issues associated with operations.

The financial institution should document all findings from the due diligence, which will be considered during the decision-making process before proceeding with a transaction. In the event that environmental and social issues are identified and should be mitigated through corrective actions, the financial institution can stipulate these in the legal agreement with the client/investee and monitor on-going progress toward completion.

For transactions that have been categorized as high risk, the financial institution may require the services of an external expert/consultant to conduct the environmental and social due diligence. To do so effectively, it is critical that the financial institution communicates to the external expert/consultant the environmental and social requirements that clients/investees are required to comply with.

Related Documents

Due Diligence for Housing Finance

The environmental and social risks associated with housing finance may include inappropriate development location, poor building design (including inability to withstand natural disasters), inadequate construction, and unresolved land tenure issues.

The environmental and social risks associated with housing finance may include inappropriate development location, poor building design (including inability to withstand natural disasters) and inadequate construction as well as unresolved land tenure issues.

The procedures and tools for conducting environmental and social due diligence for a housing transaction are described in a financial institution’s Environmental and Social Management System and should include the following steps as part of a desktop review and a site visit:

  • Review of national environmental and social regulations including construction codes that apply to a real estate development project;
  • Review of the developer’s/construction company’s track record on environmental and social issues in particular worker safety and legal issues surrounding land tenure, in terms of potential non-compliance with national regulations or negative publicity;
  • Review of the developer’s/construction company’s performance against international standards or industry best practice regarding environmental and social issues; and
  • Review of the developer’s/construction company’s actions (if any) to mitigate potential environmental and social issues associated with operations.

The financial institution should document all findings from the due diligence, which will be considered during the decision-making process before proceeding with a transaction. In the event that environmental and social issues are identified and should be mitigated through corrective actions, the financial institution can stipulate these in the legal agreement with the developer/construction company and monitor on-going progress toward completion.

Due Diligence for Insurance

The environmental and social risks associated with insurance transactions range from being minimal to significant, as a function of a client's operations or the complexity of the project (such as roads, dams, and mining operations).

The procedures and tools for conducting environmental and social due diligence for an insurance transaction are described in a financial institution’s Environmental and Social Management System and should include the following steps as part of a desktop review and a site visit if necessary:

  • Screen client’s activities against a list of excluded activities adopted by the financial institution;
  • Apply a reputational risk screen to identify projects with potentially high environmental and social risks;
  • Review of the client’s performance on environmental and social issues, in particular their safety record and accident rates, in terms of potential non-compliance with national regulations or international standards;
  • Review of the client’s actions (if any) to mitigate potential environmental and social issues associated with operations.

The financial institution should document all findings from the due diligence, which will be considered during the decision-making process before proceeding with a transaction. In the event that environmental and social issues are identified should be mitigated through corrective actions, the financial institution can stipulate these in the legal agreement with the client and monitor on-going progress toward completion.

Related Documents

Due Diligence for Leasing

The environmental and social risks associated with leasing activities are generally minimal for most transactions but will be more significant if the fixed asset involves the use of heavy equipment and as a function of the industry sector.

The procedures and tools for conducting environmental and social due diligence for leasing activities are described in a financial institution’s Environmental and Social Management System and should include the following steps as part of a desktop review and a site visit, if necessary:

  • Screening of client’s activities against a list of excluded activities adopted by the financial institution;
  • Review of potential environmental and social issues that are typically associated with the client’s industry sector and the activities for which the leased equipment and assets will be used, including operation and periodic maintenance;
  • Review of client’s capacity and resources to ensure proper use and maintenance of leased equipment and assets;
  • If the client’s operations are in a sensitive sector with potentially significant environmental and social risks (such as mining and oil production), review of the client’s track record on environmental and social issues, in terms of potential non-compliance with national regulations or negative publicity; and
  • Review of the client’s actions (if any) to mitigate potential environmental and social issues associated with operations.

The financial institution should document all findings from the due diligence, which will be considered during the decision-making process before proceeding with a transaction. In the event that environmental and social issues are identified and should be mitigated through corrective actions, the financial institution can stipulate these in the legal agreement with the client and monitor on-going progress toward completion.

Related Documents

Due Diligence for Microfinance

The environmental and social risks associated with a microfinance transaction are typically low partly due to the small size of the operation and the industry sector.

The procedures and tools for conducting environmental and social due diligence for microfinance are described in a financial institution’s Environmental and Social Management System.

The focus of the environmental and social due diligence will be on screening transactions rather than detailed assessments. The procedures should include the following step as part of a desktop review and a site visit, if necessary:

If a potential client is significantly involved in an excluded activity, the operation should be discontinued.

In addition, many microfinance institutions see the promotion of good environmental and social practices as part of their role in the community and can therefore recommend to their clients the implementation of good practices in areas such as health and safety, working conditions, resource conservation and efficiency, and pollution prevention.

Resources:

FMO: Environmental and Social Risk Management Tools for Microfinance Institutions

Related Documents

Due Diligence for Project Finance

Due to the complexity, size, and location of operations such as roads, oil and gas explorations, dams, and power plants, which are financed as projects, these projects often have challenging environmental and social issues.

Challenging environmental and social issues may include involuntary resettlement, loss of biodiversity, impacts on indigenous communities, community and worker safety, pollution, contamination, and others. The life cycle of such projects generally includes several phases such as construction, operations, and decommissioning and typically extends over many years.

