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Client/investee activities may cause environmental impacts, present a hazard to human health, or could negatively affect the surrounding community as a result of improper planning or management.

Because these risks may present a credit, liability or reputational risk to financial institutions, they can take steps to identify and mitigate these risks. A financial institution exposure to these risks will vary depending on their business lines. Banking, microfinance, leasing and private equity organizations face different E&S risks.

The extent of environmental and social risk depends, among other things, on the industry sector, in particular if there are production processes or other activities that generate emissions and byproducts that are potentially harmful to the environment and communities. High environmental and social risk is generally associated with industry sectors such as agriculture, fisheries, extractive industries, infrastructure, construction and manufacturing.

The unexpected implications of environmental and social risk associated with a client’s/investee’s operations ultimately also impact the financial institution as a result of the transaction that links the client/investee to the financial institution. The unexpected implications for a client/investee may include:

  • Disruption of operations. A client’s/investee’s operations may be impacted directly due to changing social conditions, such as high staff turnover or changing environmental conditions, such as deterioration of resources on which the operation depends. This impacts the client’s/investee’s prospects for staying in business and represents a risk for the financial institution.
  • Legal issues. A country’s environmental and social regulations establish requirements for operating licenses, occupational health and safety standards, and emission/discharge permits. If a client/investee fails to comply with these requirements or exhibits on a continued basis negligence or non-compliance, this will result in fines and penalties or even indefinite suspension of operations as operating permit may be revoked by authorities. This impacts the client’s/investee’s financial and operational viability and represents a risk for the financial institution.
  • Loss of market share. Due to new environmental and social regulations and/or market demands for socially responsible or environmentally preferable products and services, a client/investee may lose market share if it cannot meet these requirements. This impacts the client’s/investee’s ability to sustain profits from existing operations and represents a risk for the financial institution.
  • Liabilities and market devaluation. Clients/investees may face environmental and social liabilities from contamination as well as damages or injuries to third parties. This includes any land and/or groundwater remediation actions required under environmental regulations which can be extremely costly, and any claims for payment for damages or compensation due to environmental and social damages caused by a client’s/investee’s operations. For the client/investee, this represents a significant financial burden and typically results in market devaluation of assets. For a financial institution, this results in devaluation of collateral as well as a potential liability.
  • Poor reputation. As community awareness of environmental and social issues is growing, a client’s/investee’s operations are increasingly subject to scrutiny to ensure good management and accountability. Poor environmental and social performance can result in community opposition to a client’s/investee’s presence in the community and potential delays or interruptions in client/investee operations. Negative public perception will damage a client’s/investee’s reputation, which can lead to a decreased demand for a client’s/investee’s product or services. This impacts the client’s/investee’s financial and operational viability and represents a risk for the financial institution.

Clients/Investees who do not consider or effectively manage the environmental and social risks associated with their operations run the risk of exposing themselves to credit and liability risks as well as reputational damage that can ultimately threaten the viability of their operations.

Managing environmental and social risks to comply with social and environmental regulations and international environmental and social standards as well as pursuing environmental business opportunities to enhance overall performance signals good corporate responsibility. This reduces the client’s/investee’s exposure to potential environmental and social risk as well as unexpected implications for operations and also improves reputation. For a financial institution, this increases a client’s/investee’s credibility and reflects long-term financial and operational viability.

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