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Tuesday, October 4, 2022

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ESG implementation challenges and risk factors to the Islamic financial services industry

The political, business and financial leaders and policymakers around the world are now either looking into or aggressively working on plans to reduce carbon emissions to net zero by 2050 as per the agreed goals and binding commitments/pledges of the signatories to the December 2015 Paris Agreement. IJLAL AHMED ALVI explores further.

The goals of the recently concluded COP26 [2021 United Nations Climate Change Conference] meeting are to secure global net zero by mid-century, to protect and restore ecosystems, to build infrastructure and agriculture that are resilient, developed countries to make good on their promise to deliver US$100 billion in climate finance a year and to accelerate collaboration. Moreover, financial institutions and corporates in particular have pledged significant investments to develop sustainable strategies and set clear goals to achieve these strategies over the next decades.

The OIC and multilateral institutions like the IsDB are strongly supporting the environmental, social and governance (ESG) initiatives to overcome the global warming challenges caused by greenhouse gas emissions. Furthermore, a number of institutions offering Islamic financial services and corporations have incorporated the concept of green finance and designed internal policies and strategies to achieve sustainability which will lead to creating not only value for stockholders but also taking part in the development of sustainable Islamic green finance.


Moreover, as per the DDCAP Group article contribution in the International Islamic Financial Market 10th Edition Sukuk Report, as the volume of conventional sustainable issuance is reaching unprecedented levels and momentum continuing to increase, the Islamic capital markets (ICMs) would be prudent to heed this as a call to action to increase their own activity in this space. While the past 10 years have seen increased focus on green and social impact Sukuk, ICMs should begin to focus on sustainability issuances. The focus should be on reducing negative environmental impact while promoting social and governance consideration; ICMs can more efficiently mobilize capital toward responsible and sustainable causes.

The following green social sustainable (GSS) bond issuance charts mainly covering the period of 2019 to 2020 clearly indicate the shift toward the issuance of GSS securities to raise capital and provide sustainable investment opportunities.

Moreover, a study by Refinitiv reported that sustainable finance issuance is at new highs with around US$360 billion of sustainable bonds being issued in the first nine months of 2020, up 96% on the same period in 2019, as well as a record US$155 billion of sustainable bonds raised in the third quarter of 2020. Of these sustainable bond issuances, 49% were made by corporates, which was a 35% increase on the same period in 2019.

As per Refinitiv, the cumulative ESG Sukuk issuance amounted to US$15 billion by the third quarter of 2021. Total ESG issuance reached US$5 billion in 2020 and is on track to set a new record in 2021. The increasing sustainable Sukuk issuance is promising development and it shows that issuers and investors are giving preference to sustainable financing opportunities.

Carbon castoffs
As per the International Renewable Energy Agency, delaying action to tackle global warming could add trillions of dollars to the tally of worthless assets, hence the Islamic financial services industry needs to double up its efforts to achieve meaningful ESG implementation goals and avoid high stranded assets.

As per Bloomberg news, global regulators such as the European Central Bank are stepping up pressure on lenders to prepare for stress tests next year that will show just how vulnerable the industry is to climate change. The regulators also plan to study the link between profits and carbon risk in banks’ portfolios. Moreover, various media houses have reported that other global regulators and perhaps regional regulators are planning to carry out a similar ESG stress testing exercise.

One of the global regulatory bodies, the International Organization of Securities Commissions Sustainable Finance Task Force, has published its final report dated the 2nd November 2021 on recommendations for sustainability-related practices, policies, procedures and disclosures in the asset management industry.

ESG implementation challenges and risk factors to the Islamic financial services industry

ESG key risks
Although there are many challenges which the industry has to overcome to achieve the desired level of ESG implementation goals, however, in this article the focus will be only on ESG or sustainability-related risks and the impact on the supply chain especially to suppliers based in developing countries which generally have greater reliance on fossil fuel either as a producer or a user.

ESG or financial stability risks
The most common and identifiable risk factors which need to be evaluated and addressed are financial risks and non-financial risks.
The ESG non-compliant entities and their counterparties could be exposed to the following financial risks:
• Credit risk: which means that there could likely be a probability that ESG non-compliance may result in loss due to a default
• Market risk: which may lead to trading loss, and
• Liquidity risk: loss due to liquidity shortage.

The aforementioned financial risk factors will have a negative impact on a non-compliant entity’s assets, financials and earnings; the liquidity risk will require monitoring and assessment due to the changing dynamics as the financial industry move toward sustainable finance.
In addition to the financial risk factors, the following non-financial risk factors may also have a negative impact if not tackled:
• Operational risk: loss due to operational failures, and
• Business strategy risk: loss of basis for a business model.

In both cases, the common and equally important ESG risk factor is the loss of reputation or reputational risk.

The most crucial process and step needed to measure ESG risk is the assessment of the current ESG exposures and this includes the consideration of ESG risks while evaluating capital adequacy as well as calculating regulatory and economic capital.

The ESG risk factors and changing regulatory landscape are a clear indication that Islamic financial institutions need to not only be aware of the aforementioned key risk factors but also start working on their portfolios toward sustainable finance.

ESG implementation and its impact on supply chain
As per a Standard Chartered Bank report titled ‘Carbon Dated – The net-zero supply chain revolution’, governments are striving to deliver net zero by 2025 to avoid an environmental catastrophe, but without the direct engagement of businesses the efforts may fail. Multinational companies (MNCs) in turn are feeling the pressure as 73% of their total emissions are with their supply chain which make their task even more challenging and difficult.

The report also stated that the interplay between these businesses and their MNC partners will be a defining factor in the global race to net zero.

As per the study conducted by the bank, the following revelations indicate the challenges ahead especially to non-ESG compliant suppliers:
• For 67% of MNCs, reducing supplier emissions is the first step in their net zero strategy, underlining the importance of supply chains in carbon transition.
• About 78% of MNCs say they will start removing slow-to-transition suppliers by 2025 (including 15% who have already started this process).
• MNCs expect to cut around 35% of their current suppliers as they respond to net-zero pressures.

ESG implementation challenges and risk factors to the Islamic financial services industry

The study found that almost a third of MNCs are already taking a zero-tolerance approach to their supply chain, swiftly removing suppliers that endanger their transition. The bank’s economic model reveals what this means for the businesses in 12 key fast-growing markets of Asia and Africa which are at the center of OECD supply chains and it provides a US$1.6 trillion export opportunity for early movers that align with MNCs’ net-zero plans.

The report also mentioned that the collaboration between MNCs and their suppliers, particularly smaller suppliers, is key to making net zero a reality.

Conclusion
As highlighted in the article, the level of preparedness in terms of assessing the ESG or sustainability risk factors and taking the necessary steps to overcome the challenges, particularly those relating to ESG financial and operational risk factors, will be key to meeting the UN Sustainable Development Goals (SDGs). Moreover, the regulatory recommendations and requirements to financial institutions need to be addressed to achieve the common goal of the net-zero emission target by 2050 as well as to keep stranded assets to a minimum level.

The other challenge highlighted in this article is the net-zero supply chain revolution where collaborative efforts involving MNCs, suppliers (particularly based in OIC countries) and the financial intermediaries are necessary to avert a shift of business to suppliers based in the developed world as these suppliers are likely to achieve the required sustainability targets.

Ijlal Ahmed Alvi is the CEO of International Islamic Financial Market.

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