Many financial institutions that are involved in project finance transactions have subscribed to voluntary sustainability principles such as the Equator Principles, through which they commit themselves to apply international standards for managing environmental and social risks. The procedures and tools for conducting environmental and social due diligence for a project finance transaction are described in a financial institution’s Environmental and Social Management System and should include the following steps as part of a desktop review and a site visit:

  • Screening of the project against a list of excluded activities adopted by the financial institution;
  • Review of industry sector and environmental and social issues that are typically associated with this type of operation;
  • Review the project’s compliance with applicable national environmental and social regulations;
  • Review the project sponsors’ track record on environmental and social issues, in terms of potential non-compliance with national regulations or negative publicity;
  • Review the project’s compliance against international standards or industry best practice regarding environmental and social issues; and
  • Review of the proposed actions (if any) to mitigate potential environmental and social issues associated with the project throughout all phases of the life cycle.

The financial institution should document all findings from the due diligence, which will be considered during the decision-making process before proceeding with a transaction. In the event that environmental and social issues are identified and should be mitigated through corrective actions, the financial institution can stipulate these in the legal agreement with the project sponsor and monitor on-going progress toward completion.

For transactions that have been categorized as high risk, the financial institution may require the services of an external expert/consultant to conduct the environmental and social due diligence. To do so effectively, it is critical that the financial institution communicates to the external expert/consultant the environmental and social requirements that clients/investees are required to comply with. The financial institution also needs to ensure that the findings are reviewed and factored in to the decision-making process.

Related Documents

Due Diligence for Retail

The environmental and social issues associated with retail transactions that target individuals are generally non-existent.

However, for retail transactions there may be concerns associated with housing mortgage finance and potentially certain investment options that may involve controversial or high-risk projects/companies.

Basic desktop review procedures should be applied to identify the rare cases in which there may be concerns with corporate accounts that are linked to companies or individuals whose activities are viewed as harmful, including arms manufacturing, money laundry, and terrorism, which may represent a legal and reputational risk to the financial institution.

The financial institution’s procedures should include checking against a list of excluded activities and automatically checking international databases to identify companies or individuals suspected of money laundry and/or terrorism.

Resources:

Office of Foreign Asset Control (U.S. Department of Treasury)

Due Diligence for Short-Term Finance

The environmental and social issues associated with a short-term finance transaction range from minimal to complex and vary according to size, industry sector, location, and company commitment to managing environmental and social risks.

The procedures and tools for conducting environmental and social due diligence for short-term finance are described in a financial institution’s Environmental and Social Management System.

Due to the short-term nature of these types of transactions, a financial institution has only limited leverage for managing environmental and social risks. The focus of the environmental and social due diligence will be on screening transactions rather than detailed assessments. The procedures should include the following steps as part of a desktop review:

  • Screen client’s activities against a list of excluded activities adopted by the financial institution.
  • Check local and international records, where available, to identify if the company is listed as having pending issues such as fines, revoked licenses or lawsuits.

The financial institution should document the outcome of the screening, which will be considered during the decision-making process before proceeding with a transaction.

Due Diligence for Small/Medium Enterprises

The environmental and social issues associated with financing small and medium enterprises can be quite significant and are primarily related to worker health and safety and pollution.

Generally, the environmental and social issues of small and medium enterprises are not closely monitored and the risks will vary depending on company size and its capacity to manage environmental and social risks, as well as by industry sector, and location.

The procedures and tools for conducting environmental and social due diligence for this type of transaction are described in a financial institution’s Environmental and Social Management System and should include the following steps as part of a desktop review and a site visit:

The financial institution should document all findings from the due diligence, which will be considered during the decision-making process before proceeding with a transaction. In the event that environmental and social issues are identified that should be mitigated through corrective actions, the financial institution can stipulate these in the legal agreement with the client/investee and monitor on-going progress toward completion.

Related Documents

Due Diligence for Trade Finance

The environmental and social risks of trade finance are associated with the production of those goods being traded and vary by industry sector and location.

The procedures and tools for conducting environmental and social due diligence for trade finance are described in a financial institution’s Environmental and Social Management System.

Due to the short-term nature of these types of transactions, a financial institution has only limited leverage for managing environmental and social risks. The focus of the environmental and social due diligence will be on screening transactions rather than detailed assessments. The procedures should include the following steps as part of a desktop review:

  • Screen client’s activities against a list of excluded activities adopted by the financial institution.
  • Screen client’s activities for negative attention in the media.

The financial institution should document the outcome of the screening, which will be considered during the decision-making process before proceeding with a transaction.

Corrective Action Plan

Financial institution staff may develop a corrective action plan with a timeframe for the client/investee to implement appropriate mitigation measures to comply with the financial institution's environmental and social requirements.

Depending on the nature of environmental and social risks associated with a client’s/investee’s operations, financial institution staff may develop a corrective action plan with a timeframe for the client/investee to implement appropriate mitigation measures to comply with its environmental and social requirements. The purpose of a corrective action plan is to mitigate potential environmental and social risks in the context of a transaction to an acceptable level for the financial institution.

Financial institution staff should tailor the scope of a corrective action plan to each client/investee according to the specific risks identified during the environmental and social due diligence process or during subsequent transaction monitoring. Corrective action plans range from simple mitigation measures to detailed management plans with actions that can be measured quantitatively or qualitatively. The corrective action plan should include a description of the specific mitigation actions to be taken by the client/investee, a timeframe for implementation and a reporting requirement to inform the financial institution on the status of completion.

Financial institution staff will need to discuss the corrective action plan with the client/investee and agree on its scope and timeframe for completion. If the corrective action plan is developed as part of the transaction appraisal process, it should be included in the legal agreement. The timeframe for implementation of specific mitigation measures will vary according to the environmental and social risk and may range from being a condition of transaction approval to a reasonable timeframe from disbursement or when environmental and social issues were identified during transaction monitoring.

