South Africa’s R1 trillion ticking time bomb

South Africa’s biggest banks are facing R1 trillion in transition risks due to the effect of climate change on assets and the decarbonisation of the local economy. 

This was revealed in an analysis by Reserve Bank economists Pierre Monnin, Ayanda Sikhosana and Kerschyl Singh, who studied the financial sector’s exposure to climate-related risks. These risks come in two forms.

• Physical risk refers to the potential financial losses that could be suffered due to extreme weather events caused by climate change.
• Transition risk arises from the movement towards a lower-carbon economy, which would reduce the value of non-qualifying financial assets.

The economists said these risks, particularly transition risks, pose a potentially systemic threat to South Africa’s financial system. 

Some business models will become obsolete in the transition to a low-carbon economy, and assets used as collateral or stores of wealth may lose value. 

Transition risks can significantly affect businesses’ and households’ income flows and asset values. 

For example, firms heavily reliant on non-renewable energy and products will need to fundamentally overhaul their infrastructure and business models to adapt to a net-zero economy. 

As they are more likely to incur these costs, they are exposed to higher transition risks. Firms in the coal value chain are a good example of such high exposure. 

Households relying on non-sustainable economics, like those within the coal value chain, will likely face job losses and reduced wages. Public authorities collecting tax revenues from these activities or owning such firms will also be affected.

They warned that these potential economic losses will translate into credit and market risk for financial institutions. 

Companies and individuals affected by the transition may experience a significant loss in income, a declining credit rating and the values of their assets reduced. 

This will significantly impact their ability to service debt with financial institutions, resulting in an increase in defaults. In the case of defaults, financial institutions will not be fully compensated by the sale of collateral assets as their value will decline. 

The study indicated that just over R980 billion of corporate loans from South African banks are to companies or individuals whose income and assets are exposed to the energy transition. 

Corporate loans collectively amount to R2.8 trillion, comprising 37% of the sector’s total assets and 42% of its overall loans.

Of this R2.8 trillion, around 35% (R980 billion) is allocated to what are termed “transition-sensitive economic sectors (TSES).”

Insurance crisis looming

The effect of the transition is likely to be far more severe on the financial sector, with insurers also coming under immense pressure from reduced asset values and increased risk from severe weather events. 

The growing occurrence and intensity of extreme weather events are causing increased property damage, leading to significant losses for insurance companies, banks, and other financial institutions.

In 2022 and 2023, these events significantly impacted the claims statistics within the domestic insurance industry.

Insurers have witnessed a notable rise in climate-related claims in recent years, a stark contrast to the past when South Africa rarely experienced catastrophic events.

This has resulted in the cost of reinsurance rising for South African insurers, forcing them to raise premiums or consider not covering certain risks. 

The Reserve Bank warned in its latest Financial Stability Review that the rise in frequent and severe weather-related claims may increase underwriting and liquidity risks, potentially jeopardising insurers’ solvency.

Moreover, extreme climate and weather shifts could complicate insurers’ loss forecasting due to the decreasing reliability of historical data and the unpredictable nature of events across various regions.

“Given this picture, it is not far-fetched to believe climate change has the potential to destabilise the global insurance industry, with ripple effects for South Africa,” said Old Mutual Insure’s chief actuary Ronald Richman.

“While many of the recent events have not been unprecedented, insurers have experienced them as particularly acute losses hitting their bottom lines and capital reserves.”

“This is due to reinsurers taking significantly less risk from these types of events, leaving insurers unable to smooth out the losses over time,” said Richman.

This is compounded by South Africa’s unique challenges, from deteriorating infrastructure, political instability, water shortages, and inconsistent electricity supply. 

These have raised the cost of reinsurance in the country and will compound the effect of any catastrophic weather event.