Sovereign Africa Ratings

South Africa: The Climate Crisis and its Impact on Sovereign Credit Ratings

As the threat of climate change grows, countries around the world are working to decarbonise their economies, aiming for net-zero greenhouse gas (GHG) emissions by 2050. South Africa has committed itself to this cause as a signatory to the United Nations Framework Convention on Climate Change (UNFCCC) and the Paris Agreement.

The UNFCCC, adopted in 1992, is an international agreement aimed at combating climate change. Building on this basis, the Paris Agreement, adopted in 2015 at the UN Climate Change Conference (COP21) in Paris, aims to keep global warming to well below 2°C above pre-industrial levels, with efforts to restrict it to 1.5°C. This legally binding treaty establishes a collaborative framework for nations to reach net-zero emissions by 2050, highlighting the importance of collective action, innovation, and co-operation.

Decarbonising economies is critical for combating climate change, especially as the energy sector now accounts for around three-quarters of GHG emissions. This sector holds the key to mitigating the worst effects of climate change, which is widely regarded as humanity's most pressing concern. Environmental sustainability must be effectively managed, otherwise countries' financial, economic, and socioeconomic stability will be jeopardised. Since the mid-twentieth century, the main driver of observed climate change has been an increase in GHGs, mostly caused by human activity, resulting in severe effects such as droughts, floods, and other environmental disasters.

Ignoring the threats posed by climate change is much more expensive than addressing them. Recent extreme weather occurrences, such as strong rains and flooding in South Africa, highlight the importance of this issue. The World Economic Forum's Global Risk Perception Survey has identified "extreme weather" as the second most serious global risk over the next decade, highlighting the immediate and long-term concerns posed by climate change.

Greenhouse Gases: South Africa's Path to Decarbonisation

South Africa is committed to the global fight against climate change, having pledged to achieve net-zero greenhouse gas (GHG) emissions by 2050 under the UNFCCC and the Paris Agreement. The principal greenhouse gases—carbon dioxide (CO₂), methane (CH₄), nitrous oxide (N₂O), and their combined measure, CO₂e—are important markers of climate change, with each contributing uniquely to global warming.

Efforts to minimise these emissions require comprehensive policies and new technology, which are critical for negating the severe consequences of climate change. Figure 1 depicts South Africa's GHG emissions levels from 2010 to 2020, emphasising both the country's accomplishments and continued problems in this crucial global undertaking.

Figure 1: Greenhouse Gas Emissions in South Africa (2010-2020), Measured in Kilotons

Source: World Development Indicators (World Bank)

This table shows the amount of greenhouse gas emitted in South Africa from 2010 to 2020, measured in kilotons (kt). The data covers emissions of carbon dioxide (CO₂), methane (measured in CO₂ equivalents), and nitrous oxide (also measured in CO₂ equivalents). Each column represents a year and displays the emissions for that specific year.

Table 1: Greenhouse Gas Emissions in South Africa (2010-2020), Measured in Kilotons

Source: World Development Indicators (World Bank)

The primary cause of climate change is the greenhouse effect. Some gases in the Earth's atmosphere operate similarly to the glass of a greenhouse, trapping the sun's heat and preventing it from escaping into space, creating global warming. Many of these greenhouse gases occur naturally, but human activity increases their amounts in the atmosphere, particularly carbon dioxide (CO₂), methane, nitrous oxide, and fluorinated gases.

Climate Change Impacts

The Relationship Between Climate Change and Credit Ratings

There is a large body of literature giving strong empirical evidence on the relationship between climate change and sovereign credit ratings. While climate change is an unavoidable reality around the world, with rising temperatures, changing weather patterns, melting glaciers, intensifying storms, and rising sea levels, the negative coefficient on climate resilience shows that enhancing structural resilience through cost-effective mitigation and adaptation, strengthening financial resilience through fiscal buffers and insurance schemes, and improving economic diversification and policy management can help economies withstand the effects.

Several studies employ the regression model below to estimate the impact of climate change on sovereign credit ratings (𝑅𝑖t∗).

The and coefficients represent the time-invariant country-specific effects and the time effects controlling for common shocks that may affect sovereign credit ratings across all countries in a given year, respectively; represents the measures of climate change vulnerability and resilience; and is a vector of control variables that are lagged to address potential endogeneity. is an idiosyncratic error term that follows the conventional assumptions of a zero mean and constant variance.

After controlling for conventional macroeconomic variables such as Real GDP per Capita, Real GDP Growth, Inflation, Terms-of-Trade, Debt-to-GDP, Foreign Reserves, and Climate Vulnerability, this regression model can establish a correlation between a country's resilience to climate change and its credit rating level. The evaluation scores are dependent variables, whereas macroeconomic variables and climatic vulnerability are independent variables. According to the average rating specification, improving climate change resilience by one percentage point results in a 0.09 percent gain in sovereign credit rating.

It is also worth noting that markets are still generating realistic projections of how climate change would impact debt sustainability, sovereign creditworthiness, and large nations' public budgets.

