THE ROLE OF FINANCIAL INSTITUTIONS TO SUSTAINABLE DEVELOPMENT IN ETHIOPIA

THE ROLE OF FINANCIAL INSTITUTIONS TO SUSTAINABLE DEVELOPMENT IN ETHIOPIA

KOKEB GIZAW

February 2007

Addis Ababa

TABLE OF CONTENTS

Acknowledgment
Acronym
Abstract
1.	Introduction ……………………………………………………..	6
1.2.	Statement of the problem ……………………………	7
1.3.	Objective of the study ………………………………	7
1.4.	Importance of the study ……………………………...	7
1.5.	Scope and limitation of the study …………………..	7
1.6.	Methodology …………………………………………...	8
1.7.	Structure of the paper ………………………………...	8
2.	What are financial institutions? ……………………………...	9
3.	The role of financial institutions ……………………………...	10
4.	Finance and sustainable development …………………...	11
5.	Equator Principles – the way forward ……………………...	14
5.1.	What are Equator Principles? ………………………..	14
5.2.	History of Equator Principles ………………………….	17
5.3.	How do the Equator Principles function? …………	21
5.4.	What benefits are there for concerned parties? ..	22
5.5.	Experience of Equator Banks ………………………..	24
5.6.	What do stakeholders have to say? ……………….	28
5.7.	Updates made in the Equator Principles ………….	30
6.	Project financing in Ethiopia …………………………………	32
6.1.	Experience of selected banks ……………………….	33
6.2.	Procedures followed in project financing ………...	35
7.	Conclusion ………………………………………………………	39
8.	Recommendation ……………………………………………..	41
	Annexes
	Reference

ACKNOWLEDGMENT

I am grateful to all the people who have helped me obtain information. Thank you all!

ACRONYMS

CBE	Commercial Bank of Ethiopia
CEO	Chief Executive Officer
CIBC	Canadian Imperial Bank of Commerce
DBB	Development Bank of Ethiopia
EA	Environmental Assessment
EIA	Environmental Impact Assessment
EMP	Environmental Management Plan
EP	Equator Principle
FDRE	Federal Democratic Republic of Ethiopia
IFC	International Financial Corporation
NBE	National Bank of Ethiopia
NGO	Non Governmental Organization
USA	United states of America
WB	World Bank

ABSTRACT

The financial industry has a pivotal role in channeling capital flows. In the developed world it is becoming a wide practice of financial institutions to incorporate the issues of sustainability by the projects they finance. This paper focuses on the role financial institutions play in the sustainability by taking in to consideration the projects they finance. It looks at the concept of sustainability and the experience of banks in the developed world. It also looks at the current practice in Ethiopia and the problems at hand along with suggested solutions.

1. INTRODUCTION

People pose for a while to think the relationship financial institutions –especially banks – have with the environment. As it is a relatively new concept, it is not surprising if they say that it is not for financial institutions to be concerned about the environment as it has its own protector – the environmentalist. But having a concern regarding the environment does not necessarily indicate that one is an environmentalist.

The relationship banks have with the environment is a recent phenomena and it might take time to analyze why one should be concerned. But ignoring the fact that there is something going on does not hinder the consequences from happening. The wise thing to do is to open oneself and look around to see what is going on. It does not require one to be an expert in the technical aspects involved to see the role it can play by its part.

The word sustainability is used in almost every sector because it is understood that the development of one sector in the expense of the other can not be whole. Thus that is why one should carefully analyze what probable relationship might there be with a problem in another sector. In this regard, It is only enough to understand that environmental risks also bring along business risks.

This paper is about the role that financial institutions play in the sustainability of the projects they finance.

1.2. STATEMENT OF THE PROBLEM

Financial institutions take part in financing projects that might have adverse effect to the environment. But how significant is the involvement of financial institutions in minimizing the risks involved?

1.3. OBJECTIVE OF THE STUDY

The general objective is to assess the significance of financial institutions’ involvement in minimizing the risks that occur as a result of project financing.

The specific objectives are:

To review the literature in this area.
To assess the experience of other countries.
To assess the experience of project financing in Ethiopia.
To have a look at the attitudes of banks in Ethiopia.

1.4. IMPORTANCE OF THE STUDY

To know the significance of the involvement of financial institutions in Ethiopia towards environmental issues.
To enable the appropriate body to take proper measures and
To initiate scholars conduct further research in this area.

1.5. SCOPE AND LIMITATION OF THE STUDY

This study focuses on banks and it does not include other financial institutions. It has views taken from five selected banks – two state owned and three private banks – that operate in Ethiopia.

1.6. METHODOLOGY

Both secondary and primary data are used in this study. Primary data is used to obtain information from financial institutions and relevant authorities. Secondary data like books and other resources from the internet are also consulted.