Monitoring Client/Investee E&S Performance

The purpose of monitoring a client's/investee's environmental and social performance is to assess existing and emerging environmental and social risks associated with a client's/investee's operations during the duration of a transaction.

Once a transaction has been approved, the financial institution needs to monitor the client’s/investee’s ongoing compliance with the environmental and social clauses stipulated in the legal agreement. Environmental and social risks or compliance status may change from the time of transaction approval.

From the time of transaction approval, environmental and social regulations may become more stringent, the client/investee may modify its operations or production processes in a way that exacerbate previously identified risks or present new environmental and social risks. Managing emerging environmental and social risks at the transaction level ensures effective environmental and social risk management at the portfolio level.

A financial institution’s ESMS should explain the process for systematic monitoring on a periodic basis, such as by implementing procedures for verifying compliance with environmental and social requirements including implementation of any corrective action plans to resolve non-compliances. The frequency and extent of monitoring will depend on the complexity of environmental and social issues associated with a client’s/investee’s operations.

The monitoring process generally involves a review of periodic environmental and social performance reports submitted by the client/investee and regular site visits of the client’s/investee’s operations. Special attention should be paid to:

  • Assessing implementation of any mitigation measures specified in the corrective action plan
  • Monitoring for valid environmental and social permits or licenses
  • Any fines and penalties for non-compliance with environmental and social regulations
  • Recent reports from the relevant regulator or inspection authority confirming compliance with specified laws, including any emissions measurements proving that emissions are below the permitted limits
  • Environmental and social occurrences including major accidents or incidents associated with a client’s/investee’s operations such as worker injuries and spills
  • Media attention to environmental and social issues related to the client/investee
  • Any complaints submitted by stakeholders about a client/investee

If financial institution staff identify environmental and social issues, such as a client’s/investee’s non-compliance with the environmental and social clauses stipulated in the legal agreement, they should follow up with the client/investee to resolve these in a reasonable timeframe. Depending on the complexity of the environmental and social issues associated with a client’s/investee’s operations, financial institution staff should require a new corrective action plan and/or periodic reports on environmental and social performance throughout the duration of the transaction. The reporting frequency should be tailored to each individual transaction and should be based on self-monitoring by the client/investee or monitoring by independent third parties and/or regulatory authorities.

Managing Non-Compliance

In cases of a client's/investee's non-compliance with the financial institution's environmental and social standards that are stipulated in the legal agreement, the client/investee will have a timeframe for resolving the issue.

During monitoring, financial institution staff may identify environmental and social issues, such as a client’s/investee’s non-compliance with one or more of the clauses stipulated in the legal agreement.

In these cases, financial institution staff should follow up with the client/investee to resolve these issues in a reasonable timeframe. For transactions that involve complex environmental and social issues, a financial institution’s legal agreement with the client/investee may stipulate that the client/investee has a period of time, such as 30 days, during which the client/investee can resolve the issue after notification by the financial institution.

If the client/investee fails to undertake the necessary corrective action in a timely manner or fails to resolve the outstanding environmental and social issue of concern, the financial institution may be required to take legal action against the client/investee to reduce its exposure to the environmental and social risks associated with the transaction.

The financial institution’s Legal Department should determine if a environmental and social non-compliance constitutes an Event of Default under the terms of the legal agreement with the client/investee. An Event of Default entitles the financial institution to cancel a transaction and declare all amounts owed by the client/investee to become immediately due and payable. Further legal action against the client/investee may also be necessary.

Internal and External Reporting

A financial institution's ESMS should include periodic reporting on the environmental and social performance of transactions and measures taken to reduce its overall exposure to environmental and social risk.

Financial institution staff should compile all environmental and social findings from monitoring clients/investees and aggregate findings at the portfolio level. By analyzing this information, the financial institution can have a better understanding of its overall exposure to environmental and social risk through its portfolio.

Environmental and social performance reports typically include information on:

A financial institution may have internal and external reporting requirements regarding the environmental and social risks and impacts associated with its portfolio. To this end, an increasing number of financial institutions are following internationally adopted sustainability reporting guidelines.

Implementing an ESMS

Once the ESMS has been developed and formally approved by Senior Management, it can be institutionalized and rolled out across the financial institution.

Once the ESMS has been developed and formally approved by Senior Management, it can be institutionalized and rolled out across the financial institution.

To implement the ESMS, the financial institution should develop an implementation plan, including an ESMS testing phase, with a time schedule for completing each task and the designated staff responsible for doing so. Tasks should include a review of the environmental and social regulations of the country in which the financial institution operates, testing phase, communications and training plan for staff, assigning responsibilities to applicable staff, review of international best practice that apply to clients/investees and review of the ESMS on a periodic basis for continuous improvement.

When properly designed and implemented, the additional workload for staff and transaction costs associated with the ESMS are limited, especially when environmental and social risk management procedures are fully integrated into the financial institution’s existing risk management framework.

Senior Management should be kept informed of challenges, successes and other important issues associated with the implementation of the financial institution’s Environmental and Social Management System.

Assign ESMS Responsibilities

The ESMS lists the roles and responsibilities needed for effective implementation of environmental and social risk management procedures.

Additional responsibilities for environmental and social risk management should be assigned to existing staff or new staff should be hired as required by the ESMS.

A financial institution’s staff with designated responsibilities under the ESMS are required to follow the necessary procedures in their day-to-day tasks related to risk management at all stages of the transaction appraisal and monitoring process.