Impacts of Climate Disasters

Climate change can have an impact on public finances and sovereign risks via a variety of channels. It is now widely acknowledged that the fiscal effects of climate change, as well as governmental responses to it, extend beyond immediate physical costs. Indeed, some of the most significant near-term impacts on the global economy and public finances, particularly in advanced countries, will derive from the climate transition rather than the physical hazards of climate change. The term 'transition' refers to the decarbonisation process, which includes policies, consumer preferences, legal acts, and technological advancement.

Depletion of Natural Capital and Ecosystem Services

Climate change is projected to have a significant and negative impact on natural capital. The key message is that climate change has an impact on productive capital stock, production, supply chains, and resilience, both directly and indirectly, via interactions with other natural capital components. The consequences on government finances and sovereign risk must be accounted for.

Fiscal Consequences of Adaptation and Mitigation Policies

Public finances and debt sustainability are vulnerable to various fiscal risks associated with climate disasters. These encompass both macroeconomic risks and contingent liabilities. Macroeconomic risks associated with natural disasters and extreme weather include disruptions in economic activity, which may reduce tax income and other public revenues and increase social transfer payments; changes in commodity prices, which may reduce revenue or increase spending through fossil fuel or food subsidies; and effects on inflation and interest rates due to supply or demand shocks and exchange rate effects.

Contingent liabilities can expose governments to fiscal risks, both overtly and indirectly. Natural disasters can damage or destroy physical government assets and public infrastructure, necessitating major spending on relief programmes, damage repair, and rehabilitation.

Flooding in KwaZulu-Natal in April 2022 caused severe damage to infrastructure, estimated at R17 billion. Extreme rainfalls have most recently caused damage to roads, dam walls, and property in the Eastern Cape, Western Cape, Limpopo, and Northern Cape. This incidental creates a significant load on the insurance business in terms of insurance claims. These weather changes will also cause consumers and businesses in disaster-prone areas to pay more, as insurance firms raise their premiums for climate change-related coverage and claims.

According to the National Treasury, South Africa will face R503 billion in contingent liabilities for government guarantees in 2024, as well as R416 billion in exposure for public institutions such as Eskom, SANRAL, Denel, SAA, and Transnet, as well as international institutions (R583 billion in 2024) and other contingent obligations.

The National Treasury has also announced that RSA is preparing to trial an initiative that will allow the private sector to participate directly in the development and operation of Transmission Grid Infrastructure through the involvement of Independent Power Producers (IPPs). This will require Treasury to provide close to R300 billion in contingent liabilities deriving from government guarantees to support IPP procurement. This is quite incredible and puts further pressure on the Fiscus. However, Treasury is also seeking $11.5 billion in promises made available under the Just Transition Plan. RSA also plans to use its Special Drawing Rights assets to fund its Green Infrastructure Plan.

Fiscal Consequences of Adaptation and Mitigation Policies

The public sector will have to fund a significant portion of adaptation and mitigation measures. To achieve the Paris climate goals and keep global warming below sustainable limits, large investments in low-carbon infrastructure and energy systems are required. Furthermore, economies must invest in resilience to address vulnerabilities caused by extreme weather events and the effects of long-term global warming.

A related concern is that structural changes during the low-carbon transition may affect established sources of government revenue. Taxes on oil and gas production, as well as gasoline charges, can be substantial sources of revenue for the government. For example, in 2018, the UK Treasury earned around 61.3 percent of the price charged for each litre of pump fuel delivered to customers, while the G7 and OECD averages are 50 and 49 percent, respectively.

The loss of such revenues as a result of the phaseout of fossil fuels can put enormous strain on the public finances. However, for certain sovereigns, the risk is more severe. State-owned companies own the vast majority of fossil fuel assets. While private oil companies have already begun to diversify their portfolios, the risk that sovereign holdings of fossil fuel reserves would become stranded assets is even more closely related to sovereign creditworthiness.

Table 2 illustrates the economic impact of South Africa's fossil fuel industry. The Just Transition will have a significant impact on these measures.

Table 2: Value Chain Segment Contributions of the South African Petroleum Industry

Source: South African Petroleum Industry Association (SAPIA) 2021

The oil industry has a complicated and interconnected value chain. Each value chain section contributes to GDP, employment, and capital investment uniquely, reflecting its size and role in the overall process.

SAPIA members in South Africa generated and collected R121.3 billion in taxes for the government. The oil industry accounted for 9% of overall government tax revenue in the most recent fiscal year. There are three types of taxes created and collected: the fuel levy (R75.4 billion), which is paid by consumers at the point of purchase and transmitted to the government, and direct taxes (R 14.8 billion), which are paid by SAPIA members as corporate tax on revenue; indirect taxes (R31.1 billion) comprise levies imposed throughout the manufacturing process, customs and excise on imported inputs, VAT, and other levies incorporated into the gasoline price. These tax revenues will be decreased by the Just Transition.

In light of the high demand for electricity in Petro Chemicals, Coal to Liquid Processes (CTL), and Gas to Liquid Processes (GTL), as well as South Africa's electricity shortage, Sasol has launched a programme to create 1 200MW of renewable energy by 2030. According to Sasol's 2022 Integrated Annual Report, the capital cost of this renewable energy initiative, which includes wind and solar PV, is over R37 billion.

