The link between the world of ethical finance and Islamic finance is strong. In fact, the origins of the modern Islamic finance industry, which started off in the 1970s, are very similar to the ethical finance principles of not being solely focused on bottom-line profits and instead focusing on doing what is good for society and avoiding practices that are considered harmful. Investments must avoid providing income from alcohol, tobacco, gambling, pornography, prostitution and illegal arms trading, among others. BASHAR AL NATOOR explores.
It is in this spirit that the global Islamic finance industry has been venturing into the world of environmental, social and governance (ESG)-linked products with innovative and diverse issuances like green, sustainable and transition Sukuk over the last few years. Government support has also been witnessed among a number of key Islamic countries. While Islamic finance is a growing subsegment, more can be done to better align it with the ESG world. Tools from Islamic economics such as Zakat, Sadaqah and Waqf could also be utilized to promote financial inclusion, sustainability and positive impact.
The global Sukuk landscape
Islamic finance is systemically important in many jurisdictions and growing in the wider regions of the Middle East, Asia and Africa. Sukuk remain an important funding tool, with the share of Sukuk issuance in the total funding mix for key Islamic finance jurisdictions reaching 30% in the third quarter of 2021 (Q321) (2020: 23.6%). Global outstanding Sukuk volumes reached US$775.4 billion in Q321.
Key drivers of green and sustainability Sukuk
More than US$19 billion-worth of green and sustainable (GS) Sukuk have been issued since the market’s inception in 2017. GS Sukuk issuance is driven by sovereigns and multilateral development banks in key Islamic finance jurisdictions. This is because various OIC countries are signatories to the 2015 Paris Agreement on climate change, and have adopted the UN Sustainable Development Goals (SDGs) and set net-zero emission targets. These issuers require sizable funding to meet targets and to finance COVID-19 relief measures, part of which could be funded through GS Sukuk. Corporates have also issued GS Sukuk to diversify their funding.
Issuers have also been opportunistic in leveraging the spike in global investor appetite for green, sustainable and social bonds, of which more than US$790 billion were issued in the first nine months of 2021, a 145% increase from 2019. Many GS Sukuk were oversubscribed multiple times over in the past three years, with sizable interest from US, Asian and European investors. We expect that more first-time issuers are likely to enter the GS Sukuk market in the short to medium term.
Sukuk, rather than conventional bonds, were the preferred format for GS instruments in key Islamic finance countries. This is indicated by Sukuk accounting for more than 60% of the outstanding GS securities in the top 10 Islamic finance countries in the first half of 2021. This is driven by issuers’ need to attract the sizable Islamic investor base in these countries who can only invest in Shariah compliant securities. In the ASEAN region, green Sukuk represented 19% of green financing instruments in 2020, based on research from Climate Bonds Initiative.
Issuers’ concern for ESG issues is also driven by regulatory requirements, along with rising pressures from customers and employees, according to the HSBC MENAT report titled ‘Sustainable financing and investing survey 2021’. According to the report, around 63% of Middle East, North Africa and Turkey (MENAT) issuers expect their company to actively seek advice on green, social or sustainability issues in relation to capital market transactions in the next 12 months.
Investors’ interest is being driven by their recognition that paying attention to ESG issues can improve returns and reduce risk, along with meeting regulatory demands. Consequently, investors are increasingly incorporating ESG considerations into their corporate and investment strategies. The HSBC report also said around 19% of MENAT investors have a firm-wide policy on responsible investing or ESG issues.
Key market developments
Countries such as Malaysia, Indonesia and the UAE are the most active out of the top 10 key Islamic finance markets.
In 2017, the world’s first green Sukuk facility was issued in Malaysia by Tadau Energy. In 2021, Malaysia issued the world’s first US dollar sustainability Sukuk issued by a sovereign. The country issued the Sustainable and Responsible Investment (SRI) Sukuk Framework in 2014, and SRI Sukuk issuers in the country are granted cost and tax incentives under the SRI Sukuk and Bond Grant Scheme, which was expanded in 2021. Supported by it, the country houses the largest number of active GS Sukuk at 156 issues in September 2021, out of a total of 172 GS Sukuk globally.