1.7. STRUCTURE OF THE PAPER

The paper is classified into eight small units. The first unit is introduction that deals with the statement of the problem, the objective of the study the importance, scope and methodology. Sections two up to four deal with financial institutions and development in general. Section five is about Equator Principles and related issues. Section six is about the case of Ethiopia followed by conclusion and recommendation.
2. WHAT ARE FINANCIAL INSTITUTIONS?

The historical development of money tells us that barter system followed by ordinary money commodities like skins, animals, metals, etc. were used as a means of exchange. With the elapse of time and advancement of human civilization, however, not only has the commodity money changed in form but it has given for the emergence of metallic money which in turn put the hall mark for the foundation of today’s paper and credit money. (United, 2004)

The financial sector, as is commonly understood, can be considered under two headings: the formal market and the informal market. The main institutions subsumed under the formal financial market sector are banks and insurance companies. However, we can also think of those enterprises known as microfinance institutions and cooperatives.

What we call informal market consists of local financial services operating on the basis of locally accepted customs or agreements. The people mainly involved in this sector are private loaners. This informal market serves as the main source of loans, particularly in rural areas of those countries where banking services have not proliferated.

The financial sector is said to be formal if it is runs according to a set of rules and regulations, operates on the basis of consistent and visible interest rates across the board or has a predictable profit margin. On the other hand, a securities market is the type that operates on the basis of supply and demand. (Neway et al., 2006)

3. THE ROLE OF FINANCIAL INSTITUTIONS

One of the formal financial institutions is microfinance institutions. Microfinance is the supply of financial service to the poor, who are considered unbankable by the conventional financial institutions. (Degefe et.al, 2005) The second formal financial sectors are insurance companies. The fundamental role of insurance companies is to provide coverage for possible risks.

In the debate of finance and development in Ethiopia, Neway Gebre Ab stated that the main function of a bank is to accumulate money in the form of savings entrusted to it by various individuals. This is also shared by other authors - matching savers and investors (Todaro et. al, 2006). The bank collects savings at the individual, family or company levels then loans out the savings so collected to people interested in borrowing money. In effect, the bank serves as an intermediary between those who save and those who borrow money. Their role, in short is, bringing together the savers and the borrowers. (Neway et al., 2006)

Other roles of banks include providing payment services as it is inconvenient, inefficient and risky to carry around enough cash and generate and distribute information (Todaro et. al 2006). In these regards it has been said that financial markets represent the ‘brain’ of the economic system.

According to Neway Gebre Ab, an investor normally has two sources of financing, particularly if the investor is a big one. One source is the securities market from where the investor could secure the money needed for investment, while banks serve the second source. In Ethiopia, treasury bills remain to be the only security market (www.nbe.gov.et). Thus this leads us to concentrate on banks while considering investment in the country. (Neway et. al, 2006)

Efficient banking and other financial services are available in Ethiopia. While the National Bank of Ethiopia (NBE) serves as the Central Bank, Commercial Banking functions are performed by one state owned commercial bank and by a number of newly emerging private commercial banks (Neway et. al, 2006). The commercial banks offer savings and checking accounts, extend short-term loans, deal with offering exchange transactions, provide mail and cable money transfer services, participate in equity investments, provide guarantee services and perform all other commercial banking activities.

There are also specialized banks: the Development Bank of Ethiopia (DBE) and the Construction and Business Bank (CBB). DBE extends short, medium and long – term loans for viable development projects, including industrial and agricultural projects. It also provides other banking services, such as checking and saving accounts to its clients. (Neway et. al, 2006)

4. FINANCE AND SUSTAINABLE DEVELOPMENT

It is common knowledge that development is the result of a unified and coordinated interaction of many inputs. This was stated in the forum of finance and development by Ato Leikun Berhanu. It is difficult to think of healthy human organs and a healthy person without blood and its healthy circulation throughout the human body. It is also extremely hard to think of any meaningful socioeconomic development and poverty reduction without finance and its healthy flow throughout an economy. Viewed from this angle, it is clear that finance is a key instrument for development. Finance can indeed be viewed as the blood of an economy. (Neway et. al, 2006)

Furthermore, he noted that the effectiveness of finance as a tool for accelerated economic development depends upon its effective utilization (Neway et. al, 2006). Thus, mobilizing financial resources required for development is an important task. But the role of finance as a tool for development lies in its effective utilization. He mentioned that, to ensure effective utilization of financial resources it is important among other things to aim efforts in the directions of maintaining price stability, ensuring viability of projects and building capacity in the entire spectrum of project formulation, analysis, implementation and monitoring.

