One thing could crush South Africa’s big banks

South Africa’s biggest banks face a significant transition risk as the country is committed to becoming a low-carbon economy. 

This risk has been highlighted by the Reserve Bank and its subsidiary, the Prudential Authority, which regulates South Africa’s banking system 

The regulator is concerned that local banks are heavily exposed to carbon-intensive industries, given the nature of South Africa’s economy, which exposes them to significant transition risks. 

These risks come in two main forms – physical risk and transition risk. 

Physical risk refers to the potential financial losses that could be suffered due to extreme weather events caused by climate change. 

Transition risk, on the other hand, arises from the movement towards a lower-carbon economy, which reduces the value of non-qualifying financial assets and may jeopardise companies’ and households’ ability to pay back loans. 

The second risk is what the Reserve Bank and Prudential Authority are mainly concerned about, as it could significantly impact the value of collateral used for loans and cashflow to pay off debt. 

Researchers from the Reserve Bank, Pierre Monnin, Ayanda Sikhosana and Kerschyl Singh, said this risk poses a potentially systemic threat to the country’s financial system. 

They explained that South Africa’s financial system is heavily exposed to carbon-intensive industries through the country’s large mining companies. 

It is also exposed, by default, through Eskom’s use of coal in the power industry and households across the country. 

These sectors also employ millions of South Africans and thus, indirectly, give people money to deposit with banks, take on debt, and, crucially, pay off loans. 

They said some business models may become obsolete in the future amid the transition to a low-carbon economy, and assets used as collateral for loans or stores of wealth may lose value. 

Households dependent on unsustainable economic activities, such as those within the coal sector, are likely to face significant job losses and wage cuts, the researchers said. 

Public entities that collect taxes from these industries or have stakes in them will also be adversely affected.

These economic challenges will increase financial institutions’ credit and market risks.

As the transition unfolds, companies and individuals involved may experience severe income reductions, downgrades in credit ratings, and a decrease in the value of their assets.

This will impair their ability to meet debt obligations to financial institutions, resulting in a surge of defaults. In such cases, financial institutions may not be able to recoup the full value of collateral assets, as these assets will have depreciated.

The opportunity

However, banks also have a significant opportunity to make billions of rands from the green transition through financing sustainable projects. 

South Africa has committed to a Just Energy Transition (JET), requiring a significant overhaul of its carbon-intensive economy. 

Estimates indicate the country needs around R4.6 trillion to finance the transition to a low-carbon economy in the next decade. 

South African banks are already fiercely competing in this space, working to capture the immense value that will be generated by overhauling the local economy. 

Most of this capital would be committed to alternative energy sources, particularly renewable generation projects.

The opportunity is even larger if one considers the need to invest heavily in electricity infrastructure across Africa. 

Much of this is slated to be based on renewable energy as a way to leapfrog carbon-emitting power sources such as coal. 

Some banks, however, remain committed to investing in natural gas exploration and energy generation as a transition fuel. 

Standard Bank estimates Africa needs around $1.1 trillion to $1.3 trillion (R23.1 trillion) to finance this transition. 

The main players in this transition will be South Africa’s largest banks, with the traditional ‘Big Four’ of Standard Bank, FirstRand, Nedbank, and Absa gearing up to capture this value. 

They are uniquely positioned in that they operate across multiple markets in Africa and have substantial balance sheets that enable them to finance large projects. 

These four will also compete heavily to finance South Africa’s transition away from a carbon-intensive economy.