Staff responsible for environmental and social risk management are also encouraged to complete the Sustainability Training and E-learning Program (STEP), designed for managers and staff of financial institutions. This free, online training provides an understanding of sustainable finance and outlines how financial institutions can identify and manage environmental and social risks and opportunities.

Related Documents

ESMS Review and Continuous Improvement

The ESMS should be updated regularly to reflect any changes in the environmental and social regulations and/or international best practices that affect the business operations of a financial institution's clients/investees.

Throughout implementation and subsequent operation of the ESMS, the ESMS should be reviewed periodically to ensure that its procedures remain relevant to the level of environmental and social risk associated with the financial institution’s portfolio. This will ensure that new and emerging environmental and social risks are detected and identified during the environmental and social due diligence process.

Any potential difficulties and opportunities for improvement should be identified by staff and addressed in a timely manner by the ESMS Officer and concerned staff to ensure a smooth implementation and efficient operation.

The operations manual for the ESMS should be updated regularly to reflect any changes and new requirements in the environmental and social regulations and/or international best practices that affect the business operations of a financial institution’s clients/investees.

ESMS Testing Phase

The ESMS should be implemented gradually, starting with a pilot test phase with limited application (for example, at one branch or limited to a specific sector or a certain aspect of the financial institution's financial activities).

This will allow the financial institution to evaluate if there are any difficulties with implementing any aspects of the ESMS that will need to be modified before full roll-out to all operations.

In particular, the financial institution should obtain feedback from operational staff who will be responsible for implementing the procedures at the transaction level. Operational staff should provide feedback on any difficulties with implementing the procedures for screening transactions, categorizing transactions based on their environmental and social risk, conducting environmental and social due diligence and monitoring the client’s/investee’s environmental and social performance. Operational staff may also require the development of additional guidance notes to help clarify implementation of various aspects of the ESMS.

Internal Communication and Training

The purpose of the ESMS and its supporting procedures should be communicated to all staff of a financial institution. This can be achieved through an office memo or emails, staff meetings, newsletters, presentations and seminars.

To emphasize the importance of a financial institution’s ESMS, the commitment of Senior Management to environmental and social issues should also be communicated on a frequent basis. Staff responsible for environmental and social risk management are also encouraged to complete the Sustainability Training and E-learning Program (STEP) for FIs, designed for managers and staff of financial institutions. This free, online training provides an understanding of sustainable finance and outlines how financial institutions can identify and manage environmental and social risks and opportunities.

A dedicated training program should be developed for all staff with responsibilities for implementing the procedures of the ESMS. This should be conducted for all new staff and periodically for existing staff. Typical training formats include workshops, seminars, interactive sessions and office meetings. If needed, the financial institution can hire an external consultant to help develop and conduct the necessary training.

The training should highlight the purpose of the ESMS in managing E&S risks as well as specific expectations of staff in doing so. The training should familiarize staff with the environmental and social risk management procedures, their roles and responsibilities, and the practical implications in terms of conducting the enhanced transaction appraisal and monitoring process, particularly in terms of changes to existing forms or the use of new forms.

Additional periodic training may be required as updates and revisions are made to the ESMS, to share practical experience obtained through the implementation of the ESMS and to further motivate staff to pro-actively identify new environmental business opportunities.

Review E&S Regulatory Framework

A financial institution needs to be knowledgeable of the environmental and social laws of the country in which it operates, to be able to verify how its commercial clients/investees comply with applicable environmental and social laws, which vary by country.

As part of its environmental and social due diligence process, a financial institution may verify how its commercial clients/investees comply with applicable environmental and social laws, which vary by country.

To do so, the financial institution needs to be knowledgeable of the environmental and social laws of the country in which it operates, in particular the requirements for conducting an Environmental Impact Assessment. This may also include the requirements, if any, of the international conventions, agreements and international bans of which a country might be a signatory. A good understanding of the applicable environmental and social laws ensures that the financial institution will effectively identify and assess the key environmental and social risks that might be associated with a financial transaction.

To be effective, the Environmental and Social Management System should reflect the most current requirements of the environmental and social laws that apply to a financial institution’s clients/investees. The Legal Department typically reviews the regulatory framework of the country in which a financial institution operates and should review requirements in the following areas:

Related Documents

IFC E&S Requirements

IFC requires financial institution (FI) clients to manage environmental and social risks in their portfolio while encouraging them to expand product offerings into financing/lending to sustainable energy projects.

Sustainability is about ensuring long-term business success while contributing toward economic and social development, a healthy environment, and a stable society. IFC’s definition of sustainability as applied to financial institutions encompasses the following dimensions of good business performance:

  • The financial sustainability of the financial institution and its client-companies, so that they can continue to make a long-term contribution to development;
  • The economic sustainability of the projects and companies the financial institution finances, through their contribution to host economies;
  • Environmental sustainability through the preservation of natural resources; and
  • Social sustainability through improved living standards, poverty reduction, concern for the welfare of communities, and respect for key human rights.

Together, these considerations aim to capture a fuller range of factors that influence the decisions, activities, products, and services of financial institutions, including the environmental and social impacts of their work.

IFC is committed to supporting sustainable capital market development and has a significant program of investment that is implemented through financial institutions. By applying a comprehensive set of Environmental and Social Standards to projects, IFC expects to achieve environmental and social sustainability, which represents an important component of positive development outcomes of projects. IFC also helps clients identify potential business opportunities for environmental and social improvement through Sustainable Finance Products.

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Implementing IFC E&S Requirements

The International Finance Corporation (IFC) strives for positive development outcomes in the private sector projects - including financial institutions - it finances.