The word sustainability was first coined during the 1992 Earth Summit in Rio de Janeiro, Brazil. It generally refers to ‘meeting the needs of the present generation without compromising the needs of future generations (Todaro et. al, 2006). Since then, it has been incorporated in the activities all sectors. According to Jeucken, The role of banks in contributing toward sustainable development is, potentially enormous, because of their intermediary role in an economy. And their influence has impact on the pace and direction of economic growth. (Jeucken, 2001)

Marcel Jeucken, senior economist at Rabobank Group (The Netherlands) and director of Sustainability in Finance, stated that the banking sector has responded far more slowly than other sectors to the new challenges that sustainability presents. He discussed that bankers generally consider themselves to be in a relatively environmentally friendly industry (in terms of emissions and pollution). However, given their potential exposure to risk, they have been surprisingly slow to examine the environmental performance of their clients. (Jeucken, 2001)

Research, dating back to 1990, concluded that banks were not interested in their own environmental situation or that of their clients. This situation is now changing and banks are gaining pace to revise their role and interest in this respect (Jeucken, 2001). He pointed out that banks could be held directly responsible for the environmental pollution of clients and obliged to pay remediation costs. Some banks even went bankrupt under this scheme. Due to these developments, American banks became the first to consider their environmental policies, particularly with regard to credit risks.

Jeucken cited that North American banks seem to be more eager to use the World Bank guidelines than European banks. By contrast, only European banks explicitly state sectors or activities that they will not finance. (Jeucken, 2001) According to him, such exclusion of sectors or activities is for banks still a delicate subject. In many cases exclusion by one bank simply means a project is financed by another bank, whereas were the bank with an active interest in the environment to be involved, it could exercise some influence over the environmental consequences.

So, how do these banks address the problem they faced? The following section looks at the steps that are followed.

5. EQUATOR PRINCIPLES – The Way Forward

5.1. What are the Equator Principles?

Just a few years ago, it would have been hard-pressed to find a banker and an environmental activist in the same room -- much less agreeing on issues vital to the security and sustainability of our globe. This was marked by Charles O. Prince in his article ‘balancing economic growth and environmental – social responsibility’. Today, he said you will find both – People, profitability and the planet have been linked by capital (Prince, www.equator-principle.com)

Paul & Charles stated that the Equator Principles (EP) provide a voluntary framework for assessing environmental and social issues in project financing. Based on International Finance Corporation (IFC) guidelines and World Bank (WB) safeguards, they are applied by banks and financial institutions when deciding whether to provide finance to projects costing $50m or more (Watchman et. al, 2006). This amount now is reduced to $ 10 million.

According to Robinson, the EPs are essentially a set of categorization, assessment and management standards designed to identify and address any potential environmental and social risks that a proposed project may present (Robinson, 2005). Neithorpe discusses that the first means of mitigating this risk is to adopt a set of guidelines that are well-respected and reasonably neutral. The International Finance Corporation (IFC)/World Bank rules are the nearest thing to a common standard, although arguably not the strongest standards (Neithorpe, 2003).

What is the relationship between the IFC safeguard policies and the World Bank and IFC guidelines? Ravindran discusses that the safeguard policies generally represent an approach to critical issues that cut across industry sectors, such as the protection of natural habitats or the physical or economic displacement of people (resettlement), where it is important to apply a consistent set of environmental and social principles. The guidelines, on the other hand, are sector-specific environmental standards that are applicable to the processes, technology, and issues that apply in specific industries, and represent good practice within that sector. As such, the policies and guidelines are mutually supportive of each other (Ravindran, 2003).

Smith & Plit discuss that the principles are, in part, the financial services sector's response to a growing demand that it recognize the role that it can, and should, play in achieving sustainable development. Although the financial services sector has traditionally seen itself as a clean sector, financing decisions tend to determine what projects obtain funding to proceed and affect development choices (Smith et. al, 2003). According to them, the other motivation behind these principles is risk reduction, which in turn has direct bottom line implications. Environmental and social issues can no longer be regarded as soft issues as the image of lender liability grows.

For Watchman & July, the EPs are, without doubt, a huge step forward for responsible banking (Watchman et. al, 2006). As per for them, the Equator banks undertake “only to provide loans directly to projects”, which have been categorized and screened appropriately, with a comprehensive Environmental Impact Assessment (EIA) report necessary for those deemed particularly complex or risky.

What does adopting the Equator Principles mean? This does not mean financial institutions need to sign an agreement to apply EPs. Each institution adopting the Equator Principles individually declares that it has or will put in place internal policies and processes that are consistent with the Equator Principles (www.equator-principles.com).

When were the principles came in to practice? The next section looks at the historical background of Equator Principles.

