Spek Financing Pulp Mills : An Appraisal of Risk Assessment and Safeguard Procedures

This study analyses the risk assessment and socio-environmental safeguard procedures associated with the financing of pulp mill projects. The type and cost of the fibre source is clearly key to the economic competitiveness of any pulp mill. Nevertheless, investment institutions often carry out only limited assessment of the fibre source of the proposed mill. Although a growing number of financial institutions have adopted policies to employ social and environmental safeguard screening for investments in developing countries and transitioning economies, the scope of such screenings is in fact quite limited and they are often implemented ineffectively. In this way, investment institutions often underestimate both the financial risks associated with pulp mills, as well as their social and environmental impacts. Most greenfield pulp mill projects developed by new sponsors are subject to safeguard screening. The primary focus of these screenings is on the manufacturing aspects of the mill, and not on fibre supply which in many cases is still years from being realised. This is an inherent weakness. Projections and reports provided by project sponsors are often insufficiently detailed to allow investment institutions to identify weaknesses and omissions. Better results can also be obtained by looking beyond the project at hand to review the project sponsor's track record in existing and previous ventures.


Preface
In October 2003, the World Bank hosted the Forest Investment Forum, a two-day conference which brought together 150 senior executives of forest product companies, private and public sector fi nancial institutions, and conservation organizations. The Forum's central aim was "to explore opportunities for private sector companies, the World Bank, the IFC, and other fi nancial institutions to invest in environmentally, socially, and economically sustainable forest enterprises in developing and economic transition countries." Perhaps not surprisingly, much of the discussion at the Forest Investment Forum focused on anticipated capacity expansion in the global pulp and paper sector. It was projected that some 128 million tonnes of new paper and paperboard capacity will likely be needed to meet growing world demand by 2015. While much of this new capacity will be fed by recovered paper, it is estimated that 36 million tonnes of new wood pulp capacity will be installed over the next decade, including 22 million tonnes of hardwood kraft pulp. This expansion of wood-based pulp capacity is likely to require approximately US$ 54 billion in capital investment through 2015. Several billion dollars more will be needed to develop millions of hectares of fast-growing pulpwood plantations.
Even if only a fraction of this is ultimately realised, these projections suggest that a new wave of pulp mill fi nancings may soon be underway. Existing plans indicate that much of the new capacity will be brought online in Brazil, China, Indonesia, the Mekong region of Southeast Asia, and the Baltic states.
Several speakers at the Forum -including Masya Spek, the author of this study -emphasised that such projections underscore the need for investment institutions to employ stronger practices in assessing the fi nancial risks, legal compliance, and social and environmental impacts of pulp and plantation investments. Pulp mills require special attention for a number of reasons: First, the enormous scale of modern pulp mills means that they consume very substantial volumes of wood. A single BHKP mill with an annual capacity of 1.0 million tonnes, for instance, will typically require between 4.5 -5.0 million cubic meters of roundwood per year -roughly equivalent to 15 percent of the total annual timber harvest from the Brazilian Amazon. Large-scale pulp mills can also place considerable pressures on natural forests when production capacity is installed before supporting plantations are brought online, as prior CIFOR research in Indonesia has shown. In countries or regions with poor forest governance, demand for pulpwood can be a signifi cant This study was conducted to see how investors and lenders assess the fi nancial risks and social and environmental impacts associated with pulp mills. Despite the large amounts of capital tied up in these projects, it has been apparent that there are weaknesses in the risk assessment system that allow poor practice to go undetected. As a result, highly unsustainable pulp producers can often obtain funding, even though the existence of safeguards should make this impossible. Once they begin operating, the high capital cost of such mills means that they are unlikely to be closed down, while their scale frequently poses a challenge to remedial action. Moreover, once pulp projects are in existence, they can generally continue to obtain funding irrespective of the standard of their operations. Efforts to tighten the quality net so that the poorest operators do not obtain fi nancing will therefore need a two-pronged approach, with one focusing on ensuring minimum standards are effectively upheld in new projects, and another focusing on raising standards in existing projects.
To better understand to how pulp projects obtain funding, and to what extent fi nanciers can and do assess the quality of the proposed project and borrower, a sample of transactions proposed between 1995-2003 was studied. Over this period, 25.5 million tonnes of annual new pulp production capacity was proposed, of which 41% is now going ahead.
Capacity additions proposed by existing players in the pulp sector have the highest chance of going ahead with a 66% success rate. Where projects did not go through, this tended to be the result of changed corporate strategies as opposed to an inability to obtain funding. 27.1% of proposed greenfi eld mills went on to being realised. Funding forms a bigger barrier for greenfi eld projects in the absence of an existing business that provides the cashfl ows. Increasing comfort levels is critical to obtaining fi nancing, and the level of sponsor-provided capital plays an important role.
Since 2000, pulp producers raised US$ 215.5 billion in funding from commercial sources. The majority (82.7%) of this took the form of loans typically extended to existing producers in traditional producing centres (North America, Western Europe and Japan). Narrowing the focus to producers in developing countries and in countries with transitioning economies, US$ 37.8bn in debt and equity fi nancing was found for the period covering 1990 -2004. Funding is a key barrier to entry for proposed pulp mills, and funding institutions jointly and singly hold signifi cant power with regard to determining which projects are ultimately realised. Smaller scale pulp mills will typically be fi nanced by banks in their home markets. Mills with annual production capacities in excess of 200,000 tonnes will generally fi nd themselves

Executive Summary
This study looks at how investors and lenders assess pulp mills… …with reference to transactions proposed between 1995 -2003. Two-thirds of proposed capacity additions succeeded, as compared to only 27% of proposed new mills.
Before start-up is the time to weed out poor projects.
Multilateral development banks play a key role at this stage.
Along with Export Credit Agencies that facilitate purchases of state of the art equipment.
Large mills can secure easy fi nancing in the international capital markets. Size is the key criterion for entry, and this provides an incentive to up-scale in excess of direct market needs.
Pulp production is less of an equity market play due to the poor returns across the cycle.
Even when due diligence identifi es poor practise, this does not normally result in fi nancing being denied.
Sectoral considerations and ratings, rather than issuer and project quality, drive investment decision making processes.
addressing larger institutions, either multilateral development banks, or raising fi nancing in the international capital markets because the size of their funding needs are harder to accommodate in the domestic market.
From the 1960s to the 1980s multilateral development banks were signifi cant catalysts in the funding of new pulp mills. They pulled back considerably in the late 1990s, providing only some US$ 1.9 billion to the sector during the past decade as a result of restrictive lending policies adopted by the World Bank Group that considerably limited the ability of these institutions to fi nance forest based activities. Because non-engagement was considered to be more damaging than engagement, a new policy was introduced in 2003. This policy placed greater emphasis on the objectives to be achieved in making loans, as opposed to outlining what could not be done. As a result of this policy, the World Bank Group is accelerating its activities in forest based fi nancing, in particular in China, the near East and former Eastern Europe. As a result of early stage involvement, multilaterals can signifi cantly infl uence project structure and standards, and they are ostensibly organised to do just this.
Industrial country export credit agencies play a prominent role in fi nancing machinery and equipment purchases. Over the last two decades, export credit fi nancing has opened the way for pulp producers to buy technologically advanced equipment that causes limited pollution. At the same time, changes in pulping technologies have led to a substantial increase in the production capacity of world-class pulp mills. ECA's have fi nanced projects of ever-increasing scale, posing a rising challenge to fi ber supply, placing substantial demands on both water and energy supplies, as well as requiring a transport and logistical infrastructure surrounding the mill that is not always available. In some cases, the needs of the producing country may be better served by smaller mills; however, there are often considerable fi nancial and political factors that result in the construction of the largest mills possible.
Existing pulp producers of scale will typically tap the international capital markets for funding. This funding can take the form of syndicated loans, bonds or equity offerings. The international capital markets have no formal entry requirements or a central regulatory body, but informal requirements include a listing on one's domestic stock exchange for commercial entities, a credit rating and an issue size of at least US$ 100 million, if not US$ 200-300 million. This effectively limits access to only the larger players. Once a pulp producer gains entry to the capital markets, repeat issuance is relatively easy. It is thus seen that a handful of developing country pulp companies have dominated issuance in the sector.
Even the pulp producers with very low cost production bases, such as those in Latin America and Indonesia, have not succeeded in delivering superior returns to their equity holders. This has resulted in only a lukewarm stock market reception -while the companies were listed, they were hardly core to investors' portfolios. The pulp producers did at various times raise additional equity, as this was needed to support growing debt burdens taken on to fi nance continuing expansions. Eager to get more bond issuance mandates, the lead underwriters for these issues were keen to launch them and place them to their clientele.
The risk assessment and due diligence practices of banks are not in themselves suffi cient to identify poorly performing or unsustainable pulp producers. While extensive due diligence may be conducted, it generally does not result in fi nancing being denied when weaknesses are found, though the cost and pricing of the offering may increase. The weakness in question may be discussed in the prospectus, though cases have been found where such weaknesses are deliberately de-emphasised. In many cases critical risk factors are not (properly) addressed.
Financial institutions generally take a portfolio approach to risk management where sector and country allocation take precedence over individual issuer analysis. Issuer strength is critical with regard to loan pricing, but this is typically assessed based on credit risk ratings that are given x by rating agencies. Due to disintermediation and competitive pressures, lenders and investors do not have access to unambiguous and relevant data about their investee companies that would allow them to make a more detailed credit assessment at the company level should they want to.
Lenders and investors use the work of the parties who do monitor companies and industries on an continuous basis for changes in issuer-specifi c or industry-wide conditions, such as credit risk agencies and securities analysts. However, their work does not provide evidence that they proactively and effectively track issues related to fi ber supply and other key factors infl uencing the company's competitiveness, and make an effort to obtain or estimate these data where they are not given. The work also refl ects a high level of reliance on information provided by the borrower or sponsor companies, and little independent investigation into areas on which these parties are silent. In such cases, when problems come to the surface, the damage will already have been done, and the credit downgrade that follows is reactive rather than predictive.
Risk control and monitoring mechanisms are in place, but in actual practise these are geared to avoiding liabilities and meeting legal requirements, rather than to actively uncover risks and operational weaknesses. Incentives to do the deal today are effectively greater than the incentive to preserve portfolio quality.
Commercial banks, working with the IFC have adopted the Equator Principles to guide their cross-border project fi nance activities. In so doing, banks are looking to create a level playing fi eld among themselves, while upholding recognised quality standards, particularly regarding social and environmental impacts.
The Equator Principles -as currently structured -have little direct impact on pulp mill fi nancing activities of the signatory banks because pulp companies rarely use project fi nance. Nevertheless if user experiences with the Equator Principles are positive, this initiative is likely to be more broadly extended to other areas of fi nancing.
Most fi nancial institutions and ECAs still lack in-house capacity to assess a project's likely social and environmental impacts as required by the Equator Principles. EP signatories therefore tend to rely on the assessment of the IFC and other multilaterals which have greater capacity and expertise in conducting such assessments. This mechanism will do little to internalise a rounded decision making process within the banks or ECAs fi nancing a project. Moreover, it gives insuffi cient recognition to the fact that even multilateral development banks cannot guarantee positive development outcomes.
A structural weakness in the application of safeguard policies is that they are guided by Environmental Assessments that are typically commissioned by the project sponsor. At present, Environmental Assessments are often of mediocre quality that goes undetected in the absence of review by informed parties. Nor are Environmental Assessments structured to provide an effective framework for follow-up monitoring once a project is in place. Sponsor quality has been found to be a critical factor in project success. As a more balanced picture of sponsor quality emerges only well into the project, there are no effective means to enforce quality when a sponsor does not truly care about the impact of his project. Raising environmental assessment standards and defi ning hard implementation targets is one way to increase the effectiveness of safeguard mechanisms.
The Equator Principles (and multilateral development bank lending guidelines) apply to new projects when ample information about the prospective project is being made available to lenders. Disclosure drops signifi cantly once a company is already in operation. To the extent such companies are under a requirement to report their results, this applies to the fi nancial results, but not to details about their operations. At the simplest level, these disclosures should Borrowers often have little fi rst hand knowledge of their clients… … because they rely on third parties for inputs in the risk monitoring process. When major problems surface, the damage will already have been done.
The Equator Principles guide project fi nance transactions and aim to uphold common quality standards across its signatories.
Because pulp mills are rarely structured as project fi nance transactions, the EP don't impact this sector with its signifi cant environmental and social impacts.
EP signatories still need to build capacity to effectively apply the Principles so that they result in higher project quality on the ground.
A key weakness in the appraisal and implementation process is that it is driven by a sponsor commissioned Environmental Assessment. This EA is often too general in nature to be able to serve as an effective tool to guide project quality.
A lack of hard operational data stands in the way of an objective observation of operating standards of projects once they are in operation.
xi encompass (1) capacity per type of product produced; (2) use and cost of resources/inputs per type of product; (3) output/sales and price received per type of product; (4) source of fi bre, supply contracts; (5) condition of plantations, including key operational variables such as acreage planted, productivity levels, and volumes harvested. Because observing operational performance, and collecting data over time is important to arrive at a balanced assessment of what has been achieved, where standards are and how these are changing, the reporting of relevant hard operational variables by companies is a critical step in raising standards.
The voluntary Global Reporting Initiative, spondored by the UN Global Compact, is well positioned to serve as the framework for non-fi nancial reporting on a company's operations. As part of this initiative, industry specifi c reporting guidelines are established that have to be followed if a reporting company is to be in compliance. The GRI has already produced sector supplements for six industries, with two more in progress, but so-far these do not cover the pulp and paper sector. For the GRI to succeed with pulp producers, stakeholder recognition that accepted practices of existing companies in some areas will fall short of best practices is critical to success. At present, none of the 13 pulp and paper companies that are part of the GRI are reporting in accordance with the GRI, but we expect this to change over time. The focus of reporting should be on determining what minimum acceptable standards are, what behaviour is not acceptable, and how to get the bottom quartile to raise standards.

Recommendations To users of safeguard measures
The safeguard measures that currently guide the implementation of new pulp mill projects are still insuffi cient to anticipate likely problems, and act to contain them. With regard to pulp mills, this is partly because the full impact of a pulp mill on its environment is not yet properly understood. In recognition of this, it is recommended that pulp mill investments are henceforth considered as sensitive and irreversible (Category A) investments, rather than as manufacturing investments with an environmental impact (Category B).
We recommend that that Environmental Assessments (EA) are externally reviewed to ensure that they comprehensively and objectively address all material aspects and impacts. We recommend that EA's include a specifi c schedule for implementation with a built-in monitoring programme. As a condition for obtaining fi nancing, companies should be required to make periodic reports releasing key operational and social/environmental variables, that may periodically be subjected to external audits.

To all stakeholders
A meaningful discussion about what behaviour is acceptable is necessary if fi nanciers are to meaningfully apply safeguards to existing projects. This discussion can only be had based on observed behaviour, not based on theoretical best operating practices. As such there is a need for more detailed reporting of operational, in addition to purely fi nancial, data by companies. For companies to make such reports on a voluntary basis, there must be stakeholder acceptance that actual operating standards are bound to be lower than best operating practices. It is recommended that stakeholders with divergent interests and agendas -including, for instance, both pulp producers and NGO's -fi nd ways to engage constructively to raise standards across the industry.

To the fi nancial community
Having signed on to the Equator Principles or adopted safeguard measures to guide lending to environmentally sensitive sectors, the fi nancial community now needs to work on effectively implementing these across their respective organisations and in the face of aggressive and hungry dealmakers, and managers pushing for a higher slot in the ranking tables.
Within the scope of the GRI sectoral key operational disclosures could be designed to allow for a picture of actual operating standards to emerge over time. Focus should then be on improving standards of those players that do not meet minimum acceptable standards.
xii Effective implementation of safeguards requires that safeguard assessment is embedded in the credit function. As a result, it is recommended that fi nanciers develop in-house assessment capability, rather than relying on external assessments. Financial institutions also need to think about how to uphold these standards in the many areas of their business where they are currently not effectively applied.
Because sponsor quality and commitment is a critical variable in the long-term performance of both a project and the securities/loans that fi nance them, sponsor track records need to be critically reviewed. In view of the damage that can be caused by unsustainable pulp mills, it is recommended that no pulp mill fi nancing is extended to sponsors with a poor trackrecord.

To regulators
We recommend that those (self-) regulatory authorities that set disclosure levels for companies with listed debt or equity securities include the reporting of concise and material operational variables in the periodic requirement. In setting these requirements, it is advisable that there is cross-coordination with the GRI to minimise the burden on the reporting entity.
In regulating lending institutions, regulators are advised to give due considerations to the broader societal and economic impact of lax lending practises, and pay closer attention to loan specifi c due diligence and credit risk assessment practises in their oversight.

To pulp producers
Pulp producers can make a fi rst step toward fostering a better understanding of their operations by raising disclosure levels. We recommend that this is done within the existing framework of the GRI that already has a number of pulp producers as members. These producers can now move forward by establishing a common, industry-wide reporting standard. As proper impact assessment also necessitates an understanding of the operations of a company, the quality of reporting would be enhanced if it includes a comprehensive mapping of meaningful resource use in and fl ows through the production process, as fi nal output. The minimum disclosures that this would entail include: (1) capacity per type of product produced, (2) use and cost of resources/ inputs per type of product, (3) output/sales and price received per type of product, (4) source of fi bre, supply contracts, (5) condition of plantations: acreage planted, amounts harvested.

To the Equator Principles
We recommend that the Equator Principles, working through the organisations that signed up to it, aims to expand adoption of its principles to include all fi nancings in excess of US$50m raised by companies active in environmentally sensitive areas. In addition to project fi nance, this would include syndicated loans, issues of notes and bonds, and equity.
The Equator Principles assume disclosure levels that are only available for new projects, and then in the format of projections. A fi rst step should be to ensure that projects fi nanced with Equator funds commit to publishing these variables. The dissemination of relevant information about their operations and the impact thereof will deepen the understanding of the fi nancial community and other relevant parties about working with safeguards.

To the Global Reporting Initiative
For the GRI to be of use to investors, it needs to be concise and material. We recommend that the tendency to indulge in overly complex reporting is tempered by the question of what is material. The inclusion of summary GRI outputs in annual reports and periodic stock exchange fi lings will allow the results to reach a broader audience. The GRI is progressively implementing industryspecifi c reporting standards with the collaboration of member companies. The issuance of a pulp and paper industry supplement can be accellerated with the active participation of those pulp and paper producers that are already GRI members.
A CIFOR/WWF study on Indonesia's pulp and paper industry conducted in 2000 found, among other things, that 'weak due diligence practices and inadequate fi nancial reporting standards led the international investment community to channel over US$ 15 billion to Indonesian pulp producers without a secure, legal, and sustainable supply of wood fi bre'. In response to this fi nding, CIFOR's project on Financial Institutions and Forestry Investment began working to strengthen the fi nancial due diligence practices, risk assessment techniques, and regulatory reporting standards associated with forestry and plantation investments. The present study was commissioned as part of this project.
This study provides a review of how pulp mills are being fi nanced, what (credit) risk assessment and safeguard implementation practices are applied to these fi nancing decisions, and what their impact is. This study is concerned with plantations to the extent that these are part of pulp producing entities, but otherwise focusses on pulp producers because it is in fi nancing them that most of the weak due diligence practices are found. Because such practices are universally applied, and because the safeguards aim to address all critical impacts of a project, and not just fi bre supply, the scope of this study is set accordingly: global, not just Indonesia, and dealing with fi bre supply as one of a number of aspects of pulp mill sustainability.
The word sustainability is used in this paper to mean 'Meeting the needs of the present generation without compromising the ability of future generations to meet their needs.'. With respect to fi ber supply the word is used to mean 'Not using more fi bre than can be re-generated from the forest/plantation area, and without damaging the ecology of the forest and the livelihood of those that depend on this forest area'. Sustainability is a complex issue however, and we refer readers to the 1996 study of the International Institute for Environment and Development (IIED) entitled 'Towards a Sustainable Pulp Cycle' for a good introduction to the issues that are involved in sustainable pulp and paper production. This study does not aim to lay down the absolute criteria that should be applied to assess new projects, or what constitutes acceptable behaviour. This is the role of a multi-stakeholder debate, and not of CIFOR.
At the time of writing, the majority of parties involved in fi nancing pulp mills recognise their moral obligation to ensure that projects they fi nance do not cause harm, and have adopted a range of safeguards to guard against this in addition to conventional (credit) risk analysis. Applied effectively, these measures should be able to identify structural weaknesses in proposed pulp and plantation projects. Some of the simple reasons why they are not are that the safeguards that exist do not correctly recognise the principal impacts of pulp mills, and that the safeguards do not apply to the international capital markets where most of the fi nancing for pulp mills is 1 Introduction raised. This study therefore looks at how the existing measures can be applied to greater effect, rather than pushing for further perfection of these measures to utopian standards.
This study is directed at all parties that are involved fi nancing new pulping capacity, and in the design and practical implementation of safeguard measures in the pulp fi nancing process. This group includes fi rst and foremost the commercial and merchant banks that, having recently adopted safeguard standards, now have to work to implement them across their business activities.
The second target audience is the multilateral development banks. More than other groups of lenders, they that are often involved in fi nancing pulp mills at the start-up stage, and act as an arbiter of quality, in which role they are implicitly recognised by the private sector. Yet, despite a long history of safeguard implementation, even the multilateral development banks cannot always guarantee positive outcomes, although this is not universally recognised. Within the arena of multilaterials, this study pays special attention to the IFC in recognition of the fact that its standards are the most widely followed by commercial fi nancial institutions.
The third major audience of this paper are NGOs and other bodies seeking to infl uence the behaviour of pulp mill fi nanciers. It is hoped that the review of how pulp mills get fi nanced and the markets and fi nanciers involved will be of use to them, and allow them to work more effectively. NGOs have played a critical role in getting fi nancial institutions to recognise that they have a more obligation to uphold safeguards in their business practices. Now the time has come to translate these commitments into action, and this will require a willingness to accept the reality on the ground, and work to improve this as opposed to an insistence that anything short of the very best operating practices will not do.
Last but not least, this study is directed at the pulp industry. This study calls on pulp producers and plantation companies to collaborate in defi ning a set of meaningful operational data that companies can use to disclose their performance to the market so that discussions on safeguard implementation can be rooted in the realities on the ground. This study is organised into fi ve main sections, preceded by an introduction. Chapter 2 sets the scene by looking at the size of the global pulp industry, its location and expansion. It looks at what proportion of previously proposed new capacity has been realised realised and why, and how it has been fi nanced. Financing for the overall industry is also addressed. Chapter 3 looks at the most important sources of fi nancing for pulp mills. Funding sources for entirely new mills differ from those of expansions, and given the importance of getting mill design right from the start, much emphasis is placed on those markets and institutions with input at the early stages. The chapter next reviews the international capital markets where in actual practice the large mills of newly emerging pulp producing countries have been able to fund themselves. Chapter 4 deals with fi nancial risk assessment. This chapter is relevant primarily for the fi nancing of existing facilities, and thus relates more to the activities of banks and other players in the international capital markets. It shows why institutional investors assess risks the way they do, and why this process is not effective in identifying company specifi c weaknesses, even though the overall credit process would be enhanced by this. Chapter 5 discusses safeguard measures. It shows that their application is very limited with respect to new pulp mill capacity, and that where they are applicable, there are weaknesses in the implementation as a result of which they do not succeed in screening out projects that rely on unrealistic assumptions to become sustainable and/or do not effectively address the implementation processes necessary to address negative impacts. There is considerable room to enhance safeguard implementation by more effectively embedding it into the lending process in a way that is not the case now. To extend the application of safeguards to existing operations there needs to be an understanding of what actual standards at these mills are, what behaviour is not acceptable and which projects therefore should not receive fi nancing. This requires that the behaviour in existing mills can be observed, and this is not yet the case at present. Therefore, a fi rst critical step to make is to work towards improved operational reporting by the industry, that could opt to do so on a volutary basis through the Global Reporting Initiative. The Key fi ndings and recommendations of this study are presented as the fi nal chapter and can also be read as an Executive Summary. More factual summaries of the chapter contents may be found at the end of every chapter.