According to the level of potential environmental and social risk in its portfolio, a financial institution engaged in business with
the IFC may be required to:

IFC also identifies potential opportunities to help the financial institution client enhance positive environmental and social outcomes, including access to IFC’s Financial Markets Sustainability products and IFC’s advisory services.

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Designate an ESMS Officer

The financial institution is required to nominate an officer to serve as the person with the responsibility of overall administration and oversight for the implementation of the ESMS.

The ESMS Officer is expected to be someone from the financial institution’s senior management, preferably from within the risk management department and should have sufficient authority and organizational influence to ensure the ESMS is properly implemented organization-wide. He or she should have a reasonable background in both environment and finance and should maintain an active role during the implementation of the Environmental and Social Management System and in reporting to IFC on an annual basis.

Depending on the financial institution’s organizational structure and business scope, the ESMS Officer may be supported by one or more ESMS coordinators to review or coordinate the day-to-day environmental and social tasks performed by other staff (i.e., credit officers, environmental and social specialists, and consultants) in various divisions and subsidiaries, according to the staff roles specified in the ESMS.

Staff responsible for environmental and social risk management are encouraged to complete the Sustainability Training and E-learning Program (STEP), designed for managers and staff of financial institutions. This free, online training provides an understanding of sustainable finance and outlines how financial institutions can identify and manage environmental and social risks and opportunities.

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Establish and Maintain an ESMS

A financial institution is required to establish a Environmental and Social Management System to manage risks in a manner consistent with IFC's Policy on Environmental and Social Sustainability and IFC's Environmental and Social Review Procedure.

The financial institution is required to establish and maintain a Environmental and Social Management System (ESMS) to manage environmental and social risks and impacts associated with financing activities in a manner consistent with IFC’s Policy on Environmental and Social Sustainability and IFC’s Environmental and Social Review Procedure. To accomplish this and as a function of the potential risks associated with its financing activities, the financial institution is required to adopt IFC’s E&S standards – the applicable IFC environmental and social performance requirements – as part of the ESMS. The applicable performance requirements may include the IFC Exclusion List, national environmental and social regulations and the IFC Performance Standards.

During IFC’s review of the financial institution’s capacity to manage potential environmental and social risks and meet the applicable environmental and social performance requirements, IFC will determine the adequacy of the financial institution’s ESMS, in particular:

As part of the legal agreement with IFC, the financial institution will be required to enhance its ESMS to address any gaps that may have been identified in these areas or to develop an ESMS if none existed previously.

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Develop an ESMS

A financial institution may be required to develop a Environmental and Social Management System to identify and manage the risks and impacts associated with its financing activities.

Based on IFC’s review, a financial institution may be required to develop a Environmental and Social Management System (ESMS) to manage the risks and impacts associated with its financing activities in order to ensure that these comply with the IFC Exclusion List, applicable national environmental and social regulations and the IFC Performance Standards.

IFC’s financial institution clients are banking institutions, leasing institutions, microfinance institutions, Insurance/Guarantee Institutions, and Equity/Investment Funds. Typically, they are engaged in a diverse range of activities including corporate finance; project finance; lending to small and medium enterprises; microfinance; trade finance; and housing finance, each with its own environmental and social risk profile.

The scope of financing activities of different types of financial institutions varies greatly, and so do the associated environmental and social risks and impacts. The management of these risks and impacts should also be tailored to the individual institutional characteristics of each financial institution, which have different levels of exposure to E&S risk depending on their activities.

A financial institution is required to develop a Environmental and Social Management System (ESMS) that fits into specific institutional characteristics as well as adequately addresses the environmental and social risk profile associated with its financing activities. As a starting point, the financial institution should create an ESMS Working Group to understand and review IFC’s environmental and social risk management requirements as stipulated in the legal agreement with IFC. If needed, the financial institution can retain an external consultant to assist the Working Group in developing and implementing the ESMS.

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Enhance an Existing ESMS

Based on IFC's review, a financial institution may be required to enhance its existing risk management procedures for assessing environmental and social risks and meet IFC's standards

Based on IFC’s review, a financial institution may be required to modify its existing risk management procedures for assessing environmental and social risks to meet IFC’s standard for a Environmental and Social Management System (ESMS) as well as applicable IFC environmental and social performance requirements. To enhance its existing capacity for managing environmental and social risks, the financial institution may be required to:

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IFC E&S Performance Requirements

The financial institution's Environmental and Social Management System should be designed to manage and reduce its overall exposure to environmental and social risk.

Based on IFC’s review of the environmental and social risk associated with a financial institution’s portfolio, the financial institution’s Environmental and Social Management System (ESMS) should be designed to manage and reduce its overall exposure to environmental and social risk. IFC’s environmental and social performance requirements are stipulated in the legal agreement with IFC and establish criteria for the financial institution in terms of activities that it will not finance and also establish requirements for their clients/investees to comply with national environmental and social regulations and international standards, depending on the E&S risk of the transaction. IFC’s environmental and social performance requirements include:

The financial institution is required to verify as part of its environmental and social due diligence process that the activities of a client/investee are not on the IFC Exclusion List and comply with applicable national environmental and social laws and the IFC Performance Standards.

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Applicable National E&S Laws

The non-compliance of a commercial client/investee with applicable environmental and social laws may present a potential risk to the financial institution.

To manage the risk associated with non-compliance of a commercial client/investee with applicable environmental and social laws, financial institutions should avoid financing a commercial client/investee whose activities do not comply with applicable national environmental and social laws unless the client/investee agrees to a corrective action plan.

