The opportunity
The combination of global crises from climate change to the COVID-19 pandemic, combined with a new political urgency reflected at COP26 [2021 United Nations Climate Change Conference] in Glasgow and increased investor willingness to fund impact-based products, provides a unique opportunity for Islamic finance to reconsider its purpose and to tap into much larger global flows of money than can be provided by its traditional investor base. Islamic finance has always had sustainability embedded in its core ethical principles, although this is not yet recognized by many conventional investors. The conventional market’s increasing focus on finding investments that promote sustainability provides an unprecedented opportunity for Islamic finance to enter the mainstream and attract investment from a wider pool of investors.
COP26 highlighted both the climate challenge facing the world and the vital role that finance must play if the poorest countries are to make the necessary adaptations to live with higher temperatures and to achieve sustainable development. The COVID-19 crisis also highlighted global inequalities and slowed the progress of achieving the UN Sustainable Development Goals (SDGs) adopted by the UN in September 2015 as part of the 2030 Agenda for Sustainable Development. These twin emergencies of climate change and COVID-19 have galvanized the financial markets so that environmental, social and governance (ESG) is no longer a niche market but a core investment focus for many financial institutions. On the 3rd November 2021, at COP26, UN Special Envoy Mark Carney announced the Glasgow Financial Alliance for Net Zero of 450 financial firms across 45 countries, which have stated their intention to align not only their own businesses but also their lending and investment criteria to achieving net zero, harnessing up to US$130 trillion of assets to plug the US$150 trillion funding gap needed to mitigate the worst effects of climate change. Financial institutions are also increasingly using the SDGs as the basis of their reporting. As of April 2021, 220 banks are signatories to the UN Principles of Responsible Banking, which require the signatories to produce SDG-aligned reporting. This is a helpful development because the UN has estimated that the pandemic-related downturn has pushed between 119 and 124 million more people into extreme poverty and many of them live in the 57 countries which are members of the OIC which collectively represent 1.82 billion people, and where Shariah compliant solutions would be welcome.
The market
The market potential can be easily assessed when examining the public capital markets and comparing green bonds with green Sukuk. The global Sukuk market has grown from an estimated US$85 billion of Sukuk issuances in 2016 to an estimated US$172 billion in 2020. Green Sukuk issuances also increased from US$500 million in 2017 to US$3.5 billion in 2019. The market was affected by the pandemic with only US$6.1 billion of Sukuk issuances from January–July 2020, but has recovered in 2021, with notable issuances such as the IsDB raising US$2.5 billion in March 2021 through its sustainability Sukuk and the Republic of Indonesia issuing US$750 million of green Sukuk.
However, this is tiny compared with the conventional green bond market. Between 2007 and 2020, green-linked bonds raised over US$1 trillion of capital. After the first green bond in 2007 (the EUR600 million (US$676.85 million) issuance by the European Investment Bank), the market began to grow, and the Paris Agreement at COP21 [2015 United Nations Climate Change Conference] was a key driver in the further expansion of the market, with an annual average growth in the green bond market of 60% since 2015. It is likely that COP26 will result in the green bond market growing even faster.
The World Bank reported that 17 green Sukuk had been issued as of July 2020. The first green Sukuk facility was issued in Malaysia by Tadau Energy in 2017 and the Republic of Indonesia issued the world’s first sovereign green Sukuk in March 2018, raising US$1.25 billion. The majority of green Sukuk issued have used the Murabahah and Wakalah structures (eight issuances, all by issuers in Malaysia), with the second-most popular structure being Wakalah Istithmar which was used for four issuances — three by Indonesian issuers and one by a Malaysian issuer. Although the majority of issuances so far have been from Malaysia or Indonesia, there is huge potential for issuers based in other jurisdictions, such as the UAE, Saudi Arabia, Turkey or Pakistan, to also tap into this market. Energy targets have been announced by Middle Eastern governments, such as the UAE Energy Strategy 2050 and Saudi Vision 2030, which will require significant investment that the green bond and Sukuk market will be well placed to fund.
The last year has seen unprecedented demand from investors for sustainability-linked vehicles, and Bloomberg predicts that assets under management invested globally in sustainability funds and portfolios could reach US$53 trillion by 2025, accounting for more than one-third of a projected total of US$140.5 trillion. Green and sustainable Sukuk could appeal to core Islamic investors in the region as well as a wider pool of international ESG investors. Market conditions are therefore ideal for this investor demand to be harnessed by Islamic finance. The Islamic Finance Council UK estimates that an additional US$30–50 billion of capital could be raised by 2025 through green and sustainability Sukuk.
The regulatory framework
The green Sukuk issuances that have taken place have been underpinned by existing global standards such as the Green Bond Principles issued by the International Capital Markets Association (ICMA) and aligned with a local framework established by the issuer, addressing the intended use of proceeds, the process for project selection, managing the proceeds raised (including segregating the funds received) and ongoing reporting. Typically, an independent second opinion to verify the sustainability of the issuance from a third party, such as the Center for International Climate and Environmental Research-Oslo, is also required. These are all steps that Sukuk issuers are familiar with, from selecting suitable projects or assets (although note that from the Green Bond Principles perspective, it is the use of the proceeds which is key rather than the nature of the asset itself, unlike Islamic finance where the asset underlying the transaction structure is important in determining Shariah compliance) to segregating proceeds to obtaining a Fatwa from a Shariah scholar in order to confirm Shariah compliance.