Pulp production process and impacts
Pulp is used to manufacture materials such as paper, board, tissue and rayon. Pulp can be made from a variety of fi bers, of which wood is most predominant.
Pulp has traditionally been made from coniferous wood found in temperate countries. This type of wood is also known as softwood, and specifi c species include pine, aspen, spruce, fi r and hemlock. These types of wood derive their consistency from cellulose fi bers that are extracted in the pulp production process. The length of these fi bers is critical in determining the strength and consistency of the fi nal product into which it is processed. The hardwood species that grow in tropical countries, including eucalyptus, acacia and trees of the family of dipterocarp, are comparatively less suited to pulp production as they yield shorter fi bers. It was only with improvements in papermaking technology that such woods could be used, and this became a facilitating factor in the move of pulp production capacity to tropical countries as further discussed below. Despite the improvements in paper making technology, longfi ber pulp remains preferred over shortfi ber pulp, and the pricing of the relevant pulp grades expresses this. Longfi ber pulp trades at a premium over shortfi ber pulp, and pulp produced from a single species trades at a premium over pulp produced from a mixture of wood species. Different products use different proportions of long-and shortfi ber pulp, whereas for some grades, considerable amounts of recycled fi bre are also used. Because fi bers break in the recycling process, pulp products can only be recycled for a limited number of times, even where the recycled fi bre is used in conjunction with virgin fi bre.
The cellulose fi bers can be extracted from the wood in various ways. Extraction of the fi bers with grinders followed by soaking results in groundwood that is used in lower grade product such as newsprint and board. Such pulp is also called mechanical pulp. Thermomechanical pulp (TMP) is made with a slightly more sophisticated method involving the use of steam at high pressure, rather than soaking, in the extraction process. When chemicals are also used in this process, one obtains chemithermomechanical pulp (CTMP). The drawback of each of these mechanical pulp production processes is that there is considerable fi bre breakage. This is overcome in the production of pure chemical pulp when chemicals (typically chlorine) are combined with woodchips to dissolve the lignin after which the cellulose fi bers can be extracted without crushing. The remaining lignin slurry is known as black liquid, and a potential source of pollution. Black liquid can now be further reprocessed to be used as fuel or as a pulping agent itself, but this is a more costly option than simply disposing of it. Chlorine in particular is highly pollutive. Recent innovations in production technologies involve the use of alternative chemicals such as oxygen, ozone and hydrogen peroxide. Depending on the ultimate quantity of chlorine used, such pulp is known as elementally chlorine free (ECF) or totally chlorine free 2 Trends in pulp investment: Capacity and fi nancing The cellulose fi bre in wood is used to make pulp. Pulp made from long fi bres is stronger than pulp made from short fi bres. Some pulp grades use recycled fi bre.
The process of extracting cellulose fi bres from the wood using chemicals is highly pollutive. Improvements in production techniques have yielded less pollutive processes.
(TCF). Research efforts now focus on the use of biological agents such a fungi in the fi bre separation process, but these have yet to yield a viable production process alternative.
The pulp production process has evolved to an extent that much of the pollutive impact can be mitigated, provided a producer is prepared to purchase the state of the art machinery that offers these capabilities. In proportion, the impact of the fi bre demand has become more pronounced. As the pulp industry has grown in size, more fi bre is needed as raw material. While this demand is increasingly being met by plantation grown fi bre, the magnitude of this fi bre source is still insuffi cient to meet aggregate demand, so that much of it is still met by culling wood from the natural forest. This wood culling is not always done on a sustainable basis. The opening of new production facilities in resource rich countries further added to the complexities of impact. Many of these countries had forest dependent populations whose livelihoods were disturbed by the establishment of these large industries. The interests of these communities were never recognised let alone taken into account when these mills were established. It was typically an era of more autocratic regimes, and around the world there was a greater belief in the fact that that modernisation meant progress, and a lesser understanding that not all countries had adequate systems to ensure that the benefi ts of megaprojects would fl ow through to the broader population as opposed to specifi c elites.
A full discussion of all the impacts of pulp and paper making would fi ll a volume of its own. Readers can fi nd these issues discussed in the 1996 study of the International Institute for Environment and Development (IIED) entitled 'Towards a sustainable pulp cycle'. The reader can consult the bibliography for additional sources.

Pulp production capacity and industry structure
The wood pulp industry currently has an estimated installed annual production capacity of 187.6 million air dried tonnes per year (hereafter 'tonnes'). An additional 12.7 million tonnes of confi rmed capacity expansions or projects with a high likelihood of going through could raise this fi gure to 201.6 million tonnes over the next fi ve years 1 . Traditional producer countries dominate existing pulp production capacity. The US, W-Europe and Japan account for 78% of total capacity. While large, this share is gradually declining. The US and Canada are experiencing negative net capacity growth, with new capacity being added at a rapid rate in a number of developing countries and countries with transitioning economies. Brazil, Indonesia and Chile accounted for only 10% of total capacity in 2003, but for 73% of net observed capacity growth since 1996. Table 2.2 gives summary data for the principal producing countries. The traditional production centres are primarily geared to meeting the needs of their domestic markets, as evidenced by low export rates. In these markets, per capita consumption is also proportionally higher. The US, Canada, Europe and Japan account for 18.6% of global population, but consume 73% of global pulp and paper output. The new production centres of the 1970s and the 1980s established their pulp industries to serve the export markets. Although domestic demand has increased in these countries, their pulp industries are still primarily oriented towards serving the export market. More recently, large countries with emerging economies are looking to establish wood pulp capacity to serve their domestic markets, and the paper and packaging needs of their export oriented industries. A prime example is China. Here, the new capacity will partly replace older non-wood fi bre based capacity that previously met the domestic demand for paper. The challenge in these countries is posed by the shortage of wood and competion for arable land.  Pulp is an intermediate product and for this reason much of the pulp capacity is controlled by companies that are involved in the production of paper and board. Where a mill is integrated, the pulp line is linked directly to the paper/board production lines. When the pulp is produced for sale to external parties, it is dried in sheetform. Pulp produced for external sale is known as marketpulp. Marketpulp is by defi nition always dry pulp, but not all dry pulp is necessarily market pulp. Whereas paper can be made using longfi ber pulp only, the lower cost of shortfi ber pulp has made it attractive to use at least a proportion of this fi bre in papergrades. Paper cannot be made from shortfi ber pulp only, so that integrated shortfi ber pulp and paper producers still use a proportion of (imported) longfi ber pulp in their manufacturing process.
Of the world's 150 largest pulp and paper producers, 124 are based in the 20 principal producing countries (Table 2.2), accounting for 69% of total output of these countries. This fi gure has been on the increase as a result of continued consolidation in the industry. Many industry participants and observers expect this process to continue as compared to other industries the pulp industry is still highly fragmented. For example, jetliner production is concentrated in the hands of only two companies, Boeing and Airbus, and global passenger car production is controlled by some 20 companies. Proponents of consolidation argue that they need to be of a greater scale to be able to compete effectively. There is however no evidence from industries with greater consolidation that this in fact helps corporate profi tability in the absence of oligarchic pricing practices. Conversely, quite a number of smaller producers can compete effectively and profi tably. In many cases, acquisitions provide the answer to growth that companies feel they have to deliver and that investors often demand of them. Because of their large base, it is diffi cult for such companies to deliver acceptable rates of growth organically, so that acquisitions become an attractive alternative. Where pulp companies operate in countries where they have to control the forest land that yields the fi bre, an additional aspect enters into the discussion of optimal company size. Already the size of the land controlled by some pulp producing companies (including their holding companies) exceeds that of some sovereign nations! Weyerhaeuser owns 2.7 million hectares of forest land outright, which is as much as 68% of the size of the Netherlands, and the land it controls is 3.6x the size of this country. Policymakers in each of the major pulp producing countries deserve to give this issue serious thought.
In 2002, the 100 largest pulp and paper companies had consolidated sales of US$ 311.2 billion and assets of US$ 396.3 billion. This is slightly ahead of the numbers for December 1999 that are shown in Table 2.3 along with key balance sheet data. The sales number is heavily infl uenced by the price of paper and pulp. As pulp prices have risen over the past three years, the 2004 sales and profi t fi gures would be higher, while one could reasonably expect there to be more equity (as higher earnings are retained) and somewhat less debt. The balance sheets show that pulp and paper is a capital intensive business with the value of one year sales not exceeding the assets needed to generate these sales. The industry typically employs two persons per tonne of pulp/ paper produced while indirect employment levels are up to three times as high.
The focus of the remainder of this chapter is to see how expansions and new capacity have been fi nanced, and equally important, which projects did not secure fi nancing. In order to ensure that a representative set of data was used, an extensive search was done for both (proposed) investments in pulp producing capacity and fi nancing raised by pulp producers.
The data on actual and proposed investments were primarily obtained from the industry website Paperloop. The cut-off date was 1990 but given the paucity of data for these earlier years, the results effectively covered the period 1995 -2003. A minimum annual production capacity of 50,000 tonnes was taken as the lower threshold for inclusion, and projects that got a single mention without any additional information were removed from the list. It should be stressed that this list is representative, but not exhaustive. Some projects will simply have gone unreported, as would capacity expansions as a result of debottlenecking or mill rebuilds that are actually quite common for larger producers. After obtaining the list, we determined how many of these projects  were realised, while trying to see what held back those that were not realised. All this is discussed in the section 'Investments in pulp capacity after 1995'. This section is followed by a section on 'Financing raised by pulp producers' that looks at fi nancing raised by pulp and paper producers in the international capital markets, and then relates these numbers to the capacity that has been commissioned, as well as putting them within context of the entire size of the international capital markets.

Investments in pulp capacity after 1995
The project list comprises of 67 projects accounting for a proposed 25.5 million tonnes of new annual production capacity.  The majority of the proposed projects were in new producer centers with Asia accounting for 46.0%, Latin America for 28.6%, and Europe for 21%. The projects in Europe are predominantly in former Soviet block countries. Of the proposed projects 41.2% now look to be going ahead, led by expansions (66% success rate in terms of capacity) and greenfi elds (27% success rate in terms of capacity). Since these data were compiled, perceived economic prospects brightened considerably, and with it, the pulp price. This led to an increase or accelleration of projects, as well as the emergence of new proposals. Table 2.6 details the successful expansions, and Table 2.7 lists the successful greenfi eld projects of new sponsors that we identifi ed. As compared to greenfi eld projects by new sponsors, expansions have the highest chance of succeeding when proposed, although the actual timing of the expansion will still have been infl uenced by the ability to secure fi nancing and the cycle of the pulp market. In Asia, many projects were put on hold after the Asian Crisis (1997) and The 67    Temporary unavailability of fi nancing will have affected the timing of expansions, but the inability to secure fi nancing was never the reason to defer a proposed expansion alltogether.
The success rate for greenfi eld projects by new sponsors is considerably lower than that for expansions. Looking at the projects in this category that were successful, we note that they were without exception sponsored by governments or existing companies with interests in the forestry sector. This indicates that the fi eld of pulp production is effectively closed to complete newcomers to the forest sector. Two recent exceptions to this have been Tanjong Enim Lestari and Kiani Kertas in Indonesia. The companies had sponsors with existing businesses in forestry, and the ability to secure equity for the new venture. Both these companies enjoyed the support of the contemporary ruling elite. Even in cases where governments support a new mill by granting access to forest resources, the absence of an operating partner with relevant experience can still be a major stumbling block in obtaining fi nancing. Metsalito deferred its project in Latvia over uncertainty concerning fi bre supply and government insistence on what the company felt were inappropriate environmental standards.
The sources of fi nancing for the greenfi eld mills by new sponsors are distinct from those of expansions. Project fi nance, domestic bank credit and multilateral fi nance combined with export credit are the key sources of external fi nancing for these projects. Note here that we use the term project fi nance only to relate to project fi nancing given by commercial fi nancial institutions, as distinct from fi nancing from multilateral development banks. In terms of absolute amounts, the fi nancing raised from these sources (project fi nance, domestic bank credit, multilateral fi nancing and export credit) is signifi cantly smaller as compared to that raised in the international capital markets -even when fi nancing drawn by non-traditional producers is considered. However, as a source of funding these sources are as, if not more, important than the international capital markets. At the initial stage, fi nancing is a key determinant as to whether a project makes it and a new pulp producing entity is born, and consistent application of minimum standards should have a benefi cial impact on deciding which projects will be realised. If fi nance is to play a role in shaping the future pulp industry, it is at this stage that meaningful impact can be made.
At the expansion stage, lenders are dealing with a going concern that already generates cash fl ow. At current levels of disclosure, quality is harder to discern, but only in exceptional cases would it meet current standards set for new mills given that these have increased over time.

Financing raised by pulp producers
Having reviewed capacity expansions, fi nancing raised by pulp producers is considered next. This review is based on data obtained from Dealogic and Thomson Financial to which manual adjustments were made in case of omissions that could be confi rmed based on a company's annual report. These data should still be treated with caution. Neither dataset included data on transactions arranged and/or funded by multilateral agencies, export credit agencies and smaller bi-lateral loans. Where a group with pulp interests raised fi nancing and was captured by either one of the providers, it was included, even though the fi nancing need not all have benefi ted the pulp producing subsidiary. The tally excludes paper makers with no captive pulp capacity, but includes integrated companies.
Pulp producers raised a total of US$215.5 billion between January 2000 and January 2005. The composition of this funding is shown in Table 2.8. The amount is large when viewed in relation to the total asset base of the industry of around US$ 300 billion. In fact many of the fi nancings will have been of a short-term nature, so that there is a considerable amount of double counting. The majority of the fi nancing was also raised by companies in countries where no expansions took place. Thus this fi nancing refl ected refi nancing or acquisition fi nancing. To determine the fi nancing raised for expansions, it is more accurate to look only at the fi nancing activity of companies in those developing countries and countries with transitioning economies that are at the forefront of capacity expansion. This group accounted for US$ 12.7 billion or 6% of fi nancing raised since 2000. Since 1990, they raised US$ 37.8 billion in fi nancing, as detailed in Table 2.9. Again this US$ 37.8 billion fi gure is large relative to the actual capacity increases being fi nanced. At an expansion cost of roughly US$ 1,000 per tonne of annual production capacity, one would expect a fi gure of at most slightly over US$ 10 billion, before counting the funds used in downstream investments such as paper making and specialised coating machinery. The distortion in these fi gures is largely due to the funding activity of Asia Pulp and Paper (APP) and Asia Pacifi c Resources International Limited (APRIL) that raised far more fi nancing than strictly needed for the capacity they put on stream. In Brazil, some distortion can be explained by the fact that all debt raised by the Voto-Votorantim Group was included although only a portion would have benefi ted the pulp offshoot. The Voto-Votorantim Group is also engaged in cement production and banking.
The majority of the US$ 37.8 billion that the producers in newly emerging centres raised was achieved in the international capital markets. While the amount is large in absolute terms, it is small relative to the total amount of debt outstanding in the international capital markets (only cross border fi nancing). US$ 14 billion in bonds raised compares to US$ 11.7 trillion of bonds oustanding in the international capital markets (as at December 2003, source International Primary Markets Association), and US$ 15.7 billion in loans is again small when compared to the total of US$ 14.9 trillion in cross border bank claims outstanding between all banks that report to the Bank for International Settlements (BIS). These fi gures are quoted to put the fi nancing activity of pulp companies into some form of perspective. It should be noted that we are not comparing like for like because the bond and loan fi gures refl ect funding activity over a 15-year period as opposed to actual amounts outstanding at a given date. The relative insignifi cance of pulp mill fi nancing within the entire capital markets is important to note and relevant to bear in mind when reading the chapter on fi nancing. For investors it offers welcome sectoral diversifi cation in their portfolios.
The fi nancings included in the tally above were extended almost exclusively to corporate entities with existing operations in the pulp and paper sector, as opposed to fi nancing entirely new projects. The number of recipients was also extremely concentrated, with 12 borrowers accounting for 70% of total fi nancings identifi ed.
The US$ 37.8 billion excludes fi nancing provided by export credit agencies (ECA) and multilateral development banks (MDB). We identifi ed US$ 1.9 billion in direct fi nancings of the International Finance Corporation (IFC), European Investment Bank (EIB) and the European Bank for Reconstruction and Development (EBRD) for market pulp and integrated pulp and paper facilities. This US$ 1.9 billion was part of investment programmes that totalled an estimated US$ 7.34 billion. In quite a number of these cases, the multilateral participation acted as a catalyst for the entry of other fi nanciers.
Going forward, more new capacity will be built in the new production centres of the late 20 th century, while we will also see signifi cant activity in the Baltic States and China that are new to large scale pulp manufacturing. It is important to realise that despite the lessons learned in the past, today's fi nancing mechanisms are still not designed to favour the higher quality players. Instead, the lack of minimum standards effectively discriminates against those players that impose high standards on their operations, with everybody being the poorer for it. The following chapters take a closer look at pulp capacity fi nanciers and markets, and the risk assessment and safeguard mechanisms that they employ.

Conclusion
This chapter analysed how proposed new pulp capacity obtained its fi nancing and looked at fi nancing available to pulp producers. Capacity additions proposed by existing players in the pulp fi eld have the highest chance of going ahead with a 66% success rate. Where projects did not go through, this tended to be the result of changed corporate strategies as opposed to an inability to obtain funding. 27% of greenfi eld mills went on to being realised. Funding forms a bigger barrier here in the absence of an existing business that provides the cash fl ows. Raising comfort levels is critical to obtaining fi nancing: the level of sponsor-provided capital plays an important role.
Since 2000, pulp producers raised US$ 215.5 billion in funding from commercial sources. The majority (82.7%) of this took the form of loans typically extended to existing producers in traditional producing centres. To obtain a fi gure for expansion fi nancing, we narrowed the focus to producers in developing countries, and transitioning economies. Since 1990, these raised US$ 37.8 billion in debt and equity.
Funding from multilateral development banks and export credit agencies is not included in the above tally. We identifi ed US$ 1.9 billion in direct fi nancings since the late 1980s that would have enabled projects with a total value of US$ 7.34 billion. This low level of funding refl ects the impact of an abstemious World Bank forest policy, as will be discussed in the next chapter. The 1990s also did not see many signifi cant new entrants into the pulp industry.
Looking out, there are changes on the horizon. New producers are looking to enter the fi eld of pulp production, with China at the head of the queue. With limited woodfi ber, water and arable land, properly implementing these projects will present challenges of their own. Changed multilateral forest sector lending strategies are resulting in a signifi cant increase in their presence in fi nancing projects in this sector, and export credit agencies remain keen fi nanciers of the sector. We are thus entering a period of ample new capacity and funding. The challenge is to ensure that this crop of new capacity yields projects of a high quality.
The capital intensive nature of pulp mills means that raising capital is a critical barrier to entry for aspiring producers.
With rare exceptions, new entrants into pulp production receive governmental or multilateral support.
Multilateral participation creates a pre-disposition to lend.
Pulp mills are highly capital intensive, and the need for capital forms a major barrier to entry to the industry. Obtaining a production license is no guarantee that the mill that will be built can be operated economically. Investors and lenders have to assess mill viability for themselves prior to accepting the fi nancing risk. Because of this process it is to be expected that the fi nancing stage forms an additional screen by fi ltering out projects that are unlikely to be successful. By granting or denying fi nancing to parties, fi nanciers can have a major impact on which projects get fi nanced, and which do not.
The tally of fi nancing in Chapter 2 showed that pulp producers in developing and transitioning economies raised US$ 37.8 billion in new debt and equity. In all cases, these funds raised by companies with existing interests in the pulp and paper production fi eld. They did not include companies with no prior interests in this fi eld, and that entered as entirely new players. Where companies with no prior interests in forestry wish to establish themselves as a player in the pulp arena, they typically need strong government or multilateral support, as without this the jump into this highly capital intensive fi eld is well-neigh impossible to make. It is for this reason that the fi nancing activities by the multilateral lenders, while much smaller than that of commercial fi nancial institutions, are of special interest.
In providing funding, multilaterals also explicitly recognise that their participation enables the participation of other fi nanciers. The EIB gives this as one argument of its value-added in a loan it made to Brazilian pulp producer Veracel. The IFC explicitly puts its own direct lending/ investment in a project in the context of the additional investment that it facilitated.
This chapter fi rst reviews the activities by multilateral development banks, export credit agencies and continues with a review of commercial fi nancial sources.

Development funding from multilateral development banks
Multilateral development banks (MDB) are typically owned by a number of governments, and are tasked with fi nancing projects that meet the development objectives of these governments, or directing fi nancing to the projects that meet other set objectives. Unlike commercial banks, MDBs are not primarily in the business to make a profi t. They are in the development business, and by operating on a commercial basis can be self-sustaining in carrying on their work. The individual MDBs have differing roles. Some are purely geared to lending to commercial enterprises, others combine lending to governments or para-statal bodies with the disbursement of grants. They might even have the explicit mandate to act as Knowledge Banks, in which capacity they assist governments or offi cial (donor) working groups in setting policy.
The International Finance Corporation (IFC), European Investment Bank (EIB) and the European Bank for Reconstruction and Development (EBRD) are the multilateral development banks that have been the most active participants in pulp mill investments over the past two decades. This refl ects the fact that, unlike the other multilateral lenders, they have a mandate to lend directly to the private sector. We expect them to remain active, and going forward also anticipate signifi cant pulp mill fi nancing activity by the Inter-American Development Bank (IADB) and the Multilateral Investment Guarantee Agency (MIGA). The World Bank does not itself make loans to the private sector, and therefore does not appear as a direct fi nancier of pulp mills. The Bank nevertheless is a highly infl uential actor, as its investment policies also guide the IFC and MIGA, and as it has a signifi cant impact on shaping forest policy in a number of its client countries. The ADB has provided technical assistance grants to various pulp mills and plantation pulp projects in the Asian region, and also provides policy input to governments.