Over time, innovations have enabled Sasol and other top petrochemical companies to use gas as a feedstock to produce more ecologically friendly liquid fuels and other natural gas-derived products. This technique is known as Gas to Liquid (GTL). One example of this technique is the manufacturing of diesel that is almost sulphur-free and has been shown in the United States and Europe to be significantly more environmentally friendly than current fuel.

The above investment is projected to cost between R25 and R35 billion in cumulative total capital by 2030, including existing gas feedstock maintenance and roadmap expenses (transform capital). The supply of coal at Sasol Secunda has become an issue. Because of this, Sasol has already modified a portion of its plant to use natural gas as a feedstock. SASOL is expected to replace an additional 10 Mtpa of coal by 2030, representing a 25% reduction from the current usage of 40 million tons per year.

The figures above represent the financial and economic costs of a Just Transition in South Africa's fossil fuel industry. Climate change's physical and transitional effects can generate aggregate supply and demand shocks, with far-reaching consequences for output, employment, and state finances. The supply and demand-side consequences of gradual global warming and transition impacts can induce fundamental and long-term structural changes to the economy.

Impacts on International Trade and Capital Flows

Climate change can have a considerable impact on an economy's commerce in products and services as well as money movements with the rest of the world, possibly affecting countries' balance of payments balances and, ultimately, sovereign risk. Climate change's physical effects, as well as disruptions caused by trading partners' climate policies, technological advancements, or changes in consumer habits, can all have an impact on international commerce and financial flows. Historically, balance of payment issues have frequently been at the foundation of country risk, resulting in foreign debt crises. Prolonged current account imbalances tend to produce liquidity concerns and, if not addressed, solvency issues. The current account balance is thus a key measure of sovereign risk.

Decarbonising the global economy may have unexpected effects for several fossil fuel-rich countries. Finally, the amount and even sign of the influence on fossil fuel export earnings is determined by resource-endowment features such as carbon intensity and ease of extraction.

Balancing Development and Sustainability

Africa faces the complex challenge of developing its economies while limiting its contribution to climate change. Developed countries benefited from fossil fuels produced during their own industrialisation, and Africa argues for a similar opportunity. However, the urgency of the climate crisis necessitates a different approach.

The key is finding a balance. Africa has vast potential for renewable energy sources, the continent boasts vast resources like solar, wind, and hydropower, offering a sustainable and reliable alternative to traditional sources, and investing in these clean technologies can create jobs and growth while reducing reliance on fossil fuels. Developed nations can assist by providing financial and technological support for this transition. This would allow Africa to develop its economies while mitigating climate change's worst effects.

Navigating the Climate Crisis: Key Takeaways on Sovereign Credit Ratings

South Africa, one of Africa's largest economies, has a large energy sector and ranks 82 out of 120 nations on the World Economic Forum's (WEF) Energy Transition Index (ETI) for 2023. The country's overall ETI score has increased by 6% from 2014. South Africa's net energy imports (percentage of energy use) are 18.8, its energy consumption per capita (GJ/Capita) is 88.75, its energy intensity (MJ/$2017 PPP GDP) is 6.92, and its CO₂ intensity (CO/TPES) is 74.37.

South Africa's energy transition has historically been difficult, although the share of renewable energy has increased over the last decade. The country continues to generate over 70% of its electricity from coal, the carbon intensity of the energy mix remains high, and clean energy sources account for only about 13% of the entire energy mix.

South Africa's energy transition is going to face challenges in the medium to long term, including key players influencing policy development and having an incentive to support coal, as well as economic and social consequences from the loss of employment and lives in the coal sector. There is room to accelerate initiatives to decarbonise the energy mix by increasing energy efficiency, developing renewables, electrifying, and utilising carbon capture technologies.

Nonetheless, given the importance of the extractive industries in South Africa, there are additional opportunities to ensure an equitable transition by establishing a high-level centralised body to manage the process, engaging all stakeholders early and frequently, promoting transparency and accessibility in the policy process, and developing a supportive legal framework.

Climate change creates significant risks for the financial system, fiscal sustainability, and sovereign debt markets. At the same time, efforts to reach agreed-upon climate targets will necessitate an unparalleled structural restructuring of the global economy over the next two or three decades.

Many of the most significant barriers to the low-carbon transition are political and behavioural rather than technological and economic, so governments realise the need to act fast and carefully to guarantee that change benefits the many. This includes compensating, reskilling, and retooling individuals who stand to lose out, allowing them to participate in the new economy and create jobs for the twenty-first century. It also entails assisting overburdened consumers, who may face increased fees to fund transitional infrastructure investment. Providing a just transition will be critical to maintaining societal cohesiveness.

A key element of transition and climate change is that the past century's infrastructure, skills, and ideas can swiftly become liabilities. Physical, human, and information assets that are resource and carbon intensive are at risk of being devalued or rendered obsolete.