The EU implemented the Sustainable Finance Disclosure Regulation (SFDR) in March 2021, which sets out specific rules for how and what sustainability-related information financial market participants need to disclose. This additional disclosure will be significant, but as additional milestones for SFDR are met throughout 2022 and 2023, this could create a benchmark for other financial institutions, and Islamic issuers wishing to attract investment from European investors may need to align themselves to the requirements of SFDR.
If issuers want to attract investment from the wider market, in addition to implementing green Sukuk frameworks, they will also need to engage with ESG ratings criteria. Companies that currently provide ESG ratings include Bloomberg ESG Data Services and Dow Jones Sustainability Index. ESG ratings are designed to measure and assess a company’s exposure to ESG risks and evaluate its performance in managing those risks relative to its peers. There is currently no specific industry standard for establishing an ESG rating, with each provider applying its own set of criteria to the evaluation process. It is worth noting that the lack of standardization in the Islamic finance market, which has often been viewed as a weakness, may in this case help prepare issuers for the uncertainty and lack of standardization in ESG ratings.
The products
In the conventional market, there are different types of products: green bonds, social bonds and sustainable bonds, which are bond instruments where the proceeds will be exclusively applied to eligible environmental and/or social projects; and sustainability-linked bonds, which are bond instruments where the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined sustainability/ESG objectives. Sukuk equivalents need to follow the ICMA principles for these products, in addition to any locally created frameworks such as the Republic of Indonesia’s Green Bond and Green Sukuk Framework, the Sustainable & Responsible Investment Sukuk Framework issued by Malaysia’s Securities Commission or the Sustainable Finance Framework introduced by the IsDB, as well as the usual Shariah principles that apply to all Sukuk issuances, creating a number of additional processes that potential issuers will need to satisfy when compared with a conventional bond issue. A pricing premium from the market or potential tax benefits are needed in order to incentivize issuers to go through these additional steps, but the increased focus from both investors and governments suggest these may be forthcoming in the near future.
The purpose of Islamic finance
A fundamental principle of Islamic finance is that investment should have a social and ethical benefit to wider society, and not focus purely on a financial return. The Maqasid Shariah, the objectives or purposes behind Islamic law (including Islamic finance), also include as necessities the protection of life, lineage and intellect. There is therefore a natural alignment between the principles of Islamic finance and the SDGs, both in prohibitions and mandates. Prohibitions on activities that cause harm to society can be linked to SDG8 (Decent Work and Economic Growth), SDG12 (Responsible Consumption and Production) and SDG13 (Climate Action), and the benefits to society mandated for Islamic finance can be linked to many of the SDGS including SDG3 (Good Health and Well-Being), SDG4 (Quality Education), SDG6 (Clean Water and Sanitation), SDG7 (Affordable and Clean Energy) and SDG11 (Sustainable Cities and Communities).
There is already discussion in the global Islamic finance community about the benefit of shifting the focus of Islamic finance from the strictly legal requirements of Halal (permissible and lawful) to the broader ethical concept of Tayyib (pure and wholesome), which is more in line with the goals of the Maqasid Shariah. This is the moment for Islamic finance to use the SDGs to create a sustainability philosophy for Islamic finance that is easily understood and accepted by the wider markets and also answers concerns that Islamic finance is currently overly focused on formalistic compliance with Shariah principles. This will require a coordinated and consistent approach from national regulatory bodies and international bodies such as AAOIFI and possibly an increased awareness among Shariah scholars generally of the sustainability principles that are necessary in order for a Sukuk facility to appeal to the broadest range of investors, so that any negative impacts of the use of funds can be identified as part of the Shariah review and possible remediation steps identified.
There is nothing in the ICMA Green, Social, Sustainable Bond or Sustainability-Linked Bond Principles that is inconsistent with Islamic finance. There have already been green and social Sukuk issued by major Islamic issuers such as the governments of Indonesia and Malaysia and the IsDB, and the Saudi Electricity Company issued US$1.3 billion-worth of green Sukuk in September 2020 pursuant to its green Sukuk framework, with a second-party opinion on the sustainability credentials provided by Vigeo EIRIS.
Conclusion
Islamic finance, with its ethical underpinning in the Maqasid Shariah, has a significant head start on conventional finance in aligning itself to ethical standards such as the UN SDGs, although it has not yet capitalized on this advantage. Issuers such as the governments of Indonesia and Malaysia and the IsDB have produced green Sukuk frameworks and issued green Sukuk in the market with success, demonstrating that the technical requirements can be satisfied by other issuers wishing to engage the wider market. Perhaps the most important aspect of this engagement will be in communicating the congruence of the ethical dimension of Islamic finance with broader sustainable finance, which can be done through explicitly linking the ethical dimension of Islamic finance with widely recognized standards such as the UN SDGs, and engaging with other market standards such as ESG ratings by external organizations.