The financial institution is required to verify as part of its environmental and social due diligence process that the commercial client/investee complies with all applicable environmental and social laws. To do so, the financial institution needs to be knowledgeable of the environmental and social laws of the country in which it operates. A good understanding of the applicable environmental and social laws ensures that the financial institution will effectively identify and assess the key environmental and social risks that might be associated with a financial transaction.

If non-compliance with applicable environmental and social laws are identified and depending on the severity of the issue, the financial institution can require the commercial client/investee to develop a corrective action plan for addressing the issue within a reasonable timeframe and stipulate this as a condition of the financial transaction with the commercial client/investee.

IFC Exclusion List

The IFC Exclusion List defines the types of projects that IFC does not finance, either directly or indirectly through financial institution clients.

IFC’s position for not financing these types of projects ranges from economic reasons to health and cultural concerns. A reasonableness test will be applied when the activities would have a significant development impact but circumstances of the country require adjustment to the IFC Exclusion List.

The financial institution cannot finance activities that fall on the IFC Exclusion List. Therefore, as part of its procedures, financial institutions are required to verify that the activities of a commercial client/investee are not on the IFC Exclusion List.

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IFC Performance Standards

When the potential environmental and social impacts associated with a financial institution's client/investees are significant, the financial institution should apply the IFC's Performance Standards as a benchmark for identifying and managing these risks.

The IFC Performance Standards are an international benchmark for identifying and managing environmental and social risk and has been adopted by many organizations as a key component of their environmental and social risk management. IFC’s Environmental, Health, and Safety (EHS) Guidelines provide technical guidelines with general and industry-specific examples of good international industry practice to meet IFC’s Performance Standards.

In many countries, the scope and intent of the IFC Performance Standards is addressed or partially addressed in the country’s environmental and social regulatory framework. The IFC Performance Standards encompass eight topics:

  • Environmental and Social Assessment and Management System: Commercial clients/investees are required to manage the environmental and social performance of their business activity, which should also involve communication between the client/investee, its workers and the local communities directly affected by the business activity. This requires the development of a good management system, appropriate to the size and nature of the business activity, to promote sound and sustainable environmental and social performance as well as lead to improved financial outcomes.
  • Labor and Working Conditions: For any business, its workforce is a valuable asset and a sound worker-management relationship is a key component of the overall success of the enterprise. By protecting the basic rights of workers, treating workers fairly and providing them with safe and healthy working conditions, commercial clients/investees can enhance the efficiency and productivity of their operations and strengthen worker commitment and retention.
  • Pollution Prevention and Abatement: Increased industrial activity and urbanization often generate increased levels of pollution to air, water and land that may threaten people and the environment at the local, regional and global level. Commercial clients/investees are required to integrate pollution prevention and control technologies and practices (as technically and financially feasible as well as cost-effective) into their business activities.
  • Community Health, Safety and Security: Business activities can increase the potential for community exposure to risks and impacts arising from equipment accidents, structural failures and releases of hazardous materials as well as impacts on a community’s natural resources, exposure to diseases and the use of security personnel. Commercial clients/investees are responsible for avoiding or minimizing the risks and impacts to community health, safety and security that may arise from their business activities.
  • Land Acquisition and Involuntary Resettlement: Land acquisition due to the business activities of a commercial client/investees may result in the physical displacement (relocation or loss of shelter) and economic displacement (loss of access to resources necessary for income generation or as means of livelihood) of individuals or communities. Involuntary resettlement occurs when affected individuals or communities do not have the right to refuse land acquisition and are displaced, which may result to long-term hardship and impoverishment as well as environmental damage and social stress. Commercial clients/investees are required to avoid physical or economic displacement or minimize impacts on displaced individuals or communities through appropriate measures such as fair compensation and improving livelihoods and living conditions.
  • Biodiversity Conservation and Sustainable Natural Resource Management: Protecting and conserving biodiversity (including genetic, species and ecosystem diversity) and its ability to change and evolve, is fundamental to sustainable development. Commercial clients/investees are required to avoid or mitigate threats to biodiversity arising from their business activities and to promote the use of renewable natural resources in their operations.
  • Indigenous Peoples: Indigenous Peoples are recognized as social groups with identities that are distinct from other groups in national societies and are often among the marginalized and vulnerable. Their economic, social and legal status may limit their capacity to defend their interests and rights to lands and natural and cultural resources. Commercial clients/investees are required to ensure that their business activities respect the identity, culture and natural resource-based livelihoods of Indigenous Peoples and reduce exposure to impoverishment and disease.
  • Cultural Heritage: Cultural heritage encompasses properties and sites of archaeological, historical, cultural, artistic and religious significance as well as unique environmental features and cultural knowledge, innovations and practices of communities embodying traditional lifestyles, which are protected for current and future generations. Commercial clients/investees are required to avoid significant damage to cultural heritage due to their business activities.

IFC’s Performance Standards offer a framework for understanding and managing environmental and social risks for high profile, complex, international or potentially high impact project . The financial institution is required to verify as part of its environmental and social due diligence process that the commercial client/investee complies with the IFC Performance Standards. To do so, the financial institution needs to be knowledgeable of the environmental and social laws of the country in which it operates and compare the regulatory requirements against those of the IFC Performance Standards to identify gaps. A good understanding of both sets of requirements as well as potential gaps ensures that the financial institution will effectively identify and assess the key environmental and social risks and impacts that might be associated with a financial transaction.

If non-compliances with the IFC Performance Standards are identified and depending on the severity of the issue, the financial institution can require the commercial client/investee to develop a corrective action plan for addressing the issue within a reasonable timeframe and stipulate this as a condition of the financial transaction with the commercial client/investee.