In 2017, Bank Negara Malaysia launched the Value-based Intermediation initiative, a Shariah equivalent of sustainable and impact financing, with many Malaysian Islamic banks committing to integrating its principles into their own core practices. In 2018, HSBC Amanah, the Malaysian Islamic banking arm of HSBC Holdings, issued the world’s first UN SDGs Sukuk, raising RM500 million (US$120.63 million).
Indonesia issued the first sovereign green Sukuk in the world in 2018, and is a regular issuer with issues in 2019, 2020 and 2021, raising a total of US$3.5 billion to date. Indonesia also launched its Green Bond and Green Sukuk Framework in 2018.
The UAE is also increasingly active in the SRI space. In 2019, Majid Al Futtaim issued the GCC region’s first green Sukuk. In 2020, the first transition Sukuk facility was issued by Etihad Airways. The UAE launched its Sustainable Finance Framework in 2021. Dubai Financial Market, Dubai’s stock exchange, had also updated its Shariah standards to cover green Sukuk.
In 2020, Saudi Arabia-based IsDB issued the world’s first sustainability Sukuk to support responses to COVID-19 in its member countries, and followed it up with another issue in 2021. Saudi Arabia’s Public Investment Fund and National Debt Management Center have also announced plans to issue green Sukuk.
In 2021, the world’s first sustainability Tier 2 Sukuk facility was issued out of Turkey by Kuveyt Turk Katilim Bankasi. In 2021, Bangladesh’s first green Sukuk facility was issued by Bangladesh Export Import Company or BEXIMCO, and the government issued a circular that allowed banks to invest in private sector-issued green Sukuk.
Key challenges for GS Sukuk
While GS Sukuk are experiencing notable growth in key Islamic jurisdictions, they are still nascent products equaling 2.4% of the total Sukuk market. To ignite growth for GS Sukuk and bonds, especially in the GCC region, government support, attractive incentives and infrastructure are required.
Key challenges impeding GS Sukuk’s growth potential include the still-evolving market infrastructure, regulations and ecosystem for GS financing and projects in most OIC countries.
Issuance is also constrained by the lack of regulatory and/or tax incentives for GS Sukuk and bond issuers and investors in most OIC countries. While Sukuk issuance is often linked to an underlying pool of assets which can support GS securities, issuance is often still constrained by the lack of available and appropriately-sized GS assets which can enable Sukuk issuance, especially for non-sovereign issuers.
Lack of standardization of Sukuk is also a key challenge as the time spent drafting green Sukuk structures and frameworks that are acceptable to governments, investors and the Sukuk’s Shariah boards can mean substantially longer time to market, leading to higher costs, at least until a standardized framework is established.
This is in addition to the lack of standardization around GS bonds as the market norms and standards for GS products are also still evolving, again reflecting the market’s nascent status. It is essentially a self-regulated market although various voluntary guidelines exist, like the Green Bond Principles supported by the International Capital Market Association or the Climate Bonds Initiative.
According to the HSBC MENAT report, an ESG skills gap is also a challenge as investors in a number of OIC countries face a shortage of expertise and qualified staff which limits their ability to pursue ESG investing more broadly. The report also noted that environment and social performance disclosures by companies remain inadequate in a number of OIC countries, while some investors reported a lack of demand among their clients.
The GS Sukuk market has exhibited promising growth to date, with this trend likely to continue at least in the medium term. Islamic finance seems to be a logical area where GS Sukuk could flourish as Sukuk issuance is confined to a pool of assets, which by nature makes it easy to focus only on GS assets. Indeed, OIC countries have a clear potential to engage further with this growing market. Nevertheless, the segment faces significant challenges, and achieving a large, sustainable and established GS Sukuk market still seems to be a long way down the road.
Bashar Al Natoor is the global head of Islamic finance at Fitch Ratings.