5.2. History of Equator Principles

In the spring of 2002, an executive responsible for risk management at a major international bank approached Peter Woicke, IFC’s executive vice-president, reports Suellen Lazarus. This senior banker recognized the growing pressure on his bank and its clients on environmental and social issues, and had been impressed with the approach that IFC developed to manage environmental and social risk in particular (Lazarus, January 2004).

He felt that his bank needed a method for evaluating environmental and social issues in the projects that it financed, but could not do it alone. Too often when he asked questions about environmental or social issues in individual projects, the answers were not good enough. And his staff always noted that if they did not finance the project, it would be done by the competition next door, and the bank would unnecessarily lose the business. This banking executive had concluded that a common approach was needed among the banks, and he suggested that IFC convene a meeting with a small group of banks to explore whether others shared his concerns.

War stories were shared, and the banks found greater commonality than they expected in facing these issues. Not fully knowing the consequences of investments was no longer good enough. The banks agreed that they must have their own opinion on environmental and social risk management in the projects they are financing. Each bank had its own reasons for coming to this position: some felt public pressure; others were concerned about reputation risk, while others were positioned as leaders in sustainable investment. Shareholder expectations, financial loss, the need to attract talented young staff to their organizations, and increased client receptiveness to engaging on these issues were all important considerations. The banks wanted to be associated only with responsible development.

According to Lazarus, tt was agreed that there was a need to consider leveling the playing field among the banks on environmental and social issues. Environmental “shopping” by clients, whereby clients might exert pressure to negotiate their preferred standards, was not acceptable. Consistent rules were required for environmental compliance. It was time for action. Four banks made presentations that day in London – ABN Amro, Barclays, Citigroup and WestLB. These banks formed a core working group, with help from IFC, and were given the task of considering common standards and rules for engagement, particularly in the oil and gas industry.

In the report of Lazarus, the four banks went off and did their homework. While talking with colleagues responsible for oil and gas financing in their institutions, they quickly concluded that any approach could not cover only this one industry. It would be seen as unfair treatment within their institutions – and by their oil and gas clients – when there were also complicated issues in other industries, including power, mining, infrastructure and agribusiness.

The working group began to consider applicable environmental and social standards to guide their effort. They quickly concluded that it would take far too long and be too cumbersome to develop their own standards. And, if one bank created its own standards, it would be difficult for the other banks to follow it. After all, these banks are competitors. So they began to search for neutral standards that they could take off the shelf.

Lazarus discussed about the second meeting of the bankers that was held in February 2003, again in London, this time hosted by Citigroup. A few banks dropped out of the process, but more came to participate. But again, nine banks and IFC attended. After some discussion, the banks concluded that they broadly supported the principles, but needed to consult internally, with clients and with civil society, to see how they would be received.

Over the next few months, client consultations and meetings with the NGO community were held in the US and Europe. Throughout the process, the banks received strong support for the principles, and consensus continued to build. Meanwhile, as feedback came in and discussion among the banks continued, the principles evolved accordingly.

In May 2003, a third meeting of the bank group was held at WestLB’s headquarters in Germany. To reflect the fact that this was a global initiative it was labeled the Equator Principles by the originating banks. The banks wanted this to be a global initiative, not just a northern hemisphere one and the equator seemed to represent that balance perfectly.

At that meeting, IFC carefully explained its categorization process and its environmental and social policies and procedures. IFC also committed to provide training to the banks, should they adopt the Equator Principles. This training was an important consideration for the banks since they would each need to develop their own implementation plan (Lazarus, January, 2004).

According to Lazarus, in June 2003, ten international banks announced a commitment to environmental and social leadership that surprised many in the financial community (Lazarus, March 2004). Watchman also mentioned that the number of banks which have adopted the Equator Principles (known as Equator Banks) has increased from 10 in June 2003, when the Equator Principles were founded, to almost 40 at the beginning of 2006 (Watchman, 2006) and currently, the principles are adopted by 45 banks all over the world (out of which one is an African bank) (www. equator-principles.com).

Watchman further stated that the principles have been adopted by financial institutions responsible for over 80 per cent of global project finance but, given the practice of syndication of major project loans, the market penetration of the principles is much deeper. These financial institutions operate in over 100 countries. As a result, the Equator Principles have become the project finance industry standard for addressing environmental and social issues in project financing globally (Watchman, 2006). (Refer to the Annex for the list of banks who adopted EPs)

The IFC completed the review and updating process undertaken to replace their existing Safeguard Policies when its Board of Directors approved new "Performance Standards" on February 21, 2006 which become effective 6 July 2006. Because the original Equator Principles were based on IFC's environmental and social Safeguard Policies, it was necessary to revise the Equator Principles in order to reflect, and be consistent with, these changes (www.equator-principles.com).