The IFC Performance Standards help IFC and its clients manage and improve their environmental and social performance through an outcomes-based approach and also provide a solid base from which clients may increase the sustainability of their business operations. The desired outcomes are described in the objectives of each Performance Standard, followed by specific requirements to help clients achieve these outcomes through means that are appropriate to the nature and scale of the project and commensurate with the level of environmental and social risks (likelihood of harm) and impacts.

IFC E&S Requirements for FI Clients

By applying a comprehensive set of environmental and social performance standards to projects, IFC expects to achieve environmental and social sustainability, which represents an important component of positive development outcomes of projects.

Through its Policy on Environmental and Social Sustainability, IFC puts into practice its commitment to environmental and social sustainability. This commitment is based on IFC’s mission and mandate, which is to promote sustainable private sector development in developing countries, helping to reduce poverty and improve people’s lives. IFC believes that sound economic growth, grounded in sustainable private investment, is crucial to poverty reduction. Translating this commitment into successful outcomes depends on the efforts of IFC and its clients.

IFC is committed to supporting sustainable capital market development and has a significant program of investment that is implemented through financial institutions. Through this program, IFC helps strengthen domestic capital markets that support economic development at a scale of enterprise that is smaller than would be possible through direct IFC investments. IFC’s financial institution clients are engaged in a diverse range of activities including corporate finance; project finance; lending to small and medium enterprises; microfinance; trade finance; and housing finance, each with its own environmental and social risk profile.

Through IFC’s Environmental and Social Review Procedure, IFC reviews the business activities of financial institution clients to identify areas where the financial institution could be exposed to potential environmental and social risks as a result of its transactions. IFC also reviews the financial institution’s capacity to manage these risks. The outcomes of IFC’s review are an important factor in IFC’s decision to finance a client or not. As a result of the review, IFC determines the scope of the environmental and social performance requirements, which are conditions of IFC financing. Proportional to the level of potential risk, the financial institution is required to:

Also during the review process, IFC identifies potential opportunities to help financial institution clients enhance positive environmental and social outcomes, including access to IFC’s Financial Markets Sustainability products and IFC’s advisory services. This will depend on the client having expressed an interest and having an adequate ESMS in place to take the initiative forward.

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Report Annually

All IFC clients including financial institutions are required to report to IFC on an annual basis on their environmental and social performance from disbursement until the end of the IFC investment.

As part of IFC’s Environmental and Social Review Procedure, all IFC clients including financial institutions are required to report to IFC on an annual basis on their environmental and social performance, from disbursement until the project is closed as an IFC investment. Annual Environmental Performance Reports (AEPRs) from financial institutions must include portfolio information broken down by industry sector and transaction type; implementation of the financial institution’s ESMS; and any significant environmental and social issues or non-compliances associated with individual transactions. The reporting format varies for banking institutions, leasing institutions, microfinance institutions, and private equity funds.

Every year, IFC reviews the Annual Environmental Performance Report (AEPR) submitted by each financial institution client. The review focuses on the following:

  1. The environmental and social risk profile of each client’s portfolio (by transaction type and industry sector);
  2. Assessment of the client’s performance against the applicable IFC environmental and social performance requirements;
  3. Key gaps relating to the client’s performance and Environmental and Social Management System (ESMS); and
  4. Key steps the client may need to take to improve its environmental and social performance.

IFC follows up with each client to discuss gaps and shortfalls in the client’s environmental and social performance; respond to client queries or the need for clarification on applicable IFC environmental and social requirements; and identify any value-added environmental business opportunities.

In doing so, IFC helps its financial institution clients achieve positive development outcomes in emerging markets, thereby putting into practice IFC’s commitment to environmental and social sustainability. This further contributes to IFC’s overall mission and mandate, which is to promote sustainable private sector development in developing countries, helping to reduce poverty and improve people’s lives.

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Reporting for Banking Institutions

Banking institutions that are IFC clients are required to report to IFC on an annual basis on their environmental and social performance by submitting an Annual Environmental Performance Report (AEPR).

As part of IFC’s annual reporting requirements, Banking Institutions are required to provide information on:

IFC reviews the Annual Environmental Performance Report (AEPR) and follows up with the financial institution to provide clarification on applicable IFC environmental and social performance requirements, discuss how to improve environmental and social performance and the ESMS and identify any value-added environmental business opportunities.

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Reporting for Leasing Companies

Leasing Companies that are IFC clients are required to report to IFC on an annual basis on their environmental and social performance by submitting an Annual Environmental Performance Report (AEPR).

As part of IFC’s annual reporting requirements, Leasing Companies are required to provide information on:

IFC reviews the Annual Environmental Performance Report (AEPR) and follows up with the financial institution to provide clarification on applicable IFC environmental and social performance requirements, discuss how to improve its environmental and social performance and the ESMS and identify any value-added environmental business opportunities.

Related Documents

Reporting for Microfinance Institutions

Microfinance institutions that are IFC clients are required to report to IFC on an annual basis on their environmental and social performance by submitting an Annual Environmental Performance Report (AEPR).

As part of IFC’s annual reporting requirements, Microfinance Institutions are required to provide information on:

IFC reviews the Annual Environmental Performance Report (AEPR) and follows up with the microfinance institution to provide clarification on IFC Exclusion List screening, discuss how to improve its environmental and social performance and the ESMS and identify any value-added environmental business opportunities.

Related Documents

Reporting for Private Equity Funds

Private equity funds that are IFC clients are required to report to IFC on an annual basis on their environmental and social performance by submitting an Annual Environmental Performance Report (AEPR).