World Bank
The World Bank (hereafter: the Bank) provides development loans to its client countries. As at 30 June 2003, it had a balance sheet size of US$ 230.3 billion with US$ 108.5 billion in loans outstanding. These amounts were roughly stable for the past fi ve years. The current loan book is dominated by projects in healthcare, education, agriculture, infrastructure, electricity generation, urban poverty alleviation. The Bank, through these loans, gets signifi cant input in the policies of its clients, and this is part of the intention of the Bank, as it aims to steer these policies to refl ect what it judges to be most desirable for the development of its client. The Bank also chairs or provides input to country consultative groups dealing with joint-aid provision or budget support. The Bank further administers aid provided by third parties by way of Trust Funds. The combination of these roles gives the bank a global leadership role on social and environmental matters as well as development issues.
After having actively encouraged forest based investment through the 1970s and the 1980s, the Bank virtually retreated from this fi eld in the 1990s following the adoption of the 1991 Forest Strategy. (See the summary in Box 3.1) The IFC, EIB   This 1991 policy resulted in reduced Bank involvement in commercial forestry. The new policy focus of bank lending was less attractive to many of its clients, and resulted in a reduced demand for forestry loans. What forest loans the Bank made through the 1990s were typically tied to grants from the Global Environmental Facility (GEF) The GEF was launched in October 1991 as a new fi nancial mechanism to protect the global environment. GEF funds are disbursed as grants to recipient countries as payment for the provision of environmental benefi ts. The GEF is administered by the Bank, and all its clients are eligible for GEF grants.
The GEF was a major instrument in maintaining World Bank involvement in forestry after it adopted its 1991 Forest Strategy. In the words of the Operations Evaluation Department assessment of the World Bank's GEF portfolio 'without the GEF's ability to provide grant funding […] it is unlikely that the Bank could have persuaded as many client countries to borrow funds -even on a concessional basis -for [forest biodiversity conservation]' 'GEF funding allowed the Bank to remain active in forest sector policy making'. [source : Campbell G.J. and Martin, A. 2000] GEF funds could be used as a sweetener to get client countries to accept Bank funding but the mere fact that this is necessary refl ects the fact that 'many countries are reluctant to borrow for environmental projects and to implement Bank environmental policies' [Liebental A., 2002] Seeing its role in forestry decline in this way was deemed undesirable, and the Bank revisited its Forest Strategy. The Bank found that it had been 'irrelevant' in slowing down deforestation, and that its strict policies acted as a severe barrier to forest investment by Bank staff. [World Bank, Sustaining Forests, undated] The Bank's lower involvement meanwhile translated into less engagement, declining knowledge of the sector and reduced contact with stakeholders. These considerations motivated the World Bank to reformulate its Forest Strategy.
The focus of the new Forest Strategy was no longer on what the Bank was not allowed to do, but what its fi nancings should achieve. The new Forest Strategy builds on the recognition that private capital fl ows into developing countries and transitioning economies are more signifi cant than offi cial development assistance. The Bank sets itself the target of playing a role in creating enabling environments for foreign direct investment in the forestry sector, seeing it as a key stimulant for poverty alleviation that is a key Bank development objective: 'relative to the potential of wellmanaged forest resources to contribute to poverty alleviation, to sustainable economic growth and to protection of vital environmental services, current levels of investment, both domestic and foreign, fall far short of developing and transition country investment requirements.

Box 3.2 The 2002 Forest Strategy of the World Bank
The 2002 Forest Strategy of the World Bank has three main pillars 1. Harness the potential of forests to reduce poverty a. Support the scaling up of collaborative and community forest management so that local people can manage their own resources, freely market forest products, and benefi t from security of tenure. 2. Integrate forests into sustainable economic development a. Address fi nance, fi scal and trade issues related to the forest sector and forest products to enable governments to capture a higher portion of forest revenues for sustainable social and economic development b. Promote catalytic investments in the full range of goods and environmental serices available from well-managed forestsincluding sustainable timber harvesting and management… in situations that can be independently monitored through a system of verifi cation or certifi cation that meets nationally agreed and internationally acceptable standards. 3. Protect vital local and global environmental services and values a. Help governments to strengthen forest investments, policies and institution…[to minimize adverse impacts] b. Ensure that Bank investments and programs in both the forest sector and in other sectors that could potentially harm protected forests and antural habitats are implanted accorfding to the Bank's operational policies and safeguards.  The Bank's role in stimulating forest-based investments will only be indirect by way of creating a favourable policy environment. There has been no explicit World Bank involvement in pulp mills after 1983 (see Table 3.2), although the bank remained active by giving Forest Conservation and Management Project Loans that helped countries in encouraging forest-based investments 2 . Direct investment action would be taken by its sister, the International Finance Corporation (IFC).

IFC
The International Finance Corporation (IFC) was founded in 1956 as part of the World Bank Group, but it is legally and fi nancially independent of the Bank itself. The IFC provides fi nancing to private sector companies operating in developing countries 'where suffi cient capital is not available on reasonable terms', and often aims to act as a catalyst for other sources of fi nancing for developing countries. IFC loans are granted on commercial terms but with the explicit condition that they contribute to sustainable development.

Eg. IDA project No. 4 LAOPAO20 'Laos Forest Conservation and Management Project'.
The IFC is a World Bank affi liate geared to fi nancing commercial enterprises in developing countries.
As at June 2003, the IFC's balance sheet totaled US$ 31.5 billion, and its investments (disbursed loans and equity) totaled US$ 12 billion. The bank maintains a 49% capital adequacy ratio, that compares to a 12% minimum level set for banks by the Bank for International Settlements. The high capitalisation, and the bank's unparalleled access to additional capital by calling on further subscriptions from its 175 members, give the IFC a triple-A credit rating. This rating gives the IFC easy access to capital markets which is where, just like the World Bank itself, the IFC derives the majority of its funding.
In its operations, the IFC holds the middle between a development organisation and a commercial bank. The IFC competes with banks and sometimes direct investors in providing funding to commercial organisations. Unlike a commercial bank, and as seen above, the IFC has a strict set of additional funding criteria to meet. Yet because its loans are made at commercial terms, lenders get no additional benefi t from dealing with the IFC. Furthermore, the IFC often requires that it is engaged as a paid adviser to advise on the structure of the project and its funding prior to actually making an investment. In this capacity the IFC is part merchant bank, and part industrial expert. Despite these additional barriers to obtaining IFC funding, its long client list shows that companies see the value of the IFCs services. IFC involvement signals that certain quality standards have been met, thus facilitating obtaining future funding independent of the IFC. The IFC itself often brings in a syndicate, thus also contributing directly to securing additional funding sources that might not be available otherwise (see Table 3.3). Because reserve requirements for IFC-led loans are well below the reserve requirements for ordinary developing country loans, banks are keen participants in IFC syndicates. Banks are also attracted by the comfort of being part of an IFC syndicate. This highlights another difference between the IFC and commercial banks 3 .
A commercial bank will make a loan (or a merchant bank will originate a loan) based on the economic merit of the proposed transaction alone. If the risk/return ratio of the credit is acceptable, and if the loan fi ts within the overall portfolio, it will be granted. The IFC, in giving loans, pursues both a commercial and a development objective. This objective is achieved either directly through the project it fi nances, or indirectly by acting as a stimulant for capital fl ows to a country. The investments that are thus enabled can be critical to provide stimulus to countries that have recently undergone major political and/or economic transitions. The IFC's lending to Chile in 1989-90, to Brazil in 1992 and to Eastern Europe in the 1990s are clear examples of how this policy works. A side effect of the policy is that for the IFCs capital fl ows to be meaningful, loans of a substantial size have to be made. Such loans can be distortive, as the transitioning investee countries often lack the legal infrastructure to deal with the investments these loans might fi nance.
The IFC bases its lending policies on the relevant sectoral operational policies and good practices as laid down by the World Bank. This is not a straight forward process, because the Bank's activities are not commercially based, whereas the IFC acts as a commercial lender. In the case of the 1991 Forest Strategy, the IFC wrote an interpretation that reconciled the Strategy to its operations, while adhering to the 'spirit and intent' of the Strategy. Later, the IFC automatically adoped Operational Policy 4.36 (OP4.36) to guide its forestry lending 4 . In actual fact this led to signifi cantly reduced IFC involvement in the forest sector. On the one hand, there were constraints in encouraging private sector operators to adopt sustainable forest management. Many derived their wood from government owned forests against payment of stumpage rates that resulted in lower cost fi bre than that yielded by sustainable forest management. On the other hand, concerns about being associated with deforestation led to a de-facto IFC decision to avoid this type of operation entirely. (Ojumu 2002). By comparison, the World Bank itself remained more active, in particular through GEF loans (see Tables 3.1 + 3.2).

In an interview with Latin
As remarked above, the implementation of the 1991 Forest Strategy led to reduced IFC involvement in the forestry sector. In the period 1985 -91, the IFC approved 54 direct impact projects with a total cost of US$ 5 billion of which the IFC fi nanced $677 million. From 1992 through 1998, the IFC approved 65 projects with a project cost of US$ 3 billion with an IFC share of $578 million (Ojumu 2002). This suggests a decline in absolute terms, while refl ecting an even greater decline relative to total lending. This was in part due to a higher rejection rate: reports from the IFC's Operations Evaluation Department show that the IFC rejected 6 projects in the fi rst, and 42 projects in the second period 5 . Specifi cally with respect to fi nancing pulping capacity, it should be noted that on a world-wide basis the 1990s saw less new investment in pulp capacity, as a result of the sharp downturn in prices following the investment boom in the late1980s. The IFC did not participate in the Indonesian expansions, most of which did take place during the 1990s. The IFC is set to become more active in pulp fi nancing. At the end of 2001, the IFC had a disbursed forestry portfolio of US$515 million out of a total loan and equity portfolio fo US$13.5 billion. As at October 2003, it had US$605 million (IFC share) worth of transactions in the pipeline spread between E-Europe (36%), East Asia (21%) and Latin America (21%). The IFC currently expects to have a US$ 1 billion forest sector loan pipeline by the middle of 2005, refl ecting a doubling of its forestry exposure.
This rapid increase in forest-based activity is the result both of the new Forest Strategy, but also as a result of an internal reorganisation that created dedicated sector teams. The IFC now has a dedicated Forest Product Sector team that is systematically covering the sector, and actively looking to identify targets where the IFC can add value. At the same time this signals a transition from a reactive approach, where the institution responds to fi nancing requests, to a pro-active approach where they may help stimulate potential investments.
In India, where the IFC signals growing paper demand and a structural shortage of wood fi ber, the IFC has engaged major domestic Indian pulp and paper companies in large scale forestry programs to develop a fi ber base. It is currently seeing whether it can replicate such programmes with medium-size players. In China, the IFC again actively looks at fi nancing plantations, resulting in added fi bre supply as opposed to pulp mills per-se. Recognising the shortage of wood-fi ber throughout Asia, the IFC also supports efforts to develop clean non-wood pulping technologies. The IFC does support wood pulp projects in areas that have a competitive advantage in growing wood fi bre, such as Brazil and Uruguay, thought it insists these projects have to adhere to its Environmental and Social Guildelines.
With its pro-active approach to lending, and its conscious effort to maximise its value added, IFC is unique amongst the multilateral institutions that directly fi nance commercial enterprises. The next chapter will have a more detailed discussion of the safeguard process guiding the implementation of these loans, and how we feel this process could be strengthened as it relates to pulp mills.

MIGA
The Multilateral Investment Guarantee Agency (MIGA) was founded in 1988. MIGA's principal mission is to facilitate foreign direct investment into developing countries by guaranteeing non commercial risks. Membership of the MIGA is open to all World Bank members. MIGA's guarantees cover investments against political risk, currency inconvertibility, expropriation, war and civil disturbance and breach of contract, and have maturities up to 20 years. In recent years, MIGA guaranteed US$ 1 billion to US$ 1.6 billion per annum, in each case facilitating foreign direct investment of about three times that magnitude. Since inception, MIGA has issued more than US$ 12 billion in guarantees for 650 projects (translating into an average guarantee size of US$ 18.5m), helping facilitate more than US$ 50 billion in foreign direct investment.
The project list in the company's annual report does not show any forest-based investments, but with the increased activity of the Group in this sector, this is likely to change soon. Because of its ability to issue long-dated guarantees, MIGA is well positioned to facilitate investment in developing country industrial forest plantations by institutional timber investors. It yet has to take steps in this direction, and the only recent example of potential involvement in a pulp mill has been the case of UFS.
At the time of writing, United Fiber Systems (UFS) is attempting to raise funding for a pulp mill with 600,000 tonnes of annual capacity. This company has no existing operations but controls land, and 75,751 hectares of industrial plantations that were planted by a predecessor entity between 1995 and 1999. The company developed this plan in 2001, but so far has failed to raise any funding, as a result of which even the industrial forest plantations have not been developed as per the plan presented to investors at the time they sought shareholder approval to acquire this project. They project to be able to meet their entire fi bre demand from newly planted plantations by 2010. This assumes that the company started planting 20,000 hectares annually starting from 2003, something that is not the case. All four major Indonesian pulp producers, when they started their operations in the late 1980s and early 1990s, similarly projected to be self suffi cient in the production of plantation fi bre at the latest 8 years after the start of operations. Only one of four major companies met the target with a delay, and the overall industry still relies on wood from the natural forest for 70% of their fi bre needs.
MIGA publishes no information about the UFS project on its website, reporting only transactions that have already closed. However, informed sources report that MIGA came within a hair's breath of providing a guarantee to this project and was only in the end dissuaded from doing so after a local member of the World Bank Group raised very strong objections to MIGA participation in this project. It is critical to note that MIGA's internal review process did not identify the obvious weaknesses in this project.

ADB
The Asian Development Bank (ABD) was founded in 1966 and focuses its attention on the Asia Pacifi c region, where it works to achieve poverty reduction by promoting economic growth, developing human resources and protecting the environment. Other key development objectives include legal and policy reform, regional cooperation, private sector and social development. The ADB is owned by 66 countries, mainly from the Asia-Pacifi c region.
The ADB provides loans, technical assistance and credit enhancement guarantees for projects that pursue the above goals. As at 31 December 2003, the ADB's balance sheet totaled US$ 49.8 billion, and its loan book US$ 29.5 billion. It also administers three Trust Funds on behalf of Japan. The ADB is an active lender to the natural resources sector, but the thrust of its activities are in the agriculture and fi sheries sector.
The ADB does have a forest policy, but has not been very active in the sector. Ongoing projects with a pulp element include technical assistance for Hexian pulp mill (approved in 1988) and for Yunnan Simao (approved in 1994). Its list of proposed loans for 2003-05 (October 2002 update) does not include pulp related investment proposals, but the ADB is actively supporting large scale plantation development in Laos, with a view to attracting a major pulp producer to establish a production unit in this country.
The ADB is also active in policy consultation in the region, and advises a number of governments and consultative committees/ working groups. Through this mechanism it has a greater impact on the forest sector. With regard to the forest sector, a relevant example is the ADB's role in the Donors' Working Group on Natural Resource Management for Cambodia. This Group is heavily focused on the forestry sector. Another example are institutional support grants and loans given the forestry departments of various client countries, eg. the 1994-2002 US$ 1.5 million to the Laotian Department of Forestry, funded by the Japan Special Fund. The activities of the EBRD and EIB are heavily Europe centered. As a result, neither of these institutions has been confronted extensively with the potential problems that arise when investments are implemented in localities with different levels of development and different legal systems. In Chapter 2 it was discussed how new problems arose with respect to pulp mill investments once these were located in countries that had no history of dealing with such large scale, resource intensive investments.

EIB & EBRD
Both the EBRD and the EIB have had considerable involvement with pulp mills, and in both cases, these involvements focussed on mill upgrades that would be expected to result in improved production practices. However, both institutions have also played a critical enabling role in fi nancing proposed mills, that without their participation would not have seen the light.
The EIB provided the lead fi nancing for the Stendal pulp mill in former Eastern Germany. The fi nancing was made despite industry overcapacity, and its key justifi cation was that the project by created 580 direct, and 1,000 jobs. It should be noted that at an investment cost of E245m (and a total project cost of E 1 bn) the cost of creating these jobs was high, and there must have been political considerations -such as promoting the integration of Eastern Germany into the EU -that also played a role.
The EBRD provided the catalytic fi nancing for Estonia Cell/Baltic Pulp in Estonia. This example will be discussed in more detail in chapter 5 with relevance to safeguard implementation.
The level of reporting transparency of the EBRD lags that of the IFC, and the EIB reports very little, although it is at present reviewing its disclosure policies. The lesser reporting means it has been more diffi cult to gain insight into what goes on behind the scenes. Their actions meanwhile do not betray a pro-active approach with respect to structuring their investments so that they maximise development outcomes and added value. In each institution, investments are tested against the mission of the institution which can be interpreted in a rather liberal fashion. Particularly with respect to the EIB's fi nancing in developed Europe, the question can be asked whether these transactions need an EIB, given that these transactions could easily have been done in the commercial capital markets. Where it concerns the impact of the projects themselves, available evidence suggests that both the EBRD and the EIB are happy to focus on macro benefi ts such as balance of payments improvement, job creation and as yet do not work actively to mitigate any potential negative impacts that their investments might have.

Other multilaterals
Of the other multilateral organisations, we want to mention the Inter-American Development Bank (IADB). The IADB has a portfolio of 60 forest projects with a total value of approximately US$ 690 million (60 x US$ 11.5 million on average). This institution has so-far not been active in pulp mill projects, but we expect this to change. In 2002 the IADB published a report on Forest Financing in Latin America, that identifi ed a fi nancing potential of US$ 6.8 billion annually for the forest sector through 2010, with industrial investments accounting for US$ 4.8 billion of this amount. Separate studies identifi ed areas where these investments would be needed. With regard to the pulp sector, it notes a need for training and technology upgrades in Colombia, upgrading and modernization in Mexico, Chile and Argentina (mainly for paper grades), and industrial forest development in Mexico to replace part of the fi bre supply from the natural forest.

Export credit agencies
Export credit agencies (ECAs) are founded/supported by a single government, and have as their aim to promote the exports of their home country. Pulp mills are highly capital intensive, and for this reason, ECAs are a prominent player in pulp projects. ECAs normally provide their support in the form of a guarantee of a commercial loan. Some ECAs may provide fi nancing directly.
ECAs have a large involvement in pulp mill fi nancing. ECA involvement typically points to the purchase of state-of-the-art machinery that is based on increasingly environmentally friendly production processes (Sonnenfeld 1999). As without ECA fi nancing this equipment might not necessarily be bought, ECA funding has a benefi cial role for pulp mill projects. The benefi ts are not universal, because until very recently, ECAs have neglected other impacts of their projects.
ECAs fi nance or guarantee machinery exports and will take on the risk of both greenfi eld mills and expansions by existing players. The US Ex-Im Bank was, in 1995, the fi rst ECA to adopt explicit safeguard policies to govern its fi nancing policies, with many other OECD ECAs following between 1999-2002. Subsequently, the OECD have made a recommendation of Common Approaches for export credits by its member nations, that will bring practice closely in line with the safeguards and guidelines currently adhered to by the World Bank Group. The implementation of environmental standards place a high emphasis on water and air pollution, risking that other equally important aspects get overlooked.
The Export Import Bank of the US (US Ex-Im) was the fi rst ECA to have applied environmental screening to their projects, starting in 1995. Its screening criteria are based on World Bank Group operating guidelines, and include an explicit policy prohibiting logging in tropical moist forests. These policies did not prevent US Ex-Im from fi nancing APP, which continued to use considerable amounts of mixed tropical hardwoods (obtained from clearing of natural forests) in its operations, a fact that would be clear from reading any of its bond prospectuses or annual reports on form 20-F fi led by it or its key Indonesian subsidiaries. These reports would also have reported that the company is subject to Indonesian environmental legislation and government controls. While the quality of the legislation varies -it supports high standards of water and air pollution control, but condones the clear cutting of natural forest by pulp companies with fi bre defi cits -it cannot be assumed that these laws are effectively enforced. The fact that APP's signifi cant fi bre defi cit could go unnoticed does reinforce the need to focus on effective implementation on the ground. At present, ever rising standards can still not ensure that guarantees or funding will be denied to poor sponsors/projects.
ECAs have been slow to sign up to safeguards out of concern of loss of business. The introduction of OECD Common Approaches levels the playing fi eld, but could still at the margins result in a loss of business to non-OECD suppliers and ECAs. The net result may be lower standards, and this will in practice be a driver to accept projects with conditionality, which is at present not yet a widely accepted practice for ECAs.

Commercial fi nancings
The foregoing sections approached the types of fi nancing discussed per agency or agency group because each of these operate with specifi c mandates. The discussion of commercial fi nancing will be held with reference to the major types of fi nancial instrument rather than by granting institution.
Commercial fi nancings can take various forms, of which credit and equity (shares) are the principal categories. Credit is obtained from banks, or by issuing debt securities in the capital markets. In their simplest way, bank loans are provided directly by the bank to the borrower. When loans are larger, the desire to spread risk usually means that the loan will be provided by a syndicate of banks, with one bank responsible for negotiating pricing and documentation within parameters that are acceptable to the syndicate. In this case we talk about syndicated loans.    Companies can also issue bonds that are then sold by banks to end investors, such as pension funds, insurance companies, mutual funds or even individuals.
When a loan is fi rst raised, or when a bond is sold by the issuer to an investor, this is referred to as a primary market transaction. A key aspect of a primary market transaction is that money passes from investors to the issuer of a security. In the case of this study this would be the forestbased company. The fi rst investor to buy a security is very likely to sell this security in the course of its life. Financial institutions make a market between themselves for bonds, and even loans are traded in this way. None of these transactions result in raising fresh money for the issuer of the security. Transactions of this nature are said to take place in the secondary market. Secondary market investments can be made for relatively short periods of time -a trader may hold a bond for only a few hours, and even end-investors may hold bonds for only a few weeks if they were trading them with a view to anticipated changes in yields. This would be true for hedge-funds, that manage money for institutions and private individuals, and have as their objective to make money in absolute terms. Insurance companies, who buy bonds to match liabilities that they have to their policy holders, are more likely to be longer term investors. They will be active as buyers both in the primary and the secondary market.
This paper is primarily concerned with primary market transactions, as these result in actually raising new funding for the issuing companies. Thus it is at this stage that safeguards and standards should be implemented. Investor action in the secondary market affects issuers only to the extent that it infl uences pricing in the primary market, and sends a signal about the relative desirability of paper from a given issuer/sector.
Pulp and paper companies raised a total of US$215.5bn in primary market debt and equity transactions in the US and international capital markets to fi nance ongoing operations, re-pay old debt or to support horizontal and vertical expansions. In almost all cases, these funds were extended to companies that were already in existence, as a result of which the potential ability of the fi nanciers to infl uence the operations of the issuer -by insisting it upholds certain standards -is less as compared to those fi nancings that are explicitly raised to fi nance entirely new plants.
Having said that, there is much more that can be done by commercial fi nancial institutions to ensure that they do not fi nance unsustainable pulp mills, and this is the subject of the fi nal chapter.
Commercial credit has fi nanced most pulp expansions, but because commercial credit in most cases fi nance companies and operations that are already existing, it has less of an impact to shape pulp mill investment policies as compared to the actions of the fi rst-stage fi nanciers. As we have seen, the fi nancial institutions in fi rst-stage fi nancing tend to have different mandates and objectives than the purely commercial fi nancial institutions we fi nd in the next stage.
Statistics on US and international syndicated loan, bond and equity issues show that pulp and paper companies raised US$215.5 billion between 1990 and January 2005 to fi nance ongoing operations or to support horizontal and vertical expansions. The funds were raised as loans, bonds, equity or project fi nance transactions, but by a comparatively limited number of players. This refl ects the reality that gaining access to capital market funding is complex, but that once entrance has been gained, renewed tapping of these markets is comparatively easy.

