The Impact of Climate Change on Risk and Capital Management in South African Financial Institutions

Written by Willie Smith - Associate Director

Climate change poses significant challenges to financial institutions globally, and South Africa is no exception. The country’s unique socio-economic and environmental landscape makes its banks and insurers particularly vulnerable to climate-related risks. This article explores the specific impact of climate change on risk and capital management in South African financial institutions and outlines the strategies being employed to mitigate these risks.

Climate-Related Risks in South Africa

South Africa faces both physical and transition risks from climate change:

Physical Risks: The country is increasingly experiencing extreme weather events such as droughts, floods, and wildfires. These events can lead to substantial economic losses, damage to infrastructure, and increased insurance claims. Recent extreme events include the Eastern Cape Floods (February 2023), KwaZulu-Natal floods (April 2022), Cyclone Eloise (January 2021) and the drought in the Western Cape (2021-2022), fires in Table Mountain and Overberg (2023 and 2024) as well as KwaZulu-Natal (2021).

Transition Risks: As South Africa moves towards a lower-carbon economy, financial institutions must navigate regulatory changes, shifts in energy policies, and evolving market dynamics. The heavy reliance on coal and other fossil fuels poses a significant challenge during this transition. The examples of transition risks are numerous with the latest regulatory guidance for financial institutions being provided by the Prudential Authority in May of 2024.

Key impacts for Banks to consider

South African banks must contend with various climate-related risks that affect their operations and capital management:

Credit Risk: Climate change can negatively impact the creditworthiness of borrowers, especially those in agriculture, mining, and real estate—sectors critical to South Africa’s economy. Banks need to reassess their lending portfolios and possibly increase capital reserves to account for heightened default risks.

Market Risk: Fluctuations in commodity prices, influenced by both physical and transition risks, can lead to market volatility. Banks must adapt their risk models to incorporate these climate-related market changes, which can affect the valuation of assets and trading portfolios.

Operational Risk: Extreme weather events can disrupt bank operations, leading to branch closures and infrastructure damage. Banks need to invest in resilient infrastructure and develop robust business continuity plans to mitigate these risks.

Regulatory Risk: South African banks face increasing regulatory scrutiny regarding climate risk disclosures and stress testing. Compliance with frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD) requires significant adjustments in capital allocation and reporting practices.

Key impacts for Insurers to consider

For South African insurers, climate change presents direct challenges that impact their risk and capital management strategies:

Underwriting Risk: The frequency and severity of climate-related claims are rising, affecting the profitability of insurance products. Insurers must refine their underwriting criteria and pricing models to accurately reflect the increased risks associated with extreme weather events.

Investment Risk: Insurers manage large investment portfolios to back their policy liabilities. Climate change can adversely affect these investments, particularly those in sectors like energy and real estate. Adopting sustainable investment strategies is crucial to mitigate these risks and ensure portfolio stability.

Liability Risk: Insurers may face increased liability claims related to climate change, such as lawsuits against companies for environmental damage or failure to disclose climate risks. This necessitates higher capital reserves to cover potential legal costs and settlements.

Strategic Responses in South Africa

South African financial institutions are adopting various strategies to manage climate-related risks effectively:

Scenario Analysis and Stress Testing: Banks and insurers are employing scenario analysis to evaluate the potential impact of different climate scenarios on their portfolios. Stress testing helps assess the resilience of their capital under extreme but plausible climate conditions, aiding in better risk management.

Sustainable Finance Initiatives: There is a growing focus on sustainable finance in South Africa, including green bonds, climate risk funds, and investments in renewable energy projects. These initiatives not only mitigate risks but also provide new revenue streams and contribute to the country’s sustainability goals. Some examples of such initiatives include:

·?????? Futuregrowth Infrastructure & Development Bond Fund

·?????? Investec Global Environment Fund

·?????? Old Mutual ESG Equity Fund

·?????? Sanlam Investments Sustainable Infrastructure Fund

·?????? Nedbank Green Bond

·?????? ABSA NewFunds S&P GIVI SA Top 50 ESG ETF

Enhanced Disclosure and Transparency: Improving transparency through enhanced climate risk disclosures builds trust with stakeholders and meets regulatory requirements. South African institutions are increasingly aligning their reporting with international frameworks like TCFD and the Global Reporting Initiative (GRI) with some examples being Nedbank, Standard Bank, FirstRand, Old Mutual, Investec and ABSA.

Collaborative Efforts and Advocacy: Financial institutions are participating in local and international coalitions to drive collective action on climate change. They are also advocating for stronger climate policies and regulations, recognizing the importance of a coordinated approach to addressing climate risks. The initiatives where South African financial institutions have gotten involved in include (naming only a few)

·?????? The South African Sustainable Finance Initiative (SFI)

·?????? African Investor Climate Change Initiative

·?????? Climate Action 100+

·?????? Equator Principles

·?????? New-Zero Banking Alliance (NZBA)

Conclusion

The impact of climate change on risk and capital management in South African financial institutions is profound and multifaceted. Banks and insurers must proactively adapt their strategies to navigate the complex landscape of climate-related risks and opportunities. By integrating climate considerations into their risk and capital management frameworks, these institutions can enhance their resilience, ensure regulatory compliance, and contribute to the global effort to mitigate climate change. The journey towards a sustainable financial future is challenging, but it is essential for the long-term stability and success of South African financial institutions.