This is an extract from Climate Bonds Initiative’s report on “Green bonds in South Africa: How green bonds can support South Africa’s energy transition”.
South Africa has a unique position among emerging markets (EMs), particularly in Africa, in that it has a developed and large capital market with frequent bond issuers (unlike many EM) but also faces many of the same challenges as other EM countries – particularly in its capacity to take on debt. The incredibly low cost of debt capital seen across the developed world has led many commentators, including Climate Bonds, to note that now is the perfect moment in history to finance a green economy.
Such conditions, however, do not exist across much of the developing world, including in South Africa. The yield curve comparison with the US demonstrates this with the yield for 5-year bonds for the South African sovereign at 6.8% compared to 0.361% for the USA. But even despite this, and in some instances because of this, green bonds remain an important tool for the South African market.
- Green bonds offer a competitive advantage at a time of instability – with the South Africa economy seen by global credit rating agencies and some international investors as unstable, green bonds represent a possible competitive advantage to access a large pool of international investors focused on green.
- Green bonds can demonstrate evidence of credible transitions to international investors who are decarbonising their portfolios in line with the goals of the Paris Agreement.
- Asset-backed green bonds can reduce debt burdens and attract international capital by securing them against assets with low stranded asset risk such as renewable energy and separating them from balance sheets of entities that are exposed to high stranded asset risk and unable to access international capital.
All bonds must meet international climate criteria – to attract international investor capital, bonds must be in line with international criteria defining zero carbon by 2050. This is particularly important in EM where other credit concerns are at play – green credentials should be the highest demonstration of best practice. This doesn’t mean that local criteria can’t account for different starting points – buildings criteria, for example, can account for vastly different average energy efficiency levels in buildings across the world and still be aligned with the same goal. However, the development of different local rules, while useful, will risk losing international investor confidence and demand if they are not credible.
South African green bond market
Green bond issuance in South Africa has been patchy with strong issuance early on followed by small volumes in the intervening years and a bumper year in 2019. Encouragingly, there has been a good diversification of issuers including banks and cities. The City of Cape Town water bond in particular attracted a great deal of attention as part of the solution to the City’s water crisis in 2018 which saw global media attention.
Nedbank has been the most frequent issuer with 3 bonds to date while Redstone Solar Plant was the first green loan and the largest deal to date. The 100MW Redstone Solar plant is a CSP plant and was part of the REIPPP.
In July 2019 ACWA received Certification for the refinancing of its development of the Redstone Solar Thermal Power Plant. The project was developed by ACWA Power, with SolarReserve providing the CSP technology. SolarReserve is headquartered California and is an expert CSP developer. The solar farm is a Concentrated Solar Power plant located in Postmasburg, in the Northern Cape. The plant has an installed capacity of 100MW and it is one of the largest renewable electricity generation plants in South Africa. The development cost of the project is over USD1bn. It became operational in late 2018.
Transition finance in South Africa
Achieving the goals of the Paris Agreement will require entities with some of the highest emissions levels to re-imagine themselves, planning and implementing transition pathways in a world that has renewed climate priorities. Green and sustainable bonds have become an important tool to finance these transitions. Large GHG emitters, however, are still largely absent from the green bond market despite their vital role in reducing global emissions and their presence in mainstream investment portfolios. Their reluctance is perhaps partly due to accusations of greenwashing. Transition finance has emerged to fill this gap and encompass a broader range of high-emitting sectors such as fossil fuels, electricity generation, industry, aviation etc.
The transition concept is applicable, not just to individual assets, but to whole entities or economies following credible strategies that are aligned with the Paris Agreement. A credible transition strategy is not about where the entity is today but how its strategy and operating metrics show where it will be in 2030 and in 2050 (net zero emissions). While having a credible transition strategy will enable entities and economies access to a huge pool of capital across asset classes (bonds, loans, equities etc.), investors have also raised concerns around the potential for greenwash – in particular that ‘transition’ is just ‘business as usual’ by another name i.e. that the label is being used as a catch all for activities that are a ‘bit green’ but have very limited impact in moving the needle on reducing global emissions. This need not be the case. The transition concept and any associated label could and should be a useful tool for identifying sectors and entities that are making ambitious transitions, as a complement to the existing green label.
For South Africa, given its dependence on coal and that the energy sector accounts for 45% of all emissions, the transition discussion is largely focused on energy and particularly on electricity. But energy is just the beginning. South Africa has a huge role to play, for example, in the global debate on how mining is part of the transition.
In September 2020, the Climate Bonds Initiative published a proposal to market entitled Financing Credible Transitions. It outlines a Framework for evaluating what a credible transition looks like for whole entities as well as the individual activities that they operate. In simple terms, it first outlines how activities and entities can play a role in the 2050 low- carbon economy and whether an activity can be decarbonised over time (Pathway to Zero) or should be replaced with a low-carbon alternative (Interim and Stranded). It then outlines five transition principles for an activity/entity to meet to be seen as credible (see below).
South Africa is in a somewhat unique situation in that over 50% of its GHG emissions come from just two entities: Eskom (42%) and Sasol (11%). Given this, a huge focus on any transition from a country perspective needs to be focused on these two entities.