Market access
This section discusses cross border syndicated loans and bond issues. Pulp producers tap these markets to obtain funding in larger amounts and with longer maturities than can be obtained in the domestic banking system in the newly emerging production centres. The number of companies that is suffi ciently creditworthy for such amounts and tenors is automatically limited, and this results in a relatively high concentration of issuers.
Most pulp capacity expansions have been fi nanced from commercial sources.
The international capital markets are the focus of pulp fi nancings.
The international debt markets exist to provide large amounts of fi nancings with large tenors.
As a result of the high cost of origination of international syndicated loans or bond issues, the minimum economic issue size is upwards of US$ 100 million, with US$ 200-300 million being the norm. This size requirement is reinforced by the reality that only large and well known companies are likely to meet with demand for their debt. For issuers in countries with weak currencies, access to capital markets is typically restricted to sovereign names, and the largest exporters of US$ -priced products with a meaningful competitive advantage. In case of a devaluation, the sovereign is assumed to be able to raise further foreign currency debt, while the currency risk for strong exporters is much reduced, as their revenues would, in US Dollar terms, remain unaffected. The individual company needs to be a profi table enterprise with real cash fl ow, as ordinary loans are given (or bonds issued) on the strength of the existing business, although the purpose of the loan might well be to fi nance an expansion. The creditworthiness will usually be assessed by looking at the issuer's credit rating -having one is effectively mandatory. Because the international capital markets have no umbrella regulator that dictates disclosure standards, industrial companies need to have a stock market listing as that mechanism ensures the company reports periodic fi nancial information to the fi nancial markets. Issuers with debt issues registered with the Securities and Exchange Commission (SEC) in the US will also need to report fi nancial statements to the Securities and Exchange Commission. Unlisted issuers are more likely to raise syndicated loans, as these have a mechanism built in where the lead bank will have access to credit information. Once companies have made a maiden issue, returning to the markets is easy.
Only twelve companies jointly accounted for 70% of all emerging market pulp and paper issues. The implication is that market access forms a barrier to entrance, and provides an incentive for companies to gamble big time to make it into the big league ahead of the competition.
Size is a principal criterium for market access, and this is true even for new projects. E.M. Capital increased the size of its proposed mill in Estonia from 210,000 tonnes per annum to 500,000 tonnes per annum because the former fi gure was too small to attract fi nancing. The mill never materialised, and the plan was formally abandoned in 2004 because the company could not fi nd an operating partner. However, the message about size is clear.
Capital market access requirements preclude greenfi eld projects by new sponsors from being fi nanced in this market, but the international capital markets do lend themselves to effective The international capital markets have no formal regulator. Market participants decide for themselves whose credit they will accept. New issues are subject to due diligence, but there is no formal mechanism for continued reporting. It is expected that issuers already report fi nancials to another regulator, and these reports will be suffi cient.
Pulp producers with a hard currency based business of a meaningful size are amongst the developing country issuers that can gain access to the international capital markets.
Returning to the markets after a maiden issue is relatively easy.
A key criterium for access is size.
expansion fi nancing. Banks do sometimes fi nance greenfi elds, but these are then structured as project fi nance transactions, or loans are made with an ECA guarantee. Project fi nance refers to the fi nancing of projects that have yet to be realised. In project fi nance, the principal source of repayment are the future cashfl ows of the project to be fi nanced. Unlike in ordinary loan transactions, there is no existing business whose cash fl ow can help support the debt. Because of the signifi cantly higher risk, project fi nance transactions take a longer time to structure than ordinary loans or bonds, and typically involve in-house industry experts. The period under review ( -January 2005 showed US$ 1.0 billion in project fi nance transactions (2.8% of total) for developing country pulp and paper companies.
Investor risk preference will determine whether a borrower can obtain funding, and if so at what cost. For any of the developing country pulp producers, the fi rst consideration would have been the country credit. What level of credit is acceptable to banks and other providers of capital depends entirely on their risk appetite. Low interest rates or investment returns in their home market tend to increase the appetite for risk, while on the other hand recent defaults or fi nancial turbulence tends to result in a declining appetite for risk. Petrobras, the state oil company of Brazil had to postpone a bond issue in the summer of 2002, when investors, with the hurt of the Argentinan default fresh in their mind, were spooked by the prospects of a socialist president taking the reins in Brazil. Privately owned pulp producer Aracruz fared slightly better and raised US$ 250 million in export backed securities in February 2002. Still this refl ected a relative deterioration in the terms: the company made its maiden Eurobond issue in 1993, and returned to the Euromarkets three more times through 1997 when the Asian crisis cooled demand for emerging market debt for a while and Aracruz could not raise fi nancing. Chart 2.1 in Chapter 2 is a graphical representation of this phenomenon. The uncertainty of continued market access encourages opportunistic fi nancing by companies when there is a window of opportunity. The IFC sets itself apart in that it will provide fi nancing in down markets at times when commercial lenders will not take this risk. The IFC's most notable recent involvement in a down market in the pulp sector was its 2002 assistance to Klabin by providing bridging fi nancing to facilitate this company's restructuring at a time when the markets were effectively closed to Brazilian risk.

Lending cost
The interest that a lender will charge is a function of repayment risk. The higher the assumed repayment risk, the greater the cost of the debt. The debt is priced relative to the best credit in the market, for US Dollar issues this is the debt of the US Government (Treasury notes and bonds). A company's creditworthiness is a function of many factors, but many lenders are content to base their conclusions on the fi ndings of rating agencies that give a company a rating depending on the strength of their business, and individual issues ratings refl ecting both the structure of the instrument and the strength of the borrower. Relative supply and demand of credit also plays a role.

Brazil
Chile Indonesia 1 9 9 0 1 9 9 2 1 9 9 4 1 9 9 6 1 9 9 8 2 0 0 0 2 0 0 2 2 0 0 4 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 -  A study by the Bank for International Settlements on developing country syndicated loan pricing fi nds that lenders focus more on macroeconomic factors than on issuer specifi c factors to determine the pricing of their loans (Altunbas et al 2003). This is clearly refl ected in actual trading. Table 3.10 shows the spreads at which debt of various countries was traded in March 2004. A spread is the differential of the yield on the debt of the issuer as compared to that of the benchmark issue for the same maturity. This table shows that spreads for countries with higher ratings are generally lower, but also that within rating categories there can be meaningful spread differences. These would then refl ect investor preferences at that particular point in time as well as supply and demand of paper from the issuer in question. At the time that these observations were made, the perceived credit risk for Asian borrowers was signifi cantly lower than that of those from Latin American as a result of the Argentine default. Spreads decline as more investors are keen on the credit, and/or expect it to improve further, thus justifying a lower compensation for the risk taken. The movement of relative spread levels of developing countries tends to be affected by common factors such as investor risk preference. Whereas in any country the government is normally is considered to be the best credit by defi nition, in developing countries, strong exporters often trade at a premium to the debt of the national government.  The next chapter will deal with credit risk assessment and due diligence.

Domestic banks
Domestic banks and capital markets have played a minimal role in fi nancing the large pulp mills in developing countries. Once mill sizes entered the jumbo category, the international capital markets were a more attractive source of fi nancing both because of the ability to provide large amounts of funding and because of the ability to provide funds for long maturities. At this stage, the role of the domestic bank is more as a facilitator of payments and trade facilities (letters of credit).
Domestic banks do play an important role in fi nancing smaller domestically oriented mills. Whereas larger mills fi nance themselves internationally, at the outset all purely domestically owned mills will have been fi nanced by local banks. These banks have a knowledge advantage Once pulp producers have gained a certain scale they cease to rely on the domestic banking system for expansion fi nancing. In this way the superior knowledge that an independent domestic bank might have is lost to the lending syndicate.
over international lenders, although when these banks operate in countries with poor fi nancial sector governance this may not stop them from fi nancing poor projects proposed by powerful interests. Domestic banks are however, also more likely to place a higher emphasis on national priorities -building a pulp industry to gain self-suffi ciency or to gain market share -over and above considering the safeguards at the mill level.
The large funding size requirement to gain access to the international capital markets is a major incentive for producers to try and get into the big league. Conversely, this should mean that in countries where more domestic funding is available, and therefore reduced need to tap international sources), the pulp industry might be more balanced with respect to numbers of players and their size. After all, there is no need to up the mill size to meet the criterion of large lenders. This is somewhat true in Brazil and Thailand, but not in Chile and Indonesia.

Equity
The majority of the large pulp producers are publicly listed companies. Pulp production is a capital intensive business, and even when expansions can be debt fi nanced, there are limits on the effectively permissible debt-to-equity ratio, meaning that the equity base determines a company's ability to raise debt. A company's equity base is made up of its paid up capital, and grows over time by the amount of earnings that are not paid to the shareholders in dividends.
When the rate of natural growth is insuffi cient to sustain the higher debt levels that come with expansion or when a take-over is envisaged; an additional offering of shares will be made.
Of the countries in our sample, Indonesian companies were most active as issuers of equity, and in all cases it concerned additional equity offerings either the operating companies that already had small domestic listings, or by the formation of a holding company that was subsequently listed overseas.
The pulp and paper sector has only been of middling interest to equity investors. From the perspective of a buy-and-hold investor, the sector is not attractive as its return on equity through a cycle is well below levels seen in other sectors. For most of the 1990s, investors would have expected to see returns on equity in the low to mid teens. These were never delivered, not even during peak years (see Table 3.12). Initially, the equity of developing country issuers was of interest to investors because of the promise of higher returns on investment inherent in the competitive fi bre source. This promise was never made good, and even if a company showed superior operating margins, some of the benefi t was handed back in the form of higher borrowing costs. Brokers kept on promoting equity in these companies -the Indonesian producers in particular. Morgan Stanley's pulp and paper analyst kept on topping the league tables that ranked analysts on the basis of client polls, even though his work failed to recognise the steady deteriorating fi nancial condition at APP. APP reported below average profi tability in most years. Yet it needed to raise equity to support further debt issues.
The equity of these issuers performed poorly, but one of the reasons why these companies could place such substantial amounts of it was the active support of the lead underwriter for the issues. These underwriters have tremendous placement power, and high incentives to complete the issue, as this would lead to more demand for debt, and thus, more fees in addition to those being earned on the equity placement. It should be noted here that at the institutional level, commissions paid on broking transactions are very slim (0.25% to 0.40% would have been representative for the late 1990s, depending on the market and service). After covering the costs of sales staff, back offi ces and research departments, profi ts are minimal. The real money is made in origination and mergers and acquisitions. A representative fee for would be 2.5% debt origination and 7.5% for equity placements. It was these transactions, rather than secondary broking volume that the banks were after, and in order to facilitate getting access to the clients, such banks would employ large research departments. Since the dot-com fall out, lead managers may no longer write research in In Brazil and Thailand, the existence of a relatively strong domestic banking system allowed for the emergence of a number of medium size pulp producers that effectively serve the domestic market.
Low returns on equity through the cycle means that the pulp industry is of below-average interest to equity investors.
Equity issuance has been subordinated to debt funding needs, with companies issuing equity only to be able to support a larger debt burden.
support of their own transactions, but anecdotal evidence suggests that once one looks beyond a few cosmetic actions, the research departments play as ever a key role in strengthening client relationships by providing ongoing supportive research.
Research on listed companies is also a signifi cant source of input for decision makers in banks. Equity research is discussed in Chapter 5.

Conclusion
Funding is a key barrier to entry for aspiring pulp mills, and funding instutions jointly and singly hold signifi cant power with regard to determining which projects see the light. Smaller scale pulp mills will typically be fi nanced by banks in their home markets. Mills larger than 200 000 tpa will quickly fi nd themselves addressing larger institutions, either multilateral development

Box 3.3 Factors driving capital markets access by the large pulp mills:
The factors driving capital markets access by the large pulp mills are: 1. At the very macro level, there has been a continued increase in liquidity in the global fi nancial system. Dollar funding can be obtained at competitive prices for periods that match the investment. 2. Both the cost and the fl exibility of the fi nancing often compare favourably with terms that could be obtained in domestic markets.
Many domestic capital markets are not capable of providing fi xed rate funding for similar maturities (typically seven to ten years). 3. The export oriented nature of the pulp producer signifi cantly reduces the currency risk: should the domestic currency devalue, the revenues of the exporter of USD priced commodities are not affected in the way that say, a domestic consumer goods or property developer would be. Meanwhile, the devaluation is likely to reduce its cost base. 4. The investment cost of a new pulp mills is largely denominated in foreign currency as mill equipment is usually bought from machinery producers in the established pulp producing countries. In many cases, machinery vendors often attractive fi nancing packages, in which foreign lenders are keen to participate. 5. Debt of pulp producers and other large industrial companies offer a diversifi cation opportunity to international lenders, as the majority of debt is issued by sovereign, multilateral, telecommunications and fi nancial companies.
banks or export credit agencies. If their existing operations are of a suffi ciently large scale, or if the markets happen to be accomodating, these companies might even tap the international capital markets directly.
In terms of actual amounts, pulp and paper companies have raised far more money in the US and international capital markets as compared to from multilateral lenders. Financing activity in the former markets totalled US$215.5bn between 1990 and Jan-05 which compares to direct investment/lending by the IFC, EIB and EBRD of US$2.1bn. The signifi cance of multilateral lending is that multilateral involvement creates a pre-disposition to lend by commercial fi nancial institutions, and in the case of the IFC the linkage is stronger as the IFC will even arrange commercial fi nancings. In this way, multilateral involvement can make a pulp project. An example of this is the UFS pulp mill in Kalimantan. This mill has repeatedly failed to get commercial fi nancing, and came within a hair's breath of getting a MIGA guarantee. While the proposed guarantee size was small, MIGA's involvement would almost certainly have unlocked other fi nancing sources.
Because of the size of pulp mill investments, and the attendant large funding need, most mills derive their funding as large syndicated loans or bonds. In these markets, there is less of an ongoing and direct link between the issuer and the provider of the funds, and funding is often made available based on market demand for certain types of debt just at that moment. This demand is infl uenced fi rst by macro factors, such as the industry cycle, the credit status of the country of the issuer, the relative demand for debt securities by stronger or weaker issuers, and maturity. Only then will the attention turn to the individual issuer. This emphasis of investor attention goes a long way to explaining why apparently weak issuers with obvious sustainability problems can still obtain funding.
The majority of issuers in the international capital markets are fi nancial institutions, sovereign countries, municipalities, telecommunications companies and large multinationals. For many of these issues, the macro-based assessment is appropriate. The pulp sector is almost unique in the way that relatively less well known issuers can still have access to this market. Furthermore, by often moving straight from being fi nanced by domestic fi nancial institutions to the international capital markets, they can lack the scrutiny that comes with a long-term bilateral banking relationship with an international bank. It is there that pulp companies are in a somewhat unique position, and why special attention to this class of issuers is needed.
Even the pulp producers with very low cost production have not succeeded in delivering superior returns to their equity holders. This has resulted in only a lukewarm stock market reception for issuers from this sector. As a result, and also because of the high cost of capital investment, debt dominates the fi nancing activity of pulp and paper companies. The listed equity of pulp producers is hardly core to investors' portfolios, and many institutions hold zero weightings in the sector, although this is also a function of where the pulp cycle is. Pulp producers did nevertheless at various times raise additional equity, as this was needed to support growing debt burdens taken on to fi nance ever greater expensions. This equity would still get sold, with typically the lead bond underwriter for the fi rm playing an active role in marketing the issue. Underwriter fee levels and pricing would further determine the appetite for (placing) the issue.
The most common form of risk affecting all lending transactions, whether direct in the form of loans, or indirect in the form of the purchase of a debt security, is the possibility that the obligor fails to meet its obligations in accordance with agreed terms. If a debt issue is publicly traded, even a change in relative creditworthiness has an impact on the price at which the security is traded, so that credit risk considerations are relevant for companies across the spectrum of fi nancial strength, and not just those at the edge of default. The primary objective of bank risk management is to maximise a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. For large loan and bond issues, the credit risk assessment process will transcend the limited analysis of the borrower's ability to repay, and will extensively address legal and operational issues by way of due diligence. Actual due diligence exercises have shown up weaknesses in companies, but in the past lenders have not accorded much importance to such weaknesses, proceeding with funding where the rating was deemed satisfactory. As a result bank/investor credit standards do not by themselves ensure responsible fi nancing, or deny credit to poor performers.

Credit risk assessment
All forms of lending carry risk, and as the risk increases, so does the cost of funds. It is the business of a lender to understand risk, price it correctly, and make a profi t by earning more on its loans than it has to write off. Credit risk is assessed both at the individual loan basis, and at the aggregate portfolio basis in order to avoid concentrations of risk in a single sector. In actual practice banks place a greater emphasis on the sector and geographical spread of the loan portfolio than on a thorough credit assessment of the individual borrower. If in a given year a rural area experiences poor harvests and poor prices for its products, banks that lend to this area are likely to experience above average defaults on their loans irrespective of individual borrower quality. Banks manage this risk by also lending in other areas, and to industries that have little relation to each other.
At head offi ce level, credit management will focus on ensuring that limits are set per region and per industry, so as to cushion the impact of bad years in certain regions or industries. The existence of aggregate limits on risk also means that banks can sometimes be more fl exible at the company level, especially where they see good yields. Lender behaviour during the 1990s suggested that both the high coupon and the diversifi cation characteristics of the pulp industry provided enough of an incentive to lend, despite awareness of weaknesses at the individual borrower level. This comment refers to aggregate behaviour, because there will defi nitely have been banks with sensible credit departments that noted the over-leverage that characterised some of these issuers. But where these banks passed, others were keen takers.

Financial risk assessment
In lending, the most common form of risk is the possibility that the obligor fails to meet its obligations in accordance with agreed terms.
Loans are priced to refl ect their level of risk. Banks manage risk at the individual loan level and across the entire loan portfolio.
Actual bank risk management practices place more emphasis on managing the structure of the loan portfolio, as oppossed to rigourously assessing each individual component.

Box 4.1 Key credit assessment criteria for commercial banks
Key credit assessment criteria include: • the purpose of the credit and sources of repayment; • the current risk profi le (including the nature and aggregate amounts of risks) of the borrower or counterparty and collateral and its sensitivity to economic and market developments; • the borrower's repayment history and current capacity to repay, based on historical fi nancial trends and future cash fl ow projections, under various scenarios; for commercial credits, the borrower's business expertise and the status of the borrower's economic sector and its position within that sector; • the proposed terms and conditions of the credit, including covenants designed to limit changes in the future risk profi le of the borrower; and • where applicable, the adequacy and enforceability of collateral or guarantees under various scenarios. In addition, in approving borrowers or counterparties for the fi rst time, consideration should be given to the integrity and reputation of the borrower or counterparty as well as their legal capacity to assume the liability. Once credit-granting criteria have been established, it is essential for the bank to ensure that the information it receives is suffi cient to make proper credit-granting decisions. This information will also serve as the basis for rating the credit under the bank's internal rating system.
Source www.BIS.org A major trend that took place over the past three decades was a shift away from one-to-one bankto-borrower lending towards club or syndicated transactions, which has resulted in reduced contact between the borrower and the provider of the risk capital (i.e. disintermediation).This has also had a direct impact on risk analysis 6 . If previously banks lent to companies close to home and had a good knowledge of their customer, now they were lending increasingly far afi eld. This gave them the major benefi t of a better portfolio spread, but removed them from the credit assessment process. The competitive pressures present in the bank lending business also means that banks don't have due diligence access to the borrower that they would have had they originated the loan themselves. As a result, many lenders and investors place undue reliance on the due diligence and credit risk analysis done by the syndicate leader or underwriter or by rating agencies. This is especially so for those institutions that trade exposure, and do not aim to hold it on their books from the date of origination until its fi nal maturity. This goes a long way to explaining why so much of the debt of the weakest pulp producers was issued in the form of bonds, rather than as bilateral or even syndicated loans.
Banks are commercial enterprises in pursuit of maximisation of profi ts, but because of the key role they play in the economy, they are subject to different regulatory treatment as compared to ordinary commercial enterprises. Banks are subject to regulation and supervision, but supervisors will not tell banks what loans they can and cannot make. Supervisors do ensure that banks have adequate capital, as well as adequate systems in place to manage and monitor risk. In actual fact supervisors fi nd many basic weaknesses in credit granting and monitoring by banks involved in the international loan markets. This appears at odds with the observation that there have been remarkably few international bank failures over the past decade. The low failure rate might well be due to the steady decline in US Dollar interest rates, the increase in global liquidity seen over this period and the proliferation of sophisticated instruments such as CDOs (collateralised debt obligations) that packaged risks and disseminated them across the fi nancial system. When these trends reverse, we will see a serious test of the quality of loan-and derivatives portfolios and risk management.

Box 4.2 Structure of credit control mechanisms
In assessing bank credit control mechanisms, regulators focus on the following points: A Credit risk environment 1. Credit risk strategy and signifi cant policies 2. Policies and procedures for identifying, measuring, monitoring and controlling credit risk in all the bank's activities at the individual credit and portfolio levels. 3. Mechanisms to identify credit risk across all products and activities. B Credit granting process 4. Credit-granting criteria; should refl ect the bank's target market and show a good understanding of the borrower or counter party, structure and purpose of the credit and the source of repayment. 5. Credit limits: should be based on a meaningful aggregation of various types of exposure, and applicable to the banking and trading book, and on and off the balance sheet. 6. Credit approval process, and process applicable to amending (refi nancing) existing ones. 7. Procedures applicable to non arm's-length lending. C. Credit administration, measurement and monitoring 8. System for the ongoing administration of credit risk-bearing portfolios. 9. Monitoring system for individual credits, and mechanisms to determine adequacy of provisions and reserves 10. Internal risk system in managing credit risk. 11. Systems and analytics to measure credit risk inherent in all on-and off-balance sheet activity, and risk concentration 12. Systems for aggregate credit portfolio quality monitoring 13. Ability and extent to anticipate the impact of changes in economic conditions on individual positions and the aggregate portfolio D. Credit risk controls 14. Independent review and assessment of credit risk management process 15. Management of the credit-granting function, effectiveness of internal controls 16. Systems to deal with deteriorating and problem credits. Central Banks also guard against bank failures providing emergency funding by way of loan discounting. If failure cannot be prevented, most countries have explicit or implicit deposit insurance systems in place to protect depositors and contain damage to the broader banking sector and economy. The cost of an actual bank failure in terms of the economic disruption cost would be deemed higher to everybody than the taxpayer subsidy given when a bank is rescued. The knowledge that banks are too important to fail does skew the risk/return tradeoff, favouring riskier lending practices.
Even if banks do enjoy implicit offi cial protection against failure, it is still in their best interest to maintain a high credit quality on their portfolio. A banks' cost of funds is affected by the strength of its balance sheet and the quality of its business (relative stability). Normally the credit ratings from the major agencies are taken as a proxy for this strength, and this forms a key driver for banks to guard the quality of their portfolio. However, even at this level the greatest risk to aggregate ratings comes from known exposure to a troubled sector or country, with less weight given to factors on how the individual institutions manage exposure. In October 2002, the fi rst rating agencies started downgrading Brazil's sovereign credit ratings. Latin Finance (7 March 2003) quotes Diana Adams, Managing Director in Emerging Markets at AMBAC Assurance Corporation 'All the insurers are worried about taking on additional risk in Brazil because of the risk of credits being downgraded to non-investment grade, even if they are performing.' This quote deals with insurance companies, but could be equally valid for banks. What it illustrates is that by having portfolio exposure to Brazil, the institution could be downgraded, irrespective of the actual performance of the assets to which the downgrade was being applied.

Maintaining a quality loan book is nevertheless in a bank's interest as strong banks have superior access to competitive funding.
Bank failures can cause economic disruption, and authorities will go a long way to prevent a failing bank for collapsing. This skews the risk/return tradeoff for banks.
The risk discovery process is known as due diligence.