As part of IFC’s annual reporting requirements, Private Equity Funds are required to provide information on:

IFC reviews the Annual Environmental Performance Report (AEPR) and follows up with Private Equity Funds to provide clarification on applicable IFC environmental and social performance requirements, discuss how to improve its environmental and social performance and the ESMS and identify any value-added environmental business opportunities.

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Business Case for Managing E&S Risk

Considering environmental and social risks as part of the risk appraisal process for transactions helps a financial institution to decrease its exposure to overall risk and contributes to its long-term financial viability.

A financial institution can do so by developing a Environmental and Social Management System, which can be integrated into its existing risk management framework including the risk appraisal process for transactions. A well-developed Environmental and Social Management System can lead to decreased exposure to environmental and social risks, increased market opportunities, and enhanced reputation, which help contribute to the long-term financial viability of financial institution.

Business Case for Managing Environmental and Social Risk
Business Case for Managing Environmental and Social Risk

There is a clear business case for financial institutions to establish a management system that incorporates environmental and social risks into their overall approach to risk management. If environmental and social risks are considered too high or cannot be mitigated to an acceptable level, financial institutions can decide not to engage in a financial transaction, even if otherwise it is projected to have a good financial return. Similarly, financial institutions can add value to their clients or investees by helping identify and mitigate E&S risks that could threaten the viability or profitability of their business.

An increasing number of financial institutions are voluntarily adopting international environmental and social standards to identify and mitigate E&S risks, also creating opportunities and harmonizing the requirements for environmental and social sustainability for their clients/investees. These standards facilitate the unique role that financial institutions can play in promoting sustainable development outcomes.

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Addressing E&S Risk

Understanding and managing environmental and social risks is becoming increasingly recognized as an important element of a financial institution's approach to risk management.

Until recently, the environmental and social risks associated with financial transactions were not traditionally addressed in a financial institution’s approach to risk management. In part, this was because financial institutions are not directly exposed to these risks and their understanding of the environmental and social issues facing clients/investees is not normally in the financial institution’s area of expertise. In addition, quantifying environmental and social risks of clients and investees is not always straightforward.

For financial institutions, the key to identify these risks is streamlining environmental and social risk assessment with existing risk assessment practices and in a way that it can easily be understood and implemented by financial institution staff.

To systematically address environmental and social risks, financial institutions typically develop a Environmental and Social Management System, commensurate with the level of environmental and social risk of their portfolio.

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Benefits of Addressing E&S Risks

Environmental and social risk management benefits a financial institution by improving overall risk management, identifying new environmental business opportunities, and adding value to clients and investees, thus gaining a competitive advantage.

More and more financial institutions are now convinced that environmental and social risks of clients need to be considered and that this can be done effectively by incorporating environmental and social risk into risk management processes.

Benefits of Addressing Environmental and Social Risks
Benefits of Addressing Environmental and Social Risks

In recent years, financial institutions – in particular those that are operating at the international level or have positioned themselves as “sustainable” or “green” – have developed a ESMS and associated policies and procedures because they see the strong business case for E&S risk management.

Some financial institutions continue to be uncertain about the importance and benefits of addressing environmental and social risk. A few financial institutions, such as those that operate in smaller markets or engage in financial transactions with low perceived environmental and social risk, may argue that a Environmental and Social Management System (ESMS) is not relevant to their financial performance or that it increases transaction costs without bringing financial benefits. Also, some financial institutions may feel that environmental and social risk management provides no value-added to their portfolio and consider “green” markets as niche products in which their clients/investees are not interested.

Regardless of the size or type of financial institution, the type of financial transactions involved and the market in which it operates, a financial institution can benefit from environmental and social risk management by using it to improve its overall risk management, identify new environmental business opportunities, and add value to their clients and investees, thus gaining a competitive advantage.

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Better Risk Management

Financial institutions are directly exposed to credit, liability and reputational risks arising from E&S issues associated with their clients'/investees' operations.

While financial institutions may consider that the environmental and social risks of their clients/investees are not relevant to them because their exposure to those risks is indirect, they are directly exposed to credit, liability and reputational risks arising from E&S issues associated with their clients. Having a Environmental and Social Management System enables a financial institution to systematically assess the risk of each transaction in relation to credit, liability and reputational risk, by looking for example at risks related to industry sector and geographic region.

Although exposure to some level of environmental and social risk is unavoidable, an ESMS improves the ability of a financial institution to manage its portfolio and effectively control overall risk exposure. Focusing on environmental and social risk that can result in financial, legal and/or reputational damage also helps a financial institution to ensure its long-term financial viability.

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Competitive Advantage

Good governance, accountability and increased lender liability are relevant to financial institutions. Clients/investees are starting to look at a financial institution's position on environmental and social issues when deciding where to take their business.

Financial institutions that take their role in addressing environmental and social risk seriously generally have a better reputation within the market than those that do not.

Investors are expecting financial institutions to adopt a Environmental and Social Management System, which is also often a requirement of the major international lenders. In addition, as national environmental and social regulatory frameworks are becoming increasingly stringent and pressure from external stakeholders to comply with international environmental and social standards is increasing, financial institutions that systematically manage their environmental and social risks through a ESMS will be better prepared for the future to anticipate and adapt to these changes.

A financial institution can also gain a competitive advantage by providing value to their clients in identifying and mitigating E&S risks that are relevant to them. For example, many export-oriented companies may benefit from a financial institution’s expertise on E&S standards and companies facing regulatory problems can finally address compliance issues that threaten their business and credit worthiness with the support of a financial institution.

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