F in a n c in g Financing Pulp Mills P u lp M ills An Appraisal of Risk Assessment A n A p and Safeguard Procedures p r a is a l o f R is k A s s e s s m e n t a n d S a fe g u a r d P r o c e d u r e s M a c h te ld S p e k Machteld Spek Financing Pulp Mills: An Appraisal of Risk Assessment and Safeguard Procedures Machteld Spek National Library of Indonesia Cataloging-in-Publication Data Spek, Machteld Financing pulp mills: an appraisal of risk assessment and safeguard procedures/ Machteld Spek Bogor, Indonesia: Center for International Forestry Research (CIFOR), 2006. 86p. ISBN 979-24-4612-5 1. pulp and paper industry 2. risk assessment 3. investment planning 4. environmental impact 5. social impact. I. title © 2006 by CIFOR All rights reserved. Published in 2006 Printed by SUBUR printing Cover photo by Christian Cossalter Design and layout by Catur Wahyu ISBN 979-24-4612-5 Published by Center for International Forestry Research Jl. CIFOR, Situ Gede, Sindang Barang, Bogor Barat 16680, Indonesia Tel.: +62 (251) 622622; Fax: +62 (251) 622100 E-mail: [email protected] Web site: http://www.cifor.cgiar.org Contents Preface v Executive Summary viii Acknowledgements xiii Introduction 1 Trends in pulp investment: Capacity and financing 4 Pulp production process and impacts 4 Pulp production capacity and industry structure 5 Investments in pulp capacity after 1995 10 Financing raised by pulp producers 12 Conclusion 15 Principal sources of funding for pulp mills 16 Development funding from multilateral development banks 16 World Bank 17 IFC 20 MIGA 23 ADB 24 EIB & EBRD 24 Other multilaterals 26 Export credit agencies 26 Commercial financings 28 Market access 31 Lending cost 33 Domestic banks 35 Equity 36 Conclusion 37 Financial risk assessment 39 Credit risk assessment 39 Due diligence 42 Ongoing (risk) analysis 45 Credit rating agencies 45 Securities research 49 Corporate disclosure 51 Conclusion 52 iv Impact assessment and safeguards 53 Equator Principles 53 Safeguard implementation 55 Implementing safeguards in transactions in the international capital markets 59 Improving standards and implementing safeguards in existing operations 59 The Global Reporting Initiative 61 Conclusion 64 Key findings and recommendations 66 Key findings 66 Recommendations 70 Sources 72 Appendices 75 Glossary 83 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 financial institutions, and conservation organizations. The Forum’s central aim was “to explore opportunities for private sector companies, the World Bank, the IFC, and other financial 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 financings 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 financial 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 significant vi factor driving illegal logging. Plantation development, too, is often associated with displacement of forest communities and social conflicts. The present study examines how pulp mill projects – including both the development of greenfield mills and capacity expansions – get financed. The analysis is based on a close review of 67 pulp projects, with a combined 25.5 million tonnes/year of planned new capacity, that were proposed between 1995 and 2003. Spek, a Chartered Financial Analyst who has covered markets in Southeast Asia for over 13 years and worked in the financial sector for over 20 years, traces the sources of financing available, respectively, to producers seeking to expand existing operations and those planning to build new mills. She assesses why some projects got financed and why some ultimately did not. This analysis illuminates the fact that most pulp capacity expansions are funded through commercial financings – that is, through loans, bonds, or equity issues – while greenfield mill projects generally require government or multilateral support. The study also examines how financial institutions assess the risks and potential impacts of the pulp mill projects they fund. The picture that emerges suggests that most export credit agencies, merchant banks, and other private sector investment institutions have little in-house expertise related to forestry issues and/or social and environmental impact assessment. Many prefer to rely on information provided by the project sponsor and, whenever possible, on the participation of the IFC or other multilateral agencies, which have stronger capacity to carry out such evaluations. In practice, this often means that a range of issues which may have critical importance to the success of a proposed project-- such as growth rates and productivity levels at supporting plantation sites; the legality of wood to be consumed by a proposed mill; and the likely impacts of a project on local livelihoods -- are poorly assessed. The good news is that a growing number of financial institutions have, in recent years, adopted stronger safeguards to limit negative social and environmental impacts of forest- related investments. In 2001, for instance, Dutch banks ABN AMRO and Rabobank introduced policies that explicitly prohibit making loans for projects that involve conversion of primary forest, purchase of illegally harvested timber, or displacement of indigenous peoples. Moreover, since 2003 some 33 lending institutions have endorsed the Equator Principles, an initiative led by the IFC to enhance the use of social and environmental safeguards for project financings in all industry sectors, including forestry. That same year, many of the world’s leading export credit agencies adopted the OECD ‘Common Approaches on Environment’, which require environmental impact assessments to be conducted before most forest-related projects can be approved. In this study, Spek examines the relevance of such initiatives to pulp mill finance, giving particular attention to the Equator Principles. She rightly applauds signatory banks for taking an important step towards incorporating social and environmental considerations into lending practices. Yet she points out that the Equator Principles cover only project finance – and, therefore, apply only to a very small portion of total bank funding for pulp mill projects. There is clearly considerable room to expand the relevance of the Equator Principles to pulp investments if they could be broadened to include other types of financial arrangements, as well. This study also emphasises the importance of improved corporate reporting practices on the part of pulp producers and associated plantation and forestry companies, in order to enhance transparency and accountability. In particular, Spek highlights the potentially important role that the UNEP-sponsored Global Reporting Initiative could play in establishing an industry standard for corporate reporting on key operational variables, including fiber supply. vii This study is being published by CIFOR, with support from the DFID-funded Multi-stakeholder Forestry Programme and from the European Commission’s Asia Pro Eco Programme, with the aim of improving risk analysis and due diligence practices on the part of financial institutions involved in funding pulp mill projects globally. We sincerely hope that the analysis and recommendations presented here will help financial institutions to better assess the risks and impacts of the projects they fund – and, in doing so, to support more environmentally, socially, and economically sustainable investments in this important sector. Christopher Barr Senior Policy Scientist, CIFOR December 22, 2005 Executive Summary This study was conducted to see how investors and lenders assess the financial risks and social and environmental impacts associated with pulp mills. Despite the large amounts of capital tied This study looks at how investors up in these projects, it has been apparent that there are weaknesses in the risk assessment system and lenders assess pulp mills… 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 financing 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 financiers can and …with reference to transactions do assess the quality of the proposed project and borrower, a sample of transactions proposed proposed between 1995 – 2003. 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 Two-thirds of proposed capacity going ahead with a 66% success rate. Where projects did not go through, this tended to be the additions succeeded, as compared result of changed corporate strategies as opposed to an inability to obtain funding. 27.1% of to only 27% of proposed new mills. proposed greenfield mills went on to being realised. Funding forms a bigger barrier for greenfield projects in the absence of an existing business that provides the cashflows. Increasing comfort levels is critical to obtaining financing, 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 financing was found for the period covering 1990 - 2004. Funding is a key barrier to entry for proposed pulp mills, and funding institutions jointly and Before start-up is the time to weed singly hold significant power with regard to determining which projects are ultimately realised. out poor projects. Smaller scale pulp mills will typically be financed by banks in their home markets. Mills with annual production capacities in excess of 200,000 tonnes will generally find themselves