Due diligence
Due diligence is defi ned as the effort a party makes to avoid harm to another party. Within the context of issues of debt or equity securities, it is the information provided by the issuer of a security and is intended to give information about all risks that could be inherent in its operations. Typical information provided includes legal, operational and fi nancial audits. In a broader context, due diligence refers to the process preceding the granting of a loan, or the issuance of a debt or equity security, and relates to risk discovery in a broad context. The information uncovered and provided as part of the due diligence process is shared between underwriters or participants in an issue, and a portion of this information is included in the prospectus or circular that is used to market the security to investors. All too often however, investors are being given very little time to study the prospectus, and often are asked to make commitments based on incomplete documentation.
When a company lists its securities, it is required to disclose certain information by the relevant stock exchange. The focus of providing this information is risk discovery and identifi cation, and not the regulation of the merit of an issue per-se. As part of a long list of requirements, the Securities and Exchange Commission (SEC) requires that issuers in the overview of their business discuss the sources and availability of raw materials, and whether the prices of the principal raw materials are volatile. The SEC does not set limits for or otherwise proscribe acceptable levels raw material price volatility and other such operational variables, it just requires that the information is disclosed.
Foreign issuers that wish to list their securities with the SEC are required to submit information that needs to be updated on an annual basis. For companies with more than US$ 10 million in assets, and with a class of equity that is held by more than 500 persons, this is done on form 20-F. In subsequent years, the issuer updates this information by fi ling its annual report on form 20-F, and is not required to follow the standard US format (known as 10-K). Additionally, companies are required to fi le fi nancial information in the format and with the frequency that they do to their home exchange (this is a current event fi ling done on Form 8-K). The implication of the fact that the company needs to have a home-country listing underlines the fact that the SEC registration requirements relate to transparency, but that the SEC itself cannot and does not regulate this issuer beyond ensuring compliance with the SEC and its laws governing the trading of securities in the US.
Form 20-F requires the issuer to disclose whether they have a Code of Ethics that calls, inter alia, for compliance with applicable governmental laws, rules and regulations. If the issuer has such a Code, it is also required to disclose how it operates. However, the Issuer is not explicitly required to state whether it is in compliance with applicable governmental laws, rules and regulations. Ensuring that it is, and taking action if it isn't, is deemed to be the job of the home country regulator. If there is a case of non-compliance, and if this is viewed as being material by the company it would need to be disclosed elsewhere in the form. Clearly, this leaves room for omissions.
Within the context of non-public issues, the due diligence process would still comprise the same risk discovery process, except that some aspects of it would be less formal. The issuer will be required to meet whatever disclosures are needed to provide comfort to the lenders. In practice borrowers would want to deal with the lenders that require the lowest levels of disclosure.
The length of prospectuses can run into the hundreds of pages with every risk factor commented upon. Missing is the consistent reporting of factors that allow for monitoring of these variables as they relate to a company's operations. In other cases, the prospectus does not focus on analyzing the true source of risk. Barito Pacifi c is an Indonesian plywood producer that issued equity securities to domestic and institutional investors in 1993. A detailed prospectus covered all Prospectusses can run into the 100s of pages, but often fail to address critical information.

The result of the due diligence process is contained in the offering prospectus that provides all key information about the issue, issuer and industry for potential investors.
For new bond and stock issues, the due diligence process involves the reporting of a signifi cant amount of operational and other information that allows investors to make their own assessment about the company and the merit of the issue being offered. The prospectus for the IPO of APRIL shares, written by the same underwriter as Indorayon's 1992 prospectus contained signifi cantly more information, and was almost twice the length. This did not necessarily refl ect improved quality as the 1995 prospectus coolly states that wood supply was non-reviewed information. Source: offering prospectuses for: Inti Indorayon Utama 5.8% Convertible Bond 23 Sep 1992 and 20m shares APRIL 6 April 1995 aspects of its operations, but said little about the pulp mill that the proceeds of the offering were to be invested in. The listing prospectus of APRIL identifi es the dependency of the company on successful operation of the Riau Andalan pulp mill as a key risk factor. However, the prospectus coolly states that wood supply adequacy (for this mill) was 'non-reviewed information'! (see Table 4.1) It is common practise to use external experts for valuation reports, feasilibility studies or industry overviews in conjuction with proposed transactions. Jaakko Pöyry Consulting is with regard to forestry related investments the most common name, whereas Hawkins Wright is frequently used to assess proposed new investments in production capacity. Often, the mere existence of a consultants' report is taken as a confi rmation that all is in order. The pitfalls lie in the scope of these reports and / or the (implicit) assumptions on which they are based. In 2001, a valuation report was prepared for the benefi t of publicly listed Singapore construction company Poh Lian that was proposing to (and did) take a stake in the company that ultimately controls what is now known as the United Fiber Systems' Kalimantan pulp project at Satui. At the time of the acquisition, the tangible assets comprised of a 259,900 hectares forestry concession covered with 75,751 hectares of plantation forest and 44,220 hectares of merchantable timber. The consultant issued a valuation for these assets and another 14,400 ha of more recently acquired land, and based the valuation on the discounted value of timber to be harvested. The assumed harvest volumes in turn assumed that this company was planting 23,500 hectares of plantations per annum and did not even question the ability of the company to do so. Even for a company with ample fi nancial resources, restarting dormant operations and successfully planting 23,500 hectares is a tall order. But because the consultants did not even pause to discuss any pitfalls that might arise in the implementation of these plans, investors would be unlikely to do so either. Indeed, four years later, no additional plantings have taken place, but the same consultants' report is still quoted by analysts recommending the security to their clients, without even commenting on the implication of the inactivity between 1999 and 2004.
The lack of fi rst-hand borrower knowledge in international loan and bond issues, combined with the greater reliance placed on sector and geographical diversifi cations as a means of controlling risk have both led to a deterioration of effective credit risk analysis at the borrower level. Careful reading of annual reports on form 20-F or issue prospectuses would have shown up problems for a number of the issuers that went on to become bad credits. Most lenders of bond investors did not make this effort, and traded based on the credit ratings instead.
Despite the poor quality of prospectuses, competition and time pressures are such that when banks cannot get adequate or reliable information needed for a credit analysis, banks may dispense with fi nancial and economic analysis altogether and support credit decisions with simple indicators of credit quality, of which ratings are one. Because credit ratings are widely Table 4

.2 Statements made by Indah Kiat in its annual reports about its affi liated plantation resources
Year Comments on plantation resources/activity Actual pulp capacity 1990 none 1991 cumulative forest replanting reaches 50,000 ha and will proceed at 20,000 ha per annum 1992 cumulative re-plantings at Arara Abadi cover an area of 65,000 ha 380 k tpa 1993 HTI covers 75,000 ha, having expanded annually by 20,000 -30,000 ha 1994 continues to plant trees at Arara Abadi, its 300,000 ha HTI of which 90,000 ha has been set aside as an environmental reserve. About 94,000 already has been planted 1995 Receives the <Green Award> 1996 no comment on HTI 925 k tpa 1997 no comment on HTI 1998 no comment on HTI 1999 no comment on HTI Source: Indah Kiat annual reports. Table extracted from Spek, 2000 Time constraints often mean that minimal due diligence is done, with investors making their decisions on the cost of the issue, the rating of the issuer and their view on the outlook for the industry/ country of operations.
Where relevant, external experts are called in to value some or a part of the company's business or to express an opinion about the industry the company is engaged in. However investors often fail to read the actual experts' report or take note of the scope and/or underlying assumptions.
used by bank regulators as a proxy measure for credit quality, there is a tendency for lenders/ investors to use them as substitutes for their own credit decisions.
A low cost source of fi bre is at the core of a pulp mill's competitiveness. Having suffi cient information on this score, and of such a quality that would allow a lender to detect a relative improvement or deterioration of the situation is key to conducting an effective credit analysis and/or to make a sound assessment about the ongoing profi tability of a company. This makes it key information for analysts of both debt and equity securities.
Determining whether a pulp mill has suffi cient fi bre from legal sources falls within the realm of due diligence, yet is a key piece of information needed in the credit risk assessment. There is no formal mechanism to do repeat follow-up due diligence exercises once an issue has been launched. If a company lists its shares or bonds on a stock exchange it is under the obligation to fi le its annual reports (or 20-Fs) with the relevant exchange. The formal due diligence process is only repeated once the company decides to return to the market for debt or equity, but typically the repeat process is signifi cantly simpler as the issuer has a track record in the market, and for many investors, the fact that a prospectus has been produced is deemed suffi cient assurance.
A key challenge for credit risk analysis is that much of the operational information that is needed to make an informed assessment of the company's performance is often not disclosed by the company on a routine basis, making it diffi cult for the user to identify trends or make insightful comparisons with peer companies. In other cases, the information can only be inferred. Table  4.2. shows the statements Indah Kiat made about fi bre supply between 1990 and 1999 in its annual report about the plantations that would be supplying its operations with wood. During this period, the company's deadline date for fi bre self suffi ciency slipped from 1994 to 2003, and shortly after to 2007. Today, the company expects to be self suffi cient by 2007.

Ongoing (risk) analysis
The materials available for ongoing risk analysis are annual and interim fi nancial reports, other information released by the company, such as that contained on its website or in a general or investor newsletter, information released by similar companies, industry information and market observations. This can be supplemented with direct contact with the company. Companies will normally take visits from major institutional shareholders, and analysts employed by securities houses and banks. Depending on the country of incorporation and its securities laws, companies are available to all shareholders during its annual general meeting and or other open days. It is also increasingly common for companies to make presentations at broker-sponsored forums.
Ongoing (risk) analysis is carried out by a wide range of institutions, but the work of two groups of institutions is published and widely used in the broader investment community. These are credit rating agencies and security analysts. Both are discussed in turn.

Credit rating agencies
Credit rating agencies have been in existence for over a century, but their importance has grown over the past three decades since they became a formal tool to distinguish among grades of credit in various regulations under US federal securities laws. Credit ratings are also widely used as benchmarks in rules issued by fi nancial and other regulations, investment guidelines for pension funds and other investors. Both the rating and the rating report are inputs into the credit approval and review process of lenders and institutional investors. In the unregulated international bond markets, credit ratings are the primary means by which investors assess the quality of an issuer and individual debt issues.

The work of credit rating agencies and security analysts is widely used in ongoing (risk) analysis by investors and lenders.
Credit rating agencies assign grades to companies and securities issues that express the perceived fi nancial strength of subject companies. These ratings are formally recognised by the government and are incorporated into various securities laws.
The routine disclosures by companies are not as comprehensive as disclosures at the due diligence stage. This lack of information complicates the credit monitoring process.

Having a credit rating is a defacto requirement for a companies wishing to issue securities in the international capital markets.
Credit rating agencies are private companies that are licensed by the relevant capital markets authority to provide credit ratings for companies and their debt issues. A company pays to get its debt rated, and the agency derives additional revenues from selling information about its ratings, as well as ancilliary services, to institutional investors. In the US, two of the four leading credit rating agencies are (part of) listed companies, and the industry is not subject to formal regulatory oversight.
The objective of the work of a credit rating agency is to determine the creditworthiness of a borrower and a specifi c issue (these can be different, because debt is issued in different classes and will have different security/collateral attached to it). In specifi cs this means the company's ability to service its debt, and to redeem the issue on maturity. Each agency has strict guidelines on how the establish these levels, and on how the identifi ed parameters translate into a given rating. A credit rating is typically expressed on an alpha or alpha numeric scale that has about 12-16 gradations. In addition to the credit rating per-se, which becomes public knowledge after issuance, the agency will produce a report explaining the rating. These reports are available to subscribers only.
A major input for credit rating agencies are a company's fi nancials. It is not the job of the agency to determine whether these fi nancials are correct: the responsibility the fi nancial statements lies with a company's management; and auditors express an opinion on these statements after ensuring that these statements are presented according to the generally accepted accounting standards of the relevant jurisdiction. What the agency does or should do, is determine a company's ability to meet its fi nancial obligations, and extrapolate how future developments (debt issues, investments, changes in the industry dynamic) will impact the fi nancial position, and apply their knowledge of developments of the industry that the borrower is engaged in to strengthen their assessment. The rating expresses this ability, and when an agency sees relative improvement or deterioration, it will fi rst signal a revision and its direction (Credit Watch positive or negative) followed later by the revised rating. The agency will also monitor the trend of a company's fi nancial strength: the fi nancials might show continued profi tability with a declining cashfl ow. It would be the agency's job to notice this, and to highlight the impact on debt serviceability.
Credit rating agencies base their work on access to a company and its fi nancials, and supplement this with the unique insights they have into industries as a result of consistently tracking large numbers of companies in any given industry across the globe. While they have no superior access to a company as compared to major holders of their debt, they do have a knowledge advantage that is unmatched by individual lenders, and for this reason these lenders feel comfortable to rely on the assessment of rating agencies. Many lenders also do not have the resources to track each credit as closely as might be warranted based on the exposure. For them, buying the ratings reports that provide the background behind the ratings is a more effi cient means of tracking the credit. A look at bond-dealers' price lists show that price, issuer domicile, issue maturity and duration, rating and industry are the key parameters on the basis of which debt is traded.
Lenders are often under time and competitive pressure in making loans, and preference of borrowers prefer to deal with undemanding lenders. A lender who wants to drill down too deeply into a company's operations and fi nancials is likely to be cold shouldered by the company in favour of a hungrier institution that has more automatic faith in the management; spurning a leading rating agency is not quite so easy. This is a reason why rating agencies provide a valuable service. Credit rating agencies are not free from pressures. A company's rating and changes therein have a direct impact on the cost of a company's debt, and/or changes in the traded value thereof. If the downgrade would result in a company losing its investment grade status, the reverberations would be even more serious, as many holders of its debt would be forced to divest it. An example of the importance of ratings applies to Weyerhaeuser when it took on US$ 8 billion in additional debt to fi nance its acquisition of Willamette. This debt raised its ratio of long-term debt to total capital to 62%. At the time nearly 1,000 public companies had a similar fi nancial structure, but only 47, including Weyerhaeuser could boast a rating of triple-In actual fact ratings are not as objective as their legal status might suggest them to be. Judgement plays a considerable role in the rating process.
Ratings are widely used when investment decisions have to be made at short notice.
Companies pay the credit rating agency to monitor it, and the agency will issue a report when it changes the credit rating assigned to a given company. The ratings refl ect the APP group's aggressive fi nancial profi le, heavy debt maturity schedule over the next three years, and exposure to uncertainties in Indonesia's economic, political, and regulatory environment, which could severely impact its liquidity and fi bre supply. These factors are mitigated by low operating cash costs, access to abundant fi bre, extensive operational integration, and a diversity of production facilities and end markets. The group's low-cost operations, achieved through low labour costs, high utilization rates, and its access to cheap mixed tropical hardwood from Indonesian forestry concessions, allow it to compete aggressively in global markets. The terms of licenses to forestry concessions held through affi liate companies, however, could be subject to change, or the cost of fi bre may rise, particularly given the current uncertain economic and political environment in Indonesia. Such events could lead to a weakening of the group's fi bre security position for pulp production. Source: contemporary media reports as carried on factiva / Reuters Business Briefi ng B or higher. This rating was higher than that of Georgia Pacifi c Co (long-term debt of 68% of capital), and equal to that of International Paper with long-term debt at 52% of capital. Cynthia Werneth, forest products analyst for the rating agency Standard and Poor's gave the following explanation for this 'The difference in the ratings revolves around the "strategic opportunity" at Weyerhaeuser compared with its competitors. With the Willamette acquisition nearly completed … Weyerhaeuser will have opportunities to expand markets and cut costs. Georgia Pacifi c and International Paper are both in later stages of their recent acquisitions and the quick benefi ts of a merger are behind them' In its discussions with Standard and Poor's Weyerhaeuser indicated it would rely on cash fl ow to pay down debt (as opposed to selling assets). The rating also assumed that 'Standard & Poor's does not anticipate meaningful additional acquisition or share repurchase activity within the next two years' [Jones, Dow Jones Newswires 19 February 2002] It is thus seen that the assessment of credit rating agencies is very important. For this very reason also, agencies are reluctant to give ratings that anticipate, or that could be controversial. Ratings have therefore become more of a lagging than a leading indicator, and the agencies consistently fail to sound adequate warnings before corporate failures. A US Senate investigation on the rating agencies' work on Enron found that their work 'fell far below the careful efforts one would have expected from organisations whose ratings hold so much importance' (Kanjorski 2003). Ratings reports also show that the agencies implicitly trust what companies tell them, and will not double check that information. Rating agencies may be viewed as independent and without confl ict of interest, but this does not necessarily mean that the quality of their work is always of the highest level. In many cases, this is a function of the diligence of the individual credit analyst. Table 4.3 shows how APP company ratings changed in response to, rather than anticipation of key events.
Opinion also has a role in ratings. Following the Argentinian default in 2002, many Latin American borrowers faced downgrades. (Latin Finance 10 August 2002). Clearly, these are ex-

Box 4.3 Rating agencies and fi bre sources.
Standard and Poor's website lists the rating criteria that it applies to its ratings. These are general criteria, and mention that for specifi c industries (pulp and paper is mentioned), other factors may be taken on board. Standard and Poor's has not responded to CIFOR's queries on how they deal with the evaluation of woodfi bre supply for pulp mills. Part of the answer may be gleaned by reading the Standard and Poor's rating report that Aracruz posted on its website in 2003.
This report states that Aracruz controls 100% of its fi bre needs, even though Aracruz, in its 20-F of 2002 writes that 'during 2001 and 2002, we were able to meet almost 65% of our wood fi bre requirements from our own eucalyptus forests' (p 19) On page 27, the company further clarifi es that it obtained 6.2 million cubic metres from its own eucalyptus forests, and that 2.2 million cubic metres. were purchased externally. Of this amount 905,000 cubic metres were bought through its Forestry Partners Program, effectively refl ecting a source of captive supply. However, even if the Forestry Partners Program is deemed to be a controlled source (look at palmoil in Indonesia and it will be apparent that this assumption might not always hold up), this translates into 85% control over raw materials. The Standard and Poor's report states that because of the access to wood grown by Veracel, Aracruz has suffi cient fi bre to feed Fiberline-C, but does not deal with the question what happens in 2005, when the wood supply agreement with Veracel runs out, and Veracel's own mill will start production. Aracruz in its 2002 annual report mentions that it needs an increase in its forest base of about 72,000 hectares of eucalyptus plantations to meet the demand for Fiberline-C. Implicit in this number is that the company expects annual mean annual increment of 56 cubic metres per hectare over the entire 72,000 hectares if it is to obtain suffi cient fi bre. This number (56) is higher than what the company is currently getting. Standard and Poor's does not deal with these issues of fi bre supply, nor do we fi nd these discussed as a risk factor. The section on risk factors in Aracruz's 20-F is extremely comprehensive, and even analyses the risk of terrorist events such as 9/11. With respect to plantations, the risk factors identifi ed are: [1] changes in laws limiting the extent of land the company can own, and [2] overall statal restrictions on planting. The risk of disease in its clonal plantations, or a slowdown in the mean annual increment are not addressed, nor is there any direct mention about the risk of starting Fiberline-C without secured fi bre, even those though these factors would be more critical to the direct operations of the company than 9/11 like events are. These factors are also less evident to an offi cer in charge of general credit than terrorism-related disturbances are. The rating agencies do little to put this straight. post changes with no predictive value, as the debt of the affected countries would have been sold off ahead of the rating change in line with the higher perceived risk by the market.

Securities research
Securities research does not constitute due diligence or a risk assessment exercise per-se. Securities research is published by stockbrokers or banks as a service to their clients who deal in the securities discussed in the reports. The best research correctly anticipates how a security of a company will perform in the future based on a sound analysis of the company, its industry, and what changes are likely that will impact the earnings of subject companies. Thus the narrow value of research lies in the analysis provided, the investment recommendations made and the ability to enhance the decision making process of the investor. The broader value lies in the information fl ow provided by a number of (one hopes) competent and intelligent observers of an industry who spend signifi cant amounts of time tracking companies and should thus be intimately comfortable and familiar with their operations. Securities research is also widely read by banks and other groups of investors, who use it to be updated both about the industry as well as about individual companies. This explains its inclusion in this discussion of credit risk analysis. Research can relate both to existing debt issues or the equity that are being traded in the secondary market.
The process by which securities research is produced is more fl exible than the process underlying credit ratings. Industry ethics as expressed by Code Of Ethics and Standards of Professional Conduct of the CFA institute demand that investment recommendations have a 'reasonable basis' (Standard IV, item A 1). They do not prescribe what information has to included in a report; this is left to the best judgment of the analyst -rightfully so. The best research calls come from a deep insight and understanding of the industry combined with a thorough understanding of the market where the security is traded, and can be made in a very concise report. There is no requirement that an analyst publish reports with a given frequency nor that these reports need to cover all aspects of a company's operations (although sometimes they do). Securities research can thus be useful as one source of input, but it cannot replace the need for a lender or investor to conduct its own due diligence.
Research is a key differentiating factor between brokerage houses, and a major pull factor in attracting clients, alongside such factors as broadness of coverage across industries and countries, placement power (for primary business, i.e. the selling of debt or equity newly issued by a company to investors) and execution (for secondary business, i.e. the trading of debt or equity issues after these have been placed for the fi rst time). A number of fi nancial publications organise formal rankings of brokerage houses and their research based on client polls. Achieving a top ranking is often an explicit business goal of brokerage houses, and can be stated ahead of actually being profi table. The thinking here is relative: broking and underwriting revenue fl ows can be highly cyclical, but the house with the highest ranking is likely to get a larger share of the pie.
Just as an analyst can make recommendations on a given company, the analyst can also make recommendations for a specifi c industry. This is particularly so when the key determinants for profi tability are industry-wide as is the case for commodity producers. Pulp producer A may be more competitive than pulp producer B, but both companies profi tability trends will be infl uenced by the same major factor: the price of pulp. For such companies the fi rst decision is whether or not one wants to be invested in pulp. The next decision is then which company's stock to buy, and up to what price.
In keeping with the investment characteristics of the sector, most research on the pulp sector is published as industry wide research, and its objective is to keep a pulse on the aggregate market by looking at product pricing trends, and updating stock valuations, or simply by reporting industry relevant news snippets. Company specifi c pieces accounted for less than 15% of 1,585 items retrieved when searching the First Call electronic database that is widely used by the investment community for research on the forestry sector (including logging, pulp and paper, and plantations) published between 1 July -31 December 2003. The vast majority of company specifi c items are short notes on earnings. All of the former count as maintenance research. Value added research, that delves deep into sectors and companies accounted for an estimated less than 2% of the total amount of research produced during the period.
We saw above that the focus of pulp sector research is sectoral, rather than company specifi c.
The key drivers of profi tability -pulp prices and sector-wide capacity utilization -affect the entire sector. Corporate profi tability is, however, also infl uenced by costs, and when a number of Latin American and Indonesian companies started issuing securities they attracted ample attention. These companies operate in countries where wood costs are 50% to 35% of their developed markets competitors. Such competitive advantages make a compelling investment case for holders of debt, though high interest charges typically dilute much of the cost advantage to the shareholders of the company. The low cost base of these companies has consistently been one of the major drivers for investors to buy the stock of developing country pulp producers.
Given the key importance of fi bre supply to cost competitiveness, it is surprising to fi nd that only 7 documents out of 1,585 relevant publications issues between 1 July -31 December 2003 explicitly dealt with this issue. These 7 documents contained 13 references to fi bre supply. In all instances these were reactive: the analysts wrote about it, because fi bre supply affected the company's expected earnings at that point in time and because the companies themselves raised the issue. The specifi c instances involved fi bre shortages in the US North East (January 2004) and US South (September 2003) and their impact on pulp prices, the impact of fi res in British Columbia on fi bre supply (August 2003), expected declining production costs once wood supply self suffi ciency would be achieved (results conference call of Aracruz October 2003), higher cash costs due to increased wood supply costs resulting from additional purchases of third parties (Votorantim, November 2003), and restructurings of Stora Enso's forest holdings (December 2003).
It is more diffi cult the fi nd a reference to fi bre supply without this being in direct reaction to some news item. Such a reference was found in the January 2000 Brazilian Paper and Forest Sector review published by J.P. Morgan. The 133-page report initiated coverage of the pulp and paper sector and discussed three companies, Aracruz, Klabin and Votorantim, and carried on average 25-pages of information per company. A close analysis of this information, however, quickly showed that the information provided was the information that could be obtained from the company, but that no effort was made to comment on areas where information was not provided. The section on Aracruz detailed its land holdings and planted status of its plantations, the improvements in harvests per hectare on the one hand, and the reduction in the use of fi bre per tonne of pulp on the other. But we read nothing about the actual cost of this plantation fi bre. The report on Klabin again detailed landholdings, but did not comment on how the company meets the fi bre needs of one of its entities, Bacell, that according to Klabin's own admission needed to source fi bre externally. For Klabin we get no data on average annual growth rates, or fi bre consumption per tonne of pulp. Comparing these numbers against Aracruz would be interesting, both to see how the plantations of the two are different in absolute terms, and to what extent one is catching up with the other. The fi nal report on Votorantim makes no mention on fi bre supplies at all. This again shows that the analyst produced information that was available, but made no effort to test the claim of the low cost fi bre.
Analysts have access to the management of a company, and are in a position to ask about fi bre supplies or other factors relevant to the company's operations and fi nancing, but do not appear to do so. Even if a company might not answer as such information is non-public, the analyst might still try and piece the fi bre supply picture together independently. This did not happen. This is not to say that the analyst in question did a poor job: this report was by far one of the most comprehensive introductions to the Brazilian pulp industry that we have seen published over the past fi ve years. What the report does show, is that analysts deal with information that is (relatively) readily available for them. If one were to look at plywood sector research produced by the same broking fi rm at the same time in Malaysia and Indonesia (actual example is WI Carr), there would be a consistent view on the development of the plywood price, but the discussions of the sectors in each of these countries would not cover the same ground. In Indonesia, the research (whether by this broker or a sector piece from another broker) would typically include the description of the sector -the available forest resources and annual cut -but this information would not be included in the Malaysian report because in that market these statistics were not so readily available. That the statistic is quoted does not refl ect that the analyst viewed this as necessary information and therefore provided it, than that the analyst had the statistic at hand, and therefore included it. In the former case, the analyst, or the common research director overseeing efforts by both analysts, would have wanted to make sure that the analyst for Malaysia also tried to estimate these statistics for Malaysia, and think about how they would affect the sector call.
Given the crucial role that fi bre supplies have in pulp production and its costs, one might expect analysts to pay some attention to both availability and cost. As it is, this is not happening, also because equity does not value forest holdings in the way that, for instance, oil and gas and mineral reserves are integral to the valuation of energy and mining companies. At present, the implicit assumption is that there are ample fi bre supplies so that their availability nor cost need serious contemplation, and only temporary disruptions in this otherwise stable supply merit notice. The starting of a trend by European producers (Stora Enso and Mreal) to sell their forest resources off to pension investors might change this.

