National Treasury's draft technical paper: “Financing a Sustainable Economy” (“the technical paper”), published in May 2020, is a recognition by South Africa's regulators of the potential impact of climate change on the financial sector. The financial sector is well placed to respond to the urgency of enabling sustainable finance to flow towards building a more climate resilient and lower carbon economy for South Africa and the technical paper outlines the challenges and opportunities that lie ahead in this process. The document is a precursor to regulatory reform in the financial services sector. Financial institutions would do well to begin to prepare for this by exposing their strategy, risk and regulatory affairs teams to new areas of knowledge to allow for appropriate disclosures and pricing of climate related risk.
South Africa's commitment
As an energy intense economy, South Africa is the eleventh biggest contributor globally to greenhouse gas emissions and contributes significantly to global carbon emissions. In this regard, South Africa has made commitments in terms of the Paris Agreement on Climate Change to an emissions peak in 2020 to 2025, a plateau for a ten-year period from 2025 to 2035 and a decline from 2036 onwards.
To meet these commitments, an environmental risk management approach is suggested in the technical paper that seeks to encourage the reallocation of capital to have a more positive impact as well as the raising of new and dedicated funds to finance the transition to a less carbon intense economy. The technical paper makes recommendations that would apply to the local banking, insurance, pensions, collective investments, private equity and capital markets participants. It also identifies gaps in the existing regulatory framework and recommends actions required by each of the above mentioned financial institutions, the regulators as well as industry associations.
The technical paper acknowledges that climate change is a multifaceted challenge and that while climate change will give rise to direct environmental or green challenges, it will have profound indirect effects on rural and resource-based communities, as well as urban populations in cities. The technical paper also acknowledges that the financial sector will not be immune to these challenges and identifies the following potential climate-related risks for the global and South African financial sector:
- Physical risks from extreme weather, directly affecting financial institutions' own operations or assets that they finance through damage, business disruption or default risks.
- Transition risks, resulting from disruptive technologies, changing regulation, consumer or market preferences.
- Liability and disclosure risks, resulting from loss and damages, rising insurance costs, director's liability and disclosure failures.
In order to mitigate against these risks and to allow the financial sector to unlock the estimated ZAR2-trillion needed to address the transition risks faced by South Africa as a result of climate change, the technical paper focuses on the use of forward-looking scenario analysis in financial decision making through sustainable finance. “Sustainable finance” means “financial models, services, products, markets and ethical practices to deliver resilience and long-term value in each of the economic, environmental and social aspects and thereby contributing to the sustainable development goals and climate resilience.” In other words, sustainable finance requires development that is focused on the long term and material environmental, social and governance (“ESG”) factors. Mobilising capital for a sustainable economy will require shifting the current capital allocation from an unsustainable pathway to a sustainable one and filling the investment gap to ensure that objectives are achieved on time. The suggested scope of sustainable finance is broad and inclusive, and is applicable to all types of financial transactions, products and services and at all stages of decision making and during the period of investment.
The technical paper makes a number of sector-specific recommendations, but the following general recommendations were common to all financial services industries and include:
- regulators and industry are required to co-develop or adopt technical guidance, standards and norms for use across all financial sectors in identifying, monitoring and reporting and mitigating their environmental and social (“E&S”) risks, including climate-related risks, at portfolio and transaction level;
- the need to develop or adopt a taxonomy for green, social and sustainable finance initiatives, consistent with international developments, to build credibility, foster investment and enable effective monitoring and disclosure of performance;
- the need to develop an action plan to give effect to the recommendations of the technical paper, using a technical working group to be comprised of regulators and industry representatives. The action plan would seek to unlock the building of capacity across all financial sectors and to allow for the adoption of voluntary initiatives that include performance measures and monitoring as a precursor to regulation.
Notably, some sectors have progressed more than others as regards E&S risk management and the adoption of voluntary standards. For example, very little progress has been made in relation to collective investment schemes, but in the banking and retirement funds sectors, integration of ESG factors and E&S risk management has been prioritised. This makes it difficult to standardise and consolidate terminology and E&S performance measures across the financial sector. Another difficulty that National Treasury would experience in implementing the abovementioned recommendations would be that some sectors are more regulated than others. As an example, private equity funds are presently unregulated, however the Conduct of Financial Institutions Bill will change this position, making provision for the regulation of private equity funds as alternative investment schemes. Where sectors are unregulated, there is little scope for the introduction of mandatory disclosure or standards.
Internationally there is growing pressure on the financial sector as a whole, and banks in particular, to recognise their role in enabling financial flows to address global challenges, such as climate change. The technical paper is a laudable starting point for the achievement of sustainable finance in South Africa. It presents both challenges and opportunities for the South African financial sector. It also highlights the urgency for a just transition to a green economy and the role that the financial sector must play in the achievement of that just transition.
At ENSafrica we have the breadth of expertise to cover the legal aspects of the ESG enquiry from matters relating to sustainability bonds and green finance, climate change, natural resources, pollution and waste, human resources, product liability, stakeholder opposition, corporate governance and corporate behaviour.
Originally published by ENSafrica, August 2020
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