Spotlight on Eskom
Extensive research has been carried out by others on the transition pathway for Eskom which is important context for understanding Eskom within the Transition framework outline. This can be briefly summarised as follows:
- The decarbonization of the power sector is systemically important in South Africa’s decarbonisation pathway and is an enabler for the decarbonisation of other sectors – in particular for sectors such as transport, building and industry.
- The electricity sector is where the largest amount of emissions can be mitigated at the least cost. This is both because of the high existing emissions from coal as well and well as the availability and rapidly declining cost of renewable energy.
This means that for South Africa to meet Paris Agreement, all coal will likely have to be offline by 2040.
To access transition finance at an entity level requires an entity to be following a transition pathway to net-zero by 2050 as demonstrated by a credible strategy and measurable operating metrics. This involves both the decarbonisation activities as well as switching away from activities that cannot be decarbonised. For Eskom, ultimately, this will require transition away from coal toward renewable energy and, ensuring all coal is offline by 2040. It will also require Eskom to have a credible and ambitious transition plan in place which includes clear milestones to be met to 2050.
If a credible transition plan is in place that is aligned with the Paris Agreement, Eskom will be eligible for transition at the entity level irrespective of the fact that it continues to operate coal. This is a core underpinning of the transition concept – that it is about the direction of travel rather than the current state of play. This is important given the need Eskom has to keep the lights on by continuing to operate coal in the medium-term power and to be able to have access to affordable financing to maintain and operate its existing asset base while building up a new asset based. However, individual coal projects will not qualify for transition finance at the asset level whether new or existing.
For individual assets, there are ‘easy green’ areas that Eskom could easily qualify for green financing in the short term. These include financing and refinancing of renewable energy, pumped storage etc. The more challenging activities are those in the ‘Stranded’ category – here, the only eligible expenditures are measures that significantly reduce emissions in the short term. For coal, given the limited ability to significantly reduce emissions in the short term, the main areas which qualify would be early plant closure and repurposing. Repurposing of old power plants is a key part of Eskom’s Just Energy Transition strategy to maintain jobs in the areas they employ people already. Early closure and repurposing projects could attract green and sustainable finance investors.
Spotlight on Sasol
At the entity level, currently Sasol’s current transition plan is to reduce emissions by at least 10% by 2030. Sasol is due to announce its 2050 targets (as well as a review of its 2030 target) in September 2021. These targets are likely to be more ambitious. The current targets are some way off the global Paris Agreement target to nearly halve emissions by 2030 and if, seen alone, is insufficient to be eligible for entity-level transition finance.
As discussed, not every entity or sector within South Africa will have the same decarbonisation trajectory so there could be a case for Sasol to have a more gradual pathway than other sectors/entities. In the absence of this granular information, the 1.5-degree trajectory is for all sectors to roughly halve emissions by 2030 and be net zero by 2050. Given its 2030 target, Sasol will need a more stringent 2030 and 2050 commitment to attract entity-level transition finance.
On the other hand, while its 2030 commitments are not yet sufficient and its 2050 ambition is not yet available, actions are being taken in support of a strategic shift in Sasol’s business model which are encouraging albeit at a nascent stage. These include:
- The procurement of renewable energy. Sasol is building its renewable energy (RE) facilities to reduce its dependency on coal- based power which is a major part of its GHG footprint.
- Green hydrogen. Actions are already being taken to increase hydrogen ramp up through concept and pilot projects.
Green bond models for energy investment
The green label can fit a range of different green finance structures. The most relevant ones for South Africa and the energy sector are listed here:
Sovereign/sub- sovereign green bonds: Over 16 sovereign governments worldwide have issued green bonds to finance a range of different projects including energy. The case for sovereign green bonds is strong – particularly for emerging markets where investors may see the sovereign as the first entity they would invest in a new market. Investors all around the world have indicated strong interest in sovereign debt, particularly from emerging markets. For South Africa, this could be an option to finance Eskom’s transition and could attract cheaper finance than Eskom debt.
Corporate green bonds to finance renewable energy: Green bonds have been issuedall around the world by arange of entities to finance renewable energy. Importantly, as green bonds are linked to assets rather than entities, the ‘greeness’ of the issuing entity is not generally an impediment to access the green finance market. Green bonds to finance renewable energy could be issued by:
- Banks financing capital for renewable energy projects. Over ZAR200bn (USD13bn) was invested in renewable energy through the first four REIPPP bid windows of which 65.8% was financed using debt. Further, to meet the goals of the IRP 2019, an expected ZAR99bn (USD6.8bn) will be invested in solar PV, ZAR271bn in wind and ZAR48bn in distributed generation. This represents a huge opportunity for financial institutions to issue green bonds locally and internationally to finance their lending programs.
- Independent Power Producers can and have already issued green bonds to finance or refinance the construction of renewable energy projects as part of the REIPPP. The Redstone Solar Thermal bond is one example of this in practice.