Corporate disclosure
Corporate annual reports and websites are a key source of information of creditors and analysts.
Companies are under the obligation to publish audited fi nancials, but there are no formal standards governing what non-fi nancial information companies report about their operations (although this is beginning to change, see Chapter 5 below). Relevant information here would be production capacity, and actual production and sales volumes and prices received for each product line, as well as consumption volumes of key raw materials and energy, and labour statistics. In the case of a pulp producing company, this information should comprise an accounting for log consumption and log sources. This information, some of which may be found in a thoroughly compiled prospectus, has a place in annual or periodic reports, yet is not always reported, and when it is, the format from year to year might differ.
Lenders can require that their clients make key information available, but not all companies are necessarily willing to provide the detail required, and for large syndicated credits it is fair to say that information disclosed in annual report and to the markets by way of the website or periodic releases is all that a creditor will ever see. In many cases, companies will be extremely reluctant to provide any additional information, either for competitive reasons, or out of fear of running into problems with regulatory authorities for being selective in the disclosure of information.
We anticipate that reporting standards will evolve signifi cantly from here, following the launch of the Global Reporting Initiative (GRI) in 2002. The GRI is discussed in more detail in the next chapter.

Longer reports can contain a lot of information, but this is typically information that is readily available.
There is less evidence of analysts drawing up a schedule of relevant information, and trying to piece together this data as well as is possible.
The growth in popularity of the GRI, along with a movement for higher disclosures is likely to result in improved reporting in the future.
If companies do not want to release operational information, they will shun lenders who demand it, settling instead for less demanding lenders.
Corporate disclosure has typically taken the form of the fi nancial results of its operations, because this is required by fi nancial regulators. The understanding of these data could be enhanced is supplementary information about operational variables were available but there are no formal reporting requirements for this.

Conclusion
The risk assessment and due diligence practices of banks are not in themselves suffi cient to identify poorly performing or unsustainable pulp producers. While extensive due diligence may be conducted, it does not result in fi nancing being denied when weaknesses are found. The more usual approach is to look the other way and de-emphasize the weak point in question. In many cases critical risk factors are not addressed.
Financial institutions take a portfolio approach to risk management where sector and country allocation take precedence over individual issuer analysis. Issuer strength is critical with regard to loan pricing, but this is typically assessed based on credit risk ratings that are given by rating agencies.
Owing to disintermediation and competitive pressures, lenders and investors do not have access to unambiguous and relevant data about their investee companies that would allow them to make a more detailed credit assessment at the company level should they want to. Work of the parties who do monitor companies and industries on an ongoing basis, such as credit rating agencies, similarly does not provide evidence that they proactively and effectively track key factors infl uencing the company's competitiveness, and make an effort to obtain or estimate these data where they are not given. The work also refl ects a high level of reliance on information provided by the company, and little independent investigation into areas on which the company is silent. In such cases, when problems come to the surface, the damage will already have been done, and the credit downgrade that follows is reactive rather than predictive.
Since the late 1990s commercial banks have taken greater responsibility for their lending actions by integrating social and environmental considerations into lending policies that were previously guided by economics alone. This was both an expression of Corporate Social Responsibility and a response to criticism by green parties and non-governmental organisations (NGOs). Initially, banks adopted corporate values and business principles, that in some cases later found expression in explicit do-no-harm policies. In 2002 a large number of commercial banks took a step further, by proactively drawing up a code that would govern their project fi nance activities. This code is the Equator Principles.

Equator Principles
The fi nancing of the proposed Chad-Cameroon oil pipeline was the direct catalyst for the formulation of the Equator Principles. A bank that was bidding for a lead role knew that participation would invite a barrage of criticism from various parties, and on the other hand realised that turning the business down would be handing the mandate to a less scrupulous competitor. This dilemma was shared by a number of banks, and as such the concept of creating a level playing fi eld by way of formulating a code of fi nancing principles found rapid acceptance. In order to ensure the impartiality necessary for broad acceptance, the IFC was approached as a knowledgeable third party. This was a logical choice: the IFC combines practical project fi nance experience with the application of standards that have evolved over more than 20 years to take account of changing notions of development and of how to effectively apply such standards to commercial, rather than concessionary loans or development grants. The speed with which banks and even ECAs are now signing up to the Principles is indicative of the need that they meet (Lazarus 2004).
The Equator Principles are an industry approach for fi nancial institutions in determining, assessing and managing environmental and social risk in project fi nancing. The signatories of the Equator Principles have committed to only fi nance projects that meet World Bank /IFC industry standards, and if the project is located in a developing country, IFC safeguard policies are also applied. Based on the Equator Principles, potential projects will be classifi ed based on the environmental impact. The classifi cation guidelines follow those of the IFC, and dictate what safeguards have to be followed, for which detailed sector-specifi c policies are then available.
Projects that fail to meet the Safeguards will be denied fi nancing.
The Equator Principles apply only to a small portion of total funding extended to pulp sector, because commercial fi nancial institutions typically fi nance pulp projects with structures that do not count as, and are not subject to the same screening processes as project fi nance, such as a Eurobond issue. The Equator Principles are nevertheless highly signifi cant, fi rstly, because

Impact assessment and safeguards
Lacking the experience to formulate lending guidelines, a plurality of commercial banks worked with the IFC to develop a code that would guide their cross-border project fi nance activities. This code is known as the Equator Principles, and is continuing to gain in popularity.
Banks have begun to incorporate social and environmental considerations into lending practises that used to be guided by economics alone.
Project fi nance accounts for only 2.8% of developing country pulp mill fi nancings, and for this reason the Equator Principles have a negligible direct impact on shaping pulp mill investments.
The Equator Principles apply to project fi nance.

Box 5.1 Signs of success for the Equator Principles
• growing share of project fi nance transactions are Equator Principles compliant • project fi nance transactions show a rising quality standard.
• the capacity of banks to assess the non-economic impact of their transactions independently is growing.
• Positive cost/benefi t ratio they were initiated by banks as a pro-active move to adopt safeguards, and secondly, because bank experience with them is likely to determine whether, how and what speed their application could be extended to other areas of lending. For pulp this is extremely relevant because pulp is relatively untouched by project fi nance, even at the initial project stage. The ultimate goal is to ensure that a growing percentage of all (in this case) pulp production is sustainable, not just that fraction touched by project fi nance.
The principal motivation of the banks to forge the Equator Principles, or to join the initiative, is to have a standard by which they can assess their project fi nance operations, and know that provided these standards are followed, their fi nancing actions will not become subject to negative publicity. At the same time, these standards create a level playing fi eld among banks, and with the number of signatories growing, signifi cantly reduce the risk of lost business as a result of applying high lending standards. Properly implemented, the Equator Principles also come with critical benefi ts, such as higher project quality, and a greater information fl ow, both of which directly benefi t the credit assessment process. For banks, the Equator Principles will have been successful if their implementation does not lead to a loss of business, if the repayment performance of the loans is higher than average, and if their role in project fi nance transactions in developing countries invites less criticism as a result. The Equator Principles will have been successful if progressively more fi nancing transactions adhere to them. Nobody wins if the Equator Principles only succeed in moving business away to less scrupulous fi nanciers or different markets whose players have not committed to the Equator Principles, and this is why it is important to get as broad acceptance for the Equator Principles as possible. The majority of commercial banks active in project fi nance have already signed up, with the fi rst MDBs and ECAs now following.
The experience of Equator Principles signatories is key to progress in implementing the safeguards across other lines of business. The press releases issued by the signatory banks and posted on the Equator Principles website give insight into their motivations for signing, and in some cases also reveal what they hope to gain from it. For the majority of banks, the Equator Principles are one way of giving recognition to environmental and social issues in business conduct. For these banks, the Equator Principles fi t within the broader framework of Corporate Social Responsibility, and are a way to achieve progress ahead of legislation. Another attraction of the Equator Principles is that they are both a practical approach grown from actual banking experience and a common framework to address the issues than can arise in the sensitive business of project fi nance in developing countries. HVB Bank made its commitment 'based on the conviction that sustainability not only acts as security for our basic life, but is also an important driving force behind corporate value. Sustainability creates new growth and earnings potential, reduces credit risks and optimizes work fl ows' and also sees the Equator Principles as a form of promoting transparency in business dealings. Credit Lyonnais welcomed 'the adoption, over time, of meaningful, internationally recognised standards in this respect to the benefi t of stakeholders in project companies worldwide.' This refl ects concerns that it is, as an institution new to incorporating sustainability and environmental concerns into its policies, and will need time for effective implementation. Post Equator Principles mistakes could invite even sharper criticism, as the case presently with Equator Banks being criticised for not warning the World Bank to adopt the recommendation by the Extractive Industries Review. Aware that success of the Principles also hinges on maintaining an active stakeholder dialogue, signatories to the Equator Principles initiated a dialogue with leading international NGOs in July 2004, and inaugurated a joint working group at the same time.
The EP would have been successful if a growing number of transactions are governed by them, and if these transactions result in higher quality projects than would be otherwise achieved. Failure would mean that the EP result in a loss of business to less stringent lenders, with overall lower project standards as a result.
Positive lender experiences with the EP is critical in getting broader application of safeguards across the banks' entire portfolio of business.
Banks look to the EP to defi ne consensus quality that will be recognised by all stakeholders.
Because the banks themselves were the driving force behind the Equator Principles, they want these to succeed. (a more cynical view might be that the Equator Principles are a green-wash for business-as-usual). We also recognise that in spite of this desire, the road to effective implementation will be bumpy. Banks will have to deal with institutional and capacity constraints, yet they have to recognise that they have to start taking responsibility for implementing the safeguards, rather than delegating this responsibility away.
There is a difference between the will and the ability to do something. Even where banks as institutions have signed up to the Equator Principles, implementation will only be effective when employees are encouraged to focus on the implementation process. Down the line, there will be managers hungry for business who view the Corporate Social Responsibility Department as another cost center eating into their bonuses. These managers are unlikely to encourage their staff to properly implement and monitor the Equator Principles, and will be glad when this responsibility can somehow be delegated away.

Box 5.2 Potential issues arising with Equator Principles implementation
In implementing the Equator Principles, the following issues can arise: • Given that the perfect project does not exist, compromises will have to be made. The IFC often does this in cases where it deems a project to be a positive net benefi ciary. Real life consists of compromises, but when external forces decide what values should be compensated for what benefi ts, it is possible that the relative order of importance of the values differs. • Application of the Equator Principles at present demands that all fi nancing meets all standards, and has no room for Corrective Action Plans. We recommend defi ning generally accepted practice and minimum accepted practice per sector (see Global Reporting Initiatives section below) and stipulating that Corrective Action Plans can only apply to raising generally accepted practice to best practice, while not allowing any criteria to be below mimum accepted practice • The effective implementation of Corrective Action Plans requires considerable in-depth knowledge of industries, social and environmental issues, in addition to monitoring capacity. Commercial banks, and for that matter, ECAs, do not have this capacity, possibly with the exception of having industry experts. The Corrective Action Plans do not require them to make an individual judgment, and thus it will come to pass that the assessment of the IFC, seen as vested with superior environmental creditials, will be accepted as fi nal. • Sponsorship of the Corrective Action Plans will in most cases give the IFC a fi nal say in what constitutes a clean environmental bill of health. In a perverse way, this could lead to a declining, rather than an inproved quality of due diligence. The participation of the IFC will, in the eyes of many bankers, result in reduced loan risk, because of the perceived leverage emanating from its multilateral status.

Safeguard implementation
The safeguards that the Equator Principles apply to their investments are those of the IFC. At the IFC, these standards have evolved over more than two decades, and draw on almost half a century of cumulative experience. The IFC categorises investments according to their socio/economic impact, and applies screening accordingly. Sensitive and irreversible investments (category A) are subject to the most extensive screening, followed by manufacturing investments with an environmental impact (category B) (See Appendix III). Category C investments are deemed to have no environmental impact and are not subject to screening. For the purposes of IFC's classifi cation system, a pulp mill is considered category B. Given the broader impacts of pulp mills especially in the newer production countries, it might be useful to revisit this classifi cation.
Even at the IFC, properly integrating safeguards into their operations is still a challenge. As recent as 1991, many of its loan offi cers were unaware of lending safeguards, and those that were aware often saw them as one more hurdle to doing business. In a survey done in 1991, many were found to not even be aware of them. Investment offi cers that were aware of the safeguards often saw them as one more hurdle to doing business. Ten years later, signifi cant progress was achieved, but actual performance still left room for improvement. A review of the IFC's safeguard policies found that 'the accountabilities that exist within IFC to date do not reinforce the message Banks also need to give thought to how to take responsibility for effective implentation of the EP. Blind reliance on third party assessments will not result in the institutional capacity development necessary to internalise social and environmental risk assessment into decisionmaking. Yet this is an essential ingredient in EP success.
As a result more than 40% of the IFC's investments approved between 1994-96 failed to meet their development objectives.
The IFC has worked with safeguards for more than 15 years, but they still have some way to go in fully internalising them into the investment decisionmaking process. The IFC's own Operations Evaluation Group reviewed 56% of investments approved in 1994 and 1996, and that were in a stage of early operating maturity. It found that 40% had a high development outcome and a high fi nancial return, 17% had a high development outcome with a low fi nancial return, 10% had a low development outcome with a high fi nancial return, and 33% of projects were unsatisfactory both from a development and a fi nancial standpoint. The projects reviewed were initiated about a decade ago, and to assess a more recent performance we turn to a more recent review.
In 2003, the Compliance Advisor/Ombudsman published a review of the IFC's Safeguard Policies. This review found that sponsor commitment was key to successful implementation of safeguard policies. Other critical determinants of success were 'teamwork between investment, environmental and social staff, clear communication with the sponsor and a strong and enforced national regulatory framework'. The Compliance Advisor/Ombudsman notes that 'because the sponsor is key… assessing commitment and capacity on environmental and social issues should be a fundamental aspect of investment departments' due diligence of a prospective sponsor'. The report fi nds weaknesses in the Environmental Assessment, and recommends improved quality control. In terms of the safeguard policies it fi nds a lack of specifi c objectives, weak project monitoring and supervision and poor integration of safeguard policies into IFC's core business. It recommends that safeguard policies state explicit goals and targets, report on them and demonstrate accountability for achieving them or not.
The Compliance Advisor/Ombudsman's recommendations are currently being reviewed, and are expected to result in refi ned policies and guidelines early 2006. A source close to the IFC who read this report in a private capacity expected that the new procedures would go a long way to improving the IFC's handling of environmental and social issues, without however going as far as commenting on the nature of the changes. It is to be hoped that at least some of these focus on how Environmental Assessments are being produced and used. In the Equator Principles (and elsewhere in the ECA/MDB universe) the responsibility for the Environmental Assessment continues to lie with the project sponsor, leaving the risk that a poorly committed sponsor serves up an Environmental Assessment that is of poor quality. This is a key weakness given the Environmental Assessment's role as umbrella policy for Safeguard Policies. The Equator Principles sets the scope for the Environmental Assessment, but covering a topic in general terms rather than specifi cs is still accepted practice. Nor is there evidence that the Environmental Assessments are subjected to a truly critical review by qualifi ed staff in the lending organisation, or that implementation is conform the Environmental Assessment. The criticism that the safeguard policies lack explicit goals also remains true (eg. IUCN/WWF 2001). The Equator Principles require monitoring and measurement, but seem content to have this done by external review. While not dismissing the value of an external reviewer/auditor, this should not relieve the sponsor and the team responsible for drawing up the safeguards of the responsibility to measure performance against clearly stated goals, and to act on it. Moreover, setting clear targets, and measuring actual performance will result in a tangible benchmark of what best practices are, and at what rate progress is being achieved. This is particularly true where projects do not meet all standards from day one, and where non-fi nancial conditionality clauses are a part of the loan.
The IFC has environmental and social experts on staff. As such, the problems lie in effectively integrating them into the investment process to make sure that recommendations are taken on board at an early stage of structuring a project and not as an afterthought. Banks and ECAs have no such experts, and all will gladly defer to a syndicate member with superior environmental credentials. We quote Johan Mowickel, Assistant Director General at Norway's Garanti-Instituttet for eksportkreditt (GIEK): 'When support is already offered by the World Bank, Norad or some other organization with strong environmental credentials, GIEK will not question the conclusion A more recent internal assessment of safeguard implementation still found weaknesses, but also stressed that sponsor commitment to successful SP implementation is critical for success.
Lending institutions need time to develop in-house capacity to assess social and environmental impacts. The ultimate challenge will be to ensure that higher standards translate into higher project quality.

Estonia Cell
Environmental Assessments can be made with serious omissions. An example of this appears to exist in the case of the Estonia Cell pulp project. Estonia Cell are proposing to erect a 140,000 tonne Bleached Chemi Thermo Mechanical Pulp mill. It will be the fi rst new pulp mill in Estonia since the 1960s and is expected to stimulate exports by way of adding value to local raw materials. The turn-key contractor is RWE Industrie Loesungen (Germany) and the main equipment supplier is Andritz (Austria). The total project cost is Euro 165 million of which the EBRD will provide Euro 19 million by way of taking an equity stake and providing a subordinated shareholders' loan. In this case the Environmental Assessment appears to overlook critical issues with regard to fi bre supply.
The estimated fi bre consumption of a 140,000 tonne pulp mill is 560,000 cubic metre per annum. The project documents for Estonia Cell state that the fi bre needs of the mill will be met from Estonia' s 115,900 hectare of aspen forests, that have a reported annual volume increment of 800,000 cubic metre At fi rst sight, this appears ample. However, the project documents do not clarify what other demand there is for these resources. Given that Estonia presently only has one kraft pulp mill (using long fi bre), there might be none. This assumption, however, counts without exports. Pulp and Paper International (August 2000) quotes Mr. Johnson, the Managing Director of Larvik Cell, Estonia Cell's Norwegian shareholders: '"Estonia has an abundance of aspen wood and the country's only existing pulp mill produces unbleached kraft and runs on long fi bre. There is no outlet for aspen." Johnson pointed out that Larvik Cell's pulp mill in Norway already runs on aspen sourced in Estonia.' This shows that despite there being 'no outlet for aspen', the fi bre is already being exported to Norway. The impact of illegal logging is equally ignored, despite there being widespread evidence of extensive illegal logging in the Baltic and Russia (WWF Latvia 2003) Finally, the study does not appear to deal with the impact on fi bre demand by proposed other mills.
In the course of the review process, the Estonian Fund for Nature has insisted on the use of FSC certifi ed wood, and according to the latest project documents (April 2004) this is now being included as a condition. Verifying wood sources is nevertheless not part of routine monitoring. Monitoring focuses on water levels, emissions and the condition of fl ora and fauna in the vicinity of the mill. If the certifi cation requirement is in practice upheld, the project will have the additional benefi t of acting as a catalyst for the development of a market for certifi ed fi bre. But the fact remains that had it not been for Estonian Fund for Nature, the issue would not have been properly dealt with.

Metsä-Botnia (Uruguay)
Metsä-Botnia Group subsidiary Botnia S.A. is proposing to build a 1m tpa pulp mill in Uruguay. It has applied for funding to the IFC, and supplied an environmental impact assessment as part of this process. The project information was disclosed on April 20 th , 2005, and the investment will be proposed to the Board on June 23, 2005.
The June 2004 Socio-economic study of the impacts of Botnia S.A. pulp mill project in Uruguay provides a review of the macro and micro impacts of this mill. The table of contents of the 132-page report is produced in Appendix IV, and the report even includes a commentary on the methodology followed to model the impacts of the pulp mill. The report, while apparently comprehensive, does not not provide clarity on a number of critical issues, and falls far short of what a proper assessment of the mill should consider. The following paragraphs highlight three concrete examples of where the analysis in the report is insuffi cient: forestry, land use and traffi c impact.

