How we apply ESG standards in our investment process
Here we provide an explanation of the different stages in our investment process and how ESG is integrated into that process. By means of examples, we show how this works in practice.
1 Client selection
We identify investment opportunities within our key markets that contribute to our three SDGs. In our selection, we check country, exclusion list, the viability of the investment plan and the business itself. We also check if our investment is ‘additional’. This means that we can provide resources and share best practices that are critical for sustainable development and otherwise would not have been available to the company or project.
Prior to initial approval of a project that would involve dredging of an access channel and reclamation of an island for the construction of a cruise terminal, an early Environmental & Social (E&S) review flagged that the project could have serious environmental consequences. The proposed project area was a critical marine habitat, including coral reefs, with an already low reef health index. Dredging in such a unique and pristine location could destroy the coral reefs and other marine resources and endanger the long-term ability of the marine habitat to continue providing critical ecosystem services. We decided not to pursue this opportunity driven by this early assessment.
2. Clearance in principle
We perform an initial assessment of risks and opportunities, define the key terms of client engagement, and scope any further assessment needs. We document these processes in a ‘clearance in principle’ proposal, informing our decision to continue preparing an opportunity for a final investment decision. We conduct a Know-Your-Customer assessment to ensure that the client complies with anti-money laundering, anti-corruption and anti-terrorist financing regulations. The financing opportunity is also assessed against potential effects on environmental, social and human rights conditions, as well as governance structures.
Desk research during the Clearance in Principle (CIP) stage flagged potential human rights infringement in the portfolio of a selected financial institution. As part of CIP decision making concerns were raised, particularly with regards to the bank’s exposure to the mining sector, which is known for human rights violations, including child labor and forced labor. Despite potentially positive impacts, we concluded after a thorough examination of the investment that we only had limited leverage over our client and sub-clients to adequately address the human rights abuses in the mining sector. Therefore, we decided not to approve the CIP. We continue to build a portfolio in this country but select clients that do not have a significant exposure to the mining sector and that are willing to commit to adequate ESG practices.
3. Due diligence
We carry out a detailed project assessment. We document the results in a finance proposal informing FMO’s final decision to invest. We perform a site visit, including visits to key stakeholders. Where needed, we engage consultant support in various fields. We define and negotiate further ESG requirements and conduct further human rights contextual risk assessment as informed by ‘clearance in principle’. This includes on-the-ground research and consultation with local civil society.
We explored a renewable energy project, situated in a region with high poverty and unemployment as well as historical ethnic tensions. Late in the due diligence process, a pocket of opposition emerged. Root causes were found to be related to the project’s inexperience with clear and transparent community engagement, land agreements, and information flows, which was perceived negatively by one of the local groups, while others were very supportive and awaited the project eagerly. Unsubstantiated rumors about project impacts abounded and the company was no longer trusted. We were convinced of the project team’s integrity and intentions. However, our commitment to the investment was postponed to a later date to allow the project to invest in a robust expert-led conflict resolution, aimed at bringing all parties to the table to discuss a common way forward. The delay risked our participation in the transaction, as some other lenders had already received their approval to commit, but we awaited confirmation that the project was on track to achieve Broad Community Support and better cohesion between different local stakeholders, before proceeding to Financial Proposal.
4. Decision to invest
Our Credit department evaluates all finance proposals and writes Credit advice in support of a final investment decision by the Investment Committee. After investment approval, FMO discloses proposed investments for 30 days prior to contracting. This gives stakeholders the opportunity to share their concerns and feedback with us.
A renewable project, with a committed developer, is applying the IFC Performance Standards for the first time. The decision to invest was conditional to several E&S requirements being in place prior to construction, such as a lender-approved labor management plan and a local labor recruitment procedure. Two months after this decision, and one month prior to the scheduled start of construction, our review of the plans found significant gaps. Those gaps were largely caused by a lack of in-country E&S specialists and capacity, even though the developer’s management was committed to proper implementation of the IFC PS and FMO had already provided hands-on capacity building through a social risk workshop. As a result, FMO withheld issuance of Notice to Proceed to Construction for a few weeks and assisted the client in identifying and onboarding an international expert to work alongside the client’s in-country team to develop suitable plans and procedures, while building team capacity to implement them. The client developed an innovative and effective ‘staged mobilization plan’, to ensure compliance with FMO requirements, while minimizing losses to the company resulting from delayed construction.
5. Contracting & investment disclosure
FMO includes ESG requirements and conditions in all its agreements with clients to ensure that they are legally binding. We disclose all contracted investments during the full tenor of our engagement in the World Map on our website.
Our deal team conducted a due diligence on a fresh fruit and vegetable company and identified water availability and conservation, labor conditions and community health and safety as core risks. The company is experienced in E&S management and even though water was being adequately managed and current operations would not jeopardize local water sources, Credit was concerned with future changes in climate and thus future water availability for all users. This resulted in a positive advice based on the recommendation that, in addition to the existing GlobalGap certification, the company obtained the Alliance for Water Stewardship (AWS) - a global standard for entities willing to demonstrate their commitment towards ensuring (1) good water governance, (2) sustainable water balance, (3) good water quality status and (4) healthy status of Important Water-Related Areas, and to use this process to set water targets beyond existing permit. The objective was to encourage the company to become pro-active in water conservation. Because this requirement goes well beyond compliance, Credit recommended to link the AWS certification to a financial incentive in the form of an interest margin reduction.
Disbursement can take place upon achievement of the conditions, ESG and other, set out in the legal agreement.
We provided a corporate loan to a renewable energy company, which was instrumental in growing the organization’s E&S capacity and adherence to an Environmental Social Management System (ESMS). Since then, the company has grown rapidly and is now venturing into regions with elevated risks (e.g. areas with high presence of refugees, potentially contested lands, and forested areas), which were not anticipated at the time of investment. With a corporate loan, post financing leverage is limited, and our E&S officer was working with the client’s E&S team on incremental improvements through strategic influencing. However, we had since invested in a separate loan with the same company on a different product line. When a disbursement for the new product line came up, we used the opportunity to add additional E&S scrutiny to the previous transaction, resulting in a new package of E&S commitments by the company, aimed at improving performance on both product lines.
7. Monitoring & value creation
Throughout the lifetime of the investment, we monitor performance and progress and look for opportunities to add value. We continue to work with our clients to ensure implementation of our ESG requirements. We review the client’s and consultant’s ESG monitoring, accident and incident reports. We conduct client visits and perform an annual client credit review. We also conduct a regular and systemic ongoing community support check.
As a result of a merger, FMO’s overall exposure to large high-risk projects increased in the client’s portfolio. The client requested us to support it in advancing its E&S due diligence and risk management practices. We developed a technical assistance program to further develop the bank’s E&S risk management capacity. As part of the program the bank has initially reviewed current systems and practices and prepared a work plan for the next year to integrate E&S risk management within its daily operations. To date our client has revised and improved its E&S policy. Next steps include capacity building of its E&S personnel and staff through on-the-job training and refresher courses.