- Non-financial Corporates could also issue green bonds to finance new renewable energy capacity additions – this could include smaller- scale rooftop solar for retail or office space or larger scale production of energy inputs – such as Sasol’s plans to build solar PV to improve its energy mix or its plans to increase green hydrogen production.
Green asset-backed issuance: While the majority of the globalgreen bond market is unsecured(backed on the balance sheet of the issuer), asset-backed issuance can be used to overcome credit constraints in some circumstances. Debt that is tied to growth areas is much easier to finance than entity level debt, particularly for an indebted issuer. Green ABS or project finance backed by the quality of the renewable energy assets can benefit from: Reducing cost of renewable energy technology; Lower stranded asset risk; Lower entity-level risk of issuer; and International investor interest for green and renewable energy projects.
Green ABS could be issued by a financing arm of a corporate or government-owned entity, a project developer or financial institution. The key is that the balance sheet risk of the entity is removed for the investor.
Transition finance: The transition finance concept is applicable to whole entities as well as, at the more granular level, to their activities and assets. This has relevance for a range of different financial instruments. For assets/activities, transition bonds can be used in the same way as in the green bond market where the label applies to the asset and not to the issuer.
The transition bond label is seen of particular value for entities in high GHG emitting sectors to demonstrate the pathway they are following to alignment with the Paris Agreement. To understand how activities and assets can align with the Paris Agreement, better granularity is needed on the time-based decarbonisation pathways for different high-emitting sectors/activities such as industrial sectors.
At the entity-level, a range of financial instruments can be used by entities both to articulate and finance their credible transition strategy. This includes equities and sustainability- linked bonds (SLBs) and loans (SLLs). SLBs and SLLs are seen as transition instruments as they support an entity’s overall goals/strategy rather than financing specific assets. This ‘target-based’ type of finance is an emerging asset class where the financed raised is for general corporate purposes (not linked to specific assets) but the financing terms are ‘target based’ where the coupon/interest depends on the borrower’s performance against sustainability- related targets. They aim to incentivise the issuer/ borrower to achieve sustainability targets at the issuer level.
There have been some concerns around the growth of SLLs and SLBs. In particular, there are concerns that the targets set not ambitious or easy to assess against broader goals such as the Paris Agreement. For example, some targets relate to ESG scores/ratings based on proprietary methodologies that aggregate a number of ESG factors and difficult to benchmark against specific environmental or social goals (e.g. against the Paris Agreement). In South Africa, entity-level transition finance could be used by companies looking to move away from fossil fuel to, for example, green hydrogen. Transition bonds could also be used to finance accelerated coal phase down.
Blended Finance: Development banks using blended finance vehicles and instruments such as first loss or partial guarantees, grants, technical assistance, risk insurance, can accelerate the growth of green finance market in particular in overcoming barriers around credit rating. The use of blended finance vehicles and instruments like guarantees, technical assistance, grants, risk insurance and partial guarantees are gaining traction with private investors, who can use a small amount of development capital to mitigate against a range of risks. Public finance sources can be used in a number of ways to support green bond issuances focused on solar energy projects including: (i) funding technical assistance for the structuring of projects; (ii) de- risking investments through guarantees; or (iii) financing of energy substitution initiatives and project types.
The South African Green Finance Taxonomy paves the way for a clear framework for issuers that is also based on the work that is developing elsewhere – such as the EU, China, India and Colombia. This is important given that international investors are vital to financing the transition. Taxonomies are being developed all around the world to support and provide guidance around the pathway for key sectors and activities to transition in line with the Paris Agreement. While local guidance is essential to translate global goals into locally relevant and applicable benchmarks, they need to be interoperable globally to ensure that the flow of green finance across borders.
Supportive regulation is critical and can take the form of direct support for green bonds (subsidies etc.) or, more importantly for the energy sector, through strong and consistent policy support across planning, finance, procurement and energy. The REIPPP was a good starting point for the growth of the renewables sector in South Africa but more is needed. The shortcoming of renewable energy policy in South Africa have been well-articulated, in particular that the Integrated Resource Plan needs to go beyond 2030 and that there should be no artificial constraints on RE growth. Local content requirements have been key in helping to develop and maintain a local manufacturing base but this has been hampered by delays and uncertainty with the REIPPP – greater certainty will help to boost both RE supply as well as employment in the sector.
Sovereign bond, a South African green sovereign would send a strong signal to the capital markets that South Africa is preparing to meet the goals of the Paris Agreement. Public sector investment can also encourage green investment from the private sector, e.g. a sovereign green bond could include expenditures to pay for green EV charging infrastructure, car manufacturers will be encouraged to use the green bond market to finance the costs associated with the transition to zero emission vehicles.
Sub-sovereign green bonds have already been issued by the City of Cape Town and Johannesburg. Sovereign and sub-sovereign bonds can catalyse local markets by encouraging essential elements such as the necessary infrastructure, dedicated green bond funds, and visibility. But this is only one piece of the puzzle. Institutional support from public bodies such as the reserve bank, or institutional pension funds allocating investments to green or socially responsible strategies can also set a crucial example and encourage additional green bond issuance.
The complete report can be accessed here