Forestry
The company is proposing to establish a 1 million tonnes per annum pulp mill that will obtain its wood supply from sustainably managed plantations. The report does not clearly show from where this fi bre will be sourced, and how incremental plantation land has to be planted to meet in this demand. The report does state that some of this (eucalyptus) wood will be obtained from Compañía Forestal Oriental S.A. (FOSA) of which Botnia is part-owner, while the balance will be sourced externally. According to the report, the mill will have an annual fi bre demand of 3.5 m cu.m. that we assume refers to debarked volume. The plantation stands of FOSA were 31,754 ha as at 2004. In the same year, there were two more certifi ed plantations with stands of 13,059 ha and 5,040 ha respectively. The report gives no information about the productivity of these plantations, however there is mention of fungal attacks of the eucalyptus, implying less than optimal productivity, and a problem to be tackled. Even at optimal production, these stands are insuffi cient to meet future wood demand. The total amount of plantations in Uruguay is given as 575,000 ha, but this is nationwide, and not restricted to eucalyptus. Charts of future fi bre supply meanwhile show that ample resources will be available, presumably by assuming that wood can be imported from adjacent Argentinian provinces that have about 330,000 ha of eucalyptus plantations. The report nevertheless concedes that there is a fi bre defi cit, and in the section on woodharvesting states: 'As of the present wood volume, by the turn of the fi rst decade, the apparent shortage of wood resources will be covered with the wood coming from plantations established from 2003 onwards.' In the section on recommendations, it states (and this is quoted literally) 'Foster investments if present harvesting technologies are limiting considering the available wood.' Clearly, this recommendation is too vague to even be of use. There is no discussion about what the impact would be if the necessary investments in plantations were not made, nor what would happen if any of the other mills that are on the drawing board were to be realised. The fi bre defi cit is not even mentioned in the summary and conclusions that also does not make mention of any of the concerns of the surrounding population.
Land use If the mill is to obtain its fi bre from sustainably managed plantations, more of these will have to be established. This is conceded by the report. The report does not provide a meaningful analysis of how the establishment of these plantations would impact land used by the current economic activities of the population, such as agriculture, cattle farming etcetera.

Infrastructure
The report discusses traffi c loads and infrastructure. The point is made that road maintainance is the responsibility of the Road Directorate where it concerns national roads, and the municipality where it concerns other non-forest roads. The analysis for Rio Negro shows that the cost for this municipality will be US$1m p.a. but this is balanced against US$1.4m in infl ows. The report is silent about the cost of road maintainance in the other two departments (as Uruguay's states are referred to) through which wood will be transported, but that derive little taxes from the mill.
The traffi c volume generated by the wood transport is calculated to be 20% of the magnitude of long-distance trucking traffi c to and from Montevideo. But because this traffi c will not be going to Montevideo, there will be no overburden. This is painting an overly optmistic picture. The daily transport of 10,000 tonnes of wood necessitates 324 trucks that make 1.5 round trips a day. So, on certain stretches of road close to the mill there will be incessant trucking volume. This will have a deteriorating impact on the road condition, and also result in considerable traffi c delays to the farmers that rely on these roads to take their cattle and crops to the market. No effort is made to estimate the latter impact.
The national/municipal authorities may be responsible for road maintainance, but the critical issue is whether they will have the funding. This is dependent not only on how taxes are shared between the central and municipal government, but also on whether any tax is actually being paid directly. Many large industrial companies are experts at working the tax code to their full advantage to minimise actual tax payments. In Brazil, Aracruz reported taxes due of US$82.0m, US$32.7m for 2000 and 2001, and a tax credit of US$15.5m in 2002. The taxes due were never actually paid. Much of the tax took the form of deferred taxes, while others were added to liabilities as future payables. In the cash fl ow statements, these amounts were duly added back, and actual income taxes paid were reported as only US$20,000, US$66,000 and US$140,000 in each of these years respectively. Aracruz is no exception in this case. Given the low actual level of income taxes that is paid on the forestry activities, despite large reported profi ts, any unwillingness of the relevant department to do proper road maintainance works should not come as a major surprise.
of that other institution.' (Mowickel 2002) In practice this will mean that the IFC will likely end up as a lead manager or key advisor in all environmentally sensitive projects. This can lead to disappointments while banks and ECAs assume that the IFC can effectively implement the Equator Principles. A better result might be achieved if all syndicate members would feel responsible for ensuring a sustainable outcome, as this would enhance everybody's bargaining power against companies whose bias will always be towards non-disclosure of critical facts.
The lack of institutional capacity to assess social and environmental impacts has acted as a barrier both for ECAs and banks to effectively implement higher standards. Remedying this will take time. First, there is a cost element: while the IFC is a commercial operation, it operates in a different competitive environment from most commercial banks because development is offi cially recognised as being as important as achieving fi nancial returns. This allows for the existence of environmental and social experts that will not be found in the realm of commercial banks whose need to deliver returns on their capital is resulting in an obsessive drive to maximise employee productivity. Progress is being made in that the IFC is devoting time to training bankers in Equator Principles assessments; and the fact that these bankers are being taught also refl ect that institutions are recognising the need to let their staff attend such sessions. The ultimate challenge will be to ensure that higher standards translate into higher project quality. With many other forms of compliance putting severe demands on bank time and resources, active thinking Measuring progress will be a key component in assessing the effectiveness of the EP, and encouraging broader active adoption of the principles into lending decisions.
needs to take place on how the best results can be achieved most effi ciently. This is further discussed in the section entitled 'Improving standards and implementing safeguards in existing operations'.
Projects that score weakly on some points of the Environmental Assessment can often still secure funding provided their sponsors commit to a schedule of improvements that over time results in full compliance with the sustainability guidelines that the IFC adheres to. Other lenders working with safeguards will have similar policies. At the IFC, such a schedule of improvements is known as the Corrective Action Plan, and adherence to the plan is a condition of the fi nancing. If a company fails to comply with the CAP it can be called in default, although we are not aware of any case where this has actually happened.
The rewards of the Equator Principles do not lie around the corner, and best practice will not be achieved overnight. Measuring progress is therefore important, also because progress will encourage broader adoption. Actively measuring real outcomes will also enhance the learning experience. 'What works and why, and what does not work?' is a valid question to be asked over and over again, with differing answers, depending on circumstance. The IFC does publish lessons on its site, but these are necessarily general, and are still heavily oriented towards the commercial and fi nancial aspects of its lending policies, with less focus on environmental and social issues. The section on timber, pulp and paper contained no lessons relevant to fi bre supply for pulp mills, whereas this is a highly sensitive area, where the IFC has both bad and good experiences.

Implementing safeguards in transactions in the international capital markets
The majority of fund raising by pulp producers takes place in the international bond and syndicated loan markets. For the Equator Principles to be effective for all new projects, and not just in the pulp fi eld, its reach needs to be expanded to include the international capital markets. While there is some overlap between Equator Principles signatories and major players in the international capital markets, there are also signifi cant omissions, notably in the realm of merchant banks without a High Street presence. Because of the need for a level playing fi eld, these institutions need to be brought on board before existing Equator Principles players can realistically be expected to adopt an in-principle agreement about extending the scope of the Equator Principles to other forms of fi nancing. Merchant banks have lagged behind commercial banks in recognising the role of Corporate Social Responsibility in their business, and adoption will likely be driven by existing Equator Principles participants with a signifi cant capital markets presence, such as Citigroup and Credit Suisse First Boston (CSFB). Because the international capital markets fi nance existing operations as opposed to new projects, a workable means of applying safeguards to existing operations is a precondition for extending the Equator Principles to the international capital markets.

Improving standards and implementing safeguards in existing operations
The Equator Principles lay down stringent requirements on areas of operations that companies rarely report on. In the case of project fi nance, these deal with anticipated events, not with actual operational realities -after all, the project is to be fi nanced, it is not already in existence. There has to be a mechanism, preferably in the form of an explicit commitment by the sponsor, that those operational variables will be reported once the project is in operation. Presently, external advisers The EP presently only apply to project fi nance transactions, and not to loans, bonds and equity raised in the international capital markets.
Many key players in the ICM are not part of the EP because they are not visible corporate lenders in that the lack a high street presence.
are employed to check, but this does not bring data into the public arena. Transparent reporting, and in a format that all interested parties can digest without requiring extensive time investments, will foster a greater understanding of what is being reported and how to assess the numbers. This will allow for more effective monitoring, and over time will lead to the emergence a body of actual performance standards, that a growing number of people (including banks) will learn to read and interpret. Best practice is one thing, but how to defi ne average realisable practice? Consistent reporting will also allow for trend monitoring. Is a company improving or not? And if a company is sliding back, what causes the problem? Over time, greater bank familiarity with assessing nonfi nancial performance will enhance their skill in assessing new projects.
Because of the absence of public data, we are in no position to measure progress with the Equator Principles. The Equator Principles website, citing Dealogic data, reports that Equator Banks arranged US$ 55.1 billion in of project loans in 2003, accounting for 75% of the total excluding transactions by government agencies (estimated at US$ 10 billion). What one would like to know is what the specifi c impact of the Equator Principles on the structure and conditions of these transaction was, and in what cases application of the Equator Principles resulted in the sponsor increasing standards.
Success with the Equator Principles, for all stake holders but specifi cally for the banks that are part of the initiative, will be a determining factor in how fast, and with what tangible effect safeguards are extended to other areas of lending. The more positive the experience, the faster we can see effective adoption.

Box 5.4 Limitations to the effectiveness of due diligence: Sino-Forest and the IFC
The IFC leads amongst the multilateral development banks in terms of the depth and breath of its due diligence, but this by itself is no guarantee that this automatically results in water tight investments. All investors and lenders will fi nd that some projects are more successful than others, and once in a while get caught. The IFC is no exception to this. Due diligence can overlook critical aspects of a company, or a company can deliberately mislead. It is not clear which was the cause of the slip-up with Sino Forest. In May 2000 the IFC made an investment in Sino Forest, a company that in March 2004 revealed that it had signifi cantly less plantations than it stated all along in its periodic and annual reports to the investment community.
In 2000, the year that the IFC made its fi rst investment, Sino-Forest reported 177,000 hectares of its own plantations, and an intention to develop up to 603,000 hectares with local Chinese partners. The company would not own these plantations, but be entitled to 70% of the woodharvest. The 50-year land use agreements would be held in the partners' names. Though 31 December 2002, the last annual report available for the company, the company reported plantation holdings of 232,600 hectares, without commenting on progress in the joint-ventures. In March 2004, it appeared that the actual extent of the plantations controlled by the company was only 120,000 hectares, though in June 2004, a fi gure of 146,000 hectares is reported. Both these fi gures are signifi cantly less than the area the company claimed to have when the IFC invested. In the intervening period, the company's debt increased from US$ 47.9million to US$ 155.3 million (liquidity levels were constant at around US$ 30 million in cash and short-term deposits, and the reported value of its timber holdings in the fi xed asset account increased from US$ 118 million to US$ 172.4 million), refl ecting also that a considerable amount of the debt raised and cash fl ow derived from operations went to support these plantations. The IFC made a second investment in 2002, and as a result is likely to have been in close contact with the company.
It later materialised that plantations developed by the joint-ventures were only 34,000 hectares and this will go some way towards explaining why the proposed initial public offering (IPO) of Sino-Wood (the entity whose subsidiaries entered into the joint-ventures) had to be cancelled. Sino-Forest instead did an equity issue of its own that was fully subscribed! Most remarkable is that after having signifi cantly overstated its plantation holdings, the one broker that we found covered the company, and that downgraded the company after the shortfall became known, reinstated its buy on the stock three months later, without explicitly touching on the implications of the plantation area shortfall on the quality and integrity of management. It should be mentioned that the downgrade to sell was made at US$5.48, whereas the price had fallen to US$2.50 by the time the upgrade was made.
Setting a mechanism for periodic public reporting of operational variables under the EP will allow for a record of actual standards to arise, that can serve as a benchmark to assess performance across the (growing) sample.
Existing corporate disclosure on operations is insuffi cient to yield the information necessary to apply the EP.
This would require a slight broadening of the reporting focus that is currently limited to sustainability.
Companies could be encouraged to supply more comprehensive reporting about their operations within the framework of the Global Reporting Initiative.
Effective application of the Equator Principles outside the realm of project fi nance requires that lenders can observe companies' actual operating performance and how this compares to best practices. Currently, and as already noted in the section on credit risk, this is not yet possible, as companies are only required to report the fi nancial result of their operations. The reporting of actual data about operations is only done at the time when new fi nancing is raised, and there is no set format that has to be used, leaving room for gaps in reporting.

The Global Reporting Initiative
The framework in which more comprehensive reporting can be obtained already exists in the form of the Global Reporting Initiative (GRI). The GRI's mission is to develop and disseminate globally applicable sustainability reporting guidelines for voluntary use by corporations. The Initiative was started in 1997 as part of the UN Global Compact, and became independent as an offi cial collaborating centre of the United Nations Environment Programme (UNEP) in 2002. Companies that follow the Guidelines, report on the economic, environmental, and social dimensions of their activities, products, and services conform specifi c reporting standards set by the GRI. At the start of 2004, 380 companies and organizations used the GRI Sustainability Reporting Criteria to report their performance. The GRI is developing sector standards that guide implementation per sector.
The value of the GRI lies in that it provides a framework for the actual reporting of performance indicators, and that it provides standards for how these indicators should be measured, and what should be reported. Thus, the actual sustainability reporting guidelines are supported by technical protocols, issue guidance documents and sector supplements. At fi rst sight, the apparent reporting complexity may be discouraging to users, and many fi nancial sector participants despair at yet more paper hitting their desks when they already do not have the time to even read a company's annual report. The counter argument is that only a well thought-out and well defi ned reporting framework can yield the data necessary to objectively observe performance. Because the report has a separate section of performance indicators, the information that is obtained by way of a lengthy process is available in raw format to the end user. Readers are highly recommended to visit the www.globalreporting.org website and look at the tables with economic, environmental and social performance indicators.
GRI reporting focuses on the sustainability of a company's operations, and therefore has no comprehensive reporting requirements governing all of a company's operations. However, even its present scope is already impressive and meaningful for companies with environmentally sensitive operations and can easily form the basis of the Operating Reviews that companies increasingly have to provide as part of their fi nancial or annual reports. As sectoral supplements are produced, these could be drawn up to provide a format that is useful for a comprehensive operating review.
The scope to expand the GRI to the pulp and paper sector exists, with 24 pulp and paper producers already using GRI reporting guidelines. 13 among them are also pulp producers. So far, membership is tilted towards developed country players, but we expect the membership list to grow. Aracruz and CMPC are, as part of the UN Global Compact, obvious candidates to join. So far, only International Paper reports in accordance with GRI although each is making progress in terms of what is reported in its annual and/or sustainability reports. The GRI has, however, not yet developed a specifi c reporting template for the pulp and paper industry.
With regard to pulp production, GRI sector standards can add value by devoting recognition not only to pollution in the production process, but also explicitly addressing the raw materials supply chain, and the chain of custody for traded product. This will prevent companies from disavowing responsibility for raw materials that are obtained from third parties. The reporting format has to be such that it provides a clear picture on the complete fi bre supply, covering all fi bre used in the operations and allowing for a cross check on this fi gure relative to total output.
Broader application of the GRI will allow for the emergence of a picture of best current practice across industries and across localities. Best current practice will always lag behind best practice for new projects because production technologies continue to evolve, as does the notion of what constitutes best behaviour. All stakeholders will need to recognise that best current practice lags behind best practice, and place the focus on raising standards, as opposed to outright rejection of anything that falls short of best practice. Alongside this, standards of minimum accepted practice could be drawn up, with fi nancial institutions, ECAs and other relevant providers of funding committing not to fi nance expansions by companies whose standards fail minimum accepted practice. If all Equator Banks commit to this, there is again a level playing ground. Banks win to the extent that identifi ng actual levels of practice can lead to more accurate pricing of risk. Responsible corporates win because this mechanism also allows for a more level competitive playing fi eld: the mechanism prevents funding from fl owing to poorly compliant companies and/ or rogue operators.
The voluntary nature of the GRI means that the poorest performers are unlikely to adopt GRI reporting, allowing their poor practice to go undetected. A sensible policy might be for fi nancial institutions and regulatory authorities to require that companies wishing to raise incremental funding and/or obtain export credit funding for a pulp mill supply GRI compliant sustainability reports. Even GRI reporting will not eliminate all problems. For instance, a business group with poor practices could easily form a new company in which selected assets are held, and hold this company to GRI standards. Through inter group loans, this GRI compliant company could Broader application of the GRI will allow for the emergence of a picture of best current practice across industries and across localities.
Best current practice will lag best practise, and broad stakeholder recognition that this is so will be critical in getting companies to report under the GRI.
A sensible policy might be for fi nancial institutions and regulatory authorities to require that companies wishing to raise incremental funding and/or obtain export credit funding for a pulp mill supply GRI compliant sustainability reports.
then raise funding to support the arms of the group whose operations might not meet minimum accepted practice. The old adage that bankers have to know their clients rings true as ever.
GRI reporting comes with costs and benefi ts. Companies incur a fi nancial cost to produce GRI compliant sustainability reports. According to the GRI FAQ page, the cost of GRI reporting is less than US$500,000 per year, but more so for very large multinationals. This is a large amount, but not an excessive amount in comparison to the fee costs associated with large debt and equity issues. Moreover, a growing number of companies already produce sustainability reports, and go through certifi cation exercises, suggesting that companies see a value in them. The major threshold to cross in adopting GRI is that companies will be reporting hard information on a comprehensive set of data rather than on selected data only. If there is dirty laundry, it will be exposed. This is where broad stakeholder recognition that best current practice lags behind best GRI reporting is voluntary and is likely to be shunned by the poorest performers. The worst performers would then automatically be disadvantaged in the funding process. Once GRI reporting is embedded, high quality operators can set themselves apart, and use this as an opportunity to conquer markets.

Box 5.7 Raising reporting standards governing fi bre supplies
Stora Enso has extensive forest holdings in Sweden, Finland and Canada, but is still dependent on external sources for a large proportion of its fi bre. It has wood purchase and logging operations in the Baltic Sates, Canada, Central Europe, Finland, Portugal, Russia, Sweden and the US. This division supplies wood to its operations whose self suffi ciency rate is 5% in Finland, 30% in Sweden and 12% in North America. Stora Enso is a GRI member, and in its 2001 annual report writes that 'the company pursues an environmental and social responsibility policy that is committed to developing business towards economical, social and economic sustainability'. In 2001 the Principles for Corporate Social Responsibility were formulated to complement the policy and values of the Group in a concrete way. The company's Mission Statement says 'We promote communication and well-being of people by turning renewable fi bre into paper, packaging and process wood products'. These statements could be backed up by providing transparent reporting on its fi bre consumption.
The 2001 annual report announces the company's intention to move into sawmilling to get more recovered fi bre, and also states that a new newsprint mill will run completely on recovered fi bre, so that the company's total usage would come to 2.8 million tonnes per year. Its investment in the Veracel pulp mill in Brazil will further increase the company's share of sustainable fi bre use. However, the report is silent on the status of its total fi bre consumption, the source, and the grade in terms of sustainability. Similarly, we get no information regarding the standards the company sets with regard to wood obtained through traders, or even by the company's own wood procurement department. Nor do we know what the company's targets for improvement are. Yet, Stora Enso have a reputation as having a cost-competitive fi bre base, and also as being a responsible company. Unfortunately, this cannot be independently verifi ed based on consistent reports about its operations. In the author's view, hard data would be worth more than multiple statements of intent and policy.
Industry wide adoption of the GRI will lead to greater transparency that will allow poor performance to be identifi ed. However, no matter how well the various safeguards are implemented, they can only address issues at the company level.
possible practice is important. However, if minimum acceptable practice is properly defi ned, GRI reporting can help a company meet consensus quality, with hard information to back it up. Any consumer has direct access to this information, and need not feel that he/she is being led astray by slick PR talk that might not properly refl ect the true state of affairs. We would also argue that once GRI reporting is embedded, there is a multiple payoff in terms of reduced fi nancing risk premiums and improve (consumer) market acceptance.
GRI reporting differs from certifi cation in that the GRI is a comprehensive and objective framework for reporting standards. Unlike certifi cation, the GRI does not focus on only one aspect of a company's operations, and does not specify what particular standards are to be upheld. The actual reporting of indicators by company under the GRI allows users to see what standards a company applies, and to decide whether these standards meet what they expect of the company. For a company to be recognised as a GRI compliant reporter, its reports have to cover its entire operations, limiting the opportunity to mislead. As such, the comprehensive observation of company-wide data affored by GRI reporting can only enhance the quality of external certifi cation.
External certifi cation of a company's operation has value in that it communicates to stakeholders that certain standards have been met in the area that was certifi ed, but certifi cation should never take the place of a company's own responsibility for its actions. But because certifi cation typically extends to limited areas of a company's operation, it can sometimes backfi re by giving a false sense of security. That a company's mill meets ISO 14001 standards is no guarantee that its fi bre supply is sustainable. Yet this may not be immediately apparent to the consumer who buys the fi nal product that has ISO 9002 and ISO 14001 certifi cations on the wrapper.

Conclusion
Commercial banks, working with the IFC have adopted the Equator Principles to guide their cross-border project fi nance activities. In so doing, banks are looking to create a level playing fi eld between themselves, while upholding recognised quality standards. If user experiences with the Equator Principles are positive, this initiative is likely to be more broadly extended to other areas of fi nancing.
The Equator Principles has little direct impact on pulp mill fi nancing activities of the signatory banks, because the majority of commercial fi nancial institutions fund pulp mills through loans and bonds that are not classifi ed as project fi nance, and thus not covered by the Equator Principles. At present a limited percentage of the institutions that dominate the markets where pulp mills raise their funding are not part of the Equator Principles. In the interest of creating a level playing fi eld, it will be important to get these companies on board, as this in turn will stimulate existing Equator Banks to extend the Equator Principles to their capital markets activities.
The full benefi ts of Equator Principles application will come only when every lender accepts and takes responsibility for ensuring project quality, as opposed to delegating this responsibility away. The fact that even the IFC by its own admission cannot guarantee positive development outcomes shows that there is as yet no fool-proof way that results in high quality projects.
GRI reporting requies that companies report hard information on a comprehensive set of data rather than on selected data only. This makes it a powerful tool to use alongside certifi cation, because much certifi cation is limited in scope and can therefore create a deceptive image of corporate quality.
The Equator Principles apply to new projects when ample information about the prospective project is being made available to lenders. Disclosure drops signifi cantly once a company is already in operation. If such companies are under a requirement to report their results, the requirement applies to the fi nancial results, but not to details about their operations. Because observing operational performance, and collecting data over time is important to arrive at a balance assessment of what has been achieved, where standards are and how these are changing, the reporting of relevant hard operational variables by companies is a critical step in raising standards.
We recommend that increased reporting is done within the framework of the voluntary Global Reporting Initiative. As part of this Initiative, industry specifi c reporting guidelines are established that have to be followed if a reporting company is to be in compliance. For the GRI to succeed with pulp producers, stakeholder recognition that accepted practices of existing companies will fall short of best practices is critical to success. At present, none of the 13 pulp and paper companies that are part of the GRI are reporting in accordance with the GRI, but we expect this to change over time.

