How EU Climate Policy Is Pressuring South Africa’s Economy & Bond Market

Summary

• South Africa’s high GHG emissions leave its economy and bond market vulnerable.
• Forthcoming EU rules on disclosing portfolio carbon intensity accelerate the market risks from ESG requirements.
• South Africa must establish a larger and more liquid green bond segment, and quickly.

The carbon intensity embedded in South African government bonds sharply contrasts international peers. Consequently, a growing segment of offshore investors are having challenging conversations with end investors and regulators. And forthcoming EU rules on the carbon intensity of portfolio disclosures will now accelerate and strengthen the trend.

South Africa must move much faster to establish a larger, more liquid green bond segment. That will happen only with a mixture of net-zero targets, faster and more credible renewable energy procurement pipelines, and a liberated energy market combining to create a corporate green bond market. Sovereign green bonds and Eskom transition bonds will also be key to keep a growing segment of carbon-averse offshore investors engaged in South African risk.

The EU Transition to a Greener Economy is Well Underway

Following adoption of the Paris Agreement, the European Commission released its Action Plan on Financing Sustainable Growth in March 2018. Adopted on 18 June 2020, a classification system (the ‘taxonomy regulation’) for sustainable activities is the cornerstone of the plan. This will give investors clear and transparent information on environmental sustainability. Moreover, a reliable classification of green investments will combat greenwashing and enable investors to make informed decisions to increase their investments in sustainable activities.

The EU Green Deal succeeds the action plan, presented at the end of 2019. It proposes slashing the GHG emissions of EU countries by 50% over the next decade (the current target is 40%), making Europe the world’s first climate-neutral continent. Successively, financing this transition will be crucial to attaining the goal.

The EU’s Sustainable Finance Disclosure Regulation (SFDR) came into effect on 10 March 2021. It marks a significant step forward in the bloc’s efforts to ensure that financial firms are fully transparent about their commitment to sustainability. Accordingly, financial market participants (FMPs) will need to disclose information at a firm level about their sustainability policies and on a product level about their financial products. These fit into the broader context of a forthcoming EU carbon import tax – plans for which are being accelerated.

As a High Emitter, South Africa Faces Pressure to Act

As the thirteenth-largest emitter of GHG globally, South Africa is highly vulnerable to climate change. It has made commitments in terms of the Paris Agreement. But it has made no net-zero commitment at a sovereign level, and the politics of doing so before COP26 in November remains fraught.

As a G20 participant and in line with key international trends, South Africa’s financial institutions would do well to begin to prepare and adapt to the new environment. Local financial market participants and financial advisers should prepare to disclose specific information on their approaches to integrating sustainability risks and considering adverse sustainability impacts.

Without an overarching regulatory and policy framework, the primary driving force behind sustainable finance initiatives has often been the industry itself. This is largely through voluntary industry association-led initiatives or through international sector-specific initiatives. However, there has been minimal consistency or coordination within industry sub-sectors. Local policy will likely follow the EU’s lead. Meanwhile, we believe that foreign asset managers outside the EU already face pressure both because of the EU move but also independently from investors to follow similar moves to carbon disclose and carbon optimise portfolios.

South Africa’s Climate Bill is expected to pass through Nedlac soon. Once enacted, it will begin the process of establishing budgets for sectors down to the company level under a reductions envelope. To what exactly is not yet firmly clear, hence the need for a 2050 net-zero commitment. This move will push local banks and asset managers to consider the carbon footprint of their operations more carefully.

The Risk to South Africa’s Economy is Real

South African policymaking is moving very slowly versus the offshore move to underweight South Africa on carbon intensity. Numerous factors explain this gap: the non-existent renewables procurement since 2014 and now the slow pace from here; the IRP2019 is out of date and has too little renewables within it; and the reluctance to liberate ERA s2 (on embedded and distributed generation – despite Eskom and Operation Vulindlela pressuring for change).

In terms of steepness compared with peers, the SAGB curve is an outlier, and a third of new issuance in the primary market is backed by foreigners. If there is selling or underweight pressure from a growing segment of offshore bondholders, this could add additional pressure on the curve to steepen and so raise government funding costs. The tab could fall to locals buying bonds on dips or banks increasing holdings further, but that would further exacerbate the problem in banks’ balance sheets of growth-boosting, new corporate lending being crowded out. There are no other real options for foreign asset managers to buy – no sovereign green bonds and an illiquid and small bank green bond segment. This can and will change, but the question is the pace of new green issuance.

The risks of stranded assets to insurers and banks are growing, but the National Treasury’s sustainable finance paper’s next steps are unclear. The emergence of a taxonomy in the coming year will be a significant move forward, but only a partial one. An important step would be for the SARB to appoint a lead for climate and just energy transition risk in the Prudential Authority. This would focus attention on the regulatory change required rather than just research. Everything must be anchored in a view of carbon budgets and 2050 net-zero (which will come eventually). But until then, pressure for change at speed may be minimal.