Enhancing Environmental Safeguards in Financial Intermediaries

A look at how ADB, a financial intermediary (FI) itself, appraises projects and manages them over the project cycle can help give a better understanding of how other FIs manage theirs. Multilateral development banks (MDBs) and governments follow the same logic flow when deciding whether or not to invest.

First, a proposed project should meet the minimal criteria to be eligible for consideration and assessment. ADB has a Prohibited Investment Activity List, which identifies investment activities that do not qualify for ADB financing. Other FIs might have their own list to reflect their priority areas or discouraged investment. If a proposal already fails at technical and financial screening, it will be returned for revision or rejected outright without the need to proceed to environmental–social screening.

Second, after passing the eligibility screening, a project’s technical feasibility and economic–financial viability will be evaluated in the feasibility study. This necessitates development of the project’s technical design, which is also needed to estimate the cost.

The evaluation of environmental sustainability and social acceptability of a project was added in the 1970s and has gradually become stand-alone as the Environmental Impact Assessment (EIA). 

The EIA aims to (i) aid decision making (e.g. drop or proceed with a project and conditions; (ii) improve the project design to minimize negative impacts (e.g. by adding pollution treatment); and (iii) mitigate the residual impacts through action plans such as the environmental management plan.

Third, once the feasibility study and EIA show the proposed project meets technical-financial and social-environmental requirements, and related actions can be carried out, the FI (or government) can decide to approve the project and proceed with its execution.

Since these assessments are time- and resource-consuming, their intensity and level of management need to match the level of risks and impacts. Most countries and MDBs classify environmental impacts into high, medium, and low level categories that require corresponding degrees of evaluation—full EIA, simplified EIA, and no assessment—and management. Likewise on the technical aspect, not all projects require a full feasibility study.

Such impact categorization needs to take place during the proposal stage to determine the level of ensuing assessment. How can the impact level (i.e. category) of a proposal be judged? This is one of the major challenges for FIs, which has led to mis-categorization.

Some of ADB’s categorization forms state that “the project is expected to have minimal impacts, thus it is category C.” This merely repeats the ADB definition of category C and in effect says "because it has C-level impact, it is C." But why does it have C-level impacts? The factors that determine its impact need to be explained to justify its categorization. 

What factors or basic features of any proposal determine its environmental impacts? Any proposal must have basic information on physical features, i.e. nature (what it is about, its functions, etc.), scale, and location/site. It also needs to include basic financial features and institutional aspect (e.g. owner or host). While the institutional aspect can reflect the proponent’s capacity to manage impacts, impact category is determined before any mitigation and management.

Therefore, the nature and scale of a project intrinsically determine the types and levels of environmental impacts. For example, proposals on food processing may involve activities that generate high levels of pollution and utilize huge amounts of energy and water (e.g. slaughtering and tanning). Some produce much less pollution, such as grain husking or fruit sorting and packing. Others are in between, such as dairy, edible oil, and juice production. 

Further, proposals can come in different combinations of nature, scale, and site sensitivities that make judging their category impossible for any environmental expert, let alone for any FI credit officer. But collectively, it can be done through many experts' knowledge and experiences over many years and these have been captured in the threshold-based EIA classification system of most countries.

The more comprehensive the coverage and the more detailed the breakdown of sectors, scale range, and types of sites, the more useful the EIA classification criteria will be for FI staff to judge a project’s impact level and thus, categorize it properly. Yet many FIs’ ESMS do not adopt such threshold-based criteria or just use MDBs’ definition of categories. However, MDBs deal with many countries with very different circumstances that render quantitative criteria unsuitable but are more fit for principle-based criteria. They have relied on their higher-capacitated staff to make professional judgment.  

As many FIs have limited environmental workforce or budget, their ESMS need to utilize the EIA classification criteria of the countries as basis for categorization. When the country's EIA classification system has no criteria for subsectors covered by the project, sector breakdown is limited, or thresholds are too lax or non-existent, gaps filling is needed in the screening criteria of the ESMS. Doing so can not only greatly reduce wrong categorization and its related consequences but also simultaneously foster domestic compliance by aligning with national rules.

Judging impacts and categorizing a subproject is only the first step, albeit the most crucial, as it sets the trajectory of ensuing assessment and management. Given sufficient training, FI staff would be able to categorize most proposals properly if the criteria are thresholds-based and comprehensive, building on the country’s safeguard system. However, no screening criteria can cover all possible proposals in the real world. There are always outlier or trickier proposals that require professional judgment by environmental experts. Moreover, FI credit staff are unable to know if a proposed subproject is within or near a protected area or sensitive receptor, a third determinant of environmental impact/category. This needs the help of an environmental expert. A good ESMS needs specific siting criteria in addition to thresholds-based screening criteria.

FIs face two types of investment proposals: greenfield or brownfield. Projects can have both combined, such as the proposed expansion of an existing operation. Due diligence for the former needs to predict future impacts through the EIA, while that for the latter entails an environmental audit of the existing operation. Both the EIA and the audit are the responsibility of the proponent.

The EIA aims to predict future consequences, whereas audit checks actual performance against pre-set criteria and requirements. An audit also looks at risks and legacy issues, as no financier wants to get involved in anything that might incur undue liability.

Some proponents, especially small and medium-sized enterprises, cannot afford hiring EIA preparers for their proposed projects classified as category B. This has been one of the major difficulties in developing countries, prompting FIs to give up such investments or more often, misclassifying them as category C, particularly if the FIs do not have thresholds-based screening criteria.    

It is in the interest of FIs as lenders, guarantors or investors to verify before approving a project and supervising afterwards through desk review and site visit. The environmental–social aspect can be added to supervision and monitoring, with intensity and frequency commensurate with the impact category. 

Projects obtaining guarantee or insurance can become more bankable and have better chance of obtaining a loan. Proponents are encouraged to first approach guarantors to minimize due diligence repetition. The participating guarantors or insurers need to adopt the same ESMS or at least the same environmental–social screening criteria of lenders and join the training for lending FIs because their due diligence process is basically no different from that of banks or funds. They also have the incentive to supervise the projects, thus avoiding default or troubles that they might have to pay for. Therefore, site inspection and desk review have become commercial practice for guarantors and insurers as well.

The financial intermediary modality is increasingly being used by multilateral development banks as it can mobilize more resources of the FI and tap the private sector for bigger developmental impacts. It can also help green the financial sector by promoting environmental and social safeguards in their financial services. The ways to enhance safeguards in FI operations are discussed and analyzed in this article.

^[1] Asian Development Bank. 2023. Operations Manual: Policies and Procedures. Section D6: Financial Intermediation Lending. Paragraph 1.

Asian Development Bank. 2018. Financial Due Diligence for Financial Intermediaries: Technical Guidance Note. ADB.

ADB. 2003. Environmental Assessment Guidelines.