Key fi ndings and recommendations
This study has reviewed how investments in new pulp producing capacity obtain funding, and the criteria that these investments have to meet. The specifi c focus of the review was to see why it is that companies operating unsustainable mills could still obtain fi nancing despite the fact that such companies pose a higher default risk as a result of being controlled by sponsors with a poor commitment to their business. A key fi nding here was that once mills are in existence, fi nanciers assume they operate within the standards laid down by relevant national legislation, and on that basis these fi nanciers go about their job of raising fi nancing for these mills at terms that the market will accept. Meanwhile, at the project stage, no mill is unsustainable, though rigorous application of safeguard screens could provide clear indicators as to which mills might go on to be unsustainable as a result of the use of unrealistic assumptions at the planning stage. Once a project goes on to be unsustainable, the high capital cost means that they are unlikely to be closed down, while the scale poses a challenge to remedial action.
Until a decade or so ago, fi nanciers saw their task purely as providers of capital, and did not accept any responsibility for ensuring that certain minimum social and environmental safeguards were upheld in the projects that were thus fi nanced. This attitude has changed considerably over the past decade, and the majority of commercial fi nancial institutions have now adopted policies or signed on to initiatives to uphold certain social and environmental safeguards in their lending practices. Along with conventional due diligence and credit risk assessment, this now means that both the will, and the tools to fi lter out unsustainable pulp projects exist. This study also shows why it is that nevertheless proposed pulp mills that have a very high likelihood to go on to be unsustainable, and companies running unsustainable pulp mills can still obtain fi nancing. The study identifi es existing processes and mechanisms that, if made more effective and/or applied to the pulp industry could result in higher standards. Below we summarise the key conclusions by topic, followed by recommendations to specifi c parties.

Key fi ndings
Unique nature of pulp mills Pulp mills are highly capital intensive investments that are generally made in locations close to a fi bre resource, as opposed to in highly industrialised locales, close to ports and large pools of labour. They will often be the single largest investment in a wide area, unless there is a competitor upstream. Their operations will impact on the environment, in terms of demand for fi bre, land and water, and in terms of increased traffi c fl ows. A previously tranquil locale will be turned into a factory site, with signifi cant impact on the surrounding environment. For some this spells opportunity, others fi nd their livelihoods threatened without having the ability to adapt. When pulp mills are established in countries with low levels of relevant regulation that properly takes care of net negative benefi ciaries, or where the implementation of these regulations may not be effective, they can cause considerable harm. This, combined with their de-facto irreversible nature calls for great care in their planning and establishment.
Yet, for all these impacts, that may even be more material than those of a pure resource based investment, pulp mills are typically classifi ed as manufacturing investments. Regulations governing them focus on pollution while ignoring the broader set of issues surrounding the entire mill and its impacts on the communities and biophysical environment where it operates. This is not only true for regulators in producing countries, but also for many of the arbiters of safeguard implementation.

Financing new capacity
Proposed and existing mills access different pools of fi nancing. Proposed mills have to attract fi nancing based on the projected future cashfl ows of the project, where existing mills can do so based on their existing operations. Combined with the highly capital intensive nature of pulp mills, this has meant that new mills almost invariably are started with large proportions of export fi nancing and multilateral credit, as these organisations fi nd the higher risk of these fi nancings balanced by the attainment of some of their organisational objectives (stimulation of export or development). Of the multilateral development banks, the IFC applies the most stringent screening criteria to proposed new investments, and these very criteria have now been adopted by the private sector for project fi nance transactions exceeding US$ 50 million. However, most private sector lending to the pulp sector takes the form of syndicated loan and bond issues, and is therefore not subject to these safeguards. Multilateral lenders have been effectively absent from the fi nancing of forest-based industries during the 1990s, but are now stepping up their activities again, in response to changed policies and a new pulp mill investment boom. On paper these proposed projects will all look good; the key challenge lies in looking beyond rosy projections to see where the weaknesses are, and to see how and whether these can be overcome.

Limitations of projections
When a new project is designed, all that investors are working with are projections. Projections tend to be optimistic in nature and not necessarily comprehensive, especially where they are provided by the project sponsor. There is therefore an extra onus on fi rst-stage fi nanciers to look beyond the projections and assess the sponsors, their business track record and their commitment and ability to deliver. It is then important to see at every stage how actual performance lives up to projections. In Indonesia's case, the four major pulp producers all projected to be self-suffi cient in plantation fi ber eight years after the start the commissioning of new capacity installed since 1990, but to this date the industry still obtains approximately 70% of its fi bre from the natural forest. The shortfall in plantation yields were apparent from an early stage, and should have sent a warning to anybody fi nancing their capacity expansions.

The Environmental Assessment
For projects that are subject to social and environmental screening, the project sponsor has to provide an Environmental Assessment. The Environmental Assessment addresses environmental, and to a lesser extent social, impacts of the proposed investment. The quality of these Environmental Assessments are highly variable, and in some cases fail to effectively and adequately address the social and environmental issues that are critical for the mill in question. Generally such assessments do not include the design of an effective system for monitoring the mill's performance over time. In many cases, there is no external review process of the Environmental Assessment that could point out perceived weaknessess and potential problems. Instead of preparing an Environmental Assessment with the intention of producing a tool that will contribute to the structuring of a sustainable project over the long term, it is often produced to 'tick a box' on the loan process form and is, therefore, of limited actual use. Not all externally bought research is of a uniform high quality or comprehensive in its approach.

Safeguards
Safeguards are principally applied with proposed projects. At the planning and initial fi nancing stage, they have the potential to be most effective, because they can help structure better projects in a way that is more diffi cult, if not impossible, to achieve once a mill has already been built. To have maximum effectiveness, they need to be implemented early on in the investment process, before project design is too far along to incorporate meaningful changes. After safeguards have been agreed upon and applied, there also need to be clear mechanisms for observing key variables related to a mill's performance and monitoring the effectiveness of those safeguards over time.
Whereas the IFC and MIGA incorporate a clause allowing them to call for early repayment of a loan if a sponsor is not meeting the requirements of the safeguards, the reality, especially for pulp mills, is that this call has no teeth, and that even calling the loan will not result in a reversal of the investment.

Due diligence and risk assessment
Due diligence and risk assessment procedures in commercial lending/investment transactions could be expected to reveal unsustainable practices where these result in threatening the economic viability of a project. In most cases of companies with unsustainable practices, these have been duly noted along with a host of other potential risks in a prospectus that protects the underwriter and issuer against certain liabilities, but that most investors do not even read. The underwriter, taking the view that the markets should decide what level of risk they are comfortable with, has disclosed the risk and priced the issue such that investors felt that they were being adequately compensated for the risk taken.
In actual fact, while there are no doubt individual fi nancial institutions that have declined to fi nance mills for such reasons, the aggregate fi nancial markets have been found willing to fi nance mills with severe operating weaknesses that would have been apparent had they bothered to look. Within the banking world, regulators and supervisers continue to bemoan the superfi ciality of the credit risk assessment process. This clearly has much to do with the large amounts of liquidity in the fi nancial system, and the competition between fi nancial institutions to lend/invest and maintain marketshare and critical size. Thus we are dealing with a systemic weakness, and not a weakness that is unique to the granting of credit to the pulp and paper sector. This does not change the urgency of raising standards such that mills that fail to meet certain agreed standards do not have automatic market access.

Due diligence and risk assessment of pulp mill investments
The international capital markets are a key source of fi nancing for pulp mills in countries with shallow domestic capital markets as a result of the capital intensive nature of pulp manufacturing.
Based on the assumption that if a mill is allowed to operate, it must be in accordance to the law, credit is given on the strength of a fi nancial strength rating, and the industry outlook, as a means to estimate the risk of non-payment. Whereas the chance of a non-sustainable mill not repaying its debts is frequently greater than that of a sustainable mill, fi nanciers often fail to address this issue because they view it as falling outside of their areas of competence and responsibility. More generally, they all-too-frequently underestimate the risks that unsustainability poses to a company's ability to carry on its operations. In many cases, fi nancial institutions also fail to rigorously assess whether the pulp mills they fund are operating in full compliance with the laws of the country in which they are located.

Limitations to, and quality of analysis
In making their investment decisions, the international fi nancial community relies heavily on industry and borrower reports produced by external sources. There is a tendency for these reports to discuss only what information is available, but not necessarily what is relevant. With respect to the pulp and paper sector, we found that the majority of analyst reports deal with industry factors such as projected product price development and supply and demand factors, but much less with the intricacies of a company' s operations and product fl ows, let alone its impact on the social and biophysical environments in which it operates -each of which might have meaningful repercussions for the continuity of its operations.

Equator Principles
Many lenders now recognise that they have a responsibility to prevent fi nancing from fl owing to poor quality projects, and have signed on to the Equator Principles. The Equator Principles apply IFC categorisation and safeguard screening to environmentally sensitive projects that use more than US$50 million in project fi nance. Because few new pulp mills are fi nanced using project fi nancing, the Equator Principles -as currently structured -are of limited use in fostering higher standards of pulp mill fi nancing by the international fi nancial community.

Safeguard assessment capacity
Banks and export credit agencies generally have no in-house capacity dedicated to implementing social and environmental safeguards, and therefore, they commonly rely on the judgment of a senior environmental partner (read: multilateral development bank) in the investment process. Banks must realize that even those institutions they believe are vested with such credentials face internal constraints in effectively implementing safeguards. Higher quality projects can only be originated if the origination offi cers themselves develop the ability to assess the quality and sustainability of a company's operations, and in doing so learn to look beyond what the company is showing.

Observing performance
To give meaning to discussions about where standards should be, it is important to move forward with means to report actual operating performance. To be useful, these reports should provide a comprehensive accounting of resource fl ows and use through the organisation, from the start of production through to the fi nal product, as well key impacts based on the EP guidelines. This reporting can start on a voluntary basis within the Global Reporting Initiative (GRI). The GRI is already recognised as a reporting forum by a growing number of companies, and it will provide a more level reporting playing fi eld. Including a summary of the key operating information in annual and fi nancial reports to the fi nancial community should over time foster better informed analysis of the structure of a company's operations, and the company's conduct of these operations.

Defi ning standards
The increased observation of actual operating performance will result in a picture of actual operating practice that is bound to differ from the ideal, high standards currently being debated. The ranges of actual operating practice should form the basis for multi-stakeholder discussions on what acceptable ranges are, what behaviour is not acceptable, and what targets are. Basing the discusions on the current reality provides a greater opportunity for a larger number of players to actually implement improvements, and report on these so that they can be measured. To the extent that the benchmark is an ideal state that even the best players haven't achieved, the remoteness of the target is bound to result in less real action on the ground.

Certifi cation and audits
Certifi cation and audits have a role to play in verifying previously reported data by a company. Certifi cations typically apply to only a portion of a company's operation, and criteria differ across certifi cation bodies, and in this way can be misleading. It is possible for a company to get its manufacturing processes and its forestry operations certifi ed. What might not have been picked up in the process is that the crop of the forest plantations is insuffi cient to support the company' s production volume, so that a considerable portion of the fi bre demand would be fi lled from external sources that might not be sustainable. While certifi cation and audits can play a useful supporting role, they cannot and should not take the place of a comprehensive operating report that, like the fi nancial statements, is signed by management. Similarly, audits may be made to verify what a company reports, but should not take away managements' responsibility for its operations.
All institutions upholding safeguards in their lending practice should aim to internalise the application of such standards rather than relying on third parties.

To users of safeguard measures
The safeguard measures that currently guide the implementation of new pulp mill projects are still insuffi cient to anticipate likely problems, and act to contain them. With regard to pulp mills, this is partly because the full impact of a pulp mill on its environment is not yet properly understood. In recognition of this, it is recommended that pulp mill investments are henceforth considered as sensitive and irreversible (Category A) investments, rather than as manufacturing investments with an environmental impact (Category B).
We recommend that that Environmental Assessments (EA) are externally reviewed to ensure that they comprehensively and objectively address all material aspects and impacts. We recommend that EA's include a specifi c schedule for implementation with a built-in monitoring programme. As a condition for obtaining fi nancing, companies should be required to make periodic reports releasing key operational and social/environmental variables, that may periodically be subjected to external audits.

To all stakeholders
A meaningful discussion about what behaviour is acceptable is necessary if fi nanciers are to meaningfully apply safeguards to existing projects. This discussion can only be had based on observed behaviour, not based on theoretical best operating practices. As such there is a need for more detailed reporting of operational, in addition to purely fi nancial, data by companies. For companies to make such reports on a voluntary basis, there must be stakeholder acceptance that actual operating standards are bound to be lower than best operating practices. It is recommended that stakeholders with divergent interests and agendas -including, for instance, both pulp producers and NGO's -fi nd ways to engage constructively to raise standards across the industry.

To the fi nancial community
Having signed on to the Equator Principles or adopted safeguard measures to guide lending to environmentally sensitive sectors, the fi nancial community now needs to work on effectively implementing these across their respective organisations and in the face of aggressive and hungry dealmakers, and managers pushing for a higher slot in the ranking tables.
Effective implementation of safeguards requires that safeguard assessment is embedded in the credit function. As a result, it is recommended that fi nanciers develop in-house assessment capability, rather than relying on external assessments. Financial institutions also need to think about how to uphold these standards in the many areas of their business where they are currently not effectively applied.
Because sponsor quality and commitment is a critical variable in the long-term performance of both a project and the securities/loans that fi nance them, sponsor track records need to be critically reviewed. In view of the damage that can be caused by unsustainable pulp mills, it is recommended that no pulp mill fi nancing is extended to sponsors with a poor trackrecord.

To regulators
We recommend that those (self-) regulatory authorities that set disclosure levels for companies with listed debt or equity securities include the reporting of concise and material operational variables in the periodic requirement. In setting these requirements, it is advisable that there is cross-coordination with the GRI to minimise the burden on the reporting entity.
In regulating lending institutions, regulators are advised to give due considerations to the broader societal and economic impact of lax lending practises, and pay closer attention to loan specifi c due diligence and credit risk assessment practises in their oversight.

To pulp producers
Pulp producers can make a fi rst step toward fostering a better understanding of their operations by raising disclosure levels. We recommend that this is done within the existing framework of the GRI that already has a number of pulp producers as members. These producers can now move forward by establishing a common, industry-wide reporting standard. As proper impact assessment also necessitates an understanding of the operations of a company, the quality of reporting would be enhanced if it includes a comprehensive mapping of meaningful resource use in and fl ows through the production process, as fi nal output. The minimum disclosures that this would entail include: (1) capacity per type of product produced, (2) use and cost of resources/ inputs per type of product, (3) output/sales and price received per type of product, (4) source of fi bre, supply contracts, (5) condition of plantations: acreage planted, amounts harvested.

To the Equator Principles
We recommend that the Equator Principles, working through the organisations that signed up to it, aims to expand adoption of its principles to include all fi nancings in excess of US$50m raised by companies active in environmentally sensitive areas. In addition to project fi nance, this would include syndicated loans, issues of notes and bonds, and equity.
The Equator Principles assume disclosure levels that are only available for new projects, and then in the format of projections. A fi rst step should be to ensure that projects fi nanced with Equator funds commit to publishing these variables. The dissemination of relevant information about their operations and the impact thereof will deepen the understanding of the fi nancial community and other relevant parties about working with safeguards.

To the Global Reporting Initiative
For the GRI to be of use to investors, it needs to be concise and material. We recommend that the tendency to indulge in overly complex reporting is tempered by the question of what is material. The inclusion of summary GRI outputs in annual reports and periodic stock exchange fi lings will allow the results to reach a broader audience. The GRI is progressively implementing industryspecifi c reporting standards with the collaboration of member companies. The issuance of a pulp and paper industry supplement can be accellerated with the active participation of those pulp and paper producers that are already GRI members. EA results incorporated in conditions for cover. Only conditions with the exporter can fulfi ll.
Will ask sponsor or third parties (eg. Guarantee holding banks) to be responsible for proper environmental monitoring.
Confi dentiality under the Export Guarantees Act, Data Protection Act and Banking Act (stipulates banking secrecy). Will publish E10m + projects with prior written consent of the exporter.
EIA will be published for E10m up where possible and with permission.
E10k cost for A or B project reviews, exclusive of onsite visit costs, consultant fees &c.

Procedures modifi ed to incorporate OECD Common Approaches
Feb-02 Export Credits Guarantee Department (www.ecgd.gov.uk) UK Environment screening introduced Jan-00 Classifi cation into A, B or C based on info in application. B: Impact Questionnaire. A: EIA, SIA and/or resettlement action plan.
Cat A Greenfi eld: EIA required. Others assessed by a combination of desk-review and consultation with the exporters, sponsor &c.
EIA by an independent consultant on behalf of the project sponsor.
Yes for major greenfi eld Cat A projects. WBG Guidelines and Safeguard Policies, UK/EU and local standards and industry best practice.
Env. Cov and conditions precedent where necessary.
Introduced for major projects. Annual auditing and reporting, preferably by an independent party.
Disclosure of project information encouraged, consistent with legal requirements to respect commercial confi dentiality. Determined and negotiated as part of the env. Review prior to providing support. In-house by EDC environmental specialists or by consultants hired by the lending group.
Has a corporate disclosure policy. EDC encourages sponsors to publicly release available environmental impact information.
Where EDC is considering support, it seeks sponsor disclosure consent.
Cost of reviews and site visits may be shared with exporters/sponsors. Has 5 full-time environmental specialists.
Environmental Review Framework (formalised then existing review practices) balance sheet A schedule of property and obligations of a company as at a given date.
benchmark A security whose yield is taken as a representative reference for securities of a given grade and maturity. Other issues will be priced in relation to the yield on the benchmark. The difference between the two is known as the spread.
bond A debt instrument where the issuer is obliged to pay the holder of the bond periodic interest, and to repay the principal amount on maturity. Bonds are tradable, meaning that they can be bought and sold between investors.
books In a fi nancial context refers to the balance sheet of the bank or underwriter. Keeping paper on the books means the underwriter is not selling (placing) the entire issue with other investors. capital The proprietary claim in a business, normally being the difference between the total value of a company's assets less its liabilities.
capital markets Market for long-term loan and equity capital. Companies, governments and other organisations access this market to raise long-term funding directly from investors.
cash fl ow Hard cash being generated by a business. This is not the same as reported profi t, as the latter can be infl uenced by non-cash charges and timing of recognition of sales revenues.
commercial bank Here refers to a banks that takes (demand) deposits from the general public, and lends them to its clients.

commercial fi nancial institutions
In this paper used to comprise all fi nancial institutions except the multilaterals. coupon The periodic interest payment made on a debt security.
credit rating An index of reliability of expected repayment normally issued by an offi cially accredited credit rating agency. credit risk Risk due to the uncertainty that the obligor or counterparty might not be able to meet his obligations. debt What is due or owed.
debt security Paper witnessing the obligation of the issuer to pay the holder. A debt security is outstanding for a pre-determined period (tenor or maturity) and pays a pre-determined amount of interest on predetermined days.
default Failure to comply with the promises made at the time of issuing a security. This relates both to committed payments of interest and principal, and to non-payment related commitments such as not exceeding a certain leverage ratio or not selling one's productive assets.
dividend Periodic payment made to owners in a business (holders of equity securities) out of the profi t derived in a prior period.
equity Witnesses ownership (capital), as opposed to debt, that witnesses an obligation. equity security A participation in a company's capital. export backed security A debt instrument where interest and principal are serviced out of specially seggregated export proceeds from the issuer.
fi xed income Refers to securities with a pre-determined interest payment schedule. The interest amount may be absolute (as in 5% -fi xed rate) or relative by referring to an interest index such as LIBOR for a given period (fl oating rate). LIBOR is the London Interbank Offered Rate, and refers to how much banks pay for deposits in the relevant currency for the given period.
guarantee A form of credit enhancement in which an entity that is fi nancially stronger than the issuer, agrees to guarantee repayment if the issuer fails to do so. A guarantor can be a related party, such as a parent company, or an unrelated party. In the latter case one typically deals with an insurance company that sells the guarantee for a fee.
income statement A reconciliation of the result of a company's business activities resulting in sales of goods and services, with the net profi t derived from these.
insurance company A company providing insurance to its policy holders, by collecting money from each of them and holding this against future obligations that arise should certain events materialise. The funds an insurance company thus accrues are to be held as reserves against such events materialising, and until such time that the company's liability expires. Insurance companies exist in two major types, property and casualty, that typically provide insurance on a yearly-rolling basis, and life insurance companies. Life insurance companies typically have long-dated obligations to their policy holders, and are major buyers (and holders) of longterm debt securities.
interest rate Periodic compensation paid by the borrower to the lender.
investment grade Refers to a credit rating of BBB-or higher (on Standard and Poor's scale, where AAA+ is the highest rating given, and D the lowest).
issuer Refers to the company or body selling the security being offered.
leverage The proportion of debt and equity carried by a company. The higher the portion of debt relative to equity, the higher the leverage.
liabilities Any item of indebtedness, whether interest bearing or not. Liabilities are recorded on a balance sheet representing the book values at a given date of a company's obligations.
loan Advance of money to a creditor who in turn commits to pay periodic interest, and to repay principal based on an agreed repayment schedule. Unlike a bond, which is negotiable (tradable), a loan is granted directly by the lender to the borrower, and only sold between lenders in exceptional cases.
maturity Date when the principal portion of a debt instrument (loan or bond) is due to be repaid. merchant bank [in contrast to a commercial bank] A bank that provides in the banking needs of corporations, typically by arranging to place securities. Merchant banks are not licensed to take deposits from the public.
obligor Borrower; entity responsible for repayment of a debt security.
orgination The process of arranging to place, on behalf of an issuer, debt or equity securities with investors.
paper In a fi nancial context refers to any type of traded debt security (so not equity, nor a loan). par 100% of the face value of a bond. A bond can trade at, above or below par, but is normally redeemed at par. placing The process of selling securities to investors by underwriters.

portfolio
The securities held by an investor or a fi nancial house.
primary market The (virtual) space in which securities pass from their issuer to the fi rst investor, resulting in new infl ows of capital or debt to the issuer.
project fi nance A fi nancing package especially structured to support a proposed new project. The repayment of the package will be out of the cash fl ow to be generated by the project to be fi nanced, as opposed to based on the existing cash fl ow generating ability of the sponsoring company.
public company A company whose shares are quoted on a stock exchange, and can be bought by members of the general public. redemption The repayment of a debt security on its maturity or call-date. registration The process of registering the information relating to a security to be sold to the relevant regulatory authority. This process is mandatory in certain countries if one has the intention of offering said securities for sale to inhabitants of that country. When a security has not been registered in a market where such registration is a requirement, it has so-called <selling-restrictions> repayment risk The possibility that the issuer of a security fails to redeem the issue on maturity.
restructuring Corporate reorganisation. Typically relates to cases where a company can no longer meet its liabilities, as a result of which either the company or the liabilities will be reorganised in a manner that makes future repayment again a possibility.

risk
The possibility of loss. Securities with a higher risk typically yield more than lower risk securities in order to make them attractive to holders.
risk preference An investors' trade-off between the possibility of loss and the enhanced yield that higher risk securities bring.
secondary market A (virtual) market where holders of already issued securities sell these to others. In case of equity (shares) this market is physically present in the form of the stock exchange, bonds are traded between banks, in no fi xed location.
security Tradable debt or equity issued by a company or other legal entity.
share Fractional ownership in the capital of a company.
sovereign Supreme power, here referring to a national government.
stock Equity or shares.

spread (yield ~)
The difference between the yield on a given security with that of another, typically, benchmark security.
syndicate All participants in a syndicated loan.
syndicated loan A large loan that is originated by one bank and placed with a number of other banks.
tenor Number of years until the redemption of a debt security. underwriter The institution that commits to buy a security from an issuer in case the issue fails to sell.
weighting The allocation of a proportion of an investment portfolio to a given type of security/risk.